Big finance - the too-big-to-jail banks that dominate the economy and government - is designed for financiers and does not benefit most people. That is why many are in rebellion against the looting class of Wall Street. But if we don't like Wall Street finance, what would we replace it with? What would a finance system that served and protected the people look like?
It is time to put together a new kind of financial system. Since the crash of 2008, not only do fraud and high-risk investments continue with little regulation and lax enforcement, but policies that protect people have weakened. Experts predict that another collapse of the big banks is very possible. In our fragile economy, another crash could have devastating consequences.
The ideas we put forward in this series of articles are not final, but are a work in progress. In part I, we focus on approaches to regulation and breaking up the too-big-to-fail banks, as well as on the risk that derivatives pose to depositors. In part II, we will discuss the Federal Reserve, public banks and ways to opt out of Wall Street now.
We see this series as part of ongoing dialogue and action to remake our cannibalistic finance system. Thankfully, many people have been thinking in depth about pieces of a new financial system, and we bring some of these ideas together here.
Enforcement Will Be Central No Matter What We Do
We live in a time of cheater economics. In fact, the failure of enforcement in response to the current economic collapse has been staggering when compared to the response during the savings and loan crisis of the 1980s and 90s. The history of banking shows that corruption is a problem when enforcement is inadequate. As financial crimes investigator Bill Black points out, "Bad ethics drive good ethics out of the marketplace because cheaters prosper."
Conservative economists say that if you do not deter white-collar crime, you will get more of it. In criminal justice theory, the concept of "no more broken windows" has become an excuse to arrest and jail people who wash car windows at intersections, petty marijuana offenders and those who engage in minor criminal behavior. But in the case of the economic collapse, Black says, "We do not have broken windows; we have broken banks and broken countries."
The prediction of widespread fraud due to lack of enforcement has come true. A recent study of the mortgage crisis confirmed that control fraud, committed by people responsible for the legitimacy of loans, was endemic within the most elite financial institutions. Black summarizes, "The key conclusion of the study is that control fraud was 'pervasive.'"
Black pointed out that the actual policy of the Department of Justice (DOJ) was not to prosecute the big banks because they could have a systemic impact if they collapsed. The joke of "too big to prosecute" actually became the policy of the federal government.
The number of investigators working on white-collar crime is inadequate. Black points out that we have about 1 million people working in the criminal justice system, but only 2,500 who investigate white-collar crime. Those 2,500 cover 1,300 industries - fewer than two FBI agents per industry. They cannot really investigate, or even understand, an entire industry, so the only way enforcement occurs is when there are criminal referrals by regulatory agencies such as the FBI, the Securities and Exchange Commission (SEC) and the Federal Deposit and Insurance Corporation (FDIC).
During the savings and loan scandal, which Black says was 1/80th the size of the current crisis in terms of losses and criminality, his previous agency, the Office of Thrift Supervision, made over 30,000 criminal referrals and produced over 1,000 felony convictions in major cases. The top 100 list of the worst S&L frauds involved 300 institutions and 600 individuals. Virtually all were prosecuted, with a 90 percent conviction rate. This same agency which was supposed to regulate the banks made zero referrals in the current collapse.
Even banks that are involved in laundering illegal drug profits have not undergone criminal prosecution. Referrals have essentially ended and there have been no serious criminal prosecutions by the federal government. In fact, the media interviewed whistleblowers - another possible source for criminal investigations - and Black reports that none were even contacted by the FBI.
Black writes that the SEC enforcement has also been inadequate. He says the commission's web site:
showcases its record of crisis-related actions against more than 150 firms and individuals, with sanctions totaling $2.7 billion. The $2.7 billion figure is supposed to sound enormous. It is orders of magnitude too small. Losses caused by the fraud epidemic in the U.S. are well in excess of $15 trillion. A trillion is a thousand billion.
Not only have the SEC's civil enforcement and fines been woefully inadequate, but the SEC does not require any useful admissions of guilt nor has it referred any cases to the DOJ for criminal prosecution.
