Analysis and Commentary by Roosevelt Fellow Mike Konczal
Is there a Too Big to Fail (TBTF) subsidy? If so, is it large, sustained, and institutionalized by Dodd-Frank, as many conservatives claim? Since this is always coming up in the discussion over financial reform, and especially since both those who think Dodd-Frank should be repealed and those who think it didn’t go anywhere near far enough have an incentive to argue for it, let me put out my marker.
I think the TBTF subsidy was real in the aftermath of the crisis, when it was an obvious policy to prevent a collapse of the financial system. But, contrary to the conservative argument, the subsidy has been reduced to a small amount, if it still exists at all. I also think the focus on it is a distraction. My reasoning comes less from any single study but instead from the fact that the two primary yet opposite quantitative techniques for determining such a thing both tell the same exact story—a fact that I don’t think has been caught.
This post will be written for general readers, with the financial engineering in the footnotes. A TBTF subsidy just means that the largest firms are viewed by the markets as being safer than they should be. Since they have less credit risk, they have cheaper borrowing costs, and prices of their credit risks, as measured in CDS prices, will be lower.
So how would you go about answering whether a bank has a TBTF subsidy? There are two general quantitative approaches. The first would be to compare that bank to other, non-TBTF banks, controlling for characteristics, and see whether or not it has cheaper funding. The second would be to look at the fundamentals of that bank by itself, estimate its chances of failing, and compare it to the market’s estimates. These approaches are, as a matter of methodology, the opposite of each other . Yet they tell the same story. Let’s take them in turn.
First Method – Compare a Firm to Other Firms
The first approach is to simply compare TBTF firms with other firms and see if they receive lower funding. How do you do this? You get a ton of data across many different types of banks and look at the interest rates those banks get. You assume that the chances of default are random but can change based on characteristics . You then do a lot of statistical regressions while trying to control for relevant variables and see if this TBTF measure provides a lower funding cost. This is what the GAO did last year.
One major problem with this technique is that you have to control for important variables. Is TBTF a matter of the size of assets, the square of the size of assets, or just a $50 billion threshold? How do you control for risks of the firm? Given that all the information comes from comparisons across firms, the way you compare a TBTF firm with a medium-sized firm matters.
This is why you can end up with the GAO estimating 42 different models: they wanted to try all their variables. But which models are really the best? The graph below summarizes their results, where they found a major subsidy in the aftermath (dots below the line reflect models showing a subsidy) of the crisis that went back to near-zero later.
Second Method – Compare a Firm to Itself
Let’s do the exact opposite with the second approach. Instead of comparing across firms, let’s create a “structural” approach that looks at the specific structures of the bank, making an estimate of how likely it is to default . We then compare that estimate with actual market prices of default estimates from credit default swaps. If there’s a TBTF subsidy, that means that our estimate of the price of a credit default swap will be higher than the actual price, since the market thinks a loss is less likely.
How do we do this? We look at the bank’s balance sheet and figure out how likely it is that the value of the firm will be less than the debt. We can even phrase it like an option, which means we can hand it to the physicists to put on their Black-Scholes goggles and find a way to price it [details at 4]. The IMF recently took a crack at using the second approach and comparing the estimate to actual CDS prices.
Here’s what they found, where a positive value means the predicted price is larger than the actual price:
Opposites Strengths, Weaknesses
These two approaches aren’t just the opposite of each other; they also have opposite weaknesses. Where under the first approach it’s not really clear whether or not you are controlling for size and risk well at any moment, the structural model is able to ignore these issues by simply looking at the TBTF firm itself. But structural models need CDS prices, which are often illiquid, introducing numerous pricing problems. The first approach includes the bond market, which is quite deep. The structural model requires a lot of financial engineering modeling assumptions, where the statistical approach requires virtually no assumptions. Let’s take a second and chart that out:
Note again that the two approaches are the complete opposite of each other in theory, data, and relative merits, yet they both tell the same story. There was a subsidy that was real in the aftermath of the crisis but has been coming down and is now close to zero. What should we take away from this?
First, the mission isn’t done, but we are on the right path. Higher capital requirements, liquidity requirements, living wills, restructuring, derivatives clearing, and more are paying off, removing much of the concern that the markets believe we have permanent bailouts.
You’ll hear many stories about this subsidy, but they will get all their value from the 2009–2010 period. For those on the right who argued that this would become a permanent GSE regime, this isn’t the case. The only question is whether we will go further to fully eliminate it, not whether it will be a permanent feature.
Second, we should remember that this subsidy focus was always a distraction. If Lehman Brothers had collapsed with no chaos, we’d still have millions of foreclosures, a securitization and credit market designed to rip off unsuspecting consumers, and a system of enforcement that doesn’t hold people accountable. The subsidy is only one of the major problems we have to deal with.
In addition, this subsidy equaling zero doesn’t mean that we can ignore the issue. These models can’t tell the difference between a successful and an unsuccessful resolution. This conclusion just means there would be a credit loss, but doesn’t tell if bankruptcy is an option, or if a resolution is swift, certain, well-funded, and likely to create minimal chaos for the economy. Those are our bigger concerns, which aren’t the same question at all.
