Kevin Drum

Fraud and the Financial Meltdown

Bill Black lays it all out for you.

| Wed Apr. 14, 2010 9:07 PM EDT

A few days ago a reader asked me what I thought of Bill Black. Answer: he's a pretty fascinating guy. I met him at a conference last year, and probably the best time I had was the hour I spent sitting next to him and Dean Baker one night at dinner as they regaled each other with stories about financial fraud and the S&L crisis of the 80s. (Black was a bank regulator at the time.) As it happens, I don't think fraud is the be-all-and-end-all of the 2008 meltdown, but it was a significant piece of it and it doesn't get as much attention as it should.

Black isn't in the news much, which means I don't get a chance to link to him much. But TRNN recently did an interview with him, so this is my chance. And yours. Watch the video and hear him toss out Taibbi bait like this about the finance industry: "Think of it as a giant engorged leech on Main Street." Or listen to him explain that "We now have sociopaths in control of our major financial institutions." Booya! Part 2 of the interview is here.
 

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Obama and Taxes

Has Obama broken his promise not to raise taxes on the middle class?

| Wed Apr. 14, 2010 8:32 PM EDT

Peter Suderman calls out President Obama as a tax cheat today. "If you make less than a quarter of a million dollars a year," Obama said on the campaign trail, "you will not see a single dime of your taxes go up." But according to the Joint Committee on Taxation, taxpayers earning less than $200,000 a year will pay nearly $4 billion more in taxes in 2019 thanks to a change in the medical expense deduction mandated by the recently passed healthcare reform bill. J'accuse!

Well, maybe. But I need some help here. When Obama made his campaign pledge, he was talking about his comprehensive tax plan. He wasn't promising that no bill he ever signed would ever raise taxes in any way for the under-$200,000 crowd, was he?

I'd like to set the record straight on this because it keeps coming up over and over and over. It came up in the context of an increase in cigarette taxes. It came up in the context of cap-and-trade. Now it's come up in the context of the healthcare bill — which has other tax increases that would hit middle class families too. (Why do you think unions were opposed to the excise tax?) So: did Obama promise to never raise taxes in any context for any purpose for all time for everyone making less than $200,000? Or was it always just in the context of his specific campaign tax plan?

Killing Terrorist Leaders

Trying to "decapitate" terrorist groups might do more harm than good.

| Wed Apr. 14, 2010 4:59 PM EDT

Via Matt Yglesias, Robert Wright takes a look at whether drone strikes aimed at killing terrorist leaders are effective. A tentative answer comes from Jenna Jordan of the University of Chicago, who examined the results of 298 attempts between 1945 and 2004 to weaken terrorist groups through "leadership decapitation":

Her work suggests that decapitation doesn’t lower the life expectancy of the decapitated groups — and, if anything, may have the opposite effect.

Particularly ominous are Jordan’s findings about groups that, like Al Qaeda and the Taliban, are religious. The chances that a religious terrorist group will collapse in the wake of a decapitation strategy are 17 percent. Of course, that’s better than zero, but it turns out that the chances of such a group fading away when there’s no decapitation are 33 percent. In other words, killing leaders of a religious terrorist group seems to increase the group’s chances of survival from 67 percent to 83 percent.

Of course the usual caveat applies: It’s hard to disentangle cause and effect. Maybe it’s the more formidable terrorist groups that invite decapitation in the first place — and, needless to say, formidable groups are good at survival. Still, the other interpretation of Jordan’s findings — that decapitation just doesn’t work, and in some cases is counterproductive — does make sense when you think about it.

Italics mine. Jordan's sample size for religious groups is 35 — which isn't too bad — and if you combine both the ones that were targeted for decapitation and those that weren't, a grand total of eight collapsed. This suggests that religious terrorist groups are just pretty hardy organizations regardless of how you fight them. In fact, that really seems to be one of her main findings: only 22% of religious terrorist groups collapsed, compared to 70% for all the other kinds of terrorist groups. So al-Qaeda is going to be a pretty tough nut no matter how we go about fighting them.

