ataxingmatter

Another Reason to Ditch the Capital Gains Preference--Games Lawyers (and Hedge Funds) Play

Bloomberg today covers a story about another tax-shelter ploy by hedge fund billionaires to make themselves even richer at the expense of ordinary Americans who will have to pony up more (or be beset by a bigger deficit) when the billionaires don't pay their fair share of taxes.  See Zachary Mider & Jesse Drucker, Simons Strategy to Shield Profit from Taxes draws IRS Attack, Bloomberg (July 1, 2013).

 As the article notes, the IRS is challenging a tax-lawyer alchemy for converting ordinary hedging income to preferentially treated capital gain income by using a bank as an accommodation party to a derivative transaction--the bank buys the portfolio that the hedge fund wants to own, the bank then hires the hedge fund to manage the portfolio just as the hedge fund would do if it were the legal owner rather than the beneficial owner (which it probably should be considered under general tax principles, with the result that the hedge fund "manages" the purported bank portfolio by engaging in almost daily trades, as is a hedge fund's practice, and then the bank purports to sell an option on the portfolio to that very same hedge fund (surprise! :) !) and then the hedge fund exercises that option (quelle surprise!) more than a year after its purchase and claims thereby to have converted its trading gains (ordinary income) into an investment contract gain (Ipreferentially taxed capital gains).

This is the reason that most derivatives are such a financial scam.  They are merely an artificial way for banks to make more money than they should by accommodating other parties in practicing banking alchemy--doing artificial stuff that doesn't do the economy any good, produce any goods, or create economic growth that extends to non-banksters.  In fact, it does actual harm by assisting other big financial players (in this case, hedge funds and, in particular, hedge fund employees) in scamming the system for no reason other than to reduce their taxes.  Simons and Renaissance employees own nearly all of the fund in this case.  Id. This is what we can continue to expect from the "greed is good" and "I got everything by my own merit [HA!] but just let me get by with another scam while also subsidizing me with "too big to fail" bailouts" generation of financial institutions and "shadow" financial insitutions like the hedge funds.  Hedge funds aren't very good for investors (see, e.g., this item showing that hedge funds return less than the S&P 500 on average--considerably less), but they make good money for their managers--especially when they engage in derivatives to turn ordinary income into preferentially taxed capital gain.

Thankfully, the IRS has challenged the scam, utilizing the core tax principle of "substance over form".  See the November 2010 Chief Counsel Memorandum noting that the contract does not function like an option and since it provides the benefits and burdens of ownership to the hedge fund and not to the bank, the hedge fund is treated as the beneficial owner for tax purposes.  But remember that the IRS Is underresourced and outmanned by the lucratively compensated tax advising teams for funds and other wealthy institutions.  "If they [the hedge funds] win, that will signal to the rest of the hedge-fund community that aggressive strategies can work.," said Steven Rosenthal from the Urban Institute (a former tax partner at Ropes & Gray).

Related articles

tax breaks for wealthy; corporate tax shouldn't be reformed away; seed patents are a real scandal

Simons Strategy to Shield Profit From Taxes Draws IRS Ire - Bloomberg

Super-Successful Hedge Fund Reportedly a Huge Tax Dodger

IRS challenges Simons fund's tax treatment

Obama caves yet again: offering Social Security cuts to appease the right...

Obama's budget isn't even released yet and he's already caving to the "let's make the rich richer and forget the rest" crowd.  That crowd that claims that we need a capital gains preference so the rich can gather all that extra money to purportedly create jobs.  The crowd, that is, that fails to acknowledge that the rich tend to take all that extra money to Singapore, the Bahamas, or the Cayman Islands or hide it away in some Swiss bank, none of which does any good for our economy compared to what the government investing that money in infrastructure projects would do. See, e.g., David Leigh, Leaks reveal secrets of the rich who hide cash offshore, The Guardian (Apr. 3, 2013);  The corporatist crowd that refuses to admit the empirical evidence that says government investment is as important as private investment in creating jobs.  It is the government that makes the market go round.  And government money--our money--spent for schools, bridges, safer communities provides jobs and improves lives.  Without that government investment, there is no market, just barter.

President Obama seems to have forgotten that he was elected. as a Democrat, over the Republican candidate.  Obama has no business proposing cuts to Social Security benefits as part of a purported deficit reduction package.  Social Security is not a deficit driver: it is a social insurance program earned by those who receive it by payments over lifetimes of hard work.  It is the only stable retirement income most have.  The average Social Security beneficiary receives just short of $14,000 a year from Social Security--that's just 125% of the poverty line, which of course is defined so low as to guarantee that anyone living at or below that line is indeed in abject poverty and unable to move out of it.

The Republican Party has argued for cuts to Social Security benefits for decades, using whatever crisis of the momen they can engender to argue that we can't afford the system in place.  They've invented the perjorative term "entitlement" to imply that those who rely on social insurance because of disabilities or old age are just 'freeloaders' who are mooching off others.   Not so, since Social Security is an earned benefit program like insurance: workers pay premiums throughout their working life, and then once they reach retirement age they may draw benefits. 