Third, rolling back major parts of Dodd-Frank, particularly when it comes to TBTF policy, is a bad idea. These results are fragile; it’s easy for us to return to 2010. It would be a shame to remove the policies that are actually working well.
 It’s not exactly “reduced-form versus structural”, but if you want to learn more about these two methods (and to confirm I’m not making this up) there’s an extensive literature on it.  In the jargon, defaults are thought of as exogenous, with some characteristics making a random default more likely. This will become more apparent in the second approach, when we model the default as endogenous to the structure of the firm.  Full disclosure, I used to work at Moody’s KMV, a pioneer in structural models. I bleed structural modeling; it is the best.  Equity is worth the firm’s assets minus debt, or zero if the assets are less than debt. This is the same exact payout as a call option; the equity of the firm is simply a call option on the firms’ assets, with the debt as a strike price, and as such can be modeled and priced like an option.
(For those really wedded to the myth that shareholders “own” the firm, note that in the world of Black-Scholes it’s just as true to say that debtholders “own” the firm, except they sell off a derivative on their ownership to someone else.)
I have a piece at Rolling Stone, about how Yale’s giant donation and the collapse of for-profit colleges under fraud charges both tell the same story: as we defund and privatize state public colleges there no set of good institutions which will fill the void left behind.
Three quick follow-up points. First, a technical one responding to something several people have brought up. I argue: “how much will Yale increase its enrollment numbers as a result of this [Schwarzman $150 million donation]? We can make a good guess: zero. Yale’s freshman enrollment this past year [is] virtually the same as in 2003.”
Yale’s enrollment has not only been flat since 2003 but since around the 1970s, even though the number of students being educated overall has doubled over those 40 years. Some people have noted that there are plans by fall 2017 to increase Yale’s enrollment 15 percent. It’s true, though those plans have been in the works since before the financial crisis and have been significantly delayed, and are unrelated to the Schwarzman donation. The point very much stands.
Some thought this point was a cheap shot, but I think it is crucial to get out there in the debate. Private non-profits pick and choose strategically how to expand enrollment to fufill their private goals, and that’s great. But their goals do not line up with the public one of ensuring that all who qualify has access to quality, affordable higher education, and they certainly won’t step up as that system is pulled back.
Second, the for-profit stories are crazy. I need to be writing more about them, but keep an eye on their implosion, and what it means for privatization and running all government services through for-profit actors. The Corinthian debt-strikers are worth watching as well – here’s Annie Lowrey writing about them and Astra Taylor.
Third, two recommendations. Michelle Goldberg’s long Nation piece on the inequality amplifying consequences of public disinvestment at the University of Arizona, which I link to, is fantastic, and very much worth your time. I also tried to get in this great column by Andrew Hartman on how conservatives used to value mass higher education as a basis of Western Civilization during the Culture Wars – Alan Bloom describing it as “a space between the intellectual wasteland he has left behind and the inevitable dreary professional training that awaits him after the baccalaureate” – but now have traded that battle for one of defunding and privatization, but it didn’t make it. But check out my piece anyway!
I have a piece in The Nation discussing the Death of Centrism. A lot of people are discussing why the economic discussion has shifted to the left in liberal circles, and one of the big reasons is that the specific predictions centrists (as a movement, not a temperament) made about the economy didn’t pan out.
It’s very difficult to convey how different the conversation was back then. Here’s a 2010 op-ed by Peter Orszag arguing that “much more deficit reduction, enacted now, to take effect in two to three years” as well as “an improvement in the relationship between business and government” are both necessary to boost the short-term economy. (He also argues against QE2 because monetary expansion might help prevent a Grand Bargain on the budget.) When researching this piece, Josh Bivens reminded me the administration was freaking out in 2009 about how the “carry trade” could cause interest rates to spike at a moment’s notice, an argument that seems ridiculous with rates so low six years later.
All the centrists got was a counterproductive spending cut, one the GOP immediately reneged, and none of their actual goals. And now their arguments are completely absent from the debate right now. I hope you check it out!
I’m very excited to announce the release of “Rewriting the Rules of the American Economy” (pdf report), Roosevelt Institute’s new inequality agenda report by Joe Stiglitz. I’m thrilled to be one of the co-authors, as I think this report really tells a compelling story about inequality and the challenges the economy faces.
Recently there’s been a lot of discussion about a “new” conventional wisdom (“a force to be reckoned with” according to one observer), one in which choices about the rules of the economy are a major driver of the outcomes we see. This is in contrast to the normal narrative about inequality we hear, one in which globalization, technology, or individual choices are the only important parts. I like to think this report is a major advancement in this discussion, bringing together the best recent research on this topic.
