A Fake Banking History of the United States
Ask yourself this question: was the housing price bubble, which has burst, caused by (a) a Fed policy of too much liquidity, which caused artificially low interest rates, which in turn caused a great deal of malinvestment, or (b) a Fed policy of too little liquidity which caused high interest rates and a credit-starved economy? If you chose answer b, congratulations, you may have a future as a celebrated author, historian, and Wall Street Journal commentator.
Answer b is a theme of a truly ridiculous article by John Steele Gordon in the October 10 issue of the Wall Street Journal online entitled "A Short Banking History of the United States." The article is an attempt to defend the Fed, its founding father, Alexander Hamilton, and the regime that it finances. (Gordon is the author of a book entitled Hamilton's Blessing which sings the praises of a large public debt, something that Hamilton himself called a "public blessing.")
Rather than faulting the Fed for creating yet another boom-and-bust cycle, Gordon blames the current economic debacle on "the baleful influence of Thomas Jefferson." Jefferson was the foremost opponent of a bank capitalized with tax dollars and operated by politicians and their appointees from the nation's capital — Hamilton's Bank of the United States (BUS), a precursor of the Fed. Thus, despite the fact that the real blame for the current economic crisis lies squarely in the lap of the Fed and its ideological underpinnings — particularly the legends and myths surrounding Hamilton — Gordon attempts to convince us that opposition to politicized, centralized banking is the real problem. Anyone who believes this could easily be persuaded that up is down, white is black, and day is night. The purpose of the Fed, according to Gordon, is to serve as a sort of a monetary benevolent despot: "To guard the money supply … regulating the economy thereby."
Right-wing statists like Gordon, like left-wing statists, have adopted the custom of smearing Jefferson as a slave owner not so much because they are appalled that he owned slaves, but because their objective is to denigrate his laissez-faire/limited-government political philosophy. Gordon includes the Jefferson slavery smear in his article, but fails to mention that his hero Hamilton also owned "house slaves," which were brought into his marriage by his wife Eliza; he once purchased six slaves at an auction; and he supported the return of runaway slaves to their "owners" under the Fugitive Slave Clause of the original Constitution.
Indeed, nearly all of the "first families" of the New York City of Hamilton's time — his main social and political circle — were slave owners. As Hamilton biographer Ron Chernow has written, during Hamilton's time, "New York City, in particular, was identified with slavery … and was linked [economically] through its sugar refineries in the West Indies" (where Hamilton was born and raised). By the late 1790s slaves were "regarded as status symbols" by the wealthiest New York families.
Gordon spreads several other falsehoods about Jefferson in the leading paragraphs of his article. This in itself is telling, for it shows that court historians like John Steele Gordon fully understand the importance of Hamilton's statist political philosophy in propping up the Fed and the regime that it finances. Gordon claims that Jefferson, a lifelong businessman, "hated commerce," "hated banks," and "may not have understood the concept of central banking." He also argues that Hamilton, by contrast, had a "profound understanding of markets" because he worked as a bookkeeper for British slave-owning sugar-plantation operators and exporters as a teenager on the Caribbean island of St. Croix. This is nonsense on stilts, as the philosopher Jeremy Bentham is supposed to have said with regard to another spurious claim.
What Jefferson opposed was Hamilton's mercantilist policies of government-controlled banking, corporate welfare, protectionist tariffs, heavy excise taxation, excessive public debt, and other interventions. Unlike Hamilton, Jefferson had read and understood Adam Smith's Wealth of Nations and his Theory of Moral Sentiments, as well as the work of David Ricardo, Jean-Baptiste Say (who Jefferson tried to get to join the faculty of the University of Virginia), Richard Cantillon, and other economic theorists of that era. Hamilton was ignorant of or ignored all of this. His major intellectual influence was a propagandist for the British mercantilist regime named Sir James Steuart.
As Murray Rothbard wrote in an article entitled "A Future of Peace and Capitalism,"
Jefferson was very precisely in favor of laissez-faire, or free-market, capitalism. And that was the real argument between [Hamilton and Jefferson]. It wasn't really that Jefferson was against factories or industries per se; what he was against was coerced [economic] development, that is, taxing the farmers through tariffs and subsidies to build up industry artificially, which was essentially the Hamilton program. Jefferson … was a very learned person. He read Adam Smith, he read Ricardo, he was very familiar with laissez-faire classical economics. And so his economic program … was a very sophisticated application of classical economics to the American scene … classicists were also against tariffs, subsidies, and coerced economic development…. The Jeffersonian wing of the founding fathers was essentially free-market, laissez-faire capitalists.
Compared to Jefferson, Hamilton was an economic ignoramus. His reputation as some kind of financial genius has been greatly exaggerated and fabricated, as the great late-nineteenth-century Yale sociologist William Graham Sumner wrote in his 1905 biography of Hamilton. In his Report on Manufacturers, for example, Hamilton presented the cockeyed notion that international competition would cause higher prices and protectionism would cause lower prices by causing domestic producers to compete more vigorously with each other. History had proven this to be an absurd idea long before Hamilton's time.
Hamilton also condemned transportation costs, calling them "an evil which ought to be minimized" through protectionism. Of course, transportation costs also affect interstate trade, but Hamilton never voiced his opposition to them in that context. Hamilton was such a mercantilist that he even argued in favor of "a monopoly of the domestic market" by banning all imports altogether. It is little wonder that William Graham Sumner referred to Hamilton's Report on Manufactures as a mass of economic confusion, just the opposite of a "profound and practical understanding of markets."
Jefferson was not the only prominent opponent of Hamilton's scheme to establish a bank operated by politicians out of the nation's capital. James Madison also opposed the First Bank of the United States (BUS). The Virginia Senator John Taylor was as learned on the subject of political economy as Jefferson was, and immediately recognized the danger of imitating the Bank of England as a financier of mercantilist subsidies. "What was it that drove our forefathers to this country?" he asked. "Was it not the ecclesiastical corps and perpetual monopolies of England and Scotland? Shall we suffer the same evils in this country?" Hamilton's answer would have been "why yes, we shall, for it is the surest route to accumulate power and wealth for myself and my fellow Federalists." As Gordon wrote, "Hamilton wanted to establish a central bank modeled on the Bank of England."
