Savage Capitalism
A picture of what is really going on in the Shadow Banking System is beginning to emerge. It makes the coming slump much more troubling than those of the last 50 years. To begin with, we never had such large opaque pools of capital and derivatives before. The Growth of Credit Default Swaps (above) to more than $47 Trillion in the last two years is just one indication. Bill Gross said it best.
“The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system.”
As Ben Stein (surely no liberal populist) says in his column this morning, something has surely changed since the last financial crisis. It is the arrival of the pirate of the shadow system–new sort of savage capitalist–the hedge fund.
The new part is the hedge funds and the changing of Wall Street from a financing entity to a market manipulation entity. The new part is hedge funds with (supposedly) $1.5 trillion in capital, immense hedge funds within banks and investment banks. The new part is that they have so much money and so much selling power that they can do what capitalists really want and love to do: to make money not by betting on the markets, but by controlling the markets, by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets.
So last week it’s possible that Bernanke and Paulson decided to really punish some bad actors who were speculating on the down fall of the banks by betting in the Credit Default Swaps market. According to the very authoritative Gretchen Morgenson, they were the big losers last week in the Bear Stearns Bailout.
On the other hand, the big losers here are those who bought the insurance to speculate against the fortunes of two troubled companies. That’s because the value of their insurance, which increased as the Bear and Countrywide bonds fell, has now collapsed as those bonds have risen to reflect their takeover by stronger banks.
We do not yet know who these speculators are, but hedge fund and proprietary trading desks on Wall Street are undoubtedly among them.
So consider all those swaggering hedge fund managers and Wall Street proprietary traders who recorded paper gains on their credit insurance bets as the prices of Bear and Countrywide bonds fell. Now they must reverse those gains as a result of the rescues. If they still hold the insurance contracts, they are up a creek — and the Fed just took away their paddles.
We need to contemplate what these new forces that are trying to game the market mean for the future of our economy. Ben Stein feels that unless the Hedge Funds are more transparent and regulated:
As the hedge funds change the stock market into a chamber of horrors, the retirement hopes of tens of millions of Americans will be dashed, and the stock market as a place for sensible Americans to place their money for long-term growth will be destroyed. The stock market will be just a place for the sharks to eat one another, instead of eating us little fish, as they have been doing lately.
But the Savage Capitalists are not going to show their cards without a fight. Of course every good shark needs a lobbyist with a “go slow” line like,
“If we don’t tread very carefully on restructuring a very complex financial system, we might stifle the necessary animal instincts of a free market,” said Mark A. Bloomfield, president of the American Council for Capital Formation
The debate on the role of regulation in a market economy will probably be one of the most important of our generation. The Milton Friedman School of economic doctrine has been drilled into the brains of most Washingtonians by the Business Think Tanks that have dominated since 1980. Its basic principle is–all government regulation is bad. With the exception of a few real progressives, even Democrats are on the defensive when it come to the subject of regulation. But the battles at the Fed, the FCC, the FTC and the EPA over a rethinking of our Reagan era anti-regulatory bias will be the most interesting congressional fights of the next nine months.
[...] Tampa Bay News, Weather and Information | tampabaypost.com: Local Tampa Bay News and Weather wrote an interesting post today onHere’s a quick excerpt A picture of what is really going on in the Shadow Banking System is beginning to emerge. It makes the coming slump much more troubling than those of the last 50 years. To begin with, we never had such large opaque pools of capital and derivatives before. The Growth of Credit Default Swaps (above) to more than $47 Trillion in the last two years is just one indication. Bill Gross said it best. “The investment community has morphed into something beyond banks and something beyond regulation. [...]
Credit Crunch » Savage Capitalism
March 23, 2008 at 4:21 pm
It’s important to understand what KIND of regulation is needed here. Here are two specific examples:
a) standardization and clearing houses
A lot of the opacity of credit markets these days has to do with both the innovation in instruments being traded and the attendant confusion about what they all ARE and what quirks they might have. (Quick! How would you price this “snoball”?)
A lot of the trouble right now is sheer lack of bidding, which in turn relates to both subtle differences in what the contracts ARE and whom they are WITH (counterparties). The traditional institutional corrective for this problem is to standardize the contracts and use a neutral third party clearing house to help with simplifying the counterparty issues.
b) checks on conflicts of interest
We’ve have NINJA loans originated by fly-by-night operators knowing full well they will never see the borrower again or need to cope with default and foreclosure: conflict of interest. At the other end, we have bankers cutting each other immense bonuses based on products and trades that haven’t stood the test of time — and conveniently didn’t need to. Anybody in New York ever heard of a “vesting schedule”?
My overriding point here is that adding structure to a market need not “kill innovation” or otherwise mess with the creative power of capitalism. The “we don’t need no stinkin’ regs” attitude is just anarcho-stupidism — to coin a term.
STS
March 23, 2008 at 4:27 pm
If you are going to quote Ben Stein, to make a point, you should/ought to eat his prescription:
“WHAT to do? Laws requiring far more transparency in hedge fund trading are needed. They need to be enforced. And, second, there are laws against schemes and artifices to defraud. The current Securities and Exchange Commission basically ignores them.”