As we argue, inequality is not inevitable: it is a choice that we’ve made with the rules that structure our economy. Over the past 35 years, the rules, or the regulatory, legal and institutional frameworks, that make up the economy and condition the market have changed. These rules are a major driver of the income distribution we see, including runaway top incomes and weak or precarious income growth for most others. Crucially, however, these changes in the rules have not made our economy better off than we would be otherwise; in many cases we are weaker for these changes. We also now know that “deregulation” is, in fact, “reregulation”—that is, a new set of rules for governing the economy that favor a specific set of actors, and that there’s no way out of these difficult choices. But what were these changes?
Financial deregulation exploded both the size of finance and its incomes, roughly doubling the share of finance in the top 1 percent. However, finance grew as a result of intermediating credit in a “shadow banking” sector, which led to disastrous results. It also grew from asset management, a field in which pay is often determined by luck and by fees driven by the increasing prevalence of opaque alternative investment vehicles like hedge funds. For all the resources it uses, finance is no more efficient than it was a century ago.
Corporate governance also radically changed during this period, led by public policy decisions. CEO pay fundamentally shifted toward a high pay model in the 1980s. The shareholder revolution also changed the nature of investment. We now see finance acting as a mechanism for getting money out of firms rather than into them; similarly, private firms are investing more than public firms. CEOs regularly use buybacks to hit earnings targets and say they’d rather hit accounting goals than invest long-term, indicating that short-termism is now a serious problem for investment and its positive spillovers.
High marginal tax rates were cut, but there’s no evidence that the high-end marginal tax rate has any effect on growth; cutting it does, however, raise the share of income the top 1 percent takes home. Low taxes don’t just make the equalizing effects of taxes weaker; they also mean that CEOs and other executives in the top 1 percent have more of an incentive to bargain aggressively with boards or seek opportunities for extracting rents, all zero-sum games for the economy. Lowering capital taxes showed no impact on higher investment, but a positive effect on increased capital payouts; capital income growth is one of the main drivers of inequality during this time period.
During this time, the Federal Reserve’s focus moved toward low and stable inflation at the cost of higher unemployment. Unemployment from weak Federal Reserve action rises the most for low-skilled and minority workers. Inequality generally doesn’t come down unless unemployment is below 6 percent, and this has become less of a priority.
The rules changed, or were not updated, for the labor market as well. Decreasing unionization has taken a toll on workers’ wages. Men’s inequality, in particular, has risen due to collapsing unionization rates. Women’s inequality has suffered due to a falling minimum wage, which went from 54 percent of the average hourly wage in the late 1960s to just 35 percent now. Labor market protections and institutions that give workers voice and power, in general, have not been updated for a new world of service and care work.
Though not an effective driver of lower crime rates, a dramatic turn toward mass and punitive incarceration has reduced the employment prospects for millions of Americans, especially people of color. In particular, there’s a dense web of discriminatory codes for those with a record, which pushes them toward second-class citizenship. One estimate finds 38,000 such punitive statutes, with most of them related to employment and having no end date.
Our institutions and rules haven’t been updated to fully facilitate women’s ability to participate in the labor force. As a result of gender discrimination in the workplace, lack of paid sick and family leave, and the unavailability of affordable child care, women’s participation in the U.S. labor force has declined over the past 15 years, while it increased in most other OECD countries.
Many people agree inequality is a challenge, but would say that this is all driven by technology and globalization. We discuss this at length in the report, but we don’t find these traditional stories either convincing, in the case of technology, or sufficient, in the case of globalization. Both of these forces are playing out, in quite similar ways, in other advanced countries, whose growth of inequality nowhere mirrors our own. Technology and globalization don’t fall from the sky, but instead are determined in important ways by rules and institutions. This is especially important in the era of free trade agreements, which are really managed trade agreements. These agreements are less about trade and more about the regulatory environment corporations face.
But rules matter even in these straightforward stories about supply and demand for labor. Advancements in search theory tell us that supply and demand, rather than strictly determining wages, instead place boundaries or endzones on where wages can go. What determines where wages fall within those boundaries is a whole host of economic rules, including bargaining power, institutions, and social conventions. Even in the strong version of these arguments, the rules matter.
This report describes what has happened, going far deeper than this summary here. It also has a policy agenda focused on both taming the top and growing the rest of the economy. Some may emphasize some pieces more than others; but no matter what this argument about the rules is what is missing in the current debates over the economy. I hope you get a chance to check out the report!
The American Action Forum jumps into the financial reform debate with a letter on the growth consequences of Dodd-Frank penned by its president, Douglas Holtz-Eakin. This letter is a bad analysis, immediately violating the first thing you learn in corporate finance: capital structure doesn’t dictate funding costs. But there’s a deeper context that makes this letter reckless and a bad development, and I hope they are willing to walk back part of it.
Why reckless? It’s important to understand the role people like Holtz-Eakin play in the conservative movement. It is less about providing analysis (which is good, because this is a bad analysis), and more about signaling priorities. What should be done about Dodd-Frank if the Republicans win in 2016? This letter signals a new front I haven’t seen before on the right: one focused on going after higher capital requirements. Worse, going after them as if they were, using that conservative trigger word, a “tax.” I think that is a terrible move with serious consequences, and if they are going to do it, they need to do better than this.