John Steele Gordon's "short history" of banking is completely filled with falsehoods. Throughout his article, he blames Jefferson's opposition to central banking for economic problems that were in fact created by Hamilton's Bank of the United States.
As Murray Rothbard wrote in A History of Money and Banking in the United States (p. 69), as soon as Hamilton's bank was established it
promptly fulfilled its inflationary potential by issuing millions of dollars in paper money and demand deposits, pyramiding on top of $2 million in specie. The Bank … invested heavily in loans to the United States government…. The result of the outpouring of credit and paper money by the new bank of the United States was … in increase [in prices] of 72 percent [from 1791–1796].
The BUS charter was not renewed after its first twenty years. Gordon blames Jefferson for this, but the above-mentioned economic instability that was caused by the BUS surely played a role. (And I'm sure Jefferson would have been proud to accept the credit for the demise of the BUS.) The BUS was revived after the War of 1812 (in 1817) and it immediately "ran into grave difficulties through mismanagement, speculation, and fraud," wrote James J. Kilpatrick in his book, The Sovereign States. Consequently, "a wave of hostility toward the Bank of the United States swept the country," which eventually led to President Andrew Jackson's veto of the bank rechartering bill.
In 1817 the BUS quickly lent $23 million with a specie reserve of only $2.3 million. This flood of cheap credit created a brief economic boom, and then the inevitable bust, or depression, known at the time as the Panic of 1819. As Murray Rothbard wrote in The Panic of 1819, personal bankruptcies abounded, especially among farmers who had overextended themselves thanks to the BUS's cheap credit; and there was for the first time large-scale unemployment in American cities, with manufacturing employment in Philadelphia falling from 9,700 employed persons in 1815 to only 2,100 in 1819. This was all Jefferson's fault, says John Steele Gordon.
Another one of Gordon's false claims is that "The Civil War ended … monetary chaos when Congress passed the National Bank Act," which would become the state's monopolistic monetary regime until the creation of the Fed in 1913. In reality, the so-called Independent Treasury System that existed from the early 1840s to 1863 was arguably the most stable monetary system in US history. Modern economic scholars have evaluated the Lincoln regime's National Currency Acts and have arrived at the opposite conclusion of Gordon's. In an article entitled "Money versus Credit Rationing: Evidence for the National Banking Era, 1880–1914" (in Claudia Goldin, ed., Strategic Factors in Nineteenth-Century American Economic Growth) Michael Bordo, Anna Schwartz, and Peter Rappaport concluded that this Hamiltonian system "was characterized by monetary and cyclical instability, four banking panics, frequent stock market crashes, and other financial disturbances."
Gordon notes that "inflation took off in the 1960s" but does not blame the actual cause of the inflation — the Fed and its legalized counterfeiting operations. He concludes by praising the regime's current plans to nationalize the financial markets by assuming stock ownership in banks and appointing the US Treasury secretary as the nation's first financial dictator. He thinks this will finally, at long last, achieve Hamilton's dream of a "unified and coherent regulatory system free of undue political influence."
Of course, no government institution in the history of the world has ever been free of political influence, due or undue. This is perhaps Gordon's most spectacularly stupid remark.
"Unified" or centralized regulation of industry has long been a goal of statists who favor regulatory dictatorship as opposed to a governmental regime that delegates "too much" regulatory power. Gordon himself bemoans the "conflicting" regulations on the banking industry that have been imposed by the Fed, and the FDIC, FSLIC, SEC, and other federal regulators.
The system of financial regulatory dictatorship that Gordon praises, and which is about to be forced down the throats of the American public, has been tried before in other countries. During one of its own periodic financial crises, Italian government officials complained bitterly, as Gordon does, of regulation that has been "disorganic" and "case by case, as the need arises." The Italian regime altered its regulatory system so that it could pursue "certain fixed objectives," just as Gordon argues for a "unified and coherent regulatory system." This highly centralized or even dictatorial regulatory system, the Italians argued, would supposedly "introduce order in the economic field" and achieve the goal of "unity of aim" with regard to government regulation of industry.
All of the words in quotation marks in the preceding paragraph, except for the last ones, are the words of Benito Mussolini. The "unity of aim" phrase was from Mussolini apologist/propagandist Fausto Pitigliani. There is, after all, a very keen similarity between Hamiltonian mercantilism — or an economy directed and controlled by government, supposedly "in the public interest" but in reality for the benefit of a privileged few — and the economic fascism of Italy (and Germany) of the 1920s and '30s.
Lexington
The rise of the Obamacons
A striking number of conservatives are planning to vote for Obama
IN “W.”, his biopic about his Yale classmate, Oliver Stone details Colin Powell’s agonies during George Bush’s first term. Throughout the film Mr Powell repeatedly raises doubts about the invasion of Iraq—and is repeatedly overruled by the ghoulish trio of Dick Cheney, Donald Rumsfeld and Karl Rove. In one of the final scenes, with his direst warnings proving correct, Mr Powell turns to Mr Cheney and delivers a heartfelt “Fuck you”.
The real Colin Powell used more diplomatic language in endorsing Barack Obama on October 19th, but the impact was much the same. Mr Obama is a “transformational figure”, he mildly said, and his old friend John McCain had erred in choosing a neophyte as a running-mate. But you would have to be naive not to see the endorsement as a verdict on the Bush years.
Mr Powell is now a four-star general in America’s most surprising new army: the Obamacons. The army includes other big names such as Susan Eisenhower, Dwight’s granddaughter, who introduced Mr Obama at the Democratic National Convention and Christopher Buckley, the son of the conservative icon William Buckley, who complains that he has not left the Republican Party: the Republican Party has left him. Chuck Hagel, a Republican senator from Nebraska and one-time bosom buddy of Mr McCain has also flirted heavily with the movement, though he has refrained from issuing an official endorsement.
