Saturday, May 16, 2009

Is the System Still Rigged?

A past colleague of mine wrote an excellent article in the Montreal Gazette. Consultant Luc Vallée, the former chief economist at the Caisse de dépôt, thinks the system is still rigged:

The end of April marked the first 100 days in office of U.S. President Barack Obama; elected on the promise of change. Change we could believe in.

I believe that he meant it. However, by now, he met all these nice Wall St. types; powerful, quite smart, extremely charming and actually very convincing guys. Like President Obama, they want to re-establish trust in the system but they also want the system to keep working in their favour.

So how did the new president perform so far on reforming the financial sector? The approval of the markets during the last few weeks certainly suggests that he has done quite well. But let's take a closer look at things.

In raising the rhetoric against free trade and bonuses, Obama definitively tried to side with the average guy. But that sort of populism won't do it. Free trade was the backbone of global prosperity for the last few decades. Stopping it would put us on a destructive path. Moreover, bonuses are, unfortunately, legal contracts. However tempting it may be, nullifying these contracts certainly would be a trust buster. And who knows what might happen if America starts going down that path?

There are a lot of very tempting things that I refrain from doing in my life because I know they would come back to haunt me later. I choose, instead, to go see a hockey game if I need some release for my frustrations. I call this happiness by design! So far, the president has resisted his initial populist impulse but has not yet proposed viable alternatives.

Take the case of executive compensation. The problem is not with the bonuses themselves, but rather why and how some of these bonuses were awarded in the first place.

Indeed, I have nothing against flexible or performance-based compensation. It may actually be a very effective way to increase the flexibility of the U.S. economy and to help reduce unemployment in times of crises. The problem lies with the system of governance that awarded the bonuses and hence created their perverse structure. Many of those payment schemes would never have seen the day had they been designed by people held accountable for their actions. Making executives and directors personally liable for unpaid bonuses would certainly help focus their attention.

Obviously, when individuals have the power to design their own incentive reward system, abuses can be expected; all the while claiming that it is all in the shareholders' interest. The privatization of gains and the socialization of losses suit many people just fine if they stand to gain more as bonus recipients than they stand to lose as taxpayers; perhaps not very ethical but human nonetheless. That is precisely why we have the separation of powers in so many of our institutions: to avoid such conflicts of interest.

Similar dynamics led U.S. banks to overlook the opportunity to recapitalize themselves more aggressively last year when there was still time to save the financial system and the economy. It was socially optimal to do so, but the optimal private decision for a banker was to avoid dilution and gamble that the system would survive or be saved.

By doing nothing, at least bankers stood a chance to avoid dilution if the system endured. Obviously, if all bankers had raised enough fresh capital, they would have increased the likelihood that the financial system would survive. However, each individual banker elected instead to do nothing as their individual private gain would have been maximized if "others" behaved responsibly. Obviously, every selfish banker, able to make the same reasoning, waited. In any case, they figured that, in the eventuality of a disaster, the government would come up with the money. And the money did eventually come. One must admit that the system does appear to be rigged in favour of the few and that it undermines the welfare of its citizens.

What should we then think of the latest plan proposed by Treasury Secretary Timothy Geithner to save the financial system? Private equity and hedge funds are to buy toxic assets from banks using government subsidies. Isn't that the left hand selling assets to the right hand? The left hand gets to clean its balance sheet and gains access to fresh capital while the right hand stands to make a killing if the plan succeeds; while leaving the taxpayers to clean up if it does not. I get the feeling that both hands belong to the same banker's body while the only taxpayers' involvement is to finance the scheme and clean up the mess.

What else could be done? Reduce outstanding mortgages for those who need it the most, improve financial information and draft regulation that aims to get rid of conflicts of interests and sets the right incentives for executives. In other words, democratize finance! Wouldn't that be a change we could really believe in?

Democratize finance? For that we need the unemployment rate to double from these levels and a social revolution. I doubt either will happen anytime soon but who knows, 2009 isn't over yet and 2010 might bring some nasty surprises.

Let's look at the latest attempt to "democratize finance". The vilification of credit-card companies—not entirely undeserved—has reached fever pitch. On Thursday, President Obama gave a speech in Albequerque, N.M. and shared some of his thoughts in an effort to help push through a bill, currently in front of Congress, that would overhaul the way the credit-card industry interacts with its customers, including the interest rates and fees it charges:
"You should not have to worry that when you sign up for a credit card, you're signing away all your rights," the President said. "You shouldn't need a magnifying glass or a law degree to read the fine print." (Read "The Real Problem with Credit Cards: The Cardholders.")

