Too big to fail means too big to jail

If corporations are people, as some conservatives insist, they are some of the luckiest people in the world when it comes to criminal behavior.

This morning, the Department of Justice announced a settlement with HSBC Holdings Plc, regarding its violations of the Bank Secrecy Act, violations of other anti-money-laundering laws, and transactions on behalf of Iranian, Libyan, and Sudanese clients as well as drug criminals and terrorists. Under the agreement, HSBC will pay a record-setting $1.92 billion in forfeitures and fines but will also avoid prosecution if it undertakes reforms.

HSBC's role as a place for criminals and terrorists--as well as run-of-the-mill tax evaders--to launder their money has been public knowledge for some time and extends back more than a decade. In 2010, HSBC received cease and desist orders from the Federal Reserve and Office of the Comptroller of the Currency (OCC) related to its activities that allowed money-laundering. Earlier this year, HSBC's activities were the subject of a a scathing Senate Permanent Subcommittee on Investigations report and hearing.

While the $1.92 billion in financial penalties sets a record, the penalties only amount to 9 percent of the bank's pre-tax profits for this year--effectively a slap on the wrist.

Actual human beings (as opposed to gigantic corporations) who provide financial succor to terrorists and rogue states receive incredibly harsh treatment. For example, Mohamad Hammoud was sentenced in 2003 to 155 years in prison for providing $3,500 in financial support to Hezbollah, although a "successful" appeal reduced that sentence to 30 years. In 2005, Rafil Dhafir was sentenced to 23 years for "participating in a conspiracy to unlawfully send money to Iraq and money laundering." In contrast, HSBC, which looked the other way while banking hundreds of millions of dollars for criminals and terrorists, will lose the equivalent of about one month's profits.

And this is hardly HSBC's first offense. In 2007, HSBC paid a $10.5 million penalty to settle a case in which the bank allowed its name and logo to be used in a fraudulent financial offering. In 2011, the OCC issued a consent order for HSBC over "unsafe or unsound banking practices" associated with its mortgage and foreclosure documentation procedures. In that same year, HSBC was ordered to pay £40 million for luring elderly customers in the UK into risky and unsuitable investments.

Nor is this is also not likely to be HSBC's last brush with the law, as traders at the bank have been linked to the LIBOR rigging scandal.

In states with "three-strikes" sentencing rules, a human HSBC would be facing a mandatory life sentence. A corporate HSBC just promises to do better next time.

And there most assuredly will be a next time.

“You f---ing Americans. Who are you to tell us, the rest of the world, that we‟re not going to deal with Iranians.”

“You f---ing Americans. Who are you to tell us, the rest of the world, that we‟re not going to deal with Iranians.” -- Standard Chartered Bank's Group Executive Director in response to an internal warning about the bank's scheme for hiding transactions on behalf of Iranian clients.

On August 6, New York state's banking superintendent, Benjamin Lawsky, filed an order that could strip Standard Chartered Bank (SCB) of its license to conduct business in New York. The order contained explosive allegations that SCB systematically covered up 60,000 Iranian transactions worth upwards of $250 billion by falsifying business records and financial instruments and by cooking its books.

According to the order, the transactions in question occurred from 2001-2010, but the general scheme to cover up Iranian transactions was initiated immediately after the transactions were prohibited in 1995.

The alleged corruption is staggering. Through these transactions, SCB enabled the Iranian regime and may have helped it to "finance terrorist groups, including Hezbollah, Hamas and the Palestinian Islamic Jihad." Further, by covering up the transactions, SCB kept bank regulators in the dark about its actual risks. It appears that SCB has concealed transactions for other regimes as well.

More staggering still, SCB's procedures have been under investigation for some time by the New York Fed, the Justice Department, and the Manhatten District Attorney. If Lawsky hadn't acted, it's likely that the case would have been quietly settled, as a string of other illegal transactions cases have--if there had been any action at all.

For his trouble, Lawsky appears to have drawn the ire of other banking regulators, especially in the U.K., for not following the club rules and for making the charges public.

Those regulators seem over-concerned with protecting rogue banks instead of having those banks follow the law.

Thank goodness an actual regulator appears to be on the job.

Too big to fail bank loses $2 billion (so far) in bad trades

Bloomberg reports this morning

JPMorgan Chase & Co. Chief Executive Officer Jamie Dimon said the firm suffered a $2 billion trading loss after an “egregious” failure in a unit managing risks, jeopardizing Wall Street banks’ efforts to loosen a federal ban on bets with their own money.

The firm’s chief investment office, run by Ina Drew, 55, took flawed positions on synthetic credit securities that remain volatile and may cost an additional $1 billion this quarter or next, Dimon told analysts yesterday. Losses mounted as JPMorgan tried to mitigate transactions designed to hedge credit exposure. 

