Monday, March 31, 2014

While Michael Lewis's expose on HFT is a good first step , the larger and evaded issue is legalized theft ! Apart from those presented by HFTing , let's examine some other examples ......... What about Federal Reserve POMOs and Reserve Repos ? What about the Federal Reserve's low interest rate policy and its market bending effects and ripoffs of savers ? And of course , how about TBTF / TBTJ ?

Monday, March 31, 2014 2:58 PM

High Frequency Trading Hits 60-Minutes Scrutiny; Trading or Skimming?

In the wake of a 60-Minutes report on High Frequency Trading, numerous people have sent dozens of links. Let's take a look at a few of them.

CBS Video

High-Speed Traders Rip Investors Off

Michael Lewis says High-Speed Traders Rip Investors Off
 The U.S. stock market is rigged when high-frequency traders with advanced computers make tens of billions of dollars by jumping in front of investors, according to author Michael Lewis, who spent the past year researching the topic for his new book “Flash Boys.”

“The United States stock market, the most iconic market in global capitalism, is rigged,” Lewis, whose books “Liar’s Poker” and “The Big Short” highlighted Wall Street excesses, said during the interview. The new book comes out today. “It’s crazy that it’s legal for some people to get advance news on prices and what investors are doing,” he said.

The author’s comments follow New York Attorney General Eric Schneiderman’s decision to investigate privileges marketed to professional traders that allow them to place their computers within feet of exchanges and buy access to faster data streams. Officials at the U.S. Securities and Exchange Commission and Commodity Futures Trading Commission have also said market rules may need to be examined.

Dominating Volume

High-frequency traders account for about half of share volume in the U.S., a statistic that shows their pervasiveness and hints at the obstacles faced by proposals to rein them in. Exchanges rely on HFTs for profits as well as liquidity, with electronic market makers all but eliminating the old system of human floor traders who oversaw the buying and selling of equities. While critics such as Lewis see a Wall Street plot, proponents say the new system is faster and cheaper.

One of the heroes of Lewis’s book is Brad Katsuyama, who left Royal Bank of Canada in 2012 to form a new market, IEX Group Inc., along with other former traders from the Toronto-based bank. David Einhorn’s Greenlight Capital Inc. hedge fund invested in the platform, which started trading in October and was established to minimize the influence of predatory strategies, Goldman Sachs Group Inc. has endorsed IEX and is the venue’s biggest broker.
Ticket Prices

IEX was established partly to address concern that technology advances and fragmentation have made the $22 trillion U.S. equity market too fast and opaque. The platform, a dark pool with ambitions to officially become an exchange, imposes a delay of 350 microseconds, or 350 millionths of a second, on orders -- enough to curb the fastest trading firms. IEX aims for greater transparency by making its trading rules available for public review, unlike some other electronic venues.

Eric Ryan, a spokesman for the New York Stock Exchange, and Nasdaq OMX Group Inc.’s Rob Madden declined to comment on Lewis.

“We completely disagree with allegations that the U.S. equity market is rigged,” Bats President Bill O’Brien said in an e-mail. “While we should never stop trying to improve our market structure, it is unfair and irresponsible to accuse people simply because they use technology and enhance competition. This has helped make our market the most competitive and liquid in the world, greatly benefiting individual investors.”

New York’s Schneiderman is examining the sale of products and services that offer faster access to data and richer information on trades than is normally available to the public. Wall Street banks and rapid-fire trading firms pay for these services, providing millions of dollars in quarterly sales to exchanges and helping ensure their markets are supplied with standing orders to buy and sell stocks.

Bloomberg LP, the parent of Bloomberg News, provides its clients with access to some proprietary exchange feeds.

The investigation threatens to disrupt a model that market regulators have permitted for years as high-speed trading and concerns about its influence have grown. Trading firms pay to place their systems in the same data centers as the exchanges, a practice known as co-location that lets them directly plug in their companies’ servers and shave millionths of a second off transactions.

SEC Commissioner Daniel Gallagher said on March 28 that individuals are concerned that high-frequency traders detract from fairness in the marketplace.

“The problem with high-frequency trading right now is that there’s a perception that for the little guy, the markets aren’t fair,” Gallagher told CNBC during an interview. “That perception to me is a reality. It’s something we need to address.”

Video Playlist

NY Attorney GeneralMarket Race for Speed Inherently Dangerous

Synopsis: New York Attorney General Eric Schneiderman discusses his investigation into high-frequency trading and why he believes the SEC needs to revisit regulation on Bloomberg Television’s “Market Makers.”

PennTrade CEOHigh Frequency Trading Isn't Rigged

Synopsis: Steve Ehrlich, chief executive officer of PennTrade and former CEO at Lightspeed Financial, talks about high-frequency trading. Ehrlich speaks with Scarlet Fu and Tom Keene on Bloomberg Television's "Surveillance." Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia, also speaks.

Co-Founder of Themis TradingHigh-Frequency Trading Neither Good or Bad

Synopsis: Sal Arnuk, co-founder of Themis Trading, talks about high-frequency trading and industry regulation. Arnuk speaks with Stephanie Ruhle and Erik Schatzker on Bloomberg Television's "Market Makers."