A Bad Analysis
Americans for Financial Reform and David Dayen give us a solid overview of what is lacking in this analysis. It contains no benefits, confuses one-time and ongoing costs, assumes all costs derive from the cost of capital rather than profits, and so on. I’m also pretty sure there’s an error in the calculations, which would reduce the estimate by a third; I’m waiting for a response from them on that .
But I want to focus on capital requirements. Holtz-Eakin argues that the Solow growth model “can be used to transform the roughly 2 percentage point rise in the leverage ratio of the banking sector” into “a rise in the effective tax rate.” Wait, the tax rate? “The banking sector responded to Dodd-Frank by holding more equity capital,” writes Holtz-Eakin, “thus require it to have greater earnings to meet the market rate of return – the same impact as raising taxes.” Higher capital requirements, in this argument, function just like a tax.
He concludes that a 2 percentage point rise in capital requirements, much like what we just had, increases the cost of capital somewhere between 2 and 2.5 percent. (I believe I understand that to be the argument, though the paper itself is quick and not cited to any body of research.)
This is wrong, full stop. The Holtz-Eakin argument is predicated on the idea that capital structure directly affects funding costs. But our baseline assumption should be that there is virtually no impact of capital requirements on cost of capital. Economics long ago debunked the notion that changes in aggregate funding mixes can have an effect on the value of a business itself, much less a widespread, durable, macroeconomic effect. This is a theorem they teach you in Corporate Finance 101: the Modigliani–Miller theorem. And this has been one of the most important arguments in financial reform, with Anat Admati being a particularly influential advocate of pointing this out.
Just step back and think about what Holtz-Eakin’s model means. If Congress passed a law requiring companies to fund themselves with half as much equity as they did before, would the economy experience a giant growth spurt from changing the aggregate funding mix? No, of course not. The price of capital would simply adjust with this new balance; funding with more equity means funding with less debt, though the business is still the same. Investors are not stupid; they respond to a changing funding mix by simply changing the prices accordingly. This is how markets are supposed to work.
Of course, the real world doesn’t work exactly like these abstract economic models. If there’s a hierarchy of financing options, which seems reasonable, then moving up or down that ladder can impose some costs. Doug Elliott from Brookings, for instance, writes quite a bit arguing that the idea that equity and higher capital requirement is costless is a dangerous “myth” of financial reform. (Here is Admati responding.)
So Elliott’s not on the costless side, but does he agree with Holtz-Eakin’s numbers? Not even remotely. According to Elliott’s estimate, the cost of the entirety of Dodd-Frank increases the cost of capital 0.28 percent, and the “low levels of economic costs found here strongly suggest that the benefits in terms of less frequent and less costly financial crisis would indeed outweigh the costs.”
As shown in the graphic above, a model of higher capital requirements by Kashyap, Stein, and Hanson put the estimate of a 2 percent capital increase at between 0.05 percent (driven by the tax effects) and 0.09 percent (driven by a large slippage of Modigliani-Miller they assume to get a high-end estimate). These are broadly in line with other estimates throughout the past several years. Even the most industry-driven estimates designed to weaken capital requirements don’t remotely approach this 2.00+ percent increase.
(As a coincidence, Elliott did estimate what it would take to make the cost of capital rise Holtz-Eakin’s estimated 2 percent. In his view, it would be capital requirements on the order of 30 percent, which is the reach goal for some. But when you analyze Dodd-Frank and get numbers consistent with 30 percent capital ratios, you are probably doing it wrong.)
A Worse Priority
So the estimate is wrong in a fundamental way; but this is less about a specific analysis than it is about setting priorities for the conservative movement when it comes to Dodd-Frank. And if attacking capital requirements becomes a major priority for conservatives, that’s a worrying sign. When conservatives start calling things “taxes,” institutional forces go into play beyond the control of any specific person, and that’s dangerous for a successful reform with lots of support that is important for a better financial system.
A broad group of people has come together to argue for capital requirements. This includes important commentators across the spectrum, from Simon Johnson to John Cochrane to many others. And there’s good reason for this. The current capital requirement regime hits six birds with one stone: helping with solvency, balancing risk management, making resolution and the ending of Too Big to Fail more credible, preventing liquidity crises in shadow banking, right-sizing the scale and scope of the largest financial institutions, and macroeconomic prudential policy.
There are disagreements about specifics of what is the best way to do higher capital requirements—quite intense ones, actually. But there’s a broad consensus in favor of them. Having watched this from the beginning, this broad coalition is one of the most promising developments I’ve seen.
I’m excited to see the right go after Dodd-Frank. Is the argument that there’s too much accountability for consumers now, and we need to gut those regulators at the CFPB? Is it that derivatives regulations are too extensive, and we should build our future prosperity by letting a thousand AIGs bloom? Is it that there should be few, if any, consequences for firms that break the law or commit fraud? (As someone who is worried about over-policing, this is one area where I believe we are criminally under-policed.) Please, by all means, make these arguments.
