Fed Continues to Subsidize the Bonus Class

I’m again relying on the Financial Time’s for this latest bit of no suprises here. The big question is when will the political class pull the rug out from under the bonus class?

Wall Street banks are reaping outsized profits by trading with the Federal Reserve, raising questions about whether the central bank is driving hard enough bargains in its dealings with private sector counterparties, officials and industry executives say.

The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.

However, the Fed is not a typical market player. In the interests of transparency, it often announces its intention to buy particular securities in advance. A former Fed official said this strategy enables banks to sell these securities to the Fed at an inflated price.

The resulting profits represent a relatively hidden form of support for banks, and Wall Street has geared up to take advantage. Barclays, for example, e-mails clients with news on the Fed’s balance sheet, detailing the share of the market in particular securities held by the Fed.

“You can make big money trading with the government,” said an executive at one leading investment management firm. “The government is a huge buyer and seller and Wall Street has all the pricing power.”

Let me be clear that the Fed is not a government agency. It makes profits each year from services it provides banks and returns those profits to the Treasury. The Treasury uses the Fed as its agent for a few services but the Fed is a central bank, the bank of bankers. It is not part of the Treasury per se. However, even with that being said, this news continues to be disturbing. Wall Street is gaming the Fed because they can. These things are monopoloy/oligopoly behaviors and we have laws against them!

Barney Frank, chairman of the House financial services committee, said the potential profiteering may be part of the price for stabilising the financial system.

“You can’t rescue the credit system without benefiting some of the people in it.” Still, Mr Frank said Congress would be watching. “We don’t want the Fed to drive the hardest possible bargain, but we don’t want them to get ripped off.”

The growing Fed activity has coincided with a general widening of market spreads – the difference between bid and offer prices – as the number of market participants declines. Wider spreads enable banks, in their capacity as market-makers, to make more profit.

Larry Fink, chief executive of money manager Black Rock, has described Wall Street’s trading profits as “luxurious”, reflecting the banks’ ability to take advantage of diminished competition.

“Bid-offer spreads have remained unusually wide, notwithstanding the normalisation of financial markets,” said Mohamed El-Erian, chief executive of fund manager Pimco in Newport Beach, California.

Spreads narrowed dramatically during the years of the credit bubble.

Brad Hintz, an analyst at Alliance Bernstein, said he doubted that spreads would ever return to those levels, a development that could be pleasing to the Fed.

“They want to help Wall Street make money,” he said.

I’m trying to think why any one would want Wall Street to make huge profits by arbitraging what is basically government debt. Why, in the face of this situation, would Congressman Barney Frank make a lame comment like that? Any one have any suggestion?

Paul Krugman even dropped the Healthcare Reform debate today to look at how our current policies are Rewarding Bad Actors. He’s evidently been following the same series of articles on one churning tactic covered well by the WSJ that this weekend. If you need more information on high volume trading, that WSJ link is a good place to start.

The second is about Andrew Hall and his big bonus for running up gas prices during the summer of 2008. You may remember I wrote about that awhile ago, but it appears the NY Times has just put two and two together. Dr. Krugman rightly points out that these folks are being reward for economic behavior with no social value. These things should be considered scandalous and the subject of regulation and Justice Department probes. All we’re getting is one big YAWN from Capital Hill.

Americans are angry at Wall Street, and rightly so. First the financial industry plunged us into economic crisis, then it was bailed out at taxpayer expense. And now, with the economy still deeply depressed, the industry is paying itself gigantic bonuses. If you aren’t outraged, you haven’t been paying attention.

But crashing the economy and fleecing the taxpayer aren’t Wall Street’s only sins. Even before the crisis and the bailouts, many financial-industry high-fliers made fortunes through activities that were worthless if not destructive from a social point of view.

One of the basic theories of economics is if you incent a behavior, you’ll get more of it. This theory is playing out in spades right now. The other part of the theory is that if you tax that behavior, you get less of it. So, why isn’t there any discussion of taxing the profits made from some of these activities to subsidize (i.e incent) something more socially valuable, like say paying for people’s catastrophic illnesses instead of letting entire families go bankrupt? If we tax a pack of cigarettes to decrease the incident of smoking, why can’t we tax high speed trading transactions? Or, perhaps levy a special windfall profits tax on some kinds of speculation?

Just as Krugman, points out, some kinds of speculative activities in the market are valuable and necessary. It would be unwise to throw a wet blanket on all of these transactions. However, we know which transactions have caused problems. Can we discuss some regulation, tax, or fines for these? It’s not like the country doesn’t need the money and it’s not like the bonus class doesn’t have plenty of it.

But suppose we grant that both Goldman and Mr. Hall are very good at what they do, and might have earned huge profits even without all that aid. Even so, what they do is bad for America.

Just to be clear: financial speculation can serve a useful purpose. It’s good, for example, that futures markets provide an incentive to stockpile heating oil before the weather gets cold and stockpile gasoline ahead of the summer driving season.

But speculation based on information not available to the public at large is a very different matter. As the U.C.L.A. economist Jack Hirshleifer showed back in 1971, such speculation often combines “private profitability” with “social uselessness.”

It’s hard to imagine a better illustration than high-frequency trading. The stock market is supposed to allocate capital to its most productive uses, for example by helping companies with good ideas raise money. But it’s hard to see how traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve that social function.

What about Mr. Hall? The Times report suggests that he makes money mainly by outsmarting other investors, rather than by directing resources to where they’re needed. Again, it’s hard to see the social value of what he does.

I’m still appalled at the number of people (they all seem to work at CNBC too) that can’t see that people that unfairly profit from what should be a fair and transparent investment market shouldn’t be rewarded and celebrated. There was far more damage done by Wall Street and Andrew Hall to the country than some small time thug that held up a convenience store and is currently sitting in jail for a very long time. Why is it any less wrong to hold up an entire country with high gas prices or gummed up lending channels?

This is just another example of where our priorities are crossed. Why won’t Congress do right by the voters instead of their large donors? How can we change the rules to these games so a few people don’t benefit off the suffering of the majority?

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