There are a number of reasons for the amount of debt that the US government has--most of them related to the four-decade-long drive by the Republican Party to protect the wealthy and the corporations they own from much of a tax burden and to allow the accumulation of immense wealth by a few at the top of the income distribution.  Outsize military expenditures driven by Bush's preemptive wars undertaken at the same time that the Bush Administration pushed through tax cuts that favored the rich are of course a big problem.  The Bush tax cuts threw us from surplus to deficit and we haven't gotten beyond them yet.  The almost complete capture of the financial regulatory agencies by Wall Street, and the resulting financial crisis driven by casino capitalism spiked with the heady bubbles of derivative inflation is of course another part of the problem, and we haven't gotten beyond that yet, as Big Banks still exercise far too much power over their own regulation, proven by the LIBOR scandal that demonstrated their ability to manipulate the purportedly objective market rate to suit their profit machines.

But Social Security is not one of those drivers of the debt.  And the debt is not so outsize that it merits sacrificing the most vulnerable amongst us to mollify the wealthy who merely want to avoid paying their fair share of the revenues needed to get rail service up to snuff, bridges safe, and public schools owned by the public again.

 The average Social Security benefit is just under $14,000: the use of chained CPI will result in a loss to the average recipient of "$4,631 in Social Security benefits by age 75, $13,910 by age 85; and $28,004 by age 95" (from release by Social Security Works, based on “Inflation Indexation in Major Federal Benefit Programs: Impact of the Chained CPI,” Alison Shelton, AARP Public Policy Institute, March 2013.).

Obama has no business facilitating the gluttony of the rich.  He should drop the proposal to use “chained CPI” that will  result in a cut benefits for Social Security recipients.

Related articles

Obama's Social Security Cuts: Wrong Policy, Dumb Politics

Left Furious With Obama For Backing Social Security Cuts

Obama budget includes Medicare, Social Security cuts

Illinoisans Detest President Obama's Chained CPI Budget Proposal

Congressional Democrats Blast Obama 'Chained CPI' Proposal To Cut Social Security Benefits

The Inequality Gap

We're being bamboozled--debt ceiling, cuts to ordinary folks' programs, and the corporatist state continues apace

I almost can't stand watching or reading the news these days and have delayed posting on this blog because it seems there is a need to repeat the same suggestions over and over again.  Don't cave to the right.  Don't cut important social welfare programs that have enabled this country since the 1930s to treat its elderly and vulnerable populations with respect.  Quit trying to strip unions of power--they are one of the important ways that ordinary people can emplower themselves to demand a share of the prooductivity profits their labor has produced.  Quit repeating the garbage free market mantras suggesting that the wealthy investors and managers are entrepreneurs (they're not generally) and that allowing such gross accumulation of wealth as our current CEO pay of 3-400 times the salary of average workers (earning in a half day what a worker earns in a year) is somehow necessary to a good  economy in a democratic political system.  Allowing the owners and managers to continue to reward themselves with grossly oversized compensation and profits packages so that they can maintain their 20,000 square feet marble palaces with kitchens that only a caterer needs (and that the denizens of the house hardly ever use on their own) is just one of the excesses of the brute capitalism that the 'tea partiers' and other right-wing economic policy gurus are supporting.

This free market, brute capitalism where workers are expendable and the entire economy is forced to support the accumulation of wealth at the top is what we have in fact pushed on (and sometimes assisted in imposing on) developing nations in the past .  Think Argentina--where the Chicago Boys oversaw the decimation of the economy and the imposition of austere conditions on the majority so that the economy could be 'remade' to suit the owners of capital (including foreign investors and multinationals). Think Brazil, where in the 1960s we helped their military coup against a leftish president in order to support the ability of US multinationals to continue exploiting Brazilian resources. 

But now the right is so invigorated, through its ability to bamboozle the American people and elect a majority of economic extremists in the House who either don't understand history well enough to know that they are speaking gibberish, or don't care.  They are determined to undermine the meagre social welfare system of Social Security, Medicare and Medicaid, with constant untruths about 'bankruptcy' and similarly misleading statement on almost every issue.  Presidential candidates who make up facts are toasted by the purportedly 'leftleaning' mainstream media (this assertion itself a made-up fact used to continue to bamboozle the people).

The most outrageous spectacle of all is the pontificating dogmatic right in the House and Senate, threatening to cause a U.S. default on the debt ceiling issue in order to pursue their ideological dream of a 'pure' economy.  Their economic model is a disgraced one --the free market, corporatist model that ensures that the small, wealthy investor class is doing well and that Big Business gets what it wants but doesn't give a damn for ordinary folks, whatever verbiage about caring for workers, and ordinary people with mortgage difficulty, etc. they spout.

Truth is, folks, you don't get an economy working well for ordinary people when you (i) make pledges NEVER to increase taxes, (ii) reject cuts in the grossly overlarge military expenditures this country makes in order to secure the world's resources for its multinational enterprises (that then lobby for close to zero taxation on their obscene profits from that secured wealth), or (iii) try to solve all perceived fiscal problems by taking it out of the hide of ordinary folk, thus  stifling the real economy (the one where workers work in businesses that serve local people and that work generates profits that are shared with workers and owners in a way that leads to expansion of the local economy based on the broad-based workers' participation in it) and at the same time bringing the kind of class warfare that the Friedman school has long waged on Latin America and other Third World countries right here to America.  The result of those kinds of policies is concentration of income, wealth, and influence at the top, with ordinary folks in the middle class struggling just to stay even.

