AIG-Gate: The World's Greatest Insurance Heist

Remember: A derivative dollar lost on one side, is gained on another side!

http://www.huffingtonpost.com/ellen-brown/aig-gate-the-worlds-great_b_451445.html

Ellen Brown
The Huffington Post
Sat, 06 Feb 2010

Rumor has it that Timothy Geithner is on his way out as Treasury Secretary, due to his involvement in the AIG scandal that is now unraveling in hearings before the House Oversight and Reform Committee. Bob Chapman writes in The International Forecaster:
Each day brings more revelations of efforts of the NY Fed and Goldman Sachs to hide the details of the criminal conspiracy of the AIG bailout ... This is a real crisis on the scale of Watergate. Corruption at its finest.
But unlike the perpetrators of the Watergate scandal, who wound up facing jail time, Geithner evidently has a golden parachute waiting at Goldman Sachs, not coincidentally the largest recipient of the AIG bailout. At least that is the rumor sparked by an article by Caroline Baum on Bloomberg News, titled "Goldman Parachute Awaits Geithner to Ease Fall." Hank Paulson, Geithner's predecessor, was CEO of Goldman Sachs before coming to the Treasury. Geithner, who has come up through the ranks of government, could be walking through the revolving door in the other direction.

Geithner has been under the House microscope for the decision of the New York Fed, made while he headed it, to buy out about $30 billion in credit default swaps (over-the-counter derivative insurance contracts) that AIG sold on toxic debt securities. The chief recipients of this payout were Goldman Sachs, Merrill Lynch, Societe Generale, and Deutsche Bank. Goldman got $13 billion, roughly equivalent to its bonus pool for the first 9 months of 2009. Critics are calling the New York Fed's decision a back-door bailout for the banks, which received 100 cents on the dollar for contracts that would have been worth far less had AIG been put through bankruptcy proceedings in the ordinary way. In a Bloomberg article provocatively titled "Secret Banking Cabal Emerges from AIG Shadows," David Reilly writes:
[T]he New York Fed is a quasi-governmental institution that isn't subject to citizen intrusions such as freedom of information requests, unlike the Federal Reserve. This impenetrability comes in handy since the bank is the preferred vehicle for many of the Fed's bailout programs. It's as though the New York Fed was a black-ops outfit for the nation's central bank.
The beneficiaries of the New York Fed's largesse got paid in full although they had agreed to take much less. In a November 2009 article titled "It's Time to Fire Tim Geithner," Dylan Ratigan wrote:
[L]ast November . . . New York Federal Reserve Governor Tim Geithner decided to deliver 100 cents on the dollar, in secret no less, to pay off the counter parties to the world's largest (and still un-investigated) insurance fraud -- AIG. This full payoff with taxpayer dollars was carried out by Geithner after AIG's bank customers, such as Goldman Sachs, Deutsche Bank and Societe Generale, had already previously agreed to taking as little as 40 cents on the dollar. Even after the GM autoworkers, bondholders and vendors all received a government-enforced haircut on their contracts, he still had the audacity to claim the "sanctity of contracts" in the dealings with these companies like AIG.
Geithner testified that the Fed's hands were tied and that the bank could not "selectively default on contractual obligations without courting collapse." But if it was all on the up and up, why all the secrecy? The contention that the Fed had no choice is also belied by a recent holding in the Lehman Brothers bankruptcy, in which New York Bankruptcy Judge James Peck set aside the same type of investment contracts that Secretaries Paulson and Geithner repeatedly swore under oath had to be paid in full in the case of AIG. The judge declared that clauses in those contracts subordinating other claims to the holders' claims were null and void in bankruptcy.

"And notice," comments bank analyst Chris Whalen, "that the world has not ended when the holders of [derivative] contracts are treated like everyone else." He calls the AIG bailout "a hideous political contrivance that ranks with the great acts of political corruption and thievery in the history of the United States."

If you tell a lie big enough and keep repeating it, said Joseph Goebbels, people will eventually come to believe it. The bailout of Wall Street initiated in September 2008 was premised on the dire prediction that if major counterparties in the massive edifice of derivative contracts were allowed to fall, the whole interlocking house of cards would collapse and take the economy with it.

A hijacked Congress dutifully protected the derivatives game with taxpayer money while the real economy proceeded to collapse, the financial sector choosing to put their money into this protected form of speculative betting rather than into the more mundane and risky business of making loans to struggling businesses and homeowners. In the end, $170 billion of federal funds went to AIG and the banks feeding at its trough. Meanwhile, a survey of state finances by the Center on Budget and Policy Priorities think tank found that state governments face a collective $168 billion budget shortfall for fiscal 2010. If the money used to bail out AIG and the banks had been used to bail out the states instead, the states would not be facing insolvency today.

There is no law against gambling, but there is a law against fraud. In Watergate, a special prosecutor was appointed to bring criminal charges; but times seem to have changed.

Testy Conflict With Goldman Helped Push A.I.G. to Edge

http://www.nytimes.com/2010/02/07/business/07goldman.html

Gretchen Morgenson and Louise Story
New York Times
Sat, 06 Feb 2010

Billions of dollars were at stake when 21 executives of Goldman Sachs and the American International Group convened a conference call on Jan. 28, 2008, to try to resolve a rancorous dispute that had been escalating for months.

A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world's biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer.

A.I.G. executives wanted some of its money back, insisting that Goldman - like a homeowner overestimating the damages in a storm to get a bigger insurance payment - had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.

After more than an hour of debate, the two sides on the call signed off with nothing settled, according to internal A.I.G. documents and an audio recording reviewed by The New York Times.

Behind-the-scenes disputes over huge sums are common in banking, but the standoff between A.I.G. and Goldman would become one of the most momentous in Wall Street history. Well before the federal government bailed out A.I.G. in September 2008, Goldman's demands for billions of dollars from the insurer helped put it in a precarious financial position by bleeding much-needed cash. That ultimately provoked the government to step in.

With taxpayer assistance to A.I.G. currently totaling $180 billion, regulatory and Congressional scrutiny of Goldman's role in the insurer's downfall is increasing. The Securities and Exchange Commission is examining the payment demands that a number of firms - most prominently Goldman - made during 2007 and 2008 as the mortgage market imploded.

The S.E.C. wants to know whether any of the demands improperly distressed the mortgage market, according to people briefed on the matter who requested anonymity because the inquiry was intended to be confidential.

In just the year before the A.I.G. bailout, Goldman collected more than $7 billion from A.I.G. And Goldman received billions more after the rescue. Though other banks also benefited, Goldman received more taxpayer money, $12.9 billion, than any other firm.

In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Société Générale, a French bank that traded with A.I.G., was subsequently transferred to Goldman under a deal the two banks had struck.

