Normative Narratives


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Economic Outlook: Accountability and Oversight in the Financial Sector

In February I wrote a blog titled “Helping the Poor and Changing Our Standards, The DoJ vs. S & P“, and promised to keep my readers up to date on this important case. For those who do not wish to reread that whole post, here are the most pertinent details:

“The Justice Department plans to file civil fraud charges against the nation’s largest credit-ratings agency, Standard & Poor’s, accusing the firm of inflating the ratings of mortgage investments and setting them up for a crash when the financial crisis struck.”

“The Justice Department has decided to sue S & P for $5 billion. S & P contends it did no wrongdoing leading up to the housing crisis. The company will point to the facts that the Fed didn’t even know the severity of the housing bubble just days before it popped, and that its ratings were similar to those of other agencies.”

“The case is said to focus on about 30 collateralized debt obligations, or C.D.O.’s, an exotic type of security made up of bundles of mortgage bonds, which in turn were composed of individual home loans. According to S.& P., the mortgage securities were created in 2007, at the height of the housing boom. S.& P. was paid fees of about $13 million for rating them.”

Here’s the role the DoJ will argue S&P played in perpetuating the housing bubble:

“The three major ratings agencies are typically paid by the issuers of the securities they rate — in this case, the banks that had packaged the mortgage-backed securities and wanted to market them. The investors who would buy the securities were not involved in the process but depended on the rating agencies’ assessments.”

“In its complaint against S&P, the Justice Department accused S&P of defrauding Western Federal Corporate Credit Union, and other institutions that purchased certain securities based on the high ratings by S&P.

Some credit unions are required by law to rely on credit ratings issued by firms that included S&P in making its investment decisions, the complaint said.”

It is my pleasure to inform my readers that a judge has given this case the “green light“, a step towards holding S & P accountable for its role in the financial crisis:

“The U.S. government may proceed with its $5 billion lawsuit accusing Standard & Poor’s of misleading investors by inflating its credit ratings, after a federal judge rejected the rating agency’s effort to dismiss the civil fraud case

In a written decision late on Tuesday, the judge said the government could pursue claims that S&P manipulated ratings to boost profit, and in doing so, concealed credit risks and conflicts of interest.

This led to large losses for investors and contributed to the 2008 financial crisis, the government contended.

“The government’s complaint alleges, in detail, the ways in which none of S&P’s credit ratings represented the thing that they were supposed to represent, which was an objective assessment of creditworthiness, because business considerations infected the entire rating process,” wrote U.S. District Judge David Carter, in Santa Ana, California.”

“The lawsuit accused the largest U.S. credit rating agency of inflating ratings to win more fees from the issuers and bankers that pay for them.

It also said S&P failed to downgrade ratings for collateralized debt obligations despite knowing they were backed by deteriorating residential mortgage-backed securities.

According to the complaint, S&P rated more than $2.8 trillion of RMBS and nearly $1.2 trillion of CDOs from September 2004 to October 2007.”

“S&P argued that, since the issuer banks had access to the same information and models that S&P analysts did, they could not have been fooled by faulty credit ratings,” Carter wrote.

“This begs the question: If no investor believed in S&P’s objectivity, and every bank had access to the same information and models as S&P, is S&P asserting that, as a matter of law, the company’s credit ratings service added absolutely zero material value as a predictor of creditworthiness?”

This is indeed welcome news, as I am sure once the case is underway more information will be brought to light. While I do not take a normative stance on credit agencies in general, the effects of large agencies (such as S & P) ratings on financial valuation cannot be overstated.

To the extent that the lawsuit will explore what role S & P played in perpetuating the financial crisis, and then hold S & P accountable for that role, the judges decision is one that benefits society as a whole by overcoming the power-asymmetry / collective action problem(s) individuals face in holding large institutions to account. Since that is essentially what Normative Narratives is all about, I am happy that the judge will let this case go forward. Of course the wheels of justice move very slowly, so it could still be months / years until a final ruling is made/ appeals finish and any money is paid back, but this decision is a step in the right direction. Any money the U.S. government gets from this case should go towards helping people with refinance underwater mortgages; evidence suggests that low-income families were specifically targeted by lenders in the years leading up to the housing market collapse.