The idea that you cannot tax natural resource extractive industries more (by taking away the tax expenditures subsidies that literally hand them outsize profits on a silver platter) when they are making windfall profits is absurd.  The idea that you cannot reimpose a decent estate tax on the estates of the wealthiest 2% in the country, to assist with meeting the heartfelt needs of the struggling middle and lower classes, is pathetic.  The suggestion that you cannot increase taxes on financial transactions and increase capital requirements in banks to stifle the too-rapid innovation and liquidity within the financial institutions that underlies the crisis we just went through (and the worse one we will suffer within the decade if we don't enact even stronger reforms than already in Dodd-Frank) reflects the dogmatic fixation on service to the wealthy investors and financiers that permeates the right-wing in Congress.

Folks. we can't let them do this.  Congress is supposed to serve the people, and this 'tea party'/right-wing extremism that was reflected in Newt Gingrich's 'contract on America' and John Boehner's contract with the investor class is the worst of class warfare.

There was a time when the neo-imperialists and corporatists didn't dare do the same thing in America that they were  pushing for, and secreting doing in Third world countries.  Exploiting the environment without a care for the pollution that ordinary people suffer in their daily lives.  (Think of the Banana Republic attitudes of United Fruit  and  the Latin American oil enterprises conducted by US multinationals.)  Supporting militaristic regimes with a right wing flavor and a taste for torture and imprisonment of radical left thinkers. (Think Chile, Argentina, Nicaragua, Guatemala, etc.)  Labeling governing concepts that pay a lot of attention to the needs of ordinary people as 'subversive' and 'socialist' in order to bring up myths of communistic monsters that hide under the bed and eat the economy.  (Think Cuba and Brazil, especially, and Chile, and now Venezuela.)  All these tactics exist to keep ordinary people in their place as workers who get a pittance of their productivity profits and are "flexible" (meaning can be fired upon short notice by private equity firms flipping companies for their own (preferentially taxed) profits) while the military can control the resources and make good deals (for US multinationals and the military leaders, not for the people of the exploited country).  Read Chomsky's "Year 501" for a (somewhat rambling) account of the neo-liberal corporatist agenda in Latin America.

But now those same ultra corporatist, class-warfare policies are being implemented right here, in the open, with brazen disregard for our historical social contract, for the plight of the poorest and most vulnerable amonst us, all in the name of keeping the 'investor class" and Big Business (generally one and the same, since the investor class is mostly the owners and managers of Big Business) happy.

They paper it over with talk, as Joe Lieberman does in calling for cuts to Medicare, for 'bipartisanship"  or they claim the US is living beyond its budget because it doesn't pay its bills.  But of course they don't really care about that, since the budget put forward by the Republican House majority carved a multi-trillion dollar hole.  IN other words, they don't pay attention to their own rhetoric.  They just want to use the (absurd in itself) requirement in the US that we have a debt ceiling extension vote as an opportunity to blackmail the American people to get concessions on their favored targets--the programs that ameliorate, somewhat, the brute capitalism of the American economic system after forty years of reaganism, friedmania, and the rest of the Chicago School garbage that has been treated as "God's truth" so long by politicians that they don't even realize, perhaps, that they are letting a bunch of mathematicians who like to escape the real world into made-up formulas decide the policies for the nation.

Big Business has had its enablers in place for four decades--Grover Norquist, the Koch brothers and their 'tea party' followers, the various propaganda tanks like the American Enterprise Institute, the Cato Institute, the Heritage Foundation, and the rest  that have spent millions to brainwash Americans into thinking that the failed 'free market' ideas of Milt Friedman and Alan Greenspan and Wall Street are the only way to go.  It has a majority on the Supreme Court willing to be extraordinarily activist in overturning precedents on class action lawsuits (a way for ordinary people to empower themselves against Big Business) and free speech (a way for corporations and their owners/managers to control the political debate through the use of their overwhelming dollar power).  And that right-wing majority is serving its masters well, while Big Business's minions in Congress continue to roll over to make sure that the right-wing panacea of deregulation, militarization, tax cuts, and privatization contines apace. 

The US debt burden is high, but we are not Greece or Ireland or even Portugal.  We have a strong economy.  We have our own monetary system, unlike the Euro nations that are facing much higher debt burdens and can't individually control their monetary flows.  Austerity measures like the IMF has imposed on Latin America to satisfy foreign investors (not the natives of those countries) and like the Euro world is now imposing on its own members are not needed here (and probably are the wrong answer there as well).  Those measures are driven again by the failed corporatist economic model that assumes that the entire world should be run to satisfy the wishes of financial institutions, big money investors and the big multinational corporations that they own and manage. 

The world should be run to satisfy the needs of ordinary people.  Banks should be stripped of the power to create a world-wide crisis with their haystacks of derivatives that catch flame much too easily.  Big Business should make do with lower profits, paying their workers more and their managers (and owners) less and paying their fair share of taxes.  Hedge fund managers should pay tax on their "carried interest" compensation like ordinary people, and private equity firms should be subject to much more red tape that makes it much harder to buy companies and take them private in order to fire their workers.   In fact, consolidation and mergers among big businesses should be made much more difficult through new limitations on the tax-free restructuring provisions. Unionization should be strengthened, in order to give ordinary Americans something with which to have leverage over the hierarchical authorities that undermine economic growth by concentrating everything on the investor class.

Let's start a letter and call-in campaign to every Republican legislator in the coutnry, telling them that we are sick and tired of being treated as lambs led to the slaughter in order to place endless platters on the tables of the rich.  Tax policy should be based on what works, not on ideological dogma that has been the underlying cause of catastrophes and crises worldwide. 