The FDIC has also been inadequate. At the request of rule-breaking bankers, the FDIC, which insures bank deposits in the United States and shuts down failing banks, has, since 2007, repeatedly settled charges of banker wrongdoing by agreeing to "no press release" clauses that keep the settlements a secret, The Los Angeles Times reports. Further, so far the agency has been able to recover only $787 million of the $92.5 billion lost to bank collapses between 2007 and 2012.
One major reason for this failure is the revolving door in Washington. Regulators come from the finance industry and return to it after their time in government. This is most recently exemplified by Lanny Breuer, who was responsible for banking enforcement at the DOJ and made no bank prosecutions. He just left the DOJ to work for the corporate law firm, Covington and Burling, where he is expected to earn a roughly $4 million annual salary. The recent appointments of Jacob Lew as Treasury Secretary and Mary Jo White as the head of the SEC continue the Wall-Street-on-the-Potomac revolving door. Lew's appointment maintains the control of Treasury by Wall Street in the tradition of Bob Rubin, Larry Summers, Henry Paulson and Timothy Geithner.
How widespread is securities fraud? Black points out that by 2006, 40 percent of all the loans made were "liar's loans." This was the term used by the financial industry to describe loans that were based on false incomes and false appraisals. That is over 2 million fraudulent loans. These fraudulent loans grew by over 500 percent between 2003 and 2006 and were an important factor in the hyperinflation of the housing bubble.
Studies have repeatedly shown it was the lenders who put the lies in liar's loans. Testimony, which you can read in the Financial Crisis Inquiry Commission Report, details how loan officers and brokers were taught that the quality of the loans did not matter; if they led to default, it was irrelevant. Making one single jumbo loan ($600,000 house) would result in a fee for the loan broker (who is at the bottom of the finance chain) of $20,000. Brokers only got the fee if the loan was approved and sold, so they made sure that the borrower's income was inflated. Black notes a study which showed that in 60 percent of the cases, borrowers' income was inflated by at least 50 percent. So, the system invited fraud and the lack of enforcement ensured it became widespread.
No matter what kind of finance system we have, there is a need for strong, independent enforcement with transparency and audits.
Break Up the Big Banks and Prevent Them From Getting Too Big Again
The first problem that must be confronted is to break up the big banks, the systemically dangerous institutions that are too big to fail or jail. These banks corrupt the system to the point where Sen. Dick Durbin (D-Illinois) said: "And the banks - hard to believe in a time when we're facing a banking crisis that many of the banks created - are still the most powerful lobby on Capitol Hill. And they frankly own the place."
Neil Barofsky, the former overseer of the government's Troubled Asset Relief Program (TARP), said on The Daily Show that one reason TARP failed to bail out homeowners was, "A lot of the biggest banks did and still do hold the guns to our heads."
In addition to corrupting the political and regulatory system, these banks dominate the economy and prevent competition in the finance industry. As George Will writes in The Washington Post:
In 2011, the four biggest U.S. banks (JPMorgan Chase, Bank of America, Citigroup and Wells Fargo) had 40 percent of all federally insured deposits. Today, the 5,500 community banks have 12 percent of the banking industry's assets. The 12 banks with $250 billion to $2.3 trillion in assets total 69 percent. The 20 largest banks' assets total 84.5 percent of the nation's gross domestic product.
This concentration of wealth in the largest banks has gotten worse under the reign of President Obama and former Treasury Secretary Geithner. Their legacy is that the 0.2 percent now control 69 percent of everything.
Black points to three critical interrelated problems that all stem from the systemically dangerous institutions, the too-big-to-fail-or- jail banks which have a long history of crimes. When the next one fails - not "if," but "when" - we have to shrink these banks so they no longer pose a systemic risk. Three problems with the big banks:
1. They get a huge, inherent subsidy (without which they would not be profitable). There is no chance for competition or markets because big banks crush the opposition
2. They are too big to prosecute, according to the government leadership, which destroys integrity and the concept of justice.