Schneiderman, Levitt, RoachHigh Frequency Trading

Synopsis: New York State Attorney General Eric Schneiderman, former Securities and Exchange Commissioner Arthur Levitt, and Stephen Roach, a senior fellow at Yale University and former non-executive chairman for Morgan Stanley in Asia, speak about high-frequency trading. Steve Ehrlich, chief executive officer of PennTrade and former CEO at Lightspeed Financial, and Sal Arnuk, co-founder of Themis Trading, also comment.

HFT Crackdown

On May 18, Forbes reported NY AG's New Crackdown Targets High-Frequency Trading
 High-frequency trading remains in the spotlight as New York’s Attorney General announced a new crackdown on vendors in the business.

NY AG Eric Schneiderman announced he will take a deeper look at high-frequency trading world, particularly vendors that provide services for HFT traders.

He called for reforms that he says would eliminate “unfair advantages” that high-frequency trading firms have over other investors. Those advantages are offered by exchanges and other service providers and include: allowing traders to locate their computer servers within trading venues themselves; providing extra network bandwidth to high-frequency traders; and attaching ultra-fast connection cables and special high-speed switches to their servers, the AG’s office said.

Last year, after probing from the AG’s office, Thomson Reuters agreed to discontinue its practice of selling high-frequency traders a two-second sneak peek at certain market-moving consumer survey results.

“I am committed to cracking down on fundamentally unfair – and potentially illegal – arrangements that give elite groups of traders early access to market-moving information at the expense of the rest of the market,” Schneiderman said in a statement.
Trading or Skimming?

Finally, please consider Speed Trading in a Rigged Market a Bloomberg column today by Barry Ritholtz.
 On "60 Minutes" last night, author Michael Lewis made a bland assertion: High-frequency traders, he said, working with U.S. stock exchanges and big banks, have rigged the markets in their own favor. The only surprising thing about Lewis’s assertion was that anyone could be even remotely surprised by it.

The math on trading is simple: It is a zero-sum game. One trader’s gain is another trader’s loss. Only in the case of HFT, the losers are the investors -- by way of their pension funds, retirement accounts and institutional funds. The HFT’s take -- the “skim” -- comes out of these large institution’s trade executions.

Several years ago, the founder of Tradebot, one of the biggest high-frequency firms, had said that the firm had “not had a losing day of trading in four years.” The firm’s average holding period for stocks is 11 seconds.

Any professional trader can tell you that his job is to manage risks. It is a statistical certainty that a percentage of trades will be losers. You are establishing a position with an unknown outcome. Sometimes they go your way, other times they go against you.

How is it possible that one of the largest high-frequency trading firms executes millions and millions of orders for four years without ever having a down day? The short answer is what they do is not trading -- it is skimming. I call it legalized theft. High-frequency trading is a tax on investors, encouraged by the exchanges, allowed by the SEC. It is prima facie proof that something is amiss.

It is interesting to note that the rigging theme is consistent with everyone who looks closely at this subject. My colleague Josh Brown notes that markets haven't become rigged, they have always been rigged. What is different is the ability of high-frequency traders to see other people’s orders, jump ahead of them, and then sell that exact same stock to them, at a higher price. It is the ultimate market-skimming operation.

I am looking forward to reading "Flash Boys." I hope our members of Congress and the folks at the SEC do so too.
Flash Boys

Lewis is a good writer, I too will pick up a copy of "Flash Boys", sure to be a best-seller.

Mike "Mish" Shedlock

More legalized theft ... consider the POMO , reverse repos.......

Fed Releases Taper'd POMO Schedule - Allows 3 Days For Shorting In April

Tyler Durden's picture

As expected, the Federal Reserve has released its Permanent Open Market Operations (POMO) non-monetizing-of-the-debt schedule for April with $30 billion of Treasury purchases (and $25 billion MBS). This is a 33% reduction from the 'normal' $45 billion Treasury purchase of last year. The POMO schedule very generously allows traders 3 days of non-money-printing potential shorting opportunities (Friday 4th, Thursday 17th, and Wednesday 30th)... however, this Friday is non-farm payrolls day and we will not be allowed a red day after that...


