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Rob Johnson: Finance reform will get weaker; hiding actual fragility of banks through accounting tricks

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PAUL JAY, SENIOR EDITOR, TRNN: Welcome back to The Real News Network. I’m Paul Jay in Washington. We’re at America’s Future Now! Conference. Now joining us is Rob Johnson. He’s from the Roosevelt Institute in New York, and he heads up their Global Economic Policy Project. Thanks for joining us.


JAY: So, as we speak, there is negotiations going on between the House and the Senate on the finance reform bill. Just quickly, is the bill going to take on too-big-to-fail, this idea that the banks have a kind of structural blackmail against the American people, if you will? Is anything in this bill going to really change that?

JOHNSON: Well, I would say the resolution powers will help, but they’re necessary and not sufficient to end too-big-to-fail. Whether it’s President Obama or Chris Dodd, those who’ve claimed that too-big-to-fail will end with this bill are exaggerating the consequences of its passage.

JAY: So let’s get into some of the stuff that is in the bill that might play a positive role. And maybe the most controversial thing right now is an amendment that was put—or it’s—actually did come out in the Senate bill. Senate bill came out of the agricultural committee, I guess, Blanche Lincoln. So talk about what Lincoln added to the bill and why it’s important and what seems to be happening to it.

JOHNSON: What Lincoln did was she said that derivatives market making, which was a very profitable business—the top six derivatives dealers made over $30 billion last year—and derivatives market-making must be separated from the safety net: no access to the Fed discount window, no access to what you might call implicit subsidies in the event of a bailout.

JAY: So if I understand this correctly, some of the investment banks that were not part under the FDIC [Federal Deposit Insurance Corporation], in other words, were not regulated banks and therefore didn’t have access to the Fed discount window—which these days means practically zero percent money out the door, free money out the door to you that you can, as they are, turn around and buy T-bills and make money on. At any rate, this was a great advantage to them in terms of getting cash to shore up their positions. So the Lincoln bill would say you can’t have it both ways: if you want to gamble on derivatives, you’re going to have to separate that part of your company; you can’t use any of the money you’re getting from your traditional banking or from the Fed in your derivatives gambling. So is that what’s at stake?

JOHNSON: Yeah, the guarantee structure is designed to fortify what you might call the necessary plumbing—the payment system, traditional banking, consumer deposits through FDIC insurance. Proprietary trading on the one hand and derivatives market-making on the other are very profitable. To subsidize those further basically encourages overuse, and the overuse is paid for by what you might call the taxpayer guaranteeing [inaudible]

JAY: Which comes back to too-big-to-fail again, because you know if you lose your gamble your rear’s going to be covered through tax money.

JOHNSON: That’s right, and it encourages overuse and underpricing of derivatives. So they’re bigger than they otherwise would be, and they’re more profitable than they otherwise would be.

JAY: So the drumbeats coming out of these negotiations and from the administration is that the leadership of the Democratic Party itself, from the Obama administration, Treasury Department, and the people from the House and the Senate that got picked to negotiate this, are all trying to water that down. So is that true? And if so, why?

JOHNSON: I think it is true, and the reason why is what I will call a grand strategy of forbearance. In the spring of 2009 they decided not to acknowledge the losses, not to take over some of the insolvent banks, and to pretend, through relaxation of accounting standards, that these institutions were solvent or were capable of regaining their feet quickly. Here we are a year later, and the two most profitable activities are derivatives market making and proprietary trading. Those are like the sub pumps being used to fill the hole of these fragile balance sheets.

JAY: Let me just remind our viewers quickly again: proprietary trading is when a Goldman Sachs, instead of taking somebody’s pension money or investment money and on their behalf guiding them into another investment, they take Goldman money and they do their own direct trading and buying.

JOHNSON: [inaudible] capital taking positions for their own book.

JAY: Which sometimes even puts them at odds with some of the people they’re advising from these other—some of their clients, essentially.


JAY: So two of the objectives of this legislation is limit or get rid of proprietary trading and to separate the derivatives. So if the leadership of the Democratic Party is trying to weaken both of these, again, why are they doing this?

JOHNSON: Well, the whole structure of the bill is, essentially, instead of hard-wiring legislation and new rules, they’re trying to give the Fed discretion as the regulator when to impose and when to enforce rules. And that’s consistent with this idea of continued forbearance. They want to let these banks continue to earn their way back to strength. And their highest margin, highest profitability activities are proprietary trading, trading for the house, with subsidized money, and derivatives market making, which is another way to make profits that are enhanced by having access to the safety net. Those two things are the pumps that are trying to drive [inaudible] The administration, the Senate, and House leadership are quietly—’cause they don’t want to admit that these banks are still fragile, but those are the strategies used to dig out of this hole.

