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GreenTrader Weblog
GreenTraderTax & GreenTraderFunds
September 6, 2010
EU to discuss bank levy, FTT
A financial-transaction tax proposal is up for debate in the EU this week, and if passed, it could spread to the U.S. too.
An EU-wide bank levy is job number one this week, but there’s also going to be preliminary discussion of an additional bank-related tax. This expanded financial-transaction tax (FTT) won’t be imposed just on currency transactions, but on stocks, bonds and derivatives as well. (For more information, see this WSJ article.)
The EU wants a bank contribution to bailout costs and it is focusing on the bank levy, which would set aside a pound of flesh to cover prior or future bank bailout costs. An FTT isn’t the main issue at hand, which takes some of the pressure off passing it. Many EU countries can object to an FTT, since the bank levy is the main bank contribution to bailout costs. Some finance ministers keep repeating that an FTT won't work on a country-by-country basis; it needs to be passed globally. They’re certainly right because trading will move to non-FTT markets if allowed.
Notice how the CFTC may not allow Americans to get higher leverage offshore with new forex trading rules. (See past blogs and podcasts.) Could regulators and tax authorities use extraterritorial reach on an FTT too?
The bank levy approach focuses on banks and bailouts, whereas an FTT focuses on putting sand in the wheels of speculators in addition to banks. Most FTT sponsors suggest using FTT revenues for social ambitions rather than a bank safety net.
President Obama's proposed $90 billion bank responsibility fee (i.e., bank levy) has dropped off Congressional debate. The Bush tax cuts, other tax extenders and small business packages with job stimulus have taken center stage. Passing any tax-related bills before the November 2010 midterm elections will be difficult. The lame duck session will be tough too. The Republican filibuster seems to be holding for blocking tax increases. Sens. Scott Brown (R-Mass.), Susan Collins (R-Maine) and Olympia Snowe (R-Maine) filibustered Dodd-Frank Fin Reg until Democrats dropped the $19 billion in bank taxes. Perhaps these three Republican Senators might filibuster the President’s $90 billion bank fee proposal too. Bringing the bank fee up for vote in the Senate now is bad politics. Let the EU act first this time, since the U.S. acted first with passing financial regulation (Dodd-Frank).
Global ambition with the FTT reminds me of similar difficulties in negotiating a global climate change treaty (Kyoto and Copenhagen). It's hard to win global consensus, especially during a dangerous and drawn out economic recovery. A global FTT is unlikely to happen anytime soon.
Hopefully, the EU and U.S. will focus on the bank levy — which isn’t necessarily a good idea anyway — and delay an FTT as a separate idea for later debate.
With current miniscule interest yields on government bonds, an FTT is now a more terrible idea than before. Why should an investor pay, say, a 1 percent FTT on both the purchase and sale of a government bond to earn well under 1 percent — the rate on U.S. treasuries now? Would government seek to give itself an exemption again, as it does on paying taxes? (For example, teachers don’t pay state taxes on their fixed pensions.) If you want to completely freeze the movement of money and investments and put a deathblow on stimulating the economies around the world, then keep considering an FTT.
The FTT continues to be a catchall idea for hitting up traders, investors and speculators with unaffordable and excessive government spending programs. Why should important financial market makers and retail investors pay for excessive spending programs? If green energy is so great, then why don’t consumers buy it more? It's like allowing reckless spenders to run up big bills and then forcing their wealthy relatives to pay their debts. That's not fair play.
Political regime change is the best answer. In the upcoming midterm elections, let’s hope the Republican filibuster is solidified with more Republican Senators and Representatives, as Sens. Brown, Collins and Snowe can't be trusted to maintain the current filibuster. Don’t be concerned with Democrats as President Obama can always veto Republican bills. If the U.S. blocks a FTT, then the EU will too.
Is widening progressive tax rates unconstitutional?
President Obama wants to widen progressive income-tax rates to redistribute more money from the upper income to the middle-class. Does this targeted tax attack infringe on the constitutional rights of upper-income taxpayers?
Progressive tax rates have been an integral part of the American tax system for a long time. When Presidents Kennedy and Reagan reduced the top marginal rates, it spurred growth and the upper income people felt better about fairness. Lowering their top rates gave them an incentive to invest in innovation and spend on consumer items, all of which grew the economy and tax receipts.
