naked capitalism

Reader Hecht pointed out a new piece by Steven Davidoff at the New York Times’ Dealbook, illustrating the lengths to which the Fed will go to defend incumbent bank managements.

The story recounts the sorry conduct of the bank regulator with regard to two small banks, one the $1.1 billion in assets savings & loan First Financial Northwest, the second Cardinal Bankshares, which has a mere $250 million in assets. Both are under supervision of the Fed, neither bank is doing well (First Financial is under “special supervision” as a result of having lost over $90 million in recent years), yet in both cases, true to an apparent long-standing practice, the Fed is siding with the management that is responsible for the banks being in bad shape over activist investors who look to be urging sound measures.

Davidoff recounts the First Financial case in more detail. There, Stilwell Group, which bought 7.9% of the stock, got Fed approval to have its general counsel appointed as a board member. He then made radical suggestions at a first board meeting:

“terminate the director emeritus program,” which Mr. Schneider claimed paid directors as much as $150,000 a year even after their death for doing “nothing.” He also proposed to “remove the directors’ photographs from the executive suite walls” since the photos rewarded poor past performance and the bank was “not a country club or an English manor.”

Finally, as a symbol of First Financial’s newfound austerity, Mr. Schneider [the Stilwell nominee] wanted to “serve only hard candy at the upcoming annual meeting.” He also protested the board’s policy of free iPads for directors.

$150,000 for current, much the less ex, directors of a bank that small is a ridiculous amount of money. Schneider resigned when the board refused to act on his recommendations (note the Times says that Schneider wanted his demands implemented immediately; Schneider counters that the board was unwilling to act. Given the obvious feather-bedding, I suspect Schneider could tell he would be stonewalled).

Stilwell renominated Schneider and sought to have a second director appointed. The Fed intervened, invoking regulations that define 25% ownership of a bank voting shares as “control” and hence subject to Fed approval. But this is ridiculous. Stilwell doesn’t come close to having 25% of the shares, and even if it had won both board seats, it would have only 22% of director votes.

In the case of Cardinal, the activist investor, Schaller Equity Partners, got itself in the Fed’s crosshairs by proposing to place five of six directors (this when it owns 9.8% of the stock). The Fed said if it did that, it would regulate Schaller as a bank holding company, which would make its life miserable. The Fed is pushing hard to neutralize Schaller’s efforts:

Schaller has subsequently dropped the number of its nominees to three to placate the Fed. Even so, the regulator has taken more steps to ensure that Schaller does not have control over these nominees, claiming that even this number of directors could still make Schaller a bank holding company. The directors are now executing passivity agreements that will limit their ability to coordinate activity with Schaller.

This stance, of favoring bad bank managers over reform-minded investors, speaks volumes about the Fed’s priorities. These aren’t complex, difficult to operate banks where management has special know-how. If the dissidents wanted to throw the entire management team out, it would not be hard to replace.

The fact that the Fed so reflexively defends banks against any outside influence, even positive ones, is proof of how the Fed is badly in need of reform. One idea that has been set forth by the Alternative Banking Group of Occupy Wall Street is ending the private ownership of the Fed by banks and barring members of management and boards that the Fed regulates from serving as Fed directors. There are plenty of recently retired financial firm executives who know tradecraft, and the Fed through its supervisory powers can get lots of information about what is happening in markets, rather than relying on the spin of people like Jamie Dimon). The Fed is already a popular target for Congressmen on the right and left ends of the spectrum. If it does not relent from its profoundly pro-bank posture, it may find more changes foisted upon it.

Adam Davidson is moving up in the world. He has gone from fellating the 1% to the top 0.1%.

But bear in mind that we can’t hold Davidson solely responsible for his latest assault on common sense, decency, and most important accuracy. It was the editors of the Sunday Magazine that not only decided to showcase an interview with Mitt Romney’s uber wealthy former partner Edward Conard (“The Purpose of Spectacular Wealth, According to a Spectacularly Wealthy Guy“) but to give it a full 6 pages (per my browser) and put it on the magazine cover. Conard says his new career is to “make his case for a new, decidedly pro-investor way to think about the economy.” And what follows is half-baked, largely inaccurate, unabashed propaganda.

Now admittedly, Davidson as interlocutor gets to have it both ways. He presents Conard’s arguments pretty much straight up for the first half of the piece, and treats them and Conard with a good deal of respect (well, save Conard’s view of the crisis, that is was a run on sound banks which is utterly batshit, and Davidson does pause to intimate that). For instance, after pointing out that Conard is heretofore best known in the wider world as being a mystery Romney funder at the center of a pending scandal that went poof when Conard outed himself, Davidson suggests he might be media wary. But no, this is how Davidson described his first meeting:

Over lunch with editors from The Times Magazine, Conard proved the exact opposite. He looks like a benign middle-aged guy until he starts making an argument. At which point, Conard stares into your eyes and talks with intense force, punctuated by the occasional profanity, in full paragraphs. He delighted in arguing over corporate-bond rates and Chinese central-bank policy, among other arcane minutiae. It also became clear that he had exhaustively thought through the role of the superrich in our economy, and he wasn’t afraid to share those opinions.

This introduction to Conard as a real person segues into an overview of Conard as an icon of successful risk-taking (a theme in Conard’s book, due out next month, which this story also has the unfortunate effect of promoting): born into a middle class family, rising through consulting firm Bain to become partner, leapfrogging to M&A boutique Wasserstein Perella, taking a pay cut to go for greater upside by returning to the Bain fold, but this time at private equity firm Bain Capital.

Aside from the description of Conard’s devoid-of-reality take on the crisis, Davidson uncritically recites his views in the first half of the story and then only, all too politely, as no doubt fits in a world where men like Conard deserve deference, questions his ideas towards the end.

But even with this unduly respectful treatment, the picture that emerges is stunning. Conard is in fact a living, walking homo economicus. If he were written up in a novel, he’d be treated as a ridiculous parody. He treats finding a mate like a shopping exercise, and recommends a sampling phase prior to a selection phase. He thinks philanthropy is bad and money should go only to investments:

During one conversation, he expressed anger over the praise that Warren Buffett has received for pledging billions of his fortune to charity. It was no sacrifice, Conard argued; Buffett still has plenty left over to lead his normal quality of life. By taking billions out of productive investment, he was depriving the middle class of the potential of its 20-to-1 benefits. If anyone was sacrificing, it was those people. “Quit taking a victory lap,” he said, referring to Buffett. “That money was for the middle class.”

And, not surprisingly, Conar denies that rent seeking occurs any place other than despotic third world countries.

But it isn’t simply that the overly polite questioning of Conard’s utilitarian world view is too mild and comes too late. It is that Davidson happily recites things that are simply untrue. And to make matters worse, if my readership is any indicator, many people don’t get past the first page or two of this piece before deciding they’ve read plenty and so get a full dose of claptrap before tuning out.

The article is chock full of blatant falsehoods. Let’s start with Conard’s personal Big Lie: that he is a risk taker and risk taking is good. All you have to do is look at his career to see that it contradicts both claims. He sees himself as a risk taker because…hold your breath…he went to Harvard Business School rather than going to law school! I graduated from HBS the year before Conard, and was accepted by both top law schools and business schools. Anyone with an operating brain cell will tell you that the fancy grad school route, particularly back then, when tuitions were vastly lower, was a risk averse strategy. You get good grades, show up for job interviews wearing a decent suit and exhibit at least adequate social skills, and you are guaranteed a well paid job.

And of the career choices of a newly minted MBA in the early 1980s, the big consulting firms were the least risky path on offer. Unlike Wall Street, where even first year pay had a meaningful bonus component, consulting firms pay high salaries. And they hysterical thing is he repeatedly rags on lawyers as prototypical people who “don’t maximize their wealth creating potential.” Yet he went on a path exactly like that. Consulting firms take fees, like law firms, and have explicitly modeled their pay and promotion structures on law firms’. He then went to Wasserstein (another firm which takes fees, albeit largely dependent on whether deals get done), which was already an established powerhouse, hence pretty much nada in the way of financial downside in joining them. And partners in private equity firms do not take risk either. PE firms get 2% of the funds under management and 20% of the upside. Partners may but are not required to invest along side the limited partners.

Conard has absolutely no clue about what entrepreneurship is about. Experts on entrepreneurship, like Amar Bhide, who has done considerable research into Inck 500 companies and entrepreneurship generally, have found that the top performers have founders who have very high ambitions and are good at minimizing risk.

Another Big Lie that Davidson promotes is Conard’s claim that the sort of investing he did at Bain Capital and that wealthy people do generally. Earth to base, academic studies have shown that PE fund returns are due to financial engineering and application of leverage. They don’t nurture companies. Anyone who has been in an PE investee company will tell you they are aggressive cost-cutters and investment minimizers. Anything to boost cash flow and facilitate a flip at a higher price to a corporate buyer or public shareholders goes. Ex angel investors or long-term owners of private companies who reinvest their profits, the investments of the uber wealthy are in established companies, the overwhelming majority of the time in secondary trading of securities (which means they are simply cashing out other investors rather than providing growth capital). And for public businesses, the biggest source of investment funds is retained earnings, second is debt financing, and the occasional stock sale is a distant third.

Davidson says things that are factually incorrect in parroting Conard’s argument (and notice how he depicts it as cogent):

Conard, however, has laid out a tightly argued case for just how much consumers actually benefit from the wealthy. Take computers, for example. A small number of innovators and investors may have earned disproportionate billions as the I.T. industry grew, but they got that money by competing to constantly improve their products and simultaneously lower prices. Their work has helped everyone get a lot more value. Cheap, improved computing helps us do our jobs more effectively and, often, earn more money. Countless other industries (travel, telecom, entertainment) use that computing power to lower their prices and enhance their products. This generally makes life more efficient and helps the economy grow.

First, it’s clear Conard never heard of Moore’s law as the driver of falling computing costs.

Second, investors had comparatively little to do with the growth and success of the computing industry (and in general this is true. Bhide has found that only 1/4 of the Inc 500 companies were venture capital funded). If you look at the PC revolution (which was when the real falls in price and growth in reach of computers took place), the drivers were geek tinkerers and hobbyists who all wanted to create a new Hewlett Packard. HP was founded in 1939 and it grew into a dominant Silicon Valley player in the 1950s and 1960s, when top Federal marginal income tax rates were over 90% in the later 1950 and over 70% in the 1960s. Silicon Valley came into being thanks to the work of engineers who clearly were not motivated by dreams of becoming Filthy Rich, since it was pretty much impossible back then.

If you look at the iconic companies of the 1980s tech revolution, few had venture capital or wealthy individuals as backers. Apple funded itself off of purchase orders. Software firms like Microsoft and Oracle didn’t need meaningful seed money. Cisco didn’t take VC until shortly before its IPO so as to get a better multiple.

Third, the internet was created by the Federal government (remember them?). Unix, still the most robust computing platform, was funded by heavily regulated and highly profitable monopoly AT&T, not by wealthy investors. These are also important parts of the tech infrastructure.

We also have stuff like this:

There is a huge mechanism constantly trying to seek out and support these new ideas — entrepreneurs, multinationals and, crucially for Conard, investment firms and hedge funds and everyone down to individual bond traders…In a competitive market, all that’s left are the truly hard puzzles. And they require extraordinary resources. While we often hear about the greatest successes — penicillin, the iPhone — we rarely hear about the countless failures and the people and companies who financed them.

This is how bad things have gotten, that Davidson and Conard dare suggest that the discovery and solving of production problems for penicillin had anything to do with homo economicus grasping for the brass ring. Don’t New York Times fact checkers know how to use Wikipedia?

[Alexander] Fleming finally abandoned penicillin, and not long after he did, Howard Florey and Ernst Boris Chain at the Radcliffe Infirmary in Oxford took up researching and mass-producing it, with funds from the U.S. and British governments. They started mass production after the bombing of Pearl Harbor. When D-Day arrived, they had made enough penicillin to treat all the wounded Allied forces.

So penicillin was the product of a persistent but unsuccessful effort of a brilliant researcher (Fleming was highly regarded even before the potential of his penicillin discovery was realized), carried forward by researchers at Oxford (risk averse academics!) funded by the government (horrors!) who made the critical production breakthroughs.

And the iPhone was very much a product of Steve Jobs’ vision, and Steve Jobs flies in the face of the World According to Mr. 0.1%. Consider this diatribe:

What are they doing, sitting here, having a coffee at 2:30?” he asked. “I’m sure those guys are college-educated.” Conard, who occasionally flashed a mean streak during our talks, started calling the group “art-history majors,” his derisive term for pretty much anyone who was lucky enough to be born with the talent and opportunity to join the risk-taking, innovation-hunting mechanism but who chose instead a less competitive life.

Conard must not believe in art of any kind. Can’t a rich guy like him see the need of art educated adults, if nothing else, to help curate his collection, to inform the aesthetics of architects and city planners? And the decorators I know are plenty entrepreneurial, far more so than “never took a real risk” Conard.

