Daily Archives: November 7, 2011

Did Dodd-Frank Act End “Too Big To Fail”?

By Robert E. Prasch

Since the triumphal passage of the Dodd-Frank Wall Street Regulation and Consumer Protection Act on 21st of July 2010, we have been told repeatedly that the United States would “never again” be confronted with a “choice” between bailing out a large insolvent financial institution “or else.” If so, this means that one of the most pernicious and damaging features of capitalism has been forever solved. Were we convinced that the 111th Congress and the Obama Administration had actually achieved this, all right-minded persons would surely exclaim, “What a gift to the country, what a gift to humanity!” Yet, it is evident that few of us are doing that. Is the problem in ourselves? Are American voters hopeless ingrates? Or, is it that our suspicions are well-grounded?

With the emergence of Occupy Wall Street only a year before the 2012 elections, the prospects and promise of the Dodd-Frank Act is – as it should be — pivotal to our assessment of the record of this Congress and Administration. As such, let us take a moment to contemplate the specifics of the much-vaunted process that – we are told – will ensure the most important promise of Dodd-Frank – the anticipation and prevention of another fantastically costly bailout. The recent and very public troubles of Bank of America suggest that a test may be coming soon. If Dodd-Frank works as advertised, BofA’s pending failure should not cost the public a cent – and that certainly is good news, is it not? 

To assess this core claim of Dodd-Frank, let us contemplate the specifics of the process that will — we have been told — successfully identify, take over, and resolve large systemically important financial institutions before they fail. To reiterate, we have been told that firms fitting this description can and will be taken over before they are insolvent, and especially before the problem becomes a charge on the public purse. As this process is best understood by an example, let us begin by supposing that one of the nation’s largest systemically important bank holding companies (BHC) is in trouble (although it could be any financial institution designated previously as systemically important). Let us further suppose that this BHC – as so many do — relies upon short-term borrowing in the markets to support a highly-leveraged portfolio of speculative, risky, and now-troubled assets. To keep it real, let us suppose that few of these assets can be traded and thereby “priced” in open or competitive markets. It is, of course, unnecessary to point out that when traders and senior managers put together these deals they greatly enriched themselves. But, they have long since cashed their bonus checks, so the problem now belongs to the bank – and potentially the public.

Today, the BHC’s stock price is falling, credit default swap premiums on its assets and the debt it issues are rising, and counter-parties are demanding ever-greater collateral to provide short-term financing. Many money-managers who have had long-standing lending relationships with this bank are refusing to provide further financing at any price, and large clients are beginning to withdraw their funds and move their accounts. Stated bluntly, the future of this firm is bleak and the situation is worsening at an accelerating pace.

What happens now? The bank’s first defense is — as always — a flat-out denial that they are in trouble. But such protests are unlikely to convince its peers, big-time money managers, or other savvy counter-parties or players. In the nineteenth century, it used to be said that if a lady had to publically defend her reputation, it was too late. Times may have changed in these matters, but for financial institutions this old adage remains true. A need to publically proclaim its solvency can — and should — be taken as prima facie evidence that a bank either is, or is about to be, insolvent. Let us, then, suppose that the situation continues to worsen for our hypothetical firm.

The bank’s second step is to highlight its internal audit, along with the clean bill of health it has received from its highly reputable outside accountants and lawyers. Wall Street will not be convinced. Why? Because they know that these audits are readily and routinely rigged through “creative accounting.” To illustrate this point, I have my classes guess how many quarterly earnings statements showed losses at New Century Financial before its massive collapse in March 2007. The answer, dear reader, is zero. The process by which one goes from being a high-flying and highly-profitable darling of financial innovation to catastrophic bankruptcy without ever passing through an unprofitable quarter is, I will submit, “complicated.” Indeed, the SEC also thought that it was “complicated” and brought a suit. Unfortunately, this suit was settled for essentially a pittance – a “lesson” not lost on other Wall Street players and those who are obliged to interact with them. Least this case be considered a singular event, I remind them that S&P gave Lehman Brothers an “A” rating until weeks before its collapse. Similar examples abound throughout this and earlier crises.