But President Obama proposes to do the reverse, which could hurt the economy. The President wants to retain the lower Bush tax rates for all but the upper two highest income tax brackets, raising the two top brackets from 33 to 36 percent and 35 to 39.6 percent, respectively. (Actually, the top bracket would be 41 percent with phase-outs.)
With health care taxes on investment income and higher Medicare taxes coming in 2013, the top federal rate will be closer to 45 percent. Add in state taxes of 5 percent (on average in many states), and the top marginal tax rate is 50 percent. Social security FICA taxes are another 12 percent on the base amount of $106,800. The President campaigned on subjecting incomes over $250,000 to the FICA tax again too. If that happens, the top tax rate will be 62 percent.
There are more taxes to consider as well. Sales taxes average 5 percent around the country, property taxes are on the rise and there are various excise taxes, too. The deficit commission could even propose a national sales tax (VAT) as well.
Why would anyone want to continue working hard if their make-an-offer-you-can’t-refuse partner — the government — grabs 65 percent of the income? No wonder the upper income seem to be on capital and job-creating strike. More deficit-stimulus spending and paying for spending with tax hikes will not spur job growth; retaining lower Bush tax cuts for all along with business friendly initiatives will do so.
The government argues that it needs to raise tax rates, yet it has done little to nothing to rein in spending, waste and fraud in its own ranks. Obama’s government never addressed Fannie Mae and Freddie Mac’s wasteful spending and policies in Dodd-Frank financial regulation, and it protected the personal injury attorneys in health care reform. Thankfully, the media, pundits and politicians have picked up on the story of government pay and benefits far exceeding private workers. I started on that concept in early 2009 when writers asked me about the escalating problems with state deficits. I also told everyone to let Wall Street pay the bonuses, as government collects half in taxes.
As of January 2010, the budget office (CBO) projects debt will rise to $13.7 trillion (more than 65 percent of GDP) — a difference of $8.6 trillion from 2008. Of this change, 57 percent is due to decreased tax revenues resulting from the financial crisis and recession; 17 percent from increases in discretionary spending, much of it the stimulus package; and another 14 percent due to increased interest payments on the debt — because we now have more debt. Hopefully, interest rates won’t skyrocket anytime soon, as that will really hurt taxpayers. By the way, deflation increases the value of what we owe — the opposite effect of inflation.
The biggest blow to the deficit was decreased tax revenues caused by businesses collapsing — not because tax rates were decreased by President Bush. Restore the financial system and the economy, spur growth and these tax receipts will reappear. Raise tax rates and regulations and the system will not restore itself; the problems will get worse.
It’s not widely understood that President Obama proposes to retain lower Bush progressive tax bracket rates for all but the two highest brackets, which means even the rich will benefit from those lower tax brackets under $250,000 of “married filing joint” adjusted gross income. In fact, the rich will have a small tax cut, because the third-highest marginal bracket (the 28 percent rate) will be widened to reach the threshold of President Obama’s declared cut-off for the new rich of $200,000 single and $250,000 married.
The simple message of the Bush tax cut story is true. The President wants to raise taxes on the upper income and reduce taxes on the middle-class. Conversely, Republicans want to retain the Bush tax cuts for everyone including the upper income. It’s important to note that if Congress can’t pass a new tax bill before year-end, the Bush tax cuts will expire as planned and tax rates rise for all brackets.
Pundits on both sides acknowledge that President Obama has an agenda to redistribute income, capital and benefits (like health care) from the upper income to the middle-class and poor. Popular Democratic rhetoric claims the rich enjoyed most of the benefits of the economy over the past decade while the middle-class stagnated. The left often blames the upper income, big corporations and Wall Street for their economic malaise. Republicans feel raising taxes on job creators during a potential double dip in the economy may reduce tax revenues and cause more job losses.
Let’s focus on the real issue of widening progressive tax rates to redistribute money. The majority of upper-income Americans don’t feel very wealthy now and handing over more of their hard-earned money to the middle-class may seem unfair to them, especially after a large chunk of benefits were already forked over with health-care reform.
Wikipedia says “Progressive taxes attempt to reduce the tax incidence of people with a lower ability to pay, as they shift the incidence increasingly to those with a higher ability to pay.” Even Adam Smith, the great author on capitalism thought progressive taxation is a good idea and most Americans probably agree.