 

Tax information reporting by third parties

As the extraordinarily conservative Republicans in the House (and in the Senate) press to turn back progressive initiatives, the White House and responsible Democrats (assuming there are a few) need to be cautious that they don't concede before they even try to fight and end up dumping out important provisions to appease the right like they did with the "public option" in health care reform.

For example, Obama made a point in his State of the Union address of going along with the demand by small businesses for alteration of the 1099 reporting provision enacted as part of the Health Care Reform bill.  See, e.g., Lavante, What President Obama Really Said in the State of the Union Address about 1099 Reporting (Jan. 2011).  Businesses complain about any new reporting requirement.  First, because they don't want to do any reporting at all if they can get out of it.  Second, because they know that information reporting has a huge impact on the ability of small businesses generally to evade taxes by simply failing to report income.  Compliant businesses ought of course to support reporting requirements, since they end up paying their taxes in full, while the noncompliant businesses that earn income "under the table" are the ones that benefit when there is no reporting requirement. 

Think about this a minute.  Businesses inevitably track their invoices and their customers.  They know who pays and who doesn't.  They know what they've bought and who they've bought it from.  It doesn't require much to file that information (already maintained by most modern businesses on computerized accounting programs) in the appropriate forms so that the IRS has the information to match against what various business vendores report as their income.  This should therefore be a nonissue:  for a small additional cost in the time to do the paperwork, the government will be able to hold businesses accountable in the same way that it holds ordinary wageearners accountable--through the information reports filed by third parties.  

Raising the threshold on the amount for reporting or excluding all "small" businesses from reporting would be a bad idea.  Small businesses are the place where failure to report income likely adds up because of the ease with which such things can be obscured without third party reporting, whereas large companies have various audit and public reporting requirements that would hinder such failures to report: one has to think that it is a number of those family-owned businesses running sole proprietorships and S Corporations that are evading their responsibility to report their income and causing all of us to have to bear a disproportionate amount of the burden.

Of course, this is a broad issue that relates to reporting by third parties in many different situations.  With third-party reporting, the tax gap--somewhere in the range of $200 to $300 billion annually made up of taxes evaded by cheaters--would be significantly reduced, and compliant taxpayers would be restored to equity.  Noncompliant taxpayers would no longer garner a tax advantage from simply failing to report their income on the assumption that the IRS would have considerable difficulty figuring out the additional payments they've received.  It is a no-brainer, given the way that third party reporting assists in overcoming the problems of assymetry of information faced by the government.  See, e.g., United States Government Accountability Office Report to the Committee on Finance, U.S. Senate, "Tax Administration: Costs and Uses of Third-Party Information Returns," GAO-08-266, Nov. 2007 (noted in Citizens for Tax Justice report cited below).   But neither the Republicans nor the Democrats seem to be able to see past the hullabaloo raised by people (presumably including a good many of those who profit from the lack of third-party reporting) about "burdensome" reporting.

There are similar complaints about the IRS's proposed regulations requiring banks to report interest paid to foreign accountholders in the same way that they have been reporting such interest for domestic accountholders for some time, in order to be able to comply with our information reporting requirements under treaties.  Citizens for Tax Justice notes that the so-called "center for freedom and prosperity" (hereinafter CFP) (often represented by Dan Mitchell of the Cato Institute) has as usual distorted and misrepresented the issue here.  See The Tax Cheaters' Lobby is Wrong about IRS Proposed Regulations, CTJ, Jan. 31, 2011.  Not only do we have a responsibility to provide information to other governments under our agreements on tax information exchange, but such reporting will likely aid in the ongoing battle to catch flagrant tax cheats who hide as foreigners to avoid paying income tax on earned interest, as CTJ notes.   

(Again, one suspects that these are some of the same people who hide money in offshore secret banking jurisdictions and conveniently forget to report the income on it on their tax return.  At the recent ABA tax section meeting in Florida, I spoke with a lawyer whose practice includes representation of many of these tax shirks.  He estimates that there are more than 250,000 such shirks with "substantial" amounts socked away in offshore tax havens.  The right-wing CFP, of course, gathers money from these rich folks and spends it vilifying the efforts to squelch tax havens and tax competition, which it considers a wonderful thing because it permits the extraordinarily wealthy to hang onto "their" property (i.e., avoid contributing taxes to pay for the government that made that property possible).  Don't believe anything you read on the "prosperity" center's site--it will almost certainly be distorted by misleading innuendo and misinformation.  The CTJ report is an excellent takedown of the many exaggerated and misleading claims made in the "prosperity" center's materials.  You can also find a number of my own website where I have reviewed some of their videos and found them to rest on a very shaky foundation of speculation and conclusory assertions.)

The Dodd-Frank financial reform bill included a similar new reporting requirement for broker-dealers.  Some experts have concluded that about 25% of those who report capital gains from sales (in most cases, the most affluent amongst us who are making trades in financial assets such as stocks and bonds) have cheated by overreporting basis and thus underreporting gains.  That adds up to a huge part of the tax gap.  Dodd-Frank raised some revenues by requiring brokers to report basis, providing a third party check against an individual's claimed basis amount.  The banks have this information automatically when they conduct trades on stocks or bonds they've sold to the investor and they are gearing up for the initiation of this reporting this year.  See Larry Barrett, Broker-Dealers Brace for Cost Basis Reporting, Security Monitor, Feb. 2, 2011. 

