Wednesday, March 05, 2014 - Not Much Change

Not Much Change

by Sinclair Noe

DOW – 35 = 16,360
SPX – 0.1 = 1873
NAS + 6 = 4357
10 YR YLD + .01 = 2.70%
OIL – 2.40 = 100.93
GOLD + 2.40 = 1337.80
SILV + .02 = 21.26

ADP, a payroll processing company, reports its own monthly jobs estimate each month, just before the government comes out with its monthly jobs report. Today, ADP said the economy added 139,000 new jobs in February; they revised the January number down to 127,000 from the previously reported 175,000. When the Labor Department reports on jobs Friday morning the best guess is about 150,000 jobs and the unemployment rate holding at 6.6%. So, the ADP report is reasonably close.

Separately, initial jobless claims for the past week did not point to any improvement in the labor market with initial claims up 14,000 in the February 22 week to a 348,000 level.

In other news, the Institute for Supply Management’s non-manufacturing index slipped to 53.5 in February from 54 the previous month.

This afternoon the Federal Reserve published its Beige Book, which is a compilation of reports and observations from the 12 Fed districts. Growth slowed in Chicago and activity was stable in Kansas City. While the other eight districts reported growth, the Fed said it was characterized as "modest to moderate" in most cases, an overall downgrade from its last report on January 15, which showed "moderate" growth in nine regions. Business contacts were still upbeat, and real estate activity picked up in some areas, and travel and tourism remained strong. Retail sales growth softened in most districts, partly due to weather. Factory output and sales were affected in regions including Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, and Dallas, where the weather was blamed for utility outages, disrupted supply chains and a slowdown in hiring.

So, the latest Beige Book still reflects weather disruptions. If you were waiting for clean data, this wasn’t it. We might not get clean data from the Friday jobs report. We may need to rethink our idea of data clean from weather disruptions because it seems we are experiencing bad weather with regularity, whether it be the polar vortex or ice storms or drought or hurricanes or tornadoes. If it’s not one thing it’s another.

The big brouhaha in Ukraine seems to be a bit calmer today. The European Union is ready to provide $15 billion of financial support to Ukraine over the next couple of years by way of a series of loans and grants. The assistance would be delivered in coordination with the European Bank for Reconstruction and Development and the European Investment Bank, and is in part contingent on Ukraine signing a deal with the International Monetary Fund. Yesterday, Secretary of State John Kerry visited Kiev to offer moral support and a $1 billion aid package to a Ukraine fighting to fend off bankruptcy. Money soothes the savage beast. And so, there is no fighting today; that’s good.

In time we will probably find out more and more details about who and how this Ukrainian revolution came to be and why; and the best guess is that it was not quite an organic uprising of the masses; and it was probably not a coincidence that a nostalgic stroll along old Cold War paths coincided with Defense Secretary Chuck Hagel’s proposal to cut back Pentagon spending. This is not to say there are no problems in the Ukraine, there are. Internal divisions in Ukraine are real and enduring. Russian aggression in Ukraine is bad, and there really is no justification for this kind of military intervention. US credibility and security is not at stake and there really isn’t anything we can do anyway, short of a full-fledged return to the Cold War. Some people may want that but I don’t much care for the notion.

It’s a good story to imagine the downtrodden Ukrainian everyman fighting for freedom from the Russian overlords, but there’s a better chance that the real story will be told by following the money trail.

In 1998, Washington state voters raised the state’s minimum wage and linked it to the cost of living. Over the past 15 years, the minimum wage in Washington has climbed to $9.32 an hour, the highest in the country. Payrolls at Washington's restaurants and bars, portrayed as particularly vulnerable to higher wage costs, expanded by 21%. Poverty has trailed the US level for at least 7 years.

According to a Congressional Budget Office report published February 18, increasing the minimum wage would lift 900,000 people out of poverty and add $31 billion to the earnings of low-wage Americans, but it might reduce employment by up to a million jobs; actually that last point is an area where the CBO report was fuzzy, saying it might cost up to a million jobs or it might not reduce  employment; as a result, most people split the difference and say it will reduce employment by 500,000, but that’s not what the report says, and it’s  not what the data from Washington state says.