However, there are many good arguments against applying progressive tax rates: “It has been argued that progressive taxation violates the principle of equality under the law — the principle under which each individual is subject to the same laws, with no individual or group having special legal privileges.”
This brings to mind the recent ruling overturning California’s passage of Proposition 8. The court ruled that the wishes of the majority to ban same-sex marriage could not trample the constitutional-rights of the minority. Upper-income taxpayers appear to be a minority too and they deserve constitutional protection from President Obama’s active redistribution agenda.
The President’s health-care mandate forces all taxpayers who can afford it to purchase health insurance or pay stiff penalties. State attorney generals along with their courts may strike down this mandate as unconstitutional based on the commerce clause. It’s amusing that the President’s side is calling it a health-care tax to win that lawsuit. This case shows the Obama administration is trampling on citizens’ constitutional rights.
Big banks are also gearing up to fight the President’s proposed $90 billion bank fee (or tax) based on constitutional grounds. The banks’ attorneys claim it’s an unfair bill of attainder. The constitution bars bills of attainder in Section 9 of Article I. This is another example of soak the rich and people you demonize with higher taxes for redistribution. The banks have paid back TARP with high dividends already.
Progressive tax rates are fair, but widening them too much — especially during a recession cycle that won’t give up — is unfair and unwise. It may even be unconstitutional. July 26, 2010
Extend the Bush tax cuts for everyone or no one to avoid tax-class warfare
There has been a lot of talk lately about extending the Bush tax cuts, which expire at the end of this year. The Obama administration and many Congressional Democrats have discussed allowing the cuts to expire for families making more than $250,000 a year, but keeping them in place for everyone else.
Raising taxes on families earning $250,000 — each spouse making $125,000 — in expensive cities such as New York, Chicago or Los Angeles seems unfair. Many families living in Manhattan must use private schools, as public schools are overcrowded with desegregation busing and public schools are being downsized with state deficits. These families are not rich and many will be forced to leave their jobs, move and seek new jobs which are hard to find. Not indexing tax rates for cost-of-living by city and region is unfair. The housing allowance for U.S. residents abroad is indexed by city in this manner.
But even worse is singling out and attacking the perceived rich with tax policies, regulations, editorials and political stump speeches. It’s an ugly and dangerous trend in America and it will hurt our country at a time when we need to reinvent ourselves.
President Obama campaigned on uniting our country with shared responsibility and sacrifice for one America: black and white, Democrat and Republican. But current trends embodied by politics in Washington D.C. are dividing us across money lines.
We are at a very dangerous crossroads with discussion turning emotional over tax and other monetary issues, like health care redistribution and now who is entitled to extension of tax cuts and who should be singled out for tax increases. We should be careful not to inflame tax-class warfare, which may lead to further emotional calls of racism in the Tea Party, and a new term I call “richism” by the less fortunate. Attacking wealthy job creators will continue the current capital strike and prevent new job opportunities.
If we turn the wrong way at this juncture, it will unleash more racism, anti-business sentiment, anti-Wall Street emotions, and overall richism — chastising the financially successful. The wrong way is to extend the Bush tax cuts for people making under $250,000 only and to single out the rich for tax increases and more redistribution.
The right way is to unite our country in shared sacrifice and benefit to work out our common problems together; to either extend the Bush tax cuts for everyone or no one.
Will tax hikes rein in growth?
Let’s create a tax commission made up of economists appointed by both political parties (since economists can be pretty political these days too). The Congressional Budget Office (CBO) that scores tax bills should also factor in growth and/or contraction based on behavioral economics. Currently, they leave out such dynamic factors and claim it’s more conservative that way. Hogwash — this method is blind, based on lazy efforts and renders the results almost not usable at all. The CBO is almost always wrong with its scoring and projections.
The key argument is whether hiking tax rates will seriously affect and rein in growth. Supply-side economics on tax policy says that lower tax rates can lead to growth which actually raises tax revenues based on a larger tax base — even though that base pays a lower rate. This is the crux of the current argument over this issue with the Democrats and Republicans. Pundits grab at convenient facts over the past decades to credit or discredit these theories. Heavy lifting is imperative on this far-too-important issue.