A single step more than that is too much. And I have some other regs and enforcement elsewhere we can get rid of – so we need no new increase in the size of government.
Morgan Warstler
March 23, 2008 at 5:05 pm
Morgan- So we are agreed that we need new regulations that the Hedge Funds need to disclose their positions and the SEC also needs to enforce the fraudulent lending statutes. OK?
Jon Taplin
March 23, 2008 at 6:36 pm
STS- Do you think the Fed is going to try to inflate its way out of a recession? My guess is that the GDP number everyone is waiting for will not be in negative growth territory because inflation is 3%+.
Jon Taplin
March 23, 2008 at 6:40 pm
Yes.
Now will you please tell me the % of income you think the top 1% of this country’s earners ought to have taken from them. Tell me your new tax ideas later, I want to know what you think is fair now.
And don’t go emotionally factoring in hedge fund guys, we’re talking about the top 1%. I’m asking for a hard fast %, and I want a real answer.
Morgan Warstler
March 23, 2008 at 7:10 pm
At one level, yes absolutely. When losing altitude, add heat to the air in the balloon.
That’s what the Fed does (I look forward to the lampooning this metaphor may incite …) But what is new about the past several months is the concern that the balloon is starting to tear open. The credit measures (eg. TAF) are trying to avert a cascade of insolvency
which debilitates normal lending to non-financial businesses. That repair work is taking priority over the usual considerations of growth vs. inflation.
Using the analogy President Bush attempted, the Fed is gripping the wheel trying to adjust to a patch where the normal control/response is disrupted temporarily. The extreme leverage in
vogue with both banks and the “shadow banks” left them rather vulnerable to this
sudden episode of selling under pressure. Reducing leverage can be done smoothly IF
you’re the only one doing it. But when everyone is trying it at the same time, and in roughly the same markets, it can be ugly.
Once the threat of leverage-induced “lock-up” of the financial sector passes, I tend to think the Fed would be reasonably willing to resume a more hawkish posture and crank rates up to fight inflation and defend the dollar.
Positive nominal growth? That’s an intriguing possibility. It sure would confuse everybody nicely. We’ll see.
STS
March 23, 2008 at 7:55 pm
You have pushed me to work on this tax issue. Its important. I want all the help I can get. I really think we have to look at a VAT style tax system. That would allow us to lower the fed. Income tax and leave 60% of VAT revenues at the state level. I’m just thinking out loud here. Over the next couple of weeks we should discuss this.
Jon Taplin
March 23, 2008 at 8:44 pm
C’mon!! Why can’t you just eyeball it?
Is 40% enough? 45%? More than half?
I swear, I’ll do your VAT thing, but I’m asking a question, can I get an answer?
Morgan Warstler
March 23, 2008 at 8:49 pm
The maximum taxrate on someone earning $250,000 a year should be 34%. Is that specific enough? I’d like the max federal tax rate to go to 20% and raise the state tax rate, or give the states most of the VAT receipts.
Jon Taplin
March 23, 2008 at 8:54 pm
Ok, that sounds good. But what about for guys making $500K, $1M and $50M?
Can we agree on a maximum tax rate of 34% for everyone?
Morgan Warstler
March 23, 2008 at 8:57 pm
STS-The MIT econ paper is great. It’s like the book “When Genius’s Fail”. If nominal GDP growth is -1% and inflation is 3.5%, it still looks like a good quarter to an idiot pundit trying to deny the recession like Kudlow.
Jon Taplin
March 23, 2008 at 8:58 pm
Jon,
I just noticed that Bruce Wilder is a bit of a Taplinesque “New Federalist”. Check out this comment on Economist’s View (which is where I typically follow him).
STS
March 23, 2008 at 11:27 pm
The Bear deal is obviously alot more fun than previously imagined.
http://www.nytimes.com/2008/03/24/business/24deal.html?ei=5065&en=cf92462819035b80&ex=1207022400&partner=MYWAY&pagewanted=print
——
And just to close our previous Q&A:
Can we agree on a maximum tax rate of 34% for everyone? Even for guys making for guys $500K, $1M and $50M?
Morgan Warstler
March 24, 2008 at 5:35 am
Wait ’til the lobbyists get going on exemptions to VAT! There’s going to be a lot of wrangling to try to make it less regressive…food costs for the poor and all that… VAT also gets complicated in the wholesale to retail to consumer chain unless it’s simply a retail consumption tax. I ran into major weirdness with the California sales tax regulations many years ago. My company recorded the Grateful Dead’s “Europe 72″, and the State Board claimed we owed sales tax on recording services performed in Europe! Never mind that neither the Grateful Dead nor Warner Brothers Records were the final consumer of the product…in those days vinyl records…and that we had performed services, not sold products other than 2″ recording tape… We won…but it cost us.