Third, an upsurge of campaign “donations” from the troubled BHC will ensure that at a substantial portion – if not a majority — of Congresspersons will avidly assent to the firm’s own assessment of its condition and prospects (Let us note that if it is indeed insolvent, these donations and other lobbying and public relations expenses are de facto additions to the federal debt). Although the reasoning and arguments then presented to the public by these august tribunes of the people might be embarrassingly shallow, we can be sure that they will lean on the political appointees heading the regulatory agencies to take “a broad interpretation” of the situation. Simultaneously, the bank’s senior compliance and legal advisors, who in all likelihood are former senior staff at the regulatory agencies to which it answers, will contact their old colleagues to argue and reargue the bank’s version of its financial condition. They will emphasize its singularly sunny prospects for future success.

Let me digress by observing that it will not escape the attention of those who staff the government’s regulatory agencies that their former colleagues have moved into substantially higher tax brackets and much tonier neighborhoods. To that end, perhaps we should allow our regulators to indulge in a moment of wistfulness. After all, in the aftermath of such reunions it is only human to feel somewhat conscious of one’s own comparably modest socio-economic status. If our public servants are at all like most people, they might pause to consider a career move… But such ruminations are beside the point. Or are they?

Let us suppose that our regulators remain stalwart, undaunted, resolute, and unmoved by such considerations. They are good people, professionals who readily eschew fantastic opportunities to remain faithful public servants. Nevertheless, as a consequence of the bank’s previous moves, Congress is in an uproar, the White House is worried, and Wall Street has closed ranks behind the bank (the latter are sufficiently intertwined with its fortunes that they stand to take large losses). Outside of the halls of power, think-tank “experts,” television “opinion leaders,” newspaper reporters, and editorialists are running unfavorable stories about the supposed “anti-market” bias of regulators, etc. Meanwhile, the regulators, if they are doing their job properly, are not conducting interviews or discussing the story with the media. Consequently, their side of the story – and only they have access to the bank’s balance sheet – is underrepresented in the press. Moreover, those few newspapers running stories that suggest that the bank’s problems may be real will be accused of being irresponsible or anti-business. They may even have been – quietly — threatened with lawsuits claiming libel. We should recall that even spurious lawsuits can be expensive for most daily or weekly newspapers.

As the disinformation campaign moves into high gear, the regulators must get the Board of Directors of the FDIC to vote that this bank is on the brink of collapse and for that reason should be taken over quickly, before it becomes insolvent and thereby a public charge. This Board, let us recollect, is made up of three permanent members serving six year terms in addition to the head of the Office of the Comptroller of the Currency and the head of the Office of Thrift Supervision, who both serve in ex officio status. All of them are appointed by the President with Senate approval and no more than three of the five of them may be from the same political party. Stated simply, the Board may represent a variety of views, but we can be confident that the largest financial institutions have had an opportunity to carefully vet all of the participants in the discussion. After all, few administrations or senators have the stomach to fight the nation’s most powerful industry over what — to the public — may appear to be relatively obscure bureaucratic appointments. However, to give credit where it is due, over the last five years the FDIC is one of the few agencies to have shown some life in regulatory matters. One reason may be the personalities involved. Another may be that it is their funds that are used to cover depositors’ accounts and, for that reason, they are the agency left “holding the bag” in the event of a catastrophic failure.

Supposing that the FDIC has decided that this bank must be resolved, the next to vote is the Federal Stability Oversight Council (FSOC). This group is Chaired by the Secretary of the Treasury and its nine other voting members include the Chairman of the Federal Reserve Board, the Chair of the Commodity Futures Trading Corporation, the Comptroller of the Currency, the Chair of the Securities and Exchange Commission, etc. Each and every one of these individuals took their positions only after a Presidential appointment and a Senate hearing. Once again, banker views were fully present and accounted for. In short, these are people known in Wall Street/D.C. circles for their “sound views” — that is to say long-standing sympathy toward politically prominent banks, bankers, and related financial institutions. In many if not most instances, they were themselves formerly bankers or worked in law or accounting firms catering to the financial sector. This characterization also describes the bulk of their deputies. The final step is to formerly notify and advise the President of the FSOC’s decision. While lawyers and others who have examined Frank-Dodd have not agreed as to whether the President has the authority to override a vote of the FSOC, it is difficult to imagine that these several senior appointees would have allowed the process to advance this far without White House approval.