The industry, naturally, is crying foul. Having the flexibility to change interest rates and charge all sorts of fees lets card issuers free up more credit for more people, they argue: folks with lower prospects for repayment pay higher interest rates, while good, credit-worthy customers don't have to pay as much. Plus, they say, now is the exact wrong time to re-legislate the lending process. Thanks to the credit crunch and soaring default rates, card issuers are already reeling in credit limits and accepting fewer new applications. "There are two ways of managing risk—for a particular borrower and across a portfolio," Ken Clayton of the American Bankers Association recently explained. "If risk-based pricing changes, lenders will have no choice but to contract credit."

That sort of thinking, while valid, misses the larger picture. If one brackets the equally-as-legitimate notion that Americans probably should have less access to credit-card borrowing and simply dissects the bill before Congress, one starts to see that the proposed changes aren't really about dictating what a card company can or can't charge people who borrow money. There's a way to do that—impose interest rate caps, as many states' usury laws do. That isn't what Congress is on track to do. Instead, the new law, which would build on regulations issued by the Federal Reserve and other agencies at the end of last year, would, above all else, inject transparency and fairness into credit-card contracts.

That goal is easily seen in the legislation's key feature: limitations on how card companies treat customers' existing balances. When you sign up for a credit card, you agree to pay a certain interest rate on the balance you carry—you enter into a legal agreement to that end—but historically your card company has been able to change that rate for all sorts of reasons. Maybe you charge up a greater chunk of your credit limit than normal. Maybe you're late on a payment to some other company. In recent years, the difference between the interest rate folks sign up for and the average penalty rate imposed later on has skyrocketed, from 8.1-percentage points more in 2000 to 16.9 points more in 2008, according to the Center for Responsible Lending. (Read a brief history of credit cards.)

Tellingly, the proposed law doesn't try to tweak those figures. If you go from being a good credit risk to a bad one, credit card companies can still take steps to make sure they continue to be adequately compensated. When you go to buy new things, they can charge you 30% a year if they want to. The thing they wouldn't be allowed to do under the new law is go back and change the terms of your original agreement—that is, hike your interest rate on existing balances—except in a very few situations, such as you egregiously failing to pay your bill (for 60 days or more in the version of the bill before the Senate).

The approach therefore isn't to smack down credit-card companies for high interest rates, but to hold everyone to the original agreement about how much credit will cost. "Virtually no other contract in this country allows a business to change the terms of an agreement once a purchase has been made," says Travis Plunkett of the Consumer Federation of America. "That's the main issue." (One Senator did suggest an interest-rate cap, but that was shot down.)

Other provisions of the law are similarly set up. A card company can still change the terms of your contract. It just has to give you 45 days notice. It's still possible for an issuer to assess a charge when you go over your credit limit. But you'll have to have indicated that you want to be able to go over your credit limit in the first place, instead of having your card denied. Companies can still set minimum required payments however they see fit. But they'll be required to tell you how long it would take to pay off your balance if you stick to that minimum amount each month.

A few of the changes would be more heavy-handed. Those phone-payment fees would be prohibited outright (unless a customer asks for expedited service—a genuine additional cost which the card company would be allowed to pass along). It could also be substantially harder to market or sell credit cards to young people (either those under 18 or 21).

But for the most part, the bill before Congress isn't about changing the game on card companies. It's about creating a fairer set of rules to play by.

Interestingly, some think cap or limit on fees will cause credit card companies to limit their exposure particularly to minority and inner-city areas, since those with low incomes are at higher risk for default.

[Note: According to Reuter, U.S. credit card defaults rose in April to record highs, with Citigroup and Wells Fargo posting double digit loss rates, as the recession slashed more than 2 million jobs since the beginning of the year.]

Others are not convinced that that the bill could cut access to credit for millions of Americans but worry that once new credit-card rules take effect next year, card companies might cut off consumer credit even more.

I happen to think that banks, credit card companies, insurance companies, hedge funds, private equity funds, mutual funds - not to mention HMOs - have been raping people with fees for such a long time that it's time we reintroduce usury reform.

[Note: Read Illinois Progress, Durbin on Congress: The Banks "Own the Place".]

Go back to read my comment on banking with hedge funds and bailing out alternative investments. Public pension funds investing in hedge funds that then turn around and charge desperate businesses outrageous fees to extend them a loan during a credit crisis. Not only is this risky, it's a scandal and it should be illegal for public pension funds to invest in these type of "asset-based lenders".

Earlier this week I listened to Charlie Rose interviewing Elizabeth Warren, Naomi Klein and William Greider. If you didn't listen to these interviews, take the time to watch the entire show.

There is a crisis of leadership and while millions worry about losing their pensions, including retired autoworkers here in Canada, nobody is hatching a survival plan for retirement plans.

Finally, I don't know or care if the world's power elite is meeting Athens plotting to sink the global economy. I have been reading Charlie Skelton's Bilderberg files, mostly for amusement, but my thoughts are that any attempt to stop rigging the system and truly democratize finance will have to come from the bottom-up, not the top-down.

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