If this commission of economists — working with more dynamic CBO scoring — conclude that raising tax rates in 2011 will not unduly damage growth and will raise tax collections (revenues) to reduce our shared deficit, then maybe we should not extend the tax cuts for everyone. Treasury Secretary Geithner and President Obama share this view, but they only want to raise taxes on the rich, not the middle class as that would break the President’s campaign promise — read his lips.
Conversely, if economists and the CBO believe that raising tax rates will materially hurt growth which may lead to a reduction of tax collections, negatively impacting the deficit and job markets, then our government should extend the Bush tax cuts for everyone. Certainly, the wealthy are a major force in consumption, business expansion and job creation.
Leftover “extenders” items
Congress is considering a small-business package to address tax and jobs. Senate Majority Leader Harry Reid (D-Nev.) mentioned this bill would be debated and put up for voting in September.
I’m guessing this bill may include the left over “tax extenders” bill items that were stripped out of the unemployment benefit extension bill, which finally passed last week on its own — paid for with deficit spending.
Now Congress seems interested in bringing back those tax extenders (expensing, credits, AMT patch and more) and tagging them on to the explosive Bush tax cut extension debate, which is shaping up as a key battle-line vote before the midterm elections in November. Favoring the middle class or the upper class is an ideal battle line for the Democrats, since the middle class holds more voting levers.
The tax extenders bill failed because Republicans wouldn’t agree to raising taxes on investment managers and S-Corps to help pay for it. Republican Senators Scott Brown (Mass.), Susan Collins (Maine) and Olympia Snowe (Maine) are willing to break filibusters over deficit spending but to date, not on tax increases. That could change of course.
How will this new small business jobs and tax package be constructed by Democratic leadership? I predict it will bring back all tax extenders, extend the Bush tax cuts for the everyone but the rich and pay for part of it by repealing carried interest on investment managers and repealing the SE tax break in S-Corps.
How will Democratic leadership frame the tax hikes on the rich — as part of “pay go” for this bill? Or will they seek deficit spending as they did on the unemployment benefit extension bill?
I imagine the President will feel it’s improper for the rich to ask for a tax-cut extension (which increases the deficit) if it’s not paid for. Republicans will be forced to filibuster the tax extenders (including the Bush tax cuts for the middle class) because they will demand spending cuts and Democrats won’t agree to that.
Democrats will say small business-heavy tax extensions are needed — Republican language in general — and it must be paid for somehow, so there’s no room for tax cuts on the upper class. They should help pay for it along with investment managers and S-Corp owners too — groups the Democrats will say can afford it.
Republicans will argue as always that spending cuts should be utilized rather than tax increases on job creators.
In my view, growth has already been stimulated enough by the government, so why not just get out of the way now and stop social tax engineering? Let businesses recover fully from that savaging recession on their own. The worst thing to do now is to adopt further tax-class warfare, which will divide our country and lead to counter-productive policies that stunt growth and innovation.
A small-business tax package may sound like a decent idea. But the Republicans are right — many families making $250,000 are small businesses. If you want to encourage their growth, don’t single them out with targeted tax increases, which can lead to a continued capital strike, and insufficient expansion and job creation. These people are already saving up to pay more taxes. It’s not worth the risk to expand and make a few more dollars if most of that money is taxed away anyway. Why work harder and take that added risk?
A country divided...
This brings me back to my biggest point about dividing our country over these tax cuts. Being castigated and singled out for punishment is one of the worst things someone can experience in society. It makes them feel unwanted and unappreciated and it leads to negative thoughts, withdrawal and depression (or continued recession). It’s the underpinnings of racism and richism.
The NAACP recently called some people in the Tea Party racist. Many in the tea party are very upset about uncontrolled government spending, including spending on entitlement programs and redistribution of those benefits — like health care — to less fortunate Americans. Some people took their emotions too far by castigating black Congressmen.
When the benefactors of government social-spending policies attack perceived rich people, it’s richism. Racism and richism feed on each other and to suppress one you should suppress the other too. It was pretty savage during the French Revolution when rich people were carted off for death. Anti-Semitism often is similar to richism too.
