BANKS | Comptroller Curry Is Scary

Thomas J. Curry, Comptroller of the
Currency

Thomas J. Curry, Comptroller of the Currency, gave mild speeches on March 2 and April 2 focused on risks from terrorist attacks on cybersecurity, a threat to bank operations. Worrisome, but with an enemy on some distant shore and technical fixes waiting in the wings.

Yesterday at the Exchequer Club in Washington, it was different. He allowed himself to step out and make a few spicier comments. He acknowledges that at this stage of the credit cycle, credit quality is and can be expected to deteriorate, and "credit risks are coming to the forefront," ahead of threats from jihadist hackers.

Curry doesn't go much further than that in his remarks. But he plants the seeds of worry. Wall Street on Parade spells out what Curry might have said. Reforms have failed and we may see in this credit cycle a repeat of what led up to the disaster of 2008. One solution is more unified oversight of the financial sector at the Federal level, i.e., encompassing the securities industry.

When I was working for the Federal Reserve and FDIC in the 1960s, the Bureau of the Budget was looking at unifying financial regulation just as a matter of efficiency as well as effectiveness. But if you are an institution being regulated, the last thing you want is efficiency and effectiveness. You want the maximum number of regulators, so you can shop among them.

And if you are the regulator, you don't want your agency eliminated. We can't expect the Comptroller of the Currency, speaking for a 150-year-old office that has had to fight to remain independent from the Federal Reserve System, to advocate for consolidation of Federal oversight agencies.

The issues are surfacing now because of the good work of Pam and Russ Martens of Wall Street on Parade, who are keeping up a steady Pecora-like stream of revelations of what Senator Wright Patman used to call malfeasance, misfeasance and nonfeasance. The candidacy of Bernie Sanders has kept the Glass-Steagall issue in the public eye during the first Democratic debate.

Here is a snippet from today's post from the Martenses outlining the problem:

What Curry didn’t mention are the real elephants in the room – the casino room on Wall Street: the $180.29 trillion of derivatives held at the insured banking units of just four banks: JPMorgan Chase, Bank of America, Citibank (part of Citigroup) and Goldman Sachs. Just those four banks hold 91.1 percent of all derivatives held at the thousands of banks in the U.S. If that’s not concentrated risk, we don’t know what is. Curry also didn’t mention the frightening reality that some of the biggest banks are up to their old dirty tricks of dodging capital requirements through trades with dubious counterparties.
In June, the U.S. Treasury’s Office of Financial Research (OFR) released a report that set off alarm bells. The report, written by Jill Cetina, John McDonough, and Sriram Rajan, revealed that the big Wall Street banks are ginning up their capital measures by engaging in non-transparent “capital relief trades.”
The report indicated that JPMorgan’s London Whale trades, exposed in 2012 and the subject of multiple Congressional hearings and an in-depth report by the Senate’s Permanent Subcommittee on Investigations, was, in fact, a capital relief trade. JPMorgan Chase has owned up to losing at least $6.2 billion of bank depositors’ money on those trades.

Back in 1933, the Pecora Committee - a Senate Committee that was, unusually, named after the aggressive staff counsel, a New Yorker named Ferdinand Pecora - held hearings that led to the Glass-Steagall Act of 1933 and the Securities and Exchange Act of 1933 (while, alas, also skewering a few people who should not have been so impaled).

The Glass-Steagall Act was well-conceived and lasted 70 years. Banks traded deposit insurance for ring-fencing around the commercial banks to keep out the investment bankers. The flaw in the Act was there from the beginning, namely that the securities business was regulated separately and inadequately. The financial lobby has exploited that loophole in stages, notably in 1999 and 2002. The Economist Magazine in 1999 wisely opined that if the Congress was going to take away some Glass-Steagall controls, they would have to extend controls on the securities business; the reverse happened.

A predecessor of Curry as Comptroller of the Currency, John D. Hawke, Jr., in a speech to the NY State Bankers Association in 2000 said:

Regulatory competition has stimulated innovation and efficiency. Competition keeps all of us on our toes, and provides incentives to add real value to our supervision. While the system unquestionably provides opportunities for regulatory arbitrage, there is little evidence that it has stimulated the competition in laxity that former Federal Reserve Chairman Arthur Burns discussed 30 years ago.

