Who should the SEC punish next for the Madoff scandal? Itself.


J.P. Morgan Chase is nearing a settlement with federal regulators over the bank’s ties to convicted fraudster Bernie Madoff, reports The New York Times. The deal would involve penalties of up to $2 billion dollars and a rare criminal action. The government intends to use the money to compensate Madoff’s victims.

For two decades before his arrest, Madoff had banked with J.P. Morgan — and apparently laundered up to $76 billion through the bank. Employees at the bank had raised concerns about Madoff’s business. In 2006, a J.P. Morgan employee wrote after studying some of Mr. Madoff’s trading records that “I do have a few concerns and questions,” and expressed worry that Madoff would not disclose exactly which trades he had made. Madoff’s company turned out to be an elaborate ponzi scheme that stole an estimated $18 billion from clients; it collapsed in 2008.

Is it fair to blame J.P. Morgan for the activities of Madoff? Do banks have a responsibility to know if their clients are involved in criminal activities? I think so — banks should have strong checks and balances to prevent fraud and money laundering, because if they don’t then criminals like Madoff can get away with it for years and years. According to Robert Lenzner of Forbes, “J.P. Morgan never reported to the Treasury or the Federal Reserve a huge cache of checks going back and forth for seven years between Madoff’s Investment Account 703 and Bank Customer Number One, belonging to real estate developer Norman Levy, who died in 2005.”

By agreeing to pay the fine and the government’s rebuke, J.P. Morgan is admitting a failure of oversight. But it’s not as if J.P. Morgan is the only one to blame. Others on Wall Street had expressed concern about Madoff’s business much earlier.

Read More At TheWeek.com

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The Unsustainable US Financial Sector

According to Bloomberg, the vast majority of the Big Five banks’ profits consisted of a taxpayer subsidy — the Too Big To Fail guarantee. If the Too Big To Fail banks had to lend at the rates offered to their non-Too Big to Fail competitors, their profits would be severely shrunk (in some cases, to a net loss):

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What does that mean?

That means that the American financial sector is a zombie, existing on the teat of the taxpayer.

It means the huge swathes of liquidity spent on saving the financial sector are ultimately good money chasing after bad.

As Bloomberg notes:

The U.S. financial industry — with almost $9 trillion in assets, more than half the size of the U.S. economy — would just about break even in the absence of corporate welfare. In large part, the profits they report are essentially transfers from taxpayers to their shareholders.

Neither bank executives nor shareholders have much incentive to change the situation. On the contrary, the financial industry spends hundreds of millions of dollars every election cycle on campaign donations and lobbying, much of which is aimed at maintaining the subsidy. The result is a bloated financial sector and recurring credit gluts.

This is extremely prescient stuff. The Fed since 2008 has reinflated the old bubbles, while allowing the same loot-and-pillage disaster-corporatist financial model to continue.

It is insane to repeat the same methods and expect different results. This credit glut, this new boom that has seen stocks rise closer and closer to their pre-crisis high (which may soon be exceeded) will just lead to another big 2008-style slump, just as the Fed’s reinflation of the burst tech bubble led to 2008 itself. This time the spark won’t be housing, it will be something else like an energy shock, or a war. Something that the Federal Reserve cannot directly control or fix by throwing money at it.

America (and the Western world in general) post-2008 needed real organic domestic growth built on real economic activity, not a reinflated bubble that let the TBTF financial sector continue to gorge itself into oblivion. 

Too Big To Jail Is Here To Stay

Lanny Breuer, the Assistant Attorney General who claimed that prosecuting banks for crimes poses a risk to the financial sector and so corrupt bankers are “too big to jail” has lost his job:

MARTIN SMITH: You gave a speech before the New York Bar Association. And in that speech, you made a reference to losing sleep at night, worrying about what a lawsuit might result in at a large financial institution.

LANNY BREUER: Right.

MARTIN SMITH: Is that really the job of a prosecutor, to worry about anything other than simply pursuing justice?

LANNY BREUER: Well, I think I am pursuing justice. And I think the entire responsibility of the department is to pursue justice. But in any given case, I think I and prosecutors around the country, being responsible, should speak to regulators, should speak to experts, because if I bring a case against institution A, and as a result of bringing that case, there’s some huge economic effect — if it creates a ripple effect so that suddenly, counterparties and other financial institutions or other companies that had nothing to do with this are affected badly — it’s a factor we need to know and understand.

But the man who put him there, and who is ultimately responsible for the policy — the Attorney General himself — is here to stay.

eric-holder

Simon Johnson notes:

Attorney General Eric Holder expressed similar views in the context of discussing why more severe charges weren’t brought against Zurich-based UBS AG last year for manipulating the London interbank offered rate. And Neil Barofsky, a onetime senior prosecutor and former inspector general of the Troubled Asset Relief Program that administered the bank bailouts, provided a scathing assessment of Justice Department policy.