I’m not referring to super rich people like Warren Buffett and Bill Gates — they are different. They save hundreds in millions in taxes by deducting charitable donations to their own foundations. They sit on those charitable fortunes for decades and dole out monies, receiving federal and state income tax deductions for these contributions. Normal Americans must make up for their domestic tax breaks, and that’s not fair. They are contributing hundreds of millions/billions to U.S. organizations with foreign activities rather than paying American taxes to help cities like New Orleans. I support their wonderful charitable efforts, but it doesn’t help America’s budget deficit. Why don’t they just pay more taxes too? They shouldn’t get a tax deduction for these payments. They avoid estate taxes with these charitable foundations too. So when they preach about taxes, I take it with a grain of salt.
Compare a successful business to federal governments at this time. In business, the customer is very appreciated and important. The customer brings in revenue to support the business and all of its jobs. During a recession or slow down, managers rarely raise prices on customers, and they try to improve values for customers. They give their best customers the red-carpet treatment, not the red-tape treatment with onerous new regulations. Business managers seek productivity savings and reductions in unnecessary overhead and spending.
It’s the reverse with our federal government. When times are tough, government proposes raising taxes (customer prices) on their best customers (taxpayers), while giving promotional giveaways and running sales for other customers, many of whom are tax “takers,” not payers. Their promotion for rich customers is “two-for-one” — pay for two (the customer plus the less fortunate customer) and you get one (redistribution). Rather than seek productivity with computers like the rest of America, they avoid it by botching those initiatives and they increase headcount and benefits for their co-worker buddies. The federal government needs a constitutional amendment to balance its budget like states do. States are forced to rein in spending now to stay solvent.
What will rich customer taxpayers do with these tax attacks and onerous policies? They won’t shop in that U.S. and state store anymore. They can afford to move abroad and run their business on the Internet.
German news organization Der Spiegel reported today that German companies are giving up their stock-market listings on U.S. exchanges because the red tape of Sarbanes Oxley was onerous and now it’s far worse with Fin Reg. German companies are fleeing U.S. government tax attacks, anti-business policies and lawsuits. They don’t need American listings or major branch offices anymore. And Germany is one of the export powers of the world who wants to export to America.
Look at a city and state like New York. It’s been ravaged with Fin Reg attacks on Wall Street, the prospect of onerous new bank taxes and a weakening real-estate market. There are hundreds of thousands of New Yorkers who make just over $250,000. They are stretched already. Experts say that each rich New Yorker supports seven jobs around the city. These tax hikes can be the stick to break New York City’s back.
Is it patriotic?
Some on the left are raising the patriotic argument — it’s the wealthy’s patriotic duty to pay more, while others enjoy a continuation of tax cuts. I think it’s more patriotic to extend the tax cuts for everyone or no one. Singling out successful Americans for greedy redistribution and punishment is vindictive and ugly.
The President and his public-relations team will pile on the rhetoric now about how the rich should take this opportunity to pay back some of the out-sized benefits they received over the past decade. But many rich aren’t feeling so fortunate. They are being foreclosed on at a faster pace now than the middle class these days. They’re struggling with reduced compensation and benefits, decimated 401ks and falling real-estate prices. Many are stretched pretty slim financially and they can’t afford tax increases. They will save for them at the expense of consumption, business expansion and job creation.
This tax-class warfare will divide and ruin America. Before we attack the perceived rich, why not ask our federal government to follow the same goals for achieving productivity and fairness that businesses and state and local governments are now adopting.
New Jersey Republican Gov. Chris Christie is right about the inappropriate excesses in public unions, which they are fighting to not give up. He asks why should NJ teachers retire much earlier than most Americans and enjoy full goosed up fixed pensions and health care benefits until they die? Why do teachers unions control state politics, have tenure and avoid federal and state efforts for reform? I don’t want to replace rishism with “unionism,” but we need a shared sacrifice.
A united front is necessary
Everyone is contributing some good ideas; we need to find bi-partisan consensus. Democrats are right about fixing health care to help more Americans. Republicans are right about reining in government excess and spending, and forcing them to seek productivity like the rest of America. Rich people and business are right about anti-business policies coming out of Washington D.C.
Bush tax cuts helped all classes during the recession after the Sept. 11, 2001 terrorist attacks in New York City and Washington DC. Our country was more united back then, and Congress and the President passed bi-partisan tax cuts. Democrats wanted tax breaks for their constituents too. We need to be united now too, with either bi-partisan extension or expiration of the Bush tax cuts. Congress built in a trigger for expiration of the Bush tax cuts in 2010 for all taxpayers, since they were not paid for. So why change that wise Congressional action for some, but not all?