As Of This Moment Ben Bernanke Own 30.5% Of The US Treasury Market... And Will Own All By 2018

Tyler Durden's picture

As is well-known by everyone, the Fed monetizes the US deficit on a daily basis, thanks to the 45 minutes of POMO love each day when it buys Treasuries from Dealers. Of course, the Fed monetizes bonds from across the entire curve (mostly the longer end), which is why it is somewhat complicated to express the amount of risk transfer the Fed takes on every time the S&P posts an uptick as a result of yet another bond purchase by the hedge fund with the largest fixed income portfolio in the history of the world. However, one simple way of expressing just this risk is through the use of ten year equivalents: Ten-year equivalents are the amount of 10-year notes that must be held by the Fed in order to remove the same amount of interest rate risk from the market as its current holdings. What this methodology allows is to represent the Fed's holdings of all marketable securities on a linear continuum, and represent the remainder, or those bonds held by the private sector, on the side.
So what may come as a surprise to most, is that as of this week's H.4.1 update, the amount of ten-year equivalents held by the Fed increased to $1.583 trillion from $1.576 trillion in the prior week, which reduces the amount available to the private sector to $3.637 trillion from $3.668 trillion in the prior week. And also, thanks to maturities, and purchase by the Fed from the secondary market, there were $5.219 trillion ten-year equivalents outstanding, down from $5.244 trillion in the prior week.
What this means simply is that as of this moment, the Fed has, in its possession, a record 30.32% of all outstanding ten year equivalents, or said in plain English: duration-adjusted government bonds. It also means that the amount of bonds left in the hands of the private sector has dropped to a record low 69.68% from 69.95% in the prior week.
America may or may not be becoming increasingly socialist and/or nationalized, but there is no doubt about it: its bond market most certainly is.
Chart of total ten year equivalents, broken down by Private sector and the Fed (courtesy of StoneMcCarthy):
The percentage of the entire US bond market currently owned by the Fed (courtesy of StoneMcCarthy):

Finally, the above means that with every passing week, the Fed's creeping takeover of the US bond market absorbs just under 0.3% of all TSY bonds outstanding: a pace which means the Fed will own 45% of all in 2014, 60% in 2015, 75% in 2016 and 90% or so by the end of 2017 (and ifthe US budget deficit is indeed contracting, these targets will be hit far sooner).
By the end of 2018 there would be no privately held US treasury paper.
Still think QE can go on for ever?
Actually, nevermind.  
P.S. as a bonus, here is a breakdown of the Fed's SOMA holdings by CUSIP


$242 Billion: That Is How Much Record "Window Dressing" Banks Got Today Thanks To The Fed

Tyler Durden's picture

The last time banks scrambled to pad their books into the quarter end, and come begging at the front door of the NY Fed's Liberty 33 office, was on the last day of Q4 and 2013, when nearly $200 billion in Treasurys were handed out by the Fed to over 100 counterparties in what was the largest reverse repo operation conducted by Ben Bernanke, and his brand new Fixed-Rate Reverse Repo operation, in history.
That was the record until today, when just over an hour ago the Fed disclosed that as part of its most recent reverse repo operation, it had handed out to 93 dealer banks and other financial intermediaries, both foreign and domestic, some $242 billion in Treasurys in what is now the biggest reverse repo operation in history, a privilege for which the collateral-starved banks paid the Fed the king's ransom of 0.05% in annual interest, i.e., nothing.
So while hedge funds, speculators and assorted vacuum tubes are rushing all day to bid up all the overvalued stocks they can find in order to make their quarter end P&Ls appear more attractive to LPs even as the early ramp and late selloff is again set to resume tomorrow, the megabanks too were rushing to the "window dressed" safety of Treasurys in order to make their balance sheets appear more attractive to regulators and supervisors, in a world in which high quality collateral is much more valuable than the Fed's fungible reserves, and which helps indicate much higher capitalization ratios than otherwise would be observed at the collateral-starved banks.
But what today's off the charts reverse repo really shows us, aside from the fact that all the reverse repo operation really is, is a way for the Fed to make bank balance sheets appear far better than in reality (for all those still confused), is that the collateral shortage we have been warning about for the past several years, and which is getting only more acute the longer the Fed soaks up all 10 year equivalents from the Treasury market (of which it now holds 35% and rapidly rising), is getting worse for banks.
And in related news, one should consider that tomorrow - with their books well padded for the March 31 daily security "holdings" - the banks will almost certainly unwind over $100 billion if not more of today's reverse repo, an amount that is now equal to nearly two full months of QE. Where that money will go, only the (NY) Fed and a few bank CEOs know.
Then again none of this should come as a surprise - we said precisely this during our last such window dressing observation, to wit:
In short: collateral window dressing on; collateral window dressing off, all with the blessing of the banks' overarching regulator, the Federal Reserve. What is most disturbing is that both the world's largest financial firms, and by implication the Fed, just admitted there is a massive collateral shortage currently if banks are forced to pad their books to the tune of nearly $200 billion in "high quality collateral" just to pass year-end auditor muster.
Today's record quarterly window dressing merely confirmed precisely this.
So while the Fed can provide on both an orderly and on an emergency basis up to the total amount of Treasurys it holds on its entire balance sheet amounting to $2.3 trillion (as of today), what will happen if banks find themselves needing to urgently satisfy $2.4 trillion, or $2.5 trillion, or $5 trillion, or more in Treasury deliverable demands, as collateral chains suddenly collapse on themselves as they did the day after Lehman's bankruptcy and rehypothecated Treasurys, not to mention re-re-re-rehypothecated Treasurys have to be delivered once those infamous "off the books" repo and reverse-repo operations suddenly find they aren't quite netting each other off, as we have also been warning for years.
We hope not to have to find out, at least not for some time, because the outcome would make the Lehman aftermath seem like a walk in the park.


