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Under the Dodd-Frank financial reform law of 2010, Goldman Sachs had to break up its principal strategies group, the trading unit that had been very profitable. Goldman was considering several options, including moving the traders to another division or shutting the unit altogether. Morgan Stanley was considering ceding control of its $7 billion hedge fund firm, FrontPoint Partners. At Citigroup, executives had sold hedge fund and private equity businesses and were discussing reducing proprietary trading, which relies on a bank’s own capital to make bets in the financial markets. JPMorgan Chase had already begun dismantling its stand-alone proprietary trading desk and was modifying the structure of some investments of One Equity Partners, its internal private equity business. “This is the real stuff,” said Brad Hintz, an analyst at Sanford C. Bernstein & Company. “It shows that if you squeeze Wall Street, like a balloon it will come out somewhere else, and we really are squeezing Wall Street. Their business models are changing.”

However, loopholes in the legislation may enable the banks to continue to trade on their own books, even apart from serving as a counterparty for client transactions. Citigroup and others, for instance, are considering moving proprietary traders to desks that handle trades for clients, although the traders would still be able to make their own bets in the markets. The Volcker Rule’s definition of proprietary trading is open to interpretation. At first blush, it looks watertight: the rule forbids banks from buying and selling financial products for their “trading account.” That, in turn, is defined as an account meant to profit in the “near term” from “short term” movements in prices. Besides not covering such long term bets as shorting in anticipation of a fall in the housing market, the rule states that banks can still trade government and agency securities for their own account. Some of the problems at the hedge fund Long-Term Capital Management stemmed from trying to arbitrage prices between Treasuries of different terms. And the Carlyle Capital Corporation, a heavily leveraged debt fund, crashed in 2008 when prices of Fannie Mae and Freddie Mac mortgage bonds dropped. So in allowing for continued proprietary trading apart from serving as a short-term counterparty for a client’s transaction, the Dodd-Frank Financial Reform law may not change Wall Street’s landskip all that much. This is hardly surprising, as members of Congress allowed the banking lobby to participate in the writing of the legislation in spite of the industry’s culpability in the financial crisis of 2008.

Click to add a question or comment on proprietary trading and financial reform.

Sources:
http://www.nytimes.com/2010/08/06/business/06wall.html?_r=1&scp=2&sq=wall%20st%20faces%20specter%20of%20lost&st=cse
http://www.nytimes.com/2010/08/06/business/06views.html?scp=1&sq=anthony%20currie%20christopher%20swann&st=Search

To simplify how Goldman Sachs got into trouble with the SEC: According to Annie Lowrey, the hedge fund Paulson & Co. handpicked mortgage-backed securities that were doomed to stop performing, being backed with subprime mortgages, and Goldman packaged them into a kind of bond. Paulson & Co. bet against the bond by buying short-sales, with Goldman acting as the broker. At the same time, Goldman sold the bond to other clients without disclosing that Paulson had engineered the bond to fail. The SEC filing notes that those other clients lost $1 billion. Goldman had no direct stake in the success or failure of the CDO. It made money either way. “This litigation exposes the cynical, savage culture of Wall Street that allows a dealer to commit fraud on one customer to benefit another,” Chris Whalen, a bank analyst at Institutional Risk Analytics, said in a note to clients on April 16, 2010. Someone at Goldman said on the same day that “the SEC’s charges are completely unfounded in law and fact.” If the SEC charges hold up (and it is doubtful that the agency would bring such charges without supporting documentation; it is more apt to miss something than go overboard), I am astonished that the people at Goldman simply dismissed the matter out of hand. It might make sense as their legal defense, but if the bankers are convicted, those lying ought to be fired even if they were not a party to the scheme. It also appears that the bankers lied about whether they made money in betting against the housing market. “The 2009 Goldman Sachs annual report stated that the firm ‘did not generate enormous net revenues by betting against residential related products,’ ” Senator Levin, chairman of the US Senate’s committee on investigations, said in a statement in April, 2010. “These e-mails show that, in fact, Goldman made a lot of money by betting against the mortgage market.” When a spokesperson for the bank says something in the future, a rational person will be wont not to trust him or her. Lying has (or ought to have) consequences rather than being dismissed as harmless PR or a legal defense. The bank’s credibility is at issue here. The SEC has accused Goldman of outright lying to customers in order to make money both ways on a deal. Even though this ought to reflect negatively on Goldman’s future business, bigger issues involved that ought to consume more of our attention than how Goldman fares.

Given the strength of the financial sector’s lobby in Washington, this case involving Goldman suggests that we, the American electorate, were unwittingly putting our financial system and our republics in danger by enabling the lobby to have such effect in watering down the regulatory reform in the wake of the financial crisis of 2008.

In the election cycle in which the US Senate’s agricultural committee took up legislation that would regulate all derivatives (2010), people and organizations affiliated with financial, insurance and real estate companies gave members of the committee $22.8 million. Wall Street firms raised $60,000 at two fund-raisers for the committee’s chair’s re-election campaign in the cycle before the committee took up the legislation. Many of the chairs constituents want a crackdown on the speculation. This put Blanche Lincoln in a difficult situation, ethically speaking. At the very least, accepting money from the firms that would be subject to the legislation involves the appearance of a conflict of interest. I contend that given human nature, even such an appearance ought to be avoided or even outlawed. At the very least, it is unseemly in a republic, and I would argue dangerous to its viability.

Furthermore, as if the banks’ culpibility in the crisis was not sufficient to cancel their reservations at the regulatory table, the Goldman case strongly suggests that the banks ought not to be trusted as contributors to regulatory reform. And yet they push ahead to reduce the regulatation, in spite of it all. A child who drops his milkshake doesn’t turn around and tell his mother that she better not clean it up and that she had better not get involved if it happens again. Rather, such a child stands back. As if there is not enough of a natural feeling of shame at having made a mess, there is, or ought naturally to be, an even greater sense of shame in presuming to be in a position to direct the clean-up according to one’s self-interest over objections that the person who caused the problem is not the one best suited to fix it. Even if corporations can enjoy the legal fiction of personhood, there are actual human beings running them, and it is telling when those people dismiss their innate shame in their presumption–even pretending that it is not presumption! We are to blame in not calling them on it, and relegating them. We must relegate them if they won’t do it for themselves, as would be natural for them to do. In other words, we ought to call the artiface for what it is and relegate it as a parent would naturally tell a spoiled and misbehaving yet dogmatic child to go to his room. We, the American people, are enablers; bad parents. We ought to look toward solving the bigger problem, which the case of the Goldman children intimates.

The theory of regulatory capture points to the government’s need for information that the industry being regulated can provide. This theory ignores the broader power-base that an industry is apt to have in lobbying the government (and supporting candidates). In other words, information is just small change from the standpoint of an industry’s ability to influence a government. A better theory would have its primary focus on the macro level, asking the question, in effect, whether (and how) a republic is compromised by its moneyed corporations and banks. Besides looking at campaign finance law and uncovering actual lobbying practices, we ought to look at how much the society in question values money, commerical gain, wealth and economic freedom. We ought not be limited to the managerial or technocrat perspective in ascertaining whether our financial system and indeed our very republics are in danger from being used by unscrupulous firms or industies according to that which fits their peoples’ desires. Once we have uncovered the real problem, we really won’t have any excuse for not fixing it, and we would be bad parents indeed if we let the children fix it.

Sources:
http://washingtonindependent.com/82571/sec-charges-goldman-sachs-over-subprime-tied-product  http://opinionator.blogs.nytimes.com/2010/04/16/goldmans-stacked-bet/?ref=opinion
http://money.cnn.com/2010/04/16/news/companies/sec.goldman.fortune/index.htm?postversion=2010041616 ; http://money.cnn.com/2010/04/16/news/companies/goldman_sachs_questions.fortune/index.htm?postversion=2010041615 ; http://www.nytimes.com/2010/04/20/business/20derivatives.html?hp
http://www.nytimes.com/2010/04/25/business/25goldman.html?ref=us

To put a matress under a falling giant pales in comparison to placing a sign on Wall Street, reading “No giants allowed.”