Some argue the rich did well during the Clinton years, considering that the expiration of the Bush tax cuts brings back the Clinton tax rates. But the middle class and poorer people did well tax and economic-wise during the Clinton years too.
Tax cuts and the midterm elections
Politicizing the Bush tax-cut extension or expiration issue for the upcoming midterm elections is wrong. It’s too important an issue for America and how we deal with each other to solve our common problems together. Playing the race card for politics is wrong and so is playing the richism card too.
Extending Bush tax cuts for 95 percent of Americans essentially rewards 95 percent of the voters. Isn’t that morally and ethically wrong? It reminds me of pork-barrel politics that got us into this deficit mess in the first place. It’s wrong for corporations and unions to dominate political advertising and for lobbyists to curry too much favor in the halls of Congress. But it’s even worse to buy Democratic votes with a tax cut, while purposely freezing out some big contributing Republicans. Is this tax policy or political science?
Congress may want to punt this political hot potato with a universal extension for one or two years — all they will say the deficit can afford – but I doubt President Obama will agree. He will stand on principal and he won’t want this hot potato to make a mess of the presidential election in 2012.
Could be a bumpy ride in the next few months
The next few months will be intense on these issues. I think both sides won’t agree, the Republicans will filibuster and the tax cuts won’t be extended before the midterms. But each side can gain political votes over this battle line issue. Some Democrats will join Republicans on extending for all since they know it won’t come up for full vote anyway.
This issue will probably be decided in December when the deficit commission reports to Congress. In December, they will throw the kitchen sink into one bill and after lots of horse trading, who knows the outcome. At stake will be income, estate, investment and other types of taxes, spending, the deficit and more. I hope we can be united over it all. July 22, 2010
Fin Reg calls for derivates contracts to be cleared on futures exchanges, but Congress doesn’t change their tax treatment to lower 60/40 tax rates
The “Restoring American Financial Stability Act of 2010” — also known as "Fin Reg" — signed into law on July 21 moves many derivative contractors from the private marketplace to clearing on futures exchanges. In Section 1601 of the bill, Congress makes it crystal clear this movement isn't like trading and it doesn't afford these derivatives contracts the regulated futures contract tax treatment in Section 1256.
Swap contracts – a form of credit insurance – were at the center of the credit crisis. AIG wrote far too many of these swap contracts (pocketing the premium) and lacked sufficient capital to cover its eventual credit losses at the height of the financial panic. Regulators lacked transparency since swaps were private derivatives contracts.
Fin Reg addresses these problems by moving many derivative swap contracts into clearing on futures exchanges to provide market-based transparency of pricing and terms and normal exchanged-based margin and leverage rules. However, in moving to futures exchanges, Congress did not want to reward swap contracts with the lower 60/40 treatment in Section 1256.
The new law amends Section 1256 to broaden the list of contracts that are barred from the definition. Section 1256 contracts include: regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options, and dealer securities futures contracts. Under pre-Act law, the term Section 1256 contract doesn't include securities futures contracts or options on such a contract unless the contract or option is a dealer securities futures contract.
Law change
For tax years beginning after July 21, 2010 all of the following also are excepted from the definition of a Section 1256 contract: any interest-rate swap, currency swap, basis swap, interest-rate cap, interest-rate floor, commodity swap, equity swap, equity-index swap, credit default swap, or similar agreement. (Code Sec. 1256(b), as amended by Act Sec. 1601. You can find Section 1601 - Title XVI – Section 1256 Contracts on the last pages of the bill.)
The Conference Report says the change addresses the recharacterization of income as a result of increased exchange trading of derivatives contracts by clarifying that Code Sec. 1256 doesn't apply to certain derivatives contracts transacted on exchanges.
Leading tax attorney for investment-management businesses Roger Lorence emailed me, stating that “Swaps were not 60/40 under prior law. The new law clarifies that their status is not 60/40. Leading experts have expressed their views that there was confusion in the marketplace about the treatment of swaps cleared by clearing arms of exchanges, although the swap contracts themselves were not traded on a qualified board or exchange (traded on a QBE is a requirement for 60/40 treatment). There is a difference between clearing and trading — trading means a designated contract market for that contract has been approved by the CFTC and swaps are not eligible for designation as a contract market (there can’t be trading in a swap). No contract that legitimately is 60/40 now loses 60/40 under this bill. The amendment is designed to foreclose aggressive taxpayers from taking the position that swaps are 60/40.”