3. Crony capitalism cripples democracy because banks have so much economic power that they get immunity and are able to dominate and corrupt politics.
So the top priority in creating a finance system that serves the people has to be to get rid of systemic institutions that are massively criminal institutions. Our most supposedly "reputable" banks are pervasively criminal.
Once the banks are broken up, they need to be prevented from getting too big. Black suggests passing laws that forbid them from getting too large by putting an absolute limit on their size, perhaps based on a percentage of GDP; currently, Black suggests a limit of $50 billion to prevent banks from posing a systemic risk. Dallas Fed Chair Richard Fisher suggests $100 billion. This change would transform the global financial system so that there is room for public banks, credit unions and community banks to compete with commercial banks.
There is a lot of support for breaking up the big banks. Fisher has called for the break-up of the systemically important banks, as has Daniel Tarullo, a member of the Fed Board of Governors. In addition, many former bank executives see the big banks as too big, including former CEO of Citigroup and father of the modern too-big-to-fail bank Sandy Weill, former Merrill Lynch CEO David Komansky, former CEO of Citicorp John Reed, Chairman and CEO of M&T Bank Robert Wilmers, Chief Researcher of the Dallas Federal Reserve Harvey Rosenblum, former CEO of Morgan Stanley Phil Purcell, former Citigroup CFO Sallie Krawcheck, former partner at Goldman Sachs Roy Smith, and Former Chairman of Citigroup Richard Parsons. Sen. Sherrod Brown (D-Ohio) introduced legislation to break up the big banks.
Half of Americans support breaking up the big banks and only 23 percent oppose it. according to a 2013 Rasmussen Poll. And an IMG Forum survey of 39 US economists shows that a majority, 54 percent, either agreed or strongly agreed that we should shrink the big banks. Only 10 percent disagreed, and no one strongly disagreed.
Others, like Leo Panitch, the Canada research chair in comparative political economy and a distinguished research professor of political science at York University in Toronto, suggest that rather than breaking up the big banks, we take them "into the public domain and turn them into public utilities and have them serve the functions that are needed, in terms of a financial market, in a way that is determined by state policy and by a system of democratic planning."
Big Risk on the Horizon: The Unregulated, Massive Derivatives Market
There are many areas of regulation needed, such as the return of Glass-Steagall to separate commercial banking and investment banking. One area where there is a lack of regulation that deserves special attention is the derivatives market.
Derivatives are "a financial product derived from another financial product." They are not traded on well-regulated markets (like the Chicago Board of Trade) but are contracts between parties who want to trade risks outside of a recognized exchange. According to this report from America Blog, "The contracts are not standardized" and "the parties aren't vetted by any controlling institution." Further, "the only guarantee that either party will get paid is trust ... or the naked belief that they just can't lose on this one."
Another way to define derivatives as the blog Demon-ocracy would have it: "Pick something of value, make bets on the future value of 'something,' add contract and you have a derivative." Derivatives really are a form of betting on the future in an unregulated casino market:
A derivative is a legal bet (contract) that derives its value from another asset, such as the future or current value of oil, government bonds or anything else. Ex- A derivative buys you the option (but not obligation) to buy oil in 6 months for today's price/any agreed price, hoping that oil will cost more in future. (I'll bet you it'll cost more in 6 months). Derivative[s] can also be used as insurance, betting that a loan will or won't default before a given date. So it's a big betting system, like a [c]asino, but instead of betting on cards and roulette, you bet on future values and performance of practically anything that holds value. The system is not regulated [whatsoever], and you can buy a derivative on an existing derivative.