In April of 2010, President Obama gave a speech in New York City to counter what he called “the furious efforts of industry lobbyists” trying to weaken or kill new financial regulations that he claimed are needed to stave off a second Great Depression.  It is telling that the banks that contributed to the financial crisis of 2008 were trying to diminish any new regulation. The President wanted more consumer protections, limits on the size of banks and the risks they can take, reforms on executive compensation and greater transparency for controversial securities known as derivatives.  He maintained that each of these areas must be in any bill that he signs. In giving the speech with some of the banking titans in the audience, the President wanted to confront the financial industry more directly through a sharp speech. After castigating their “failure of responsibility” in recent years, he called on them to stop resisting tighter regulation through the army of lobbyists now staked out on Capitol Hill. The president’s address at Cooper Union in Lower Manhattan circled back to another speech he had given at the same location in March 2008 warning of financial manipulation, market bubbles and the concentration of economic power.

Analysis:

At the time of his speech, the President was supporting the bills coming out of the House and Senate, neither of which forestall or minimize market bubbles and reduce the concentration of economic power.  Regarding the latter, it is my understanding that nothing in either bill limits the the size of the big banks.  For the President to say that the bill reaching his desk must include something limiting the size of institutions in the US financial sector yet also say that he supports the bills coming out of Congress does not make sense as it involves a contradiction. On the eve of the President’s speech, Fox News pointed out that the President’s chief of staff had met behind closed doors with reps of Wall Street firms. The message was reportedly: we’ve got to trash you in public, but know that we will take care of you in private.  While Fox News was at the time certainly no friend of the President, the account would explain why the President would contradict himself concerning the size issue.   Given the inevitable lag of regulators amid the fast pace of innovation in product development on Wall Street, simply regulating existing products would not forestall another crisis; the concentration of private capital in the form of large banks must be reduced for “too big to fail” to be effectively mitigated.  Sadly, the President will probably get away with demanding limits on the banks’ size while signing bills that do not contain such language.  That he received just under a million dollars from Goldman Sachs in his Presidential campaign is just part of the story, for once elected the President was undoubtedly focused on 2012.  Recalling Andrew Jackson, who successfully took on the bank of the US by refusing to fund it in 1832, and Theodore Roosevelt, who supported the Sherman Anti-trust Act in 1911, I must admit to thinking that Barak Obama does not have their guts to take on the big guys. How many of us in the twenty-first century remember Jackson or Roosevelt?  We are more likely to make our current President the default from which we measure.  I submit that this is a mistake.  If we ignore or are ignorant of the strong points in our history, we cannot benefit from them and we are doomed to repeat the weak points.

Source: http://www.nytimes.com/2010/04/23/business/economy/23prexy.html?hp

For years, banks and other issuers have paid rating agencies to rate their securities. This is a bit like restaurants paying food critics to write on their food.  In the wake of the SEC’s charge that  people at Goldman Sachs built the Abacus investment to fall apart so a hedge fund manager, John A. Paulson, could bet against it, the Senate’s Permanent Subcommittee on Investigations questioned representatives from Moody’s and Standard & Poor’s about how they rate risky securities. Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.” Throughout the testimony, the institutional conflict of interest was salient whereby credit-rating agencies put market-share considerations foremost in rating securities presented by the banks that are paying the agencies. Someone at one bank, J. P. Morgan, went so far as to communicate to one of the agencies that the agency’s ratings should reflect market-share considerations.  Essentially, the bank was reminding the agency that the bank was a client. To be fair, the agency replied that such considerations are not part of the ratings process.  However, the testimony before the committee suggested that the reality has often been quite otherwise. The upper managements of the agencies in particular regularly pressure their ratings analysts to rate in such a way that the agency’s market share does not suffer.  In other words, the message is: “Rate so we don’t lose any clients.”

In fact, the agencies even shared their models with the banks.  As a result, the banks could game the models so the securities would get high ratings.  To be sure, there was also fraud involved, such as making it seem like the mortgages in a CDO came from different servicers or different regions of the US.  Some bankers relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same. Others were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer. “If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive.  The assymetry was no accident, for there is an underlying structural conflict of interest at the core of the ratings system. The actual clients–the general public that relies on the ratings–are not the parties paying the agencies.  Also, the agencies get more when their ratings are higher because more of the underlying securities are sold.   To demand that an agency be independent of the “client” paying it is to place the agency in a structural or institutional conflict of interest that cannot be effectively remedied by simplying subjecting the agency to higher regulatory standards. Worse still, often times the underlying structure is ignored.

Although not made transparent in the Senate hearing, I want to point to the assumption that the agencies would be able to handle their conflict of interest, even in the face of rising pressure for profits as increasing attention was directed to their stock prices. There seems to be a belief in American society that businesses can rise to the occasion when a structural conflict of interest is involved.  In other words, we tend to mitigate the force of such ethical dilemmas, essentially assuming that human nature can be relied upon to surmount them.  Even in the committee testimony, former employees from the rating agencies suggested that common regulatory standards for rating, similar to the FASB standards in accounting, would suffice. This is actually a rather poor choice of comparison, for the public accounting profession is rife with its own conflict of interest that has thus far been shoved under the rug.  One need only look to Arthur Andersen in giving the go-ahead to Enron’s use of “unrelated” partnerships to hide debt or to Arthur Young knowing of the Repo 105s at Goldman Sachs to question whether using regulatory standards goes far enough.

Institutional conflicts of interest are not solved by common regulatory standards because they too can be gamed. The incentives have not been changed, so we can expect the pent-up water to eventually make its way through the muddy dams we construct.  In both public accounting and securities rating, the “independent” assessors cannot be paid by the institutions whose books or products are being assessed.  The unwarranted assumption that turning these functions over the government is the only alternative adds to the easy decision that simply creating or tweeking regulatory standards must suffice.

As an alternative to having the government rate securities, the financial industry as a whole could be required to contribute to a pool that would fund the rating agencies. The SEC would assess the agencies periodically and decide how much each would receive.  Essentially, the government would be the umpire rather than perform the rating function itself.  As long as the banks do not capture the SEC (which is another problem in need of a solution), they would not be able to pressure the rating agencies.  It might be suggested that industry self-regulation could work. That is, the banks altogether would assess the rating agencies.  However, this alternative would simply allow the banks to collude to pressure the agencies.  We ought not replace the government with one of the teams in performing the role of umpire.

It is unlikely that Congress will go beyond mandating stricter disclosure statements and allowing plaintiffs to sue the agencies. Within the fecklessness of Congress in extracting the structural conflicts of interest from the rating function is a fear that tampering with it might risk the salubrity of the credit markets.   Under this logic, riding the ratings function of a structural bias would somehow compromise the function because the public might get a true look at the lack of credit-worthiness of some of the securities currently deemed credit-worthy. An illusion is thought better, or more expedient, than a solid economy. Besides the dubiousness of such reasoning, there is the argument more generally that we can’t afford to tamper with our financial system as long as it is still at risk.  However, before assuming power, Barak Obama argued that the only time when real change can happen is during a crisis–while the forces of the status quo are temporarily marginalized.   So it would seem that we are in a catch 22–or, more accurately, we have put ourselves in one.   In actuality, riding our financial system of institutional conflicts of interest would strengthen rather than risk our economy.
I suspect that the true reason why neither the ratings nor the public accounting structural conflicts of interest have been removed goes beyond our collective ignorance of the nature of an institutional conflict of interest.  As Dick Durbin said after the  banking industry scuttled foreclosure reform, “the banking industry owns Congress.”  Apparently it owns the credit-rating agencies too, as well as the public accounting firms. The wolves are paying the guards of the chicken coop.  Regulating the pay does not go far enough; we need to address the question of the payor.  Until we do so, we are bound to keep scratching our heads as chickens continue to come up missing.