Fed's unnaturally low interest rates steal money from savers......


6 ways Federal Reserve policy hurts retirees

Retirement » 6 Ways Federal Reserve Policy Hurts Retirees
Savers languish on fixed income
Savers languish on fixed incomeIn late 2012, Federal Reserve Chairman Ben Bernanke fessed up and revealed the worst-kept secret in finance: The low rates the Fed has maintained in an attempt to ignite the U.S. economy are badly hurting retirees and others who rely on fixed income.
"My colleagues and I know that people who rely on investments that pay a fixed interest rate, such as certificates of deposit, are receiving very low returns, a situation that has involved significant hardship for some," Bernanke said in an October speech in Indianapolis.
Such sympathy is probably small consolation to millions of Americans who saved diligently over the years but now find themselves struggling, thanks to rates that have remained near zero percent for more than five years.
"Our firm has long been of the belief that artificially low interest rates have punished savers and retirees," says Samuel Scott, president at Sunrise Advisors in Leawood, Kan.
How does Fed policy hurt retirees? Bankrate counts six ways.

Fed policy effect No. 1: Paltry returns on savings
Fed policy effect No. 1: Paltry returns on savings © Diego Cervo/Shutterstock.comIn June 2006, the federal funds rate stood at 5.25 percent. At the Federal Reserve's meeting in September 2007, it began lowering the federal funds rate and continued to do so until it fell to a range of between zero percent and 0.25 percent in December 2008. It remains there today.
Rates on certificates of deposit, money market accounts and savings have plunged in tandem.
The result has been devastating for retirees counting on safe, fixed returns, says Michael Rubin, founder of Total Candor, a financial planning education firm based in Portsmouth, N.H.
"They're earning a lot less on their savings than any other time in recent history," says Rubin, author of "Beyond Paycheck to Paycheck."
Despite such low returns, CDs and other savings vehicles still have a place in a retiree's portfolio. Even getting a sad-sack 1 percent return is better than exposing all your savings to higher levels of risk, says Alan Moore, founder of Serenity Financial Consulting in Milwaukee.
"I look at cash as market insurance," he says. "When the stock market takes a dive, (retirees) don't want to be in the position of having to sell stocks to fund their lifestyle."

Fed policy effect No. 2: Low rates on fixed annuities
Fed policy effect No. 2: Low rates on fixed annuitiesMany retirees buy an annuity in hopes of getting a safe stream of income. Low rates undercut that strategy, Moore says.
"The problem is that the monthly income a client receives from their fixed annuity is based on interest rates at the time they purchase the annuity," he says. "With interest rates at all-time lows, annuity payouts are also at all-time lows."
Nathan Kubik, a Certified Investment Management Analyst at Carnick & Kubik, which has offices in Denver and Colorado Springs, Colo., agrees that now is among the worst times to buy an annuity.
"Locking in these historically low rates right now through fixed-rate annuities is the height of folly," Kubik says.
Kubik suggests talking to a fee-only adviser who is an expert in fixed-income investments. Such a pro can suggest alternatives to annuities.
Meanwhile, Moore urges investors to avoid purchasing annuities until rates climb.
"Another option is to buy a smaller annuity today, such as 25 percent of what (investors) would normally buy," he says.
Doing this several times from different companies over a few years allows you to buy at various interest rates, he says. Plus, buying from separate companies protects you if one of the companies goes bankrupt.

Fed policy effect No. 3: Underfunded pension funds
Fed policy effect No. 3: Underfunded pension funds © Africa Studio/Shutterstock.comToday's pension funds are in big trouble. Ninety-four percent of corporate defined benefit pensions were underfunded in 2012, according to a recent report by Wilshire Consulting.
Pension funds must make sure their assets grow at a pace adequate to cover future liabilities. The Wilshire report notes that today's low interest rates make this especially difficult to achieve.
"It is putting pressure on the already-weak pension system," Scott says.
But Rubin notes that pension woes are unlikely to affect large numbers of retirees.
"Most retirees don't have pensions and will not be affected," he says.
He also believes that current pension recipients are unlikely to see their payout cut. But future retirees may not be as lucky, he says.
Moore agrees. "It is hard to know if clients can depend on them for their retirement income," he says. Workers who are worried about their company's pension plan must take action now. "They need to save more or work longer, as well as delay Social Security, to maximize the benefit they will receive."

Fed policy effect No. 4: Costly long-term care premiums
Fed policy effect No. 4: Costly long-term care premiums © Jennifer Walz - Fotolia.comLong-term care insurance covers the cost of a wide range of expensive services you may need in your final years, including nursing home care, assisted living facilities and adult day care. This insurance potentially can save you and your family hundreds of thousands of dollars.
But thanks to falling interest rates, long-term care insurance premiums have skyrocketed, says Jesse Slome, executive director of the American Association for Long-Term Care Insurance.
"Lower rates have wreaked havoc on long-term care insurance costs," Slome says. "Rates today are about 50 percent higher than they were five years ago."
As interest rates have fallen, insurers have seen the return on their investments slip. For every 1 percent decline in rates, insurers need to hike premiums by between 10 percent and 15 percent, according to Slome.
Consumers may be tempted to delay buying long-term care insurance while they wait for interest rates to rise. But that strategy carries risks, Slome says.
"Twenty-four hours from now, your health can change," Slome says. "Or, you go to the doctor and some condition is diagnosed. Now, you are uninsurable."
Instead of delaying a purchase, Slome encourages people to talk to a long-term care insurance specialist who can offer options for making care more affordable.