In addition, Conard apparently does not read newspapers and has not heard that unemployment is really high these days. He clearly labors under the delusion that anyone not working is a dilettante. I’d hazard that at least some of these Starbucks denizens are underemployed and go there to get out of the house (yours truly also did a lot of work on ECONNED at Starbucks for similar reasons).

Most important, Steve Jobs, the capitalist’s wet dream, did everything Conard rails against: took art courses, didn’t graduate from college, followed his inner muse (doing drugs, spending a year in India).

But the key to Conard is in that last section. He doesn’t revere risk taking. He reveres competition and numbing overwork. Davidson close to the end picks up on that:

The world Conard describes too often feels grim and soulless, one in which art and romance and the nonremunerative satisfactions of a simpler life are invisible. And that, I realized, really is Conard’s world. “God didn’t create the universe so that talented people would be happy,” he said. “It’s not beautiful. It’s hard work. It’s responsibility and deadlines, working till 11 o’clock at night when you want to watch your baby and be with your wife. It’s not serenity and beauty.”

His vision is the logical outcome of the belief system of early industrialists, who needed to justify their exploitation of formerly self sufficient farmers. Per Yasha Levine:

English peasants didn’t want to give up their rural communal lifestyle, leave their land and go work for below-subsistence wages in shitty, dangerous factories being set up by a new, rich class of landowning capitalists. And for good reason, too. Using Adam Smith’s own estimates of factory wages being paid at the time in Scotland, a factory-peasant would have to toil for more than three days to buy a pair of commercially produced shoes. Or they could make their own traditional brogues using their own leather in a matter of hours, and spend the rest of the time getting wasted on ale. It’s really not much of a choice, is it?…

Faced with a peasantry that didn’t feel like playing the role of slave, philosophers, economists, politicians, moralists and leading business figures began advocating for government action. Over time, they enacted a series of laws and measures designed to push peasants out of the old and into the new by destroying their traditional means of self-support.

Levine quotes a book by Michael Perleman, The Invention of Capitalism, which cites numerous tracts bewailing the idleness of the lower orders (notice this was never perceived to be a problem prior to the Industrial Revolution). For instance:

Our Forests and great Commons (make the Poor that are upon them too much like the Indians) being a hindrance to Industry, and are Nurseries of Idleness and Insolence.

So Conard celebrates competitiveness, when he managed to find his way onto the low-risk elite path when it was less crowded than today. And high income disparity serves that end. If you lose your economic perch, unlike in more equal societies, you are almost certain to lose most of your putative friends. If you can’t socialize at their level, over time you disappear from their set (and that’s before you factor in the possibility of serious budget problems). Yet as you peel the layers back, despite his confidence that the world would work better if it was mashed into his template, it sounds utterly miserable.

Just because someone has an internally consistent world view does not make it accurate. Fans of slavery, alchemy, the Inquisition, trial by combat, and Ptolemaic astronomy all had logical looking arguments supporting their now discredited views. Conard at first seems to yet another evangelist of a hopelessly flawed and dangerous orthodoxy, and the more he speaks, the more he seems to be deeply imbalanced, so intensely invested in his distorted personal mythology that he is driven to make the world at large reflect it back. It would be far better for Davidson and the New York Times to treat people like Conard as epitomes of deep-seated cultural pathologies, rather than promote them.

Update: In a misrepresentation I missed (hat tip Lynn Parramore), Davidson cites Dean Baker as supporting Conard’s views. Baker objects:

At one point, the piece cites me as saying that for each dollar earned by investors (corporations), the rest of society gets five dollars.

This should not sound surprising. This is simply the division of national income between capital and labor. The after-tax capital share of corporate income is roughly one-sixth of total income. This means that if GDP increases by $1 billion, then capital will typically get around $160 million, with the rest going to labor and corporate taxes.

Note that this does not mean that investors are responsible for this $1 billion increase in output. Their actions contributed to the growth of output in the same way as did the actions of workers and the government. The misleading part of the picture is Conard’s implication that if not for the heroic investor, none of this wealth would have been created.

In standard economic theory if one investor had not put money to use, then another one would have have. The difference in output would have been trivial.

Wonder why states are broke? It isn’t just the global financial crisis induced knock-on effects of a plunge in tax receipts and a rise in social safety net payments. Nor is it just pension fund time bombs (note that despite the press hysteria, the problem is unmanageable only in a comparatively small number of states, with New Jersey way out in front, thanks to 15 years of the state stealing from the workers’ kitty, plus a decision to take big risk at exactly the wrong moment, in 2007, which resulted in large losses). A significant unrecognized culprit is companies managing to divert tax revenue from stressed states to their coffers. The device, in this case, is demanding the right to keep state income taxes withheld from employee paychecks.

David Cay Johnston detailed this stunning development in an April 12 column and a related interview late last week (hat tip p78). He suggests that this movement is driven by banks, since financial players and private equity fund owned firms are heavily represented among these corporate welfare queens. His discovery seems to have gone largely unnoticed and I hope readers circulate this clip widely.

The Wall Street Journal and New York Times have reports on a pilot program at Bank of America to allow homeowners who are likely to default a graceful exit. The Charlotte bank will allow 1000 borrowers in New York, Arizona, and Nevada to turn in the deeds to their houses in return for a one year lease with a two one year renewal options at or below market rates. The program will be only with borrowers invited by the bank, which will target homeowners who are at least two months behind on payments but can demonstrate that they can pay the rent. The Journal cites an example of a Phoenix home with a $250,000 mortgage with payments of $1600 a month. It estimates the rent as $900.

This is clearly a preferable alternative for homeowners to foreclosure. They escape the credit score damage, stress, and indignity of the foreclosure process and save moving costs. They are also spared the difficulty of finding a landlord who will accept a tenant with a tarnished payment record. It isn’t clear how the program will handle the usual rental deposit. So what’s not to like?

The devil, as always, lies in the details. Even if the program turns out to be a positive experience for borrowers and the bank, it is not clear that it is a magic bullet for the foreclosure mess. The bank is conducting the pilot on loans it owns. It appears adhere the IRS rules governing REMICs, which limit leases to two years, so the hope is that this program would be rolled out to Countrywide mortgages, which were almost always securitized.

However, it is hard to imagine that balance-sheet-stressed Bank of America would include properties that had bank-owned second liens on them, since the second would be a total loss. Borrowers with second liens have much higher default rates than those with first liens only, so many borrowers in need of help are likely not to be invited to participate.

One open question is property management. Anyone who has had a bad or lazy landlord can tell you what an awful experience it is. Banks have done a terrible job of securing and maintaining foreclosed properties. How responsive will they be when a boiler fails or the roof develops a leak or a tree falls down in a storm and damages the house?

A second question is the appetite of investors. Bank of America maintains it has plenty of demand from big investors, and the Obama administration is separately keen to promote bulk sales of foreclosed properties. I don’t see the sort of investors being bandied about, namely private equity firms or distressed investors, being good candidates. They have high return requirements and can’t manage their way out of a paper bag. And being a landlord is operationally intensive, particularly when dealing with dispersed single family homes.

Consider two cautionary tales. One is the famed purchase of Stuyvesant Town, a large complex of middle income rentals in Manhattan with a lot of rent-regulated apartments. It is still a mystery to me how this deal got done. Tishman Speyer and Blackrock made the purchase at top of market prices, and the marketing pitch assumed that they’d be able to turn a very high percentage of units into condos and sell them. But that made no sense on these apartments. Any tenant that is current in a rent regulated apartment in New York City can’t be denied a lease renewal. The housing courts have seen every bad landlord trick in the book and have little patience with them. The new owners tried harassing tenants to get them to give up their leases. When the court ruled that the investors had brought apartments illegally out of rent stabilization, the owners defaulted.

The other is the behavior of Fortress, which happens to be the name most bandied about as a prospective bulk sales buyer. But the model for Fortress appears to be the Gagfah. Some cash-strapped German cities were privatizing housing, and Fortress-controlled Gagfah bought 45,000 rental units from Dresden. Gagfah agreed to give existing tenants the right of first refusal on any sale. It was also criticized in local media for neglecting repairs. Gagfah was sued for €1 billion by Dresden and settled for €40 million.

Mind you, both of these deals were far simpler from an operating standpoint than what investors in any Bank of America sold homes will encounter Sty Town and the Dresden apartments were large, compact complexes with seasoned property management in place. By contrast, any houses acquired will be dispersed and the new buyers will have to set up or contract out the property management, and it’s unlikely that there is a turnkey solution..

And if returns flag because investors underestimated operating cost or aren’t able to flip homes when the leases expire, what do you think they will do? They are certain to neglect upkeep. They are likely to jack up rents but presumably will be constrained by supply in the area. And who will investors sell these properties to when they realize that the prices they can get in 3-4 years don’t provide their target returns? Private equity firms are not interested in being long term managers; they want to get their money out as quickly as possible.

I’m not certain the appetite for these properties lives up to the curiosity level, unless PE investors somehow have convinced themselves that the real estate market will rebound strongly on their timetable. I suspect all the hype and a few cherrypicked deals will set up dumber money, like insurance companies and public pension funds, which will go into REITs or other securitized investment vehicles. But the big issue is that these deals being done in scale and working out well depends not just on banks figuring out how to make them work to salvage borrowers, but also addressing the property management challenge.

But the real driver came at the very end of the Wall Street Journal article:

Foreclosures have slowed sharply in some states amid heavy scrutiny of allegedly forged paperwork used by processing firms. Banks completed 860,000 foreclosures last year, down from 1.1 million in 2010, according to CoreLogic Inc.

“One of the outcomes of the ‘robo-signing’ scandal is that it is more difficult to foreclose,” said Mr. [Dean] Baker. “It’s more worthwhile for banks to pursue alternatives.”

In other words, banks are so badly hoist on their own petard that they have to consider doing the right thing. But given their track record, I wouldn’t bet on them pulling it off in the way the great unwashed public hopes they will.

Felix Salmon has been bending over backwards listening to and reporting on Andrew Schiff’s claim that he’s suffering making ends meet on $350,000 a year and only wants to give his kids a “middle class lifestyle” in New York City.

For those who missed the salient points of Schiff’s Howard Beale moment, he’s unhappy because he is making less money than last year and is feeling pinched financially. He is paying for a child in private school ($32,000 a year), a summer rental, saves, and complains that he can’t afford to trade up from his 1200 square foot duplex in Cobble Hill and worries he will feel even more strained when his 7 year old starts to attend private school.

Schiff’s argument to Felix as to why his critics have it all wrong is that the cost of what would have been a “middle class lifestyle” in 1987 has risen much faster than incomes. Felix tried running down some indicators and didn’t reach any firm conclusions, save pointing out that the competition among the rich (which means the proliferating hedgies and private equity barons) has driven up “positional goods” in New York like real estate much faster than wages. (Note to Felix: if you really are going to try to do this more rigorously, you need to factor in the changes in tax rates too).

I’m not about to reach any hard and fast answers either, but that’s in large measure because Schiff’s “middle class” claim is bollocks. I’ve lived in Manhattan since 1981, save two years in Sydney (2002 to 2004). On the one hand, it is absolutely undeniable that the cost of real estate, both rentals and purchases, has gone up so much that it has driven a ton of people into less desirable neighborhoods. You used to have a lot of artists and writers living in Manhattan, along with teachers, small firm lawyers, ad agency professionals, and so on. The more favorably priced areas, such as Manhattan on the West Side just below Columbia, Chelsea, Little India, Harlem, the West 50s, keep gentrifying, and true middle class people either live in smaller space or face longer commutes. I dated artists when I first came to Manhattan, when they lived in artist in residence or illegal loft space in Soho. If you saw one other person on a block there on a Sunday morning, that was a lot. The city has become a lot tidier looking and much less diverse.

On the other hand, what Salmon and Schiff miss is that someone “middle class” in the 1980s would have been very unlikely to raise kids in the five boroughs (Schiff and Salmon really mean upper middle class). The city was not considered safe for children. When I first came to Manhattan, pretty much everyone I knew who did not live in a doorman building had had an apartment break-in. I had my wallet stolen on two occasions in 1987. The subways were gross and no woman would dare ride them wearing real or real-looking jewelry (gold chain snatchings were a regular occurrence). I was a member of the 1% then (although not in terms of Manhattan incomes, trust me, there was a huge amount of headroom between me and them) and I lived in a 1100 square foot apartment on 69th Street between Park and Madison, which is a nice block (yes this was a glam apartment, a wreck I had renovated, long shaggy story as to why I no longer have it). I’d be the first out of the building in the morning. The townhouse kept the inner door locked and the outer door unlocked. I’d always have to step over a homeless man sleeping between the two doors.