The Justice Department likes to quote Thomas Jefferson: “The most sacred of the duties of government [is] to do equal and impartial justice to all its citizens,” a line that appears in its latest budget documents.

This sentiment is hardly consistent with saying that some companies have characteristics that put them above the law. Jefferson himself was very worried about the concentrated power of financiers — he would have seen today’s problems much more clearly than do Holder and Breuer.

Fundamentally, Obama’s continued support for Holder illustrates that Obama is still committed to the policy of holding financiers to a lesser standard of justice than other citizens.

The continued failure to implement even the Volcker rule — let alone a Glass-Steagall-style separation between retail and investment banking — illustrates that Obama is committed to letting bailed-out banks continue to operate in the risky manner that led to the crisis. So does the total failure to ensure a level playing field for retail investors in a market now totally dominated by algorithms.

The big banks continue to ride roughshod over the American people with the complicity of the political class. Too Big to Jail is an affront to the Constitution, an affront to the Bill of Rights, an affront to those like Rosa Parks, Martin Luther King, Lysander Spooner, Frederick Douglas and all those who at various times crusaded to make equality before the law a reality in America.

The only sensible way forward is that lawbreakers on Wall Street must be prosecuted in the same way as other lawbreakers. That means that Eric Holder and all others associated with Too Big To Jail must lose their jobs.

But I doubt that will happen any time soon.

Of Wages and Robots

There is a popular meme going around, popularised by the likes of Tyler CowenPaul Krugman and Noah Smith that suggests that recent falls in worker compensation as a percentage of GDP is mostly due to the so-called “rise of the robots”:

For most of modern history, two-thirds of the income of most rich nations has gone to pay salaries and wages for people who work, while one-third has gone to pay dividends, capital gains, interest, rent, etc. to the people who own capital. This two-thirds/one-third division was so stable that people began to believe it would last forever. But in the past ten years, something has changed. Labor’s share of income has steadily declined, falling by several percentage points since 2000. It now sits at around 60% or lower. The fall of labor income, and the rise of capital income, has contributed to America’s growing inequality.

In past times, technological change always augmented the abilities of human beings. A worker with a machine saw was much more productive than a worker with a hand saw. The fears of “Luddites,” who tried to prevent the spread of technology out of fear of losing their jobs, proved unfounded. But that was then, and this is now. Recent technological advances in the area of computers and automation have begun to do some higher cognitive tasks – think of robots building cars, stocking groceries, doing your taxes.

Once human cognition is replaced, what else have we got? For the ultimate extreme example, imagine a robot that costs $5 to manufacture and can do everything you do, only better. You would be as obsolete as a horse.

Now, humans will never be completely replaced, like horses were. Horses have no property rights or reproductive rights, nor the intelligence to enter into contracts. There will always be something for humans to do for money. But it is quite possible that workers’ share of what society produces will continue to go down and down, as our economy becomes more and more capital-intensive.

So, does the rise of the robots really explain the stagnation of wages?

This is the picture for American workers, representing wages and salaries as a percentage of GDP:

WASCURGDP

It is certainly true that wages have fallen as a percentage of economic activity (and that corporate profits as a percentage of economic activity have risen — a favourite topic of mine).

But there are two variables to wages as a percentage of GDP. Nominal wages have actually risen, and continued to rise on a moderately steep trajectory:

WASCUR_Max_630_378

And average wages continue to climb nominally, too. What has actually happened to the wages-to-GDP ratio, is not that America’s wage bill has really fallen, but that wages have just not risen as fast as other sectors of GDP (rents, interest payments, capital gains, dividends, etc). It is not as if wages are collapsing as robots and automation (as well as other factors like job migration to the Far East) ravage the American workforce.

It is more accurate to say that there has been an outgrowth in economic activity that is not yielding wages beginning around the turn of the millennium, and coinciding with the new post-Gramm-Leach-Bliley landscape of mass financialisation and the derivatives and shadow banking megabubbles, as well the multi-trillion dollar military-industrial complex spending spree that coincided with the advent of the War on Terror. Perhaps, if we want to look at why the overwhelming majority of the new economic activity is not trickling down into wages, we should look less at robots, and more at the financial and regulatory landscape where Wall Street megabanks pay million-dollar fines for billion-dollar crimes? Perhaps we should look at a monetary policy that dumps new money solely into the financial sector and which has been shown empirically to enrich the richest few far faster than everyone else?