Part of learning from past mistakes is holding the actors who perpetuated / profited from them accountable. Another part of learning from past mistakes is putting safeguards in place to prevent them from occurring again. The former has been addressed on an ad-hoc basis (many would argue not enough has been been done, but lets not allow the unattainable pursuit of perfection get in the way of achievable progress). The later was partially addressed this week with the confirmation of Richard Cordray as the head of the Consumer Financial Protection Bureau:

“The Consumer Financial Protection Bureau was conceived by a Harvard professor, embraced by the Obama administration and pushed into law by Congressional Democrats determined to expand the federal government’s authority to protect borrowers from abusive lending practices”

” [Senator Elizabeth] Warren proposed the creation of a federal agency to protect consumers of financial products in a 2007 article, memorably arguing that the government put more effort into ensuring the safety of toaster ovens than the safety of mortgage loans. The idea resonated with Mr. Obama and his senior advisers, and it became a centerpiece of the administration’s proposal to overhaul financial regulation.”

“‘It is a truly historic day,’ Warren told reporters before the vote. ‘There’s no doubt that the consumer agency will survive beyond the crib. There is now no doubt that the American people will have a strong watchdog in Washington.’”

“…the agency has begun to assert authority over non-bank financial companies, including mortgage and payday lenders, but its actions have been shadowed by uncertainty about the legality of Mr. Cordray’s appointment.”

“‘Today’s action brings added certainty to the industries we oversee and reinforces our responsibility to stand on the side of consumers and see that they are treated fairly in the financial marketplace,’ Mr. Cordray said in a statement.”

It remains to be seen how effective an institution the Consumer Financial Protection Bureau will be. But given the optimism of high ranking officials and the efforts that went into preventing Mr. Cordray’s appointment, it is safe to assume this is big news in the realm of financial reform.

I leave you with words from a previous blog of mine on the subject of accountability, which I believe continues to ring truer and truer with each passing day.

Despite the political and economic cynics out there, who in their great “wisdom” will tell you nothing is happening to hold powerful interests accountable for their role in the financial crisis, we have learned lessons (albeit incredibly hard learned lessons) and are taking steps to ensure we do not repeat our past mistakes.


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Economic Outlook: “Financialization”, “Commoditization” and the Real Economy

In a recent Economix blog, Bruce Bartlett explores the role “financialization” has played in American (and global) economic stagnation:

“Economists are still searching for answers to the slow growth of the United States economy. Some are now focusing on the issue of “financialization,” the growth of the financial sector as a share of gross domestic product.”

“According to a new article in the Journal of Economic Perspectives by the Harvard Business School professors Robin Greenwood and David Scharfstein, financial services rose as a share of G.D.P. to 8.3 percent in 2006 from 2.8 percent in 1950 and 4.9 percent in 1980. The following table is taken from their article.”

Data from the National Income and Product Accounts (1947-2009) and the National Economic Accounts (1929-47) are used to compute added value as a percentage of gross domestic product in the United States.

They cite research by Thomas Philippon of New York University and Ariell Reshef of the University of Virginia that compensation in the financial services industry was comparable to that in other industries until 1980. But since then, it has increased sharply and those working in financial services now make 70 percent more on average.”

“While all economists agree that the financial sector contributes significantly to economic growth, some now question whether that is still the case. According to Stephen G. Cecchetti and Enisse Kharroubi of the Bank for International Settlements, the impact of finance on economic growth is very positive in the early stages of development. But beyond a certain point it becomes negative, because the financial sector competes with other sectors for scarce resources.”

“Ozgur Orhangazi of Roosevelt University has found that investment in the real sector of the economy falls when financialization rises. Moreover, rising fees paid by nonfinancial corporations to financial markets have reduced internal funds available for investment, shortened their planning horizon and increased uncertainty.”

“Adair Turner, formerly Britain’s top financial regulator, has said, “There is no clear evidence that the growth in the scale and complexity of the financial system in the rich developed world over the last 20 to 30 years has driven increased growth or stability.”

He suggests, rather, that the financial sector’s gains have been more in the form of economic rents — basically something for nothing — than the return to greater economic value.

Another way that the financial sector leeches growth from other sectors is by attracting a rising share of the nation’s “best and brightest” workers, depriving other sectors like manufacturing of their skills.”

“The rising share of income going to financial assets also contributes to labor’s falling share. As illustrated in the following chart from the Federal Reserve Bank of St. Louis, that share has fallen 12 percentage points since its recent peak in early 2001 and even more from its historical level from the 1950s through the 1970s.

Labor Share of Nonfarm Business Sector

Bureau of Labor Statistics, Department of Labor

The falling labor share results from various factors, including globalization, technology and institutional factors like declining unionization. But according to a new report from the International Labor Organization, a United Nations agency, financialization is by far the largest contributor in developed economies (see Page 52).