One possible explanation is that businesses have plenty of ways besides job cuts to absorb the costs of a minimum-wage increase: price increases, reductions in profits and savings from lower turnover can help soak up the shock.

As of January, 21 states and the District of Columbia had a higher minimum wage than the federal floor. Cities including San Francisco and Santa Fe, New Mexico, require even higher hourly earnings than the proposed federal level, at $10.74 and $10.66 respectively.

New Jersey voters in November approved increasing the minimum wage by $1 an hour to $8.25, tying future increases to the consumer price index. In January, after the raise took effect, private employers added 8,320 jobs in New Jersey, according to ADP Research Institute. That was the fastest pace of job growth since December 2012.

Today, the Center for American Progress issued a report showing that raising the minimum wage from $7.25 to $10.10 an hour would reduce federal food stamp spending by $4.6 billion a year. Last year, a report done by researchers at Berkeley and the University of Illinois asserted that taxpayers are spending nearly $7 billion a year to supplement the wages of fast-food workers, many of whom earn the minimum wage or close to it.

Now, let’s get caught up on banks behaving badly. The latest news on this front regards Citigroup which disclosed on Friday that it had been defrauded of $400 million in a scheme involving a financially shaky oil services company in Mexico. And while that was going on, a Citigroup affiliate based in Los Angeles received a grand jury subpoena from federal prosecutors in Massachusetts related to anti-money-laundering compliance. The focus of the subpoenas is unclear.

The affiliate has also received a subpoena from the Federal Deposit Insurance Corporation related to its anti-money-laundering program and the Bank Secrecy Act. The affiliate, Banamex USA, provides banking services to individuals and small businesses in the United States and Mexico. Until recently, it was a large player in transferring money across the border between family members.

Apparently the two issues, one involving fraud and the other involving money-laundering compliance, are unrelated.

In 2006, the bank’s computer systems got fouled up and certain business units failed to process Citi’s foreign transactions to ensure compliance with anti-money laundering regulations for about 4 years until the computer error was fixed. In 2012, Banamex USA entered into a consent order with the FDIC and California Department of Financial Institutions to improve its oversight and tracking systems. In 2013, Citigroup entered into another consent order with the Federal Reserve and agreed to take companywide actions also intended to bolster its compliance efforts. Now we have subpoenas in the case.

Meanwhile, the New York Times is reporting that the Treasury Inspector General believed that JP Morgan had used attorneys to “investigate” its conduct in dealing with Bernie Madoff with the intent of impeding regulatory scrutiny and allowing staff to get away with perjury. In this case it goes back to the idea of what JP Morgan knew about Madoff’s Ponzi scheme and when did they know it.

We know that JPMorgan was Madoff’s banker. JPMorgan hired lawyers to investigate, or maybe they hired outside law firms as a way to put a shield around the questionable activity, to impede regulators from getting to the bottom of criminal or merely potentially costly conduct. This raises the question of attorney client privilege.

Federal regulators at the Office of the Comptroller of the Currency sought copies of the lawyers’ interview notes, hoping they would open a window into the bank’s actions. The issue gained urgency in 2012, when the comptroller’s office conducted its own interviews with JPMorgan employees and discovered a “pattern of forgetfulness.”

Suspicious that the memory lapses were feigned, the regulators renewed their request for the interview notes held by JPMorgan’s lawyers. But JPMorgan, which produced other materials and made witnesses available to the comptroller’s office, declined to share those notes. In its denial, the bank cited confidentiality requirements like the attorney-client privilege. The inspector general argued that the lawyers’ interviews were essentially “made for the purpose of getting advice for the commission of a fraud or crime.” The reporters also stress that the use of attorneys as an information shield for banks is already troublingly widespread.

But the Department of Justice will not pursue subpoenas of the potential perjury or potential obstruction of justice, because, according to a DOJ letter the action would “risk developing negative precedent that could result in harm to the long-term institutional interests of the United States.”

Just in case you were wondering, too big to fail and too big to jail is still the law of the land. 