So in the 1980s and even into the early 1990s, only the comfortably affluent (those who lived in large apartments in doorman buildings or could afford an entire townhouse, which in those days were cheaper than the bigger apartments in good addresses) expected to stay in the city if they had kids. Everyone else moved to the ‘burbs either as soon as the arrival of a child made their living arrangements unduly cramped or no later than when the young ‘un was going to go to elementary school. And that family would have gone to a nice suburb, ideally one where the children could have gone to public school till at least 6th or 8th grade, and gotten a home with a decent sized yard and would not have spent on a summer rental, but on a nice summer vacation and maybe a winter or spring break getaway.

So Felix’s trying to price out what it would have cost in the late 1980s for a Schiff equivalent to live in the better parts of Brooklyn or the nice but less than prime parts of Manhattan is the wrong comparable. It isn’t what people like Schiff did back then. It didn’t become common to raise kids in the city until into the 1990s. I’ve seen it in my own building (I’ve been here 20 years) and with couples in my peer group (the ones that stayed in the city had two high earners, often one member of the pair in private equity or M&A, the other a partner in a law firm, or else a male super high earner, and they’d have only one or two kids). There was all of one child in the building when I arrived and she was the only one until the early 2000s. Now we seem to have between 6 and 8 (there is also more turnover in the building than there once was).

So the pressure on real estate prices wasn’t simply due to rising Wall Street incomes, although that has been the biggest driver. It has also come from more couples in all professions being more likely to stay in the city once they have kids. You can see it in what has happened to townhouses. Many that had been divided into apartments have been reassembled into single family homes. Similarly, my building, like many other in the city, has been putting one bedrooms together and making them into larger apartments. And on top of that, both with the city being safer and the dollar falling over time, more foreigners have been buying apartments too.

The other part is what it takes to be “middle class” has changed. As Elizabeth Warren pointed out in the Two Income Trap, good quality public education has become more scarce, leading to escalating real estate prices in districts seen as having good schools (note that yours truly only went intermittently to schools that would have been considered pretty good, since I lived mainly in hick towns, but even so did well academically in college. I doubt someone who now went to the schools I had attended would have a shot at going to an Ivy unless they had an obvious sign of achievement, like winning a major math competition). But on top of that, people eat out more (partly due to more working spouses, but it is also a broader cultural shift), spend more on household help, entertainment, even Starbucks. There are a lot of routine spending items now that weren’t routine back then.

So the people who take Schiff on are correct. He has assumed he would have upward mobility in a society where that is no longer generally the case, even for those in finance. And his adjustment to new normal is a lot less painful than that being experienced by most people in their 40s. So instead of grousing, he ought to consider himself lucky.

By Satyajit Das, derivatives expert and the author of Extreme Money: The Masters of the Universe and the Cult of Risk Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

In the old Soviet Union, Pravda, the official news agency, set the standard for “truth” in reporting. Discriminating readers needed to be adroit in sifting the words to discern the facts that lay beneath. Readers of The Economist’s “Special Report on Financial Innovation” (published on 23 February 2012) would do well to equip themselves with similar skills in disambiguation.

Faith Based …

The Economist sees financial innovation as positive; regarding it in the same sense as charity and goodwill to one’s fellow creatures. The reader is told that: “Finance has a very good record of solving big problems, from enabling people to realise the value of future income through products like mortgages to protecting borrowers from the risk of interest-rate fluctuations.” The definition of the “big problems” of our time is obviously subjective.

The Report lacks doubt: “The evidence of this special report suggests that the market does a brilliant job of nurturing and refining instruments that people want.” A closer review of the evidence suggests that the authors of the Report have followed Adlai Stevenson, the Democratic candidate for president in the 1952 and 1956 elections: “Here is the conclusion on which I base my facts.”

The approach is puzzling as the Report repeatedly admits the difficult of actually measuring the benefits of financial innovation: “… quantifying the benefits of innovation is almost impossible” and “To sift through the arguments on both sides is to confront a basic problem with any financial innovation: the difficulty of measuring its benefits.”

The Economist quotes a 2011 NBER paper by Josh Lerner and Peter Tufano which argues the impossibility of quantifying the impact of a financial innovation because finance involves many (often unintended) externalities. Instead the paper proposes a “thought experiment”, imagining what the world would look like without a particular innovation. The Report undertakes this thought experiment, without the requisite imagination and with a pre-disposition to the self evident benefits of finance.

In David Hare’s play The Power of Yes, Adair Turner, head of the English FSA, is asked whether the fact that nobody understood what was going on was an issue. Turner responds that no, it wasn’t a problem as, for people like Alan Greenspan, it was just a matter of faith. The Economist follows their mentor’s modus operandi.

Finance is as Finance Does….

Arguably, the function of finance is to match borrowers and savers, provide safe and secure payment mechanisms and also provide efficient tools for risk management. But the Report lacks a discernible working thesis as to what finance should do and how specific financial instruments, new and old, either do or do not further these objectives. Finance’s primacy is held by The Economist as another self evident truth.

Despite a self conscious mention of innovations in “microfinance products aimed at the very poor, social impact bonds, and all manner of whizzy payment technologies”, the focus is on “wholesale products and techniques”. This is because “they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis”. The Report outlines the case for securitisation, credit default swaps (as an example of derivatives), exchange traded funds (“ETFs”) and high frequency trading (“HTF”).

The thesis is that all financial innovations are prima facie good and useful. Occasionally people push them too far and things go wrong. It is Alan Greenspan’s “irrational exuberance”. Excesses are the work of out-of-control “rogue traders”. The sub-text is that the products and system are fundamentally sound. Occasionally unavoidable accidents are always an acceptable cost of progress – collateral damage for greater good.

In 2008, defending deregulated markets, Greenspan stated: “You can have huge amounts of regulation and I will guarantee nothing will go wrong, but nothing will go right either.” This is the central premise of The Economist’s analysis.

Transference…

Techniques of risk transfer – securitisation (collateralised debt obligations (“CDOs”) and credit default swaps (“CDS”) – are good: “… even now it is hard to find fault with the concept [of the CDO], as opposed to the practical application, of many of the most demonised products.”

The defence of securitisation is: “[a CDO] is really just a capital structure in miniature”. In addition, “securitisation—which worked well for decades—allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them”. Europe’s ill-fated and discredited adoption of CDO technology for its bailout fund (the European Financial Stability Fund) is the proof of concept, at least for The Economist.

While securitisation is not without benefits, the extension of the technique, for example, into re-securitisations (CDO2) created problems – as the Report readily accepts. However, the Report does not fully understand the true role and effects of securitisation.

While a CDO might be like a bank (a capital structure in miniature), it is unregulated. Securitisation for the last 15-20 years entailed shifting assets from banks to structure which reduced the amount of capital required, arbitraging regulatory capital requirements.

If a bank already held a loan funded with deposits, then in aggregate by selling the loan to the same depositors does not increase the supply of credit. The increase in credit is a function of the several things: (1) shifting risk into the shadow banking system; (2) alchemy (tranching) to create highly rated securities (AAA or AA) which acts as collateral to allow further re-leveraging; and (3) the ability to re-hypothecate the collateral over and over again, such as in re-securitisation.

The process increased leverage (crudely the capital against risk in reduced), model risk, liquidity risk, complexity and linkages via counterparty risk. It also moves risk from somewhere where it is highly visible to where it is less visible. In cutting and dicing risk, it encourages mis-pricing. It also creates difficulties in resolving problems – a delinquent loan is difficult to restructure when it no longer exists in its original form and different slices of the cash flows are held by different investors.

The case for securitisation also misses that banks sell off risk and then re-acquire it either directly through linkages with the shadow banking system or indirectly by financing investors secured against the securitised bonds created. Instead of actually assisting diversification, the entire process concentrates risk while simultaneously lowering the amount of capital and liquidity reserves held against the loans.

Recent research and enquiries have presented considerable evidence that CDOs were a direct contributing factor for the toxic phase of the asset bubble in US housing, commercial real estate and private equity market. But if The Economist is aware of these problems, then they are not covered in any detail.

The only problem with CDOs apparently was that “they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated”. Given that sub-prime mortgages were only a part of the much larger CDO market, the wider fall in value of securitised debt and the losses must have been a collective hallucination.

Giving Credit…

After the expected Oxbridge cross Channel sneer at “choking Europeans”, the Report concludes that CDS contracts are “sound”. Sovereign CDS contracts perform “a useful signalling function”.

The only problem apparently is that banks sometimes sell protection on their own governments increasing their exposures to the sovereign. Given large banks dependence on the sovereign for their own existence, the absurdity of a bank insuring the nation’s risk collateralised by government debt is ignored.

CDS, if it is used as a pure hedge, can be useful. Over time, the market, led by dealers keen to make credit a tradeable commodity, has evolved differently. The major drivers of the market are the ability to short credit and take leveraged positions on bonds. In addition, the fact that CDS contracts are not limited by the availability of underlying bonds or credit assets (at the peak the CDS market was around 4/5 times the available underlying assets) has encouraged the growth of the market.

Standardisation of the contract to facilitate trading has created significant “basis risks” for hedgers. The recent restructuring of Greek debt, designed to specifically, avoid triggering CDS contracts, highlights the problems. A number of episodes over the last 4 years have highlighted documentary issues – trigger events and loss payouts – which cast serious doubts as to the utility of the contract.

Curiously, The Economist cites that fact that “conservative” India has recently given permission for CDS contracts to commence trading as proof of the utility of the product. The Report neglects to mention that approval was highly conditional, being designed to ensure that the only contracts traded were pure hedges of underlying positions.

In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city “for the waters” because of his health. Informed that they are in the desert, Rick ironically rejoinders that he was “misinformed”. The Economist as well as investors and banks, including those who purchased Greek sovereign CDS to protect themselves against the risk of default, may have been similarly misinformed.

ETF….

Exchange Traded Funds (“ETF”) are a hoary old chestnut, a listed and tradeable version of an index fund; hardly a revolutionary “innovation”. As the Supplement notes the absolute size of the ETF market is also relatively modest compared with estimated global assets under the control of fund managers.

Vanguard founder John Bogle might take justifiable issue with the statement that ETFs “allow retail investors access to diversified portfolios of assets that had previously been the sole preserve of institutional investors”. Mr. Bogle founded the Vanguard 500 Index Fund as the first index mutual fund available to the general public in 1975, more than a decade before ETFs.

Argument and analysis is replaced by over energetic prose – “finance’s infectious creativity”; “vibrancy looks like a victory for the investor over the fund manager”; “It is in the nature of finance that experimentation never stops.”

ETFs are “good”, reducing transaction costs and increasing efficiency. The Report notes criticism of ETFs – counterparty risk to delaers where funds use derivatives to replicate exposure to the underlying assets. Closer reading of the IMF report on ETFs suggest deeper concerns that do not merit mention – the market impact of simultaneous trend following trading by ETFs and “innovations”, such as leveraged and other versions.

There is no discussion of a key underlying issue – the idea of diversification. The Economist argues that “the dotcom bust had underscored the importance of diversification”.

Diversification to reduce risk is not without problems. As equity indexes are weighted typically by market capitalisation, as an individual share price rises it becomes a larger part of the index and therefore the ETF. During manic market phases, such as the dot com and now the AGF (Apple Google Facebook) boom, ETF investors may inadvertently find them heavily exposed to such stocks.

In asset classes such as debt, the idea of indexation is more problematic. As the indexes are weighted by the amount of bonds on issue, as an issuer borrows more it becomes a larger part of the ETF, irrespective of its ability to make repayments. As Worldcom and more recently European sovereign debt shows, the results are not pretty.

While successfully managing the portfolios of an insurance company and the King’s College endowment, Keynes insisted that diversification was flawed: “To suppose that safety…consists in having a small gamble in a large number of different [stocks] where I have no information…as compared with a substantial stake in a company where one’s information is adequate, strikes me as a travesty of investment”. Mark Twain’s Pudd’nhead Wilson would have agreed: “Put all your eggs in one basket, and watch that basket.”

HFT….

The Economist sides with the high frequency trading (“HFT”) practitioners who are “frustrated by what they perceive as an unfair onslaught”. The Report resorts to tried and tested rhetoric – HFT is difficult to define; there is not enough data. But these factors present no barrier to the conclusion reached that “high-frequency traders provide liquidity and ‘knit’ together our increasingly fragmented marketplace, resulting in tighter spreads that benefit all investors” (citing testimony delivered to the Securities and Exchange Commission in 2010 by George Sauter of Vanguard, a big fund manager).

Liquidity and lower transaction costs only benefits an investor when they trade. High liquidity and tight bid-offer spreads are only available, as all practitioners know, when it is not needed, becoming the first casualties of market downturns and volatility. Market-making needs adequate compensation for the risk assumed. Forcing return below sustainable levels encourages dealers to boost revenue from proprietary trading (often using the information gained from client activity) and trading structured products, creating different risks.

The Report ignores the real problems of HFT – the problems of potential market manipulation, insider trading, front running client flows and increased market volatility often at critical times. The Economist cannot imagine a world without HFT which is “an “outcrop” of the market structure”.

