Slouching Towards Wall Street… Notes for the Week Ending Friday, 20 January 2012
Make Me A Capitalist — But Not Yet
The modern theory of the perpetuation of debt has drenched the earth with blood, and crushed its inhabitants under burdens ever accumulating.
Like St. Augustine, the US ardently desires to become virtuous. Just not yet.
This week saw musings from Fed officials — launched like 700-ton lead trial balloons — that it might be a good idea to provide more stimulus. We thought this a singularly bad idea the first time around, and the taxpayer trillions that vanished down the federal Johnny-flusher in the past few years did nothing to change our mind. Even those who say the government should be spending lots more are forced to admit it is not because government should support enterprise, but because it acts as the bailer-out of last resort. At the same time, those ringing the tocsin of excessive debt seem loath to cut the cord, saying that while the current situation is unacceptable, stopping funding would be like withdrawing life support while the patient is in a delicate recovery stage. Others are willing to go no further than to say that more debt is a truly bad idea, meanwhile acknowledging that we really do have to borrow just a wee little bit for the moment.
Booshwah, we say. Our simplistic notion of Capitalism is that companies — and individuals, and even nations — should get to keep profits they earn fairly, and should suffer their own losses, whether inflicted by their own incompetence, or sheer bad luck. In this election year, we cast about in vain for a leader willing to articulate that vision of American capitalism in a single declarative sentence.
Former investment banker, and former advisor to Treasury, and former car czar (take your pick) Steven Rattner wrote a lucid piece in the Sunday New York Times (22 January, “The Dangerous Notion That Debt Doesn’t Matter”) that spells out some stark facts: “In 1975, government debt per household was roughly equal to half of a typical householder’s annual income. Today, it’s 1.7 times.” What Rattner does not mention — constrained either by editorial space, or by his own blindness to the shifting destinies of vast segments of our population to whom a thousand dollars makes a meaningful difference — is that “typical householders” in 1975 had income that was a much larger percentage of the income of senior executives of the companies they worked for, and had realistic prospects for seeing their own children benefit from a better education, leading to lives that were both more successful financially, and more fulfilling in a broader human sense.
Since then there have been tectonic shifts in our society. Between Rattner’s magic year of 1975 and 2007 — the eve of The Day The World Stood Still — compensation on Wall Street doubled as a percentage of national earnings, and financial sector profits doubled. In 1980, Wall Street firms represented 13 per cent of all corporate profits in America. By 2007, it was 27 per cent. The shift in focus was stark. GE, for example, went from earning over 90 per cent of its profits from manufacturing in 1980, to earning more than half from financial services by 2007.
The definition of Capitalism has changed. It is no longer true to argue, as Wall Street executives shrilly do, that the financial services sector provides the finance that is the life-blood of industry. For many years now, it has been industry that provides the life blood of finance, as Wall Street firms packaged businesses into public offerings for the sole purpose of paying themselves fees and commissions. Bankers talk about the Market placing a value on a company, but when businesses are created out of thin air for the sole purpose of being offered in IPOs, it is a deliberate inaccuracy to argue that the invisible deity named “Market” establishes prices through acts of corporate grace.
But equity offerings were but the tip of a giant iceberg, because the equity markets are puny compared to the markets for debt, and debt derivatives. And it is the debt markets that continue to have a stranglehold on America’s finances, placing entire nation and generations unborn into a global form of indentured servitude.
The frenzy of securitizations that fed the meltdown of our markets was stoked, so we hear, by demand from China. The Chinese are the biggest holders of our Treasury debt, if no longer its most enthusiastic buyers, and their widely-bruited appetite for American debt instruments drove armies of financial executives to create trillions of dollars of face value of worthless paper. This closely mirrors the situation in the mid-1400’s, when China relinquished paper money and sanctioned the use of silver as the basic currency — the government accepted it for tax payments, which is perhaps the best definition of currency. So great was China’s appetite for silver and gold that Europe’s coffers soon emptied out. There was a traders’ imperative: the Chinese would sell you anything you wanted, if you paid in silver or gold. After 1492, the Spanish gained access to vast quantities of gold in Mexico and Peru, most of which found its way to China.