There are several stunning concerns here.

First, these colossal losses occurred within a unit that had initially been set up to manage risk but in recent years had been given the go ahead to expand into other markets to generate profits. This suggests that the bank's risk management strategy has been compromised.

Second, the episode exposes a potential counter-strategy by the big banks to restrictions on proprietary trading. Banks argue that those restrictions inhibit their ability to hedge and manage risk. However, if the banks are going to use their risk-management units as profit centers, any hedging exceptions in the proprietary trading rules would allow the banks to play a shell game where they simply move the same trading from one unit to another but call it "risk management."

Third, while the losses are huge, the underlying trades are larger still. Again from the same Bloomberg report

Bloomberg News first reported April 5 that London-based JPMorgan trader Bruno Iksil had amassed positions linked to the financial health of corporations that were so large he was driving price moves in the $10 trillion market.

Here we have a single unit within a single bank influencing prices in a $10 trillion market. It's anti-competitive--the bank has moved from a price taker to a possible price maker. Worse, the bank's actions have introduced a systemic risk. Indeed, one of the problems for JPMorgan right now is that its unit's position in the market is so large that it can't be immediately unwound.

JPMorgan risks losing more money now because other market participants will figure out what the bank has to do to unload its position, said Charles Peabody, an analyst with Portales Partners LLC in New York. Costs from the trades may affect earnings through the end of the year, he said.

“When there’s blood in the water, the sharks are going to attack that animal,” said Peabody, who downgraded his recommendation on the stock in March to sector perform. “It could make it very difficult for them to unwind a trade.”

Republicans are already attempting to eliminate the restrictions on proprietary trading and gut other provisions of the Dodd-Frank financial reform legislation.

This latest episode shows that, if anything, tougher regulations are needed and that the biggest banks need to be split up.

Too big to manage? Too big to trade competitively? Too big to fail? Too big period.

Romney directed company that defrauded the U.S. of $25 million

Mitt Romney is getting clobbered with a new set of ads in Florida that describe how the Damon Corp., a company that Mitt Romney's company purchased and that Romney directed, defrauded the Medicare program of $25 million, was caught, and eventually paid $119 million in fines.

Politifact reports

The story begins in 1989, when Romney was the head of Bain Capital, a private equity firm that specialized in buying troubled companies, turning them around, and then selling them for a profit. That year, Bain bought Damon Corp., a medical testing company based in Needham, Mass.

Bain took the company public in 1991, and Romney served on the company’s board of directors. In 1993, Bain orchestrated a sale of the company to Corning Inc., getting a handsome return on its investment and earning Romney himself $473,000, according to The Real Romney. After the sale, Corning closed the main facility in Needham, laying off 115 people.

In October 1996, federal prosecutors announced that Damon was agreeing to pay $119 million in both civil and criminal fines after pleading guilty to defrauding Medicare. The company was providing doctors with forms that didn’t make clear what tests included, so doctors were checking off additional tests that weren’t necessary, according to the Globe’s summary of the government’s case.

The overbilling went from 1988 through 1993, prosecutors said. "This is a case, pure and simple, of corporate greed run amok," U.S. Attorney Donald Stern said when the settlement was announced.

The story is all too typical of the "heads I win, tails you lose" approach of modern big business.

Under the most charitable explanation, Romney failed in his ethical and fiduciary responsibilities. Despite these failures, he was handsomely rewarded and was able to walk away from this mess he was involved in.

In this week's debate, Romney said,

...I think it's important for people to make sure that we don't castigate individuals who have been successful and try and, by innuendo, suggest there's something wrong with being successful and having investments and having a return on those investments.

Speaker, you've indicated that somehow I don't earn that money. I have earned the money that I have.

There is "something wrong" with running or overlooking a multi-million dollar criminal enterprise. There is "something wrong" with pocketing money that activity. And there is "something wrong" with foisting that illicit enterprise off on some other unwitting investors.

The same types of unethical and irresponsible behavior--create a mess, take your cut, and sell it to the next person--were at the heart of the financial crisis that led to the Great Recession. Romney was just a few years ahead of his time.

Insider trading by Congress?

An article earlier this year by a Georgia State University researcher and colleagues in the electronic journal, Business and Politics, uncovered evidence that suggests that Congressional representatives may have been financially benefiting from insider information.

We measure abnormal returns for more than 16,000 common stock transactions made by approximately 300 House delegates from 1985 to 2001. Consistent with the study of Senatorial trading activity, we find stocks purchased by Representatives also earn significant positive abnormal returns (albeit considerably smaller returns). A portfolio that mimics the purchases of House Members beats the market by 55 basis points per month (approximately 6% annually).

As the blurb indicates, the study produced results that were consistent with an earlier analysis of Senators' stock returns, and some of you may recall an earlier insider financial transaction by a panicked Sen. Burr.

