Friday, May 18, 2012

Unrighteous mammon.

As I write this, Bruno Iksil is still riding the Bongo Board. We have all done it, at least those of us of a certain age. We got up on the Bongo Board and we thought we could stay up forever.

One can only imagine the endorphins pumping across the world’s trading desks. The king of the hill, JPMorgan, has seen its killer trade—reputed to entail multiple hundreds of billions of credit default swap notional amount—go the wrong way, and now they need to reverse out of their position before the stink gets worse. The loss of two billion dollars announced a week ago grew by a billion in a week, and clearly the fire sale is not over.

Faced with a public relations fiasco, Jamie Dimon let his long-time, trusted lieutenant, Ina Drew, take the fall. Meanwhile, Iksil—the trader that amassed the positions that have been a topic online since early April—cannot be let go because he is the one that understands the billions and billions of complex derivative contracts that now need to be unwound. It must be quite a spectacle on derivatives trading desks around the world. It is get-back time, and in that world no one takes any prisoners.

As the hedge funds continue to circle in the water, feeding off of JPMorgan's exposed balance sheet, Dimon’s friends on Capitol Hill have been quick to come to his defense. House Financial Services Committee Chairman Spencer Bachus (R-Alabama) was quick to minimize the importance of one loss, whatever its size, while across the aisle President Obama lauded Dimon's bona fides and JPMorgan as “one of the best-managed banks there is.”

Politicians jumping to Jamie Dimon’s defense are missing the point. This is not about a single trade or one loss. Iksil, whose nicknames “Voldemort” and the “White Whale” (think Ahab’s nemesis, not a fat Frenchman) should give a hint as to his industry reputation, and now that the hedge funds have tasted blood JP cannot get out until the counterparties are good and ready. That the loss is still growing simply means that they are not ready to let go.

But if JP’s counterparties have Bruno by the balls, so too does Dimon have a firm grip on the nation’s political leadership. Last week on Meet the Press, Jamie Dimon described himself as still a Democrat, but just barely. Once a prominent Obama supporter, Dimon is one of many across the finance community who feel that they have been unfairly tarred for cratering the global economy.

To put a finer point on it, despite the media feeding frenzy surrounding Voldemort’s personal Black Swan event (Nicholas Taleeb’s now-famous phrase for things that can’t go wrong, until they do) comments from our nation's capitol remain measured, almost fawning. Democrats and Republicans have fallen over each other to praise Dimon as America’s Greatest Risk Manager notwithstanding JPMorgan's contretemps. Dimon's reputation grew out of the ease with which JPMorgan navigated the financial crisis, though some have suggested that Dimon's predecessor as CEO, Bill Harrison, deserves a fair share of the credit. Harrison, apparently, minimized the bank's exposure to exotic mortgage derivatives and handed Dimon a pretty clean balance sheet when Dimon arrived on the scene as CEO in 2006.

While some of the adulation garnered by Dimon may well be warranted, it is likely that most of the politicians uttering the hosannas have no idea what risk management is. It may be that what we are actually watching is a not very subtle food fight between our two political parties for campaign cash. Simply stated, this is not about Dimon's management skills, rather it is about his wallet.

Over the past two decades, the financial services sector has been the most generous source of political money, and that money has been up for grabs. For decades, the Republican Party was the party of Wall Street. That singular identity ended during the Clinton administration, which was determined to lure Wall Street's lucre across the aisle. While Clinton and the Democrats grabbed the golden ring, the price for the nation was steep: the Financial Services Modernization Act of 1999 and the ensuing Commodity Futures Modernization Act of 2000 that together laid the groundwork for the financial services world as we know it, and as the world came to experience it in the global financial meltdown of 2008. During the last presidential cycle, according to, the financial sector remained far and away the largest source of political contributions, with 54% going to Democrats, while this time around—in the wake of industry anger over Dodd-Frank reforms—the tide has turned and 77% of that money is gracing Republican coffers.