But let’s focus specifically on jobs. The problem with the view that this is mostly a technology shock is summed up beautifully in this tweet I received from Saifedean Ammous:

The Luddite notion that technology might render humans obsolete is as old as the wheel. And again and again, humans have found new ways to employ themselves in spite of the new technology making old professions obsolete. Agriculture was once the overwhelming mainstay of US employment. It is no more:

farmjobs

This did not lead to a permanent depression and permanent and massive unemployment. True, it led to a difficult transition period, the Great Depression in the 1930s (similar in many ways, as Joe Stiglitz has pointed out, to the present day). But eventually (after a long and difficult depression) humans retrained and re-employed themselves in new avenues.

It is certainly possible that we are in a similar transition period today — manufacturing has largely been shipped overseas, and service jobs are being eliminated by improvements in efficiency and greater automation. Indeed, it may prove to be an even more difficult transition than that of the 1930s. Employment remains far below its pre-crisis peak:

EMRATIO_Max_630_378

But that doesn’t mean that human beings (and their labour) are being rendered obsolete — they just need to find new employment niches in the economic landscape. As an early example, millions of people have begun to make a living online — creating content, writing code, building platforms, endorsing and advertising products, etc. As the information universe continues to grow and develop, such employment and business opportunities will probably continue to flower — just as new work opportunities (thankfully) replaced mass agriculture. Humans still have a vast array of useful attributes that cannot be automated — creativity, lateral thinking & innovation, interpersonal communication, opinions, emotions, and so on. Noah Smith’s example of a robot that “can do everything you can do” won’t exist in the foreseeable future (let alone at a cost of $5) — and any society that could master the level of technology necessary to produce such a thing would probably not need to work (at least in the sense we use the word today) at all. Until then, luckily, finding new niches is something that humans have proven very, very good at.

Too Big To Understand

One thing that has undergone hyperinflation in recent years is the length of financial regulations:

Too Big To Understand

The Dodd-Frank regulatory hyperinflation crowds out those who cannot afford teams of legal counsel, compliance officers, and expansive litigation. Dodd-Frank creates new overheads which are no challenge for large hedge funds and megabanks armed with Fed liquidity, but a massive challenge for startups and smaller players with more limited resources.

As BusinessWeek noted in October:

The law requires Hedge Funds to register with the Securities and Exchange Commission, supply reams of sensitive data on trading positions, carefully screen potential investors, and hire compliance officer after compliance officer.

So, is this expansion in volume likely to improve financial stability? No — the big banks are bigger and more interconnected than ever, which was precisely the problem before 2008, and they are still speculating and arbitraging with very fragile strategies that can incur massive losses as MF Global’s breakdown and more recently the London Whale episode proves.

Andy Haldane laid out the problem perfectly in his recent paper The Dog and the Frisbee:

Catching a frisbee is difficult. Doing so successfully requires the catcher to weigh a complex array of physical and atmospheric factors, among them wind speed and frisbee rotation. Were a physicist to write down frisbee-catching as an optimal control problem, they would need to understand and apply Newton’s Law of Gravity.

Yet despite this complexity, catching a frisbee is remarkably common. Casual empiricism reveals that it is not an activity only undertaken by those with a Doctorate in physics. It is a task that an average dog can master. Indeed some, such as border collies, are better at frisbee-catching than humans.

So what is the secret of the dog’s success? The answer, as in many other areas of complex decision-making, is simple. Or rather, it is to keep it simple. For studies have shown that the
frisbee-catching dog follows the simplest of rules of thumb: run at a speed so that the angle of gaze to the frisbee remains roughly constant. Humans follow an identical rule of thumb.

Catching a crisis, like catching a frisbee, is difficult. Doing so requires the regulator to weigh a complex array of financial and psychological factors, among them innovation and risk appetite. Were an economist to write down crisis-catching as an optimal control problem, they would probably have to ask a physicist for help.

Yet despite this complexity, efforts to catch the crisis frisbee have continued to escalate. Casual empiricism reveals an ever-growing number of regulators, some with a Doctorate in physics. Ever-larger litters have not, however, obviously improved watchdogs’ frisbee-catching abilities. No regulator had the foresight to predict the financial crisis, although some have since exhibited supernatural powers of hindsight.

So what is the secret of the watchdogs’ failure? The answer is simple. Or rather, it is complexity.

Big, messy legislation leaves legal loopholes that clever and highly-paid lawyers and (non-) compliance officers can cut through. Bigger and more extensive regulation can make a system less well-regulated. I propose that this is what the big banks will use Dodd-Frank to accomplish.

I predict that the regulatory hyperinflation will make the financial industry and the wider economy much more fragile.

The High Frequency Trading Debate

A Senate panel is looking into the phenomenon of High Frequency Trading.