Goldman stood to gain from the housing market's implosion because in late 2006, the firm had begun to make huge trades that would pay off if the mortgage market soured. The further mortgage securities' prices fell, the greater were Goldman's profits.

In its dispute with A.I.G., Goldman invariably argued that the securities in dispute were worth less than A.I.G. estimated - and in many cases, less than the prices at which other dealers valued the securities.

The pricing dispute, and Goldman's bets that the housing market would decline, has left some questioning whether Goldman had other reasons for lowballing the value of the securities that A.I.G. had insured, said Bill Brown, a law professor at Duke University who is a former employee of both Goldman and A.I.G.

The dispute between the two companies, he said, "was the tip of the iceberg of this whole crisis."

"It's not just who was right and who was wrong," Mr. Brown said. "I also want to know their motivations. There could have been an incentive for Goldman to say, 'A.I.G., you owe me more money.' "

Goldman is proud of its reputation for aggressively protecting itself and its shareholders from losses as it did in the dispute with A.I.G.

In March 2009, David A. Viniar, Goldman's chief financial officer, discussed his firm's dispute with A.I.G. in a conference call with reporters. "We believed that the value of these positions was lower than they believed," he said.

Asked by a reporter whether his bank's persistent payment demands had contributed to A.I.G.'s woes, Mr. Viniar said that Goldman had done nothing wrong and that the firm was merely seeking to enforce its insurance policy with A.I.G. "I don't think there is any guilt whatsoever," he concluded.

Lucas van Praag, a Goldman spokesman, reiterated that position. "We requested the collateral we were entitled to under the terms of our agreements," he said in a written statement, "and the idea that A.I.G. collapsed because of our marks is ridiculous."

Still, documents show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with A.I.G. required. And Goldman based some payment demands on lower-rated bonds that A.I.G.'s insurance did not even cover.

A November 2008 analysis by BlackRock, a leading asset management firm, noted that Goldman's valuations of the securities that A.I.G. insured were "consistently lower than third-party prices."

To be sure, many now agree that A.I.G. was reckless during the mortgage mania. The firm, once the world's largest insurer, had written far more insurance than it could have possibly paid if a national mortgage debacle occurred - as, in fact, it did.

Perhaps the most intriguing aspect of the relationship between Goldman and A.I.G. was that without the insurer to provide credit insurance, the investment bank could not have generated some of its enormous profits betting against the mortgage market. And when that market went south, A.I.G. became its biggest casualty - and Goldman became one of the biggest beneficiaries.

Longstanding Ties

For decades, A.I.G. and Goldman had a deep and mutually beneficial relationship, and at one point in the 1990s, they even considered merging. At around the same time, in 1998, A.I.G. entered a lucrative new business: insuring the least risky portions of corporate loans or other assets that were bundled into securities.

A.I.G.'s financial products unit, led by Joseph J. Cassano, was behind the expansion. To reduce its own risks in the transactions, the company structured deals so that it would not have to make early payments to clients when securities began to sour. That changed around 2003, however, when A.I.G. began insuring portions of subprime mortgage deals. A lawyer for Mr. Cassano said his client would not comment for this article. A.I.G. also declined to comment.

Alan Frost, a managing director in Mr. Cassano's unit, negotiated scores of mortgage deals around Wall Street that included a complicated sequence of events for when an insurance payment on a distressed asset came due.

The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.'s own credit rating was downgraded. If all of those things happened, A.I.G. would have to make even larger payments.

Mr. Frost referred questions to his lawyer, who declined to comment.

Traders loved Mr. Frost's deals because they would pay out quickly if anything went wrong. Mr. Frost cut many of his deals with two Goldman traders, Jonathan Egol and Ram Sundaram, who had negative views of the housing market. They had made A.I.G. a central part of some of their trading strategies.

Mr. Egol structured a group of deals - known as Abacus - so that Goldman could benefit from a housing collapse. Many of them were actually packages of A.I.G. insurance written against mortgage bonds, indicating that Mr. Egol and Goldman believed that A.I.G. would have to make large payments if the housing market ran aground. About $5.5 billion of Mr. Egol's deals still sat on A.I.G.'s books when the insurer was bailed out.

"Al probably did not know it, but he was working with the bears of Goldman," a former Goldman salesman, who requested anonymity so he would not jeopardize his business relationships, said of Mr. Frost. "He was signing A.I.G. up to insure trades made by people with really very negative views" of the housing market.

Mr. Sundaram's trades represented another large part of Goldman's business with A.I.G. According to five former Goldman employees, Mr. Sundaram used financing from other banks like Société Générale and Calyon to purchase less risky mortgage securities from competitors like Merrill Lynch and then insure the assets with A.I.G. - helping fatten the mortgage pipeline that would prove so harmful to Wall Street, investors and taxpayers. In October 2008, just after A.I.G. collapsed, Goldman made Mr. Sundaram a partner.

Through Société Générale, Goldman was also able to buy more insurance on mortgage securities from A.I.G., according to a former A.I.G. executive with direct knowledge of the deals. A spokesman for Société Générale declined to comment.

It is unclear how much Goldman bought through the French bank, but A.I.G. documents show that Goldman was involved in pricing half of Société Générale's $18.6 billion in trades with A.I.G. and that the insurer's executives believed that Goldman pressed Société Générale to also demand payments.

Goldman's Tough Terms

In addition to insuring Mr. Sundaram's and Mr. Egol's trades with A.I.G., Goldman also negotiated aggressively with A.I.G. - often requiring the insurer to make payments when the value of mortgage bonds fell by just 4 percent. Most other banks dealing with A.I.G. did not receive payments until losses exceeded 8 percent, the insurer's records show.

Several former Goldman partners said it was not surprising that Goldman sought such tough terms, given the firm's longstanding focus on risk management.

By July 2007, when Goldman demanded its first payment from A.I.G. - $1.8 billion - the investment bank had already taken trading positions that would pay out if the mortgage market weakened, according to seven former Goldman employees.

Still, Goldman's initial call surprised A.I.G. officials, according to three A.I.G. employees with direct knowledge of the situation. The insurer put up $450 million on Aug. 10, 2007, to appease Goldman, but A.I.G. remained resistant in the following months and, according to internal messages, was convinced that Goldman was also pushing other trading partners to ask A.I.G. for payments.

On Nov. 1, 2007, for example, an e-mail message from Mr. Cassano, the head of A.I.G. Financial Products, to Elias Habayeb, an A.I.G. accounting executive, said that a payment demand from Société Générale had been "spurred by GS calling them."

Mr. Habayeb, who testified before Congress last month that the payment demands were a major contributor to A.I.G.'s downfall, declined to be interviewed and referred questions to A.I.G. The insurer also declined to comment for this article. Mr. van Praag, the Goldman spokesman, said Goldman did not push other firms to demand payments from A.I.G.

