Is Speaker Boehner trying to tank the economy?

You really have to wonder whether House Speaker John Boehner is purposefully trying to tank the U.S. economy and possibly the world economy with his reckless statements.

Two days ago, Speaker Boehner poured a big steaming bowl of economic uncertainty into the U.S. markets by announcing a return to debt-ceiling brinksmanship--that Republicans would be using the specter of a U.S. bond default to enact their extremist, radical slash-and-burn budget.

Not content with the uncertainty that he had created at home, Speaker Boehner today turned to roiling markets in Europe by commenting, "What’s going in Greece, and the effect it’s having on Spain … it’s quite likely that this contagion is going to continue."

To be sure, the U.S. and E.U. economies face real challenges. Their problems shouldn't be sugar-coated and their structural deficiencies must be addressed. But to artificially inject the possibility of a default into the U.S. markets and to blithely comment that financial "contagion" is likely across Europe risks a wider financial panic.

Perhaps that's what the Speaker has in mind.

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.

Financial and moral bankruptcy

In the New York Times Economix blog, Simon Johnson glummly assesses Europe's financial prospects over the next few months as countries reach deadlines to roll over their debts.

He outlines some painful steps for the European Union, including greater fiscal integration, more intervention by the European Central Bank in core countries, but a casting off of some weaker countries. Although the steps are painful, Johnson concludes that

At the end of the day, the Europeans will save themselves, with the measures outlined above, only because there will be no other way to avoid wasting 60 years of political unification.

Although the U.S. faces some similar pressures, Johnson is less sanguine about our ability to solve our problems.

Our leading bankers looted the state, plunged the world into deep recession and cost the United States eight million jobs. Now many of them stand by with sharpened knives and enhanced bonuses – willing to suggest how the salaries and jobs of others can be further cut. Consider the morality of that.

Will no one think hard about what this means for our budget and our political system until it is too late?

FCIC Republicans: the only villian is the government

Republicans on the "bipartisan" Financial Crisis Inquiry Commission (FCIC), which was established by Congress and the President to "examine the causes, domestic and global, of the current financial and economic crisis in the United States," have distributed a pre-buttal to the commission's anticipated report.

The pre-buttal lays the blame for the crisis squarely at the feet of the government, which (p. 2) "was following a social policy in addition to an investment policy" and "pushed investors toward investing in mortgage debt." Or as the report states on page 3

Through the GSEs, FHA loans, VA loans, the Federal Home Loan Banks, and the Community Reinvestment Act, among other programs, the government subsidized and, in some cases, mandated the extension of credit to high-risk borrowers, propagating risks for financial firms, the mortgage market, taxpayers, and ultimately the financial system.

The crisis was also spurred by a loss of confidence, which "exploded into a generalized market panic." The panic was precipitated by, but distinct from "mortgage losses." This is a reprise of John McCain's famous assertion in the midst of the market meltdown that "the fundamentals of our economy are strong" (the parallels shouldn't be too surprising given the McCain's principal economic advisor, Douglas Holtz-Eakin, was one of the pre-buttal's authors).

What was the role of the housing bubble? It was merely an "interrelated event" and not "a sufficient condition for the financial crisis."

Maybe the big banks come in for some blame? Nope, their "primary role ... was that of financial intermediary, providing a link between those who wished to invest in mortgages and those who wanted to take out a mortgage to buy a home."

How about the ratings agencies? They made "mistakes" and did not "appreciate" the risks of declining home prices. The report does allow that "their ratings on MBS (mortgage-backed securities" proved to be severely inflated," but notice the passive voice. The report gives an example of a security with a marginal rating but never mentions the AAA ratings that the agencies bestowed on many securities or how those agencies allowed issuers to make minor modifications to otherwise unsuitable securities to obtain a AAA rating (sort of like a health inspector allowing a restaurant to clean up just enough filth to stay open).

The report also doesn't mention the critical, knife-edge role that AAA-rated securities played.

Fraud and shoddy underwriting in originating the mortgages? The words "fraud" and "underwriting" do not appear in the body of the report ("fraud" is on the front page but only in the title of the enabling legislation), and the word "originators" only appears three times and then only in the context of a "system (that) had worked this way for decades, and worked well."

While underwriting goes unmentioned, the report does include the term "lending standards." But who, exactly, lowered lending standards? The government.