High trading volumes are regarded as normal and desirable. In the zero sum game of trading, the presence of super fast computers copulating with other super fast machines provides uncertain benefits in financial intermediation.

Average investment periods for shares have shortened from around 7 years to 7 months since 1940. HFT now accounts for over 60% of equity trading, with an average holding period of around 11 seconds. High levels of trading may create excessive “noise” preventing prices from reflecting true value, ultimately leading to a loss of confidence in certain markets discouraging investment. HFT may damage the process of long term capital accumulation and allocation.

Collateral Damage …

The Report believes that collateral is problematic “the whirring of financiers’ minds … spells trouble” but confusingly sees it is as also breeding innovation. The discussion may remind the reader of an observation of Groucho Marx: “A child of five would understand this. Send someone to fetch a child of five”.

The use of collateral contributed significantly to the financial crisis. Secured lending, collateralised by securities, including high quality bonds especially created through securitisation, contributed to the increase in debt. It allowed a shift of focus from repayment ability based on income and cash flow to the value of the asset securing the borrowing. As debt fuelled a virtuous cycle of price appreciation it allowed the level of debt to increase rapidly.

The process relies on a steady and unending rise of debt and prices – a Ponzi scheme, in effect. It also relies on the ability to trade and the liquidity of markets. Unfortunately, the virtuous cycle turns vicious when the supply of debt ceases and prices fall.

The system creates exposure to short term price fluctuations as the amount of collateral required varies. It effectively amplifies the broader financial problems of funding short and lending long.

Collateral also facilitates access to derivative markets for less credit worthy counterparties.

The problems of Bear Stearns’ hedge funds, AIG and Lehman all can be traced, in different degrees, to the system of collateral. Unfortunately, those unlikely to be able to meet demands for payment are unlikely to be able to meet collateral calls – a fact which financial institutions and their regulators failed to understand.

At a broader level, collateral underlies the entire shadow banking system, which proved so problematic during the crisis.

Left Unsaid…

Mistakes of commission are compounded with errors of omissions.

The Report notes that risk transfer may encourage excessive risk taking and lending. It identifies that the illusion of stability may cause instability, an idea first put forward by economist Hyman Minsky (who does not gain a mention).

The systemic side effects of financial innovation are barely recognised. Financial innovation played a crucial role in allowing the increase in debt levels and leverage. It created complex linkages between financial participants increasing systemic risk and informational failures.

The appropriate size of some markets, such as for over-the-counter derivative, is not considered. The Economist points to interest-rate swaps “which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era”.

Interest rate derivatives (including interest rate swaps) are about 70% of total derivative outstanding on $600 trillion, which equates to over $400 trillion roughly 6 or 7 times global GDP and a significant multiple of all financial assets in existence. Daily currency turnover is between 30 and 50 times trade flows.

Derivative volumes are inconsistent with pure risk transfer. The necessity for or utility of such high trading volumes does not figure in the discussion.

A quaint economic concept – cost benefit analysis -. weighs the benefits of any actions against the costs. Unable to identify the benefits accurately by their own admission, the Report decides to ignore costs arguing: “Even bad ideas are not a problem when they first arise. If only a few people get burned by a duff product, the wider world need not care”.

Given the high cost of failure of financial innovations as evidenced by the significant and ongoing costs of global financial crisis, the case for financial innovation, at least of many of the products cited, may fail on cost-benefit grounds. Defenders of financial innovation have a high burden of proof to overcome.

Super Smarts…

The Economist fails to understand the real motivations of financial innovation. They believe that: “Products … mutate constantly, in part because patenting is not common”. Citing Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, wholesale financial innovation, they argue, is the creation of new capital structures that align the interests of lots of different parties.

In practice, the major alignment of interests relates to getting a deal done to enable the bankers to receive substantial bonuses based on mark-to-market values of the product. The profit frequently does not fully recognise the long term consequences or risks to either the client or the financial institution.

Confusing bankers with saintly figures in line for beatification, the Report approvingly cites Goldman Sach’s Martin Chavez who explains that innovation is in response to the “clients call”… We can’t tell them ‘no thanks’.” This, undoubtedly, is “doing God’s work”, which the head of the firm once stated was its primary mission.

It is difficult to reconcile this position with statements by another Goldman Sachs’ employee Fabrice Tourre, who sold the Abacus deals to unwitting “widows and orphans”. Among tender emails to his girlfriend Serres, the self-styled “Fabulous Fab” observed in January 2007: “More and more leverage in the system. The whole building is about to collapse anytime now?.?.?.? Only potential survivor, the fabulous Fab[rice Tourre] standing in the middle of all these complex, highly leveraged, exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!”

Tourre stated that Abacus was “pure intellectual masturbation”, “a ‘thing’ which has no
purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price”. But Tourre was not assailed by self-doubt: “Anyway, not feeling too guilty about this, the real purpose of my job is to make capital markets more efficient and ultimately provide the U.S. consumer with more efficient ways to leverage and finance himself, so there is a humble, noble, and ethical reason for my job :) amazing how good I am in convincing myself!!!”

Stéphane Mattatia, Société Générale’s global head of equity flow engineering and advisory, told The Economist of a hedge based on the Euro falling and gold rising for a client worried about French CDSs. Of course, SG managed to lose Euro 5.9 billion through its inability to hedge its own risk on positions taken by rogue trader Jerome Kerviel. If the client was concerned about positions in French CDS, wouldn’t it have been just easier to close out its existing position rather than enter into a complex, potentially expensive and illiquid instrument?

There is no acknowledgement that much of what is called financial innovation is economic rent extraction, exploiting lack of transparency as well as information and knowledge asymmetries. There is no discussion of the destructive bonus culture which encourages certain behaviours in financial institutions. Thomas Philippon and Ariel Reshef have estimated that around 30-50% of the extra pay bankers received compared to similar professionals is attributable to economic rents.

In a January 2009 speech, Lord Adair Turner, chairman of UK’s Financial Services Authority, observed that: “Much of the structuring and trading activity involved in the complex version of securitized credit was not required to deliver credit intermediation efficiently, but achieved an economic rent extraction made possible by the opacity of margins and the asymmetry of information and knowledge between…users of financial services and producers…financial innovation which delivers no fundamental economic benefit, can for a time flourish and earn for the individuals and institutions which innovated very large returns.”

The unpalatable reality that few, self interested industry participants and their cheerleaders are prepared to admit is that much of what passes for financial innovation is specifically designed to conceal risk, obfuscate investors and reduce transparency. The process is entirely deliberate. Efficiency and transparency is not consistent with the high profit margins on Wall Street and the City. Financial products need to be opaque and priced inefficiently to produce excessive profits. The Report does not canvas this issue.

Fixing It ….

The Report makes prescriptions for strengthening financial innovation – protection of investors, more capital, improved operational procedures and stronger regulators. The solutions are familiar dictums which have been tried before with limited success. As former New York Federal Reserve President Gerald Corrigan told policy-makers and financiers on 16 May, 2007: “Anyone who thinks they understand this stuff is living in lala land.”

The problem of protecting investors arises because of the difficult in “judging the sophistication of a client”. Not only retail investors, it seems, need protection. The Report approvingly quotes a regulator: “A German Landesbank should be treated like a child”.

The risk management problems of “sophisticated” firms (Citibank, UBS, Lehman, Bear Stearns, Merrill Lynch and Long Term Capital Management (whose numbers included Myron Scholes and Robert Merton as well a large number of highly trained financiers)) suggest that most of the industry have not reached pimply adolescence let alone sage maturity. Given a tendency to self harm, most industry participants need protection from each other and themselves. Regulatory initiatives may need to encompass preventive detention for all parties.

In the last 20 years, capital held by banks and brokers against loss fell, increasing leverage. The definition of capital was expanded to include hybrid capital, debt ranking below deposits and senior borrowings. Cheaper than normal equity, hybrids avoided dilution of existing shareholders. Increases in debt and leverage reflected “improved financial flexibility…the results of massive improvements in technology and infrastructure”, according to regulators. Banks’ liquidity reserves, designed to cover withdrawal of deposits, were reduced, freeing up money for lending.

The risks were ignored. Alan Greenspan argued: “The lack of a spare tire is of no concern if you do not get a flat.”

The prescription for higher capital and liquidity reserves has been tried before. Each capital regime promises more stringent control, but is ruthlessly arbitraged. This time around a fragile global economy means the willingness to compromise the integrity of the financial system for greater credit fuelled growth will be difficult to avoid.

In his review of the global banking crisis, Lord Adair Turner noted that: “An underlying assumption of financial regulation in the U.S., the UK and across the world has been that financial innovation is by definition beneficial, since market discipline will winnow out any
unnecessary or value destructive innovations. As a result, regulators have not considered it their role to judge the value of different financial products, and they have in general avoided direct products regulation, certainly in wholesale markets with sophisticated investors.”

Regulators may always lag markets and financial institutions in knowledge, experience and pay. Regulatory capture ensures over time the loss of oversight and control. History suggests that the next time will not be different.

Realpolitik…

Given its reputation, the weaknesses of The Economist’s Special Report are disappointing.

Information on the issues is all in the public domain. There are a plethora of reports, such as Financial Crisis Inquiry Commission Report, the Turner Report etc, which explore financial innovation and the financial crisis. There is also, I understand, a relatively new innovative Internet-based tool – the “search engine” – with could have been used by The Economist to check and research such facts.

In recent stories and reports, The Economist has presented an increasingly strident defence of bankers and their ‘City’ as well as resistance to regulation of the financial system.

Professor Simon Johnson has pointed repeatedly to one cause of the financial crisis – the political economy of the financial system and the lobbying power of financial institutions. If the press becomes part of this political economy, consciously or subliminally, then the problems are exacerbated. Advertising and sponsorship revenues as well as control over access to information and key decision makers, deemed news worthy, are essential commercial links which make newspapers and media susceptible to being influenced.

Zdener Urbanek, the dissident Czech novelist, observed that assumptions about what was written are dangerous: “In dictatorships…. We believe nothing of what we read in the
newspapers and nothing of what we watch on television, because we know it’s propaganda and lies. Unlike you in the West. We’ve learned to look behind the propaganda and to read between
the lines and, unlike you, we know that the real truth is always subversive.”

There is an important and necessary debate about financial innovation but it is not to be found in The Economist’s Special Report on the subject.

Political scientist Tom Ferguson agreed with our dim take of the news reports last night on the formation of a “new” financial fraud commission on mortgage abuses (which is actually just part of an existing fraud commission that has done squat). He also saw the apparent co-optoins of New York’s Eric Schneiderman as an effort to rein in the attorneys general that oppose the mortgage settlement.

If you are concerned and skeptical as I am, PLEASE write or call Schneiderman’s office. While it is unlikely to derail this particular train, it does not hurt Schneiderman know that you recognize this as a likely Faustian bargain.

Reader DS sent this note as an example:

Dear Atty General Schneiderman,

Having admired the integrity with which you have supported the rule of law
related to Wall St shenanigans and the mortgage crisis, I find it deeply distressing to read the following:

http://www.nakedcapitalism.com/2012/01/is-schneiderman-selling-out-signs-up-to-co-chair-committee-designed-to-undermine-defectors-to-mortgage-settlement-deal.html

I hope/trust that you will not ‘sell out’.

You can call Schneiderman’s office at 800-771-7755 or send a message via this page.

To the Ferguson interview:

By Lynn Parramore. Cross posted from Alternet.

Representing the twin evils of ruthless capitalism and government corruption, the GOP candidates are bringing core Occupy issues to the fore.

The Occupy Movement brought key issues like economic inequality, Wall Street greed, and political corruption to the table. And we may have the GOP front runners to thank for keeping them there. Here’s a look at how the Battle of Newt and Mitt can help keep the OWS flame alive…

The Populist Platform

Newt Gingrich’s populist messages in South Carolina dealt Mitt Romney a body blow. Newt hit the multi-millionaire on his low tax rate and his role in the oft-reviled private equity industry to leave him stumbling through debate questions and looking generally ill at ease. Getting branded as a corporate raider who pays less in taxes than your housecleaner is not a great image, to say the least.

Newt leveled three sets of charges at his rival on economic issues, all of which resonate with core Occupy Wall Street concerns. The first two were key in the South Carolina primary, and the third may be important in the next phase as Newt attempts to draw Ron Paul supporters into his camp. They are:

1) Taxes (OWS concern = economic inequality)
2) Private equity (OWS concern = Wall Street predation, ruthless capitalism, senseless job destruction)
3) Federal Reserve (OWS concern = power of big banks over government)

Each of these issues, of course, is viewed through somewhat different lenses by left and right-leaning populists. For Occupiers, questions about the Federal Reserve, for example, tend to call up issues of the banking industry’s influence on government at the expense of the ordinary Americans. For many Tea Partiers, a greater concern is 1) the relationship between the Fed’s activity and the government deficit and 2) the desire of some to abandon fiat money in favor of a return to the gold standard. Newt signaled his stance in Saturday night’s victory speech:

“Dr. Ron Paul, who on the issue of money and the Federal Reserve, has been right for 25 years. While I disagree with him on many other things, there’s no doubt that a lot of his critique of inflation, of flat money into the federal reserve is absolutely right, in the right direction, and its something I can support strongly.”