Sources:
http://www.nytimes.com/2010/04/24/business/24rating.html?hp=&adxnnl=1&adxnnlx=1272117625-MtgpixNdFNobkGOTVoD0NA ; http://www.nytimes.com/2009/12/08/business/08ratings.html?_r=1&ref=business

After watching hours of the US House Government Affairs committee on Investigations’ hearing on Goldman Sachs,  I concluded--totally contrary to the disavowals by the Goldman managers who testified--that there was indeed a conflict of interest between Goldman’s proprietary and market-making functions.  By proprietary, I mean a bank trading on its own books beyond simply being the counter-party in its market-making transactions. In their testimony, Goldman managers presumed that all of the bank’s proprietary transactions are part of its market-making role. However, I contend that the bank has been both a market-maker and a player in those markets, and furthermore that the latter function has affected the former in ways that are intended to benefit the bank. That is to say, Goldman Sachs’ financial interest has been put before that of its customers. In some cases, Goldman’s employees refused clients’ requests for shorts related to the housing market so Goldman’s own profits in shorting the market  could be preserved. Sen. Susan Collins (R-ME) said, “There is something unseemly about Goldman betting against the housing market as it is selling housing-related products to its customers.” Sen. Conrad, a more conservative Republican, echoed this sentiment.  The fact that Republicans on the subcommittee joined with Democrats rather than joined in Goldman’s paradigm points to a major disconnect between Wall Street “speak” and the discourse of the general public.  In other words, the financial managers and the politicians were largely talking past each other.  Even so, the two “worlds” can be translated into a common language that nonetheless finds Goldman culpable, while acknowledging some of the managers’ points.  In what follows, I discuss a number of the points raised in the hearing to bear out my contentions here.

Broker dealers do not have a legal fiduciary obligation to their clients in the US. This, Sen. Collins argued, is the root cause of the conflict of interest at Goldman (i.e., pitching toxic investments to its clients while betting against them).  Goldman bankers view their obligation being to be market makers.  A duty to serve the clients or act in their best interest?   Goldman’s managers tended to affirm the former because where the bank is making markets, similarly to an exchange, it is not in an advising capacity. According to one of the managers, market-makers do not have an obligation to tell clients of the market-maker’s position in the market.  The manager contended that how Goldman is positioned may not affect how the instrument performs.  So long as clients understand what they are investing it, the position of the market-maker is not relevant to the client.

Paulson (of the hedge fund, Paulson & Co) had a role in picking the securities in the Abacus CDO. The rating agency said that if the rating analyst had known this, the rating would have been far different.  Torre, the manager at Goldman who oversaw the deal, claimed in testimony that he had told ACA (the major long buyer) that Paulson was going short, but in a memo from ACA afterward refers to Paulson going long. Paulson was involved in the selection of the securities, according to Torre, though ACA left off more than half of the securities that Paulson had recommended. Even so, Paulson was in the room as the securities were being selected, and he had selected the criteria of their removal. Goldman employees did not indicate in the Abacus CDO that Paulson, whose intent it was to short, had been involved in the selection of the securities (which were subprime mortgages from 2006—presumably the stated-income-only variety).

In replying to Sen. Levin’s questions regarding whether it is correct that Goldman made money on its net short position in 2007, two of the Goldman managers replied, “I didn’t write that.” A third replied, “I can only comment on what I did.” Although such non-answers could have been directed by lawyers or the answers could be due to the difference in general paradigms between Wall Street and the general public, I submit that the managers’ underlying attitude is particularly troubling because it involves some cognitive warping.  Because Chairman Levin (D-MI) was not asking  whether they wrote the Goldman document he was referring to, the reply “I didn’t write it” simply doesn’t apply.  At the very least, the managers were adding assumptions into Levin’s question that simply were not there. My question is this: what, cognitively or affectively speaking, would prompt such “value-added addendums”? After a similar answer to one of his questions, Sen. Colburn (R-OK) replied, “Mr Burnbaum, you didn’t hear what I said.”  Similarly frustrated after a question, Sen. Levin gave up with the witness, saying, “I think you’ve not answered the question as best you can.” At one point, Sen. Colburn asked Mr. Burnbaum whether he had any knowledge of whether his firm had a short position on an issue, he replied that he didn’t take the position.  “I don’t speak for the firm; I speak only for my position.” But Sen. Colburn didn’t ask him to speak for his firm; rather, he asked him whether he knew anything about something regarding the firm.  What could prompt such mistaken assumptions?  I don’t think it is entirely a subterfuge; rather, I suspect that the managers’ cognitive processes had been distorted by a particular organizational or industry culture. Such cognitive warping could be part of the reason why Goldman’s managers have blind-spots concerning the institutional conflicts of interest.

To potential customers who asked how Goldman got comfortable with Anderson securities, which were put together by New Century (a mortgage servicer), the sales people at Goldman did not say that the bank was comfortable because it was betting against them by buying 51% of the shorts.  Did Goldman have an obligation to disclose the fact that the bank had bought shorts (i.e., that Goldman had an adverse interest to the client)?   Goldman’s bankers point to the potential buyers’ ability to investigate the securities themselves. The Anderson was downgraded from AAA to junk in seven months.

“Boy, that Timberwolf was one shitty deal.”  This is from an internal Goldman email from the head of a division prior to the bank selling hundreds of millions from that deal to customers. Sales people were told that that deal was their top priority. “Should Goldman be trying to sell a shitty deal?”, Sen. Levin repeatedly asked throughout the hearing.  Seventeen of the people at Graywolf’s research group were Golden alums. Was that why the sales people were told to make the deal a priority?

In general terms, some of the managers at Goldman liked the risk involved in securitizing stated-income mortgages because clients wanted to buy them.  As a market-maker, Goldman’s managers believe that there is a price for any risk, so they would sell a deal they believed to be bad because some clients would like the price. In one case, 90% of the mortgages from an originator were stated-income.  In spite of the high number of stated-income mortgages, the rating agency involved gave some of the securities the AAA rating. Did the Goldman sales people tell their clients of the extent of the stated-income mortgages in the securities? Or did the sales people assume that the clients could investigate the securities in spite of there being the AAA rating on at least some of them?  Goldman claims that it investigated the due diligence of originators, like Long Beach.   So why did the investment bank not cut off that originator?

When asked about the bonuses paid out even as the clients lost money, the Goldman managers said that the compensation incentives were or are in line with ethical behavior.  Even if Goldman lost money, its executives didn’t. So it is reasonable to ask whether the incentives are in line with “performing.”

Goldman magnified the rise and fall of the housing market. Lloyd Blankfein, Goldman’s Chairman and CEO (which is itself a conflict of interest) admitted that the bank had played a role, as did the other investment banks, in the system that included too loose lending criteria. The managers at Goldman said the bank was a market-maker for instruments that reflected those low standards. Sparks, who headed the mortgage securities unit at Goldman, said he didn’t think Goldman did anything wrong; rather, some of the deals it put together did not “perform”—meaning that they were downgraded to junk.  “Goldman made some bad business decisions.”  In a business sense, “bad” does not mean “wrong” in the sense of “ought not” (i.e., unethical).  Rather, “bad” refers to making an error in business calculations.   Similarly, David Vinair, Goldman’s executive VP, said he didn’t think there is a conflict of interest in Goldman selling a security long while shorting it on its own books.  The client buying the security long may have a different stance toward risk as well as a different time horizon than the bank.  Also, the bank may change its short to a long depending on factors that are different from those impacting a given client.  Sen. Levin countered that the conflict of interest is at the moment of sale (hence the bank’s changing preferences are irrelevant). The customer, Levin said, has a right to expect that the bank selling the security wants it to do well.  “In what sense do you mean well?”, Vinair countered.  More semantics ensued. In spite of using vague terms like “perform” (which is actually relevant to acting), Vinair wanted a definition of “doing well” from the chairman. Blankfein also said that there is no conflict of interest; he likened Goldman’s market-making function to that of a stock exchange. Investors don’t ask what positions the exchange has in given stock.  But unlike the NYSE, Goldman Sachs is not limited to its market-making function; the bank takes proprietary in the markets, or instruments, that it “creates” not only to protect its positions in the market-making transactions, but to make a profit by trading on its own books. Hence Goldman, unlike the NYSE, has financial interests other than simply making a market and such interests can warp its market-making function in ways that are not transparent to Goldman’s clients.