The biggest brigade in the Obamacon army consists of libertarians, furious with Mr Bush’s big-government conservatism, worried about his commitment to an open-ended “war on terror”, and disgusted by his cavalier way with civil rights. There are two competing “libertarians for Obama” web sites. CaféPress is even offering a “libertarian for Obama” lawn sign for $19.95. Larry Hunter, who helped to devise Newt Gingrich’s Contract with America in 1994, thinks that Mr Obama can free America from the grip of the “zombies” who now run the Republican Party.
But the army has many other brigades, too: repentant neocons such as Francis Fukuyama, legal scholars such as Douglas Kmiec, and conservative talk-show hosts such as Michael Smerconish. And it is picking up unexpected new recruits as the campaign approaches its denouement. Many disillusioned Republicans hoped that Mr McCain would provide a compass for a party that has lost its way, but now feel that the compass has gone haywire. Kenneth Adelman, who once described the invasion of Iraq as a “cakewalk”, decided this week to vote for Mr Obama mainly because he regards Sarah Palin as “not close to being acceptable in high office”.
The rise of the Obamacons is more than a reaction against Mr Bush’s remodelling of the Republican Party and Mr McCain’s desperation: there were plenty of disillusioned Republicans in 2004 who did not warm to John Kerry. It is also a positive verdict on Mr Obama. For many conservatives, Mr Obama embodies qualities that their party has abandoned: pragmatism, competence and respect for the head rather than the heart. Mr Obama’s calm and collected response to the turmoil on Wall Street contrasted sharply with Mr McCain’s grandstanding.
Much of Mr Obama’s rhetoric is strikingly conservative, even Reaganesque. He preaches the virtues of personal responsibility and family values, and practises them too. He talks in uplifting terms about the promise of American life. His story also appeals to conservatives: it holds the possibility of freeing America from its racial demons, proving that the country is a race-blind meritocracy and, in the process, bankrupting a race-grievance industry that has produced the likes of Jesse Jackson and Al Sharpton.
How much do these Obamacons matter? More than Mr McCain would like to think. The Obamacons are manifestations of a deeper turmoil in the Republican rank-and-file, as the old coalition of small-government activists, social conservatives and business Republicans falls apart. They also influence opinion. This is obvious in the case of Mr Powell: Mr Obama is making liberal use of his endorsement to refute the latest Republican criticism that he is a “socialist”. But it is also true of lesser-known scribblers. At least 27 newspapers that backed Mr Bush in 2004 have endorsed Mr Obama.
Moreover, the revolt of the intellectuals is coinciding with a migration of culturally conservative voters—particularly white working-class voters—into Obamaland. Mr Obama is now level-pegging or leading among swing-groups such as Catholics and working-class whites. A recent Washington Post-ABC poll shows him winning 22% of self-described conservatives, a higher proportion than any Democratic nominee since 1980.
Don’t blame the rats
The more tantalising question is whether the rise of the Obamacons signals a lasting political realignment. In 1980 the rise of the neocons—liberal intellectuals who abandoned a spineless Democratic Party—was reinforced by the birth of working class “Reagan Democrats”. Is the Reagan revolution now going into reverse? There are reasons for scepticism. Will libertarians really stick with “Senator Government”, as Mr McCain labelled Mr Obama in the best slip of the tongue of the campaign? Will economic conservatives cleave to a president who believes in “spreading the wealth around”?
Much depends on how Mr Obama governs if he wins, and how the Republicans behave if they lose. Mr Obama talks about creating an administration of all the talents. He promises to take the cultural anxieties of Reagan Democrats seriously. For their part, hard-core Republicans are handling their party’s travails abysmally, retreating into elite-bashing populism and denouncing the Obamacons as “rats” who are deserting a sinking ship. If the Republican Party continues to think that the problem lies with the rats, rather than the seaworthiness of the ship, then the Obamacons are here to stay.
The Fed's rate cut
Approaching zero
With rates down to 1%, the Fed may next try more unconventional steps
AFTER the most eventful and creative six weeks in the history of central banking, a half-point interest rate cut by the Federal Reserve on Wednesday October 29th was almost anti-climactic. Nonetheless, it was an important strike at the deepening recessionary forces surrounding the American economy, and the Fed made it more significant by jettisoning concerns about inflation from the statement accompanying its action.
The Fed also announced new dollar swap lines with four big emerging-market central banks to help them cope with shortages of dollars that are roiling their financial markets. It is a sign of how the locus of the crisis has shifted from developed to emerging markets, requiring a corresponding shift in policy. The swaps will complement a new $100 billion liquidity facility announced by the International Monetary Fund that countries in solid macroeconomic shape can access without the usual conditionality.
Within America the financial crisis is showing signs of easing, but the economic crisis is only just starting, as the Fed broadly acknowledged. “The pace of economic activity appears to have slowed markedly,” the Federal Open Market Committee, the central bank’s policy panel, said in lowering the target on the federal funds rate to 1% from 1.5%. “Moreover, the intensification of financial market turmoil is likely to exert additional restraint.”
The Fed noted both the staggering scale of the recent policy stimulus—it called its own lending initiatives “extraordinary”—and implied that more is probably on the way by saying that: “Downside risks to growth remain.” That simple sentence was made more striking because it was no longer coupled with a reference to the risk of inflation.
Inflation concerns have lingered over the Fed’s actions since the crisis began in August of last year and at times held it back from even more aggressive action. Its concerns were understandable as long as commodity costs were soaring and in the face of a lower dollar. But commodities have dramatically reversed course and the dollar has rebounded. The new optimism on inflation is due not just to falling energy costs—petrol in America is now $2.66 a gallon, compared with $4.11 in mid-July—but to a weakening economy that some economists think could eventually push unemployment over 8%, up from 6.1% in September. The Fed now expects inflation to fall “in coming quarters to levels consistent with price stability.” In practical terms, that means to between 1.5% and 2%. In August inflation was 4.5% (using the price index of personal consumption), or 2.2% excluding food and energy.