However Newt spins them, all three issues are likely to produce robust discussions that highlight and educate the public on matters that OWS would like to have at the center of national economic debate. OWS and Tea Partiers often agree that the Fed should be more transparent and that it’s structure is problematic, so even if Newt comes at the issue from the perspective of right-wing populism, there are enough intersections that OWS can celebrate the discussion.

The tax and private equity issues have brought a flood of commentary throughout the media, such as a recent New York Times piece by Floyd Norris questioning the fact that investment income is now taxed at a lower rate than earned income—a debate driven by Mitt’s admission that he pays a mere 15 percent in taxes. Norris demonstrated that this discrepancy has not historically been the case and also why it is unfair . Thanks to the attacks on Mitt, Americans have been talking about “vulture capitalism” (Newt’s term for private equity) and the ruthless policies and game-rigging financial engineering it is known for. Of course, this produced an entirely predictable chorus of “Shame on Newt” from financiers and their apologists, succinctly captured by Steve Moore of the Wall Street Journal, who whined on Fox News: “This is what our capitalist system is about!”

Truly, Occupiers could not have hoped for better media coverage of their grievances.

Newt, Incorporated

Having won in S.C. on a wave of populist discontent, Newt must now must do some fancy footwork in the ring. He has to figure out how to continue tapping into widespread resentment against elites while simultaneously bringing many of those same elites – particularly the financiers — on his side in the fall presidential battle. If Newt decides to go full force on populist economic issues, he will certainly garner enthusiasm from some elements on the right. But he’s got a problem: If you keep hitting the Money Men, they tend to hit back. And they might just leave the show altogether and throw their weight behind Obama, who has served their interests well on many fronts.

Another small problem: Just as Mitt became the face of the brutal and unfair aspects of our capitalist system in recent debates, Newt may find himself the poster boy for the corrupt influence of money in politics. In the final days of the S.C. showdown, Mitt began to signal that he was willing to hit on his opponent’s big Achilles’ heel in his demand that records of Newt’s 1997 ethics violation be released.

Here’s a little history on why Newt’s populist-champion narrative has more holes that a slice of Swiss cheese.

As Speaker of the House, the number of ethics violations Newt racked up through unsavory money transactions is breathtaking, and resulted, as Mitt reminds us, in a $300,000 fine. But there’s more. Oh, so much more.

The worst thing about Newt is what political economist Thomas Ferguson pointed out in a paper for the Institute for New Economic Thinking – namely that Newt was the key architect of the current pay-to-play system in Congress. More than anyone else, he is responsible for building the system in which members of Congress who bring in the most cash get the plum and powerful committee appointments. It was not always thus. Before Newt and his buddy Tom Delay saw the potential for pay-to-play, committee appointments came through seniority. But after Newt & Co. came to power, influence in Congress was nakedly up for sale. Today, both parties actually post prices for key positions, as Ferguson noted in the Financial Times.

This crass turn in American politics has undermined democracy and has done more to separate the will of the voters from the actions of the politicians they elect than perhaps anything else in the last fifty years. It’s the shameless mentality that once prompted Newt’s former buddy and fellow Georgia politician Ralph Reed to talk giddily about his aspiration to start “humping corporate accounts” following his turn in electoral politics.

When Newt left Congress, he then went on to become a consultant for, oh, Everybody in the Universe. He cozied up to Big Oil and changed his stance on climate change. He hopped into bed with health care executives, selling access to lawmakers and collecting millions from the industry for his think tank. And he famously took $1.6 million from Fannie Mae and Freddie Mac for his services as a “historian.” Know any real historians who rake in that kind of cash?

Americans’ deep anger about the degree to which Big Business buys the political system has been channeled through the Occupy Movement, and Newt’s role not only as a key conduit in this system, but one of its engineers, may open up public discussion of this issue, much as Mitt’s low tax rate and corporate raiding have helped keep the torch burning on income inequality and predatory capitalism.

Mitt will certainly try to overwhelm Newt with money. But he can also call out Newt’s particular affinity for channeling cash through the political system and expressing more enthusiasm for lobbying than anyone in recent memory. Calling him Mr. Anti-Free Market Capitalism is one tactic, branding him as Mr. Corruption is yet another. And the branding has begun. On Sunday, Mitt headed to Florida and challenged the former Speaker on his influence-peddling, criticizing him for “what’s he been doing for fifteen years…working as a lobbyist and selling influence around Washington.”

Mitt asked Newt to release his records concerning his years working for Freddie Mac, emphasizing the GOP view that the government-backed lender played a key role in the housing bubble and subsequent collapse, which has been a major source of economic distress to Florida residents.

Newt and Mitt will continue to duke it out, each trying to position himself as a Man of the People. As for the Occupiers, we’ll be sending “thank you for your support” letters to both candidates.

By dint of news flow, we are having a private equity fest tonight. David Stockman, the former Reagan budget director, made a cogent case against the idea that being at the helm of a private equity firm has much to do with knowing how to run a business on Dylan Ratigan. I thought readers would enjoy this segment, not simply due to the content but also because Stockman is a compelling and blunt speaker.

Visit msnbc.com for breaking news, world news, and news about the economy

It’s perverse that it takes a Mitt Romney presidential bid to shed some long-overdue harsh light on the private equity industry.

It was not as hard as you might think to do well in the private equity business in the 1990s. Rising equity markets lift all boats, and PE is levered equity. A better test of the ability to deliver value is how they did in more difficult times.

The Financial Times reports on a wee study it commissioned to look into who reaped the fruits of private equity performance. Its findings:

From 2001 to 2010, US pension plans on average made 4.5 per cent a year, after fees, from their investments in private equity. In that period, the pension funds paid an average 4 per cent of invested capital each year in management fees. On top of those, private equity often collects a variety of other fees and a fifth of investment profits
“Assuming a normal 20 per cent performance fee, this would amount to about 70 per cent of gross investment performance being paid in fees over the past 10 years,” said Professor Martijn Cremers of Yale.

Now some readers might argue that even with fund managers feeding at the trough, 4.5% per annum returns were still better than the S&P 500, which delivered 1.7% compounded annual returns over the decade. But they are missing several things. First is that the S&P is extremely liquid and tolerates trades in size. By contrast, when you hand your money over to a PE fund, it is an expected 5 to 7 year commitment, and if the fund does badly, they will hold on to your money longer hoping a rally will allow them to unload some garbage barges at a decent price. I have no idea what rules of thumb are used to adjust returns to allow for extreme illiquidity and a lack of any control over exit timing, but in the stone ages when Goldman would value illiquid securities for estate purposes (a task that fell to junior investment bankers), we’d apply a 20% to 40% haircut.

A lot of investors, notably university endowments, took big hits when they put too much in private equity and found they were stuck in the crisis during 2007 to 2009. Some actually tried selling PE stakes in a pretty much non-existant secondary market and took huge haircuts. In addition, there were widespread complaints of the PE funds publishing phony valuations of their portfolios during that period. Bigger swings in value mean more risk, which mean worse Sharpe ratio, which is one of the benchmarks used by the pension fund soothsayers consultants.

So where are the customers’ yachts? The release of Mitt Romney’s tax returns, which show $21.7 million of income in 2010 and $20.9 million for 2011, demonstrate he could buy a fleet of yachts. Wonder how often he takes his clients for a ride, in both senses of the word.

The public keeps losing and losing and losing to big finance because financiers have made an art form of using complexity, opacity, and leverage to cover their tracks.

The last example comes in an anodyne-seeming article in the Financial Times about collateralized loan obligations, or CLOs. CLOs are a structured credit product, in this case, made from leveraged (as in risky) corporate loans. Think of it as the corporate lending analogy to subprime bonds. The major differences between CLOs and RMBS are that CLOs are not secured by collateral (houses) and that CLOs turned out to be much better diversified than RMBS (the mortgage bond designers thought that a geographic mix would provide adequate diversification, since the modern US had never suffered a nation-wide housing market price decline. Whoops!)

CLO volumes exploded in the runup to the crisis due to a cheap-debt-fueled M&A boom, with private equity firms the big source of increased deal demand. And when the music stopped, the big banks were stuck with lots of unsold inventory. While their losses were no where near as bad as the ones they suffered on CDOs, they were still well above what was thought to be consistent with AAA rated paper. In the spring and summer of 2008, Bloomberg would report intermittently on the sorry state of the CLO market, with prevailing prices in the mid to low 80s. There were also reports of dealers selling small lots to compliant hedge funds at inflated so they could use those values to justify the marks on their positions.

Now the banks seem to have amnesia as far as the crisis is concerned, but US regulators (at least for the moment) have taken an uncharacteristic interest in reducing the risks banks carry, including those of CLOs. But the unfortunate aspect of the discussion in the Financial Times, and we assume elsewhere, is that this issue is being framed too narrowly, as being a matter of bank and financial system safety. Absent is the notion of the societal cost of making cheap debt too readily available to what in the 1980s were called takeover artists.

As an unnamed insider noted in Ron Suskind’s Confidence Men, private equity depends on being able to load companies up with debt, and (according to him) only one in ten deals needs to succeed for the fund to do well. Many industry professionals would argue a bigger proportion of deals to work out for a PE player to be deemed successful, but the general point still holds: a leveraged buyout firm can drive a lot of companies into the ditch and still come out a winner. And low cost debt allows them to operate at a much higher level of activity. As we noted in ECONNED:

Cheap funding similarly played a major role in the breakneck pace of mergers and acquisitions, which became more and more frenzied until the onset of the credit contraction, in the summer of 2007. Global mergers for the first six months of 2007 were $2.8 trillion, a remarkable 50% higher than the record level for the same period in 2006. And takeovers for the full year 2006 ran at a stunning seven times the level seen four years prior.

The EU has decided it does not like the nasty propensity of PR funds to lever up corporations, pull out a lot in the way of special dividends, and too often overdo the cash extraction and leave a bankrupt hulk in their wake. The EU has been working on a proposal to restrict investors in the EU from putting funds in private equity and hedge fund firms outside the EU, and also limit the ability of foreign investors to buy European companies. The response was huffing and puffing, that this move would “seriously disturb” the biggest PE firms. So? That was the plan, wasn’t it?

But in the US, the home of the biggest players, you hear nary a peep of this sort of talk, one that would likely argue for even bigger curbs that the ones being contemplated (and sure to be watered down). And the banks are certain to fight hard against any restriction, because M&A is a source of big advisory fees as well as new issue profits. Key extracts from the Financial Times:

Wall Street is set to pick another fight with regulators as the loan industry and big banks push back against new rules that they say could limit lending to companies with low credit ratings…

The desire among regulators – the Federal Reserve, Federal Deposit Insurance Corp and Office of Comptroller of the Currency – to prevent another financial crisis carries the risk of unintended consequences; namely that tough rules could impair market liquidity and ultimately hurt the broader economy.

Yves here. Ah, yes, the perennial threat: cut off our cheap leverage, and you’ll damage the economy. I’d love to see an analysis of how many levered loans went to fund corporate investment as opposed to takeovers (although the percentages deemed a failure vary, pretty much every study that has looked at corporate takeovers has concluded that most fail, so discouraging corporate acquisitions would also be salutary).

The FT article does mention, in a single sentence, that the levered loans used in CLOs stoked acquisitions during the credit bubble. But the political argument is over a proposed increase in capital for CLOs kept on bank balance sheets as a way to reduce systemic risks. This debate may seem a bit overdone, since CLO issuance was a mere $12.5 billion this year versus $97 billion in 2006. But in many ways, these debates are not simply over how the rules should read, but what form of capitalism will have. And unfortunately, despite occasional tough gestures by regulators, the framework and assumptions that produced the last crisis remain largely intact.

Police Lacerate Army Ranger’s Spleen and Cause Internal Bleeding … Then Deny Him Medical Treatment for 18 Hours

Reuters notes:

A former U.S. Army Ranger and Occupy Oakland protester was in intensive care on Friday after a veterans group said he was beaten by police during clashes with demonstrators this week.

The veteran, identified as Kayvan Sabeghi, was the second former American serviceman during the past two weeks to be badly hurt in confrontations between anti-Wall Street protesters and police in Oakland.

The group Iraq Veterans Against the War said Sabeghi was detained during disturbances that erupted late on Wednesday in downtown Oakland and was charged with resisting arrest and remaining present at the place of a riot.

Highland General Hospital confirmed that Sabeghi was a patient in the intensive care unit there.