Fed policy effect No. 5: Making safe havens unsafe
Fed policy effect No. 5: Making safe havens unsafe © Stephen Mcsweeny/Shutterstock.comScott says many retirees are risk-averse and typically park a good percentage of their cash in "safe havens," such as savings accounts and CDs. But low returns are forcing many older Americans to wade into the more turbulent waters of the stock market.
Other retirees are buying bonds with the belief they are safer than stocks. But Scott says Fed policy may be creating a bubble in the bond market that will burst once rates return to normal.
"For 30-plus years, bonds have been safe, and this seems ingrained in the minds of people," he says. "But with a rise in rates, these safe assets will lose value."
That's because when rates rise, bond prices fall. Investors purchasing new bonds with higher yields will shun existing low-yielding bonds.
Kubik agrees that safe havens are not what they used to be. He urges investors to consult with their financial adviser and create a plan for dealing with rising rates.
"The most important thing investors can do right now is ensure that they are properly positioned for the impending rising interest rate environment," he says.
Moore believes the danger lurking in today's supposed safe havens presents a lesson that investors should remember in all markets.
"Safe-haven investments have never truly been safe," he says. "Investments that did well during one market downturn may do awful in another."

Fed policy effect No. 6: Stoking future inflation
Fed policy effect No. 6: Stoking future inflation © Brian McEntire/Shutterstock.comThe Fed's policy of keeping rates low is intended to make borrowing less costly and, thus, stimulate the economy. But all that "cheap money" may come with a high price if the money supply ignites inflation somewhere down the road.
A surge in prices would easily overwhelm the returns retirees get from CDs, savings and other fixed-income investments.
The Fed is closely watching for any hints of rising prices. Raising the federal funds target rate is the best way to tamp down incipient inflation.
"I suspect that the Fed's policies will change at the first sign of inflation," Kubik says.
But once inflation starts, it can be difficult to stop. In the early 1980s, the Federal Reserve was forced to crank up rates to a high of 20 percent before it got inflation under control.
Moore says investors who fear future price increases should keep some of their bond portfolio in Treasury inflation-protected securities, or TIPS, which increase your principal in tandem with rising inflation.

and of course - TBTF.....

A Political History of “Too Big to Fail”