But taking on capital requirements with this weak argument is a bad development. The financial market is not understudied, and though nobody has ever found anything like these results, and though it’s clear Holtz-Eakin’s analysis doesn’t even engage with this other research, those who think the cost of capital requirements are low could be wrong. But to prove that, we’ll need an analysis far better than the one provided here. And until one has that, the responsible thing is to not unleash the conservative movement against reform that is doing good work and that should be advanced rather than dismantled.
 I’m pretty sure for “rL-C” in equation 11 he uses net income ($151.2bn) rather than EBIT ($218.7bn), though, from equation 9, “rL-C” should be pre-tax. However using the wrong number is the only way I can replicate the estimate he has. I’ll update this either way if they respond.
If I’m right this decreases Holtz-Eakins’ growth costs of regulations by about 30%, meaning that the economy will probably be skyrocketing any second now.
A lot of people were surprised last month when the investment giant BlackRock flagged the rise in stock buybacks and dividend payments as a major economic concern. Its CEO argued that the “effects of the short-termist phenomenon are troubling both to those seeking to save for long-term goals such as retirement and for our broader economy,” and that this was being done at the expense of “innovation, skilled work forces or essential capital expenditures necessary to sustain long-term growth.”
They are right to be concerned. The cash handed back to shareholders in the form of buybacks and dividends was 95 percent of corporate profits in 2014, climbing from 88 percent the year before and 72 percent in 2010 and expected to go even higher in the future. These numbers are far above historical norms, but they are the culmination of a long process starting in the 1980s. Private investment remains a weak part of the recovery, and it is necessary to investigate the connection between corporate governance and those decisions.
With that in mind, Senator Tammy Baldwin (D-WI) has sent a letter to the SEC looking for answers on these issues. In particular, she flags whether the SEC’s mission to “foster capital formation and prevent fraud” is jeopardized by short-termism in the market. It will be good to see how the SEC responds, and which other senators and organizations join in with their concerns.
Personally, I’m happy that it quotes J.W. Mason’s work on profits and borrowing shifting from investment in a previous era to cash leaving the firm now. This issue is a major piece of our Financialization Project here at Roosevelt, and we will continue to develop it in the future.
I think there are two additional things of interest. One is that this relationship is becoming more of an interest for academic and popular scrutiny. Recent, high-level research is showing that as a result of short-termist pressures, “public firms invest substantially less and are less responsive to changes in investment opportunities, especially in industries in which stock prices are most sensitive to earnings news” compared to private firms before the Great Recession.
Second, this looks like a centerpiece agenda item for liberals going into 2016. Larry Summers’s Inclusive Prosperity report for the Center for American Progress discusses concerns over short-termism, noting, “it is essential that markets work in the public interest and for the long term rather than focusing only on short-term returns. Corporate governance issues, therefore, remain critical.”
The problem of short-termism was also in Senator Elizabeth Warren’s big speech on the future of the financial reform agenda, in which she noted we need to change the rules of the economy because we “too often reward short-term risk-taking instead of sustained, long-term growth” and allow CEOs to “manipulate prices in the short-term, rather than investing in the long-term health of their companies.”
And it will be central to work from the Roosevelt Institute about inequality coming next month. (Get excited!)
I’m not sure if the right has a response to this issue. One of their core policy goals, removing all taxes on capital, will certainly make the situation worse, as the Bush dividend tax cuts increased dividends payouts without encouraging any real investment or wage growth. If the Republicans want to have real answers about inequality and stagnation, it’s important that they tackle real questions. And short-termism is one of those essential questions.
Two bits of exciting news this week.
First, I’m starting a biweekly newsletter. It’ll have what I’m up to, including all the things I’ve been writing, collected into one place. It’ll also have my favorite stuff I’ve read, random personal stories, and more. (Blame Google Reader for this I suppose.) Oh, and pictures of my dog too. Given the rate at which I’m writing it’s probably more of an every other week update; we’ll see how it goes. But for now, sign up!
Second, I’m joining the masthead at Dissent as a contributing editor. Here is the annoucement; I was happy to join even before I knew the excellent people they were bringing on board. Nothing much changes for me, I just get to formalize my relationship with the brilliant team they’ve built over there and help make it a standard for left thought going forward.
I also have a review of Naomi Murakawa’s new book on liberal punishment in the latest issue. This newest issue is excellent, but the piece on the assistant economy by Francesca Mari is one of the most bizarre and enlightening business pieces I’ve read recently. Also check out Sarah Jaffe on punk rock feminism and the left once it’s out from the paywall (or better, subscribe!).
News is breaking that GE Capital will be spinning off most of its financing arm, GE Capital, over the next two years. Details are still unfolding, but, according to the initial coverage, “GE expects that by 2018 more than 90 percent of its earnings will be generated by its high-return industrial businesses, up from 58% in 2014.”