Competition in laxity is exactly the term I would choose to describe what happened to the mortgage sector during the next seven years. New York State has now recognized that financial services has  become one industry, and has consolidated banking and securities oversight into one regulatory oversight body that talks openly about financial risk and the risk-taking enemies closer to home. It's time we consolidate financial regulation in Washington.

THE FED | Moral Hazard

Paul Volcker

Wall Street on Parade in recent years has been playing the role that the Pecora Committee played in 1933.

Ferdinand Pecora was hired as general counsel to the Senate Banking Committee to investigate the causes of the 1929 Crash. His hearings in 1933 revealed many practices that tilted the financial marketplace against small investors. He laid the groundwork of public opinion to ensure passage of the Securities Acts of 1933 and 1934.

In the process, the testimony that Pecora extracted injured the reputations of many Wall Street leaders and their friends. Some practices were illegal. Others were attacked with the benefit of hindsight, in the new light of the Crash of 1929. What seemed normal in 1929 had become unethical or unfair... and with the new laws would become illegal.

Today's installment of Wall Street on Parade by Pam Martens and Russ Martens looks at the Latin American financial crisis of the early 1980s and cites from the transcript of the FOMC meeting of June 30, 1982 to examine why the Fed approved a loan to Mexico of $700 million. Mexico owed U.S. banks $21.5 billion. The Fed bailed out Mexico to bail out the banks that had loaned money to Mexico.

In an interview published in the fall of 2013, Harvard Professor Martin Feldstein asked former Fed Chairman Paul Volcker whether the high interest rates of the early 1980s caused debt problems in emerging economies. Volcker responded that U.S. bank loans were of great concern to his predecessor as Fed Chairman in the 1970s:

Arthur Burns, to his credit, was the Paul Revere on this thing. He'd go around and make speeches: "This can't continue. ... We've got to do something about it." The borrowing continued until the winter [1981-82] when a couple of banks stopped lending. Mexico ran out of money. What do you do? [my emphasis]... The big US banks and some of the big foreign banks had more exposure to Latin America than they had capital. It wasn't something you could just say: "Okay, knock off the loans by 50 percent or something and everybody will be happy." They all would have been bust. You look for other approaches, and it took nearly a decade until Mr. Brady [Nicholas Brady, Treasury Secretary, 1988-1993] came along and settled them [Brady bonds replaced Latin American debt, paying lower rates or reducing the face value, but with greater certainty of repayment].  (Martin Feldstein, "An Interview with Paul Volcker, Journal of Economic Perspectives, 27:4, Fall 2013, pp. 112-113.)

Wall Street on Parade argues that the too-big-to-fail attitude, on view in 1982, was behind the Fed and Treasury response to the financial crisis of 2007-2009.

These issues go back to the earliest years of the Fed. Founded in 1913, the Fed published a statement of its policy intentions in 1924, in its Tenth Annual Report in 1924. It announced that it would seek to encourage "productive" loans and discourage "speculative" ones. As loans to purchase securities rose the following year, the Fed tightened money. Benjamin Strong in 1927 complained about the tightening. Concerns about productive lending were shelved that year in favor of expansionary monetary policy - the Fed purchased government securities to add to liquidity.

When the Fed tightened again in 1928, it created the disastrous crisis of 1929-30, and the expansion of 1927 was viewed as the root cause. When banks started to fail, the Fed often refused to lend to them. Not until April 1932 did it expand the money supply, and this ended by August. Julio Rotemberg, "Shifts in US Federal Reserve Goals and Tactics for Monetary Policy: A Role for Penitence?", Journal of Economic Perspectives, 27:4, Fall 2013, 67-69.

Thus a "too-big-to-fail" attitude emerged from the panics caused by a tough line on the banks in 1929-32, which was motivated by a reaction to the expansion of 1927. The "too-big-to-fail" idea creates moral hazard, as Wall Street on Parade notes. As long as that is not addressed, speculative lending will grow and the global financial structure remains shaky.

Tweet

FED | Getting Ready to Start to Crunch.

Janet Yellen, Chair of the Federal Reserve Board.

When the Fed starts to crunch, it's time to go to lunch.

The FOMC meets next week. There is talk of moving out of the zero-bound zone. Scary.

Especially when it's been nearly seven years since the 2008 meltdown and there are young people on Wall Street who have never lived through such a crisis.

