Good Evening: U.S. stocks rallied today, shaking off the worries that generated yesterday’s first and only down day of 2010. Brushing aside apparently trivial items such as Alcoa’s earnings miss, higher reserve requirements for Chinese banks, a proposed tax on large U.S. financial institutions, dimmer credit prospects for Greece and California, lower energy prices, and a weak 10 year note auction, the major averages managed to gain back on Wednesday most of what they had shed on Tuesday. Even though news flow is often no match for bullish sentiment, it might be helpful to examine why “Bailout Nation” author, Barry Ritholtz, is all in favor of the Obama administration’s proposal to impose a tax on the 20 or so largest U.S. financial institutions.
Despite a downdraft in Chinese equities overnight, stocks in Europe and index futures in the U.S. were both in the green prior to this morning’s open. Today’s economic data releases were of the junior variety, with mortgage applications a non event, and crude oil inventories coming in much higher than had been expected. The resulting fall in energy prices helped trim the early gains in equities, and stocks were soon thereafter in negative territory. That market participants were witness to a developing spat between Google and the Chinese government was also a source of concern in the early going. And yet, the major averages soon recovered, beginning an upward journey that would last for most of the rest of the trading session.
To save ink, I will resist the urge to comment upon the mock inquisition of Wall Street CEOs by our elected officials in Washington , except to say that the massive amounts of hot air expended helped to bring an end to the nation’s recent cold snap. I will instead point out that stocks were able to make headway this afternoon despite a poor 10 year Treasury note auction, a .less than ebullient Beige Book report, and the news that the December of 2009 budget deficit was the worst on record. The major averages finished with gains of between 0.5% (Dow) and 1.27% (Russell 2000). Treasury yields climbed by 6 to 10 basis points, while the U.S. dollar index fell 0.25%. Falling energy prices were just more than offset by a gain in precious metals and other items, enabling the CRB index to finish with a gain of 0.2%.
During the dark days prior to and just after his 2008 election, President Obama promised that financial reform would be high on his list of priorities for 2009. “Never again” was the theme of his calls for stricter oversight of financial firms, policies our leaders in Congress said they would be only too happy to see become law. Sadly and unsurprisingly, little in the way of meaningful reform has taken place. It could even be argued that our nation’s largest surviving institutions are even bigger and better positioned now than they were before the credit bubble popped. This item on Mr. Obama’s agenda has thus been thwarted, and the lobbyists for the financial industry would probably be high-fiving each other if they weren’t so busy popping champagne corks.
I don’t know whether or not this lack of legislative action truly bothers our president, but I do know the subject really irks Barry Ritholtz. Barry is not only the author of the well-received book, “Bailout Nation”; he also runs both a firm (Fusion IQ in New York ) and a thoughtful financial blog (The Big Picture on the worldwide web). Like many of us who’ve written about sensible ways to strengthen our financial system, Barry is frustrated by the creatures in Congress who promote reform while at the podium and yet accept campaign contributions while at their desks from those who wish to stop it. In a piece he published today on his Big Picture website, Barry even goes so far as to claim that America’s shining democracy has been replaced by a dirty, green “corpocracy” (see link below).
My disappointment with our current system doesn’t extend as far as Barry’s does, but we both do share a sense of hope that President Obama’s latest proposed reform will help. Mr. Obama’s idea is fairly simple: Tax the 20 largest financial institutions (see below). Barry thinks this concept will do more than just penalize the firms that brought our financial system to the brink of failure and raise some sorely needed revenue in the process. He thinks the tax will modify behavior in the executive suites on Wall Street almost as much as would a sackful of regulatory changes. In short, he sees this proposal as a way of giving banks an incentive to shrink themselves. Becoming smaller institutions may or may not turn the targeted 20 into better banks, but it will lower their systemic risk profiles. Here is an excerpt from Barry’s article:
“Pushing regulation through the front door may have become impossible due to this corruption; However, a TBTF tax can be passed because it raises money to close the deficit. It will be difficult to vote against, given all the undirected anger against banks and wall street during big bonus time.
“And, here’s the interesting part: It could potentially do more than reduce the deficit — if it goes far enough, it could actually solve the TBTF problem. Exempt small regional banks with under $25 billion in deposits. Make the tax progressive so it become increasingly larger as deposits become(s) greater. $25-$50 billion in deposits is one fee (Let’s say 0.1%, that’s $25 million on $25 billion in assets). Have it scale to the point where its punitive — 1% on a trillion dollars in deposits.
“The goal here isn’t to raise money — its to force the TBTF banks to become smaller — to break up the Citigroups and the Bank of Americas. This tax will restore competition to the banking industry.
“These jumbo firms are the ones that can and will bankrupt the FDIC; They are the ones that put the entire system at risk. The bailouts reduced competition for them, and allowed a concentration of power that has been unprecedented.”
I usually oppose higher taxes because they tend to be a disincentive to productive behaviors, but structured properly, this tax is one which might do the constructive opposite. Personally, I would prefer to see hard leverage caps on bank balance sheets and a mandate to put all OTC derivatives on proper exchanges. But if positive changes such as these cannot wriggle past those in Congress who steadfastly protect their financial benefactors, then perhaps this tax concept will have to do. Given the public’s mood, Congress will have a tough time voting this one down.
I do have a few suggestions, though, before the administration’s bill hits the floor. First, keep it as simple as possible. Second, don’t just target institutions by the size of their deposits. Investment banks like Goldman and Morgan Stanley are every bit as systemically important as Wells Fargo, but their smallish deposit bases would exempt them from a deposit-based tax. Besides, deposits are liabilities that can be replaced or repackaged into other obligations that would enable the shrewdest banks to escape. Third, the Obama administration should work with governments on every continent to impose similar restrictions on leverage. Unilateral action by the U.S. will only drive business offshore over time.
Ultimately, I think it would be better to base this tax on the size of the assets each firm holds. More specifically, the size of the tax should relate to the size of assets on the balance sheet in relative proportion to the size of the tangible equity cushion supporting it. A tax that is low at safer leverage ratios (e.g. 10 – 1) and then punitively escalates with rising leverage ratios would be the best way to implement such a tax. At least such a mechanism would preserve the capitalistic element of choice. If firms want to take on higher risks in search of higher rewards, they can still choose to do so — at least until their bonus pools run dry.
— Jack McHugh
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Too Big To Fail Tax, by Barry Ritholtz
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