The evidence from the latest study is suggestive but far from convincing. First, the evidence is indirect; the authors don't examine insider trading directly but instead try to infer it from stock returns.

Second, the study includes evidence that counters the insider trading argument. For example, the authors found that stock returns were high for junior members of Congress but not for senior members. To the extent that insider knowledge and influence increase with seniority, we might expect the opposite relationship to hold.

Will BofA lose money over its $5 debit card fee?

In introductory economics, we teach that when the price of a product goes up, the demand for that specific product goes down. When Bank of America (BofA) announced its new $5 debit card fee for certain types of accounts and effectively raised the price on those accounts, those well-known economic laws kicked in, though possibly to BofA's advantage.

This morning's Charlotte Observer reports on the predictable and intuitive result--customers are leaving BofA for credit unions.

Charlotte-area credit unions have seen an increase in phone calls and new members in the last two weeks as people upset about new fees at big banks look for new places to park their money.

Several credit unions have launched advertising campaigns promoting their fee-free offerings, hoping to capitalize on the wave of consumer discontent since Bank of America announced its $5 monthly debit card fee late last month.

"It's been wonderful," said Nicol Morris, chief operating officer of the Charlotte Metro Federal Credit Union, which has about 33,000 members.

She said the credit union saw a 350 percent increase in online account creation, along with a 90 percent increase in calls.

"They are extremely fed up with the continued talk about fees, whether it's in regard to checking or the debit card fee," she said.

The loss of customers is undoubtedly bad news for BofA and surely must have been anticipated by its management.

Nevertheless, the new fee might still improve BofA's bottom line and leave BofA laughing all the way to, well, um, itself.

Some of the other things that we teach in introductory economics is that the sizes of the responses matter and that you have to consider all of the responses.

To the first point, the loss of customers might not be that large--that is, the demand response might be inelastic. Some simple, completely made-up numbers can help to illustrate. Suppose that the new fee adds 20 percent to BofA's revenues from the average basic checking account but that the new fee also causes 10 percent of the accounts to close. In this (made-up) example, BofA's total revenues on basic accounts go up by 8 percent (it gets 20 percent more revenue on the 90 percent of accounts that stay with the bank but loses 10 percent of its initial revenue from the accounts that close).

With respect to the sum of responses, BofA appears to be steering its existing basic-service customers toward other more-profitable services. From another article in the Charlotte Observer

Bank of America CEO Brian Moynihan said Tuesday that a recently announced $5 monthly debit-card fee is a way to encourage people to bring more of their "banking relationships" to the Charlotte-based bank.

The comments were among Moynihan's first responses to the debit-card fee, which has drawn a significant outcry from consumers and politicians since it was announced late last month.

"When we look at the profile of customers who have their entire banking relationship with us and those that don't, a lot of people can qualify, will qualify and do qualify not to pay the fees...," Moynihan said on a conference call with analysts to discuss the bank's quarterly earnings report.

"The issue is when people split their relationship and use our convenience and our access and our 18,000 ATMs ... and our online banking products and all that and yet have their relationship elsewhere," he said.

"That is tough for us to afford to provide and... be competitive. And so the fees are to get people to bring more of their relationships, and we're comfortable that we'll end up in a good dynamic there."

Debit-card users will not have to pay a fee if they have at least $5,000 in a linked savings account, a mortgage or a substantial investment account with Bank of America.

The new fee will cause some people to substitute away from basic services toward other BofA services. Also, BofA's creepy "relationship" language is telling.

The "relationships" themselves not only represent additional streams of revenues but also represent ways of reducing future demand responses. It turns out that breaking up is hard to do, especially when those "relationships" are with your bank.

Each "relationship" that BofA establishes with its customers, is one additional "relationship" that would have to be terminated in order to leave for another bank or credit union. If a customer has set up automatic deposits and automatic bill-paying, he or she would need to go through the hassle of changing each of these "relationships" before leaving for good. Instead of one change in service, there would now be multiple changes. People aren't formally locked into an account. However, it becomes much harder to leave, especially given people's predisposition toward behavioral inertia.

In the end, the sizes of these responses--the loss of customers versus the gain of per-customer revenues and the tie-in effects--will determine whether BofA comes out ahead. At this point, it would be premature to count BofA out, and you better believe that other banks (and geeky economists) are watching carefully.

Farmer Stanley

If you you thought that Wall Street's pre-crash gambling binge couldn't get any kookier, you should read Bloomberg's story on Morgan Stanley's investments in Ukrainian farm land.

Iowa native Justin Bruch marveled at the opportunity when Morgan Stanley (MS) called in late 2007 to recruit him for an unusual assignment.