Similar results come from a study by Aaron Mannes, which Wright mentioned last year. Mannes' conclusion:

The result that consistently stood out from this research was the propensity of decapitation strikes to cause religious organizations to become substantially more deadly. There are several possible reasons to explain this outcome. Many religious organizations are robust, such as Hezbollah and Hamas, which is an important criterion for surviving the loss of a leader as well as having the resources to strike back....The indication that killing religious organization’s leaders rather than arresting them is more likely to lead to a surge of deadly violence may be worth further exploration.

So then: killing the leaders of a religious terrorist group doesn't cause them to collapse but it does cause them to embark on even more deadly attacks. What's more, the collateral damage on civilian populations is, as Defense Secretary Robert Gates put it yesterday, "one of the greatest risks to the success of our strategy." That's worth further exploration, all right.

Ratings Agency Followup

It was even worse than I thought.

| Wed Apr. 14, 2010 3:50 PM EDT

Earlier this morning I wrote about the practice of banks shopping around to get the best ratings for their latest structured investment vehicles. But Robert Waldmann says it was much worse than that:

If only the ratings agencies had waited for financial firms to come through their doors bearing rocket science securities the conflict would have been less severe. The ratings agencies decided to consult too (remember how well that worked out for Arthur D Anderson). So they charged large fees to help financial firms design financial instruments. This was a new practice and the blatant conflict of interest was obvious.

Not only is the conflict of interest worse, but Robert says there's an additional, subtler problem here: when both the bank and the rater use the same models, there's only one opinion about how safe a security it. If they used separate models, at least you'd have a little bit of a check.

However, I think the problem mostly remains. If all three of the ratings agencies had been tougher on new rocket science assets, the whole huge industry would never have existed and all of them would have been poorer. A reasonable rule would be that no asset gets AAA unless an asset which is identical except for maturity dates paid on time and in full in each of the past 3 recessions — that is no AAA for new stuff for decades — no exceptions. Obviously with or without agency shopping, they wouldn't have done that. So I don't really have a solution.

Neither do I. For the moment, anyway.

The Nuclear Summit

Knee-jerk partisanship and loose nukes.

| Wed Apr. 14, 2010 2:19 PM EDT

Via Spencer Ackerman, here is Sen. Jon Kyl (R–Ariz.) kvetching about the recently completed Nuclear Security Summit:

“The summit’s purported accomplishment is a nonbinding communique that largely restates current policy and makes no meaningful progress in dealing with nuclear terrorism threats or the ticking clock represented by Iran’s nuclear weapons program,” said Sen. Jon Kyl (R-Ariz.), a prominent critic of Obama’s nuclear policies.

Well now. China agreed to sanctions on Iran. Ukraine agreed to give up their HEU. Russia agreed to close down its last plutonium plant. And the entire conference agreed to focus far more attention on keeping fissile material out of the hands of terrorists.

But, yeah, it didn't solve every world problem instantly in its first meeting. By that yardstick the whole thing was a failure.

And that sound you just heard? It was Kyl's knee jerking so hard he gave himself a concussion. Crikey.

The Muzzles

How's free speech doing these days?

| Wed Apr. 14, 2010 1:50 PM EDT

Via Jon Fasman, here are this year's Muzzles, given each year by the Thomas Jefferson Center for the Protection of Free Expression. I suppose this won't be a widespread opinion, but I'd say they go to show that the First Amendment is doing pretty well these days. Some of the items are infuriating (Texas basing tax breaks on whether you say nice things about Texas, Southwestern College banning peaceful protests practically everywhere on campus), but really, if the ten things on this list are the worst offenses of the entire year then free speech is in pretty good shape. I was expecting a lot worse.

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Five Fights to Watch

How do we fix the ratings agency problem?

| Wed Apr. 14, 2010 12:25 PM EDT

Andy Kroll has a good piece up about "Five Fights to Watch" in the upcoming battle over financial regulatory reform. The whole thing is worth reading, but it's #2 that I have the hardest time figuring out how to fix:

2) The Ratings Agencies' Conflict of Interest Problem
The toxic mortgage bonds and other products that helped demolish the economy were stamped with blue-chip ratings from the big three ratings agencies — Moody’s, Standard and Poor’s, and Fitch. Why did they affix their seal of approval to junk investments? The answer is complex, but largely centers on the fundamental conflict of interest with the rating agencies: they get paid by the same firms that are seeking ratings for their products. This arrangement allowed banks to shop around for the highest score regardless of whether the product deserved it or not.