rcwhalen's picture

For Barry Ritholtz

When people talk about the concept known as “too big to fail” or “TBTF,” they generally are referring to the idea that the government is bailing out a private bank and its shareholders.  The $10 per share paid to the Bear, Stearns equity holders is a case in point.  The big banks, so the saying goes, privatize the profits and socialize the losses.  But if you really focus on that phrase, it reflects a deeper truth about the nature of financial markets and politics in the United States that is often missed.
If you think of the end of WWI as the death of capitalism in America, what comes after is a hybrid model, part public, part private.  If the years before Woodrow Wilson and WWI was the age of utopian reform, the years which followed were a time of anger and bitter betrayal for old fashioned progressives and conservatives alike.  Before WWI we had private monopolies controlled by Robber Barons, but since WWII all of the monopolies have been controlled by bureaucrats in Washington.
Fred Siegel, in his excellent 2013 book about the modern roots of American liberalism, “The Revolt Against the Masses: How Liberalism has Undermined the Middle Class,” notes:
[L]iberalism began as a fervent reaction to wartime Wilsonian Progressivism, and it took its current cultural shape in the 1920s well before the Great Depression came crashing down on the country.  It was the seminal 1920s that the strong strain of snobbery, so pervasive among today’s gentry liberals, first defined the then nascent ideology of liberalism.
The liberalism which evolved after the Great Depression and WWII was anti-business and anti-democratic.  It despises the small town business ethic which drove to much of American life.  In its place was a heroic model populated by elite experts, writers and social scientists who fundamentally distrust the public and place great confidence in the “leading role” of the state, to borrow the Marxist term.  The scorn and fear generated among liberals by the Tea Party movement illustrates the basic contempt that liberals hold for the common man and the American middle class in general.
The economic model that emerged from WWII was decidedly European in nature, with a central function assigned to state sponsored entities and nominally private corporations.  Siegel notes that while the mobilization for WWI did provide “the administrative model for the early years of the New Deal, culturally, socially and politically, liberalism represented a sharp break from Progressivism.”  The economic model for modern day liberalism was elitist and antithetical to the private sector and also the rights of the individual.
The notion of free-market capitalism driving the growth of the US economy and the American dream after WWII was a convenient fiction.  Behind this facade, generations of liberal political operatives worked to realize the dreams of a society led by an enlightened elite with heroic overtones that bear close resemblance to the fascist era of 1920s Europe. Men like Herbert Crowley, editor and co-founder ofThe New Republic, advanced the ideal of a secular priesthood that would Europeanize America.  He envisioned an elite vanguard of intellectuals, writers and scientists who would not be swayed by outmoded ideas of popular democracy and individual freedom.  And the mechanism for advancing the new liberal agenda was government.
From the late 1940s through into the 1970s, government control over the financial markets, banks and much of the rest of the US economy enforced a certain stability that many observers find remarkable.  But by the 1970s, the popular demand for jobs and opportunity began to force change and with it deregulation of the markets.  Yet the basic model of banks as government sponsored entities or “GSEs” remained.  With it came a partnership that assumed the state would control access to credit and the financial markets.  
Seen in the political context of modern American liberalism, the idea of TBTF is not so much about bailing out purely private corporations and their shareholders as it is about a partnership between various GSEs.  The housing agencies created since the Great Depression, including Fannie Mae, Freddie Mac and the Federal Housing Agency are partners with the biggest TBTF banks.  Together they monopolize the highest quality portion of the housing markets, leaving the “subprime” dregs for the smaller private sector firms.  But no private company can compete with a GSE, bank or otherwise.
For a brief period from 1992 until 1998, the private sector was actually able to compete with the big bank/GSE monopoly and produced some of the best years of economic growth that the US economy had seen in decades.  General Motors avoided bankruptcy in 1992 because it was able to circumvent the commercial banks and issue its own paper directly in the bond markets.  By 1998, however, following several financial crises, the liberal political class in Washington closed ranks and handed the TBTF banks and GSEs the housing and asset backed securities markets on a silver platter.  
Non-bank financial and commercial firms were no longer allowed to place assets with money market funds, a change that essentially gave the banks a monopoly on funding all aspects of the US economy.  Home builders and mortgage companies could not compete with the federal housing agencies in the bond market, again reinforcing the de facto monopoly of the TBTF banks and housing agencies.  As the 2000s began, the combination of the TBTF banks and the GSEs was firmly in control over the housing market and followed the policy prescriptions of the liberal tendency in Washington when it came to promoting “affordable housing.” 
Seen in this political context, the period of financial deregulation in the 1980s was not so much about the private sector throwing off the shackles of government regulation as the public-private monopolies comprised of the TBTF banks and the GSEs misbehaving.  There was never any end to the public/private partnership between the top banks and the federal housing agencies.  To spend time arguing whether Wall Street or Washington caused the 2008 subprime crisis is absurd, yet it is precisely that fictitious duality that still defines public perceptions about the crisis. 
The new ethos of America in the 21st Century is about liberals creating opportunities for their friends and political supporters, while preserving the social and economic problems for which liberalism presents itself as the solution.  In their book Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armagedon, Gretchen Morgenson and Joshua Rosner describe how skillful exploitation of the public/private monopoly between the largest banks and housing agencies such as Fannie Mae fueled the housing crisis.  They highlight Jim Johnson, the former head of Fannie Mae and the longtime chairman of the compensation committee at Goldman Sachs.  Johnson typifies the modern day liberal who skilfully exploits opportunities to gain from “public/private partnerships” that are unavailable to the average American.  
In 2007 and 2008, when the private investment community realized that the TBTF banks and the GSEs had created tens of trillions of dollars’ worth of toxic waste, the global economy started to melt down.  Many smaller private financial institutions were either acquired or failed, including Washington Mutual, Countrywide Financial, Bear, Stearns & Co., Wachovia and Lehman Brothers.  But the TBTF banks that are the monopoly partners of the GSEs were saved.  This fact caused great anger and consternation among the American electorate, but largely due to the fact that the public thinks that these banks were and are today private corporations.
To understand the concept of TBTF, you must first appreciate that the notion that unsuccessful companies and individuals should fail is an anachronism that only applies to smaller entities.  The larger banks which are essential to advancing the agenda of the liberal elite must be preserved.  In the case of Citigroup, the bank was bailed out by successive loans from the US Treasury championed by Timothy Geithner, who ran interference for Citi first as President of the Federal Reserve Bank of New York and later as Treasury Secretary.  
While then FDIC Chairman Sheila Bair wanted to shut down Citigroup, Geithner and his allies circled to wagons to protect Citi and former Goldman Sachs CEO Robert Rubin.  As Chairman of Citigroup, Rubin presided over the bank’s issuance of tens of billions of dollars’ worth of Structured Investment Vehicles or “SIVs”.  These SIVs were issued based on subprime toxic waste and were fraudulently structured as “sales,” but were in fact secured borrowings sponsored by the bank.  Geithner and other members of the Rubin political tendency argued that saving Citigroup was necessary to protect the US economy, but in fact the real recipients of the Citigroup bailout were Rubin and the bank’s other officers and directors.       
To really appreciate “too big to fail,” you must first and foremost understand that it is a political concept that springs from a sense of liberal privilege and entitlement. Conservatives generally oppose TBTF and advocate market based outcomes for banks, large and small.  But most politicians of either political party support the model of public/private monopoly that is typified by the relationship between the largest banks and the various GSEs in Washington.  Big banks are not really important to preserving American competitiveness, as the banking industry likes to suggest, but the TBTF banks are very important to preserving the political and economic privilege of a select few Americans.  That, at the end of the day, is what “too big to fail” is all about.