Later that month, Mr. Cassano noted in another e-mail message that Goldman's demands for payment were becoming problematic. "The overhang of the margin call from the perceived righteous Goldman Sachs has impacted everyone's judgment," he wrote to five employees in his division.

By the end of November 2007, Goldman was holding $2 billion in cash from A.I.G. when the insurer notified Goldman that it was disputing the firm's calculations and seeking a return of $1.56 billion. Goldman refused, the documents show.

In many of these deals, Goldman was trading for other parties and taking a fee. As the mortgage market declined, Goldman paid some of these parties while waiting for A.I.G. to meet its demands, the Goldman spokesman said. But one reason those parties were owed money on the deals was that Goldman had marked down the securities.

Adding to the pressure on A.I.G., Mr. Viniar, Goldman's chief financial officer, advised the insurer in the fall of 2007 that because the two companies shared the same auditor, PricewaterhouseCoopers, A.I.G. should accept Goldman's valuations, according to a person with knowledge of the discussions. Goldman declined to comment on this exchange.

Pricewaterhouse had supported A.I.G.'s approach to valuing the securities throughout 2007, documents show. But at the end of 2007, the auditor began demanding that A.I.G. provide greater disclosure on the risks in the credit insurance it had written. Pricewaterhouse was expressing concern about the dispute.

The insurer disclosed in year-end regulatory filings that its auditor had found a "material weakness" in financial reporting related to valuations of the insurance, a troubling sign for investors.

A spokesman for Pricewaterhouse said the company would not comment on client matters.

Insiders at A.I.G. bridled at Goldman's insistence that they accept the investment bank's valuations. "Would we call bond issuers and ask them what the valuation of their bonds was and take that?" asked Robert Lewis, A.I.G.'s chief risk officer, in a message in January 2008. "What am I missing here, so I don't waste everybody's time?"

When A.I.G. asked Goldman to submit the dispute to a panel of independent firms, Goldman resisted, internal e-mail messages show. In a March 7, 2008, phone call, Mr. Cassano discussed surveying other dealers to gauge prices with Michael Sherwood, Goldman's vice chairman. At that time, Goldman calculated that A.I.G. owed it $4.6 billion, on top of the $2 billion already paid. A.I.G. contended it only owed an additional $1.2 billion.

Mr. Sherwood said he did not want to ask other firms to value the securities because "it would be 'embarrassing' if we brought the market into our disagreement," according to an e-mail message from Mr. Cassano that described the call.

The Goldman spokesman disputed this account, saying instead that Goldman was willing to consult third parties but could not agree with A.I.G. on the methodology.

Trouble Grows at A.I.G.

By the spring of 2008, A.I.G.'s dispute with Goldman was just one of its many woes. Mr. Cassano was pushed out in March and the company's defenses against the growing demand for payments faltered. By the end of August 2008, A.I.G. had posted $19.7 billion in cash to its trading partners, including Goldman, according to financial filings.

Over that summer, A.I.G. had tried, unsuccessfully, to cancel its insurance contracts with the trading partners. But Goldman, according to interviews with former A.I.G. executives, would allow that only if it also got to keep the $7 billion it had already received from A.I.G. Goldman wanted to keep the initial insurance payouts and the securities in order to profit from any future rebound.

In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance A.I.G. had written for several other banks at severely distressed prices, according to three people briefed on the discussions.

Negotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.

On Aug. 18, 2008, Goldman's equity research department published an in-depth report on A.I.G. The analysts advised the firm's clients to avoid the stock because of a "downward spiral which is likely to ensue as more actual cash losses emanate" from the insurer's financial products unit.

On the matter of whether A.I.G. could unwind its troublesome insurance on mortgage securities at a discount, the Goldman report noted that if a trading partner "is not in a position of weakness, why would it accept anything less than the full amount of protection for which it had paid?"

A.I.G. shares fell 6 percent the day the report was published. Three weeks later, the United States government agreed to pour billions of dollars in taxpayer money into the insurer to keep it from collapsing.

The government would soon settle the yearlong dispute between Goldman and A.I.G., with Goldman receiving full value for its bets. The federal bailout locked in the paper losses of those deals for A.I.G. The prices on many of those securities have since rebounded.

Banks’ Derivatives Activity Falls Under I.R.S. Scrutiny

http://www.nytimes.com/2010/01/21/business/21tax.html

January 21, 2010
By LYNNLEY BROWNING

Federal authorities are scrutinizing certain financial derivatives that may enable Wall Street banks to avoid collecting billions of dollars in withholding taxes on stock dividends.

The instruments, known as equity swaps, mimic ordinary shares and give investors like hedge funds the benefits of stock ownership, including payments similar to dividends, without actually owning the shares. Big banks also benefit from the swaps because, under federal tax rules, the banks may avoid paying a 30 percent tax that is normally levied on stock trades.

The Internal Revenue Service is examining whether banks are using the swaps to mask who really owns the shares underlying the instruments, thereby avoiding collecting dividend withholding taxes.

In effect, the I.R.S. suspects that the banks are disguising who owns the stock in order to help their offshore hedge fund clients avoid the withholding tax — a tax the banks are supposed to collect.

Mark H. Leeds, a tax lawyer at Greenberg Traurig, said on Wednesday that the scrutiny indicated the I.R.S. increasingly viewed equity swaps as “evidence of tax avoidance.”

In a directive issued last Thursday, the I.R.S. instructed its field agents on how to audit American banks and United States branches of foreign banks with an eye to “uncovering and developing cases” related to certain swap transactions “that may have been executed in order to avoid tax with respect to U.S. source dividend income” paid to offshore hedge funds and foreign investors.

“The audit guidelines reflect suspicion that all cross-border equity swaps are tax-avoidance transactions, even though the I.R.S.’s own regulations treated these transactions favorably,” Mr. Leeds said.

Tax lawyers regard the directive as significant because it concerns a vast, unregulated market and could lead to tax disputes between the I.R.S. and Wall Street banks. The exact size of the equity swaps market is difficult to ascertain, but the Bank of International Settlements puts the notional value of all equity-linked swaps and forwards, which are similar derivatives, at nearly $1.7 trillion as of last June.

The I.R.S. made rooting out abuses with equity swaps a top priority in March. A bill in the Senate, which passed the House last December, would sharply curtail the tax benefits on equity swaps.

In September 2008, a Senate subcommittee issued a scathing report, “Dividend Tax Abuse,” that accused Wall Street banks of marketing and selling complex swaps intended to evade taxes on dividend payments.

The report said trades in equity swaps had flourished over the last 10 years and grown lucrative for Wall Street banks.

A typical equity swap involves a hedge fund agreeing to pay a Wall Street bank’s losses on a stock in exchange for the bank’s promise to pay stock gains and dividends to the fund. Because the swaps are derivatives, no shares actually change hands.

The I.R.S. directive identified four types of swaps: cross in-cross out; cross in-interbroker dealer out; cross in-foreign affiliate out; and synthetic equity transactions.