Thursday, December 12, 2013 - Three Strikes

Three Strikes

by Sinclair Noe

DOW – 104 = 15,739
SPX – 6 = 1775
NAS – 5 = 3998
10 YR YLD + .03 = 2.88%
OIL - .06 = 97.38
GOLD – 27.10 = 1226.20
SILV - .81 = 19.60

Stocks down for a third day in a row, and except for that big gain on the news of the monthly jobs report, this has been a nasty start to December. Weekly jobless claims jumped to 368,00 from 300,000 the week before. Overall retail sales climbed a seasonally adjusted 0.7% last month, the most since June.  Auto sales jumped 1.8% in November, the most since June. Meanwhile, there were drops in retail sales of 0.2% for clothing and accessories stores, and 1.1% at gasoline stations. Online and other non-store retailers saw sales rise 2.2% in November, the most since July 2012. Over the past year, retail sales have grown 4.7%. Inventories at US businesses rose 0.7% in October. Maybe businesses are expecting a great holiday shopping season but it isn't looking good.

Neither the jobless claims nor the retail sales will move the Fed’s current position on tapering. Markets have been focused on the timing and the slope of Fed bond-buying tapering and not on anything else. Most likely, the Fed will meet next week and not taper, but they will likely communicate clearly their intent to taper.

The just agreed 2014-2015 US budget deal faces a crucial test today when the House of Representatives votes on the bill, with Speaker John Boehner urging skeptical conservatives to back it. The agreement sealed between top Democratic and Republican negotiators is seen as a chance to end the brutal cycle of fiscal crises that have plagued Washington in recent years. The legislation, which sets spending caps at $1.012 trillion for 2014 and $1.014 trillion for 2015, and repeals billions in a package of arbitrary cuts known as sequestration, appears likely to pass the Republican-led House. It would then go to the Senate for a vote, likely next week before the chamber adjourns for the year-end holiday.

Pemex is the pride of Mexico. Part of the reason may be that it is ubiquitous. Every gas station in Mexico has the green and white sign of the state owned oil company. When all else failed, Pemex was the economic lifeblood of the Mexican government. Today, the Mexican Congress passed legislation  declaring that Mexico still owns its oil, but allowing private companies to drill for oil and natural gas in partnership with Pemex, or on their own, returning international oil companies to territory they were kicked out of 75 years ago.

The stated goal is to stimulate Mexico’s sliding oil production and vault the country into the developed world by tapping vast pockets of oil and natural gas deep under the earth and sea. Foreign oil companies have long been eager to gain access to Mexico’s oil and have quietly lobbied the government to open up for years, while Pemex is known for inefficiency at best, and corruption at worst. Mexico’s oil production has declined by 25 percent from its 2004 peak, to just over 2.5 million barrels a day. Pemex is spending more to pump less: investment has more than doubled in the same period to more than $20 billion a year. It may not be the best run oil company but Mexicans tend to consider it their oil company. In a country where controlling oil is often equated with sovereignty and national pride, the plan has set off furious debate.

And it's just part of a bigger plan. President Pena Nieto is also pushing to break up telecommunication monopolies, raise taxes and weaken the teachers union grip on faltering public schools. Two decades after Mexico sold off banks and the telephone monopoly, Mexicans pay more for credit and phones service than other Latin Americans, and they suspect they will pay more for gas under the new law, too.

Five years ago, Bernie Madoff was arrested in New York for running a Ponzi scheme. Madoff's banker was JPMorgan. Federal authorities suspect JPMorgan continued to serve as Madoff’s primary bank even as questions mounted about his operation, with one bank executive acknowledging before the arrest that Madoff’s “Oz-like signals” were “too difficult to ignore.” And so now, the authorities are going after JPMorgan; apparently close to a settlement that would involve about $2 billion in penalties and criminal action, or what passes as criminal action in the world of Wall Street bankers.