It’s good that our industrial businesses will be focusing more on innovating and services rather than financial shenanigans, but this also tells us two important things about Dodd-Frank: it confirms one of the stories about the Act and disproves the core conservative talking point about what the Act does.
A very influential theory of the financial crisis is that there were financial firms acting just like banks but without the normal safeguards that traditionally went with banks. There was no public source of liquidity or backstops through the FDIC or the Federal Reserve, a public good capable of ending self-fulfilling panics. There was no mechanism to wind down the firms and impose losses outside of the bankruptcy code. There weren’t the normal capital requirements or consumer protections that went with the traditional commercial banking sector.
Though we now call this regulatory arbitrage, at the time it was seen as innovation. GE Capital was explicitly brought up as a poster child for deregulation. You can see it in Bob Litan and Jonathan Rauch’s 1998 American Finance for the 21st Century, which lamented the “twentieth-century model of financial policy” that, using transportation as an analogy, “set a slow speed limit, specified a few basic models for cars, separated different kinds of cars into different lanes, and demanded that no one leave home without a full tank of gas and a tune-up.” GE Capital was explicitly an example of a firm that could thrive with a regulatory regime that “focuses less on preventing mishaps and more on ensuring that an accident at any one intersection will not paralyze traffic everywhere else.”
This was very apparent in the regulatory space. The fact that GE owned a Utah savings and loan allowed it to be regulated under the leniency of the Office of Thrift Supervision (OTS), so it was able to work in the banking space without the normal rules in place. It was also able to use its high-level industrial credit rating to gamble weaker positions in the financial markets, arbitraging the private-sector regulation of the credit ratings agencies in the process.
How did that work out? First off, there was massive fraud. As Michael Hudson found in a blockbuster report, one executive declared that “fraud pays” and that “it didn’t make sense to slow the gush of loans going through the company’s pipeline, because losses due to fraud were small compared to the money the lender was making from selling huge volumes of loans.” Then there were the bailouts. The government backstopped $139 billion worth of GE Capital’s debts as it was collapsing and essentially had to manipulate the regulatory space to allow it to qualify for traditional banking protections. So much for not paralyzing traffic, and so much for the old rules not being important.
Dodd-Frank looked to normalize these regulations across both the shadow and regular banking sectors. It eliminated the OTS and declared GE Capital a systemically risky firm that has to follow higher capital requirements and prepare for bankruptcy with living wills just like we expect a bank to do, regardless of what kind of legal hijinks it is using to call itself something else. And GE Capital, faced with the prospect of having to play in the same field as everyone else, decided it should go back to trying to bring better things to life rather than making financial weapons of mass destruction. That’s pretty good news, and a process that should be encouraged and continued.
The Collapse of the Conservative Argument
But there’s one ask GE has as it spins off GE Capital, one that actually disproves the core conservative argument on Dodd-Frank. In the coverage, GE Chairman and CEO Jeff Immelt states directly, “GE will work closely with [the regulators at the Financial Stability Oversight Council] to take the actions necessary to de-designate GE Capital as a Systemically Important Financial Institution (SIFI).”
Dodd-Frank designates certain financial institutions, mostly over $50 billion in size, as systemically important. Or as the lingo goes, they get designated SIFI status. Those firms have stronger capital requirements and stronger requirements to be able to declare themselves ready for bankruptcy or FDIC resolution if they fail.
Conservatives, from the beginning, have made this the centerpiece of their story about Dodd-Frank. They argue that SIFI status is a de facto permanent bailout and claim that firms will demand to be designated as SIFIs because it means they will have a favored status. This status gives them easy crony relationships with regulators and allow them to borrow cheaply in the credit markets.
This has become doctrine on the right; I can’t think of a single movement conservative who has said the opposite. Examples of the mantra range from Peter Wallison of AEI writing “[t]he designation of SIFIs is a statement by the government that the designated firms are too big to fail” to Reason’s Nick Gillespie repeating that “everyone agrees [Dodd-Frank] has simply reinscribed too big to fail as explicit law.” (I love an “everyone agrees” without any sourcing.)
It’s also the basis of proposed policy. The Ryan budget cancels out the FDIC’s ability to regulate SIFIs, stating that Dodd-Frank “actually intensifies the problem of too-big-to-fail by giving large, interconnected financial institutions advantages that small firms will not enjoy.”
If that’s the case, GE should be desperate to maintain its SIFI status even though it is spinning off its GE Capital line. After all, being a SIFI means it gets all kinds of favored protections, access, and credit relative to other firms.
But, instead GE is desperate to lose it. This is genuine; ask any financial press reporter or analyst, and they’ll tell you that GE is very sincere when it says it doesn’t want to be designated as risky anymore, and is willing to take appropriate measures to remove the designation.
If that’s the case, what’s left of the GOP argument?
In JPMorgan’s latest shareholder newsletter (p. 30-34), Jamie Dimon walks through a narrative of the next financial crisis and why we should be worried about it. But instead of worrying, I think it points to interesting details of what we’ve learned from the last crisis, what we evidently haven’t learned, and where we should go next.
