Wall Street Still Doesn’t Get It

Forget the bonuses. Sure, it is disgusting that Wall Street is funneling government bail-out funds straight to what my colleague Bill Black calls the “control frauds”—the top managers of financial institutions. And, yes, they are blowing the black hole of financial insolvency bigger day by day even as they thumb their noses at Washington while Timmy Geithner and Ben Bernanke look the other way. But what is even more disturbing is that Wall Street is still maniacally creating risk, inventing new ways to bet on the death of “peasants”, economies, and nations.

Previously, Marshall Auerback and I have written about the securitization of “life settlements” (see here). A Wall Streeter buys the life insurance policies of individuals with terminal illnesses, packages them into securities, and profits when the underlying collateral dies. In his most recent movie, Michael Moore documented the practice of taking out “peasant insurance” on employees. Now we learn that firms continue to carry life insurance on former employees, hoping they will die untimely deaths so that the firm can collect (see here). We know how devastating unemployment is for most people, ruining their marriages, mental and physical health, and social life. Hey, why not fire employees in the midst of the worst downturn since the Great Depression, when chances of finding another job are nil? That ought to hasten death. And if a firm can hold life insurance policies on former employees, why not take out policies on down-and-outers who never worked for the firm? Death is the new profit center, packaged and sold by Wall Street insurers.

Second, there is of course Greece. Goldman Sachs sold them financial products to disguise their budget deficits. Of course, Goldman argues that it was doing nothing unusual—it has been creating complex products to hide risk for decades (see here and here). Goldman gets huge fees, but of course the risks always come back to bite its suckers. However, in the case of Greece, Goldman might have bit off more than it can chew. From 2001 through November 2009 Goldman created financial instruments to hide European government debt, for example through currency trades or by pushing debt into the future. But not only did Goldman help (and perhaps even encourage) Greece to take on more debt, it also apparently brokered credit default swaps on Greece’s debt—making income on bets that Greece would default. We don’t know whether Goldman has placed its own bets on the death of Greece—nor is it clear what role Goldman has played in whipping up hysteria about the likelihood of default, but the bank is almost certainly benefiting by the booming business in default “insurance”. As CDS prices rise and Greece’s credit rating collapses, the interest rate it must pay on bonds rises—fueling a death spiral because it cannot cut spending or raise taxes sufficiently to reduce its deficit. And it is probable that other Euronations—perhaps Italy and Portugal—used similar financial products sold by Wall Street. While Washington will not do anything to constrain Goldman, it looks like the European Union, which is launching a major audit, just might banish the bank from dealing in government debt.

Finally, according to a report, Citi is going to launch a new derivative that will allow gamblers to bet directly on financial crises. here Rather than betting on the death of an individual, firm, or government Citi would create a tradable liquidity index, the CLX. Essentially this would allow one to place a bet that a liquidity crisis would occur. If funding costs spike in a run to liquidity the derivative sellers would have to pay. Recall that our current financial collapse began with just such a liquidity “event”: the commercial paper market dried up, which meant that holders of mortgage-backed securities could not continue to finance their positions. The CLX products are supposed to hedge the liquidity risk of a spike of funding costs. The problem, of course, is exactly the one faced by those who had bought CDS “insurance” from AIG: counterparty risk. As Cambridge Professor Chris Rogers says, “This is basically a kind of insurance product. The main issue is: how good is the party issuing it? If it’s going to be paying out huge numbers in the event of a crisis, will it be able to meet obligations? Insurers can buy reinsurance for their liabilities, but the buck has to stop somewhere—there’s a limit to how much a private insurer can pay out. Only the government can cover unlimited losses.” Hence, only the chosen few “too big to fail” sellers of this kind of insurance will be able to play the game. That is, folks like Goldman, J.P. Morgan, Citi, and Bank of America. And guess who will get stuck with the bill when the whole scheme crashes? You betcha, it will be the Treasury.

And that is what this whole Wall Street house of cards boils down to: risky bets, private profits, socialized losses. Worse, yet, it misaligns interests so that Wall Street profits are higher if there is economic and social instability—and Wall Street is powerful enough to generate exactly those conditions. Until Wall Street is constrained and downsized, it will continue on its path of death and destruction.

In spite of all the happy talk about the end of the recession and the successful resolution of the financial crisis, things are much worse today than they were two years ago. Commercial real estate is toast. Option ARMs (the toxic mortgages with low teaser rates) are resetting ahead of schedule because of clauses that allow mortgage holders to jack up rates as homeowners go underwater. Every class of consumer debt—much of it securitized—looks a lot like subprime mortgages. Euroland and Japan are cratering, the UK is going to try to reduce its budget deficit, and even China has decided to slow its growth to reduce inflation pressures. Note that all of these markets are linked, and for every debtor that goes delinquent there are numerous linked financial products that go bad. There are well over $500 trillion of those products still floating around. While it is true that every derivative has both a buyer and a seller—so that every “event” should be a zero-sum game, with the seller paying the buyer—that works only if bad bets can be covered. But we know that Wall Street institutions are not good counter-parties. So what happens instead is that there is a rush to liquidity as everyone tries to sell out positions in assets to cover their commitments, causing asset values to plummet. Be prepared for another global crisis by summer. And also get ready for another Washington bail-out of Wall Street, because the $23 trillion promised so far will not be enough.

So here’s the best policy. Unwind the $23 trillion committed by the Treasury and the Fed. Let the market operate. It wants to close down all the “too big to fail” institutions. The market is right—these institutions are not necessary, indeed, they represent the biggest problem facing the financial sector. Their CEOs instinctively recognize that these institutions serve no useful purpose—which is why their efforts are directed to creation of ever more dangerous and socially destructive financial products. As I have said before, Washington needs to get on the right side of the leverage ratio: for every dollar of real productive activity and income generated, there can be $30 or more of leveraged financial bets. Rather than trying to make all of those good, it makes far more sense to allow default to wipe out the bets, and then work to save the productive activity, jobs, and income.

I know that Wall Street’s protectorate, led by Geithner, Rubin, and Summers, will claim that failure of the behemoths will create an economic disaster. But that is not true. All real economic fall-out can be contained and the economy will emerge much healthier. Replace Wall Street’s life support with support for mainstreet. Start with a payroll tax holiday (don’t collect any payroll taxes from employers or employees for the next two years); add $500 billion for direct job creation to immediately get to full employment; add another $500 billion for relief of state and local governments distributed on a per capita basis; and give all mortgaged homeowners the option of immediate default with a “rent to own” plan. True recovery would begin immediately, and we’d be out of the mess by summer.