It’s not clear whether the Senate bill will fix this problem. Senate banking committee chair Chris Dodd (D-Conn.) has proposed creating a new watchdog within the Securities and Exchange Commission to keep an eye on the agencies. The bill would also give investors the right to sue them for “a knowing or reckless failure” to thoroughly investigate a product before issuing a rating. But will that SEC watchdog address the conflict of interest in how rating agencies get paid? Will it revisit the pseudo-governmental role played by the Big Three agencies, whom the SEC has used as official arbiters of safety in the markets? These questions, raised by academics, experts, journalists, and others, have yet to be fully addressed by the Senate.

This is a head scratcher. Ratings agencies made a ton of money out of the housing bubble. Basically, banks came to them with a swelling array of rocket-science securities and paid them to provide a rating. Because these structured securities were complex, the fees for figuring out the rating were high, and it turned into a lucrative source of business.

The conflict of interest is obvious: banks wanted high ratings and the agencies wanted lots of deal flow. That meant they were motivated to push the envelope in order to insure a steady stream of business. After all, if you get a little too picky about things, clients will just head across the street to see if a different agency might treat them a little better.

So the problem is pretty clear. But what's the solution? Ideally, someone else should pay the ratings agencies. But there's no one to do that, so that's out. Regulation might work, but then again, it might not. Complex securities really are complex, and figuring out the right model to apply is genuinely difficult. What's more, the guys structuring the deals are a lot smarter than the working stiffs at the agencies. It's really not a fair fight. Another idea is to open up the industry to more competition, but I've never really understood how that would improve things. The basic conflict of interest is still there no matter how many federally approved ratings agencies there are.

The lawsuit idea is an interesting one, though. Ratings agencies are immune from suits right now because years ago the courts bought their argument that ratings are just opinions and therefore protected by the First Amendment. You know, just like George Will and Paul Krugman are protected for their opinions. That sounds silly, but hey — the law is an ass. But even if that gets changed, "knowing or reckless failure" is a pretty high standard and it's not clear to me that it would really provide much of a brake on reckless behavior. Maybe worth a try, though.

Luckily, I don't think ratings agencies were really at the core of the financial meltdown. They helped things along for sure, but other stuff was a lot more fundamental. It would still be nice to come up with some kind of compelling fix for the conflict of interest at the heart of the ratings business, though. I'm just not sure what it is.

Talk to Chuck

It's long past time to end the outrageous carried interest rule.

| Wed Apr. 14, 2010 11:35 AM EDT

When I wrote my piece on financial regulation a few months ago ("Capital City," January), my intent was to illustrate the power of the finance lobby by providing examples of laws so egregiously favorable to the industry that even the fabled man on the street would instantly be outraged by them. Debit card fees was one example. The Commodity Futures Modernization Act was another. The SEC's ruling that investment banks could increase their leverage in 2004 was yet another.

But my favorite has always been the carried interest rule:

Wall Street bankers may seem like a pretty well-off bunch, but when they decide that a million dollars doesn't go as far as it used to, they leave and start up a hedge fund. Hedge fund managers typically get paid 2 percent of the value of the assets under their control plus 20 percent of the investment profits, and for a successful manager this can add up to tens or even hundreds of millions of dollars a year. Aside from market reversals, the only real threat to their riches is the IRS.

Their defense against the taxman is something called the carried interest rule, and it's elegant in both its simplicity and its shamelessness: It simply declares their compensation to be capital gains, not ordinary income. That means it gets taxed at 15 percent instead of 35 percent.

At first, it's hard to figure out how they get away with this. After all, capital gains are the profit you make on money of your own that you invest. But hedge fund managers invest other people's money and get paid a piece of the action. By any customary definition, this is ordinary income, the same as a sports agent taking his 10 percent or a CEO whose bonus depends on performance.

But enough money can buy you a defense of the indefensible.