Fed Finds TBTF Banks Increase Systemic Risk, Have A Funding Advantage

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For some inane reason, about a year ago, there was a brief - and painfully boring - academic tussle between one group of clueless economists and another group of clueless economists, debating whether Too Big To Fail banks enjoy an implicit or explicit taxpayer subsidy, courtesy of their systematic importance (because apparently the fact that these banks only exist because they are too big in the first place must have been lost on both sets of clueless economists). Naturally, it goes without saying that the Fed, which as even Fisher now admits, has over the past five years, worked solely for the benefit of its banker owners and a few good billionaires,has done everything in its power to subsidize banks as much as possible, which is why this debate was so ridiculous it merited precisely zero electronic ink from anyone who is not a clueless economist. Today, the debate, for what it's worth, is finally over, when yet another set of clueless economists, those of the NY Fed itself, say clearly and on the record, that TBTF banks indeed do get a subsidy. To wit: " in fact, the very largest (top-five) nonbank firms also enjoy a funding advantage, but for very large banks it’s significantly larger, suggesting there’s a TBTF funding advantage that’s unique to mega-banks."
Hopefully this will put this absolutely meaningless and most obtuse "debate" in the dustbin of time-wasting economic discourse, which is virtually all of it, where it belongs.
For those who care, here is some moredrivel from the NY Fed:
Until recently, having mega-banks seemed like an unmitigated bad; they create systemic risk and there was little convincing evidence of economies of scale beyond a relatively small size. However, just in the last five years several papers have found scale benefits even for trillion-dollar banks. The first paper in the volume, “Do Big Banks Have Lower Operating Costs?” by Anna Kovner, James Vickery, and Lily Zhou, contributes to that recent literature by showing that bank holding company (BHC) expense ratios (noninterest expense/revenue) are declining in bank size. In a back-of-the-envelope calculation, the authors estimate that limiting BHC assets to 4 percent of GDP, as has been advocated, would increase noninterest expense for the industry by $2 billion to $4 billion per quarter. Breaking up mega-banks is not a free lunch.

The other edge of the sword, of course, is the potential funding advantages and moral hazard associated with being perceived as too big and complex to fail (TBTF). A paper by João Santos, “Evidence from the Bond Market on Banks’ ‘Too-Big-to-Fail’ Subsidy,” adds to the growing literature that tries to quantify the TBTF funding advantage, but Santos adds a twist; he tests whether all very large firms, including nonfinancial firms, enjoy a funding advantage. He finds that, in fact, the very largest (top-five) nonbank firms also enjoy a funding advantage, but for very large banks it’s significantly larger, suggesting there’s a TBTF funding advantage that’s unique to mega-banks.

Along with a funding advantage, being perceived as TBTF may create moral hazard. While it’s almost universally presumed that TBTF banks take excessive risk, recent research challenges that presumption; if the TBTF subsidy increases mega-banks’ franchise value, they may play it safe to conserve that value. In “Do ‘Too-Big-to-Fail’ Banks Take On More Risk?” Gara Afonso, João Santos, and James Traina test the moral hazard hypothesis using Fitch’s government support ratings as a proxy for TBTF status (a support rating reflects a rating agency’s views on the likelihood of government assistance for a systemically important bank). They find that a one-notch increase in support ratings is associated with an 8 percent (relative to average) increase in the impaired loan ratio, consistent with the traditional moral hazard story.

The takeaway from these three papers is that bank size has benefits and costs: The upside is the potential for economies of scale and lower operating costs; the downside is the TBTF problem and the attendant funding advantages and moral hazard.
And Bloomberg's take, which as a reminder was one of the very "serious" news organization that - correctly - accused the Fed of providing banks with tens of billions in implicit funding subsidies. What other media outlets, or anyone who defended the opposite view, were thinking is simply beyond comprehension.
The largest U.S. banks, including JPMorgan Chase & Co. and Citigroup Inc., can borrow more cheaply in bond markets than smaller rivals, in part because of investor perceptions that they are too big to fail, according to a Federal Reserve Bank of New York researcher. The five largest banks pay on average 0.31 percentage point less on A-rated debt than their smaller peers, according to a paper released today by the Fed district bank based on data from 1985 until 2009.

“This insensitivity of financing costs to risk will encourage too-big-to-fail banks to take on greater risk,” Joao Santos, a vice president at the Fed bank, wrote in his paper. This “will drive the smaller banks that compete with them to also take on additional risk.