Former Morgan Stanley Infrastructure & Energy Specialist, Who Was Also Director of Private-Equity Firm EQT Partners, Found Dead in Back of Delivery Va

http://www.altassets.com/private-equity-news/article/nz17700.html

Alt Assets
Tue, 19 Jan 2010 15:29 EST

A director of private equity firm EQT Partners has been murdered, according to reports. The body of Dirk von Poschinger-Camphausen, who worked at Morgan Stanley before joining EQT last year, was reportedly found in a delivery van in a suburb of Munich over the weekend.

A Munich police spokesman told Bloomberg there was "no doubt" that Poschinger-Camphausen had been murdered.

According to Munich newspaper Abendzeitung, police have made three arrests in connection with the case. The paper said the men may have killed Poschinger-Camphausen as they were attempting to take his high-end Audi car, which he had been seeking to sell for €54,000 online in preparation for a move to the US.

The car was reportedly found near the delivery van where Poschinger-Camphausen's body was discovered on Saturday.

EQT issued the following statement, "It is with great sadness and dismay we learned that our dear colleague Dirk von Poschinger-Camphausen was found dead by the Munich police this weekend."

"This is a horrible tragedy for Dirk's family as well as for EQT and our thoughts go to Dirk's wife and two young daughters. We are doing everything we can to support them at this difficult time."

Regulators Seek to Throw Light on Hedge Fund Impact in Energy Trading

http://www.opednews.com/articles/Regulators-Seek-to-Throw-L-by-OilGuy-100111-332.html

January 12, 2010
By OilGuy

Do hedge funds have an impact on energy trading?

While the answer might seem intuitive, the debate as to whether they actually do has come to resemble the medieval theological dispute about how many angels can dance on the head of the pin.

Because, like angels, many trades in energy futures are invisible, and it is often not possible to pinpoint where they take place.

And yet, for most of us, including lawmakers on Capitol Hill, it seems obvious that when hedge funds buy and sell billions of dollars worth of oil and gas futures, it must be having an impact on energy prices. While hedge funds and other speculative traders would never dream of taking delivery of a barrel of oil, their trading activity affects the prices for actual consumers of oil and gas and their downstream customers or so it would seem.

When Gary Gensler, a former Goldman Sachs banker and Treasury Department official, was nominated last year as chairman of the Commodity Futures and Trading Commission the chief regulator for energy futures trading he reversed the CFTC party line that speculators don't have an impact on energy trading.

"I believe that excessive speculation in commodity futures can cause sudden or unreasonable fluctuations or unwarranted changes in commodity prices," Gensler said in a written response to lawmakers' questions ahead of his nomination hearing.

Gensler went on to pledge that if confirmed, he would have the CFTC guard against such speculation.

While he stopped short of saying that excessive speculation had taken place in the run-up of energy prices in 2008, he did express the opinion that the rapid growth of commodity index funds and increased hedge fund allocation to commodity assets contributed to the "bubble in commodities prices that peaked in mid-2008."

He noted that non-commercial investors sometimes account for up to 90% of open interest in a contract. (Open interest is a calculation of the number of active trades for a particular market, and is used as an indicator whether trading is becoming more or less active.)

Gensler's answer, enshrined in draft legislation currently before Congress, is to make trades more visible by requiring all over-the-counter derivatives to trade through an approved clearing house. While the thrust of new legislation is to get a better handle on financial derivatives such as credit default swaps, it will give regulators a better picture of all derivatives trading, including energy contracts.

At the same time, the CFTC and the Securities and Exchange Commission both are beefing up their ability to monitor hedge fund activity. The SEC for the first time will require hedge funds to register as investment advisors, and Gensler has pledged closer oversight of the funds that it supervises as commodity pool operators.

The industry, predictably, is pushing back. In congressional testimony on the new legislation, the Chicago Mercantile Exchange, the largest futures exchange in the world, and other exchange operators presented studies based on CFTC data to show that large positions held by index funds and other managed money were not "routinely detrimental" to the commodity markets in the period January 2005 to June 2008.

"All of the trader groups displayed instances of non-optimal behavior (including small traders), but none were consistently harmful to the studied markets," they said.

A task force of the International Organization of Securities Regulators (IOSCO) released a report last March that came to a similar conclusion.

"While reports reviewed by the task force concluded that fundamentals rather than speculative activity was the plausible explanation for price changes, the task force has made a number of recommendations to improve the transparency and supervision of these markets," IOSCO said.

These included suggestions regarding information about the underlying commodities, access to and sharing of information about trading positions, beefing up enforcement powers, and improving global coordination.

The spectacular collapse of the Amaranth Advisors hedge fund in 2006 when it lost $6 billion on natural gas futures did pull back the veil on hedge fund activity in energy markets. Amaranth built up its huge position in natural gas futures through OTC contracts that exactly mirrored the contracts on the New York Mercantile Exchange but remained hidden from regulators, who were unable to enforce position limits designed to rein in speculative trading.

In hearings about Amaranth before various House and Senate committees as well as at the CFTC itself, it became clear, at least to many lawmakers, that contracts on unregulated trading venues can influence prices.

The case was so straightforward that it prompted the Federal Energy Regulatory Commission to flex its new post-Enron mandate to stop manipulation of energy prices by pursuing disciplinary action against Amaranth.

This led to a turf war with the CFTC, which claimed exclusive jurisdiction over futures trading and argued that FERC's mandate extended only to spot trading. FERC countered that when activity in the futures market affected spot prices, it was authorized to act.

Those proceedings ended in a joint settlement last August, before either CFTC or FERC held their administrative hearings and before an appellate court could decide the jurisdictional issue.

But the Amaranth case remains as a reminder of what a hedge fund can do in energy markets if these trades are not more transparent. Legislation bringing more visibility to the market and strengthening the hand of regulators will ensure that hedge fund activity in the energy markets will be more closely monitored and limited.

This article was written by Darrell Delamaide for OilPrice.com who focus on Fossil Fuels, Alternative Energy, Metals, Oil Prices and http://www.oilprice.com/articles-geopolitics.php" target="new">Geopolitics. To find out more visit their website at: http://www.oilprice.com

Tactics that would make a mafia loan shark blush

The Quiet Coup

http://www.theatlantic.com/doc/200905/imf-advice

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform. And if we are to prevent a true depression, we’re running out of time.

by Simon Johnson
The Quiet Coup
May 2009

ONE THING YOU learn rather quickly when working at the International Monetary Fund is that no one is ever very happy to see you. Typically, your “clients” come in only after private capital has abandoned them, after regional trading-bloc partners have been unable to throw a strong enough lifeline, after last-ditch attempts to borrow from powerful friends like China or the European Union have fallen through. You’re never at the top of anyone’s dance card.