Brian Kelly, who co-owns a brew pub with Sabeghi, said his business partner served as an Army Ranger in Iraq and Afghanistan. He said Sabeghi told him he was arrested and beaten by a group of policemen as he was leaving the protest to go home.

“He told me he was in the hospital with a lacerated spleen and that the cops had jumped him,” Kelly said. “They put him in jail, and he told them he was injured, and they denied him medical treatment for about 18 hours.”

The Guardian reports:

Kayvan Sabehgi, who served in Iraq and Afghanistan, is in intensive care with a lacerated spleen. He says he was beaten by police close to the Occupy Oakland camp, but despite suffering agonising pain, did not reach hospital until 18 hours later.

***

Sabehgi told the Guardian from hospital he was walking alone along 14th Street in central Oakland – away from the main area of clashes – when he was injured.

“There was a group of police in front of me,” he told the Guardian from his hospital bed. “They told me to move, but I was like: ‘Move to where?’ There was nowhere to move.

“Then they lined up in front of me. I was talking to one of them, saying ‘Why are you doing this?’ when one moved forward and hit me in my arm and legs and back with his baton. Then three or four cops tackled me and arrested me.”

Sabeghi … said he was handcuffed and placed in a police van for three hours before being taken to jail. By the time he got there he was in “unbelievable pain”.

***

Sabehgi was due to undergo surgery on Friday afternoon to repair his spleen, which would involve using a clot or patch to prevent internal bleeding.

***

Some protesters had set fire to a hastily assembled barrier at the corner of 16th Street and Telegraph, in a bid to prevent access to the occupied building, but police drove demonstrators away from 16th Street using tear gas, flashbang grenades, and non-lethal rounds.

Sabehgi said he had not been in the occupied building, and was walking away from the main area of trouble when he was injured.

He said he had his arms folded and was “totally peaceful” before being arrested.

Local San Francisco ABC affiliate KOFY News interviewed Sabehgi’s sister tonight, who said that Sabehgi lived near Frank Ogawa Plaza (the center of the Occupy protests), and was walking home Wednesday night away from violence when police stopped him. Sabehgi said that police ordered him to walk in another direction, and he simply asked “why?”

In response, according to Sabehgi’s sister, the police beat him mercilessly with batons.

Sabehgi was then kept in a holding cell for 18 hours. Despite begging to see a doctor, Sabehgi was refused medical assistance. Instead, according to Sabehgi, his jailors accused Sabehgi without any cause of being a heroin addict and alcoholic and – instead of providing medical help for his severe injuries – told him to stop taking heroin.

There is apparently a videotape of the incident (KOFY noted that “police are reviewing video of the incident”).

Given the outcry over the unprovoked injury of Marine veteran Scott Olsen – which has caused veterans from all over the country to come out to support the protesters – Sabehgi’s treatment by the police could generate even more support for the “Occupy” protests .

A corollary to Upton Sinclair’s famous saying, “It is difficult to get a man to understand something if his salary depends on his not understanding it” is “People promote ideas that help them secure or preserve a privileged position on the totem pole.”

A glaring example of these observations came in an op ed in the Sunday New York Times by Steve Rattner, former Lazard mergers & acquisition partner, later head of the private equity firm, Quadrangle Partners. He is best known as the chief negotiator in the auto bailouts (and he was criticized for not involving any auto industry experts). He paid $10 million to settle a kickbacks investigation and agreed not to work for a public pension fund in any role for five years. I happened to see Rattner on a panel at a Financial Times conference earlier this week and he elaborated on some of the themes in this piece, “Let’s Admit It: Globalization Has Losers,” which reader Brett asked me to debunk line by line. I’ll spare you and focus just on the most critical and bald-facedly dishonest bits.

Let’s start at the top:

For the typical American, the past decade has been economically brutal: the first time since the 1930s, according to some calculations, that inflation-adjusted incomes declined. By 2010, real median household income had fallen to $49,445, compared with $53,164 in 2000. While there are many culprits, from declining unionization to the changing mix of needed skills, globalization has had the greatest impact.

Apparently the NYT fact checkers give guys at Rattner’s level a free pass. This is false. Where was Rattner in 2007 and 2008? Real median income peaked in 2007, and that was modestly higher than in the last cyclical peak, in 1999. The decline in income (nominal, not just inflation adjusted) is the direct result of the global financial crisis, not inflation. So his entire piece is based on an inaccurate claim which has the effect of diverting blame from bankers like him.

This next bit is sneaky but worth pointing out:

The phenomenon that free traders like me adore has created a nation of winners (think of those low-priced imported goods) but also many losers.

We don’t have a system of free trade. It’s managed trade. As William Greider has pointed out, most other countries play the game in a way to produce better national outcomes (fewer lost jobs and trade surpluses). We seem to be running our trade policy not to optimize our national interest, but that of large international corporations, which is far from the same thing.

The next bit is pure reductivism:

A typical General Motors worker costs the company about $56 per hour, which includes benefits. In Mexico, a worker costs the company $7 per hour; in China, $4.50 an hour, and in India, $1 per hour. While G.M. doesn’t (yet) achieve United States-level productivity in China and India, its Mexican plants are today at least as efficient as those in the United States.

American management is also more expensive than management in Mexico or China or India. And I think you’d be hard pressed to say American management is better than management, say, from Sweden or Australia, where CEOs are vastly less well paid than here. So shouldn’t we expect CEO and upper management wages also to fall?

And remember, as we have said in other posts, the evidence is overwhelming that not only is CEO pay in the US not correlated with performance, it is negatively correlated with performance. The best paid CEOs deliver the worst results, and the leaders of Jim Collin’s stellar performers in Good to Great all paid themselves modestly.

We need to peel back several layers to debunk this notion that labor costs trump everything. First is that Rattner is implicitly arguing that the world is frictionless. But that is misleading. The US is a big market, and there are advantages in being close to the customer, in terms of rapid response, carrying smaller inventories (and thus having smaller losses when you get it wrong), lower shipping and financing costs. IKEA, which is in a low end manufacturing business, has its manufacturing for the US located in the US.

Second, he is also assuming that all products are more or less commodities. But the job of management is to find a way to gain competitive advantage, and being a low cost competitor is one of many options. I’m sure you’ve paid a big premium to buy food or a drink at a convenience store now and again. They are competing on location, not cost. Similarly, I’m always amused at techies who hector Apple product users in comments. They seem angry that consumers will pay a big premium for ease of use or maybe just sheer coolness (and I have to say, as a Manhattan person, being able to see a live person at 3 AM and get something diagnosed and fixed is worth a lot to me). So a fixation on costs too often reveals a management lacking in imagination and gumption facing increasingly competitive and mature markets.

Third, his focus on direct factory labor is disingenuous. Direct factory labor is typically just north of 10% of the cost of most manufactured goods; for cars, we are told it’s 13%. Even if you can extract meaningful savings there, you have significant offsets: the upfront cost of re-orgainzing production (which in the outsourcing scenario include hiring costly outsourcing “consultants” and paying attorneys to paper up the deals), higher ongoing managerial costs, higher shipping and related inventory financing expenses. Yes, there are cases where outsourcing and offshoring have been a big success, but there are also others where the benefits have been underwhelming and have come at considerable costs to US workers, communities, and the economy (see a very good long form discussion by Leo Hindery).

And in many cases where big multinationals come out ahead, it isn’t due solely to labor cost savings. As Greider pointed out:

At IBM back in the 1980s, [Ralph] Gomory watched in awe as Japan and other Asian nations captured high-tech industrial sectors in which US companies held commanding advantage. IBM invented the disk drive, then dropped out of the disk-drive business, unable to compete profitably. Gomory marveled at Singapore, a tiny city-state, as it lured American manufacturers with low-wage labor, capital subsidies and tax breaks. The US companies turned Singapore into a global center for semiconductor production.

And this sort of thing continues. I discussed long form the fate of a world class coated paper mill in Escanaba, Michigan. The main culprit in its demise was overleveraging and excessive compensation to executives who knew bupkis about the paper industry. But another factor I did not include in my getting-to-be-too-long post and was pointed out by readers in comments were the considerable subsidies given by the Chinese and Indonesian governments to their papermakers.

Consider the implications: if the only factor at work were factory labor, as Rattner implies, you’d see far fewer jobs ceded to foreign markets (put it another way: if the labor cost differential were a sufficient inducement, foreign governments wouldn’t need to offer such generous subsidies).

To put it another way, the argument that Rattner is making is basically that of the Stopler-Samuelson theorem. Let’s turn the mike over to development economist Dani Rodrik:

The Stolper-Samuelson theorem is a remarkable theorem: it says that in a world with two goods and two factors of production, where specialization remains incomplete (plus a few more technical assumptions), one of the two factors–the one that is “scarce”–must end up worse off as a result of opening up to international trade. Not in relative terms, but in absolute terms. But the theorem is also quite limited in its applicability. It applies only to a case with two goods and two factors, and so its real world relevance is always in question.

But there is a version of the theorem that is remarkably general and powerful. It says that regardless of the number of goods and factors, at least one factor of production must experience a decline in real income from trade as long as trade induces the relative price of some domestically produced good(s) to fall (and as long as the productivity benefits from trade are restricted to the traditional, inter-sectoral allocative efficiency improvements, about which more later). All that this result requires is a very mild assumption, namely that goods be produced with varying factor intensities (i.e., use different combination of factors). The stark implication is that someone will lose, even if the nation as a whole becomes richer.

So to give an example: Let’s say that as a result of globalization, the wholesale price of a car falls from $20,000 to $15,000. Let’s further assume that materials costs were $6000, direct factory labor was $3000, factory overheads were $2000, shipping is $1000, marketing is $2500, other management costs (top brass, IT, legal, accounting) were $2000, interest cost are $1000, and $1500 is for capital investment (as in repairs and replacements), with a target profit of $1000. Per Stopler-Samuelson, something has gotta give to get the manufacturing price down to $15,000.

But it does not have to be worker wages. For instance, over the years, we’ve seen manufacturers of all sorts get smarter (and in some cases, just stingier) in their use of raw materials. And all bets are off if you increase productivity. That means you can use fewer workers, but maintain their pay levels. As Rodrik continues by discussing a paper by Broda and Romalis that found that trade with China reduced income inequality in the US. Huh? Per Rodrik:

The puzzle here, at least on the face of it, is that one would expect China’s trade to have had the largest price impact on labor-intensive goods. And if so, wages of unskilled workers must have fallen even more, along the lines of the Stolper-Samuelson logic sketched out above. Can we still say that trade with China has helped reduce U.S. inequality?

The first thought that comes to mind is that Broda and Romalis are talking about consumer prices, and Stolper-Samuelson effects depend on changes in producer prices–i.e., prices of goods that are actually produced in the U.S. If nobody in the U.S. produces the garments and toys that China exports to the U.S., then it is conceivable that the relative price of labor-intensive goods will fall without hurting real wages.

But then this is unlikely, given substitutability between Chinese- and U.S.-made goods. And indeed another paper, by Raphael Auer and Andreas Fischer, employs a clever technique to document a sizable negative impact on U.S. producer prices from trade with China and other labor-abundant countries. So the benign effect of Chinese exports, if any, is not due to the fact that the U.S. no longer competes head-to-head with that country in similar products.

What gives? The Auer and Fischer paper underlines another important result. What lies behind the decline in U.S. producer prices in trade-affected sectors is not wage or other input price reductions but mostly increases in total factor productivity. So perhaps what is going is that the Stolper-Samuelson logic is defeated by increases in sectoral productivity induced by import competition. The mechanical link between prices and factor costs–which I appealed to above in the proof of the generalized S-S theorem–breaks down whenever there is productivity change. After all, if TFP increases, employers can afford to pay unchanged wages even if the prices they face decline.

So this is where the misdirection by Rattner is crucial. Until the 2000s, in every economic expansion, labor got the bulk of the increase in GDP, typically over 60%, via more jobs and increased pay. Post 2000, there was an astonishing change, a shift from labor share, which fell to below 30%, and a massive increase in corporate profits. In other words, there was huge shift away from labor to capital. This has little to do with globalization and much to do with the weakened bargaining power of US workers. As much as it has become fashionable to look down on unions (and their corruption and short-sightedness hasn’t helped), having well paid blue collar workers helped the negotiating position of non-unionized white collar employees.

Rattner also conveniently fails to discuss how the rapacious tendencies of private equity firms made matters worse. An unduly candid investor described the business model in Confidence Men: pile debt on the acquisitions, and if only one of ten made it (meaning survived!) you still made a good return for investors. So many companies in Europe have gone bankrupt thanks to the tender ministrations of PE pirates that the officialdom has read them the riot act. PE firms have to register, and they cannot either buy companies or raise money in the Eurozone unless the conform to regulations, which include strict limits on leverage.