Now, let us recall that all of the above will occur as the large financial institution in question is in the throes of a rapid and accelerating downward spiral – yet it is supposed to be completed even as the firm remains – if just barely – solvent. While the Feds might try to keep their deliberations a secret, it is hard to imagine that financial markets will long remain in the dark about them. For that reason, the bank in question will find that it must post ever-greater collateral to retain the short-term financing it requires to operate. Credit Default Swaps will soar, ratings agencies might decide to (belatedly) issue a downgrade on the firm’s debt, and the bank will struggle to place its commercial paper or otherwise raise funds. Consequently, it will become increasingly dependent upon the Fed’s Discount Lending facility, which means that that latter institution stands to be even more embarrassed by the pending failure, and for that reason inclined to postpone the resolution of this bank.

Since the passage of Dodd-Frank a year ago, I have attended multiple conferences in a variety of locations in the United States and Canada. At each of them, I have informally polled a range of colleagues studying monetary and financial economics to find out if they believed that the above process has any chance of working as described. I specifically ask them if they believe that the FDIC and FSOC could (1) identify a pending failure some time before it becomes insolvent, and then (2) organize the regulatory and political will to take over a massive, interconnected, and politically powerful institution, and (3) navigate the process of arriving at a decision in a time frame sufficiently short to avoid a massive run on the institution, a run that could readily spread to similar institutions and to those firms dependent upon them. Let us recall that the prevention of just such a run is the primary task of financial regulation. To date, I have not found a single individual who believes that it will work.

For myself, I will continue to accept the view of Vermont Senator Bernie Sanders (I-VT), that “If an institution is too big to fail, it is too big to exist.” Despite what we were told, alternatives to Frank-Dodd do, and did, exist. For example, on November 6th 2009, Senator Sanders introduced legislation that would give the Secretary of the Treasury 90 days to report to the Senate with a list of commercial banks, investment banks, hedge funds, insurance companies, and other financial institutions that were “Too Big To Fail” (TBTF). The Secretary would then be granted a year from the date of that report to break them up. Sanders’ bill was not taken up.

Later, Senators Sharrod Brown (D-OH) and Ted Kaufman (D-DE) actually got a bill called the SAFE Banking Act of 2010 to the Senate floor. It would have imposed binding leverage and liability limits on bank holding companies and financial institutions, thereby effectively breaking up the largest of them. This bill was opposed by most Republicans and leading Senate Democrats (including Senators C. Dodd (CT), D. Feinstein (CA), J. Kerry, and both Senators from New York and New Jersey). The White House and the Treasury Department were also opposed. Unsurprisingly, it failed by a vote of 61-33 on June 17th, 2010 despite attracting the support of three Republicans. Senator Judd Gregg (R-NH), whose “centrist” views had once moved the Obama Administration to nominate him for Secretary of Commerce, summarized the sentiments of those voting against this act, “I don’t understand this Brown-Kaufman Amendment. Basically, what it says is if you’re successful … you’re going to break them up? I mean, where does this stop?”

Alternatives to Frank-Dodd’s cumbersome resolution authority clearly exist, and continue to exist. The key is prevention – do not allow individual banks to become so large or so leveraged as to threaten the system (while the system itself can be a source of risk, that is a separate issue). The problem was and remains a lack of political will on the part of both political parties. On the matter of Too Big To Fail, Occupy Wall Street and the broader American public are themselves asking, “Where does this stop?” Good question, maybe the Senator from New Hampshire, one of his colleagues from the Democratic Party, or someone from the Treasury or the White House will deign to let us know. 

Robert E. Prasch is Professor of Economics at Middlebury College where he teaches courses on Monetary Theory and Policy, Macroeconomics, the History of Economic Thought, and American Economic History. His latest book is How Markets Work: Supply, Demand and the ‘Real World’ (Edward Elgar, 2008).