As Bernard Shaw said: "We learn from history that we learn nothing from history."

Federal Reserve Bank of New York William Dudley's understated ruminations about financial market challenges ahead ahead are being echoed more loudly and nervously elsewhere by comments and stories from:

• Richard Berner of the Office of Financial Research at the Treasury
• Bloomberg News
• Pam and Russ Martens at Wall Street on Parade  

The rest of this post provides a summary of the difficult options facing the Fed and the implications for financial markets by Risk Management Advisors LLC in their June Chartbook. I am grateful to Noralyn Marshall for sending this to me and for allowing me to excerpt here from her chart book.

The zero-bound interest-rate policy that the Fed has pursued and other central banks have echoed has helped in the seven years since 2008 to restore some financial stability, at the expense of huge debt and a loss of the usual tools of monetary policy.

Risk Management Advisors sums up the perilous situation as one dominated by global central bank policy. We know that

• Risk assessment has been distorted by a sea of liquidity and very low policy rates. The reach for yield has favored weaker credits, longer durations, and equities.
• Debt is higher than it would have been under normal conditions, despite knowing that the great recession was the result of a debt-fueled bubble.
• Some people have assumed debt based on excessively optimistic interest rate assumptions.
• Credit has been granted by those with little experience in evaluating and managing credit risk (crowd funding for example).
• Volatility-based measures of risk are understating future volatility when the Fed no longer dampens it.
• Boosting financial assets has widened the wealth gap. 
• The major economies all face fiscal constraints. [And so do state and local governments.]
• Central bank purchases have temporarily removed market risk from government financing and dramatically lowered its cost.

What we don’t know is how central banks in the US, Japan, EMU, and the UK will navigate out of their iron grip on markets and bloated balance sheets.

Tweet

STOCK BUYBACKS | More Risk, Inequality

Source: IZA

Business school professors have struggled with aligning the interests of executives with the interests of company owners. It is called the principal-agent problem, or just agency problem.

One idea is stock options to reward executives when stock prices rise.

It was understood from the inception of this idea that some long-run measure of stock price should be used to avoid gaming the system. Michael Porter recommended that stock options not be exercisable for five years, and then only a portion of them. Those who have studied abuses of stock options recommend that averages of stock prices over several years be used, again to avoid executives goosing the stock price at a benchmark date.

Sadly, those who have studied the impact of executive pay on stock prices find a negative correlation. CEOs with pay that is in the top ten percent of their industry and size have stock prices that are 13 percent lower for periods up to five years after the high payouts.

OMG, how could this happen? Researchers try to explain the result as overconfidence among executives or investor mistrust of companies with high-paid executives, or both.

Now a better explanation of what has been going on has been presented by none other than Goldman Sachs. A big problems seems to lie in the timing of stock buybacks. What is going on is worrisome both from a social welfare standpoint and from the perspective of managing risks in financial markets. I am grateful to Wall Street on Parade for noting the implications.

In a research note, Goldman has compared the buybacks at high market multiples to the bad investment decisions that corporations made in this arena just before the market crash of 2008:

[B]uybacks peaked in 2007 (34 percent of cash spent) and troughed in 2009 (13 percent). Firms should focus on M&A [mergers and acquisitions] rather than pursue buybacks at a time when P/E [price to earnings] multiples are so high.

Goldman's alert picks up on an article in the September Harvard Business Review, “Profits Without Prosperity”, which notes that corporate profits have been high, but are not being passed through to workers or shareholders. The culprit? Stock buybacks.

[I]n the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42 percent of their compensation came from stock options and 41 percent from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.

In calendar years 2006-2013, says Birinyi Associates, public corporations authorized $4.14 trillion in buybacks of their U.S.-traded stock; in 2013 alone, corporations borrowed $782 billion, almost all paid out for stock buybacks.

In the past two quarters, investment-grade non-financial companies have issued $366 billion in bonds; the $195 billion of bonds they sold in the first quarter alone was a record.  Companies in the S&P 500 are expected to spend more than $1 trillion - two-thirds of their cash - buying back stocks and repaying dividends in 2015.

The debt these companies are taking on to prop up their stock prices is diverting corporate profits to executive pay, and is making the U.S. stock market a riskier place to put money. It helps explain why the prosperity at the top of the companies is not trickling down to the 99 percent very fast.