It seems to me that the major conflict of interest at Goldman manifests when Goldman managers suspect that a security won’t “perform” (hence the desire to short it) without telling the potential buyers of this belief.  The Goldman managers want to make money not only off its shorts, but also off the client, whom the Goldman sales staff have given a misconception of the security’s soundness either by omission or lying).  The conflict of interest deepens if Goldman managers actually know that a derivative has been put together to fail, and because the bank (or a favored client) will profit from its failure (having bought shorts), the relevant manager does not disclose what he or she knows to the client so the latter will purchase the security.  Goldman would profit both from trading the security (shorting it) on its own books aside from being a counter-party to clients taking long positions, and from being such a counter-party.  That is, profiting from Goldman’s books entails transactions beyond the counter-party transactions prompted by a client wanting to buy or sell. Not recognizing this as a conflict of interest, Sparks limited conflicts of interest at Goldman to picking between two customers, or between one of its customers and Goldman’s proprietary bank. The problem with such a narrow reading of the bank’s conflicts of interest is that it omits the impact of Goldman’s proprietary transactions based on profiting on its own capital. I wonder if this narrowness of perception isn’t related to the “cognitive warping” that was evinced in many of the non-answers of the managers testifying before Congress. “I didn’t write that” is irrelevant; so too are the bank’s proprietary transactions geared to profiting from the bank’s own books aside from being a counter-party to a client in the bank’s market-making function.

I believe that even Lloyd Blankfein viewed all of Goldman’s transactions as market-making.  But he was correct, then every single economic transaction by any party constitutes market-making; every business is making a market.  At Goldman, there was still the conflict of interest regarding the bank’s profiting on its own books not from being a counter-party to a client as part of serving the client versus from serving a buyer or seller client by being the counter-party if necessary.  Goldman can be understood to profit as a broker (a fee in putting a buyer and seller together), as well as from how it does as a counter-party in such a transaction. In addition, Goldman can profit from trading on its own books irrespective of being such a counter-party. I contend that if Goldman is to do the first function, then either of the latter two—and especially the third—constitutes a structural or institutional conflict of interest.  The second function would not be a conflict of interest were Goldman’s counter-party profits (and losses) passed on to the client.  Perhaps even the third function would not constitute a structural conflict of interest were the profits distributed to the bank’s clients.  However, to the extent that there could be an interest in currying favor with particular clients who would benefit differentially in either the second or third function, there could still be a conflict of interest for Goldman.

In general terms, a conflict of interest can be seen as involving lying (or duplicity) in order to benefit “both ways” from having two conflicting interests.  The solution is to reduce the number of interests that a party has such that he or she has no interests that could or do conflict.  This is a different question than asking what legislation is needed, for the field of business ethics ought not be conflated with the field of business & government (i.e., institutional political economy) or even with that of business & society.

Societal norms are not justifying regarding whether a given practice is or is not a conflict of interest.  Theoretically, a firm could deviate from the norms of a society in order to avoid structural conflicts of interest, or a society could simply be blind to such conflicts and a firm act to avoid them anyway.  In other words, business ethics need not involve “social responsibility”  (and the latter need not involve the former).   In the case of Goldman, the social norms regarding such conflicts of interest (i.e., structural) are in their infancy, at least in the US.  Hence, this discussion of business ethics is a distinct project.  Business & Society would investigate the disjointedness of the paradigms of the bankers and the general public–that is, how and why they differ. Business & Government would investigate legislative and/or regulatory matters concerning the conflicts of interest as evinced by Goldman.

While the three fields are related, so too are medical ethics, sociology and biology. You don’t find schools putting these three in one class because it would be cheaper.  So part of the problem concerning business ethics might be how it is treated by business schools; it (as well as CSR and business & goverment) is essentially relegated to one third of a course in most undergraduate and MBA curriculi.  Among the lessons that we ought to have learned from the financial crisis of 2008 is that of the value, or importance, of the fields of business ethics, business & society, and business & government in business schools.  Sadly, even in educating their respective scholars, these fields are conflated–hence the scholars are not apt to study sufficiently in the basic discipline of their particular field.  That is, they tend to skim along the surface in order to cover three rather than one field. Perhaps business schools have a conflict of interest of their own whereby they have an interest in cost-saving expediency and in covering all of the fields of business. The three fields being discussed here have been willingly mitigated (or enervated) into “one” such that business schools could appear to have it both ways.  The problem is when something happens like the financial crisis of 2008, which shows just how vital each of the three fields are–meaning worthy of courses of their own.

If the American financial houses on Wall Street are among the most powerful forces in American politics-- powers, as it were, behind the throne--does it make sense that the strongest bank would be politically impotent?  In other words, can a public blemish nullify the power of all that capital?

According to The New York Times, Goldman Sachs employs perhaps the country’s most well-connected stable of Washington lobbyists, and it spent $2.8 million [in 2009] to bend the ear of federal officials and lawmakers. Goldman executives and its political action committee gavve more than $24 million to federal candidates in the first decade of the twenty-first century, including nearly $1 million to Obama’s 2008 presidential campaign. Even so, the pounding in the media that Goldman Sachs took in April, 2010 left it sidelined — at least in public — as Congress moved toward a decision that could reshape the very industry it rules.  In particular, the SEC filing of charges and eleven hours of grueling testimony before Sen. Levin’s Investigations Committee left the bank a lobbyist persona non grata, if only for a day.  However, even then, the reality behind the scenes was doubtlessly very different.  Even as politicians publicly vilified the bank, they were picking up lucrative campaign contributions sourced in the bank, even if through intermediaries; any large scale electorate is notoriously bad at tracing links.  To be sure, The New York Times was reporting that Goldman Sachs was trying to find a way to influence the debate, even if it could not play as visible a role as it otherwise could have.

Goldman Sachs managers declined to comment the day after the hearing before Carl Levin's committee at the U.S. Senate. The question that the bankers were refusing to answer was on the impact that the bank's legal and public relations troubles were having on its Washington lobbying operations. Even so, one person briefed on its plans spoke on condition of anonymity because of the firm’s continuing legal and political troubles. He or she said it was still trying to push its agenda. The New York Times reported that according to industry officials, the bank had been “largely relying on trade groups, like the Securities Industry and Financial Markets Association. However, this could have been a smoke screen. The real deals could have been made behind closed doors, even by industry standards.  According to the paper, “More often, the firm — whose lobbyists and outside lawyers include such Washington luminaries as Richard A. Gephardt, the former House majority leader, and Ken Duberstein, the former Reagan administration official — has relied largely on intermediaries because politicians are worried about being associated with it, government and industry officials said.”  Members of Congress were worried about public association, but willing to be influenced through intermediaries. Therefore, even though Sen. Blanche Lincoln, who was in a tight race at the time, canceled a fund-raiser at the bank’s New York offices after the SEC filed its lawsuit, I would not be surprised that she accepted contributions by an intermediary.

Most voters are too far away from Washington to get the real scoop, and journalists who want to continue with their career are not apt to dig too deep. We are left with the surface, and can only guess as to the subterranean dynamics.  It seems to me that traces of the underground rumblings can be discerned in lines such as “at least in public.”  We are left wondering how deep the wells of gold run.  Perhaps only the goldman knows.  The actuality can be far different than appearances.  If possible, a study on the real influence of Wall Street in Washington would be very helpful. For this reason, it is apt to be a difficult task with many self-interested obstacles.  In any case, we ought not be so incredulous as to rest on the public appearances. Even as Lloyd Blankfein was testifying, senators turned increasingly friendly to him–with the exception of Carl Levin and perhaps John McCain.  The Democratic side in particular almost made excuses for the CEO, saying that any number of firms should be there with him. Those senators had given their soundbites to be picked up at home; it was time to make sure they were not cutting off one of the ruddy fat hands that feeds them. This expression comes from Nietzsche’s description of businessmen and their propensity to overreach. 

To be sure, Nietzsche is no advocate of modern morality; he viewed it as a defense of weakness.  Weakness cannot be other than weakness, he writes. So too, strength, he writes, cannot be other than strong.  So I contend that we ought to take reports of the political impotence of Goldman Sachs with a rather large grain of salt (or gold, in this case).  He or she who has the gold makes the rules. There is no natural law stating that this process must be transparent.  My question is: can we, the American public, get to it, or does the well of gold run too deep for our patience and perseverance?