Could it be that Chairman Bachus was quick to rise to the defense of JPMorgan because that bank has been the leading source of contributions to his campaigns over the course of his career? Could it be that President Obama is treading lightly on the issue because to date he appears to have lost his edge with two of his largest financial supporters from 2008—Goldman Sachs and JPMorgan—who according to are the two largest sources of contributions to the Romney campaign?

It is getting boring reading about how the events of the past week—to say nothing of the past decade—suggest why our banks should be smaller or risk trading functions separated from traditional commercial banking. Democrats that continue to believe that we can regulate our way out of this either don’t want to give up their share of the money or simply lack imagination. Banks should be smaller so they can fail with the regularity with which small banks do fail. JP’s oft-repeated argument that their nearly one hundred trillion dollars derivatives book is book-matched and therefore does not constitute a systemic risk to the financial system is disingenuous at best and simply dishonest at worst. 

Lost in the endless—and endlessly self-serving—arguments is the fact that commercial banking is essential to the economy—and thus is supported by numerous institutions including the FDIC and the Fed—and that the integration of investment banking and commercial banking—a brainchild of Dimon’s mentor Sandy Weill—has brought little to no demonstrable value to commercial banking’s core societal function, while bringing much to the investment banking world—massive bonuses, a bottomless supply of free capital and the socialization of trading risk.

Both Jamie Dimon and our nation’s political leaders face the same fundamental problem: as risky as the status quo might be, no one can afford to give it up. For Jamie Dimon, derivatives trading is a gravy train that has underpinned JPMorgan's profitability, regardless of the larger threat it may entail, while for our political leaders major contributors are an irreplaceable constituency always for sale to the highest bidder. 

But don’t worry about Bruno Iksil. Whether Jamie Dimon finds he has to let him go, or figures out a way to keep him, he will be fine. There will always be a market for a proven derivatives trader, particularly one with the moniker of the true master of the universe. He will not be tainted by this trade, no matter what the final damage turns out to be, or at least not for long. After all, take a look at his new boss who took over from Ina Drew. He was formerly a trader at Long-term Capital Management.

Same story, just a few crises ago.

Tuesday, May 08, 2012

Not the way it was supposed to be.

Last month, the Territory of the Northern Mariana Islands became the first U.S. public pension fund to declare bankruptcy. Like many public pension plans across the country, the financial condition of the Northern Mariana's pension fund deteriorated significantly over the past five years. With $256 million of pension fund assets available to fund $1 billion of pension fund liabilities—a "funded ratio" of just 25%—the trustees of the Northern Mariana's pension fund have suggested that they may be able to pay out just 50% of the retirement benefits promised to public employees under the defined benefit pension plan.

There may be those who hope that because this tiny U.S. territory is way, way offshore—situated as it is somewhere between Japan and Papua New Guinea—events there cannot be a harbinger of things to come here on the mainland. But just two weeks later, much closer to home, Mayor Angel Taveras of Providence, Rhode Island, approved a plan to sharply curtail pension benefits to current workers and retirees in an effort to keep that city out of bankruptcy. Faced with a pension fund that is 32% funded, Taveras' pension reforms ended cost of living increases for retiree benefits until the City pension system’s funded ratio increases to 70% and capped the annual pension payable to any one individual at 150% of the median state household income.

Problems with public employee pension plans have been brewing for some time. These plans promise retirees a “defined benefit” that is generally calculated as a percentage of an employee’s average compensation over the last few years on the job. The cost of the future benefits are supposed to be budgeted and funded each year by a combination of employer and employee contributions in an amount calculated by the system actuary to be sufficient to fund—together with projected earnings rate on those contributions—the future benefits earned in that year. That way, as long as these “normal costs” are budgeted and paid over to the pension trust fund each year, and the assumed earnings rate on the pension fund deposits are achieved, the pension system will be fully funded and future taxpayers will not be required to fund benefits earned by employees in prior years.

As recently as a decade ago, in the wake of the stock market boom of the late 1980s and 1990s, municipal pension plans were in good shape, with many boasting funded ratios in excess of 100%. But over the past decade, equity markets have not fared well and pension fund investment returns have fallen short of actuarial targets, averaging less than 6.00% over the course of the decade and 1.00% over the last year.