The study may reinforce efforts by lawmakers to eradicate the implicit federal subsidy by either breaking up the biggest banks or increasing capital requirements. Large banks have said their advantage has been overstated in studies, including a May 2012 report by the International Monetary Fund estimating their borrowing edge at 0.8 percentage point.

Santos’s report is one of 11 studies resulting from a year-long research project on the U.S. banking system involving about 20 New York Fed staff economists. Fed district banks in Dallas, Minneapolis and Richmond have also published research on too-big-to-fail, or the perception that large banks will be rescued by the government if they get into trouble.

The study also found that the largest banks enjoy a funding-cost advantage over large non-bank financial firms as well as the biggest non-financial corporations.

This finding suggests that “investors believe the largest banks are more likely to be rescued if they get into financial difficulty,” according to Santos. The five largest banks by assets are JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., Wells Fargo & Co. and Goldman Sachs Group Inc.

The perception the banks are too big to fail may not be the only reason the big banks can borrow more cheaply, Santos said. “To the extent that the largest banks are better positioned to diversify risk because they offer more products and operate across more businesses (something not fully captured in their credit rating), this wedge could explain part of that difference in the cost of bond financing,” he said.

The New York Fed report says its findings are “pertinent to the ongoing debate on requiring bank-holding companies to raise part of their funding with long-term bonds, particularly if the regulatory changes that were introduced are unable to fully address the too-big-to-fail status of the largest banks.”
Even that wise sage of monetary policy, the Mr.Chairmanwoman, chimed in. Wrongly of course.
Fed Chair Janet Yellen said last month it may be premature to say regulators have eliminated the too-big-to-fail challenge.

“I’m not positive that we can declare, with confidence, that too-big-to-fail has ended until it’s tested in some way,” she testified to the Senate Banking Committee on Feb. 27.
Wait someone said it ended?  As for testing it, how about sending the market plunging by 1% or more? Surely with leverage being where it is, that should be sufficient for the Fed to need to bail out at least a few hundred of America's most insolvent banks.
Finally, for those who missed it, the sheer idiocy of the Fed spending millions in taxpayer funds to "find" whether TBTF banks are getting implicit taxpayer funds is something only economists are capable of.
The NY Fed's "research" paper on the topic can be found here, while the NY Fed's blog on this topic is here.


Guest Post: Too Big To Jail Is Here To Stay

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Submitted by John Aziz of Azizonomics blog,Lanny Breuer, the Assistant Attorney Generalwho claimed that prosecuting banks for crimes poses a risk to the financial sector and so corrupt bankers are “too big to jail” has lost his jobMARTIN SMITH: You gave a speech before the New York Bar Association. And in that speech, you made a reference to losing sleep at night, worrying about what a lawsuit might result in at a large financial institution.   LANNY BREUER: Right.   MARTIN SMITH: Is that really the job of a prosecutor, to worry about anything other than simply pursuing justice?   LANNY BREUER: Well, I think I am pursuing justice. And I think the entire responsibility of the department is to pursue justice. But in any given case, I think I and prosecutors around the country, being responsible, should speak to regulators, should speak to experts, because if I bring a case against institution A, and as a result of bringing that case, there’s some huge economic effect — if it creates a ripple effect so that suddenly, counterparties and other financial institutions or other companies that had nothing to do with this are affected badly — it’s a factor we need to know and understand. But the man who put him there, and who is ultimately responsible for the policy — the Attorney General himself — is here to staySimon Johnson notesAttorney General Eric Holder expressed similar views in the context of discussing why more severe charges weren’t brought against Zurich-based UBS AG last year for manipulating the London interbank offered rate. And Neil Barofsky, a onetime senior prosecutor and former inspector general of the Troubled Asset Relief Program that administered the bank bailouts, provided a scathing assessment of Justice Department policy.   The Justice Department likes to quote Thomas Jefferson: “The most sacred of the duties of government [is] to do equal and impartial justice to all its citizens,” a line that appears in its latest budget documents.   This sentiment is hardly consistent with saying that some companies have characteristics that put them above the law. Jefferson himself was very worried about the concentrated power of financiers — he would have seen today’s problems much more clearly than do Holder and Breuer. Fundamentally, Obama’s continued support for Holder illustrates that Obama is still committed to the policy of holding financiers to a lesser standard of justice than other citizens. The continued failure to implement even the Volcker rule — let alone a Glass-Steagall-style separation between retail and investment banking — illustrates that Obama is committed to letting bailed-out banks continue to operate in the risky manner that led to the crisis. So does the total failure to ensure a level playing field for retail investors in a market now totally dominated by algorithms. The big banks continue to ride roughshod over the American people with the complicity of the political class. Too Big to Jail is an affront to the Constitution, an affront to the Bill of Rights, an affront to those like Rosa Parks, Martin Luther King, Lysander Spooner, Frederick Douglas and all those who at various times crusaded to make equality before the law a reality in America. The only sensible way forward is that lawbreakers on Wall Street must be prosecuted in the same way as other lawbreakers. That means that Eric Holder and all others associated with Too Big To Jail must lose their jobs. But I doubt that will happen any time soon.