The reason, of course, is that the IMF specializes in telling its clients what they don’t want to hear. I should know; I pressed painful changes on many foreign officials during my time there as chief economist in 2007 and 2008. And I felt the effects of IMF pressure, at least indirectly, when I worked with governments in Eastern Europe as they struggled after 1989, and with the private sector in Asia and Latin America during the crises of the late 1990s and early 2000s. Over that time, from every vantage point, I saw firsthand the steady flow of officials—from Ukraine, Russia, Thailand, Indonesia, South Korea, and elsewhere—trudging to the fund when circumstances were dire and all else had failed.

Every crisis is different, of course. Ukraine faced hyperinflation in 1994; Russia desperately needed help when its short-term-debt rollover scheme exploded in the summer of 1998; the Indonesian rupiah plunged in 1997, nearly leveling the corporate economy; that same year, South Korea’s 30-year economic miracle ground to a halt when foreign banks suddenly refused to extend new credit.

But I must tell you, to IMF officials, all of these crises looked depressingly similar. Each country, of course, needed a loan, but more than that, each needed to make big changes so that the loan could really work. Almost always, countries in crisis need to learn to live within their means after a period of excess—exports must be increased, and imports cut—and the goal is to do this without the most horrible of recessions. Naturally, the fund’s economists spend time figuring out the policies—budget, money supply, and the like—that make sense in this context. Yet the economic solution is seldom very hard to work out.

No, the real concern of the fund’s senior staff, and the biggest obstacle to recovery, is almost invariably the politics of countries in crisis.

Typically, these countries are in a desperate economic situation for one simple reason—the powerful elites within them overreached in good times and took too many risks. Emerging-market governments and their private-sector allies commonly form a tight-knit—and, most of the time, genteel—oligarchy, running the country rather like a profit-seeking company in which they are the controlling shareholders. When a country like Indonesia or South Korea or Russia grows, so do the ambitions of its captains of industry. As masters of their mini-universe, these people make some investments that clearly benefit the broader economy, but they also start making bigger and riskier bets. They reckon—correctly, in most cases—that their political connections will allow them to push onto the government any substantial problems that arise.

In Russia, for instance, the private sector is now in serious trouble because, over the past five years or so, it borrowed at least $490 billion from global banks and investors on the assumption that the country’s energy sector could support a permanent increase in consumption throughout the economy. As Russia’s oligarchs spent this capital, acquiring other companies and embarking on ambitious investment plans that generated jobs, their importance to the political elite increased. Growing political support meant better access to lucrative contracts, tax breaks, and subsidies. And foreign investors could not have been more pleased; all other things being equal, they prefer to lend money to people who have the implicit backing of their national governments, even if that backing gives off the faint whiff of corruption.

But inevitably, emerging-market oligarchs get carried away; they waste money and build massive business empires on a mountain of debt. Local banks, sometimes pressured by the government, become too willing to extend credit to the elite and to those who depend on them. Overborrowing always ends badly, whether for an individual, a company, or a country. Sooner or later, credit conditions become tighter and no one will lend you money on anything close to affordable terms.

The downward spiral that follows is remarkably steep. Enormous companies teeter on the brink of default, and the local banks that have lent to them collapse. Yesterday’s “public-private partnerships” are relabeled “crony capitalism.” With credit unavailable, economic paralysis ensues, and conditions just get worse and worse. The government is forced to draw down its foreign-currency reserves to pay for imports, service debt, and cover private losses. But these reserves will eventually run out. If the country cannot right itself before that happens, it will default on its sovereign debt and become an economic pariah. The government, in its race to stop the bleeding, will typically need to wipe out some of the national champions—now hemorrhaging cash—and usually restructure a banking system that’s gone badly out of balance. It will, in other words, need to squeeze at least some of its oligarchs.

Squeezing the oligarchs, though, is seldom the strategy of choice among emerging-market governments. Quite the contrary: at the outset of the crisis, the oligarchs are usually among the first to get extra help from the government, such as preferential access to foreign currency, or maybe a nice tax break, or—here’s a classic Kremlin bailout technique—the assumption of private debt obligations by the government. Under duress, generosity toward old friends takes many innovative forms. Meanwhile, needing to squeeze someone, most emerging-market governments look first to ordinary working folk—at least until the riots grow too large.

Eventually, as the oligarchs in Putin’s Russia now realize, some within the elite have to lose out before recovery can begin. It’s a game of musical chairs: there just aren’t enough currency reserves to take care of everyone, and the government cannot afford to take over private-sector debt completely.

So the IMF staff looks into the eyes of the minister of finance and decides whether the government is serious yet. The fund will give even a country like Russia a loan eventually, but first it wants to make sure Prime Minister Putin is ready, willing, and able to be tough on some of his friends. If he is not ready to throw former pals to the wolves, the fund can wait. And when he is ready, the fund is happy to make helpful suggestions—particularly with regard to wresting control of the banking system from the hands of the most incompetent and avaricious “entrepreneurs.”

Of course, Putin’s ex-friends will fight back. They’ll mobilize allies, work the system, and put pressure on other parts of the government to get additional subsidies. In extreme cases, they’ll even try subversion—including calling up their contacts in the American foreign-policy establishment, as the Ukrainians did with some success in the late 1990s.

Many IMF programs “go off track” (a euphemism) precisely because the government can’t stay tough on erstwhile cronies, and the consequences are massive inflation or other disasters. A program “goes back on track” once the government prevails or powerful oligarchs sort out among themselves who will govern—and thus win or lose—under the IMF-supported plan. The real fight in Thailand and Indonesia in 1997 was about which powerful families would lose their banks. In Thailand, it was handled relatively smoothly. In Indonesia, it led to the fall of President Suharto and economic chaos.

From long years of experience, the IMF staff knows its program will succeed—stabilizing the economy and enabling growth—only if at least some of the powerful oligarchs who did so much to create the underlying problems take a hit. This is the problem of all emerging markets.

Becoming a Banana Republic
In its depth and suddenness, the U.S. economic and financial crisis is shockingly reminiscent of moments we have recently seen in emerging markets (and only in emerging markets): South Korea (1997), Malaysia (1998), Russia and Argentina (time and again). In each of those cases, global investors, afraid that the country or its financial sector wouldn’t be able to pay off mountainous debt, suddenly stopped lending. And in each case, that fear became self-fulfilling, as banks that couldn’t roll over their debt did, in fact, become unable to pay. This is precisely what drove Lehman Brothers into bankruptcy on September 15, causing all sources of funding to the U.S. financial sector to dry up overnight. Just as in emerging-market crises, the weakness in the banking system has quickly rippled out into the rest of the economy, causing a severe economic contraction and hardship for millions of people.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.