Of course, in enacting the provision, Congress provided much too much flexibility to investors selling financial assets, by allowing them to specifically identify which of completely fungible items they sell (thus cherry picking the basis that gives them the lowest tax liability).  If average basis isn't used (and this is an area of considerable complexity regarding the appropriate rule), then there should be a first in-first out rule that requires investors to be treated as selling their oldest acquired items first.  It is hard to see any justification for allowing cherrypicking that has nothing but a tax-minimization goal as its object--these are fungible financial assets that are exactly the same for every purpose other than tax, so recognizing the tax differences as a basis for a tax beneficial election makes no policy sense at all.  The identification provision that has been in the Code for a long time should be deleted, and owners of financial assets should not be able to specfically identify consideration received for such items in any context, whether reorganizations (where the Bush Treasury instituted a rule permitting such identification in 2006, claiming wrongly that it was a necessary corollary to their decision to treat a share of stock as the base unit of property in reorgs) or otherwise.

Meanwhile, other provisions in the Dodd-Frank reforms, limited though they were, now face a struggle against a headwind of Republican cost-cutting and business-friendly attitudes.  The SEC seems to be suggesting that it thinks it will have to rely on the banks' own self-regulatory apparatus--i.e., it appears to be willing to let the fox watch the henhouse when it comes to the Dodd-Frank fiduciary standard.  And the CFTC sees itself needing considerably more resources in order to institute the swaps exchange which is essential to the re-regulation of the swaps market that lay at  the heart of the financial speculation carried on by TBTF banks.  See Dodd-Frank Tax Battle Coming, Securities Monitor, Feb. 2, 2011.  Too many in the new Congress seem to think that the tea party crazies represent the majority of American voters, and are planning a range of truly stupid actions, from failing to approve a new debt ceiling (this, of course, after fighting singlemindedly for hundreds of billions of tax cuts for the extraordinarily wealthy) to failing to fund the regulatory apparatus necessary to give us any hope that 21st century global capitalism can be responsive to democratic, people-centered objectives for society.

Derivatives: greater transparency is needed

The big banks got into considerable trouble doing derivatives trades--especially the credit default swaps where AIG was the major counterparty and the taxpayers ended up bailing out the Big Banks like Goldman Sachs.

So surely one of the results of "financial reform" in the wake of the casino banking financial crisis would be utter and complete transparency about derivatives, correct?  One would think so.  But it may not be so.

For a detailed picture of the way the Big Banks have controlled derivatives trading in order to make it a lucrative noncompetitive market for them and a costly market for derivatives endusers, read the article in the Saturday New York times:  Louise Story, A Secretive Banking Elite Rules Trading in Derivatives, New York Times, Dec. 11, 2010.

As Story notes, there is an exclusive group of bankers that has a great deal of say about derivatives trading.  The theoretical purpose is to "safeguard the integrity" of the derivatives market.  The real purposes is to "defend[] the dominance of the big banks" which the banksters do by thwarting efforts to create transparent markets where end users get real information on prices and fees and comparable trades.

The CFTC chair wants to push for more transparency about the derivatives clearinghouses, which will have more power under the Dodd-Frank bill.  But the banks don't want transparency--in fact, the group of nine banksters that is the subject of the article meets monthly with the ICE Trust clearinghouse, and has enormous influence and power over them. 

But Republicans in Congress aren't exactly supportive of financial reform, unsurprisingly.  They've gotten big contributions and backing from Big Banks, and they plan to push back against banking reform.  Apparently they think another crisis like the one that hit us won't be so bad.  After all, the banks survived this one just fine (and are making billions off the very low funding costs available to them through the Fed, while charging their depositors and customers huge fees).  As did most of the multimillionaires who own substantial financial assets.  Apparently, those who want to ease back on banking reform don't care much for ordinary Americans who are paying through the nose for credit and getting nothing for their deposits.

Here's an excerpt from the piece on the way the Big Banks control the derivatives market by keeping the facts about derivatives trades secret.

In the midst of the turmoil, regulators ordered banks to speed up plans — long in the making — to set up a clearinghouse to handle derivatives trading. The intent was to reduce risk and increase stability in the market.

Two established exchanges that trade commodities and futures, the InterContinentalExchange, or ICE, and the Chicago Mercantile Exchange, set up clearinghouses, and, so did Nasdaq.

Each of these new clearinghouses had to persuade big banks to join their efforts, and they doled out membership on their risk committees, which is where trading rules are written, as an incentive.

None of the three clearinghouses would divulge the members of their risk committees when asked by a reporter. But two people with direct knowledge of ICE’s committee said the bank members are: Thomas J. Benison of JPMorgan Chase & Company; James J. Hill of Morgan Stanley; Athanassios Diplas of Deutsche Bank; Paul Hamill of UBS; Paul Mitrokostas of Barclays; Andy Hubbard of Credit Suisse; Oliver Frankel of Goldman Sachs; Ali Balali of Bank of America; and Biswarup Chatterjee of Citigroup.

Through representatives, these bankers declined to discuss the committee or the derivatives market. Some of the spokesmen noted that the bankers have expertise that helps the clearinghouse.

Many of these same people hold influential positions at other clearinghouses, or on committees at the powerful International Swaps and Derivatives Association, which helps govern the market.

Critics have called these banks the “derivatives dealers club,” and they warn that the club is unlikely to give up ground easily.

