Wall Street vs. Your Street

Bang for Your Buck
“Nothing has a quicker return on the dollar than unemployment insurance. Once you get to 70 or 80 weeks, and instead of earning $1,000 a week you earn $300 a week, you are in pretty rough shape and everything you get goes right back into the economy.”

—Ross Eisenbrey
Economic Policy Institute

 
THE DIN OF SELF-CONGRATULATION that swept across this city after the Dodd-Frank financial reform bill was voted out of a conference committee almost made me forget what Wall Street had visited on the country: $14 trillion in lost household wealth, 8 million jobs gone and yet to return, 200 community banks closed, more than $14 trillion in bailouts, and a staggering increase in deficit spending required to keep the economy out of a depression.

The gloating seemed excessive. The country had been plundered by what FDR would have called “economic royalists” and it was time for them to face a Jacobin Congress. If the six CEOs who presided over the destruction of our economy weren’t going to jail, at least the system would be fixed to ensure they would never again get away with the depredation that made them richer and the rest of us poorer.

Another sure bet was that reformers in Congress would craft a radical fix for what caused, or at least precipitated, the most severe global financial crisis since the Great Depression: over-the-counter derivatives trading.

The underlying cause of the Great Recession was the deflation of a housing bubble created by bankers force-feeding mortgage loans to sketchy borrowers, then packaging tranches of high-risk mortgages in collateralized debt obligation bonds.

But derivatives — in particular credit default swaps — brought down the house of cards.

A former state insurance regulator demystified credit default swaps in testimony before a Congressional committee (see Washington Spectator 3/1/2010): “Let’s say you own Ford bonds and you want to hedge your risk that Ford is going to default on those bonds. So you go to a third party and ask them essentially to insure you against the default. That’s the swap … you’re swapping the risk of default with a third party.”

The problem occurs when you buy a default swap on bonds you don’t own. “Neither of you own any exposure to Ford,” the regulator said. “You’re taking a gamble on whether Ford is going to default or enter bankruptcy or not.”

So credit default swaps are essentially insurance, except that the insurance business is regulated; at least, it is subject to capital-reserve requirements to ensure that companies selling policies can meet their obligations in the event of default. And a party buying insurance is required to have an interest in what is insured.

By the time credit-default-swap trading destroyed the economy, 90 percent of the traders were speculators, many of them banks.

The swap market was deregulated on the day Congress adjourned in December 2000, when Texas Republican Senator Phil Gramm added a 252-page amendment to an omnibus appropriations bill. The amendment (the Commodities Future Modernization Act) was written by Wall Street bond lawyers.

Gramm was Wall Street’s operative in the Senate. Bill Clinton’s Treasury Secretary Larry Summers and Fed Chairman Alan Greenspan were the intellectual authors of the bill that unleashed the creative power of the markets. (That’s the same Larry Summers who directs Obama’s National Economic Council.)

With regulatory constraints out of the way, over-the-counter derivatives grew from roughly $100 trillion in 2000 to $600 trillion when the economy collapsed in 2008 — 10 times the gross domestic product of the entire world.

After the collapse of Bear Stearns, Lehman Brothers, and AIG foundered the world’s economy because no one actually knew the extent of their derivatives obligations, the solution seemed simple: Fix the derivatives market.

Senator Chris Dodd and Congressman Barney Frank, chairs of the Senate and House committees that would draft the financial reform legislation, would make it happen.

Isn’t it pretty to think so?

FOLLOW THE MONEY—Five big Wall Street firms control more than 80 percent of derivatives trading in this country and together have assets of $8.58 trillion. The notion that they would give up their derivatives operations, or would allow the Congress to take it away from them, was kind of silly, after all.

Even if it almost happened. It almost happened because Blanche Lincoln, a moderate Democratic Senator from Arkansas, took up the cause of the working people who had been screwed by the big banks. It was a novel position for Lincoln, who never demonstrated much of a populist streak. And it was entirely predicated on her fear of a primary defeat by a genuine progressive: Arkansas Lieutenant Governor Bill Halter.

Mike Konczal, an economist and fellow at the Roosevelt Institute, called Lincoln’s derivatives bill, which became an amendment to what would become the Dodd-Frank Wall Street Reform and Consumer Protection Act, a “game changer.”