No one seemed troubled that the gold and silver trade with China was one-sided. The Chinese provided silks and porcelains, the Europeans provided gold and silver in a frenzy. European governments required taxes to be paid in metal coin, but so much of it was being sent to China, there often was not enough around for the government to spend on its own purchases, and thus not enough for taxpayers to pay back. When the government issues scrip, you have to hand over whatever they are buying. But those desiring to pay their taxes in scrip found this was not a reciprocal relationship, and many ended up dispossessed or in labor gangs. More, whole nations found themselves in danger of sovereign bankruptcy, a situation that ultimately redrew not only the map of Europe, but the Western consciousness. Debt was the primary stimulus for Magna Carta, and for both the American and French Revolutions. That’s what we call Influence.
Debt is about one group of people — Debtors — being in some way owned by another group — Creditors. The financial sector recognizes this only too well. Notice that the budget surpluses of the Clinton years drove Wall Street into a panic. If the government did not owe money, the banks would not be able to guarantee themselves a steady flow of new Treasury financings. But the deeper fear was that a government used to having its coffers full would soon demand that industry take its own losses. The game of privatizing profits, while socializing losses, has been in the ascendant since the late 1970’s. Imagine what this nation would look like if that were suddenly reversed. Indeed.
Along came Greenspan, Rubin, Summers with their retinue of financial Merlins. Like Pharaoh’s magicians, they plied their alchemy before the dazzled eyes of the President and Congress. Glass Steagall was set aside and Citigroup was born, then a law was passed making it illegal to regulate the derivatives industry. Soon enough, the surplus was history — for good measure, George W. Bush pushed us deeper into debt than we had been in generations. For good measure, Obama has created regulatory proposals so complex they can not be comprehended, much less implemented. Everyone can breathe a sigh of relief. America, you see, has been saved from itself.
This continues to play out. As we predicted, Judge Rakoff, who took the SEC to task for their standard practice of settling major cases with only a cash payment, is now taking the heat. In a calculated move, which could backfire, the SEC filed an appeal last month, asking the court to reverse Judge Rakoff’s order. Now the Business Roundtable, one of the most powerful lobbying groups in the nation, has filed an Amicus brief asking the federal appeals court to throw out Judge Rakoff’s ruling that the SEC and Citigroup may not settle a case in which Citi is accused of massive fraud (Reuters, 12 January, “CEOs Urge Court To Throw Out SEC-Citigroup Ruling”). The Roundtable says companies face “protracted and expensive litigation” if the court allows Judge Rakoff’s “novel, and potentially dangerous” order to stand.
Former SEC chairman Arthur Levitt, who did so much to attract investors to the US securities markets, was ultimately unsuccessful in many of his broader efforts at corporate reform. He said “nothing astonished me more than witnessing the powerful special interest groups in full swing” as they unleashed lobbying attacks against even the smallest bits of legislation or rule proposals. Meanwhile, says Levitt with a clarity that we could all use today, “Individual investors, with no organized labor or trade association to represent their views in Washington, never knew what hit them.” It is the SEC’s job to be the representative for the investor, big and small. Whatever the merits of the Citi case may turn out to be, Judge Rakoff has called the Commission out for failing to act in the interest of their primary constituency: investors.
Last November Judge Rakoff refused to rubber stamp a proposed SEC settlement with Citigroup, accused of a billion-dollar fraud in the marketing of risky mortgage-backed securities. The bank and the Commission presented Rakoff with a $285 million settlement — without, as is standard SEC practice, naming any responsible executives, and with the bank neither admitting nor denying the charges.
Judge Rakoff ordered a trial, saying he refused to exercise his authority without being given the opportunity to exercise judgment. The Business Roundtable’s brief argues that Rakoff’s order will open the door to courts “micro-managing agencies’ enforcement decisions,” which will delay fraud victims receiving restitution. Among the multiple ironies in this position is the fact that the $285 million proposed payment will come out of the shareholders, and it is not clear how individual investor losses will be established, or compensation allocated.