*****

For many, there is no central exchange, like the New York Stock Exchange or Nasdaq, where the prices of derivatives are listed. Instead, when a company or an investor wants to buy a derivative contract for, say, oil or wheat or securitized mortgages, an order is placed with a trader at a bank. The trader matches that order with someone selling the same type of derivative.

Banks explain that many derivatives trades have to work this way because they are often customized, unlike shares of stock. One share of Google is the same as any other. But the terms of an oil derivatives contract can vary greatly.

And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.

It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.

Goldman's Settlement with the SEC

On July 15, it was announced that Goldman had reached a settlement of the SEC's charges regarding material misrepresentations in  an Abacus CDO deal, acknowledging that its materials were "incomplete".  See Chan & Story,  Goldman Pays $550 Million to Settle Fraud Case, NY Times (July 15, 2010).

Goldman sold the deal to buyers without informing them of the involvement of the counterparty to the deal.  The counterparty was Paulson, a hedge fund manager, who had personally selected  "most likely to fail" mortgages on offer and gotten Goldman to create a CDO package with those deals in it so that he could bet against the deal.  The bet against the deal was a naked credit default swap.  The person who bought the other side of Paulson was essentially buying a deck intentionally stacked against him, rather than a more diversified cross-section of subprime mortgages.  Not surprisingly, that particular Abacus deal  was particularly bad and went south within months of its creation and sale.

Now, in my view naked credit default swaps should be illegal.  They are nothing but an insurance contract when the protected insurance buyer has no insurable interest in the reference property.  As many have observed, such a situation presents a dangerous moral hazard-- it is like letting an arson take out an insurance contract on the most expensive house in the neighborhood and then reap the benefit of the payout after he burns the house down.  Nonetheless, the financial lobby is extraordinarily powerful, and Congress did not yet bite the bullet to ban naked credit default swaps in the financial reform package.  (I say "yet" because I am convinced that we must dampen the use of such derivatives or stand by to witness destruction of both financial system and economy through continuing crises fueled by rampant speculation.)

But even if naked credit default swaps aren't illegal (which is the current situation), that doesn't mean that a bank should be able to cater to one client to create a financial product stacked with the worst of the worst subprime mortgages and neglect to tell another client about that critical fact.  The SEC might have had difficult proving fraud:  Goldman is no dumbie, and it is adept at selecting facts to cast itself in the best life and working to obscure facts that do not.   Anyone hearing Paulson's side of the story (read Michael Lewis, The Big Short) would want to know about his involvement in a deal, especially when those products were nonetheless rated AAA.  (Yeah, rating agencies were in on the game too, but the banks were tailoring their synthetic CDOs to match the known rating agency procedures, sort of like stacking up a room full of people paid the average income and needing to boost it to make it look like incomes are higher, so adding a multimillionaire with just the right income to the mix to bring the average up to the desired goalpost and no more.  Crapola.)  And I for one suspect that the SEC could have rather easily proven material misrepresentation.

Goldman took a battering from having the suit out there and clearly wanted to settle. But Big Banks want to settle on terms that don't produce real pain.  So Goldman got a deal with essentially a $550 million price tag, which, as the weekend Wall St. Journal editorial notes, is "a mere two weeks worth of recent trading profits."   Goldman's Bailout Fee, Wall St. Journal, July 17-18, 2010, at A12.  Too little, methinks, even with the concession not to seek a tax deduction for any part of the fine which might otherwise have been deductible.  See Donmoyer, Goldman Sachs Waives Tax Deduction on SEC Settlement, Bloomberg.com (July 16, 2010).  In my view, anything under 10% of Goldman's profits last year, plus no tax deduction, is de minimis.  Anything smaller than that will be viewed by the financial industry as no more than a slap on the wrist.  To be instructive and to spur more prudential banking from Big Banks, the penalty needs to be severe enough to be taken very seriously.

Dodd-Frank Bill closer to passage as Republicans Sign On

Senators Brown (R-MA), Snowe (R-ME) and Collins (R-ME) have indicated that they will support the financial reform package.  Along with Maria Cantwell, who had hesitated because of the bill's relative weakness at correcting the key problems that caused the financial crisis, it appears the bill is headed to passage by the Senate this week.  See Financial Times, Wall Street Reform Proposal Wins Key Support, July 12, 2010.

Perhaps the weakest part of the bill is its failure to definitively wean big banks from the risky (but lucrative, as long as the US picks up their losses) derivatives business and investments in hedge funds and similar entities.  Naked credit default swaps, the critical derivatives that permitted banks to become interconnected casinos gambling on ups and downs in companies without owning a cent of their equity or bonds (an insurance product without insurance regulation to prevent moral hazard), are essentially unregulated in the conference report agreement.  The Fed will have the power to regulate them, but the Fed has long been in bed with the banks and has insufficient independence to recognize the depth of the problem.  Moving most derivatives into subsidiaries is not the same as spinning them off entirely into separate entities.  The banks won on this one, and this was the most important stake in the bundle.

While the consumer protection agency is much needed, it is weaker than it should be.  It is under the Fed, which can veto rules if the Fed thinks they pose a risk for banks.  Since banks always say that any rule that limits their profits poses a risk, this will be a constant worry for consumer protection rules.  Further, auto dealers--one of the primary issuers of credits to ordinary consumers--lobbied for and won exemption from the agency's rules.  Of course, every Congressman has auto dealers in his or her district, but you'd think that the thousands of car buyers in each district who will fall prey to any shucksterism from auto dealers would garner more of the reps/ attention.