A federal funds rate target of 1% is freighted with symbolism. The Fed's decision to lower the rate to that level and hold it there in 2003-04 has been regularly blamed for inflating the credit bubble that led to the current crisis. Policymakers did not appear to worry about the similarities: the vote in favour was unanimous. Appropriately so. The crisis may have been brought on by too much risk taking, but animal spirits have since swung dangerously far in the opposite direction. Spreads between the federal funds rate and other short-term rates are astronomically wide, reflecting both the lack of lending capacity by banks whose capital is under pressure, and rising probability of default by borrowers which naturally leads to wider spreads. While a lower federal funds rate will not narrow that spread, it will reduce the actual level of short-term rates and should help at the margin.
How much lower can the federal funds rate go? Certainly at least to 0.5%, a level it has not been close to since the 1950s. But beyond that, things get tricky. Ordinarily, the Fed can keep the federal funds rate on target by adding or draining reserves from banks. But its liquidity operations have left banks with billions of excess reserves to lend out, forcing the federal funds rate well below target on most days. The Fed now pays interest on reserve deposits at 35 basis points below the federal funds rate target. So banks will leave reserves at the Fed once the market rate on federal funds falls to that deposit rate, which is the new de facto target. So that means if the Fed wants to maintain a 35 basis point spread between what it pays on reserves and the federal funds target rate, it might be hard to get the funds rate target much below 0.5%.
Even if the Fed did target zero, it might encourage banks just to leave their money at the Fed rather than lend it to each other, causing the federal funds market to dry up. It would also make it hard for money market mutual funds to pay a competitive yield and cover their operating expenses. Money would flow out of them and into government-guaranteed bank deposits, straining bank capital ratios.
For these reasons, before pushing its rate to zero, the Fed might want to consider variants of “quantitative easing”. This means expanding its balance sheet through the purchase of either government bonds or increased loans to the private sector. It has already in effect taken this route through its many liquidity programmes and swap lines with central banks, which have doubled its balance sheet to $1.8 trillion. But it could go much further.
On Wednesday it announced another such step: the creation of new swap lines with Mexico, Brazil, Korea and Singapore of $30 billion each to enable those countries to provide dollar liquidity to their banks. It is unusual though not unprecedented for the Fed to make such arrangements outside of the rich world economies.
Bold as its actions have been, the Fed cannot battle the recession alone. It needs fiscal policy as well, both to recapitalise lenders through the Troubled Asset Relief Programme–both banks and nonbanks, such as insurers—and to stimulate spending directly through increased public spending or tax cuts.
Commentary by Mark Gilbert
Oct. 30 (Bloomberg) -- In the third quarter of 2007, Volvo AB booked 41,970 European orders for new trucks. Guess how many prospective purchases Volvo, the world's second-biggest maker of heavy rigs, received in the third quarter of this year?
Here's a clue. Picture a highway gridlocked by 41,815 abandoned trucks -- because Volvo's order book got destroyed to the tune of 99.63 percent, with customers signing up for just 155 vehicles in the three-month period, the Gothenburg, Sweden-based company said last week.
The pathogen that has fatally infected swathes of the banking industry is now contaminating non-financial companies. ``We're heading toward the sharpest downturn I've ever seen in Europe,'' said Chief Executive Officer Leif Johansson.
Volvo has company. Daimler AG, the world's biggest truckmaker, said earlier this month that its U.S. deliveries slumped by a third in the first half of the year.
After months of money-market madness, slumping stock markets, collapsing currencies and bank bailouts, the headlines from the broader economy are starting to roll in -- and the news is all bad and getting worse, fast.
Let's begin with the shipping news. If nobody is buying your trucks, you don't need to rent a vessel to carry that shiny new 18-wheeler to its new owner. Hence the Baltic Dry Index, which tracks the cost of shipping goods and commodities, fell below 1,000 this week for the first time in six years.
Slow Boats From China
Put another way, it is now almost 90 percent cheaper to ship goods over the oceans than it was at the beginning of the year. And because the huge vessels known as capesize ships can't currently charge much more than their daily operating cost of about $6,000 per day, their captains have slowed down to economize on fuel and save money, to about 8.68 knots from 10.33 knots in July, according to data compiled by Bloomberg.
It isn't just the oceans that are emptying. Air freight traffic dropped 7.7 percent in September, according to the latest figures from the International Air Transport Association. That's the steepest decline since the trade group began compiling the data in January 2003.
Figures this week showed U.S. consumer confidence collapsed to a record low in October; retail therapy probably isn't the cure. With Christmas looking like it might be canceled, why bother fighting with your bankers for the letters of credit you need to export the stocking-stuffers you make in the factory?
`Growing Anxiety'
``The October reading signals the deepening concern about the marked deterioration in the overall economy as well as the growing anxiety arising from the continued travails in the financial markets,'' David Resler, chief economist at Nomura Securities in New York, wrote in a research report. ``Confidence declined across all regions, all age groups and all income categories.''
One way in which the current recession/depression/meltdown (take your pick) will differ from previous economic collapses is the granularity of information now available. The world is awash with more data than ever before, generating a plethora of ways to scare yourself silly.
The Bank of England, for example, produces what it calls a Financial Market Liquidity Index, a global measure of stress that gauges how far a basket of nine indicators strays from its historical mean. The index gets updated twice a year; this week's bulletin, which recalculates the level up to Oct. 17, showed liquidity at its lowest level in at least 17 years.
Default Danger
The next wave of headlines to scare shoppers out of the mall is likely to come when companies find they can't pay their debts. Credit-rating company Moody's Investors Service predicts that the default rate among sub-investment grade borrowers will surge to 7.9 percent in a year, from 2.8 percent at the end of the second quarter of 2008 and from just 1.3 percent 12 months ago.