Maybe Judge Rakoff is not out to bash Citigroup, pace those who hold him up as an antagonist of Wall Street. He is certainly exercising a long-held peeve against the SEC. He is concerned that the courts are being manipulated into sanctioning legal remedies, but without having insight into the facts of the case and with no disclosure to determine whether the punishment fits the crime. Or, indeed, whether a crime was even committed. One thing that is clear: the practice of allowing major companies to pay a fine that is far less than the profit they make on a transaction is an incentive to bad behavior, not a deterrent. Even an SEC enforcement attorney ought to be able to figure that out.
We hope the appeals court will not be swayed by the SEC’s argument. Given the Commission’s dismal record in recent years, this is one slope we should all be happy to slip on. We rather fear the Court of Appeals will focus on a more fundamental aspect of the argument: the Business Roundtable, according to Reuters, represents “companies that generate more than $6 trillion of annual revenue.” Now that’s what we call a colorable argument.
Citi chief Vikram Pandit is among the 200-plus members of the Roundtable, as are the chief executives of Goldman, JPMorgan Chase, and Bank of America — firms which, as Reuters points out, have collectively paid close to $900 million in SEC settlements, without admitting or denying guilt.
The legal situation is slightly unusual. An appeal has been filed, but only the side filing the appeal is likely to be heard. Unless the court provides it of its own accord, there may be no legal standing for Judge Rakoff to argue his own side. Observers are comparing this to judge Stanley Sporkin who, in 1995, rejected a proposed settlement between the Justice Department and Microsoft. Sporkin’s ruling was overturned, and he was taken off the case faster than you can say Crony Capitalism. But we think this is not analogous. Sporkin’s ruling found that the settlement did not satisfy antitrust standards and was not in the public interest. Rakoff’s order seems to go to a more fundamental point: he says there are no facts at issue, and thus no way to determine the appropriateness of the settlement. One thing seems obvious to us: it is not in the public interest for the largest financial institutions in the world to make private deals with the agencies that regulate them, then draw the courts into collusion in a way that precludes any future challenge.
As bad as things have been between the fiscal lunacy of the Bush and Obama presidencies, a rejection of Judge Rakoff’s order will be a declaration that Wrong is Right. It will clearly establish the government as a willing facilitator of bad behavior and enshrine the privatization of profits and the socialization of losses as the New Normal. Citi may have broken the law. And maybe they did not. We suspect the SEC is not really sure. Still, we are tired of being debt slaves. Real Capitalists have to take the risk of losing, as well as the chance of winning.
Make Me A Regulator — But Not Yet
Speaking of the SEC, Chairman Schapiro sent a letter to the House Financial Services committee saying the Commission is “drafting a public request for information to obtain data specific to the provision of retail financial advice and the regulatory alternatives” (Reuters, 12 January, “Timing Of SEC Fiduciary Rule In Flux”). The Fiduciary Rule is another hot button with the financial industry lobby. It is intended to require all persons offering investment advice to be deemed fiduciaries. Currently, the broker-dealer segment of the industry is governed by a Suitability standard: investments proposed to customers must be suitable, in light of the customer’s financial situation, risk tolerance, and level of sophistication.
As far as the investor’s Financial Situation is concerned, anyone who has worked in the brokerage industry will tell you that 90% of new account forms submitted for management approval show $100,000 + in annual income, and one million dollars in net worth. The reason is simple: below those levels, most managers will not approve a new account.
The standard for Sophistication is a combination of prior investment experience, education, and profession. People with advanced degrees are almost automatically deemed “sophisticated” investors, often regardless of investment experience. This makes no sense. Having a successful career as a neurosurgeon does not automatically mean one understands the concept of short selling, or how to calculate a margin requirement.
Risk Tolerance is based on asking the customer “how would you describe yourself?” A seasoned broker will explain to the customer that certain investment opportunities will not be available if the customer is deemed “risk-averse.”
Chairman Schapiro has told Congress the Rule proposal will be out this year — a long time horizon, but there is stiff opposition. The Commission is soliciting comments in an attempt to analyze the retail investment marketplace. These comment periods are one of the few ways individual investors can have their voices heard. More’s the pity so few people are even aware of the process.