Finally, Brown's vote was a costly one.  He was one who fought to permit banks to own hedge funds--essentially a decision to allow them to continue to gamble with other people's money.  And he nixed the proposal to have the banks pay for the cost of increased regulation due to their risky behavior.  Why in the world shouldn't the banks pay?  I suppose they must have contributed a good deal to Brown's campaign chest.  There's no other reason for failing to assess the banks their fair share of the added monitoring costs.

What convinces me that this bill is much too weak is that the banks are satisfied that they won sufficiently to keep doing business as usual.

Financial Reform: Agriculture approves derivatives regulation

Blanche Lincoln 's Senate Agriculture committee voted 13 to 8 (including lone Republican Grassley) to pass a bill that goes a good ways towards establishing real oversight of the derivatives (and other financial innovations) market.  See Dennis & Kane, Senate committee approves derivatives oversight bill, Washington Post, Apr. 21, 2010.

The bill, known as the Wall Street Transparency & Accountability Act of 2010 (available in the Senate Agricultural website) is generally tougher on derivatives than the current Dodd bill on financial regulatory reform, but leaves considerable loopholes that will need to be closed if real financial reform is to be achieved.  It seems fairly close to the Obama administration's proposal (with separate rules for "swaps" under the Commodities Exchange Act generally regulated by the Commodities Futures Trading Commission (CFTC) and for "security-based swaps" under the Securities Exchange and Investment Acts regulated by the SEC)--which caused much consternation among Wall Street banks, but had commentators worried about the exceptions and discretion.

As described in the WaPo article:

Lincoln's legislation calls for banning big Wall Street firms acting as brokers for commercial companies and financial speculators who want to trade derivatives. It also would require nearly all derivative contracts to be traded in public on exchanges and approved by a separate body called a clearinghouse.

Those dealing in derivatives would have to raise money to cover unexpected losses, in case one party to the contract defaults. Lincoln also said swap dealers will have a fiduciary duty, just like investment advisers, to act in the best interest of their clients. The draft of her bill provides a relatively wide exception for agricultural and other commercial companies but still requires them to raise money for derivative trades.

Some officials view the legislation as too friendly to the commercial firms who have sophisticated derivatives trading desks, while overly punishing financial firms. If allowed to stand, they have said, the market would simply shift its activities away from Wall Street to the commercial firms, critics argue, but become no less dangerous to the financial system.  Id.

The bill would also prevent the Fed or FDIC from using federal funds to bail out Wall Street firms who engage in derivatives--those swap desks must be spun off or the firms will not be able to receive any federal assistance.   According to Lincoln, the bill's refusal of Fed funding for risky derivatives trades will require that banks choose whether "they want to be banks or [whether]they want to engage in the risky trading that caused the collapse of firms such as AIG."   RTT News, Senate Agriculture Committee Passes Derivatives Reform Bill (Apr. 21, 2010).

The exception from mandatory clearing is intended to cover end-users who are actually hedging business risks, such as electric cooperatives.  The summary describes this exception this way:  "Commercial businesses and manufacturers who use these markets and customized contracts to manage risk will still be permitted to do so without imposing additional margin costs."  See  the Ag Committee's summary of the bill.   In my view, however, that is a gaping loophole that lets a agribusiness interests off the hook, especially if those "customized contracts" are not hedges of commodities but tax minimization transactions or regulatory avoidance transactions.

As the Wall Street Journal noted when Lincoln revealed her proposal last week, the proposal is "likely to draw the ire of the largest Wall Street banks."  See Crittenden & Favole, Lincoln: Derivatives Bill to Provide '100% Transparency', Wall St. J. (Apr. 16, 2010).  But the view seems to be that financial reform will pass, and this suggests that it will contain at least some form of derivatives regulation. See Dennis & Murray, Once critical of finanical regulation, Republicans change their tone, Washington Post, Apr. 21, 2010.

As I've said before, regulating derivatives is essential.  Regulation needs to be comprehensive, however, and disincentivising and perhaps banning specific types should also be in the package.  It is hard to find a good rationale for permitting naked credit default swaps, which amount to casino bets that compound any misinformation in the markets and multiply the volatility. 

Breaking News: SEC charges Goldman Sachs with fraud in mortgage deal

The SEC filed a suit today (Friday, Apr. 16, 2010) against Goldman Sachs and Fabrice Tourre (a Goldman Sachs vice president who helped create the investment in question).  See  Story & Morgenson, U.S. Accuses Goldman Sachs of Fraud in Mortgage Deal, NY Times (Apr. 16, 2010).  The suit accuses the huge investment bank of creating and selling a mortgage investment that it intended to fail, and betting against the investment.  This involves Abacus 2007-AC1, one of 25 deals created to permit Goldman to bet against the housing makret in the months after the potential for catastrophe was becoming apparent to banks facing losses on their hitherto enormously lucrative mortgage securitization product.

According to the complaint, Goldman created Abacus 2007-AC1 in February 2007, at the request of John A. Paulson, a prominent hedge fund manager who earned an estimated $3.7 billion in 2007 by correctly wagering that the housing bubble would burst.

Goldman let Mr. Paulson select mortgage bonds that he wanted to bet against — the ones he believed were most likely to lose value — and packaged those bonds into Abacus 2007-AC1, according to the S.E.C. complaint. Goldman then sold the Abacus deal to investors like foreign banks, pension funds, insurance companies and other hedge funds.