The government would use a chunk of the money, probably less than half to compensate Madoff's victims. The settlement would include a deferred prosecution agreement, which would list the bank’s criminal violations in a court filing but stop short of an indictment as long as JPMorgan pays the penalties and acknowledges the facts of the government’s case. The deferred prosecution agreement is expected to fault JPMorgan for a “programmatic violation” of the Bank Secrecy Act, which requires banks to maintain internal controls against money laundering and to report suspicious transactions to the authorities. And just to be clear, this case involves money laundering by JPMorgan.

The government has been reluctant to bring criminal charges against large corporations, fearing that such an action could imperil a company and throw innocent employees out of work. Those fears trace to the indictment of Enron's accounting firm, Arthur Andersen, which went out of businesses after its 2002 conviction, taking 28,000 jobs with it. Ever since, prosecutors have increasingly relied on deferred prosecution agreements, which is a slap on the wrist and allows the bank to continue, as long as they don't continue with their illegal activities. So the basic idea is that JPMorgan can break the law, pay off the government and promise not to do it again. Prosecutors insist that no one is too big to indict or too big to jail. It will be interesting to see if JPMorgan can indeed clean up its business and manage to stop breaking the law; and if they can't keep their nose clean, it'll be interesting to see if the prosecutors actually have the fortitude to enforce the law.

Two years ago JPMorgan entered an “non-prosecution agreement” to settle antitrust charges. I'm sure there is some sort of fine distinction between a “non-prosecution agreement” and a “deferred-prosecution agreement” but they sound similar; no criminal charges as long as they kept to the straight and narrow for 2 years. Then there was that problem of manipulating electricity markets between 2010 and 2012. The head of their commodities trading division, Blythe Masters, was accused of making false and misleading statements to federal energy regulators. No criminal charges were filed.

Pope Francis is at it again. Francis, who was named Time magazine's Person of the Year on Wednesday, has urged his own Church to be more fair, frugal and less pompous and to be closer to the poor and suffering. A couple of weeks ago he published an apostolic exhortation title, The Joy of the Gospel, where he attacked unfettered capitalism, as “a new tyranny” and  condemned the "idolatry of money".

Now in a new message for the Roman Catholic Church's World Day of Peace, marked around the world on Jan. 1, he also called for sharing of wealth and for nations to shrink the gap between rich and poor, more of whom are getting only "crumbs". And he says that huge salaries and bonuses are  symptoms of an economy based on greed and inequality.

Titled "Fraternity, the Foundation and Pathway to Peace", the message also attacked injustice, human trafficking, organized crime and the weapons trade as obstacles to peace.

Francis said many places in the world were seeing a "serious rise" in inequality between people living side by side. He attacked the "widening gap between those who have more and those who must be content with the crumbs", calling on governments to implement "effective policies" to guarantee people's fundamental rights, including access to capital, services, educational resources, healthcare and technology. The Pope says: "The grave financial and economic crises of the present time ... have pushed man to seek satisfaction, happiness and security in consumption and earnings out of all proportion to the principles of a sound economy."

I'm going to take a little vacation time over the next couple of weeks. Don't worry, I'll continue to update the blog on a kind of regular basis.

Tuesday, November 19, 2013 - Too Good To Be True

Too Good To Be True

by Sinclair Noe

DOW – 8 = 15,967
SPX – 3 = 1787
NAS – 17 = 3931
10 YR YLD + .04 = 2.70%
OIL + .31 = 93.34
GOLD - .80 = 1276.20
SILV - .06 = 20.44

No record high today; not a surprise; it can't happen every day. So, we'll see if this is a pause or whether we have to wait six years till we have milk and cookies again. Likely the former, but you never know.

JPMorgan Chase and the Justice Department have reportedly finalized a $13 billion settlement and resolves an array of state and federal investigations into JPMorgan’s sale of troubled mortgage securities to pension funds and other investors from 2005 through 2008. The government accused the bank of not fully disclosing the risks of buying such securities which, as we know, failed.

JPMorgan had to acknowledge a statement of facts that outline the bank’s wrongdoing in the case. JPMorgan also backed down from demands that prosecutors drop a related criminal investigation into the bank and largely forfeited the right to try to later recoup some of the $13 billion from the Federal Deposit Insurance Corporation. The $13 billion deal also comes just days after the bank struck a separate $4.5 billion deal with a group of investors over the sale of toxic mortgage-backed securities.