Banks earn enormous sums of money speculating in derivatives, secure in the knowledge that if the speculation fails, the U.S. taxpayer has their back. Lincoln’s derivatives language would have changed the game by forcing banks to divest themselves of their derivatives trading operations.

What is remarkable is how long Lincoln held out. It wasn’t until 2 a.m., in the marathon, financial reform conference committee hearing that continued until dawn, that she agreed to a compromise.

Campaigning as the people’s champion facing down the Wall Street banks, Lincoln narrowly defeated Bill Halter in Arkansas. It would have been unseemly to walk away from that principled position as soon as she returned to Washington.

Three weeks before the conference committee went to work on the financial reform bill, Konczal observed that Bill Halter had been “recruited and supported by many local Arkansas Democrats, Glenn Greenwald and Jane Hamsher of Accountability Now, the hundreds of thousands of members of the Progressive Change Campaign Committee, Markos Moulitsas-Zuniga and the DailyKos community, the millions of members of MoveOn and the millions of members of the SEIU.”

Lincoln’s big underwriter in the primary was the U.S. Chamber of Commerce.

Two observations: The outcome of Lincoln’s derivatives language was preordained once she disposed of Halter. Progressive change originates with grassroots organizations, not in the Congress.

Konczal has paid careful attention to derivatives reform. I spoke to him the day after the conference committee voted on the Dodd-Frank bill. Konczal and a colleague were still poring over the language on derivatives. Though they hadn’t mastered the details of the bill, one thing was clear.
“The banks won this,” he said. “Most of the market still goes right through. The big banks are hardly affected by this.”

By a “back-of-the-envelope calculation,” 95 percent to 97 percent of derivatives trading will be controlled by banks, he said. Instead of spinning off their derivatives trading operations, banks will be required to move them to subsidiaries.

“You won’t hear big bankers crying over this,” Konczal said. ” This is pretty far from what is needed to prevent the next crisis.”

The markets seem to agree. As soon as they opened on the day after the Dodd-Frank bill was passed out of committee, bank stocks rallied. The House passed the bill 237-121 before the July 4 recess. Its fate is pending in the Senate.

WHO KILLED REFORM?—The bill that bears the name of the two Democratic committee chairmen who shaped it, like the stimulus bill and health care reform, is wholly owned by the Democrats (Republicans limited their role to obstruction). So it should come as no surprise that it was Democrats who weakened the bill, in particular a group of conservatives in the “pro-growth” New Democrat Coalition.

The coalition has been working on behalf of the big banks since the House Financial Services Committee began shaping the legislation last year. In October 2009, New Democrat Coalition Chair Joseph Crowley (NY) led a New Dem delegation to New York to meet with executives from JPMorgan Chase and Goldman Sachs — the two Wall Street firms with the largest derivatives-trading operations. The trip also included a NewDemsPAC fundraiser.

In the end the New Democrats prevailed by threatening to withhold 43 House votes if Lincoln’s derivatives provision was not watered down.

This is not to say that there is not some good in the bill.

Elizabeth Warren, the Harvard law professor appointed by Obama to oversee the use of bank bailout funding, has tirelessly advocated for a consumer protection agency. While she didn’t get the freestanding, independent agency she proposed more than a year ago (the agency will be housed in the Fed), she said in an e-mail that “members of the House-Senate conference committee and their staffs … created a strong, independent consumer agency that will have the tools to rein in industry tricks and traps and to cut out the fine print. For the first time, there will be a financial regulator in Washington watching out for families instead of banks.”

That’s real progress.

But lenders have been screwing borrowers since before such behavior was proscribed in Leviticus without destroying economies. Derivatives — which investor Warren Buffett describes as “weapons of mass financial destruction” — are a category unto themselves. And they didn’t get fixed.

LET THEM EAT CAKE—Back in February, Kentucky Senator Jim Bunning mounted a one-man filibuster against a 30-day extension of unemployment benefits. The unemployment bill had been agreed to by the leadership of both parties and was subject to unanimous-consent rules, so Senate Republicans distanced themselves from Bunning.