But the deck was stacked against the Abacus investors, the complaint contends, because the investment was filled with bonds chosen by Mr. Paulson as likely to default. Goldman told investors in Abacus marketing materials reviewed by The Times that the bonds would be chosen by an independent manager.

***

"Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party." Id. (quoting Khuzami, director of SEC's division of enforcement).

Paulson, the hedge fund manager that wanted to short the housing bond market, was a good picker.  84% of the Abacus deal bonds, selected by Paulson as likely to default and good to go short against, were underwater within five months.  These deals were synthetic CDOs --i.e., deals with junkier tranches from earlier CDO deals with mortgage loans and credit default swaps finangled to get high ratings from the ratings services; but where the "investor" in the deal was essentially buying the original subprime bonds underlying the embedded CDOs.  Investors did not know they were investing in a group of bonds pre-selected for high likelihood of default. 

Michael Lewis's book, the Big Short, mentions these types of deals as well.  See, e.g.,the asterisked note on page 77, where Lewis notes:  "Goldman was in the position of selling bonds to its customers created by its own traders, so that they might bet against them." 

Goldman's stock has dropped 10% today, according to the Times.  Maybe holding Wall Street's TBTF banks accountable for fraud will be a way to downsize them, supplementing whatever financial reform package can actually make it through Congress?

Bank reforms: back on the front burner?

As calls increase for cracking down on trading in derivatives --especially credit default swaps that are purchased to bet on a position rather than to hedge a long position--Congress seems to be responding with a growing awareness that it must act and cannot simply let the financial system regenerate exactly the same systemic risk problems by continuing to operate under "self regulation" (i.e., nonregulation).

Remember that CDS are unregulated--they are an insurance-like product, except that the one who buys the insurance doesn't have to have an interest in the item insured, which creates a significant moral hazard problem.  So a bank may buy "credit protection" on a notional principal amount of IBM or GE bonds, not because they have the bonds and want to limit the risk of loss on those bonds, but because they think the bonds are going to go down in value and by buying this "insurance" they will make money when that actually happens.  That's pure casino-type speculation.  For real insurance, we worry that the holder of a life policy on a person who has no real interest in the life of the insured may commit murder.  It's the same with "naked" CDS that are not hedging a long position.  They are casino bets that can manipulate the price of the item insured rather than just protecting against losses in that position.  And they have no positive social benefit other than the increase in wealth to those who "win" their bet.  Greece's problems might not be so deep if the CDS market hadn't pushed Greece's cost of funds so high, etc.

For the Times' selection of resources on CDS, see this link.

For the calls to crackdown on CDS, see Browning & Saltmarsh, European Leaders Call for Crackdown on Derivatives, NYTimes (Mar. 9 2010).  A similar story ran in the Mar. 10 Wall Street Journal.  The article notes that Goldman Sachs (one of the big banks that profited enormously from the Fed's bailout of AIG when the Fed paid AIG's CDS at par even though they would have brought no more than about 50% on the market or in bankruptcy) pushed its clients into CDS on some EU countries last fall.  European leaders note that the swaps don't just sit innocently by--they can worsen the position of the country swapped against.  That is, in fact, the way markets work--they record in prices the "bets" that people are making.  If enough people make the same bet, efficient market theorists claim, it means that that is the "real price".  But the efficient market hypothesis doesn't hold water, since people who want to manipulate the market can do it the same way investors who think they are making investments do it--purchases change the price, and changing the price changes the market.  As with most studies focussing on one thing, the study itself affects what can be learned about that thing.

CDS weren't the only cause of the global financial crisis, but they were a significant factor, having grown from a few billion of notional principal amount outstanding in the late 1990s to about $70 trillion at the peak before the financial crisis hit.  As the chair of the Commodity Futures Trading Commission noted, they "played a lead role throughout the story" of the crisis.  Id.  He urges over the counter swaps be regulated.  I think that stops far short of what is needed--customized and over the counter swaps must be regulated, traded transparently with pricing posted for all to see, and speculative trading not related to hedging prohibited.

Congress needs to open its financial crisis review to a broader look at the role of particular banks, such as Goldman Sachs, in the markets.  Proprietary trading should be limited.  Trading on client data (proprietary flash trading programs) should be banned.  Speculative trading in derivatives like CDS should be banned.  These are tough steps, and the banks can and will put a lot of money behind politicians who will take wishy-washy positions on these issues.  If people want a fair government, they will have to help politicians hold the line.  Without financial reform that severely limits the power of the big bank holding companies and investment banks, the banks will be calling the shots, and not the American people.

Will Senator Dodd's latest attempt pass muster?  The Washington Post today noted that Sen. Dodd to unveil updated legislation to overhaul financial regulatory system, Mar. 11, 2010.  He claims it will be "sweeping legislation" following months of negotiations with Republicans Shelby and Corker.    Personally, I doubt that any "consensus" package could hold much good news for ordinary Americans.  The Republicans don't want an agency to protect consumers from the crerdit card banks' ridiculous, outrageous, even obscene charges, fees, hidden tricks and the mortgage companies similar tricksterism.  If banking reform doesn't fix the problems--i.e., if there is nothing protecting the consumer from banks' bullying, nothing preventing the cronyism displayed by the Fed with Wall Street during the September 2008 implosion under the Bush regime, or nothing handling the "too big to fail" problem--it will be just windowdressing and the Big Banks will continue business as usual (which seems to translate to speculating in the financial system in ways that they win, we lose--socialization of losses, privatization of gains).