Source: http://www.nytimes.com/2010/04/29/business/29lobby.html

Structural, or institutional, conflicts of interest are of great significance in applied ethics, even though they are often disregarded or ignored. Far more salient are personal conflicts of interest, such as when an employee pockets money meant rather than declares it as revenue for his or her company. Structural conflicts of interest are institutional in the sense that organizational arrangements inherently evince a conflict of interest such that people in them are necessarily subject to a conflict in their interests simply by participating in one of the organizations in the arrangement. An organizational or institutional conflict of interest, whether within one organization or involving relations between organizations, is not any less unethical than a personal conflict of interest because in both cases people are subject to a conflict of interest--only one being valid.  I present two cases and an argument that “firewalls” in an organization to prevent it from a conflict of interest are insufficient.

In the EU, the European Commission (the executive branch of the EU Government) sued four elevator companies that were part of a cartel in Belgium and Luxemburg.  Essentially, the Commission was seeking anti-trust damages—a first in EU jurisprudence.  Benoit Allemeersch, attorney for one of the companies, argued that the jurisdiction of the the commercial court of Brussells, the Tribunal of Commerce, violated the jurisdictional clauses in the contracts between the companies and the Commission.  He argued that the Commission acted as “police officer, prosecutor, jury and sentencing judge” in finding the existence of a cartel, and then used its own decision to make a private claim for itself before the commercial court. He argued that “the mere statement by the Commission that they respected their own ‘Chinese walls’ in making their decision and bringing the claim is not a sufficient guarantee to the defendants nor to any other citizen.” He maintained that in the case being argued, there was no “equality of arms” between the two sides, given the commission’s privileged position. According to Allemeersch, “the European Court of Human Rights requires that justice is not only done, but is also seen to be done.”  In other words, even the appearance of a conflict of interest, which can be in an institutional arrangement even if not acted upon, is enough to dismiss claims. The existence of “firewalls” within an organization does not sufficiently mitigate either the dismissal or, more generally, the institutional conflict of interest.

Even though the commission had previously argued that its own “Chinese walls” ensured the independence of the claim, Allemeersch correctly maintained that these safeguards could not be proven, tested or substantiated. I contend that the counsel is correct. Even if the Commission could show policies and procedures that act as its safeguards, such internal guidelines do not have the force of law and thus are insufficient to be relied upon—especially by external parties.  It can not be assumed, moreover, that an organization’s policies and procedures outweigh whatever internal interest happens to be dominant in the organization, given the nature of power to overflow its boundaries.

To say that the most powerful person a room is constrained by parchment alone is to be woefully ignorant of the reality of human nature.  Even if there are two equally-powerful people in the room with antipodal objectives, institutional checks and balances can only work as long as too great of a power imbalance does not exist.  If a US President is intent on invading a country, for example, and the Congress does not have sufficient power over his, the separation of powers institutionally could not be counted upon to keep Congress from rubber-stamping the President’s declaration of war.  For the President to be able to effectively declare war while being the commander in chief of the US military and the armies of the union’s republics is itself a structural conflict of interest.

Essentially, I am making a Nietzschean and Hobbesian argument that the most powerful person in the room is not apt to be constrained by invisible ”firewalls” in the room that are intended to level the powers of that person and a weaker person.  As Nietzsche writes, the strong must be strong and the weak cannot be other than weak.  To ask the strong to be weak or treat the weak as though it were strong goes against the nature of power.  In my analogy of the room, the two persons can represent heads of departments whose respective goals are at odds with each other. A “firewall” of policies and procedures is not sufficient to inhibit the more powerful head from pressuring the other.  Furthermore, the existence of a person whose authority includes both departments relativizes the firewall.  To bring in this element, I turn to the roles of rating agencies and Goldman Sachs in the American financial crisis of 2008. In the case of Goldman, the bank sold what its salespeople referred to as “crap” because the bank’s own proprietary position profited by the sales. In the case of the rating agencies, they were paid by the issuers of the securities that they were rating.  That either of these conflicts of interest were allowed to exist at all points to a proclivity among the general public to ignore institutional conflicts of interest—focusing instead on personal ones involving someone’s compensation and job.

In listening to and reading about the banks and rating agencies culpable in the American financial crisis, I doubted the “firewalls” argument given by the rating agencies.  The CEO of Moody’s for example, stated in Congressional testamony that he placed an equal emphasis on market-share and the quality of the ratings.  However, several of his former employees testified that they had been pressured not to lose a client to a competitor.  They stated that when ratings were changed, it was typically to protect the firm’s market-share (i.e., out of fear of losing the issuer).  The CEO’s faith in his own equipose as well as his firm’s “firewalls” was mistaken, even if he didn’t realize it.  To be sure, he may not have been aware of a more-powerful department putting such pressure on a less-powerful one.  It is possible, however, that the CEO was actively pushing his subordinates behind the scenes for more market-share, essentially profiting from the conflict of interest in the issuer-pays system.

In general, because an organization has an official above its firewalls, it is possible, even legitimate in terms of that position’s authority, for that official to put pressure on one side of the wall to capitulate in the interest of the whole (i.e., the entire organization).   Consider, for example, Lloyd Blankfein, who was CEO of Goldman Sachs at the time of the financial crisis.  He was over both the market-making and proprietary-trading units.  He could therefore have put pressure on the units selling securities to do so in a way that complements the bank’s own proprietary holdings.  For example, he (or his VP’s) could have pushed shorting sub-prime mortgage-backed derivatives in market-making (the clients taking long positions) because the proprietary interests of the bank would benefit from a fall in the housing market.  The bank’s sales people did indeed clients to go long even as the bank itself was going short in the belief that the housing market bubble was headed for a hard landing.  Before a US Senate committee, Blankfein claimed that the market-making and bank’s trading on its own books were unrelated unless the bank took out a position on its books as a counter-party needed by a client.  However, the bank sold clients on taking long rather than short positions on the housing-based securities even as the bank was taking a net short position on its own books above and beyond what was necessary to be a counter-party to its clients’ transactions.  This conflict of interest manifested in the duplicity involved in selling clients on what the sales people knew privately was “crap.”  As one of them wrote, if the clients knew the bank’s reason for going short, that would interfer with the bank’s ability to profit from the shorts.  Structural conflicts of interest are designed such that there is an incentive in favor of duplicity. Given a company’s overall interest and the fact that senior managers have authority over the entire firm, firewalls should not be relied upon by outside parties (or by those inside).
In the end, given the nature of human beings and power, we ought not be blindsided by claims of the efficacy of paper “firewalls.”  We ought not assume that the most powerful person or coalition in an organization will necessarily be voluntarily restrained by a weaker party in the same organization.  Moreover, we ought to take more seriously institutional or structural conflicts of interest in how we design and reform arrangements between institutions.  Where the status quo contains a structural conflict of interest, that condition ought to be put on a limited lifeline, with a deadline set for changing the arrangements.  Even if the alternative is not as efficient (it would doubtlessly not be flawless), it would be better than the status quo.  Charges of an institutional conflict of interest can be treated as red flags that instantly move to the front burner on people’s agendas.  We need not be hoodwinked by the duplicitous and self-interested into believing their asseverations concerning their own paper “firewalls.”

In the process whereby financial reform legislation made its way through Congress after the financial crisis of 2008, the U.S. House and Senate had different approaches concerning who would be required to go through a clearing house to buy or sell deriviative securities. According to Michael Masters, "The clearing house would stand in the middle of the transaction and guarantee both sides of the trade. If one counterparty to the transaction fails, then the central counterparty absorbs those losses, protecting the system as a whole from collapse."  Masters claims that "Wall Street firms hate this idea because their prodigious profits will dwindle when derivatives are traded in the light of day, letting their counterparties see the true costs. So Wall Street is pushing hard to exempt as many transactions as possible."  Given the culpability of Wall Street in the financial crisis, they were in no position to "push hard." That they did nonetheless is a telling sign of the underlying character, or lack thereof, "on the street."  Furthermore, that the representatives and senators were listening to them ought to cause the voters some concern.  Yet because of the reality of the banks' muscle on the hill, the power of the banks to exploit any loopholes in the final legislation should have been salient as the legislation made its way through Congress. This can be seen in whether to favor the House or Senate version.