Here’s Matt Levine’s summary. Dimon makes two arguments: First, the new capital requirements, especially the liquidity coverage ratio (LCR) that requires banks to fund themselves with enough liquidity to survive a 30-day crisis, will be procyclical. This means they will bind the financial sector more tightly in a crisis and prevent it from being a backstop. This is made even worse by his second argument, which is that there’s a safe asset shortage. Each individual bank is much safer than before the crisis, but using safe assets to meet the LCR means there will be fewer out there to provide stabilization when a crisis hits.
To use Dimon’s language, “there is a greatly reduced supply of Treasuries to go around – in effect, there may be a shortage of all forms of good collateral” in a crisis. Meanwhile, new capital requirements, especially the LCR, mean that in a crisis banks won’t want to lend, roll over credit, or purchase risky assets, because they would be violating the new capital rules. As such, “it will be harder for banks either as lenders or market-makers to ‘stand against the tide’” and to serve as “the ‘lender of last resort’ to their clients.”
What should we make of the fact that Dimon’s target is the LCR, an important new requirement under constant assault by the banks? Four points jump out.
The first is that the idea that we should weaken capital requirements so banks can be the lender of last resort in a financial crisis is precisely what was disproven during the 2008 panic. One reason people use the term “shadow banking” to describe this system is that it has no actual means of providing liquidity and the backstops necessary to prevent self-fulfilling panics, and that was demonstrated during the recent crisis.
Rather than financial firms heroically standing against the tide of a financial panic, they all immediately ran for shelter, forcing the Federal Reserve to stand up instead and create a de facto lender-of-last-resort facility for shadow banks out of thin air.
It’s good to hear that Dimon feels JPMorgan can still fulfill this function in the next crisis, if only we weakened Basel. But we’ve tried before to let financial firms act as the ultimate backstop to the markets while the government got out of the way, and it was a disaster. Firms like AIG wrote systemic risk insurance they could never pay; even interbank lending collapsed in the crisis.
This is precisely why we need to continue regulating the shadow banking sector and reducing reliance and risks in the wholesale short-term funding markets, and why the Federal Reserve should actually write the rules governing emergency liquidity services instead of ignoring what Congress has demanded of it. No doubt there needs to be a balance, but if anything we are counting too much on the shadow banking sector to be able to take care of itself, not too little.
As a quick, frustrating second point, it’s funny that regulators bent over backwards for the financial industry in addressing these issues with LCR, and yet the industry won’t give an inch in trying to dismantle it. That LCR is meant to adjust in a crisis and that the funds would be available for lending was emphasized when regulators weakened the rule under bank pressure, and it is explicitly stated in the final rule (“the Basel III Revised Liquidity Framework indicates that supervisory actions should not discourage or deter a banking organization from using its HQLA when necessary to meet unforeseen liquidity needs arising from financial stress that exceeds normal business fluctuations”).
If risk-weighting is too procyclical, which requires several logical leaps in Dimon’s arguments, the solution is to adjust those rules while raising the leverage ratio, not to pretend that the financial sector would be a sufficient ultimate backstop. Bank comments on tough rules like LCR are less give-and-take and more take-and-take.
But the third point is more interesting. Beyond whether or not the rules are too procyclical and unnecessarily restrictive in a crisis, there’s Dimon’s claim that there aren’t enough Treasuries to go around. If that’s the case, why don’t we simply make more Treasury debt? If the issue is a shortage of Treasuries needed to keep the financial sector well-capitalized and safe, it’s quite easy for us to make more government debt. And right now, with low interest rates and a desperate need for public investment, strikes me as an excellent time to do just that. Dimon is correct in his implicit idea that the financial markets, with enough financial engineering and private-market backstopping, can produce genuinely safe assets is a complete sham. This is a role for the government.
And for fun, a fourth point from Ben Walsh: Dimon says one of the biggest threats to the financial markets is that there isn’t enough U.S. debt. From January 2011: “Dimon Says Government Deficits, Spending Are New Global Risk.” We are risking a major rise in interest rates in the years following 2011 if we have trillion-dollar deficits, Dimon warned. How did that turn out?
Imagine how much worse shape we’d be in if we’d listened to Dimon.
So just as a friendly reminder: not only would more federal debt issued at incredibly low rates do cool things like rebuild schools, fix bridges, and give money to poor people, it would also serve as an important element of reducing the risks of the next financial crisis. This federal debt seems like a pretty useful thing to have around.
John Oliver dedicated his main segment on last Sunday’s episode to the epidemic of municipal fees. He walks through several stories about tickets and citations that are overpriced and end up being more expensive for poor people because of a series of burdensome fees. This was one of the conclusions of the Justice Department’s report on Ferguson, which argued that “law enforcement practices are shaped by the City’s focus on revenue rather than by public safety needs.”
Oliver had a memorable phrase to describe how this system catches people and won’t let them go: he called it a “f*** barrel,” and started a NSFW hashtag on Twitter to draw attention to it.