Farther removed from the mortgages, how about the synthetic derivatives (essentially, side bets that referenced but did not include an actual stake in the mortgage-backed securities)--surely, these had some role in over-leveraging the market? Not according to the report, which omits any mention of these.

A report on the financial crisis that omits the words, "Wall Street," "fraud," "underwriting," "collusion," and "derivatives" and that overlooks Wall Street's view of most clients as "suckers" isn't worth the paper it's written on.

Your TARP's got a little Wessonality

How is the Troubled Asset Relief Program (TARP) like Wesson oil? It's all coming back except for one tablespoon.

In its latest report on the TARP, the Congressional Budget Office (CBO) estimates that the eventual cost will only be $25 billion.

So far, the program has disbursed $389 billion, and when all is said and done, that total will rise to $433 billion. Both of these figures are far less than the original $700 billion authorization.

To date, the program has been repaid $216 billion. Much of the remaining expenditures were used to purchase assets that will eventually be resold to make up nearly all of the remaining amount.

The CBO analysis only accounts for the direct, anticipated financial costs of the program and does not include government revenues that were saved when the economy was kept from imploding. Similarly, it omits the wider benefits to the economy from those same actions.

For instance, the Center for Automotive Research estimate that the $80 billion in TARP expenditures that went to GM and Chrystler saved the economy approximately $100 billion in further income losses.

The record is all the more remarkable given the rocky start of the program. Recall that the Bush administration requested the original $700 billion authorization and got Congressional approval late in its term (Oct. 2008) but then almost immediately decided not to use the funds for their original purpose--buying troubled assets. A substantial portion of the program was handed off to the Obama administration during its transition, and the new administration, in turn, had to contend with the sideshow over executive pay at the banks that had been assisted.

The TARP continues to fry up the Party of No and their Tea Party crybabies. Ultimately, though, the program is turning out to be better than it was cooked up to be--except perhaps for one $25 billion tablespoon.

Dissecting the demise of Lehman

The court hearing the Chapter 11 bankruptcy case involving Lehman Brothers has released an examiner's report on the investment bank's failure. There's a lot of blame to go around.

There are many reasons Lehman failed, and the responsibility is shared. Lehman was more the consequence than the cause of a deteriorating economic climate. Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders, was exacerbated by Lehman executives, whose conduct ranged from serious but non‐culpable errors of business judgment to actionable balance sheet manipulation; by the investment bank business model, which rewarded excessive risk taking and leverage; and by Government agencies, who by their own admission might better have anticipated or mitigated the outcome.

The examiner describes how Lehman significantly increased its leverage (specifically, its short-term borrowing to finance long-term assets) starting in 2006. When the subprime mortgage market began to deteriorate, Lehman pursued the worst possible strategy (in hindsight), further increasing its leverage and "doubling down" on its subprime involvement. And then when this strategy didn't work, "Lehman painted a misleading picture of its financial condition."

The examiner reports that it did this through an accounting gimmick called a "Repo 105," in which it moved $50 billion of assets off its books and reported short-term financing agreements based on these as sales rather than as financing. This made Lehman appear to be less leveraged. Indeed, the examiner reports evidence indicates "their sole function as employed by Lehman was balance sheet manipulation." Nevertheless, Lehman's accountants from Ernst & Young signed off.

The examiner also reports that Lehman grossly overstated its liquidity pool.

These misstatements helped Lehman raise more capital to keep its schemes going and to increase investor losses by billions more.

The examiner also finds that unreasonable claims by two other investment bank creditors, JP Morgan - Chase and Citibank, in Lehman's final days hastened the firm's demise.

Government agencies, especially the Security and Exchange Commission (SEC) and the Federal Reserve Bank of New York (FRBNY), also appear to be culpable. Both agencies were aware of Lehman's problems. The examiner reports, "at the time of Bear Stearns’ near collapse in March 2008, it was widely thought at the highest levels of every relevant Government agency that Lehman could be the next investment bank to fail." Despite this, neither agency forced Lehman to disclose those problems, and the FRBNY, under Timothy Geithner, continued to lend to Lehman through the discount window.

The government also failed to clearly communicate its hands off approach, leaving Lehman executives and others to anticipate a bailout that never arrived. The government was also hampered by rules that made the SEC Lehman's primary regulator. When the SEC failed to act, the hands of other agencies were tied.

It looks like Lehman executives, some of its banks, its accountant, and the government were aware of its problems. However, none of them let the investing public in on the secret.