The financial industry has not always enjoyed such favored treatment. But for the past 25 years or so, finance has boomed, becoming ever more powerful. The boom began with the Reagan years, and it only gained strength with the deregulatory policies of the Clinton and George W. Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest-rate swaps, and credit-default swaps greatly increased the volume of transactions that bankers could make money on. And an aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.


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Not surprisingly, Wall Street ran with these opportunities. From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent. Pay rose just as dramatically. From 1948 to 1982, average compensation in the financial sector ranged between 99 percent and 108 percent of the average for all domestic private industries. From 1983, it shot upward, reaching 181 percent in 2007.

The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent.

The Wall Street–Washington Corridor
Of course, the U.S. is unique. And just as we have the world’s most advanced economy, military, and technology, we also have its most advanced oligarchy.

In a primitive political system, power is transmitted through violence, or the threat of violence: military coups, private militias, and so on. In a less primitive system more typical of emerging markets, power is transmitted via money: bribes, kickbacks, and offshore bank accounts. Although lobbying and campaign contributions certainly play major roles in the American political system, old-fashioned corruption—envelopes stuffed with $100 bills—is probably a sideshow today, Jack Abramoff notwithstanding.

Instead, the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.

One channel of influence was, of course, the flow of individuals between Wall Street and Washington. Robert Rubin, once the co-chairman of Goldman Sachs, served in Washington as Treasury secretary under Clinton, and later became chairman of Citigroup’s executive committee. Henry Paulson, CEO of Goldman Sachs during the long boom, became Treasury secretary under George W.Bush. John Snow, Paulson’s predecessor, left to become chairman of Cerberus Capital Management, a large private-equity firm that also counts Dan Quayle among its executives. Alan Greenspan, after leaving the Federal Reserve, became a consultant to Pimco, perhaps the biggest player in international bond markets.

These personal connections were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street. It has become something of a tradition for Goldman Sachs employees to go into public service after they leave the firm. The flow of Goldman alumni—including Jon Corzine, now the governor of New Jersey, along with Rubin and Paulson—not only placed people with Wall Street’s worldview in the halls of power; it also helped create an image of Goldman (inside the Beltway, at least) as an institution that was itself almost a form of public service.

Wall Street is a very seductive place, imbued with an air of power. Its executives truly believe that they control the levers that make the world go round. A civil servant from Washington invited into their conference rooms, even if just for a meeting, could be forgiven for falling under their sway. Throughout my time at the IMF, I was struck by the easy access of leading financiers to the highest U.S. government officials, and the interweaving of the two career tracks. I vividly remember a meeting in early 2008—attended by top policy makers from a handful of rich countries—at which the chair casually proclaimed, to the room’s general approval, that the best preparation for becoming a central-bank governor was to work first as an investment banker.

A whole generation of policy makers has been mesmerized by Wall Street, always and utterly convinced that whatever the banks said was true. Alan Greenspan’s pronouncements in favor of unregulated financial markets are well known. Yet Greenspan was hardly alone. This is what Ben Bernanke, the man who succeeded him, said in 2006: “The management of market risk and credit risk has become increasingly sophisticated. … Banking organizations of all sizes have made substantial strides over the past two decades in their ability to measure and manage risks.”

Of course, this was mostly an illusion. Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 billion in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.

Wall Street’s seductive power extended even (or especially) to finance and economics professors, historically confined to the cramped offices of universities and the pursuit of Nobel Prizes. As mathematical finance became more and more essential to practical finance, professors increasingly took positions as consultants or partners at financial institutions. Myron Scholes and Robert Merton, Nobel laureates both, were perhaps the most famous; they took board seats at the hedge fund Long-Term Capital Management in 1994, before the fund famously flamed out at the end of the decade. But many others beat similar paths. This migration gave the stamp of academic legitimacy (and the intimidating aura of intellectual rigor) to the burgeoning world of high finance.

As more and more of the rich made their money in finance, the cult of finance seeped into the culture at large. Works like Barbarians at the Gate, Wall Street, and Bonfire of the Vanities—all intended as cautionary tales—served only to increase Wall Street’s mystique. Michael Lewis noted in Portfolio last year that when he wrote Liar’s Poker, an insider’s account of the financial industry, in 1989, he had hoped the book might provoke outrage at Wall Street’s hubris and excess. Instead, he found himself “knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share. … They’d read my book as a how-to manual.” Even Wall Street’s criminals, like Michael Milken and Ivan Boesky, became larger than life. In a society that celebrates the idea of making money, it was easy to infer that the interests of the financial sector were the same as the interests of the country—and that the winners in the financial sector knew better what was good for America than did the career civil servants in Washington. Faith in free financial markets grew into conventional wisdom—trumpeted on the editorial pages of The Wall Street Journal and on the floor of Congress.

From this confluence of campaign finance, personal connections, and ideology there flowed, in just the past decade, a river of deregulatory policies that is, in hindsight, astonishing:

• insistence on free movement of capital across borders;

• the repeal of Depression-era regulations separating commercial and investment banking;

• a congressional ban on the regulation of credit-default swaps;

• major increases in the amount of leverage allowed to investment banks;

• a light (dare I say invisible?) hand at the Securities and Exchange Commission in its regulatory enforcement;

• an international agreement to allow banks to measure their own riskiness;

• and an intentional failure to update regulations so as to keep up with the tremendous pace of financial innovation.

The mood that accompanied these measures in Washington seemed to swing between nonchalance and outright celebration: finance unleashed, it was thought, would continue to propel the economy to greater heights.

America’s Oligarchs and the Financial Crisis
The oligarchy and the government policies that aided it did not alone cause the financial crisis that exploded last year. Many other factors contributed, including excessive borrowing by households and lax lending standards out on the fringes of the financial world. But major commercial and investment banks—and the hedge funds that ran alongside them—were the big beneficiaries of the twin housing and equity-market bubbles of this decade, their profits fed by an ever-increasing volume of transactions founded on a relatively small base of actual physical assets. Each time a loan was sold, packaged, securitized, and resold, banks took their transaction fees, and the hedge funds buying those securities reaped ever-larger fees as their holdings grew.

Because everyone was getting richer, and the health of the national economy depended so heavily on growth in real estate and finance, no one in Washington had any incentive to question what was going on. Instead, Fed Chairman Greenspan and President Bush insisted metronomically that the economy was fundamentally sound and that the tremendous growth in complex securities and credit-default swaps was evidence of a healthy economy where risk was distributed safely.

In the summer of 2007, signs of strain started appearing. The boom had produced so much debt that even a small economic stumble could cause major problems, and rising delinquencies in subprime mortgages proved the stumbling block. Ever since, the financial sector and the federal government have been behaving exactly the way one would expect them to, in light of past emerging-market crises.

By now, the princes of the financial world have of course been stripped naked as leaders and strategists—at least in the eyes of most Americans. But as the months have rolled by, financial elites have continued to assume that their position as the economy’s favored children is safe, despite the wreckage they have caused.