Here’s the infamous and hypnotic graphic from Nanex showing just how the practice has grown, showing quote volume by the hour every day since 2007 on various exchanges:

It is a relief that the issue is finally being discussed in wider venues, because we are witnessing a stunning exodus from markets as markets mutate into what we see above, a rampaging tempestuous casino of robotic arbitrageurs operating in millisecond timescales.

The conundrum is simple: how can any retail investor trust markets where billions of dollars of securities are bought and sold faster than they can click my mouse and open my browser, or pick up the phone to call their broker?

And the first day of hearings brought some thoughtful testimony.

The Washington Post notes:

David Lauer, who left his job at a high-frequency trading firm in Chicago last year, told a Senate panel that the ultra-fast trades that now dominate the stock market have contributed to frequent market disruptions and alienated retail investors.

“U.S. equity markets are in dire straits,” Lauer said in his written testimony.

One man who I think should be testifying in front of Congress is Charles Hugh Smith, who has made some very interesting recommendations on this topic:

Here are some common-sense rules for such a “new market”:

1. Every offer and bid will be left up for 15 minutes and cannot be withdrawn until 15 minutes has passed.

2. Every security–stock or option–must be held for a minimum of one hour.

3. Every trade must be placed by a human being.

4. No equivalent of the ES/E-Mini contract–the futures contract for the S&P 500 — will be allowed. The E-Mini contract is the favorite tool of the Federal Reserve’s proxies, the Plunge Protection Team and other offically sanctioned manipulators, as a relatively modest sum of money can buy a boatload of contracts that ramp up the market.

5. All bids, offers and trades will be transparently displayed in a form and media freely available to all traders with a standard PC and Internet connection.

6. Any violation of #3 will cause the trader and the firm he/she works for to be banned from trading on the exchange for life–one strike, you’re out.

However, I doubt that any of Smith’s suggestions will even be considered by Congress (let alone by the marketplace which seems likely to continue to gamble rampantly so long as they have a bailout line). Why? Money. Jack Reed, the Democratic Senator chairing the hearings, is funded almost solely by big banks and investment firms:

It seems more than probable that once again Congress will come down on the side of big finance, and leave retail investors out in the cold. Jack Reed opened a recent exchange on Bloomberg with these words:

Well I believe high frequency trading has provided benefits to the marketplace, to retail investors, etcetera.

Yet retail investors do not seem to agree about these supposed benefits.

Retail investors just keep pulling funds:

Reed failed to really answer this question posed by the host:

Senator, US equity markets are supposed to be a level playing field for all kinds of investors; big companies, small companies and even individuals. That said, how is it possible for an individual investor ever to compete with high frequency traders who buy and sell in milliseconds. Aren’t individuals always going to be second in line essentially to robots who can enter these orders faster than any human possibly can?

The reality is that unless regulators and markets can create an environment where individual investors can participate on a level playing field, they will look for alternative venues to put their money. It is in the market’s interest to create an environment where investors can invest on a level playing field. But I think the big banks are largely blinded by the quick and leverage-driven levitation provided by high frequency trading.

Assange or Corzine?

Priorities are a bitch.

The United States won’t prosecute Corzine for raiding segregated customer accounts, but will happily convene a Grand Jury in preparation for prosecuting Julian Assange for exposing the truth about war crimes.

From the New York Times:

A criminal investigation into the collapse of the brokerage firm MF Global and the disappearance of about $1 billion in customer money is now heading into its final stage without charges expected against any top executives. After 10 months of stitching together evidence on the firm’s demise, criminal investigators are concluding that chaos and porous risk controls at the firm, rather than fraud, allowed the money to disappear, according to people involved in the case.

Corzine is considering opening a new hedge fund, though the notion that anyone — even a slack-jawed muppet happy to buy whatever Goldman ‘s prop traders want to sell — would seed Corzine money so he can trade or steal it away seems absurd — rather like putting a child molester in charge of a day-care.

But nobody knows how much dirt Corzine has on other Wall Street crooks. Not only may Corzine get away with corzining MF Global’s clients’ funds, he may well end up with a whole raft of seed money to play with from those former colleagues and associates who might prefer he remain silent regarding other indiscretions he may be aware of.

But the issue at hand is the sense that we have entered a phase of exponential criminality and corruption. A slavering crook like Corzine who stole $200 million of clients’ funds can walk free. Meanwhile, a man who exposed evidence of serious war crimes is for that act so keenly wanted by US authorities that Britain has threatened to throw hundreds of years of diplomatic protocol and treaties into the trash and raid the embassy of another sovereign state to deliver him to a power that seems intent not only to criminalise him, but perhaps even to summarily execute him. The Obama administration, of course, has made a habit of summary extrajudicial executions of those that it suspects of terrorism, and the detention and prosecution of whistleblowers. And the ooze of large-scale financial corruption, rate-rigging, theft and fraud goes on unpunished.