The Symbiotic Washington-Wall Street Alliance

Despite all of the political rhetoric surrounding financial reform legislation, “Too Big To Fail”, over leverage in the banking system, and high risk bets at proprietary Wall Street trading desks will not be resolved in the pending legislation because Washington and Wall Street have a symbiotic relationship held together by the realization on both sides that they need each other for survival.

Recently, The Wall Street Journal (‘Banks Trim Debt, Obscure Risks’, Rapoport & McGinty, May 25, 2010) revealed that the large Wall Street banks manipulate (“window dress”) their end of quarter numbers to make it appear that they have significantly less leverage (and therefore more capital) than, in reality, they have.  In looking at 10 quarters of average data that the largest eight banks are required to disclose, the Journal found that, on average, borrowings were 41% higher than reported on their required quarterly “Call Report”.  Those reports only require a snapshot of the balance sheet on the call report date, i.e., the last business day of the quarter.  So, by significantly reducing “borrowings” on the last day of the quarter, they are able to hide their true leverage and technically produce higher capital ratios for their regulatory reports.

Such leverage, of course, was and continues to be the major cause of financial instability.  Leverage, along with the risks taken by the proprietary trading desks of the “Too Big To Fail” were supposed to be fixed by the financial regulation bill now in a House-Senate conference committee.  But, a closer look at the pending legislation reveals that neither excessive leverage nor the risks taken on the proprietary trading desks have really been addressed.  A Wall Street Journal opinion piece entitled ‘The New Lords of Finance’ (May 24, 2010), indicates that the Volcker Rule (restrictions on proprietary trading) “is really a Volcker Suggestion”, as the bill gives the appointed regulator the “authority to immediately rewrite the law”.  Imagine the lobbying and campaign contributions that are now about to take place!

Let’s not forget that the new financial regulations were also supposed to resolve the “Too Big To Fail” issue, itself.  But, according to the Journal, the pending legislation fails here too.

… the discretion handed to the FDIC as the resolution overseer allows a replay of the AIG debacle in which the company was used as a conduit to pay counterparties 100 cents on the dollar

Remember that the beneficiaries of the AIG payouts of 100 cents on the dollar for AIG highly impaired credit default swaps were Goldman Sachs, JPMorganChase, Citigroup etc.

The FDIC will now be empowered to do the exact same thing, except that it will be allowed to discriminate even further – with the discretion to give some creditors a total bailout while imposing losses on others.  Think United Auto Workers versus Chrysler bond holders.

Given the gravity of the financial meltdown and its implications for the well being of the economy, one has to ask why neither the leverage nor the proprietary trading (gambling) issues of the “Too Big To Fail” are being adequately addressed.  The fact is, there is a symbiotic relationship between the giant banks and Washington, D.C.  Worse, the recent actions of the European Central Bank (ECB) reveal that this problem is not endemic to the United States alone.

So, why the kid gloves?  As government expands and the politicians deficit spend furiously to try to turn the economy around in order to save their own jobs come next election, who buys all of this new debt?  There had been fears in the marketplace that the explosion of debt would find few buyers, fears that foreign central banks and the Chinese would shun Treasury Bills and Notes.  Who would buy this mountain of debt?  The answer: “Too Big To Fail” banks.  Perhaps this was the main reason they were given TARP!  And the slope of the yield curve is the icing on the cake.  That is, “Too Big To Fail” banks borrow from the central bank (the Fed or ECB) or the public at near 0% and buy sovereign debt at 300-400 basis point spreads.  Because of capital rules (both in the U.S. and Europe), no capital is required as reserves against potential default, because, after all, these are AAA rated sovereign government securities.

Or are they?  The fact that Fitch downgraded the debt of Spain (from AAA to AA+) on May 28, 2010 may yet be another canary in the coal mine.  The exploding Debt/GDP ratios in the U.S. and industrialized world (see Wow!! That’s a Lot of Debt! At TheStreet.Com or at http://ancorawest.wordpress.com/) indicates that there is real risk to holding large volumes of such sovereign debt despite AAA ratings to the contrary.  Unfortunately, the “Too Big To Fail” institutions, both here and abroad, hold significant levels of sovereign debt, much of which is now of increasingly questionable quality (see Europe Pulls a TARP at TheStreet.com).  Worse, there is no back up capital.

Not to worry!  Given the symbiotic relationship between the governments in the U.S. and Europe and their banking systems, we can count on further assistance from taxpayers should the need arise (and it appears that there is a good chance that it will).  “Too Big To Fail” institutions know that because their governments need them to buy their ever growing debt, they won’t have to give up their highly leveraged ways or their immensely profitable proprietary trading (gambling) habits.  All they have to do is play the debt purchase game.

Robert Barone, Ph.D.

June 1, 2010