Rattner argues in his piece that we should imitate Germany and focus on high skill manufacturing. But Germany’s population is roughly 1/4 ours and they already dominate certain niches. Rattner at the FT conference called for the US to start producing more engineers, which readers will laugh out of the room. Engineers don’t get paid enough for more people to want to seek out that career path; many of you have told me the only way to make a good living was to get another degree, like law, and go into another line of work.

And even if copying Germany might be a viable approach, it would take something like industrial policy to get there. Note the US already has industrial policy by default, with banks, the mortgage-industrial complex, military contractors, agriculture, and Big Pharma among the favored groups. But no, Rattner pooh-poohs the whole idea. Better to have industrial policy determined by lobbying effectiveness than a more thoughtful process:

The prospect of Washington lurching into the private sector is terrifying, as illustrated by the debacle of Solyndra, the solar energy company that failed with $535 million of taxpayer loans. While countries like China have put large resources behind industries they want to nurture, we should resist the temptation to plunge deeply into industrial policy.

I wish I had the space to discuss Solyndra in depth, but the sort form is that the failure of that deal is not an indictment of the overall program. If you are a VC investor, you expect a certain percentage (actually a pretty high percentage) to come a cropper. Solyndra was only a bit over 1% of the portfolio, and it appears to be the only loss. This looks like a classic “shit happens” deal failure: the investment looked sensible at the time, silicon prices collapsed, which had a direct, negative impact on competitiveness. Even so, a later-stage independent investor provided funding, which further confirms the original investment was not misguided (you’d get no rescue investors coming in if it looked like a hopeless turkey).

Rattner apparently missed a different Rodrik article, a Financial Times op ed, in which he warned:

If there is one lesson from the collapse of the 19th century version of globalisation, it is that we cannot leave national governments powerless to respond to their citizens.

Yet an unfettered system is precisely what Rattner is promoting, no doubt because it works to his and his fellow rentiers’s advantage.

One frequent and frustrating line that often crops up in the comments section of this blog is that American labor has no hope, it should just accept Chinese wages, since price is all that matters. That line of thinking is wrongheaded on multiple levels. It assumes direct factory labor is the most important cost driver, when for most manufactured goods, it is 11% to 15% of total product cost (and increased coordination costs of much more expensive managers are a significant offset to any savings achieved by using cheaper factory workers in faraway locations). It also assumes cost is the only way to compete, when that is naive on an input as well as a product level. How do these “labor cost is destiny” advocates explain the continued success of export powerhouse Germany? Finally, the offshoring,/outsourcing vogue ignores the riskiness and lower flexibility of extended supply chains.

This argument is sorely misguided because it serves to exculpate diseased, greedy, and incompetent American managers and executives. In the overwhelming majority of places where I lived in my childhood, a manufacturing plant was the biggest employer in the community. And when I went to business school, manufacturing was still seen as important. Indeed, the rise of Germany and Japan was then seen as due to sclerotic American management not being able to keep up with their innovations in product design and factory management.

But if you were to ask most people, they’d now blame the fall of American manufacturing on our workers. That scapegoating serves to shift focus from the top of the food chain at a time when executives have managed to greatly widen the gap between their pay and that of the folks reporting to them.

Let me give you an all too typical example of how American management has contributed to the demise of our industrial competitiveness, namely, the former Mead Corporation paper mill in Escanaba, Michigan, which is now part of NewPage, owned by Cerberus.

The Escanaba mill makes coated paper. Coated paper is shiny paper, the sort you find in most magazines, catalogues, and art books. Coated paper is fussy to manufacture, which makes it daunting in a continuous process setting like a mill. In a highly-capital intensive continuous process business, downtime is hugely expensive.

In 1969, Mead added a #3 machine in Escanaba. Paper machines are very long-lived; you’ll find machines over 100 years old in use, since older, well maintained, well-located machines (as in with access to comparatively cheap power and pulp) can be competitive on grades of paper which are made in small runs (as in the slow speed of the machine is not a negative). The #3 machine was world class at the time of its installation. There was no reason to think it could not be highly competitive through 2020 or 2030 if properly maintained.

Starting up a new machine, however, is not an easy process, and the #3 machine was not operating at the expected efficiency level. Management nevertheless pressed forward with a further mill expansion in 1970-1971, of a kraft-recovery system. The best workers on the #1 machine were moved to the #3 machine which did not solve the problems on #3 and worsened the results of the #1 machine. It took an over two year turnaround effort to get the mill operations up to a good level of productivity.

By the mid 1970s, the Escanaba mill had gone from being the dog to the star. Mead had reorganized to be decentralized, so the Escanaba mill had its own sales force and a true stand-alone P&L Escanaba was one of 40 divisions yet produced the majority of Mead’s free cash flow. Mead added added a #4 machine in Escanaba in 1982. The mill was recognized as one of the best coated paper makers in the US, and demanding publishers such as National Geographic, Smithsonian, and Playboy sought out its product

Mead has also had troubled period with its unions, in particular a bad strike in 1975-6. But a real turn came in the later 1980s. Mead had had a series of record-breaking profit years, each higher than the last, yet sought to squeeze the unions in 1989.

The 1980s were the heyday for papermakers. By the later 1990s, Mead had started scrimping on shutdowns, which is when the plant’s equipment gets maintenance and repairs. Twice a year shutdowns were replaced by annual shutdowns.

In 2002, Mead merged with WestVaco to form MeadWestVaco. The shallow dot-bomb era recession led to further reductions in reinvestment. A $5 million shutdown budget for Escanaba was reduced to under $2 million, even as the departing Mead CEO received a $30+ million golden parachute.

Cerberus acquired the Escanaba mill along with four other MeadWestVaco mills in 2005, forming the company now known as NewPage. Cerberus set return on invested capital targets that were, to put it politely, audacious for the paper industry, which led it to scrimp even more on keeping the plant operations up to snuff.

Cerberus also, in a remarkably bone headed move, bought some troubled mills from Stora Enso, apparently on the hope that it would be able to corner the coated paper market. Consistent with that strategy, Cerberus prefers to shutter mills that don’t meet its return targets rather than sell them, apparently out of the misguided view that it can remove enough capacity to affect its pricing power (this logic is questionable for a second reason: paper grades are specific, and the mills sold may not wind up being competitors of remaining NewPage operations). From CapeCod Today:

Some revealing statistics: NewPage shut down six mills in 2008. It closed its paper mill in Niagara, Wisconsin, the only major source of employment in a city of 1,800. The mill provided 319 jobs, with workers averaging $60,000-a-year. According to local officials, the plant had two potential buyers, but NewPage let the mill sit idle. Wrote newspaper columnist Ed Lowe at the time, “The hardship of the mill closure here parallels that of Kimberly (Wis.), where 600 well-paying paper mill jobs were scuttled as part of the evolving business plan of NewPage…Both mill closures devastated their communities…Some lifelong residents of Niagara worry that their city’s future ended with the production at the mill.”

In Kimberly, NewPage refused to sell to two buyers and declined the support of the Governor to keep the plant open. “This is a case of a corporation taking a productive, profitable plant and closing it, and refusing to sell it to anyone else,” Andy Nirchl, president of the United Steel Workers local, said at the time.

It tried putting through a 60% price increase in 2009, and was forced to roll it most of the way back as its competitors implemented only modest price hikes. This took place when the standing of the mills was falling. Escanaba was shipping product that had breakage problems; its quality had gone from being among the best to middling to low. In 2010, NewPage has had three CEOs, including the notorious Bob Nardelli, who has been named one of the worst CEOs of the 2000s and the worst CEO of all time by CNBC. Paper industry incumbents have not thought much of Cerberus’s management acumen. From Paper and Other Absolute Truths:

President and CEO, E. Thomas Curley, had barely learned the most efficient traffic routes to the office, when he was handed a check for $1.265 million, told not to come back, and, by the way, “don’t forget that you ‘resigned’”. Not a bad four month gig – I doubt that Lady Gaga does that well.

I believe that Mark Suwyn, Chairman and company Director, had been with NewPage from the “Cerberus” beginning. NewPage lost money every year under Suwyn, and was the worst managed company in the business. For that performance, Suwyn will walk away with a cool $2 million.

As an aside, it was reported that Suwyn engaged his son’s consulting firm in 2009, at a cost of $747,000, to provide training for “improving communications skills, consensus building and problem solving abilities.” (NewPage 2009 SEC Form 10-K, at 117). That is so disappointing, and in such bad taste. The program apparently didn’t work either.

The very good news is that there is no upper level management of NewPage. There is no Chairman. There is no President. There is no CEO. If this were allowed to continue for a few years, some real progress could be made.

Robert Nardelli, who has a big Cerberus title, is responsible for the NewPage performance, and is now the non-executive chairman of NewPage. That non-executive title is very important. It means he shouldn’t be in a position to make any decisions.

This entire mess was created, of course, by Cerberus mismanagement. They hired the wrong people, gave them impossible marching instructions, and have continue to play an expensive game of musical chairs at the highest levels of the company. The initial strategy of “pump and dump” didn’t work, and now Cerberus is relegated to actually operating a company. This is not their strength. But then, what is their strength?

If you think this criticism sounds overly harsh, read some earlier posts on NewPage (see here and here). Independent of the bad management, the paper industry is a poor candidate for an LBO, since it has high operating leverage, high ongoing reinvestment needs, is cyclical, and does not offer high returns even at the best of times. Unless you are confident you’ve bought at the bottom of a cycle, it’s one of the worst conceivable industries for a private equity investment.

NewPage lost $88 million in the first quarter 2011, which is an improvement over the $175 million loss for the same quarter in 2010. Its second quarter loss widened to $132 million. NewPage has held up payments to contractors, apparently to preserve dwindling cash.

Cerberus is negotiating a restructuring of the NewPage debt and may file for bankruptcy. The financiers will all get their cut and will move on to the next deal. Yet the workers at these mills and the communities they anchor, like Chillicothe, Ohio and Luke, Maryland (two other places I lived when I was growing up) will suffer the consequences of this rent extraction.

Readers new to this site may be unfamiliar with our summer reruns, in which we reprise vintage NC posts that we think have stood the test of time pretty well.

We’ve done these more or less in chronological order (our last one was our post on the unveiling of the TARP), but we decided to skip ahead to one in 2010 because it focuses on a crucial bit of history that is too often overlooked, and were were reminded of it by a very good Frank Rich piece in New York Magazine on Obama’s failure to bring bankers to account.

Even Rich’s solid piece treats Obama more kindly that he should be. He depicts the President as too easily won over by “the best and the brightest) in the guise of folks like Robert Rubin and his protege Timothy Geithner.

We think this characterization is far too charitable. Obama had a window in time in which he could have acted, decisively, to rein the financial services in, and he and his aides chose to let it pass and throw their lot in with the banksters. That fatal decision has severely constrained their freedom of action, as we explain below.

This post first appeared on March 10, 2010

I’ve seldom seen so much rubbish written by people who ought to know better in a single day. Many critical thinkers have heaped the scorn and incredulity on three articles, one a piece on Rahm Emanuel slotted to run in the Sunday New York Times Magazine, another an artfully packed laudatory piece on Timothy Geithner by John Cassidy in the New Yorker and a more even handed looking one (I stress “looking”) in the Atlantic.

Ed Harrison has skillfully shredded parsed the Geithner pieces . Simon Johnson thrashed the New Yorker story. A key paragraph below:

The main feature of the plan, of course, was – following the stress tests – to communicate effectively that there was a government guarantee behind every major bank or quasi-bank in the United States. Of course this works in the short-term – investors like such guarantees. But there’s a good reason we usually don’t guarantee all financial institutions – or act happy when other countries do the same. Unconditional bailouts lead to trouble, encouraging reckless risk-taking and undermining responsible governance. You can’t run any form of reasonable market system when some big players hold “get out of bankruptcy free” cards.

Banking expert Chris Whalen was so disturbed by the numerous distortions in the New Yorker piece that he had already fired off a long letter to the editor by the time I pinged him, with these starting paragraphs:

Jack Cassidy tells us that “Timothy Geithner’s financial plan is working—and making him very unpopular.” Unfortunately this is completely wrong. Cassidy’s comment just illustrates why the New Yorker has fallen into such obscurity, namely because it is more Vanity Fair than its vivacious sibling and unable to perform critical journalism.

In fact, the banking system is continuing to sink under bad loans and even worse securities losses. Telling the public that the banks are “fixed” is irresponsible. Unfortunately this false perception is widespread, including among major media such as CNBC and also with a number of my clients in the hedge fund world.

