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Gerald Epstein is codirector of the Political Economy Research Institute (PERI) and Professor of Economics. He received his Ph.D. in economics from Princeton University. He has published widely on a variety of progressive economic policy issues, especially in the areas of central banking and international finance, and is the editor or co-editor of six volumes.
PAUL JAY, SENIOR EDITOR, TRNN: Welcome to The Real News Network. I'm Paul Jay in Washington. And in Washington, Ben Bernanke, chairman of the Federal Reserve, talked about S&P's downgrading alert, warning that maybe in two years they'll downgrade the AAA rating of US sovereign debt. Here's a little bit of what Mr. Bernanke had to say.~~~BEN BERNANKE, CHAIR, FEDERAL RESERVE: In one sense, S&P's action didn't really tell us anything, because everybody who reads the newspaper knows that the United States has a very serious long-term fiscal problem. That being said, I'm hopeful that this event will provide at least one more incentive for Congress and the administration to address this problem.~~~JAY: Most of the analysts and pundits that have looked at this S&P downgrading what I think if some objectivity find it a bit hard to understand the odds of the United States government defaulting on its sovereign debt are rather slim [sic], and if it did, you would have to downgrade everything there is in terms of US currency around the globe, and in fact you would really talk about an unraveling of the global financial system, which would--one would think would create a little more alarm than what S&P is suggesting. But when you dig into the S&P report, there is a piece of it that is alarming but isn't getting very much attention in the media or by Mr. Bernanke and others in his circles, and that goes like this. Here's a quote from S&P. The potential for further extraordinary official assistance to large players in the US financial sector poses a negative risk to the government's credit rating. Because of the increased risk, S&P forecast a potential initial cost to taxpayers for the next crisis to approach 34 percent of gross domestic product. S&P puts that into cash numbers. It may be as much as $5 trillion if there's another meltdown of the American and global finance sector. So that really then begs the question: if the real threat here is not sovereign debt default because of the size of the American deficit, but if it's really the threat of another collapse of the finance sector, then why isn't Mr. Bernanke and everybody else talking about Dodd-Frank financial regulation and how to make some actual enforceable rules that might prevent or mitigate such a meltdown? Now joining us to talk about all of this is Gerry Epstein. He's the codirector of the PERI institute in Amherst, Massachusetts. Thanks for joining us, Gerry.GERALD EPSTEIN, PERI CODIRECTOR, PROFESSOR OF ECONOMICS: Thank you, Paul.JAY: So where are we? Well, first, what's your take on the S&P? I mean, S&P has had such a stellar role in the crisis themselves.EPSTEIN: They're very credible, aren't they? They rated all the CDOs AAA, and then the CDOs crashed. So they shouldn't have any credibility at all. It's all part of an ideological battle to bring austerity to the United States and cut the size of government. It really should not have--be any basis for investors' decisions. JAY: So let's talk about, then, what S&P says. As I say [incompr.] read the actual full report of S&P, this piece about the possible meltdown of the finance sector and what that might cost the American economy is buried way down in the report. But that really seems to be the most significant thing they had to say. So what is going on on the question of regulation?EPSTEIN: Well, you're absolutely right about this, about the point about the possible continuing meltdown of the financial sector. There are so many vulnerabilities facing large financial institutions like Bank of America, Citicorp, and so forth that simply have not been resolved. At the moment, some of these banks are showing good profits, but partly it's because of accounting tricks. They've shifted some of their income from their loan loss reserves, which are supposed to be held in case credit card debt and other things go south, and they've put it into their profits so they can pay themselves high bonuses. But the housing market is still very weak. The US economy is not growing, creating jobs and sustainable investment. So these banks are still extremely vulnerable. So I think S&P is right about that.JAY: So the fight is taking place mostly on how to implement Dodd-Frank, what was supposed to be the regulatory reform bill for the finance sector. Now, that bill is, if I understand it correctly, 875 pages. There's 243 separate rules called for. They've called for 67 separate studies to decide how to write and then execute those rules. And three's a real battle taking place, Wall Street lobbyists on one side and reformers on the other side. So talk a