The rest of this riff was mainly an attack on Sen. Chuck Schumer (D–NY), who, whatever his other fine qualities, was a defender of the indefensible when he blocked action on the carried interest rule three years ago. Now it's back in the news again, and there's at least one Republican who's practically daring Democrats to take action:

Senate Finance ranking member Chuck Grassley said he didn’t think Democrats would let things get that far. “The House first voted to change the taxation of carried interest almost two-and-a-half years ago, and has passed legislation three times,” Grassley said. “Senate Democrats must have concerns, since the Senate hasn’t adopted the change in that timeframe. So the policy appears to be controversial with Senate Democrats.”

Grassley is, to put this delicately, not exactly the most calm and composed member of the world's greatest deliberative body. But a dare is a dare, and if Grassley is willing to vote with Dems to end the insanity of the carried interest rule and start taxing billionaires at at least the same rate as bus drivers — well, who are we to turn him down? Among big ticket tax items, this is probably the most outrageous example of coddling the rich currently on the books, and if we can't change it now, with the public practically in a mood to lynch Wall Street bankers, when can we change it? So why not give Chuck Schumer a call and politely suggest that it's time to do something about this? He's at 202-224-6542.

Quote of the Day: Close to Zero

Being trigger happy really doesn't go well with being president.

| Tue Apr. 13, 2010 5:27 PM EDT

It's Jonah Goldberg day! Here he is again, writing about Obama and nuclear weapons:

Even if we had no missile treaties of any kind, the likelihood that he would ever use nukes remains close to zero. I think pretty much everyone around the world knows that about him.

Jesus. I sure hope that the likelihood of Obama ever using is nukes is "close to zero." Not exactly zero, mind you, because you never know. But close? Oh yeah. I wonder what likelihood Jonah would prefer?

Wait, $45 To Stow Your Carry-on?!

Why new bag fees might not be so bad.

| Tue Apr. 13, 2010 4:59 PM EDT

Matt Yglesias tries to convince me that charging $45 to stow a carry-on bag on my next flight isn't such a bad thing:

Everyone outraged by Spirit Airlines’ decision to start trying to charge an extra fee for people who want to use the overhead bins — including Chuck Schumer who seems to be aiming for a quasi-regulatory solution or else a way to get on camera — should consider Paul Krugman’s argument that price-discrimination in monopolist-dominated markets is socially optimal.

Technically, I don't really disagree. Ever since deregulation, airlines have been the poster children for rampant price discrimination. Everybody says they hate it, but the fact that airlines have practically been driven out of business by their inability to make money suggests that consumers have done pretty well by it. What's more, Spirit's bag fee has all sorts of excellent arguments in its favor. It gives you an incentive to pack light. It gives you an incentive not to slow everyone down loading and unloading the overhead bins. It lets people fly extra cheap if they're willing to fly with no baggage — as my grandmother used to do. (Don't ask.)

And yet....there's a social aspect to this that gnaws at me a little bit. A while back there was a minor blog thread that made the rounds over the issue of free bread at restaurants. Economically, this is inefficient. People eat more bread than they really want because it's "free." People who don't want bread subsidize everyone else. Etc.

All true. But one of the primary causes of personal stress is decisionmaking, and modern life jacks that up every time we're forced to make yet another goddam decision. Do we really want to have to decide if we want the bread or do we just want to enjoy dinner? Do we want a dozen different options on our flight, or would we rather just buy a ticket that includes all the usual stuff? Should credit card apps have 30 pages of legalese attached to them or would a few simple rules about interest rates and annual fees be enough?

Choice is good. Most of the time we want it, and economically it's often beneficial. But it can also hide things and make prices hard to compare.  Is the Spirit flight really cheaper? Better do a close comparison! Is dinner at Joe's the same price as dinner at Mary's? If Joe charges for bread, maybe not. And that cheap credit card might not be as cheap as you think if your rate suddenly gets jacked up because you paid your water bill late and didn't realize that made a difference. Not having to worry about that stuff might be worth a few dollars.

Anyway, just a thought. Cheap flights are good, but sometimes there's such a thing as a market that's too efficient. We might all find ourselves a little bit happier and a little bit less frazzled if prices were a few dollars higher and, in return, there were a few less decisions forced on us every day.