The breakdown of the money includes a $2 billion fine to prosecutors in Sacramento and $4 billion in relief to struggling homeowners in hard hit areas like Detroit and certain neighborhoods in New York. Half of that relief will go to reducing the balance of mortgages in foreclosure-racked areas and offering a so-called forbearance plan to certain homeowners, briefly halting collection of their mortgage payments. For the remaining $2 billion in relief, JPMorgan must reduce interest rates on existing loans and offer new loans to low-income home buyers. The bank also will receive a credit for demolishing abandoned homes in an effort to reduce urban blight.

So, for about $6 billion of the deal, it appears JPMorgan is getting off quite easy; they were unlikely to see much or any of this, with or without a deal. Also, in the past, we've seen how loan mods have tended to favor the banks over the homeowners. And it'll be interesting to see what kind of terms they offer for low-income home buyers.

The government earmarked the other $7 billion as compensation for investors. The largest beneficiary is the Federal Housing Finance Agency. JPMorgan will pay the remaining compensation to a credit union association and state attorneys general in California and New York as well as the Justice Department’s own civil division.

The $13 billion settlement represents the largest amount that a single company has ever paid, even though they won't really “pay” the full amount, and it represents about a half year of profits for JPMorgan. While the deal put numerous civil cases to rest, it would not save JPMorgan from any criminal inquiries into its mortgage practices. Under the terms of the deal, the bank would also have to assist prosecutors with an investigation into former employees who helped create the mortgage investments. So, the biggest settlement ever, and it looks like JPMorgan will be able to hand pick a few lower level executives to throw under the bus for criminal charges.

How the hell is Jamie Dimon still in charge of this vast criminal enterprise? Well, for shareholders, it's just the cost of doing business.

MF Global, the collapsed brokerage firm that was run by former New Jersey Sen. Jon Corzine, must pay back $1.2 billion to ensure customers recover losses they sustained when it failed in 2011. The restitution is being levied following a complaint filed by the Commodity Futures Trading Commission earlier this year that alleges MF Global unlawfully used customer funds to meet the firm's needs in its final weeks; at least that's the quick explanation; more on that point in a moment.

MF Global Holdings, the New York-based parent company, imploded in October 2011 after making big bets on bonds issued by European countries that later fell in value. When it collapsed, more than $1 billion in customer money was reported to be missing. It was later determined the money was used to pay for the company's own operations. It was the eighth-largest corporate bankruptcy in US History. MF Global also faces a $100 million civil penalty due after it has fully paid customers and certain creditors.

MF Global admitted in the consent order that it is liable for some of the allegations pertaining to the acts and omissions of its employees as set forward by the CFTC. The commission is still involved with litigation against MF Global Holdings Ltd.

So, where did the money for restitution come from and where did the money go to when it just sort of vanished two years ago? When the music stopped on Halloween 2011, properly segregated customer funds were dispersed in the custody of a large number of financial institutions (such as JPMorgan), exchanges, clearinghouses, and other third parties in the form of investments and margin accounts and other perfectly permissible uses. Following the collapse, a trustee was appointed and one of the trustee's first tasks was to recover those moneys.

And according to the trustee, the banks were "quite cooperative" when it came to returning properly segregated customer accounts. JP Morgan, for instance, returned more than $1 billion in such funds within weeks of the trustee's appointment, as did BMO Harris Bank. Accordingly, such funds were never counted as composing any part of the $1.5 billion shortfall. The bank funds that took longer to retrieve, were different. These were the funds the banks received during, for the most part, that wild final week of October 2011, when money was being wired all over the place without much to discern what was being wired for what purpose. The origins of those transfers were hard to trace. Many of MF Global's banks handled its proprietary transactions as well as customer transactions, and without satisfying distinction.