little bit about how--what's happening in that.EPSTEIN: Right. Well, it's interesting that Bernanke, as you said, didn't say much about this, because in fact the institution that is really most in charge of implementing a lot of these rules, especially with respect to the large financial institutions, is the Federal Reserve. It's not well known, but part of the Dodd-Frank bill, towards the very end, the Federal Reserve was given a third mandate. It already has two--high employment and stable prices--but Dodd-Frank gave the Federal Reserve the mandate of maintaining financial stability. And Ben Bernanke should have been talking about, you know, what is the Federal Reserve going to do to maintain financial stability. And one of the things that it has to do is get these large banks cut down to size so they can't threaten the system and, as Standard & Poor's warned, cost taxpayers up to $5 trillion. So there are a lot of places inside the Dodd-Frank bill that, if it were implemented strictly and properly, it could go some distance--not all the way that's needed, but it could go some distance to reducing the chances of another big bailout by the government and by the taxpayers. One of them is the so-called Volcker rule.JAY: So talk a bit about that. This is this issue of proprietary trading. If I understand that's--correctly, this is when big banks like Goldman Sachs or Citibank and others take their own money and do very risky plays, make direct investments either into future markets or derivatives, commodities. And tell me the--what--how big a piece of their business was that, prior to the crash?EPSTEIN: Well, that's a very good question. You know, when the Volcker rule first came out, a lot of these banks would tell newspaper reporters, look, you know, this really isn't very important to us. Maybe we earn 5 to 10 percent of our earnings from proprietary trading. And so--and also, proprietary trading didn't cause the crisis. So why are you bothering with this? But in fact, what--neither of those things was true. My colleague Jim Crotty and I and former graduate student [incompr.] looked at this, and what we found was that for some of the largest investment banks--Goldman Sachs, Morgan Stanley, Merrill Lynch, and so forth--this kind of trading was anywhere from 45 to--at the height of the--right before the crisis hit in 2008, up to 60 or 70 percent of their profits. It's very difficult to measure, in fact, so these are rough estimates. We don't have direct measures of proprietary trading because they don't reveal these data. But our measures suggest that it was very important to their bottom line.JAY: Why was this a systemic threat? Why did this contribute to the crisis?EPSTEIN: Well, it contributed in several ways. First of all, proprietary trading is at the heart of how these investment banks and former investment banks--now they're either bankrupt or, like Goldman Sachs, have been turned into commercial banks. This is at the heart of how they made a lot of their profits. What they would do is make bets on, say, the housing market and use complicated derivatives and other kinds of instruments to make complicated bets on this. This would create a demand for these assets and would push up the price of these assets, and that led to--contributed to the bubble, the housing bubble being as high as it was. And then they'd borrow very short-term--sometimes 80 percent of their borrowing was overnight borrowing in the repo market and other wholesale borrowing--and then they'd invest more in these assets, driving up their prices even more. So this proprietary trading was one of the main drivers of both the housing bubble and the accumulation of debt structures and complex bets all around the housing bubble. So when it crashed, it not only brought down the housing market, but that's why it brought down these banks, 'cause they had engaged in so much proprietary trading. And it was bringing down these banks that was really at the center of why the crisis was so serious.JAY: And the other part of this proprietary trading is you could be trading absolute crap in terms of long-term effects on the economy, but if you make a short-term turnover, the way the compensation schemes were worked out, you would make a fortune as senior management of one of these banks. Let me get into a little bit of the detail of this, because I think it's important for people to understand the kind of lobbying battle that's taking place in the specific wording of how regulations are going to be enacted. And here's a little piece from Dodd-Frank. No transaction, class of transactions, or activity may be deemed permitted if--and here's the direct quote--one, would involve or result in a material conflict of interest--and then it goes on--two, would result directly or indirectly in material exposure by the banking entity to high-risk assets or high-risk trading strategies, and then in three, would pose a threat to the safety and soundness of such banking entity, or four, would pose a threat