And from Marshall Auerback, who had a ringside view of the aftermath of the Japanese bubble:

Cassidy’s article brings to mind a retort by Chou En Lai when he was asked about the success of the French Revolution. He said, “It’s too early to tell”. Yet here we have John Cassidy from the New Yorker and Joshua Green from The Atlantic both making the assumption that the Geithner plan “worked”. This whole line about “taxpayers to recover bailout money” is based on an accounting fraud, because accounting abuses are the primary means by which TARP recipients have repaid bailout money — putting us at greater risk. That may seem paradoxical, but the rush to repay is driven by a desire to have unrestrained executive bonuses (a very bad thing associated with far greater accounting fraud and failures — requiring future, larger taxpayer bailouts) and accounting abuses produce the (fictional) ability to repay the United States (primarily by failing to recognize existing losses). The TARP recipients weakened their financial condition, and increased moral hazard, when they rushed to repay the TARP funds. Both factors increase the risk of making more expensive future bailouts more likely.

Yves here. The reason that people who can discern clearly what is afoot are so deeply disturbed is simple, and all the comments touch on it. The campaign to defend Geithner and Emanuel, both architects of the administration’s finance friendly policies has gone beyond what most people would see as spin into such an aggressive effort to manipulate popular perceptions that it is not a stretch to call it propaganda.

This strategy, of relying on propaganda to mask their true intent, has become inevitable, given the strategic corner the Obama Adminstration has painted itself in. And this campaign has become increasingly desperate as the inconsistency between the Adminsitration’s “product positioning” and observable reality becomes increasingly evident.

Recall how we got here. Early in 2009, the banking industry was on the ropes. Both the stock and the credit default swaps markets said that many of the big players were at serious risk of failure. Commentators debated whether to nationalize Citibank, Bank of America, and other large, floundering institutions.

The case for bold action was sound. The history of financial crises showed that the least costly approach is to resolve mortally wounded organizations, install new management, set strict guidelines, and separate out the bad loans and investments in order to restructure and sell them. An IMF study of 124 banking crises concluded that regulatory forbearance, the term of art for letting impaired banks soldier on, found:

The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred…

Shuttering sick banks is hardly a radical idea; the FDIC does it on a routine basis. So the difference here was not in the nature of the exercise, but its operational complexity.

This juncture was a crucial window of opportunity. The financial services industry had become systematically predatory. Its victims now extended well beyond precarious, clueless, and sometimes undisciplined consumers who took on too much debt via credit cards with gotcha features that successfully enticed into a treadmill of chronic debt, or now infamous subprime and option-ARM mortgages.

Over twenty years of malfeasance, from the savings and loan crisis (where fraud was a leading cause of bank failures) to a catastrophic set of blow-ups in over the counter derivatives in 1994, which produced total losses of $1.5 trillion, the biggest wipeout since the 1929 crash, through a 1990s subprime meltdown, dot com chicanery, Enron and other accounting scandals, and now the global financial crisis, the industry each time had been able to beat neuter meaningful reform. But this time, the scale of the damage was so great that it extended beyond investors to hapless bystanders, ordinary citizens who were also paying via their taxes and job losses. And unlike the past, where news of financial blow-ups was largely confined to the business section, the public could not miss the scale of the damage and how it came about, and was outraged.

The widespread, vocal opposition to the TARP was evidence that a once complacent populace had been roused. Reform, if proposed with energy and confidence, wasn’t a risk; not only was it badly needed, it was just what voters wanted.

But incoming president Obama failed to act. Whether he failed to see the opportunity, didn’t understand it, or was simply not interested is moot. Rather than bring vested banking interests to heel, the Obama administration instead chose to reconstitute, as much as possible, the very same industry whose reckless pursuit of profit had thrown the world economy off the cliff. There would be no Nixon goes to China moment from the architects of the policies that created the crisis, namely Treasury Secretary Timothy Geithner, Federal Reserve Chairman Ben Bernanke, and Director of the National Economic Council Larry Summers.

Defenders of the administration no doubt will content that the public was not ready for measures like the putting large banks like Citigroup into receivership. Even if that were true (and the current widespread outrage against banks says otherwise), that view assumes that the executive branch is a mere spectator, when it has the most powerful bully pulpit in the nation. Other leaders have taken unpopular moves and still maintained public support.

Obama’s repudiation of his campaign promise of change, by turning his back on meaningful reform of the financial services industry, in turn locked his Administration into a course of action. The new administration would have no choice other that working fist in glove with the banksters, supporting and amplifying their own, well established, propaganda efforts.

Thus Obama’s incentives are to come up with “solutions” that paper over problems, avoid meaningful conflict with the industry, minimize complaints, and restore the old practice of using leverage and investment gains to cover up stagnation in worker incomes. Potemkin reforms dovetail with the financial service industry’s goal of forestalling any measures that would interfere with its looting. So the only problem with this picture was how to fool the now-impoverished public into thinking a program of Mussolini-style corporatism represented progress.

How did the Administration and financial services message control teams work together?

The first was the refusal to consider investigations of any kind. Obama is widely reported to have studied the early days of Franklin Delano Roosevelt’s administration for inspiration; it would be impossible for him to miss the dramatic steps FDR took, including supporting the continuation of a Senate Banking Committee investigation into the misdeeds of the Roaring Twenties, the Pecora Commission. The Pecora Commission not only kept the bankers on the defensive, but it also did the forensic work into the abuses. It was critical to bring the nefarious practices to light to devise durable and lasting reforms.

Why were there no inquiries into how the firms that needed bailouts got themselves into a mess? This was an obvious and comparatively easy avenue of inquiry which would make a great deal of useful background accessible and identified issues for further examination. For instance, after the rescue of UBS, the Swiss Federal Banking Commission required UBS to provide an extensive report of what went wrong, and also had the bank make considerable portions of that information public, via a special report to its shareholders. Yet no US firm has been asked to make any explanation of how it managed its affairs so badly as to require extensive public support to keep from failing.

The choice here was obvious. A refusal to investigate was tantamount to a refusal to reform. A good understanding of what had happened was essential, not merely to develop sound new rules, but also to keep the industry from muddying the waters, which would be easy to do, given how complex and opaque many of the products are

More compelling evidence of the Administration’s lack of interest in reining in the money-changers came via Treasury Secretary Timothy Geithner’s first presentation on his reform plan, which was more accurately a plan to have a plan. It was widely criticized for its sketchiness, but most observers missed the true significance. Had the Obama transition team done any serious thinking about the financial crisis? Obviously not, because you don’t need to think too hard if the game plan is to go back to business as usual to the extent possible. Geither’s presentation came nearly three weeks after Obama was sworn in, and all its initiatives were Bush/Paulson wine in new bottles: a new go at the failed idea of having the government overpay for bad bank assets; “stress tests” to put more discipline around the process of handing out TARP funds to the needy; and a mortgage modification program which pretended to be able to square the circle of saving borrowers without taking on investors in mortgage securitizations.

Geithner’s not-much-of-a-plan exemplified the second tool in the Obama campaign to sell doing as little as possible to the financiers: the Theory of Positive Thinking.
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That notion has a proud tradition in America and was much in evidence in the run-up to the crisis. It promises that the economy will be fine as long as everyone thinks happy thoughts about it. For instance, I noted in a March 2007 blog post that while the tone of the Financial Times as of March 2007 had become generally grim, the US had become a Tinkerbell market, where valuations are held aloft by faith, and participants conspire to stoke true belief. And as the crisis wore on, other magical personages intervened. As a hedge fund manager who writes as Augustus Melmotte noted,

The market responded with enthusiasm to reports that the Tooth Fairy has agreed to acquire Lehman. The purchase price has not yet been determined and will be set by Dick Fuld wishing upon a star, clicking his heels three times, and being transported back to that magical place where Lehman still sells for over $70 per share….. Meanwhile, the SEC has announced an investigation of mean, evil, bad short-seller David Einhorn. …. Einhorn reportedly suggested that the Tooth Fairy does not exist and that wishing upon a star is not a wholly reliable price discovery mechanism. Christopher Cox, chairman of the SEC, said, “Vicious rumors attacking the Tooth Fairy will not be tolerated. Our entire financial system and indeed the American way of life depend on the Tooth Fairy and wishing upon a star…” The SEC is reportedly planning to set up re-education camps for short-sellers.

Remember that the US has an entire cable channel devoted to the Theory of Positive Thinking, namely CNBC, and a goodly portion of the financial media falls into CNBC-style cheerleading with more than occasional abandon.

Now it is true that this idea has a kernel of truth. John Maynard Keynes attributed the Depression to a change in investor “liquidity preferences,” which meant they had suddenly become very risk averse and preferred to hold cash until they felt conditions had improved, with devastating consequences for economic activity. Uncertainty can morph into a self-reinforcing downcycle. But it is one thing to use confidence boosting as a tool, quite another to regard it as a magic bullet. Merely clapping our hands all together will not cure the long-standing ailments in the economy.

Moreover, the Theory of Positive Thinking has been used, upon occasion, to suggest that conditions will only deteriorate if the public examines the financial services industry critically. It isn’t hard to see whose interests benefit from that posture.

Now it is hard to prove in a tidy way that the tone of financial press coverage had shifted suddenly, and decisively, to optimism as of early March. But many professional investors in my circle started regularly talking of cheerleading. Two Wall Street veterans, Sandy Lewis and William Cohan, weighed in on this pattern at the New York Times:

Whether at a fund-raising dinner for wealthy supporters in Beverly Hills, or at an Air Force base in Nevada, or at Charlie Rose’s table in New York City, President Obama is conducting an all-out campaign to try to make us feel a whole lot better about the economy as quickly as possible… We’re concerned that nothing has really been fixed. We’re doubly concerned that people appear to feel the worst of the storm is over — and in this, they are aided and abetted by a hugely popular and charismatic president and by the fact that the Dow has increased by 35 percent or so since Mr. Obama started to lay out his economic plans in March.

This result relied on more than mere dint of personality. A Pew Research Center study found that roughly government and businesses originated over half the economics-related news after the crisis. Obama himself “dominated” the key images and ideas. The reporting had a clear arc. The early coverage focused on the struggles over the stimulus plan and the banking industry plans, and as those faded, so did coverage of the crisis in any form. The tacit assumption was that the crisis was over, and the performance of the supposedly forward looking stock market was proof. But as anyone with a modicum of detachment could see, the market was a false positive, treating an aversion of utter disaster as an imminent return to normalcy.

The stock market has rallied over 60% from its early March lows, enabling the wounded banks to sell new equity to the public and avoid further contentious taxpayer-funded rescue measures. But the justification for the soft glove treatment of the banking classes, that what was good for them would prove to be good for everyone else, has proven to be wildly false. When the Dow levitated over 10,000, mainstream news outlets celebrated the event, with nary a mention of the continued train wreck in the real economy. As Matt Taibbi observed, “the dichotomy between the economic health of ordinary people and the traditional ‘market indicators’ is not merely a non-story, it is a sort of taboo — unmentionable in major news coverage.”

But banking boosterism has succeeded all too well, allowing Team Obama to fantasize that it can get away with creating Potemkin prosperity in lieu of waging the pitched battles needed to lay the groundwork for the real thing.

Indeed, the adoption of the Theory of Positive Thinking has virtually guaranteed that nothing will change, unless there is sufficient deterioration in the real economy or the financial markets to provide compelling counter-evidence. One example is the “paying back the TARP” charade. As the banks continued to post improved earnings, no matter how phony they were, they argued that they were now healthy and should be allowed to pay back the TARP funding that had been crucial to their survival. The reason they were so keenly motivated to do should have been reason enough to deny their request: namely, that they wanted to escape restraints on executive compensation, virtually the only demand that the government had made. But overpaying staff and keeping too little in the way of risk reserves was precisely the behavior that led to the near collapse of the financial system. Going back to business as usual would virtually guarantee more looting of major financial firms and another series of collapses.

But the Obama administration miscalculated badly. First, it bought the financiers’ false promise that massive subsidies to them would kick start the economy. But economists are now estimating that it is likely to take five years to return to pre-crisis levels of unemployment. Obama took his eye off the ball. A Democratic President’s most important responsibility is job creation. It is simply unacceptable to most Americans for Wall Street to be reaping record profits and bonuses while the rest of the country is suffering. Second, it assumed finance was too complicated to hold the attention of most citizens, and so the (non) initiatives under way now would attract comparatively little scrutiny.

But as public ire remains high, the press coverage has become almost schizophrenic. Obvious public relations plants, like Ben Bernanke designation as Time Magazine’s Man of the Year (precisely when his confirmation is running into unexpected opposition) and stories in the New York Times that incorrectly reported some Goldman executive bonus cosmetics as meaningful concessions have co-existed with reports on the abject failure of Geithner’s mortgage modification program. While mainstream press coverage is still largely flattering, the desperation of the recent PR moves versus the continued public ire and recognition of where the Adminsitrations’s priorities truly lie means the fissures are becoming a gaping chasm.

So with Obama’s popularity falling sharply, it should be no surprise that the Administration is resorting to more concerted propaganda efforts. It may have no choice. Having ceded so much ground to the financiers, it has lost control of the battlefield. The banking lobbyists have perfected their tactics for blocking reform over the last two decades. Team Obama naively cast its lot with an industry that is vastly more skilled in the the dark art of the manufacture of consent than it is.