The New York bank, flush with $7.5 billion in fiscal 2006 profit -- the biggest in its history -- was going to be farming 11 parcels on the steppes of Ukraine. The commodities team wanted Bruch, a redhead with meaty hands who’d been farming all his life, to manage one of them.

...Morgan Stanley gave up on farming in Ukraine in July 2009, abandoning the initiative in the middle of a harvest. It bought out its local partner, Aleksandr Mamontenko, then sold Enselco to an investment firm based in Jersey in the Channel Islands, at what people familiar with the situation say was a loss. All told, Morgan Stanley put about $30 million into Enselco through loans, according to Igor Bobrov, who was hired in 2008 to be Enselco’s chief financial officer and later became its CEO. Hugh Fraser, a London-based Morgan Stanley spokesman, says bank officials declined to comment for this story.

Morgan Stanley’s failed gamble in Ukraine shows how Wall Street firms, in the last gasp of a debt-fueled bull market, strayed further from their traditional business of advising companies and underwriting stock sales to embrace diverse projects with unfamiliar risks.

The story is a great example of how Wall Street, enabled by its own creative debt instruments, pursued ever more speculative returns towards the end of the financial bubble. While conservatives continue to blame the Community Reinvestment Act, Fannie Mae and Freddie Mac for these types of shenanigans, Morgan Stanley's foray into Ukrainian farming shows that none of these were necessary. An under-regulated and over-leveraged Wall Street was quite capable of causing a financial disaster on its own, thank you.

Corporate entitlement

Entitlement seems to start at the top.

Bank of America's CEO defended his bank's new $5 fee on debit cards on Wednesday, saying that customers and shareholders understand the bank has a "right to make a profit."

...Moynihan (BofA's CEO) said that the bank will talk to its customers, teammates and shareholders and "they'll understand what we're doing -- understand we have a right to make a profit."

I'm sure that BofA's CEO and some of its shareholders sincerely believe that their company has this right, but they should not expect any such understanding from their customers or "teammates" (especially the 30,000 "teammates" who are about to be kicked to the curb).

BofA has a limited right to pursue success and to pursue profits; it can't, for instance, pursue profits through restraints of trade or collusion. But even these rights are different from any rights "to make a profit."

BofA's entitlement attitude in this $5 debit card fee debacle has been clear from the beginning. The new regulations that cap debit card interchange fees leave plenty of room for reasonable profits from BofA and other large banks, while protecting merchants from the excessive fees that these banks had been able to charge because of their size and market power. Indeed, banks in other countries have remained profitable despite facing much lower caps on interchange fees.

These reasonable profits weren't enough, and BofA is now trying to reach into its poorer customers' pockets (the richer customers are, of course, "entitled" to free debit-card use) for an extra $5 a month.

BofA has every right to ask this sum from its customers. It also has a right to bad-mouth the government and to deflect attention.

Customers, however, have the right to change their behavior to avoid the fee. Given BofA's behavior, the safest route would seem to choose a less-entitled financial institution. Just avoiding debit-card purchases with your BofA card (paying cash) is another.

Changes in customer behavior might not be enough to cure BofA of its entitlement mentality (the entitlement force is strong with this one). Changes in customer behavior would though send an appropriate signal.

Big bank collusion in the derivatives market

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public.

Adam Smith, The Wealth of Nations, 1776

Adam Smith warned the world about collusion more than two centuries ago. More recently, shady, inside, nontransparent dealing in derivatives contributed to a financial meltdown and the deepest recession since the 1930s. And yet, we continue to allow the too-big-to-fail banks to collude in the derivatives market.

The New York Times reports

On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.

The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.

Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.

In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.

The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available.

To be clear, the issue isn't derivatives themselves. When traded fairly, derivatives serve an important function in financial markets, allowing firms and investors to diversify and hedge risks. Rather, the problem is how the market is operated.

At a minimum, the lack of transparency and lack of competition lead fees to be higher than they need to be. In essence, it's hard to get a good deal because buyers can't see the other deals that are out there. As the article explains

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.

The profits of the colluding banksters soar but at the expense of firms and investors who buy the products.

The clearing house also gives the participating banks a tremendous and unfair information advantage. Banks start with an information advantage from assembling the derivatives. The same way that a used-car salesman has inside information about a lemon he may be trying to offload; the banks often have inside information about the securities that make up the derivative (Goldman Sachs' scandalous participation in the ABACUS CDO is but one example).

And there are other information advantages. The clearinghouse allows participating banks to see how the overall market is trending, while investors are left largely in the dark.

If banks were always neutral market makers, these information asymmetries might matter less, but the investment banks are also often parties to these transactions, trading from their own accounts or using derivatives to offload their own risks.

The clearinghouses should, in principle, be advantageous by increasing the information in the market. However, these advantages only obtain if the clearinghouses are open to all qualified institutions and if the resulting information is shared with all market participants.