Bunning is considered a crank by many of his Republican colleagues. (Minority leader Mitch McConnell spent most of last year trying to push him into retirement.) Yet with Glenn Beck and the Fox News chorus cheering him on, Bunning held out until Olympia Snowe and Susan Collins of Maine and Scott Brown of Massachusetts joined Democrats to provide the 60 votes needed to end the filibuster.

By the end of June, all the Senate Republicans were voting like Jim Bunning, blocking the Democrats’ attempt to extend unemployment benefits to 1.7 million Americans who drop off the roles this month. Nebraska Democrat Ben Nelson joined the Republicans. Robert Byrd, who died on June 26, was hospitalized at the time of the vote. The arithmetics of a 57-vote majority and the 60 votes needed to break a filibuster requires the Democrats to pick up at least one Republican vote (two until Byrd’s replacement is sworn in) and both of the Senate’s independents in order to end a filibuster. After three attempts to invoke cloture, Majority Leader Harry Reid folded.

It is no state secret that Senate Republicans abuse the filibuster. But the extension of unemployment benefits is almost always approved as a deficit-financed emergency measure. McConnell held his conference together by protesting that the bill would “add $30 billion to an already staggering $13 trillion national debt.”

What most Republicans in the Senate considered irresponsible in February — refusing to extend unemployment benefits with unemployment near 10 percent — is now the party line. With the elections four months off, Congressional Republicans are aligning with their right-wing base, which now includes the national Tea Party movement.

The crazies and the extremists have become the party’s bellwethers, leading on politics and now policy.

Sharron Angle, the Tea Party’s choice who won the Nevada primary and will face Harry Reid in November, believes unemployment checks are making Americans lazy.
“You can make more money on unemployment than you can going down and getting one of those jobs that is an honest job. But it doesn’t pay as much. What we need to do is make that unemployment go down,” Angle said. (Fourteen percent of Nevada’s population is out of work.)

Rand Paul, the Tea Party-backed candidate who won the Kentucky primary, made a similar argument on a Lexington, Kentucky, radio talk show. (Paul is also the unintended consequence of McConnell’s campaign to retire Jim Bunning.)

“In Europe, they give about a year of unemployment. We’re up to two years now in America,” Paul said. “As bad as it sounds, we do have to sometimes accept a wage that’s less than we had at our previous job in order to get started again. Nobody likes that, but it may be one of the tough-love things that has to happen.”

Some of the extreme elements in the party are speaking on the floor of the Senate. Arizona Senator Jon Kyl makes a similar argument. “That doesn’t create new jobs. In fact, if anything, continuing to pay people unemployment compensation is a disincentive for them to find work.”

Utah Senator Orrin Hatch suggested that some people receiving benefits are “just going to blow it on drugs.”

Not only does it bring to mind the stereotype of a Republican as someone who “can’t enjoy a meal unless he knows that someone else is going hungry.” None of this ideological claptrap makes economic sense. Unemployment checks don’t just provide for the basic needs of out-of-work individuals and their families. The broader economic benefit they provide is critical when the economy is in recession.

“Unemployment benefits are pretty much universally considered the most stimulative investment government can make right now,” said Ross Eisenbrey of the Washington-based Economic Policy Institute.

“Nothing has a quicker return on the dollar than unemployment insurance,” Eisenbrey said. “Once you get to 70 or 80 weeks, and instead of earning $1,000 a week you earn $300 a week, you are in pretty rough shape and everything you get goes right back into the economy.”

Unemployment benefits are as close as we get to a direct subsidy for small businesses, which makes Republican opposition to benefits even more perverse.

“If you don’t have that check coming in,” Eisenbrey said, “you can’t buy gas for the car to look for work, you can’t buy other things you need from local businesses, and the effect is that the business that would have sold you those things can’t hire someone, or lays someone off.

Eisenbrey directed me to a January 2010 Congressional Budget Office report that describes aid to the unemployed as superior to any other policy option available to the federal government to stimulate the economy.

He also described the Dickensian world that prolonged unemployment has created in hard-hit states such as Michigan, where unemployment is almost 14 percent. As people have been dropped from the state’s unemployment roles, the number of families enrolled in TANF [Temporary Assistance for Needy Families] has also decreased. The welfare reform signed into law by Bill Clinton makes access to public assistance both less accessible and more temporary.

“There’s nowhere left for these people to go,” Eisenbrey said.