So, in a way, the money wasn't exactly missing, it was just a matter of sorting out between assets on hand and outstanding claims against those funds. There were two categories of commodity customer at MF Global, each covered by slightly different CFTC rules. Those trading on domestic exchanges were protected by laws and regulations that very clearly required the broker to maintain segregated customer accounts and to perform certain daily calculations to ensure that sufficient moneys would always be available on hand to liquidate fully each account if needed.

When MF Global began to feel a liquidity crunch in the summer of 2011, its officials inquired into whether they could dip into the regulatory excess to find cash to prop up the proprietary end of their business. And technically speaking, they were allowed to dip into the “regulatory excess” in the foreign exchange accounts but only to the extent that there was an equal amount of “excess segregated funds” on hand for the domestic exchange accounts to make up for it.

On October 26, 2011 the technical line for segregated funds was crossed as MF Global officers dipped into regulatory excess funds, trying to right the ship before the end of the trading day, but that didn't quite work out and MF Global slipped into oblivion, and the funds slipped into oblivion; a shadowy ether not quite in segregated accounts, and somewhere between domestic and international, and nowhere to be found; or rather, the money was found, it just took about two years to find it.

And so the lesson here is that the money in that brokerage account is not quite as safe and secure as you might imagine.

The largest category of victims in the Bernie Madoff Ponzi Scheme will be first in line for compensation from a $2.35 billion fund collected by the Justice Department; this includes clients who lost cash through accounts with various middleman funds.

These so-called indirect investors represent about 70 percent of all the claims filed after Madoff’s arrest in December 2008, and about 85 percent of the claims for out-of-pocket cash losses. But because they were not formal customers of Mr. Madoff’s brokerage firm, they are not eligible to recover anything from the federal bankruptcy court, where the Madoff trustee has so far collected $9 billion to apply toward eligible claims. However, the indirect investors — at least 10,000 people and possibly many times that — are eligible for compensation from the federal Madoff Victim Fund.

Generally, anyone who withdrew less from their Madoff-related account than they paid in will be eligible to recover from the Madoff Victim Fund, even if they invested indirectly through the hundreds of “feeder funds,” investment groups and other pooled investment vehicles that poured cash into Madoff’s hands during his decades long fraud. Apparently, the use of feeder funds is a common tactic of Ponzi schemes, a way of building a network of fresh clients to be funneled into the scheme.

Unfortunately, there are some people who didn't live long enough to get their money back.

And the other connection here is the Madoff/JPMorgan link. JPMorgan was Madoff's banker and there is an ongoing criminal investigation that the bank turned a blind eye to Madoff's Ponzi scheme. The investigation centers on whether JPMorgan failed to alert federal authorities to Madoff’s conduct.

The trustee trying to recover funds for Madoff's victims says the bank generated handsome sums by allowing Madoff’s brokerage firm to “funnel billions of dollars” through its account with JPMorgan, “disregarding its own anti-money laundering duties.” The bank, starting around 2006, also pursued derivatives deals linked to Madoff’s so-called feeder-fund investors, the hedge funds that invested their clients’ money with him.

The case will most likely hinge on a series of e-mails that suggest JPMorgan continued to work with Madoff even as questions mounted about his operation. In one e-mail that surfaced in a separate lawsuit, a JPMorgan employee acknowledged that Madoff’s outsize returns seemed “a little too good to be true.”

Thursday, October 24, 2013 - Liquidity and Leverage and a bit of Levity

Liquidity and Leverage and a bit of Levity

by Sinclair Noe

DOW + 95 = 15,509
SPX + 5 = 1752
NAS + 21 = 3928
10 YR YLD + .04 = 2.52%
OIL + .37 = 97.23
GOLD + 13.60 = 1348.30
SILV + .16 = 22.82

“Liquidity is essential to a bank's viability and central to the smooth functioning of the financial system," so says Fed Chairman Ben Bernanke; and so today the Fed proposed that big banks keep enough cash, government bonds and other high-quality assets on hand to survive during a severe downturn like we saw in 2008, and the idea is that we avoid a global financial meltdown like we almost saw in 2008. Liquidity is the ability to access cash quickly; that's important when nobody is sure about what the bank truly has in the vault. Liquidity is what prevents a bank run; liquidity averts a financial meltdown or credit crunch.