According to Masters, "The Senate version of the clearing house requirement, which is currently the base text for the bill, includes a narrow, well-defined exemption that allows commercial end-users a complete exemption from clearing, while denying this exemption to financial players. The House language, however, would exempt anyone hedging "balance sheet risk." Since every financial player has a balance sheet, it is estimated that more than 50% of the outstanding derivatives would go uncleared under the House plan, compared to just 10% under the Senate version."  One might say: Ah, 50% is a pretty wide door--better go with the Senate version (assuming it could resist threats and favors from the banking lobby).

Masters explains the rationale for the Senate's version. There "is a critical policy distinction that must be made between commercial end-users like airlines, and financial entities like hedge funds. For a commercial end-user, risk arises naturally out of the ordinary conduct of business. For a financial entity, pricing and managing risk is their core business. As an example, an airline cannot fly without incurring the risk of wildly gyrating jet fuel prices. Allowing them to hedge their jet fuel exposure without a clearing requirement would provide stability for the airline, confidence for airline investors and ensure that the broad U.S. economy benefits from reliable airline service. A hedge fund, however, starts with no inherent risk. Its mission is to evaluate investment options, balancing risk and reward. If a hedge fund enters into a jet fuel derivatives contract on a bet that prices will increase, then it's nonsense to say that they are "hedging" when they subsequently enter into an offsetting deal to reduce the risk they voluntarily took on in the first place. These semantic charades can easily be carried to such extremes that every transaction a hedge fund enters is "hedging" something. An exemption for hedge funds serves no social purpose and, in fact, it puts our entire financial system at risk."  In other words, there are good business reasons for non-financial companies to be able to use derivatives to hedge for risk related to price volitility even if the companies cannot meet the clearing requirements. Of course, it could be asked what proportion of commercial use should but would not occur were such use subject to the clearing house requirements.  I don't know the answer to this question. I contend, however, that even if it is significant, the danger that the loophole would be exploited such that the financial system would once again be at risk outweighs any such inconvenience.  In other words, in reaching too far for perfect efficiency, we could unwittingly be inviting the irrational exuberance of the market to destroy the market mechanism itself.  We ought not fly too close to the sun or we might get burnt and fall to the ground. Masters concludes that the Senate language is "superior to the House's simply because it forces far more derivatives into the open." This may be so, but what would prevent a financial player from using a commercial user as a front to bypass the clearing requirements? Furthermore, there might be legislative language in the exemption that allows financial firms to obviate the clearing houses without even needing such a front.

In short, I contend that having any loopholes, or exeptions, is an unwise practice when we know (as Sen. Dick Durbin said) that the banking lobby owns Congress. We also know that managers and their lawyers are oriented to exploiting loopholes.  To expect otherwise is to tell a shark that it should not be a feeding machine.  That is, we must accept the nature of business for what it is, and not do what can reasonably be assumed to be taken advantage of.  It is like saying to sharks: those of you who do not eat any swimmers can go through the hole in the net and into the shore area.  It is just too dangerous to have a hole in the first place, even if there are some benefits to having it.

Source: http://money.cnn.com/2010/06/23/news/economy/congress_derivatives/index.htm

The EU and US can be seen to differ markedly in the degree to which the interests of big business are etched in the respective societies and polities.  That is to say, the difference goes beyond the question of the relative influences of the lobbyists. I contend that the relative proclivity toward business in the American states tilts the political playing field in the direction of the financial interests. This difference reflects a more basic subterranean difference on how much wealth and its manifestation as business are valued.  That is to say, it is easier for financial sector lobbyists in the United States because the societal values lean in their favor. This can be seen from the respective financial reforms in the EU and US after the financial crisis of 2008. This case bears strongly on my thesis because in both economies the financial sector was viewed as culpable. So one would expect the ensuing laws to come down on the banks rather than be conducive to their interests, unless a societal value on the profit-motive were still in force.

On March 10, 2010, the EU Parliament adopted a Resolution (536 votes in favour to 80 against) calling for the financial sector to contribute fairly towards economic recovery since the costs of the crisis are being borne by taxpayers. On 25 March, Members of Parliament’s special “Financial, Economic and Social Crisis Committee” debated the rationale behind a possible financial transaction tax. Stephan Schulmeister of the Austrian Institute for Economic Research in Vienna said short-term financial transactions can make short-term prices of currencies and other financial products such as derivatives and shares vary wildly. Schulmeister claimed that a tax on financial transactions of just 0.05% would eliminate these short-term transactions, bring greater stability and bring €300 billion of additional revenues to the EU. While the tax would undoubtedly bring in revenue, it is not clear to me that short-term transactions would be eliminated, as they can be worthwhile even with such a tax. Moreover, the financial crisis of 2008 shows us that the volitility can come from the market mechanism itself (in so far as it magnifies irrational exuberance). At any rate, even as there has been division on the matter of such a tax in the parliament, that the proposal has been made distiguishes the legislative body of the EU from the Congress in the US, where such a proposal would undoubted by blocked. Indeed, the EU Parliament has gone ever further.

On July 7, 2010, the EU Parliament approved some of the strictest rules in the world on bankers’ bonuses.  In the legislation, caps are imposed on upfront cash bonuses and at least half of any bonus will have to be paid in contingent capital and shares. MEPs also toughened rules on the capital reserves that banks must hold to guard against any risks from their trading activities and from their exposure to highly complex securities. “Two years on from the global financial crisis, these tough new rules on bonuses will transform the bonus culture and end incentives for excessive risk-taking. A high-risk and short-term bonus culture wrought havoc with the global economy and taxpayers paid the price. Since banks have failed to reform we are now doing the job for them”, said British MEP Arlene McCarthy. Upfront cash bonuses are capped at 30% of the total bonus and to 20% for particularly large bonuses.  Between 40 and 60% of any bonus must be deferred for at least three years and can be recovered if investments do not perform as expected. Moreover at least 50% of the total bonus would be paid as “contingent capital” (funds to be called upon first in case of bank difficulties) and shares. Bonuses also have to be capped as a proportion of salary. Each bank must establish limits on bonuses related to salaries, on the basis of EU wide guidelines, to help bring down the overall, disproportionate, role played by bonuses in the financial sector. Finally, bonus-like pensions are also covered. Exceptional pension payments must be held back in instruments such as contingent capital that link their final value to the overall strength of the bank. This is to avoid situations, similar to those experienced in the wake of the financial crisis of 2008 in which some bankers retired with substantial pensions unaffected by the crisis their bank was facing. The rules apply to foreign banks operating in the EU and to subsidiaries of EU banks operating abroad. The law gives state regulators in the 27 EU states binding powers to take action against banks that fail to comply with the new rules (contrast this with the US Gov’t going after Arizona for trying to enforce US immigration law).

Clearly, the US financial reform does not go this far. Notably, it does not put much of a crimp in the American bankers’ life. This is no accident. The feeling among big bankers in the US is that they dodged a bullet concerning what could have been in the bill. That is to say, there was no “too big to fail” limit put on a bank’s capital or size generally speaking, or on the bankers’ compensation. The American media and President Obama have been strangely silent on why.  Perhaps it is as in the case of the health reform, where the President removed his objection to an insurance mandate and dropped his desire for a public option after the lobbyist for the American health insurance companies told him that her support was contingent on these changes. My point is simply this: Were not American society leaning in a pro-business direction (e.g., economic liberty being salient in how liberty itself is viewed), the President might not have felt the need to be bent in the lobbyist’s direction. That is to say, the lobbyist would not have had so much leverage. Wall Street no doubt had massive influence in the crafting of the financial reform as it was making its way through Congress (even though the banks were culpable in the financial crisis—which is itself telling). I submit that the reasons go beyond the sheer power of money. Fortunately, we can look across the pond for a better look at ourselves.

Sources: http://www.europarl.europa.eu/news/public/story_page/044-71441-088-03-14-907-20100329STO71433-2010-29-03-2010/default_en.htm
http://www.europarl.europa.eu/news/public/focus_page/008-76988-176-06-26-901-20100625FCS76850-25-06-2010-2010/default_p001c011_en.htm
http://www.dw-world.de/dw/article/0„5769943,00.html

See related:http://euandus3.wordpress.com/2010/06/23/regulating-financial-and-commercial-derivatives/ (for a look at the US financial reform—esp. derivatives) and http://euandus3.wordpress.com/2010/07/01/immigration-and-federalism/ (contrast this federalism with that of the EU wherein the states are to enforce the bank bonus limits passed by the EU Parliament).