Rick Turner
March 24, 2008 at 5:48 am
The tax rate doesn’t matter, as long as they actually pay it. Personally I’m for a graduated tax rate and zero deductions. Capital gains should be treated same as normal income.
Kevin
March 24, 2008 at 8:03 am
Kevin, then please humor me with the graduated schedule you suggest… whats the top tax rate? Whats next?
Morgan Warstler
March 24, 2008 at 8:22 am
Rick,
I love Europe ‘72! That little snippet of information made my day! Gonna go dig that out again!
Sad that you had to defend yourselves against overzealous tax collectors.
There is an answer for the tax problems, and I like some of the things that I have heard here. One of the things that I think we should do is remove the cap on Social Security Taxes. Currently, I think a person making $110k pays the same as a person making $110m. Remove the cap I say, and tell the people that are paying it to find another country they can make that kind of money in and be allowed to keep it (see Russia, China, etc.). I like percentage flat taxes. Without loopholes. I want something equitable for all, and a flat percentage seems to be that to me.
If you are wealthy, that tax appears to hurt more than it actually does. If you are poorer, you can sleep better at night knowing that Warren Buffet is paying the same percentage.
Or am I just too simple-minded to see the big picture?
- Zhirem
Zhirem
March 24, 2008 at 12:16 pm
“Remove the cap I say, and tell the people that are paying it to find another country they can make that kind of money in and be allowed to keep it (see Russia, China, etc.).”
Be careful what you wish for.
Zhirem, I encourage you to list out a single amount of taxes you think the vbery richest should pay, rather than turing Soc. Sec. into just another federal incomes tax, can you give me a % you think is high enough, so if someone asked for higher than that, I would know you’d turn to them and say, “that % is too high!”
Maybe we agree. But I need to know specifically how much you want to take from our rich.
Can we agree on a maximum tax rate of 34% for everyone? Even for guys making for guys $500K, $1M and $50M?
Morgan Warstler
March 24, 2008 at 12:36 pm
Can we move the tax discussion over to my new post on this?
http://jtaplin.wordpress.com/2008/03/24/new-federalism-the-global-resource-squeeze/
Jon Taplin
March 24, 2008 at 12:41 pm
“Adam Smith’s invisible hand has a puppeteer: the Federal Reserve.”
http://www.nytimes.com/2008/03/25/business/25sorkin.html?_r=1&hp&oref=slogin
John Hurt
March 25, 2008 at 5:36 am
“So right now the so-called median home price is $196,000, roughly back to 2004 levels. And it’s still about 60 percent higher than ten years ago. (Studies show homeowners generally don’t sell for about a decade, so I use ten years as the comparison.) But here’s where Gentle Ben comes in. A $196,000 home and a 10 percent equity down payment leaves $176,000 to be financed, perhaps with an adjustable-rate mortgage. And since the Fed slashed its target rate and LIBOR rates dropped roughly in sync, the owner of this median-price home is now saving $300 a month compared to last summer, or about $3,600 a year.
That’s a big rebate from the Fed. It’s about three-times bigger than what Uncle Sam is promising. The official IRS notice says the average married couple filing jointly may get $1,200. But Fed head Bernanke is giving median homeowners $2,400 more than that amount. A lot better, right?”
http://www.realclearpolitics.com/articles/2008/03/ben_bernanke_is_my_kind_of_guy.html
Morgan Warstler
March 25, 2008 at 6:45 am
[...] 4, 2008 · No Comments Last week I wrote that a certain kind of Savage Capitalist was responsible for a good deal of market manipulation. Just how powerful that force was, leaked [...]
Who Was Shorting Bear Stearns? « Jon Taplin’s Blog
April 4, 2008 at 8:04 am
[...] As I pointed out last month, this new savage capitalism works (in the words of Ben Stein) “not by betting on the markets, but by controlling the markets, by putting so much sell side (and occasionally buy side) firepower in play that they know they will move the markets.” These market manipulations have begun to distort the prices of basic commodities like the aforementioned wheat and oil, leading to the food riots we have talked about in the last few weeks and pain at the gas pump. [...]
Rich Get Richer « Jon Taplin’s Blog
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getluky.net » Blog Archive » A Couple Observations About Financial Politics
September 17, 2008 at 10:08 am
[...] The Growth of Credit Default Swaps to more than $47 Trillion in the last two years is just one indication. Bill Gross said it best. “The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system….We need to contemplate what these new forces that are trying to game the market mean for the future of our economy. Ben Stein feels that unless the Hedge Funds are more transparent and regulated: As the hedge funds change the stock market into a chamber of horrors, the retirement hopes of tens of millions of Americans will be dashed, and the stock market as a place for sensible Americans to place their money for long-term growth will be destroyed.” Source: http://jtaplin.wordpress.com/2008/03/23/savage-capitalism/ [...]
September 18, 2008 « Rising in Phoenix
September 18, 2008 at 4:22 am
[...] a year ago, I wrote that the hedge funds were turning Wall Street into a casino where the fix was in. The extreme volatility you see on the chart above of the last five days [...]
Savage Capital II | ABR Magazine
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