to the financial stability of the United States. This is the section you were talking about earlier, Gerry. So the question is: what is material conflict of interest? What is high-risk trading strategy? So if I understand this right, correctly, Gerry, the fight is: what meat do you put on the bones of these words? And then what regulation comes out of that?EPSTEIN: That's right. The quote that you just read is really central to what we say is the best way to interpret the Volcker rule, this ban on proprietary trading. The way it worked was there was a basic ban on proprietary trading by these banks, with the idea that if they're going to engage in this kind of risky gambling, then they shouldn't have--be guaranteed by the taxpayer, they shouldn't have access to the discount window from the Federal Reserve or other kinds of bailouts from the government; let them do this gambling on their own. So anybody that has access to this kind of bailout from the government shouldn't engage in this kind of proprietary trading, period. But they were able to get written into the law all kinds of exceptions and all kinds of vague language that in fact would allow them to engage in proprietary trading. So the quotes that you just read was what we call a backstop legislation, which says, even if you are able to get through a loophole and do some proprietary trading, if the regulators can show that it involves a material conflict of interest or will be risky for the bank or will be risky for the United States as a whole, even if according to the letter of the law you can do it, you can't do it, period. And this is very important. So what's a material conflict of interest? Well, it's the kind of thing that Goldman Sachs did when they got together with the hedge fund operator Paulson to put together a CDO, a package of mortgages that the--Goldman Sachs knew was going to fail. Then they sold those mortgages to their customers without telling them that they had been put together to fail. And then Goldman Sachs shorted those, so that they would make a killing when they failed, and took a big fee from Paulson. That would be outlawed by the Volcker rule. Now, in the Volcker rule, it says, well, okay, the banks aren't supposed to do this kind of proprietary trading, but they can do it if it's to meet the short-term demands of their customers. Well, there's a huge loophole, because if they're holding securities to meet the short-term demand of their customers, that means they're actually holding these securities for some period of time. That means that they can take proprietary bets on that. That can create risks for these banks. And so they can hide a lot of their own proprietary trading within that kind of exception. So this backstop legislation is very important to try to prevent that. Now, we've talked to regulators about this backstop language that you just read, and most of the regulators that we've talked to--we talked to the Fed, we talked to the SEC, we talked to the FDIC--most of them don't want to touch this backstop legislation. They just want to interpret the letter of the strict rules and the exceptions. And we're afraid that if they do it that way, then the banks are going to be able to hide a lot of proprietary trading inside the exceptions.JAY: So if people are talking to their congresspeople or senators, what should they be telling them about this?EPSTEIN: What they should tell them is that they want to restrict all proprietary trading that's dangerous for the banks or that's dangerous for the government or the taxpayer, and no exceptions or loopholes should be accepted which could lead to another bailout of these banks, period.JAY: So, in other words, as Standard & Poor's said, if you don't take a position on this--and I'm talking to us, the viewers and the makers of this--we could be risking another $5 trillion of public money again.EPSTEIN: Absolutely. It's even worse than that, because what's happening now is Ben Bernanke at the Federal Reserve, they're trying to restore the health of these banks by keeping short-term interest rates really low, allowing the banks to take that money and engage in proprietary trading, and make a lot of money. And the Fed is hoping that that's going to restore the balance sheets and the health of the banks, and so that we won't have a financial crisis. But in fact what they're doing is facilitating precisely the kinds of behavior that led to the last financial crisis.JAY: Well, we'll dig into this more in further segments. As Standard & Poor's says, we're talking about a 34 percent of gross domestic product that could be on the line here.EPSTEIN: That's real money.JAY: Real money not getting talked about. And of course what that really means for most of us: more or increasing the high unemployment, and a much deeper recession. Thanks very much for joining us, Gerry.EPSTEIN: Thanks, Paul.JAY: And thank you for joining us on The Real News Network.
End of Transcript
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