MMP Blog #23: The Debate About Debt Limits (US Case)

This week we will look at a “special case”, and one that preoccupied Washington recently.As we know, governments spend by keystrokes that they can never run out of–asovereign government that issues its own currency through keystrokes can neverface a financial constraint. However, it can choose to “tie its hands behindits back” by imposing rules and procedures that limit its keystrokes. It could,for example, simply impose a limit of “100 keystrokes per year”. It couldrequire the Treasury Secretary to climb Mount Everest or to seek approval fromterrestrial or extra-terrestrial gods before he is allowed to enter akeystroke. It could require a solar eclipse or similar “miracle” beforegovernment is allowed to credit a balance sheet.

We shouldnot be fooled by such self-imposed constraints. We should be able to seethrough them to understand that since they are imposed by government on itself,they can be removed. Unfortunately, virtually all economists and policymakerscome to see such self-imposed constraints as “natural”, something to neverviolate. Today we will look at the US “debt limit” that consumed policy makersin the US last summer—and will likely be visited again.

Before weproceed, let me acknowledge that I’ve promised our wonky readers some balancesheets and a detailed treatment of internal operating procedures used by theFed and Treasury to get around the self-imposed constraints. I have notforgotten. That is a matter for a later post.

In theUnited States Congress establishes a federal government debt limit. When theoutstanding quantity of federal government debt approaches that limit Congressmust approve expansion of the limit. Note that this debt limit is establishedby policy, not by markets—that is, Congressional action is required byCongress’s own rules, and not by market pressure. Hence, it is not a questionof whether the US government could sell more bonds, or even over the interestrate it would pay on the debt it sells.

In the aftermath of the Global FinancialCollapse of 2007, the US budget deficit increased (mostly due to loss of taxrevenue, as discussed in a previous blog). Predictably, the amount of debtoutstanding grew to the limit, and so each year Congress has had to increasethe limit.

This blogwill look at current procedures to see if there is an alternative to increasingthe limit—while allowing the Treasury to continue to spend. We examined most ofthe details of the operating procedures in a previous blog; in this blog weextend that understanding to come up with an alternative procedure. We will usethe distinction between High Powered Money (Federal Reserve Notes, Reserves,and Treasury Coins) and Treasury Debt (bills and bonds)—only Treasury Debt isincluded in the debt limits, although we know that all of these are governmentIOUs.

So let ussee how we can untie Uncle Sam’s purse strings while living with current debtlimits. It is actually a relatively easy thing to do, requiring only a modestchange of procedure.

First weneed to review how things usually work. Congress (with the President’ssignature) approves a budget that authorizes spending. Treasury then eithercuts a check or directly credits a recipient’s bank account. While the USConstitution vests in Congress the power to create money, in practice theTreasury uses the US central bank, the Fed, to handle its payments. Currentprocedure is for the Treasury to hold deposits in its account at the Fed forthe purposes of making payments. Hence, when it cuts a check or credits aprivate bank account, the Treasury’s deposit at the Fed is debited.

TheTreasury tries to maintain a deposit of $5 billion at the close of each day.Taxes paid to the Treasury are first held in deposit accounts it has withspecial private banks. When it wants to replenish its deposit at the Fed,Treasury moves deposits from these banks. Obviously there are twocomplications: first, tax receipts bunch around tax due dates; and, second, theTreasury normally runs an annual budget deficit—more than a trillion Dollars in2011. That means Treasury’s account at the Fed is frequently short.

To obtain deposits, the Treasury sells bonds(of various maturities). The easiest thing to do would be to sell them directlyto the Fed, which would credit the Treasury’s demand deposit at the Fed, offseton the Fed’s balance sheet by the Treasury’s debt. Effectively, that is whatany bank does—it makes a loan to you by holding your IOU while crediting yourdemand deposit so that you can spend.

But currentprocedures prohibit the Fed from buying treasuries from the Treasury (with somesmall exceptions); instead it must buy treasuries from anyone except theTreasury. That is a strange prohibition to put on a sovereign issuer of thecurrency, if you think about it, but it has a long history that we will notexplore in this box. It is believed that this prevents the Fed from simply“printing money” to “finance” budget deficits so large as to cause highinflation–as if Congressional budget authority (and threatened Presidentialveto) is not enough to constrain federal government spending sufficiently thatit does not take the US down the path toward hyperinflation.