The Fed proposal today subjects US banks for the first time to liquidity requirements. The big banks, with more than $250 billion in assets, would be required to hold enough cash and securities to fund their operations for 30 days during a time of market stress. Smaller banks, those with more than $50 billion and less than $250 billion, would have to keep enough to cover 21 days. Fed officials said the rules are stronger than new international standards for banks. The public has 90 days to comment on them. After that, they would be phased in starting in January 2015. The requirements were mandated by Congress after the financial crisis.

The proposal would require setting aside about $2 trillion, and the Fed estimates US banks are currently $200 billion short. The Basel Committee on Banking Supervision in January agreed on a liquidity coverage ratio meant to ensure banks can survive a 30-day credit squeeze without bailouts like 2008. That standard would let lenders go beyond cash and low-risk sovereign debt to include some equities and corporate debt.The US version would permit a limited amount of government-sponsored enterprise debt while excluding private-label mortgage-backed securities; so some Fannie Mae and Freddie Mac. The US version is considered a bit tougher than the international version as far as what can be considered reserves.

Where this starts to get interesting is in the requirements dealing with what the banks have to hold to be considered liquid. It's not just cash; it's cash and securities and other high quality assets.

Bank regulation has moved to a system where bank assets are measured on a risk-weighted basis. This is the mechanism that encouraged Eurobanks to buy toxic AAA rated CDOs and sovereign debt; both had zero risk weights under Basel II; and because there was no risk, the banks could and did leverage those no risk positions. The US did not implement Basel II prior to the crisis, but similarly focused on risk-weighted assets rather than simpler total leverage measures.

The credit risk weightings mean that instead of reserving the standard 8 percent of capital in respect of a debt, the bank can cut that by the weighting applied to the asset class. Effectively, the reduction in credit risk weighting operates as a powerful subsidy to the borrowers and equally powerful incentive to over-leveraging the lenders. So the 2008 crisis started with bad mortgage debt, spread to bad bank debt, carried over into bad agency debt, and now encompasses bad sovereign debt. Each of these categories was given preferential capital weighting under the Basel Accords, and now all are open sores on the financial system and the stability of excessively indebted governments. Not only did the Basel weightings encourage poor risk assessment, they directly contributed to the inadequate capitalization of banks for the risks they assumed.

So, the idea of increasing capital reserves sounds good in theory, and to a certain extent in practice, but it only goes so far. It's a good thing to have the banks have a lot more equity capital, so they're not just gambling with other people's money. The problem is that high-quality assets are only high quality until they aren't. A system in which banks or bank-like institutions are tightly coupled with one another, and in which those institutions have too much debt relative to equity, is prone to meltdowns that can spill into the real economy and cause massive damage. Whether these liabilities are in the form of derivatives and off-balance-sheet assets or overvalued tulips pledged as collateral, too much debt without loss-absorbing equity to match it is simply too dangerous to exist.

It is difficult to measure the exact cost to society of our undercapitalized large banks blowing up during the most recent financial crisis, but it was certainly enormous. The nonprofit advocacy and research group Better Markets pegged the cost at roughly $12 trillion, whereas the U.S. Government Accountability Office put it at $22 trillion. Regardless of which figure one uses, it is obvious that the United States is a much poorer society because there was too much leverage backed by over-valued collateral in our financial system. The proposed rule strikes at this problem.

In a crisis the market cares about the leverage ratio, not risk-adjusted capital. Risk weights are prone to manipulation by internal bank models. In 2008 there was a steady downward trend in risk weights and upward trend in leverage leading into the crisis, and less-capitalized banks manipulated risk weights after their internal models were approved by regulators. The use of a leverage ratio in the United States by regulators meant that American banks were, relatively speaking, better capitalized than their European counterparts.