``With the global credit crisis intensifying and credit spreads widening, it is increasingly likely that corporate default rates will spike sharply in the next 12 months,'' Kenneth Emery, the director of default research at Moody's, said in a research report published earlier this month.
The Markit iTraxx Crossover index of credit-default swaps on mostly speculative-grade companies traded as high as 920 basis points this week. That level suggests investors and traders are anticipating more than half of the companies in the index will default, based on bondholders recouping 40 percent of their money from companies that fail to keep up their debt payments.
Going Bust
At a recovery rate of 20 percent, the implied default level is about 45 percent. At a salvage percentage of just 10 percent, the index is still suggesting about 40 percent of its members will renege on their commitments. It is hard to see how consumer confidence will recover when companies start going bust.
``Worries about defaults are mounting as liquidity is strained,'' Guy Stear and Claudia Panseri, analysts at Societe Generale SA, wrote in a research note this week. ``Earnings expectations still look optimistic, with analysts projecting 2009 earnings for the S&P 500 rising by 19 percent.''
There's a great scene in the film version of Annie Proulx's Pulitzer Prize-winning novel ``The Shipping News.'' A grizzled journalist explains to rookie hack Kevin Spacey how dark clouds on the horizon justify the hyperbolic headline ``Imminent Storm Threatens Village.''
``But what if no storm comes?'' Spacey asks. The veteran replies with a second-day headline: ``Village Spared From Deadly Storm.'' Unfortunately, the global village we live in is unlikely to survive unscathed.
Oct. 30 (Bloomberg) -- As George Miller welcomed 60 bankers to the chandeliered Charlotte City Club one evening in September, the focus was on more than the recent bankruptcy of Lehman Brothers Holdings Inc. From their 31st-floor perch, members of the American Securitization Forum, which Miller leads, fretted about the future of their $10.7 trillion industry.
The bankers were warned that a Financial Accounting Standards Board plan would force trillions of dollars back onto balance sheets, requiring cash reserves to soar. Their business of pooling and reselling assets had dropped 47 percent in the first six months of the year, and the industry couldn't afford another setback.
The next day, Miller, 39, the forum's executive director, took that message from North Carolina to a Senate hearing in Washington examining the buildup of off-balance-sheet assets. ``There are great risks to the financial markets and to the economy of moving forward quickly with bad rules,'' he said of FASB's proposal.
Miller was trying to preserve an accounting rule for off- the-books assets that helped U.S. banks export toxic debt around the world. It is a loophole that Jack Reed, the Rhode Island Democrat who chairs the Senate securities subcommittee, said had contributed ``to the severity of the current crisis.''
The damage to date: more than $680 billion dollars in losses and writedowns, about one-third of that by European banks.
Unregulated Derivatives
Efforts by lobbyists have delayed FASB decisions and kept key parts of the American financial system beyond the reach of regulators. Their victories included ensuring that over-the- counter derivatives stayed unregulated and persuading the Securities and Exchange Commission to let investment banks reduce capital requirements. That allowed them to increase borrowing and magnify profits. Bank watchdogs also didn't move to tighten mortgage-industry standards until after the collapse of the subprime market.
Today, a road snakes from the foreclosed homes of California and Ohio to the capital cities of Europe, where politicians and bankers have struggled to contain a widening credit crisis by pumping hundreds of billions of euros into the financial system. The road was paved with decisions like ones by FASB that allowed banks to keep shifting assets into blind spots outside the view of shareholders and industry overseers.
`Magic Trick'
``I've always regarded it as a bit of a magic trick,'' Pauline Wallace, a partner at PriceWaterhouseCoopers LLP and team leader in London for financial instruments, said of off-balance- sheet accounting. ``Magicians come to parties, and they make things seem to disappear. The risk is somewhere, but you never knew where.''
Pushed by taxpayers angry about financing a bailout of Wall Street while their retirement accounts wither, Congress is likely to shake up bank and securities regulation, giving the Federal Reserve more power.
``I wouldn't be surprised if the Fed ends up officially becoming our systemic-risk regulator,'' said Robert Litan, an economist at the Brookings Institution in Washington.
That's ironic to Donald Young, an investor advocate and FASB board member from 2005 until June 30. He testified at the same Senate hearing on Sept. 18 that both the Fed and the SEC joined the banks they oversaw in resisting proposals for more disclosure of off-the-books assets.
``There was an unending lobbying of FASB'' by companies and regulators, Young told the committee.
`Lack of Transparency'
The former FASB board member made a similar point in a June 26 letter to Senator Reed. ``We lacked the ability to overcome the lobbying efforts that effectively argued that if we made substantive changes we would hamper the credit markets and hurt business,'' Young wrote. ``Our inaction did not hamper credit markets -- it helped to destroy them.''
The issue, Young said in an interview, was the ``lack of transparency'' that comes with off-the-books accounting.
``There is a perceived free lunch that they can take on risk and not reflect it, and make things look better than they are,'' he said. ``That encourages them to do it more and more.''
A spokesman for FASB, Neal McGarity, said in an e-mail that Young voted with the majority of the board in a January 2005 decision to expand the use of an off-balance-sheet vehicle.
UBS Writedowns
Regulators outside the U.S. didn't do a good job policing investments in subprime-mortgage assets either. Zurich-based UBS AG, hurt the most in Europe with writedowns and losses totaling $44 billion, told the Swiss Federal Banking Commission early last year that it was ``fully hedged, yes, even overhedged,'' director Daniel Zuberbuehler said at a press conference in April.
``This answer subsequently proved to be wrong, because UBS did not correctly capture its actual risk exposure and seriously overestimated its hedges,'' Zuberbuehler said. The Swiss commission now says it will force the bank to hold more capital in reserve and is negotiating with UBS over new capital requirements.
An International Monetary Fund report in April described how the housing turmoil in the U.S. ``spread quickly to Europe, prompting bank rescues and capital injections.'' It said that as of March, European banks still had $173 billion in subprime mortgage-backed securities and collateralized debt obligations, about the same amount as U.S. banks.