JAY: So President Obama a few months ago, when he tried to sell the bailouts and defend why they were following the policy they were, said, we’re only strengthening Wall Street because we’re really trying to strengthen Main Street, but you got to do that to get this. So is that true?

JOHNSON: The credit allocation system is a necessary but not sufficient condition for real economy strength. The strategy that they’ve chosen is to use this forbearance to strengthen these balance sheets. It’s not the only way, but it’s the way they’ve chosen. When you talk to treasury officials or White House officials, they will often tell you that after TARP there was no chance of going back and doing proper restructuring and proper bailouts with more of taxpayers’ money. The public was very, very hostile after that September/October 2008, around the time of Lehman Brothers’ failure. So they felt in many ways they had no option but forbearance because the public would be outraged. Unfortunately, during forbearance, with 30 percent rates on credit cards—many small businesses used to be charged 7.99 percent, with payday lending at 30 percent, without restructuring mortgages, that the public has borne the brunt while the bankers paid themselves renewed bonuses in 2009 and made everybody angry again. So it might have been the bailouts and repair, what you might call more instant repair, like in the RFC case—Reconstruction Finance Corporation in the 1930s that Roosevelt did. The credit system would’ve gotten back on its feet sooner. But instead, with forbearance, this is a prolonged grind, and a burden is imposed on the backs of the users of credit.

JAY: So what’s the real alternative? I mean, if you could write this legislation, what would it be?

JOHNSON: If I could write this legislation, I would make more transparent the accounting standards, snapshot these balance sheets.

JAY: But if it was really transparent, people would run for the hills, because if I understand correctly, the amount of debt they’re hiding on their books right now would show that they’re practically insolvent.

JOHNSON: Well, with a lot of mortgages underwater, so-called first mortgages, equity lines of credit, and second mortgages should be worthless. My understanding from security analysts is they’re being carried at $0.80 on the dollar on the books of many banks. That’s a fiction. The biggest danger of this fiction has been that by playing along with the fiction allowed overstated earnings and overstated bonus pools. Last year, over $40 billion was paid in bonus pools. That money should have been used to recapitalize these banks.

JAY: I mean, if you want a cynical look from the outside, the policies seem to have been far more about defending those bonus points and defending the individuals who were running these institutions than about fixing the American economy.

JOHNSON: Those are big donors to the political process both on the Hill and in the administration. People depend upon the mother’s milk in politics, called money, to get reelected.

JAY: Now, I heard Goldman Sachs had a dinner last night and the guest speaker was Condoleezza Rice. What message are they trying to send here?

JOHNSON: They’re probably talking about oil spills. Condoleezza Rice had a lot of influence in the national security and oil world.

JAY: But is this sort of a message that—to the Democrats, like, while you’re negotiating the finance reform bill, let us remind you we may have other alternatives?

JOHNSON: I think they’ve been serving that reminder both, I would say, last fall and this spring during the financial reform process. We’ve seen the money from the Federal Election Commission shift markedly towards the Republicans. Democrats are in a dangerous place regarding passage, because if they don’t pass the bill, the American public can look at them and say, you had the White House, majority in the House, you had 59 votes in the Senate, and you didn’t pass financial reform? You’re not fit to govern. If they do pass a bill that’s watered down—and it’s largely been watered down ’cause of this competition over fundraising from the financial industry, and the Republicans have played a role in this—at the end of it they can pass a bill that’s not strong enough, the public will know it, and Republicans can vote against it and say, “See? The Democrats are in the pocket of Wall Street.” This is a very, very treacherous game in terms of politics right now. The public policy is not being well served, ’cause the role of money in politics is far too great. And that’s true in health care, in energy, and most powerfully in finance.

JAY: In the real world of today’s politics—and what I’m about to propose may not be passable in the real world of today’s politics, but without some kind of public option, in other words, some kind of public type of banking, is this actually fixable? I mean, has it simply gotten to a point that the existing structure of the finance sector is essentially—some people have called so parasitic that it really isn’t fixable? In other words, like, go gamble, but don’t use any public money, and let’s take our public money and build a public institution.

JOHNSON: Well, what you have to ask is: who’s going to run the public institution in a healthy manner? Some might argue that it can’t be any worse than what we just had.

JAY: I mean, I would say a good place to start is it shouldn’t be someone that used to run Goldman. That might be a good place to begin for your hiring committee.