Given the $13 tillion amassed in US Treasury debt plus all the debt amassed by the American states, the US dollar was losing out in percentage terms to other currencies as the global reserve currency in 2010. To be sure, in absolute terms, there were still more dollars being held abroad than twenty or thirty years ago, but as a report from Emma Lawson of Morgan Stanley shows, other currencies were taking on more of a relative presence.

The Euro had been making the greatest strides in percentage terms, particularly in 2002. The slight downturn in 2009 might have reflected the impact of the financial crisis of 2008 in Europe, though the Greek debt issue had not yet reached a boil (it would be interesting to see the figures from 2010).  In any case, the dramatic drop in the dollar’s percentage terms also came in 2002, before the Iraq war and the bank bailout spending (i.e., the $13 tillion dollar debt). The drop could have been in reaction to September 11, 2001, though it would seem an exaggeration even then to say that the US financial system would be undone by the attack.  Even so, as we know from 2008, irrational exuberance can take hold in even a global market. We ought nevertheless not lose sight of the fact that the number of dollars held in reserves around the world increased. The pie got bigger, and even though the dollar piece became larger, it was a smaller proportion of the pie in 2010.  Even so, the $13 tillion in US Treasury debt, the decision of the Chinese to allow their currency to appreciate to a limited extent, Russia’s call for a mix of global reserve currencies, and the EU’s bailout of the Greek bonds all pointed to trouble for the US dollar as “the” reserve currency. Also troubling was the UN report at the end of June, 2010, which urged that the US dollar is no longer stable enough to be the world’s reserve currency. Ouch! The dollar slid %5 in June. Fortune reports that central banks had been preferring gold to the greenback.

Lawson believed that  ”over time we anticipate that reserve managers may reduce their holdings further.” She is looking at the significance of small percent changes over a short time—and this I see as perhaps susceptable to overblowing small trends. For example, she found that central banks had dropped their allocation to U.S. dollars by nearly a full percentage point to 57.3% from 58.1%, and calls this “unexpected given the global environment.” But was such a change, relative to those shown in the chart, really significant? She argued that other dollars - the kind that come from Australia and Canada - had been benefiting from skiddishness on the dollar. The allocation to those currencies, which fall under “other” in the data, rose by a full percentage point to 8.5%, accounting almost exactly for the drop in the U.S. dollar allocation. She was undoubtedly assuming that the trend would continue, but a look at the chart can demonstrate that even the dramatic changes in 2002 had not continued at such a rate (e.g., for the euro and the US dollar). 

Even so, Treasury’s huge debt could not but undermine the US dollar over the long term. This point ought not to be minimized or ignored under the fiscal pressure to push the US economy out of recession. Even if the US did not admit that the debtload was too high to be paid down one day (the debt then approaching the annual GNP of the US), the market rendered its verdict. Relative the huge debt facing the US dollar (and remember there are huge state debts, such as in California, Illinois and Florida!), the “crisis” facing the euro in 2010 paled in comparison.  As of mid 2010, the euro was still over $1.20. Years earlier, it had been at parity. The media frenzy on Greece's debt in 2010 ought therefore to be put into some kind of perspective, and the impact of the dollar’s public debt not be lost. 

It’s not clear to me that the human mind can conceptualize a trillion, not to mention thirteen of them. Yet we glide over the public debts in the US as though they were sustainable. If the US falls, it will be from within--from consolidation at the empire-level.  Such a fall will likely come as a surprise to most Americans, who in being oriented to external threats tend to miss the gravity of the black hole amassing under our very noses.  To be sure, the additional debt enables us to live beyond our means as a society, and such a condition can be very addictive.  Perhaps the parallel question for us to reflect on is whether Rome fell from within or simply from the Goths.

Sources:
 http://www.businessinsider.com/morgan-stanley-dollar-euro-reserve-holdings-2010-7#ixzz0tBDYFjMd
 http://wallstreet.blogs.fortune.cnn.com/2010/07/09/central-banks-start-to-abandon-the-u-s-dollar/

According to The New York Times, Wall Street bankers were busy working on how to weaken the regulations or otherwise profit from them before the ink was dry on the financial reform law of 2010 . First, regarding trying to profit from the new regulations, BOA, Wells Fargo and other big banks that were faced with new limits on fees associated with debit cards were imposing fees on checking accounts. Compelled to trade derivatives in the daylight of closely regulated clearinghouses rather than in murky over-the-counter markets, titans like J.P. Morgan Investment Bank and Goldman Sachs were building up their derivatives brokerage operations. Their goal was to make up any lost profits — and perhaps make even more money than before — by becoming matchmakers in the vast market for these instruments. That critics were pointing to them as a principal cause of the financial crisis made no difference to those bankers. Even when it comes to what is perhaps the biggest new rule — barring banks from making bets with their own money — banks found what they thought was a solution: allowing some traders to continue making those wagers as long as they also work with clients.

Lest one conclude from the banks’ stretegic responses that the new law passed in the wake of the financial crisis of 2008 goes strongly against their interests, it is important to remember that the reform is more geared to giving government officials adequate power to mop up a future mess than to enabling them to prevent one in the first place by clamping down on the banks. The devil is in the details. This in itself can be an opportunity for banking lobbyists to work over regulators who depend on information from the industry and can be swayed by legislators who have received campaign contributions and fund-raisers from the bankers. Regulators are tasked under the new law with writing the specific rules of the road governing limits on risk-taking by financial firms and previously unregulated trading. By leaving so much to the discretion of existing regulators, the new law is “a boon to Wall Street lobbyists, who will now be working behind the scenes to influence the regulators,” according to John Taylor, president & CEO of the National Community Reinvestment Coalition. Furthermore, in enforcement, there is evidence that regulators are apt to look the other way. The wave of predatory lending that sank the housing market, for example, could have been largely prevented if the Federal Reserve had enforced existing rules on mortgage lending, according to Cornelius Hurley, director of the Morin Center for Banking and Financial Law at Boston University.

Under the financial reform law of 2010, banks and other financial institutions are overseen by a council of  regulators. That group is charged with identifying the kinds of “systemic” risks that spun out of control in the collapse of Bear Stearns and Lehman Bros. in the financial panic of September 2008. But there’s little to be gained by entrusting that task to the same regulators who failed to spot the causes of the panic the first time, said Isaac, the former FDIC head. “If a bank went to the regulators and said, ‘We’ve got a good idea: we’re going to put our lending officers in charge of risk management,’ that bank would be put out of its misery immediately,” said Isaac. “That’s what the government just did. It put the regulators in charge of assessing their own performance. It’s a very bad system.” While the law creates a separate agency with a single consumer mandate, even it remains beholden to those regulators, who retain the power to veto its regulations and enforcement actions. That setup, said Taylor, could seriously hamper the board’s effectiveness. “That club of regulators is very insular, and usually in agreement,” he said. “They can kill serious reform, and the financial lobby remains much more influential with regulators than consumer advocates.”

The problem can be broadened by considering that President Obama brought to head his economic team people like Larry Summers, who while in the Clinton Administration lobbied against regulating derivatives, and Tim Geithner, who had been appointed as President of the New York Federal Reserve at the urging of Citigroup and its major stockholder. In other words, it is not just a matter of relying on the same regulators; the construction of the law involved the same advisors.  Indeed, that members of Congress listened to the banking lobby at all even as the banks were complicit in the financial crisis of 2008 can be viewed as going back to the same. At a fundamental level, the banking industry may have too much leverage over top government offiicals, whether legislators or regulators.

Sadly, according to Newsweek, “the bill does more to help regulators detect and defuse the next financial crisis than to actually stop it from happening. In that way, it’s like the difference between improving public health and improving medicine: The bill focuses on helping the doctors who figure out when you’re sick and how to get you better rather than on the conditions (sewer systems and air quality and hygiene standards and so on) that contribute to whether you get sick in the first place.” This might be because it is in the big bankers’ interest that the government come in and clean up, but not restrict them in the meantime.  In the 1980s, the financial sector’s share of total corporate profits ranged from about 10 to 20 percent. By 2004, it was about 35 percent. According to Newsweek, “What you get for that money is favors. The last financial crisis fades from memory and the public begins to focus on other things. Then the finance guys begin nudging. They hold some fundraisers for politicians, make some friends, explain how the regulations they’re under are onerous and unfair. And slowly, surely, those regulations come undone.”