The accounting standards board, housed in a corporate office park in Norwalk, Connecticut, an hour northeast of New York City, operates in an unusual position between the public and private sectors. It was set up in 1973 as an independent rulemaking group, though the SEC gets a say in who is named to the board and can override its rules.
FASB Rules
For the past decade, FASB has been wrestling with how to account for off-balance-sheet assets, which include the majority of securitized financial products. In a securitization, a company pools loans such as mortgages and credit card receivables, slices them into securities and sells them to investors, usually through a separate trust.
The process allows the originating company or bank to get cash up front, while investors are paid off with the consumers' monthly payments. The issuer can also record profit from the sale to the trust and take the loans off its balance sheet. That reduces the amount of capital required as a buffer against losses, letting the company increase lending and boost earnings.
Citigroup Inc. reported that it had $1.18 trillion in off- balance-sheet holdings as of June 30, including $828.3 billion in qualified special purpose entities, or QSPEs, a type of trust that is supposed to be beyond a lender's control.
SIVs, QSPEs
Banks also created off-balance-sheet entities known as structured investment vehicles, or SIVs, that were marketed to outside investors. SIVs purchased many of the mortgage-backed notes issued by QSPEs, either directly or through other structures called collateralized debt obligations.
Securitization accelerated in the mid-1990s. The total amount of mortgage-backed securities issued almost tripled between 1996 and 2007, to $7.27 trillion, according to the Securities Industry and Financial Markets Association, or SIFMA.
Ten years ago, Wall Street was enjoying a bull market fed by a booming dot-com industry, a Fed chairman, Alan Greenspan, who trusted the market to correct its own ills, and a Congress amenable to lightening the touch of regulators.
In 1998, the imminent collapse of hedge fund Long-Term Capital Management forced the Fed to organize a bailout by Wall Street. Investment banks had loaned the fund billions and were among counterparties in more than $1 trillion in derivative contracts used to hedge investment risks.
Greenspan, Rubin
That same year Greenspan, Treasury Secretary Robert Rubin and SEC Chairman Arthur Levitt opposed an attempt by Brooksley Born, head of the Commodity Futures Trading Commission, to study regulating over-the-counter derivatives. In 2000, Congress passed a law keeping them unregulated.
Levitt said he went along with concerns by Greenspan and Rubin that Born's action might throw derivatives contracts into ``legal uncertainty.'' He said he now regrets that he didn't press a presidential advisory group ``to take a closer look'' at the issue. Rubin said in an interview that ``you could have had chaos'' if Born's plan found existing derivatives contracts invalid because they weren't traded on an exchange. Both Born and Greenspan declined to comment.
Outstanding credit-default swaps, derivative contracts used to hedge or speculate on a company's debt, would grow to $62 trillion from $631 billion in 2001. While the swaps spread risk, as intended, they also helped spread fear. Ninety percent of the trades were concentrated in the hands of 17 banks, according to the Federal Reserve Bank of New York. That left them exposed to losses if one failed, as Lehman Brothers did in September, and contributed to the unwillingness to lend to each other that's at the center of the recent credit squeeze.
3 Percent Rule
FASB had issued off-balance-sheet accounting standards in June 1996 to deal with the growth in securitizations. They were replaced in 2000 by FAS 140, which required more disclosures and rules for dealing with collateral.
Companies were allowed to push an entity off their books if an outside party put up as little as 3 percent of the capital. Houston-based Enron Corp. declared bankruptcy in late 2001 when it was forced to put trusts back on its balance sheet because it hadn't met the 3 percent rule.
The Enron scandal put pressure on FASB to make it harder for companies to keep assets hidden. In January 2003, it proposed a new rule, known as FIN 46, which increased the outside-party requirement to 10 percent.
`Bill of Goods'
Banks went on the offensive. The rule ``was developed in a rush,'' the American Bankers Association wrote in a letter to FASB that July. That same month Robert Traficanti, deputy controller of Citigroup, wrote that the proposed change would have a ``significant impact,'' forcing the lender to move the entities to the balance sheet and raise more capital.
In December 2003, FASB published FIN 46R, a revision that gave the banks more flexibility to keep off the books investment vehicles they managed for a fee.
Banks have lobbied on the issue since at least the early 1980s, said Timothy Lucas, who was at the FASB for more than two decades starting in 1979.
``I think we were sold a bill of goods'' by banks on some off-the-books structures, Lucas said.
In 2004, the SEC allowed the biggest securities firms -- Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman and Bear Stearns Cos. -- to set up a system giving the commission oversight of the investment banks' holding companies, rather than just their brokerage units, as had been the case.
Increased Leverage
With the change, approved in April that year, the Wall Street firms avoided having their operations in Europe regulated by the European Union. They were also able to reduce the amount of cash their broker-dealer units had to set aside as a cushion against unexpected losses by as much as 30 percent, Annette Nazareth, then head of the SEC's market-regulation staff, said in an interview. Nazareth, who later became an SEC commissioner, is now a partner at New York law firm Davis Polk & Wardwell.
That allowed the banks to increase their leverage, the ratio of borrowed funds to each dollar of equity capital held, and to invest even more heavily in subprime-related securities. Bear Stearns increased its leverage to 33.5-to-1 after the rule change from 26.4-to-1.
The continued delays and revisions of FASB's off-balance- sheet rules let financial institutions keep the scope of their assets from public view.
In May 2007, after the subprime mortgage crisis began to unfold, the accounting board proposed abolishing QSPEs altogether. It approved the move this April.
`Time Bombs'
Under FAS 140, entities are allowed to be kept off the books only if their activities are beyond the control of the sponsor. The problem, FASB Chairman Robert Herz said in a Sept. 18 speech in New York, was that the QSPE concept was ``stretched'' by the addition of subprime loans, which require ``active management and large-scale restructuring'' by the lender.
``We now know with hindsight that some of these entities, treated as Qs for accounting purposes, were effectively ticking time bombs,'' Herz said, referring to rising subprime defaults. ``And the bombs started to explode.''