Stanley O’Neal, the CEO of Merrill Lynch, pushed his firm heavily into the mortgage-backed-securities market at its peak in 2005 and 2006; in October 2007, he acknowledged, “The bottom line is, we—I—got it wrong by being overexposed to subprime, and we suffered as a result of impaired liquidity in that market. No one is more disappointed than I am in that result.” O’Neal took home a $14 million bonus in 2006; in 2007, he walked away from Merrill with a severance package worth $162 million, although it is presumably worth much less today.

In October, John Thain, Merrill Lynch’s final CEO, reportedly lobbied his board of directors for a bonus of $30 million or more, eventually reducing his demand to $10 million in December; he withdrew the request, under a firestorm of protest, only after it was leaked to The Wall Street Journal. Merrill Lynch as a whole was no better: it moved its bonus payments, $4 billion in total, forward to December, presumably to avoid the possibility that they would be reduced by Bank of America, which would own Merrill beginning on January 1. Wall Street paid out $18 billion in year-end bonuses last year to its New York City employees, after the government disbursed $243 billion in emergency assistance to the financial sector.

In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy—ultimately making the problem much harder to solve. Yet the principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector.

The response so far is perhaps best described as “policy by deal”: when a major financial institution gets into trouble, the Treasury Department and the Federal Reserve engineer a bailout over the weekend and announce on Monday that everything is fine. In March 2008, Bear Stearns was sold to JP Morgan Chase in what looked to many like a gift to JP Morgan. (Jamie Dimon, JP Morgan’s CEO, sits on the board of directors of the Federal Reserve Bank of New York, which, along with the Treasury Department, brokered the deal.) In September, we saw the sale of Merrill Lynch to Bank of America, the first bailout of AIG, and the takeover and immediate sale of Washington Mutual to JP Morgan—all of which were brokered by the government. In October, nine large banks were recapitalized on the same day behind closed doors in Washington. This, in turn, was followed by additional bailouts for Citigroup, AIG, Bank of America, Citigroup (again), and AIG (again).

Some of these deals may have been reasonable responses to the immediate situation. But it was never clear (and still isn’t) what combination of interests was being served, and how. Treasury and the Fed did not act according to any publicly articulated principles, but just worked out a transaction and claimed it was the best that could be done under the circumstances. This was late-night, backroom dealing, pure and simple.

Throughout the crisis, the government has taken extreme care not to upset the interests of the financial institutions, or to question the basic outlines of the system that got us here. In September 2008, Henry Paulson asked Congress for $700 billion to buy toxic assets from banks, with no strings attached and no judicial review of his purchase decisions. Many observers suspected that the purpose was to overpay for those assets and thereby take the problem off the banks’ hands—indeed, that is the only way that buying toxic assets would have helped anything. Perhaps because there was no way to make such a blatant subsidy politically acceptable, that plan was shelved.

Instead, the money was used to recapitalize banks, buying shares in them on terms that were grossly favorable to the banks themselves. As the crisis has deepened and financial institutions have needed more help, the government has gotten more and more creative in figuring out ways to provide banks with subsidies that are too complex for the general public to understand. The first AIG bailout, which was on relatively good terms for the taxpayer, was supplemented by three further bailouts whose terms were more AIG-friendly. The second Citigroup bailout and the Bank of America bailout included complex asset guarantees that provided the banks with insurance at below-market rates. The third Citigroup bailout, in late February, converted government-owned preferred stock to common stock at a price significantly higher than the market price—a subsidy that probably even most Wall Street Journal readers would miss on first reading. And the convertible preferred shares that the Treasury will buy under the new Financial Stability Plan give the conversion option (and thus the upside) to the banks, not the government.

This latest plan—which is likely to provide cheap loans to hedge funds and others so that they can buy distressed bank assets at relatively high prices—has been heavily influenced by the financial sector, and Treasury has made no secret of that. As Neel Kashkari, a senior Treasury official under both Henry Paulson and Tim Geithner (and a Goldman alum) told Congress in March, “We had received inbound unsolicited proposals from people in the private sector saying, ‘We have capital on the sidelines; we want to go after [distressed bank] assets.’” And the plan lets them do just that: “By marrying government capital—taxpayer capital—with private-sector capital and providing financing, you can enable those investors to then go after those assets at a price that makes sense for the investors and at a price that makes sense for the banks.” Kashkari didn’t mention anything about what makes sense for the third group involved: the taxpayers.

Even leaving aside fairness to taxpayers, the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

The Way Out
Looking just at the financial crisis (and leaving aside some problems of the larger economy), we face at least two major, interrelated problems. The first is a desperately ill banking sector that threatens to choke off any incipient recovery that the fiscal stimulus might generate. The second is a political balance of power that gives the financial sector a veto over public policy, even as that sector loses popular support.

Big banks, it seems, have only gained political strength since the crisis began. And this is not surprising. With the financial system so fragile, the damage that a major bank failure could cause—Lehman was small relative to Citigroup or Bank of America—is much greater than it would be during ordinary times. The banks have been exploiting this fear as they wring favorable deals out of Washington. Bank of America obtained its second bailout package (in January) after warning the government that it might not be able to go through with the acquisition of Merrill Lynch, a prospect that Treasury did not want to consider.

The challenges the United States faces are familiar territory to the people at the IMF. If you hid the name of the country and just showed them the numbers, there is no doubt what old IMF hands would say: nationalize troubled banks and break them up as necessary.

In some ways, of course, the government has already taken control of the banking system. It has essentially guaranteed the liabilities of the biggest banks, and it is their only plausible source of capital today. Meanwhile, the Federal Reserve has taken on a major role in providing credit to the economy—the function that the private banking sector is supposed to be performing, but isn’t. Yet there are limits to what the Fed can do on its own; consumers and businesses are still dependent on banks that lack the balance sheets and the incentives to make the loans the economy needs, and the government has no real control over who runs the banks, or over what they do.

At the root of the banks’ problems are the large losses they have undoubtedly taken on their securities and loan portfolios. But they don’t want to recognize the full extent of their losses, because that would likely expose them as insolvent. So they talk down the problem, and ask for handouts that aren’t enough to make them healthy (again, they can’t reveal the size of the handouts that would be necessary for that), but are enough to keep them upright a little longer. This behavior is corrosive: unhealthy banks either don’t lend (hoarding money to shore up reserves) or they make desperate gambles on high-risk loans and investments that could pay off big, but probably won’t pay off at all. In either case, the economy suffers further, and as it does, bank assets themselves continue to deteriorate—creating a highly destructive vicious cycle.

To break this cycle, the government must force the banks to acknowledge the scale of their problems. As the IMF understands (and as the U.S. government itself has insisted to multiple emerging-market countries in the past), the most direct way to do this is nationalization. Instead, Treasury is trying to negotiate bailouts bank by bank, and behaving as if the banks hold all the cards—contorting the terms of each deal to minimize government ownership while forswearing government influence over bank strategy or operations. Under these conditions, cleaning up bank balance sheets is impossible.