So,instead, the Treasury sells the Treasuries (bills and bonds) to private banks,which create deposits for the Treasury that it can then move over to itsdeposit at the Fed. And then the Fed buys treasuries from the private banks toreplenish the reserves they lose when the Treasury moves the deposits. Got that?The Fed ends up with the treasuries, and the Treasury ends up with the demanddeposits in its account at the Fed—which is what it wanted all along, but isprohibited from doing directly. The Treasury then cuts the checks and makes itspayments. Deposits are credited to accounts at private banks, whichsimultaneously are credited with reserves by the Fed.

In normaltimes banks would find themselves with more reserves than desired so offer themin the overnight Fed Funds market. This tends to push the Fed Funds rate belowthe Fed’s target, triggering an open market sale of treasuries to drain theexcess reserves. The treasuries go back off the Fed’s balance sheet and intothe banking sector. (With the Global Financial Crisis, the Fed changedoperating procedure somewhat—it began to pay interest on reserves, and adopted“Quantitative Easing” that purposely leaves excess reserves in the bankingsystem. That is a topic for another blog.)

And that iswhere the debt gridlock problem bites. Treasuries held by banks, households,firms, and foreigners are counted as government debt (and nongovernment wealththrough accounting identities!) and thus subject to the imposed debt ceiling.Bank reserves, by contrast, are not counted as government debt. (One solution isto just stop the open market sales of treasuries in order to leave the reservesin the banking system. That is essentially what Bernanke’s Quantitative Easing2 does: the Fed is buying hundreds of billions of treasuries to inject reservesback into banks—the reserves that were drained by selling the treasuries tobanks in the first place.) So we are getting treasuries back onto the Fed’sbalance sheet, and yet gridlock remains because there are still too manyTreasuries off the Fed’s balance sheet.

Here is aproposal to change procedures in a way that eliminates the need to raise debtlimits. When Uncle Sam needs to spend and finds his cupboard bare, he canreplenish his demand deposit at the Fed by issuing a nonmarketable “warrant” tobe held by the Fed as an asset. With the full faith and credit of Uncle Samstanding behind it, the warrant is a risk-free asset to balance the Fed’saccounts. The warrant is just an internal IOU—from one branch of government toanother—really not anything more than internal record keeping. If desired,Congress can mandate a low, fixed interest rate to be earned by the Fed on itsholdings of these warrants (to be deducted against the excess profits itnormally turns over to the Treasury at the end of each year). In return, the Fedwould credit the Treasury’s deposit account to enable government to spend. Whenthe Treasury spends, its account is debited, and the private bank that receivesa deposit would have its reserves at the Fed credited.

From theFed’s perspective it ends up with the Treasury’s warrant as an asset and bankreserves as its liability. The Treasury is able to spend as authorized byCongress, and its deficit is matched by warrants issued to the Fed. Congresswould mandate that these warrants would be excluded from debt limits since theyare nothing but a record of one branch of government (the Fed) owning claims onanother branch (the Treasury). The Fed’s asset is matched by the Treasury’swarrant—so they net out.
AndCongress would not need to increase the debt limit when a crisis hits thatresults in growing budget deficits.

Thisproposal just shows how silly it is to tie the Treasury’s hands behind its backthrough imposing debt limits. We already require that a budget is approvedbefore Treasury can spend. That constraint is necessary to imposeaccountability over the Treasury. But once a budget is approved, why on earthwould we want to prevent the Treasury from keystroking the necessary balancesheet entries in accordance with Congress’s approved spending?

Thebudgeting procedure should take into account projections of the evolution ofmacroeconomic variables like GDP, unemployment, and inflation. It should try toensure that government keystroking will not be excessive, stoking inflation. Itis certainly possibly that Congress might guess wrong—and might want to reviseits spending plan in light of developments. Or, it can build in automaticstabilizers to lower spending or raise taxes if inflation is fuelled. But itmakes no sense to approve a spending path and then to arbitrarily refuse tokeystroke spending simply because an arbitrary debt limit is reached.