In the wake of the financial crisis, the American people had a chance to brake up the banks too big for our republics, but even then the bankers were able to quietly get this option off the airwaves. I contend that the too big to fail systemic risk is actually greater with respect to the viability of the US than to the financial system. That is to say, the ability of Wall Street to dodge the bullet even when it was culpable for a near melt-down of the financial markets may mean that we are living in a plutocracy rather than a democracy—the latter being mere window-dressing. Even when Wall Street is “bad,” it owns Congress, according to Sen. Dick Durbin of Illinois.  This ought to tell us that the game is over, yet with regard to the regulators I suspect the games will go on for some time.

Sources:
http://www.msnbc.msn.com/id/38266914/ns/business-eye_on_the_economy/  http://www.newsweek.com/2010/07/15/five-problems-financial-reform-doesn-t-fix.html  http://www.cnbc.com/id/38272518

See Related:
http://euandus3.wordpress.com/2010/07/09/is-the-us-too-banker-friendly-relative-to-the-eu/
http://euandus3.wordpress.com/2010/06/23/regulating-financial-and-commercial-derivatives/

I contend that Robert Benmosche, CEO of AIG, had an incorrect understanding of corporate governance when he told Harvey Golub, then-chairman of the board, on July 14, 2010, “One of us should stay and one of us should go.” He should have, “Please let me know if the board would like me to go.” Put bluntly, the CEO works for the board, not vice versa. The previous May, Benmosche told Golub, “We can’t work together. I need a partner who I can bounce ideas off and give me advice.” However,a CEO and a chairman do not work together as partners. Rather, the chairman—and the board more generally—act on behalf of the stockholders to oversee the management, which the board has hired. In other words, a CEO is an employee whereas a chairman is not. Benmosche’s comment is actually rather presumptuous.

Benmosche’s upside-down approach to corporate governance is evident from the way he went about trying to sell AIG’s biggest overseas life insurer, AIA, to Prudential. Rather than being surprised that Golub did not support the sale, he should have taken note of Golub’s surprise that he had not informed the board earlier. As another example, rather than being annoyed that the board didn’t push Treasury’s pay czar harder to sign off on his $10 million pay package, Benmosche might have asked the board if they supported the proposed compensation.

One of the principal jobs of a corporate board is to assess the CEO (and hence the management) and to fire him or her if the board decides it would be in the stockholders’ interest. The CEO works for the board, not vice versa. It is not a partnership arrangement. It is the CEO’s responsibility to act within the support of the board, rather than to threaten its chair for not playing ball. Benmosche illustrates the arrogance that come occur when an employee is over-compensated and spoiled.  Benmosche should have been grateful to the AIG board for having agreed to a compensation package of $10 million rather than critizicing them for not essentially working for him in pressuring the Treasury.

From this case, we can extract the following lesson. A CEO should not chair the board whose task it is to assess him or her. Such duality is a contradiction in terms—effectively attempting to interiorize within the CEO accountability that is external (i.e., interpersonal). As Benmosche had already turned to Robert Miller, who replaced Golub, for advice and found him to be supportive, AIG may have essentially installed a puppet—hence compromising the board’s role in overseeing the CEO.

I once asked Armstrong when he was both CEO and chairman of ATT whether he saw any conflict of interest in his chairing of the body tasked with assessing him. He replied that the buck stopped with him—that he needed the authority to integrate cable, computer and telephone technologies into broad-band. However, in hiring him, the board should have signed off on his strategy, hence giving him all the authority he needed to implement it. In effect, Armstrong was over-reaching in claiming that such authority was not sufficient. When his strategy failed, the external accountability function of the board was compromised.

In general terms, CEOs are too powerful with respect to “their” boards.  In being an enabling partner rather than a parent, too many boards are unwittingly undercutting their raison d’etre. To the extent that the managements of banks contributed to the crisis in September, 2008, corporate governance with real accountability can be seen as critical not only to our financial system, but to the economy itself. We can ill-afford too many spoiled adult-children.

Source: Joann S. Lubin and Serena Ng, “Battle at AIG Board: You Go, or I Do.” The Wall Street Journal (July 16, 2010), pp. C1, C4.

The near credit-freeze that came to a head in September of 2008 meant that even in the ensuing recovery, managers at American companies would be hesitant to spend their companies’ cash reserves. $838 billion for S & P’s 500 Index in March, 2010, was up 26% from March, 2009. Accordingly, managers have been hesitant to hire. From late 2007 to late 2009, payroll employment dropped by nearly 8.4 million by July, 2010; only 11% of the lost jobs were regained. Robert Gordon, an economist at Northwestern University, points to the shift in executive compensation more in the direction of stock options. This arrangement gives managers more incentive to cut costs more in recessions and hold off in hiring in recoveries so that profits might surge first. However, one could point to the mandatory delay stipulated in some executive’s options to buy stock as giving them an incentive to look to the longer term.  Lynn Reaser, another economist, points to the lack of available external credit even more than a year after the financial crisis of 2008. She argues that managers conserved cash because they couldn’t rely on outside financing. However, firms like Apple, Yahoo, and Google are debtless and doing very well, so I would question the premise that outside credit is something to be desired.  Managers betting on leverage typically allow their irrational exuberance to distort their debt-to-assets and debt-to-profit benchmarks. If managers have become more averse to debt, maintaining higher cash reserves is not a bad thing, even when little interest is made on the cash. Once the new level is achieved, then only replenishments would be needed, so the diminishment of a firm’s investing in equipment or new hires would be temporary—to build the reserves and then to keep them stocked.  Drawing on their firm’s cash reserves rather than asking a bank for a loan or selling bonds proffers more freedom and self-reliance—qualities that are valuable even though they are difficult to quantify.  So we might view the recovery from the financial crisis of 2008 as a systemic correction in which managers were weened off their reliance (i.e., addition) on debt. Of course, the key lies in holding to the correction rather than falling off the wagon. Perhaps there should be an AA for debt-ridden businesses.

Source: Robert J. Samuelson, “The Big Hiring-Freeze,” Newsweek (August 2, 2010), p. 26.

Goldman Sachs’ settlement with the SEC in July, 2010 amounts to just two weeks of profits for the bank—hardly even a slap on the wrist.  However, the bankers had to concede that they had not had “full and complete disclosure in their marketing materials.”  Even so, few if any clients left the bank in the wake of the settlement. To be sure, since the impropriety had come to light in Sen. Karl Levin’s investigations subcommittee, Goldman had slipped in the pecking order of top underwriters of stocks and bonds to eighth. There is reason to think this was the extent of the damage.  Oklahoma’s Teachers Retirement System, for example, was unlikely to terminate Goldman even though the system’s general director said he was disappointed in the admission.

In general terms, the US Government was having trouble holding bankers accountable for the financial crisis of 2008. Wall Street’s defense that the bankers had simply made mistakes does not explain the liars’ loans or Goldman’s knowingly misleading clients who went long on subprime derivative securities. The government’s difficulty could itself give Wall Street an incentive to keep up the deceit.  That the market mechanism does not reflect the fraud by removing the offenders suggests a second major drawback—the first being internal volitility from irrational exuberance.  On the government side, even with regulations on the books and a willingness to enforce them, it may simply be too difficult for anyone to prove fraud when Wall Street is hanging together rather than turning each other in. That is to say, both the market mechanism and regulation may not be able to correct for the risk involved in the existence of banks too big to fail. In a way, we all enable the presumptiveness of fraud by refusing to break up the big banks both organizationally and in terms of ownership.  A lesson available from the financial crisis of 2008 might be that we can ill-afford to continue to enable giants who could fall on us any day.

Sources: Thomas Catan and Kara Scannell, “Convictions From Crisis Hard,” Wall Street Journal (July 17-18, 2010), B2; Susanne Craig and Randall Smithy, “For Goldman, Reputation Reclamation Project,” Wall Street Journal (July 17-18, 2010), B1-2.