The report estimates that 46 percent of labor’s falling share resulted from financialization, 19 percent from globalization, 10 percent from technological change and 25 percent from institutional factors.

This phenomenon is a major cause of rising income inequality, which itself is an important reason for inadequate growth. As the entrepreneur Nick Hanauer pointed out at a Senate Banking, Housing and Urban Affairs Committee hearing on June 6, the income of the middle class is critical to economic growth because of its buying power. Mr. Hanauer believes consumption is really what drives growth; business people like him invest and create jobs to take advantage of middle-class demands for goods and services, which must be supported by good-paying jobs and rising incomes.”

“According to research by the economists Jon Bakija, Adam Cole and Bradley T. Heim, financialization is a principal driver of the rising share of income going to the ultrawealthy – the top 0.1 percent of the income distribution.”

“Among those pointing their fingers at financialization is David Stockman, former director of the Office of Management and Budget, who followed his government service with a long career in finance at Salomon Brothers and elsewhere. Writing in The New York Times, he recently said financialization was “corrosive” and had turned the economy into “a giant casino” where banks skim an oversize share of profits.

It’s not yet clear what public policies are appropriate to deal with the phenomenon of financialization. The important thing at this point is to be aware of it, which does not yet appear to be the case in Washington.”

A complementary practice that has accompanied “financialization” is the practice of “commoditization“:

“Commoditization” has led to food price volatility and food insecurity in the developing world. It also perpetuated the housing bubble–while it is true that mortgages were always financial products, the way the mortgage backed securities grouped mortgages together turned a practice that was once a means of saving into an opportunity for people to use the equity in their homes like credit cards. When the housing bubble burst, many people found their mortgages “under water”. While there is certainly an element of personal responsibility, the scope of the housing crisis was certainly deepened due to “financialization” and “commoditization”.

Financialization attracts the best and brightest away from other non-financial fields. When all these talented people are working in a saturated market (such as more traditional investments), a natural effect will be the creation of “innovative” financial products–“commoditization”. While commoditization creates short run value by making products more liquid, in the long run it leads to price volatility and bubbles. 

Financialization has led to greater income inequality (as the vast majority of capital gains go to the ultra-wealthy), and diverts resources and man-power away from non-financial industries (the “real economy) due to higher fees paid to financial services (these resources could go to, say, MORE HIRING). It has also perpetuated destabilizing, high-speed, arbitrage-seeking investment. 

It is interesting that Mr. Bartlett says that it is unclear what public policies should be used to correct for this misalignment of resources. The answers are there (and Bruce himself has mentioned some in previous posts), the problem is implementation, as the proper policy responses require transparency and international cooperation and coordination (due to the global nature of capital in the digital age in order to prevent “capital flight”). Therefore, these commitments are rife with incentives to cheat (“prisoner’s dilemma”) which makes it much harder to come to binding agreements. 

One appropriate response is a financial transaction tax (FTT). Such a tax would deter short-run destabilizing trades that have accompanied “financialization” and “commoditization” and direct investments into more long-run wealth creating endeavors (think venture capitalism as opposed to high-speed trading). This would also temper the price volatility effect of “commoditization”.

Another appropriate response would be to have a global standard tax rate for short-run capital gains. By setting such a rate higher than regular income taxation, resources would be diverted away the financial sector and back into the real sector (are you seeing a theme here?). Financial bubbles would be less prevalent, as people would be more likely to hold their income in safer assets / reinvest it in non-financial assets. Due to the relative ease of making short-term capital gains, and differences in national income tax rates, a global short-term capital gains tax rate of 50% seems like a good baseline to start from. Long-term capital gains should be taxed like ordinary income, not at lower preferential rates.

“Financialization” and “commoditization” have had adverse effects on our real economy. The brightest people and an increasing share of national output have been diverted towards (generally) unproductive activities  In the short run this leads to economic growth. But this growth in unsustainable; in the long run crises occur when these bubbles burst, which  have adverse effects that  reach far beyond the financial sector (due in part to “commoditization”). 

Because public policies have allowed financial institutions to grow so powerful, the were able to become “too big to fail“, necessitating tax-payer backed bailouts.

It is a good sign that economists are scrutinizing these practices. If it can be proved that not only do these practices lead to crises, but also have adverse effects on growth, employment, consumption and equality during “good” times, then it will be much harder for politicians around the world to resist the call for greater financial industry accountability via higher taxation (despite the threats from vested interests; if global standards are established, the 0.1% are welcome to setup the Mars Stock Exchange is they so desire).