By 2010, according to a study by Barclays, state pension funds on average were just over 60% funded, and underperformance relative to actuarial earnings targets has led to new "unfunded actuarial pension liabilities" that are now the responsibility of the sponsoring governments in the same manner as a communities general obligation bonds. The Barclay's study began by noting that the unfunded pension liabilities of the states are estimated to be as much as $3 trillion, or six times the amount of bonds outstanding. The impact of pension problems at the local level has been dramatic, as pension system actuaries have required significant, long-term increases in pension contributions to fund theses new, unfunded pension liabilities.

For example, based on data from the California State Controller, in my city of Berkeley, the employer contribution rate for police—the largest area of municipal spending—has grown from 3.6% of salaries ten years ago to 40.4%, usurping much needed funds from other purposes to meet these new pension costs. The same issue is affecting funding for government services across the County, according to data from the Stanford Institute for Economic Policy Research.  The following graphic illustrates dramatic impact of the growing cost of these new pension liabilities, which will soon consume 10% of the entire County operating budget. This translates into a diversion of approximately $200 million that would otherwise be available for spending on public safety, public assistance, healthcare and other critical public programs.

This is not the way it was meant to be. Beginning around the 1840s—in the wake of defaults by a number of states in the nascent United States—new state constitutions were established across the country that placed severe restrictions on the ability of states to take on debts or other liabilities that would place a burden on subsequent generations. For example, the California constitution that provides that "The Legislature shall not, in any manner create any debt or debts, liability or liabilities" without a two-thirds vote of the legislature and subsequent approval by popular referendum. However, at the same time, that constitution and the federal constitution prohibit the impairment of contracts, which has been presumed to protect public employee pensions.

The moral dilemma presented by the pension issue is embodied in the apparent conflict between two first principles of governance: Limitations on the creation of debt and the sanctity of contracts. On the one hand, the constitutional framework established in the 1840s placed severe hurdles on the ability of elected officials of one generation to place burdens on future generations. On the other hand, sanctity of contract provisions of both state and federal constitutions provides both the moral and legal basis for non-impairment of vested pension rights.

As defined benefit pension plans have evolved—by taking on greater investment risk as they increased benefit payouts—the effect has been to shift 100% of that investment risk to the taxpayers. When pension fund investment returns fell short of the actuarial earnings target, new liabilities were created. Essentially, the labor agreements that embodied the pension commitments became a source of new public liabilities, bypassing what in many states are long-standing rules constraining the creation of new liabilities.

Moral indignation lies at the heart of the pension crisis. For their part, workers have for decades paid into their pension plans based upon contractual commitments. Pensioners reasonably believe that they are entitled to what the rules say they are entitled to, that they obtained their benefits openly and legally and properly, and that the benefits are owed to them as a matter of rights.

On the other side are communities that are being forced to cut essential services as the cost of unfunded pension liabilities—liabilities that appeared as out of thin air—grab an increasing share of current budgets. Public support for public pensions has been further eroded by stories about abuses of pension rules—pension "spiking" schemes and double dipping—that game the system to increase individual payouts.

Although early on the pension crisis seemed destined to play out as a one more Democrat vs. Republican spat, it has migrated beyond party boundaries. It was a Democrat mayor in Providence that approved new, draconian pension reforms, and a Democrat Governor in California that is proposing pension reforms that so far have only received Republican endorsement. And last year, San Francisco's elected Public Defender Jeff Adachi—an unabashed progressive—ran for mayor specifically to confront the pension question and the huge diversion of funds from core social services that is undermining that city's social service infrastructure. 

The pension issue is not going to go away. The financial impacts of pension deficits are going to be felt at the state and local level for years, and will continue to influence the political landscape as politicians are forced to confront that which is manifestly broken. And lying in the background will be the experience of the Northern Mariana Islands, a harbinger of things to come if communities and public workers fail to confront, and ultimately fix, the problem.

Published on The Huffington Post on May 24, 2012.