Risk-weighted capital ratios also have the added downside of increasing, rather than reducing, systemic risk. Regulators deemed certain asset classes as less risky than others. Mortgage backed securities, some sovereign debt, agency debt, and interbank debt all effectively received subsidies because regulators determined that banks had to hold limited capital against them. Risk-adjusted capital allowed banks to treat Greek sovereign debt as bearing the same risk as German sovereign debt. Regulators cannot predict the future, but risk-adjusted capital models require them to. Leverage ratios do not. So, a crisis beginning in mortgage debt spread through agency debt, interbank debt and into sovereign debt. Everything fell apart because the chain was only as strong as the weakest link.

This also takes us back to the differences between insured depository institutions that are subsidiaries of bank holding companies and the holding companies themselves; another way of looking at it is the difference between FDIC insured bank accounts and the trading desk of a bank such as the London Whale trading desk. We need firewalls between these institutions. The less interconnected the system is, the less risk it poses to the real economy. The greater the interconnection and the reliance, and the ability to dip into insured accounts in times of trouble – the greater the risk. We used to have a great firewall; it was called the Glass-Steagall Act. We should consider it again.

Fed vice-chair Janet Yellen, who has been nominated to replace Fed chairman Ben Bernanke, expressed concern that there could be a shortage of high quality liquid assets if the Fed tapers and reduces its reserves. Fed officials said that was a concern but that is why the products covered under high-quality liquid assets are varied to include invest-grade corporate debt securities, among other instruments. What that means is that not much has really changed with the vulnerability of banks over the past 5 years, and also that the Fed is not yet ready to taper. So, for today at least, it was risk on.

Now, one more bit on the banking front today, we've talked a bit about the $13 billion settlement over JPMorgan's mortgage practices. It looks like Jamie Dimon wants to clear the decks of all the legal problems. You may recall the Bernie Madoff case. Madoff's bank of choice for about 20 years was none other than JPMorgan Chase; perhaps he liked them because they didn't scrutinize his Ponzi Scheme. 

Federal authorities are preparing to take action in a criminal investigation of JPMorgan, suspecting they turned a blind eye to Madoff's shenanigans.

Prosecutors are reportedly weighing criminal charges against JPMorgan employees who did business with Madoff. It is unclear which employees are under investigation. Prosecutors and JPMorgan have held preliminary discussions about a so-called deferred prosecution agreement. Such an arrangement would suspend criminal charges against JPMorgan in exchange for a fine, certain other concessions and an acknowledgment that the bank will face charges if it fails to behave. Prosecutors may also require JPMorgan, which has repeatedly said that “all personnel acted in good faith” in the Madoff matter, to hire an independent monitor.

Prosecutors could demand that the unit plead guilty to a criminal violation of the Bank Secrecy Act, a federal law requiring financial institutions to report suspicious activity to the government. Prosecutors have reportedly discussed the ramifications of criminal charges with one of JPMorgan’s regulators.

The actual repercussions would depend on the underlying criminal charge. The most serious potential violation could complicate JPMorgan’s business with certain clients, possibly forcing investors like pension funds to withdraw some money from the bank. But a lesser violation would be likely to have more of a reputational consequence.

For the government, it would represent an extraordinarily rare show of force. Ever since a criminal indictment led to the demise of the accounting firm Arthur Andersen, Enron's auditor, the government has been wary of imposing criminal charges on big corporations for fear that it would imperil the institution and have ripple effects on the broader economy. Under federal guidelines, prosecutors must weigh “collateral consequences,” like job losses and economic implications, in such an action.

Ok, I've been talking quite a bit about JPMorgan and their $13 billion settlement. I tend to be a bit serious when I talk about the banksters. Sometimes I wonder if the rest of the world realizes what's going on. Well, last night Jon Stewart of the Daily Show talked about the media coverage, specifically the coverage by CNBC. Stewart showed a clip of Alex Pareene, a reporter for Salon, questioning whether Jamie Dimon should lose his job as chief executive of the bank. And Maria Bartiromo, acting as the great defender of JPMorgan. And then, they went to the videotape from 2008, where CNBC's Jim Cramer waxed eloquent about how Jamie Dimon got such a great deal when he purchased Bear Stearns in a deal with the Federal Reserve. I have to say that a takedown of Maria Bartiromo is probably easier than shooting fish in a barrel. Still, it was entertaining, so click here to link to the videotape.