Thanks Roger, this clarifies my question about traders gaining a new opportunity to trade these derivatives contracts – they don’t get this opportunity. They can gain from the transparency on the exchange clearing. July 21, 2010
Economic outlook grim after Fin Reg passage
The Financial Regulation Bill ("Fin Reg") passed the Senate last week and President Obama said he plans to sign the bill into law today (July 21). Kudos to our President for working hard to pass another major piece of his reform agenda, after allowing for some give and take with Congress too.
After mounting a significant effort to change Fin Reg, I was saddened to see three Republican Senators — Scott Brown, Susan Collins and Olympia Snowe — break the Republican filibuster to stop this version of Fin Reg. Omitting reform of Fannie and Freddie and the rest of my grievances was unfortunate. There will probably be repercussions in the markets soon.
Now that the bill has passed, it’s time to find opportunities for the future and to avoid pitfalls wherever possible within this new law.
With the Volcker rule limiting investment-management business to 3 percent of bank tier 1 capital and not allowing proprietary trading in FDIC-covered banks, many traders may leave banks to join hedge funds and prop-trading firms. Some may start their own trading and investment-management businesses. Registration rules have been tightened, but those compliance costs are reasonable. For others, it may simply lead to the loss of their jobs and/or reduced compensation and bonuses.
Financial markets and analysts didn’t like Goldman Sachs Q2 2010 earnings reports this week. One contributing factor: Trading revenues (gains) were down by approximately 89 percent. Once Fin Reg is in full effect after a long transition period, imagine trading revenues down by 100 percent (with no trading at all). Focusing on loans only can be a risky business, especially if Fin Reg calls for more forced social lending to less-than-desirable borrowers, and demands that banks retain 5 percent ownership of securitizations. Morgan Stanley released it's earnings after I wrote this blog and they surprised on the upside due to stronger than anticipated trading gains. Taking trading gains out of these banks is like taking the iPad or iPhone out of Apple's earnings and leaving them with computers only.
There doesn’t seem to be many provisions that affect our trader clients in the first read of Fin Reg. There may be new opportunities for traders to trade derivatives which are moving to exchanges. Most stay behind at banks in the private marketplace. I didn’t notice any mention of stiffer leverage and margin requirements or access to markets.
If Fin Reg was in effect in 2008…
Before moving on to greener pastures, I wanted to vent a little more about one last big problem I have with Fin Reg. The bill’s raison d'etre was preventing “too big to fail.” I think Fin Reg may not prevent the next big bank failure, run on the bank, and/or contagion among institutions and toxic asset prices. In fact, I think it may in some cases accelerate all of the above. Let’s apply Fin Reg to the 2008 crisis that precipitated this bill, and project how it may have changed the outcome. For better or worse?
I admit that Fin Reg provisions and new regulators may have spotted and reined in unsustainable risks, abuses in mortgage underwriting, poorly packaged and rated mortgage securitizations and excesses with the GSEs. On the other hand, regulators had tools in place already to deal with these problems and they ignored them thinking the housing market juggernaut would only go up.
Here’s my biggest problem with Fin Reg. During the height of the crisis, it may have accelerated the spread of toxic asset pricing, leading to a faster run on Bear Stearns and Lehman (and other banks too).
Here’s why. This crisis brewed in two Bear Stearns real estate hedge funds, which eventually blew up and contributed to the cause of the crisis. The fund manager told Bear’s clients the fund was net short real estate and not to worry. He was lying and the funds were very long real estate and hiding large losses. Bear Stearns corporate management was not focused enough on these funds and didn’t want to bail them out with corporate monies, or close them down. They hoped real estate would turn around. Remember, Bear turned its back on the Long-Term Capital hedge fund that needed a bailout in 1998. We all know how this “House of Cards” (the book by William Cohan on Bear Stearns demise) worked out.