Switching metaphors, he added: ``Unfortunately, it seems that some folks used Qs like a punch bowl to get off-balance- sheet treatment while spiking the punch. That has led us to conclude that now it's time to take away the punch bowl.''
In July, FASB decided to keep the bowl on the table a little longer, postponing by a year the effective date of the changes, to Nov. 15, 2009. The decision came after major banks, a member of Congress, Miller's securities association and other trade groups complained that the board was moving too fast and that the results would be confusing for investors.
`Intense Pressure'
FASB was ``under intense pressure from industry,'' Alan Blinder, a former Federal Reserve Board vice chairman and now a Princeton University professor, said in an interview.
``It's fair to say that the industry and the regulatory community alike failed to look through the off-balance-sheet entities with a skeptical eye and see the extent of what they might be on the hook for in a bad-case scenario,'' Blinder said.
That view is shared by Susan Bies, a Federal Reserve Board governor from 2001 to 2007.
``The No. 1 reason we're in this crisis is the deterioration of underwriting of mortgage loans,'' Bies said. ``What has made it worse is the lack of transparency in disclosures of the exact nature of assets both on and off the books. We need a clearer description of what potential exposures are out there.''
Miller said in an interview that the securitization industry got a bad rap from the Enron bankruptcy and that equating off- the-books entities with ``fraud or abuse'' is ``clearly an over- generalization.''
Greenspan Blasted
At hearings in Congress last week, financial experts and industry groups urged House and Senate committees to consider changes, including a regulator with overall authority to protect the system from risk. T. Timothy Ryan, SIFMA president, and Steve Bartlett, president of the Financial Services Roundtable, both supported the idea of a clearinghouse for credit-default swaps at an Oct. 21 House hearing. The clearinghouse would help ensure payment if counterparties failed to manage risk.
Two days later, Greenspan was blasted at another House hearing for failing to curb the growth of subprime-mortgage loans. He came out in favor of new rules requiring issuers of securitized assets to ``retain a meaningful part of the securities they issue.''
Barney Frank, chairman of the House Financial Services Committee, said in a speech in Boston on Oct. 27 that he is also in favor of rules ``to contain the excesses of this great innovation of securitization.''
Others took a more global view.
``We exported our toxic mortgages abroad,'' Joseph Stiglitz, a professor of economics at Columbia University and a Nobel Prize winner, said at the Oct. 21 House hearing. ``Had we not, the problems here at home would have been even worse.''
Oct. 30 (Bloomberg) -- U.S. stocks rose after the economy contracted less than forecast in the third quarter and investors speculated global interest-rate cuts will stem a further slump.
Intel Corp., Merck & Co. and Alcoa Inc. gained more than 5 percent after the government said the economy shrunk 0.3 percent last quarter. Colgate-Palmolive Co. climbed 7.4 percent on better-than-estimated earnings. The advance added to a global rally after Hong Kong joined the U.S. in lowering borrowing costs and the Federal Reserve provided $120 billion to spur lending in emerging markets.
The Standard & Poor's 500 Index jumped 24.03, or 2.6 percent, to 954.12 at 10:16 a.m. in New York. The Dow Jones Industrial Average added 213.3, or 2.4 percent, to 9,204.26. The Nasdaq Composite Index increased 46.01, or 2.8 percent, to 1,703.22. Eleven stocks rose for each that fell on the New York Stock Exchange.
``There weren't any nasty surprises,'' in the economic data, said Jeffrey Davis, chief investment officer at Lee Munder Capital Group in Boston, which manages $4 billion. ``GDP was better than expected. The real economy didn't fall as dramatically as the financial markets. The central bank cuts are bringing a little bit of confidence.''
All 10 industry groups in the S&P 500 advanced at least 1.4 percent after the decrease in GDP was less than the 0.5 percent forecast by economists in a Bloomberg survey. The benchmark for U.S. equities extended its gain this week to 5.4 percent.
Global Rally
Russia's benchmark index rallied 18 percent, South Korea's climbed 12 percent and the Czech Republic jumped 9.2 percent after the Fed provided $120 billion to spur lending in emerging markets. Hong Kong's Hang Seng Index surged 13 percent and Taiwan's Taiex jumped 6.3 percent after their central banks lowered rates.
The S&P 500 is still down 35 percent in 2008 and more than 18 percent in October. The Fed cut its benchmark rate by 0.5 percentage point to 1 percent yesterday and has reduced it from 5.25 percent in the past 13 months, while also creating lending programs to channel more than $1 trillion into the financial system.
A slump in the final 12 minutes of trading yesterday erased a 3.1 percent rally in the S&P 500 that was spurred by the rate cut. Some traders attributed the drop to a report that General Electric Co. Chief Executive Officer Jeffrey Immelt said he's asking managers to match this year's profit in 2009, even if revenue declines. GE spokesman Russell Wilkerson later said the initial comments were taken out of context and that Immelt was not making any kind of forecast about 2009.
Commodities Rebound
Alcoa, the biggest U.S. aluminum producer, rose 53 cents to $11.68. Newmont Mining Corp., the nation's largest gold producer, gained $1.38 to $27.28. Gold, crude oil and corn extended the biggest surge in commodity prices in five decades on speculation the rate cuts may revive demand for raw-materials consumption.
Colgate increased $4.45 to $64.45. The world's largest maker of toothpaste said third-quarter profit rose to $499.9 million from $420.1 million a year earlier, driven by overseas sales and higher prices. Sales jumped 13 percent to $4 billion, matching the average analyst estimate.
Hartford Financial Services Group Inc., the insurer that got an investment from Germany's Allianz SE this month, plunged 32 percent to $13.60 after reporting its first unprofitable quarter in five years. The shares were downgraded to ``neutral'' from ``buy'' at Merrill Lynch & Co., which said the company may need to raise capital.