As an indication of where this is likely to be headed, note that one major hurdle facing the Commission will be the possibility of legal challenges based on a cost-benefit analysis. If protecting investors costs the financial services industry too much money, the courts will disallow it. Go figure.
Also lurking in the wings is the new Consumer Financial Protection Bureau, where President Obama’s — possibly illegally empowered — appointee is charging ahead. Cordray’s first target is payday lenders, a category that was so loosely defined in his speech last week it seems to include every institution from “Wee-Rip-U-Off Loan Sharks,” to Citi and Wells Fargo. If the SEC imposes a fiduciary standard, the CFPB could take on a broad interpretation of its mandate and declare open season on the brokerage industry. But not to fear. Two things need to be established before this happens. First, the SEC must get Congress’ permission to institute a rule that actually makes a difference. Pardon us if we consider that a stretch. Second, we have not yet seen what legal challenges may tie Mr. Cordray’s hands.
It would be great if a competent regulator could institute true accountability in the financial services industry. As Hemingway so poignantly writes at the end of The Sun Also Rises, isn’t it pretty to think so?
Make Me A Republican — But Not Yet
Our all-star Financials sector team, captained by Josh Steiner, notes that “Occupy Wall Street” has all but disappeared from the list of most-searched items on Google. Last year, when the non-movement was in full swing, it was mooted that, come winter, the occupiers would have to seek indoor space and would either go home, or in any event drop out of sight. This, indeed, seems to have happened.
Now it turns out cold weather may not be the only problem they are facing. An opinion piece in Forbes (18 January, “Almost Broke, Occupy Wall Street Should Scale Down Its Goals”), quotes Margaret Thatcher’s pithy observation. The perennial problem plaguing socialists is “they always run out of other people’s money,” a problem that appears to have Occupied the occupiers since they dis-occupied Zuccotti Park.
In its heady early days, Occupy Wall Street drew spontaneous donations. While it is not clear how much they actually took in, the group’s finance committee announced they had a fund of some $700,000 last year, sparking a spate of news stories about how the Occupiers had to do something they hated and actually open an account at a bank. That war chest has reportedly dwindled to $170,000, a combination of declining contributions — which nosedived in lockstep with declining media coverage — and profligate spending practices in the movement’s early days. All expenditures over $100 had to be approved by the General Assembly, a potentially lengthy process as all GA decisions require unanimity, but the group still managed to spend large amounts of money on projects that, in retrospect, they may wish they had passed on. Presumably the porta-toilets, food and bedding material were easy enough to sell. But by the time the finance committee realized they had a spending problem, the expectation of largesse seems to have permeated the group, causing bitter disputes when they cut off funding for cigarettes, Halloween puppets, and homeopathic herbal treatments.
In this election year, we look for leadership from whatever quarter, and we recognize that the peccadilloes of public figures are quickly forgiven. How else could Newt Gingrich bring down the house with his counterattack against debate moderator John King, who had the effrontery to ask Gingrich about allegations of marital infidelity. Talk about tossing him a fat lob… Newt — who went after then-president Clinton for marital infidelity, apparently while actively engaging in it himself — has now romped through South Carolina, showing that he retains the hearts of those who identify with his message, whatever that may be.
This is not to attack Gingrich, Clinton, John King, or anyone else, but to point out the superficial knee-jerk support American popular figures enjoy. It is immensely difficult to change people’s minds, which is why there is no need for tough questions in the debates, and why no moderator ever tells a speaker to shut up and answer the bloody question. They are either for you, or agin you. If they hate you, an extramarital fling becomes cause for impeachment. If they love you, well… “I’ve done lots of things I’m not proud of.” Gingrich’s cynicism is the very stuff of politics. Romney, for one, could learn a thing or two from this master.
Occupy Wall Street will be back, too, no doubt having learned some political lessons. We can only imagine what the Obama campaign will unleash when its turn comes.
America is awash in politicians. Sadly, though, not in leaders.
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