Nationalization would not imply permanent state ownership. The IMF’s advice would be, essentially: scale up the standard Federal Deposit Insurance Corporation process. An FDIC “intervention” is basically a government-managed bankruptcy procedure for banks. It would allow the government to wipe out bank shareholders, replace failed management, clean up the balance sheets, and then sell the banks back to the private sector. The main advantage is immediate recognition of the problem so that it can be solved before it grows worse.

The government needs to inspect the balance sheets and identify the banks that cannot survive a severe recession. These banks should face a choice: write down your assets to their true value and raise private capital within 30 days, or be taken over by the government. The government would write down the toxic assets of banks taken into receivership—recognizing reality—and transfer those assets to a separate government entity, which would attempt to salvage whatever value is possible for the taxpayer (as the Resolution Trust Corporation did after the savings-and-loan debacle of the 1980s). The rump banks—cleansed and able to lend safely, and hence trusted again by other lenders and investors—could then be sold off.

Cleaning up the megabanks will be complex. And it will be expensive for the taxpayer; according to the latest IMF numbers, the cleanup of the banking system would probably cost close to $1.5 trillion (or 10 percent of our GDP) in the long term. But only decisive government action—exposing the full extent of the financial rot and restoring some set of banks to publicly verifiable health—can cure the financial sector as a whole.

This may seem like strong medicine. But in fact, while necessary, it is insufficient. The second problem the U.S. faces—the power of the oligarchy—is just as important as the immediate crisis of lending. And the advice from the IMF on this front would again be simple: break the oligarchy.

Oversize institutions disproportionately influence public policy; the major banks we have today draw much of their power from being too big to fail. Nationalization and re-privatization would not change that; while the replacement of the bank executives who got us into this crisis would be just and sensible, ultimately, the swapping-out of one set of powerful managers for another would change only the names of the oligarchs.

Ideally, big banks should be sold in medium-size pieces, divided regionally or by type of business. Where this proves impractical—since we’ll want to sell the banks quickly—they could be sold whole, but with the requirement of being broken up within a short time. Banks that remain in private hands should also be subject to size limitations.

This may seem like a crude and arbitrary step, but it is the best way to limit the power of individual institutions in a sector that is essential to the economy as a whole. Of course, some people will complain about the “efficiency costs” of a more fragmented banking system, and these costs are real. But so are the costs when a bank that is too big to fail—a financial weapon of mass self-destruction—explodes. Anything that is too big to fail is too big to exist.

To ensure systematic bank breakup, and to prevent the eventual reemergence of dangerous behemoths, we also need to overhaul our antitrust legislation. Laws put in place more than 100 years ago to combat industrial monopolies were not designed to address the problem we now face. The problem in the financial sector today is not that a given firm might have enough market share to influence prices; it is that one firm or a small set of interconnected firms, by failing, can bring down the economy. The Obama administration’s fiscal stimulus evokes FDR, but what we need to imitate here is Teddy Roosevelt’s trust-busting.

Caps on executive compensation, while redolent of populism, might help restore the political balance of power and deter the emergence of a new oligarchy. Wall Street’s main attraction—to the people who work there and to the government officials who were only too happy to bask in its reflected glory—has been the astounding amount of money that could be made. Limiting that money would reduce the allure of the financial sector and make it more like any other industry.

Still, outright pay caps are clumsy, especially in the long run. And most money is now made in largely unregulated private hedge funds and private-equity firms, so lowering pay would be complicated. Regulation and taxation should be part of the solution. Over time, though, the largest part may involve more transparency and competition, which would bring financial-industry fees down. To those who say this would drive financial activities to other countries, we can now safely say: fine.

Two Paths
To paraphrase Joseph Schumpeter, the early-20th-century economist, everyone has elites; the important thing is to change them from time to time. If the U.S. were just another country, coming to the IMF with hat in hand, I might be fairly optimistic about its future. Most of the emerging-market crises that I’ve mentioned ended relatively quickly, and gave way, for the most part, to relatively strong recoveries. But this, alas, brings us to the limit of the analogy between the U.S. and emerging markets.

Emerging-market countries have only a precarious hold on wealth, and are weaklings globally. When they get into trouble, they quite literally run out of money—or at least out of foreign currency, without which they cannot survive. They must make difficult decisions; ultimately, aggressive action is baked into the cake. But the U.S., of course, is the world’s most powerful nation, rich beyond measure, and blessed with the exorbitant privilege of paying its foreign debts in its own currency, which it can print. As a result, it could very well stumble along for years—as Japan did during its lost decade—never summoning the courage to do what it needs to do, and never really recovering. A clean break with the past—involving the takeover and cleanup of major banks—hardly looks like a sure thing right now. Certainly no one at the IMF can force it.

In my view, the U.S. faces two plausible scenarios. The first involves complicated bank-by-bank deals and a continual drumbeat of (repeated) bailouts, like the ones we saw in February with Citigroup and AIG. The administration will try to muddle through, and confusion will reign.

Boris Fyodorov, the late finance minister of Russia, struggled for much of the past 20 years against oligarchs, corruption, and abuse of authority in all its forms. He liked to say that confusion and chaos were very much in the interests of the powerful—letting them take things, legally and illegally, with impunity. When inflation is high, who can say what a piece of property is really worth? When the credit system is supported by byzantine government arrangements and backroom deals, how do you know that you aren’t being fleeced?

Our future could be one in which continued tumult feeds the looting of the financial system, and we talk more and more about exactly how our oligarchs became bandits and how the economy just can’t seem to get into gear.

The second scenario begins more bleakly, and might end that way too. But it does provide at least some hope that we’ll be shaken out of our torpor. It goes like this: the global economy continues to deteriorate, the banking system in east-central Europe collapses, and—because eastern Europe’s banks are mostly owned by western European banks—justifiable fears of government insolvency spread throughout the Continent. Creditors take further hits and confidence falls further. The Asian economies that export manufactured goods are devastated, and the commodity producers in Latin America and Africa are not much better off. A dramatic worsening of the global environment forces the U.S. economy, already staggering, down onto both knees. The baseline growth rates used in the administration’s current budget are increasingly seen as unrealistic, and the rosy “stress scenario” that the U.S. Treasury is currently using to evaluate banks’ balance sheets becomes a source of great embarrassment.

Under this kind of pressure, and faced with the prospect of a national and global collapse, minds may become more concentrated.

The conventional wisdom among the elite is still that the current slump “cannot be as bad as the Great Depression.” This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances. If our leadership wakes up to the potential consequences, we may yet see dramatic action on the banking system and a breaking of the old elite. Let us hope it is not then too late.