So, these unstandardized, off-market, unregulated gambles (a k a "investments") are highly risky. And here is the scary part: the size of the derivatives market. Based on 2010 data, according to America Blog, it has "$1.2 quadrillion in notional value; at least $12 trillion in cash at risk." The notional value of the derivatives market is 20 times the size of the world economy. The world's annual GDP is between $50 trillion and $60 trillion. The $12 trillion actually at risk (credit exposure) is 20 percent of the world economy and just under the $16 trillion US economy. So, if the derivatives market crashes, who is going to bail out the banks that collapse as a result?
The recent collapse in Cyprus revealed who will be at risk when the next collapse occurs: the depositors. Ellen Brown reports Cyprus can happen in the United States: "A joint paper by the US Federal Deposit Insurance Corporation and the Bank of England dated December 10, 2012, shows that these plans have been long in the making; that they originated with the G20 Financial Stability Board in Basel, Switzerland (discussed earlier here); and that the result will be to deliver clear title to the banks of depositor funds."
Further, she told us in a radio interview that in US banks' living wills, which they are required to develop under Dodd-Frank to explain how they will survive an economic collapse, they include transforming deposits into bank stock. As we saw when Lehman Brothers failed, bank stock was worth only pennies on the dollar. This puts not only every person who has accounts in the big banks at risk, but also state and city governments and pension funds that do.
The global derivatives market comes primarily from big banks in the United States. According to the Office of the Comptroller of the Currency's third quarter report, the total amount of derivative exposure at just the top four banks is now some $212 trillion (notional exposure) or 93.2 percent of the total $227 trillion in outstanding US derivatives. With a national economy of $15.8 trillion, if the big banks lose derivatives bets of 10 percent of this notional value, it will be bigger than the entire US economy. Here are some charts that show what is at risk, the banks that are at risk and some of the security fraud they have been involved in.
The collapse that comes from this unregulated market could come very quickly because, says a Demon-ocracy writer, "derivatives are traded in microseconds by computers, we really don't know what will trigger the crash, or when it will happen, but considering the global financial crisis, this system is in for tough times, that will be catastrophic for the world financial system."
Derivatives put the world economy at serious risk, and the too-big-to-fail banks betting in the derivative casino do not have a record for being corporations we can trust. Indeed, their record is one of "pervasive" fraud. Derivatives need to be aggressively regulated, quickly! But right now the government is moving to weaken the already inadequate regulation that exists.
Regulation of big finance is going to get more difficult if the Trans-Pacific Partnership becomes law. It will protect big finance by, one, preventing regulation of the finance industry by locking in a model of extreme financial-service deregulation; and, two, allowing capital to move in and out of countries without restrictions. This prevents countries from controlling the flow of capital, which has many negative consequences. It will also make it more difficult to create public banks because the agreement is opposed to state-owned enterprises.
Continuing the Discussion
This article is the first of a two-part series. The issues examined here - shrinking the banks, regulating their practices (especially the derivative market) and enforcing the law against the white-collar crimes of the finance industry - are only the beginning of remaking the finance system. In Part II, we will describe how the Federal Reserve can be re-made and central banking designed to serve the people, not the bankers and how every state and many cities should have their own public banks to build local economies, as well as outline the many steps you can take right now to opt out of Wall Street finance.
Remaking the finance system so it serves and protects the people is foundational to creating a new economy. And the deep corruption in the Wall Street finance system, corruption the participants are well aware of, presents an opportunity for transformative change. The American public, elected officials and even those involved in the finance system know that change is urgently needed and may be forced on us sooner than expected if the system collapses again. It is hard to imagine not looking back at this time period, where there was inadequate enforcement, corrupt regulation and virtually no regulation of the massive derivatives market, and not saying "we knew it would collapse." The path to disaster that the country is on seems obvious, but the future beyond Wall Street finance is not yet determined. Creating the economy we want is the responsibility of all of us.
Next week, in Part II, we examine remaking the Federal Reserve, creating public banks throughout the country and opting out of Wall Street now. You can listen to "Big Finance Fraud and Public Banks" with Bill Black and Ellen Brown on Clearing the FOG Radio.