It gives us no pleasure to suggest that the President is being poorly served by his economic advisors. The President’s latest proposals may be designed to appeal to populist outrage at Wall Street (which HCM shares), but they are poorly designed and would accomplish little to create a more stable financial system.
If we were cynical, we might think that Obama was deliberately proposing these plans with the knowledge that they would cost Wall Street nothing and do nothing to promote financial stability. If we were really cynical, we might think instead that Larry Summers and Tim Geithner didn’t really oppose these plans too strenuously (as the press reported) because they know perfectly well how ineffective these plans will be. With all of the gray matter in the White House, it’s difficult for HCM to accept these proposals with a straight face.
On January 14, 2010, the President introduced a proposal to tax banks for the bailout. The proposal would levy a tax on the non-depository assets of banks with more than $50 billion of such assets. The purpose of this tax would be to recover the cost of the bailout for the American taxpayers. This proposal is inadequate from several standpoints. By only taxing the banks, it ignores the complicity of many other speculators who benefitted from the reckless financial practices that led to the financial crisis, such as hedge funds and other investors who continue to speculate in naked credit default swaps and other dangerous financial instruments.
It is widely known by knowledgeable market professionals that the vast majority of trading in such instruments is done for the purpose of speculation, not for the purpose of hedging underlying positions. Accordingly, this proposal gives a free pass to much of the speculative activity that comprises the most profoundly flawed practices in the system. The Tax on Speculation that was proposed in this publication recently is more precisely aimed at unproductive activities that, if permitted to fester, will continue to push the U.S. economy down the road to ruin.
The tax also lets the banks off easy. The $90 billion price tag (it was initially reported to be $120 billion but quickly shrunk without explanation to the lower figure) over ten years is a drop in the bucket compared to the trillions of dollars of damage that the banks’ reckless practices imposed on the American economy. Recapturing just the cost of the TARP does not go far enough to compensate society for the damage that modern financial practices have imposed. This tax does not go nearly far enough in imposing financial responsibility on these quasi-public utilities.
President Obama did not stop his financial reform revival with the ill-begotten tax on banks, however. On the day after the Massachusetts massacre, he unveiled a three part plan to limit risk-taking by banks with insured deposits. The so-called “Volcker Plan” would prevent banks from owning hedge funds, private equity funds or engaging in proprietary trading with insured deposits. No details were provided, which suggests that the plan was rushed out the door in order to burnish the President’s reform credentials.
The “markets,” meaning Wall Street, panicked at this announcement as they feared that the game they have been running on the rest of us would be coming to an end. Unlike Meredith Whitney (fellow Brown University alum), who believes that this proposal has a high likelihood of passing in some form, HCM does not expect any such legislation to gain much traction in the current Congress (although we do concur with her general point that profitability at these institutions is going to come under increasing regulatory and political pressure).
Moreover, just as with the tax on banks, the Volcker Plan misses the point, which should be to legislate the financial products that cause damage, such as naked credit default swaps. Moreover, this legislation promotes the fantasy that something can actually be done to prevent firms from growing “too big to fail” when it is virtually impossible to do so without placing limits on such products. You could cut down to size the largest firms in the world, but if they are all still trading toxic products with each other and are thereby still interconnected, the system would still be at risk if one of them failed because the entire system would only be as strong as its weakest link. It is not a question of individual firms being “too big to fail”; products such as credit default swaps effectively turn the entire system into the equivalent of a single firm that is too big to fail!
That is why the products must be regulated. The proper approach is to significantly strengthen capital requirements AND eliminate toxic products, as I argue in my forthcoming book, The Death of Capital (publication date early May 2010). There can be little quarrel with the argument promulgated by Paul Volcker that banks should not be trading with depositors’ funds, but that begs the question of the systemic risks they still pose by trading toxic products with their own capital.
Moreover, as many others have pointed out, while proprietary trading creates its share of blowups, it was not the primary cause of the financial crisis. As much money as it lost during the financial crisis, Wall Street was fairly adept at shifting the risks in its proprietary trading to its counterparties (like AIG, whose losses the government was forced to pick up, a story for another day).
The major Wall Street losses were primarily attributable to bad lending decisions, which were driven by a failure to recognize the procyclical monetary policies of the Federal Reserve and the boom and bust cycle in which both fiscal and monetary policy has trapped the United States and global economies. That has little to do with proprietary trading, although it does have to do with profound failures of risk management and intellect. Unfortunately, we can be assured that these mistakes will be repeated again, probably in the relatively near future.
*(Reprinted with permission from The HCM Market Letter)