Oct. 30 (Bloomberg) -- The economy suffered its biggest decline since 2001 in the third quarter, ushering in what may be the worst recession in a quarter-century and boosting the chances of Barack Obama and fellow Democrats in next week's elections.
Gross domestic product contracted at a 0.3 percent pace from July to September, according to a Commerce Department report today in Washington. The decline was smaller than forecast and stocks rose. Even so, the economy may be in for a larger drop this quarter after the record two-decade expansion in consumer spending came to an end.
``The crisis really kicked up in late September,'' Ethan Harris, co-head of U.S. economic research at Barclays Capital Inc. in New York, said in a Bloomberg Television interview. ``We're going to be looking at a very unfriendly GDP number in the fourth quarter, with a drop of 2 to 4 percent.''
The weak economy has been bad news for Republican presidential candidate Senator John McCain, who's fallen further behind Illinois Senator Obama as the credit crisis intensified. A Bloomberg/Los Angeles Times survey taken Aug. 15-18 showed McCain with 42 percent support to Obama's 41 percent; five weeks later, the poll showed Obama leading 49 percent to 45 percent.
``The economy is playing very well for the Democrats, especially since the financial shock hit,'' said Daniel Clifton, head of policy research for Strategas Research Partners in Washington. ``People just got scared.''
Stocks Higher
Stocks, which were up in futures trading earlier in the day, remained higher after the GDP report. The Standard & Poor's 500 Stock Index rose 1.4 percent to 942.73 as of 10:50 a.m. in New York. Benchmark 10-year Treasury note yields rose to 3.92 percent from 3.86 percent late yesterday.
The Federal Reserve yesterday warned of further ``downside risks'' even after cutting interest rates twice this month and pumping billions of dollars into markets.
The slump last quarter was the biggest since the third quarter of 2001, and follows a 2.8 percent growth rate the previous three months.
GDP was forecast to drop at a 0.5 percent pace in the third quarter, according to the median forecast of 75 economists surveyed by Bloomberg News. Estimates ranged from a 1.2 percent rate of expansion to a contraction of 1.9 percent.
The report is the first for the quarter and will be revised in November and December as more information becomes available.
Consumer Spending Drops
Consumer spending dropped at a 3.1 percent annual pace, the first decline since 1991 and the biggest since 1980, after President Jimmy Carter imposed credit controls. The median forecast was for a 2.4 percent drop.
The 6.4 percent rate of decline in spending on non-durable goods, like clothing and food, was the biggest since 1950.
Consumers have been hit by a triple whammy: rising unemployment, tightening credit and shrinking wealth.
Unemployment is at a five-year high of 6.1 percent and may rise to 8 percent by end of 2009, according to Jan Hatzius, chief U.S. economist at Goldman, Sachs & Co. in New York. Consumer borrowing fell in August by the most on record as banks tightened credit. And the steep drop in the stock market so far this quarter has wiped about $2.8 trillion from investors' portfolios.
Cutbacks in investments in business equipment and less spending on residential construction projects also contributed to last quarter's contraction, today's report showed.
A narrower trade deficit and a smaller decline in inventories prevented a deeper contraction. Excluding those two categories, the economy would have contracted at a 1.8 percent pace, the most since 1991.
Inflation's Last Burst?
The report also showed what may be the last burst of inflation before the economic slowdown forces companies to limit price increases. The price gauge rose at a 4.2 percent pace last quarter, the biggest gain in 17 years. Costs tied to consumer spending and excluding food and energy, increased 2.9 percent, the most in two years.
The Fed yesterday cut the benchmark interest rate by a half percentage point to 1 percent, matching a half-century low, and projected inflation would ebb.
``The intensification of financial market turmoil is likely to exert additional restraint on spending, partly by further reducing the ability of households and businesses to obtain credit,'' the Fed's statement said. ``The pace of economic activity appears to have slowed markedly.''
Campaigns Comment
Both presidential campaigns issued statements promising policies to revive growth.
``The decline in GDP didn't happen by accident -- it is a direct result of the Bush administration's trickle-down, Wall- Street-first, Main-Street-last policies that John McCain has embraced for the last eight years and plans to continue,'' Obama said in a statement. ``We need to grow our economy by creating jobs, providing tax relief for middle-class families and helping people stay in their homes.''
McCain's economic policy adviser, Douglas Holtz-Eakin, said in a statement that ``the economy is shrinking'' and ``Barack Obama would accelerate this dangerous course.'' He said McCain's policies would lower taxes, ``clean up Wall Street, clean up Washington and create nearly 2 million more jobs'' while Obama's would ``destroy nearly 6 million jobs over the next decade.''
It's the Economy
``The economy really does matter for elections,'' said Ray Fair, a professor at Yale University. A macroeconomic model he's developed to forecast the presidential elections put the odds of an Obama victory at about 80 percent, based on the latest GDP data. Fair said Obama's chances of winning may even be larger than that as the economy looks to have deteriorated even further since the end of the third quarter.
The National Bureau of Economic Research, the Cambridge, Massachusetts-based official arbiter of U.S. economic cycles, has yet to call a recession.
The group bases its assessment on indicators including GDP, employment, sales, incomes and industrial production, and usually takes six to 18 months to make a determination. According to the NBER, the last recession lasted from March to November 2001.
Chief executive officers from Ford Motor Co., Starwood Hotels & Resorts Worldwide Inc. and Caterpillar Inc. are among those in the past two months that have said the U.S. is in a recession.
``Finally consumers have capitulated,'' James Flaws, chief financial officer of Corning Inc., said in an interview on Bloomberg Television yesterday after the biggest maker of glass for flat-panel televisions forecast fourth-quarter sales and profit that missed analysts' estimates.
Whirlpool Corp., the world's largest appliance maker, this week said it'll cut 5,000 jobs, and forecast lower annual profit as the credit crunch clipped sales. Williams-Sonoma Inc., the biggest U.S. gourmet-cookware chain, yesterday forecast a third- quarter loss because sales slowed ``significantly'' during the past six weeks.
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