JOHNSON: That might be supported by the body politic at this point. But you’ll also see, on the other side, Freddie Mac and Fannie Mae do not have a stellar track record. And what concerns me—.

JAY: But to a large extent after they were mostly privatized, though.

JOHNSON: After the middle of 2007, Tom Ferguson and I, who I know you’ve had as a guest on the program, have written a paper about how it was mysterious that Fannie Mae’s balance sheet started to expand in subprime mortgages just as everybody else’s balance sheet on Wall Street was declining. And what we’re suggesting—we don’t have a smoking gun, but what we’re suggesting is that was almost like a pre-TARP bailout. Those were asset purchases on a public balance sheet that next year the Republicans are going to make hay with, because when they come back and recapitalize and restructure Freddie and Fannie, they can point to much bigger losses. Should have been bigger losses on the balance sheets of the private sector.

JAY: Well, I’m just saying that that’s not a very good model for judging whether a public institution can work or not, because it wasn’t, you know, clearly a public institution with a public mandate.

JOHNSON: [inaudible] it was a hybrid [inaudible]

JAY: It was a weird hybrid, yeah. I mean, there are—for example, I understand in South Dakota there is essentially a publicly owned bank, and apparently people are quite happy with it.

JOHNSON: Well, my first job was with Cadillac Motor Company. My second job was with the Republican Senate Budget Committee. And unlike many people who have what you might call religion about the private sector and public sector, I thought the Senate Budget Committee under Pete Domenici was much better run than Cadillac Motor Company in the 1970s. So I’m a little bit confused about saying public sector can’t be good, private sector can only be good. I think it’s—how would I say it? Original sin is inside the soul of both public and private agents. It makes it complicated. We have seen over the course of history, though, many public credit institutions used very politically, and we’ve seen very, very substantial losses and mismanagement. So I am somewhat cautious about a public option. On the other hand, the American people right now should be doing what Gerald Taylor said on a panel I was on yesterday at this conference, which is: we should be talking about what is the purpose of a financial system, what is the purpose of a bank, what role does it play in a healthy society. Obviously, the institutions we’ve had in recent years are kind of ungovernable and doing things that are quite unrelated to that mission.

JAY: If the Lincoln piece of the Senate bill is not in the final legislation, in other words, if it’s so watered down that it’s not meaningful, in fact, if the whole bill is essentially so watered down, would you still think it should be voted for? Or would it be better to say this thing isn’t real and you should go back and get something real?

JOHNSON: A little bit depends on psychology. I think some of the consumer financial protection dimensions have a shot at being a stepping stone of progress. I think that there are pieces that may involve rating-agency reform that could be healthy. I think the resolution powers are a step in the right direction. But in terms of what you might call the danger of saying, well done, mission accomplished, when—.

JAY: ‘Cause that’s what they said about the health-care bill. Once they finally pass something, you know, now everybody’s calling it a victory, all the same people that two weeks before it was voted for were saying it’s an atrocity.

JOHNSON: Codifying corporate monopolies and pushing off the budget fight that medical costs that are two to three times what they are in the rest of the world, which are now going to lead to a fight over curtailment of Medicare, is not a victory. That’s kind of a passing moment. But the codification—.

JAY: But that seems to be the plan here is you fight, you pass something weak, and then you call it a victory.

JOHNSON: You know, that’s the marketing spin. We’ll see if the American people believe that in November.

JAY: Thanks for joining us.

JOHNSON: My pleasure.

JAY: Thank you for joining us on The Real News Network.

DISCLAIMER: Please note that transcripts for The Real News Network are typed from a recording of the program. TRNN cannot guarantee their complete accuracy.

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Dr. Robert A. Johnson - Executive Director of The Institute New Economic Thinking (INET) and a senior fellow at the Roosevelt Institute. Dr. Johnson served on the United Nations Commission of Experts on International Monetary Reform under the Chairmanship of Joseph Stiglitz. He is also the Director of Economic Policy for the Franklin and Eleanor Roosevelt Institute (FERI) in New York. Dr. Johnson was previously a managing director at Soros Fund Management where he managed a global currency, bond and equity portfolio specializing in emerging markets. Prior to that time, Johnson was a managing director of Bankers Trust Company managing a global currency fund. He also served as Chief Economist of the U.S. Senate Banking Committee under the leadership of Chairman William Proxmire (D. Wisconsin) and before that, he was Senior Economist of the U.S. Senate Budget Committee under the leadership of Chairman Pete Domenici (R. New Mexico).