Now let’s apply Fin Reg to this situation. Under Fin Reg’s Resolution Authority and wind-down provisions, regulators would have seized the Bear Stearns hedge funds quickly and probably sold off the toxic assets at fire-sale prices. That government takeover would have spooked the markets more than what happened in the crisis. Yes, it brings more transparency, but in this case, it would have spread more fear. If you think the new accounting rules for mark-to-market accounting caused havoc on bank balance sheets and accelerated the crisis, then this would have been far worse. Also, bank-sponsored funds of this size wouldn't be allowed with the Volcker Rule but that rule is phased in over many years, so we could have this problem sooner rather than later. Big banks are increasing their investments into hedge funds since Fin Reg was agreed-to and they are not downsizing those departments yet.
Fin Reg doesn’t allow a bank to bailout its own hedge funds. So, Bear would not have had that option. Bear should have bailed out its funds, as it sold them on its good name, not the character manager’s name. That may have stopped the crisis from spreading and not caused a run on real estate prices and fear. Prices had gone up with market sentiment and confidence.
Now we get to even more serious problems. Fin Reg grants the government the ability to modify and even rescind financial, employment and other business contracts executed by an institution during the wind-down procedure. Remember the President, Congress, public and media were inflamed by AIG using TARP-funds to honor 100 percent of its swap contracts with Goldman Sachs and other banks (and their employment contracts as well). Many thought the government should pay for (at a discount) what amounted to a pre-packaged bankruptcy. Treasury Secretary Paulson thought discounts would cause chaos in the financial markets and he was right.
Banks now understand that under Fin Reg, if a counterparty bank runs into trouble, and the government steps in very fast to wind them down, their contracts can be modified or rescinded. Therefore, all financial institutions are only as strong as their weakest link in counterparty transactions. It’s ironic that Fin Reg is intended to prevent contagion, but this linking of losses actually spreads contagion.
After a wind-down, the government is entitled under Fin Reg to send the final bill for all losses to the rest of the big banks in the form of bank taxes or levies. Fin Reg may have dropped $19 billion of upfront bank taxes, but these bank taxes remain on the back-end. It was an accounting gimmick only to drop them and win curry for passage.
Spreading losses from the failed to the strong fundamentally changes capitalism in America and weakens our marketplace. No wonder banks and corporations are on a capital strike now. Who can they trust? Make a deal with a weak player and it can come back to haunt you.
Back to the Bear Stearns saga. If the government took control of the Bear Stearns hedge funds because Bear Stearns wasn’t allowed to, that would have started the contagion and spread of toxic asset prices. All counter parties would then avoid Bear Stearns like the plague thinking the losses could be passed to Bear Stearns and the government might take it over next and rescind its contracts. Banks would start questioning each other and inter-bank lending would seize up. That is the recipe for this type of crisis.
What would management do during these difficult times under Fin Reg? New provisions in Fin Reg allow the government to claw back compensation from managers and that’s just the least of it. The government can also charge managers with a share of the losses. After I read these new provisions, I realized that someone would have to be crazy to work for a bank subject to Fin Reg without knowing their true risks and the bank’s full situation. It reminds me of working for a private partnership in the old days of Wall Street, except now managers don’t see all the cards and they have less say than old time partners in these firms. Certainly, bank managers should take precautions such as seeking their own legal counsel and obtaining sufficient insurance just like directors were forced to do years ago with Sarbanes Oxley regulations.
Some Fin Reg provisions like prop trading and hedge funds phase in over many years, but resolution authority containing these wind-down provisions starts immediately.
Auto bailout results
How did the government do with its decisions on the last bailout? Neil Barofsky, the Treasury special inspector general responsible for TARP, reported not so well. His report released on Monday stated “Treasury made a series of decisions that may have substantially contributed to the accelerated shuttering of thousands of small businesses and thereby potentially adding tens of thousands of workers to the already lengthy unemployment rolls -- all based on a theory and without sufficient consideration of the decisions' broader economic impact." This is not surprising to me as regulators and politicians don’t know business as well as industry pros do. They often make big mistakes in business decisions.
With this Fin Reg bill, we went from “heads: business wins” to “tails: taxpayers lose” to the reverse. Now the government holds the purse strings for business in health care and banking and they can heap huge losses onto industry participants. With this type of anti-business over-reach regulation, I expect the capital strike and lackluster job market to continue.