But I had actually heard a similar (and safe-for-work) phrase for this years ago: the “sweat box.” Law professor Ronald Mann coined it in 2006 to describe how the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) would affect consumer debt, and it applies to the criminal justice system now. The problems with this system also sound like the problems in mortgage debt servicing, which has been a focus here. It turns out that these issues are generalizable, and they illustrate some of the real dilemmas with privatization and introducing the profit-motive into the public realm.
The Sweat Box
First, the barrel/box. Credit card companies and other creditors really wanted BAPCPA to become law. But why? Mann argued that the act wouldn’t reduce risky borrowing, reduce the number of bankruptcies, or increase the recoveries these companies got in bankruptcy.
But what it would do is make it harder to start a bankruptcy, thanks to a wide variety of delaying tactics. The act did this “by raising filing fees, but also by lengthening the period between permitted filings and by imposing administrative hurdles related to credit counseling, debt relief agencies, and attorney certifications.” This kept distressed debtors in a period where they faced high fees and high interest payments, which would allow the credit card companies to collect additional revenue. Instead of trying to alter bankruptcy on the front or back ends, what it really did was give consumers fewer options and more confusion in the middle. It trapped them in a box (or over a barrel, if you will).
But this also sounds familiar to those watching the scandals taking place in servicer fraud as the foreclosure crisis unfolded over the past seven years. Servicers are the delegated, third-party managers of debts, particularly mortgage securitizations but also student debt. They sound disturbingly similar to the companies Oliver describes as managing municipal fees.
As Adam Levitin and Tara Twomey have argued, third-party servicing introduces three major agency problems. The first is that servicers are incentivized to pad costs, as costs are their revenues, even at the expense of everyone else. The second is that they will often pursue their own goals and objectives as the expense of other options, especially when they don’t ultimately care about the overall goals of those who hire them. And a third problem is that when problems do occur, they are often incentivized to drag them out rather than resolve them the best way possible.
Among other heart-breaking stories, Oliver walks through the story of Harriet Cleveland, who had unpaid parking tickets with Montgomery, Alabama. Montgomery, however, outsourced the management of this debt to Judicial Correction Services (JCS). JCS followed this script perfectly.
JCS had every reason to increase its fees and keep them at a burdensome rate, as it was to be paid first. It was completely indifferent to public notions of the county that hired it, such as proportional justice or the cost-benefit ratio of incarceration, such that they threw Cleveland in jail once she couldn’t handle the box anymore. And it economically benefited from keeping Cleveland in the sweat box as long as possible, rather than trying to find some way to actually resolve the tickets.
For those watching the mortgage servicing industry during the foreclosure crisis, this is a very similar story. Mortgage servicers can pyramid nuisance fees knowing that, even if the loan goes into foreclosure when the debtor can’t handle the box, they will be paid first. They are ultimately indifferent to the private notion of maximizing the value of the loan for investors, so much so that, compared to traditional banks that hold loans directly, servicers are less likely to do modifications and do them in a way that will work out. And servicers will often refuse to make good modifications that would get the mortgage current, because doing so can reduce the principal that forms the basis of their fees.
The Perils of the Profit Motive
There are three elements to draw out here. The first is that these problems are significantly worse for vulnerable populations, particularly those whose exit options are limited by background economic institutions like backruptcy or legal defense. The second is that many of our favorite buzzword policy goals, be they privatization of public services or the market-mediation of credit, involve piling on more and more of these third-party agents whose interests and powers aren’t necessarily aligned with what those who originally hired them expected. Assuming good faith for a second, privatization of these carceral services by municipalities requires a level of control of third-party agents that even the geniuses on Wall Street haven’t been able to pull off.
But we see the sweat box when it comes to purely public mechanisms too, as we see in Ferguson. So the third takeaway is that this is what happens when the profit motive is introduced in places where it normally doesn’t exist. Introducing the profit motive requires delegation and coordination, and it can often cause far more chaos than whatever efficiencies it is meant to produce. Traditional banking serviced mortgage debts as part of the everyday functions within the firm. Putting that function outside the firm, where the profit-motive was meant to increase efficiency, also created profit-driven incentives to find ways to abuse that gap in accountability.
The same dynamics come into play with the profit motive is reintroduced into the municipal level. Our government ran under the profit motive through the 1800s, and it was a major political struggle to change that. Municipal fees are very much part of the reintroduction of the profit motive into city services. As libertarian scholar and Reason Foundation co-founder Robert Poole wrote in 1980 regarding municipal court costs, “Make the users (i.e., the criminals) pay the costs, wherever possible.” As Sarah Stillman found, this is what an “offender-funded” justice system, one that aims “to shift the financial burden of probation directly onto probationers,” looks like now as for-profit carceral service providers shift their businesses to probation and parole. Catherine Rampell reports this as a total shift away from taxes and towards fees for public revenues, and the data shows it.
This is the model of the state as a business providing services, one in which those who use or abuse its functions should fund it directly. And it’s a system that can’t shake the conflicts inherent whenever the profit motive appear.