American Politics: Who’s The Fiscal Conservative?

Sometimes, in American politics, it can be very disconcerting to notice the jarring differences between the “spin” of public relations and the reality of public policy. One such example emerged just last week, in an economic tussle that recently broke out on the border between New York City and New Jersey.

JP Morgan Chase, one of the “too big to fail” banks that received a $25 billion TARP program bailout from the federal government during the 2008/09 global crisis, earned over $21 billion of net income last year on total assets of over $2.5 trillion. Such immense wealth didn’t deter bank officials, though, from threatening to move 2,000 jobs from New York City across the river to northern New Jersey unless Bill de Blasio, the mayor of the Big Apple, granted them hundreds of millions of dollars in tax breaks.

At the same time, the bank offered New Jersey Governor Chris Christie the identical deal: 2,000 jobs in exchange for a massive amount of tax breaks. And then the institution played one politician off against the other, and waited to see whether either one would accept the offer.

The result? One politician refused to offer the tax breaks to JP Morgan Chase, retorting that the bank’s request was “excessive” and a “non-starter.” But the other politician offered close to $200 million in tax breaks, and ultimately won the jobs.

So which politician adhered to a fiscally conservative position and turned down the bank? Was it Mayor de Blasio, a liberal progressive Democrat? Or was it Governor Chris Christie, who is currently running for President as a conservative Republican?

If you listen to political spin, you’d undoubtedly guess that the Democrat offered the tax breaks and the Republican refused to do so. But if you made that guess, you’d be wrong.

In truth, the Christie administration has offered government fiscal support to many private corporations during his time in office. And some of his decisions, such as those to support a failing Atlantic City casino and a giant insolvent shopping mall development, have not turned out well.

In all fairness, though, other states in the New York metropolitan region have made similar mistakes. In Connecticut, for instance, massive fiscal benefits to global firms like the Swiss banking giant UBS and the pharmaceutical firm Pfizer have similarly failed to pan out.

In other words, this is not a partisan issue. It’s a concern that cuts across both political parties. And what lesson can we learn from this common experience?

Namely, it is not always wise for politicians to offer massive government tax breaks in exchange for short term employment promises by private organizations. And, perhaps more importantly, voters should never assume that government officials of either political party will necessarily act in a fiscally conservative manner when such promises are dangled before them.

How Important Is MetLife?

MetLife, the parent company of the Metropolitan Life Insurance Company, is one of the largest financial institutions in the world. Founded in New York City approximately 150 years ago, the firm now manages insurance, annuity, and employee benefit programs for 90 million people across the globe.

It’s an important firm, isn’t it? That’s why U.S. government officials voted to propose that MetLife be labeled a “systemically important” financial institution. Such a decision would serve to acknowledge the insurer’s dominant position within the nation’s economic system. And, accordingly, it would place the insurer under a more intensive spotlight of oversight and regulation.

Understandably, MetLife is eager to avoid any additional regulatory oversight activities, especially in light of its high profile failure of a government “stress test” two years ago. Thus, it is acting vigorously to avoid the “systemically important” label, even going so far as to threaten the government with a lawsuit.

To a certain extent, we can certainly understand MetLife’s argument about the inappropriateness of being labeled a “systemically important” financial institution. After all, the firm only began to expand from its insurance origins into the banking sector in 2001. And it didn’t receive any TARP bailout funds at all during the 2008 – 09 global financial crisis.

On the other hand, during the crisis in the autumn of 2008, American Express, Goldman Sachs, and Morgan Stanley all converted their corporate structures into bank holding companies in order to qualify for billions of dollars in TARP funds. One can easily argue that MetLife, by refraining from any reliance on TARP funding, should (out of a simple sense of fairness) be spared the levels of oversight that are now imposed on these other institutions.

And yet three non-bank institutions — AIG, GE Capital, and Prudential — have now been labeled “systemically important.” How can one argue that MetLife deserves to be excluded from this group?

So what should we make of MetLife? Is it a “systemically important” firm? Should a global financial giant that did not accept TARP funds, but that did fail a stress test in 2012, be given a label that draws enhanced regulatory scrutiny?

As the global financial crisis recedes into history for contemporary decision makers, it becomes less relevant than recent events. Because MetLife failed a stress test just two years ago, and given its current dominant position in the insurance sector, its designation as a “systemically important” institution may be inevitable.

Libor: Are There Any Winners?

You didn’t really think that supporters of the global banking industry would simply surrender to public condemnation regarding the Libor manipulation scandal … did you?

Two weeks ago, we described why the scandal posed a threat to the public interest. And last week, we discussed the difficulties that plaintiffs may face when filing lawsuits to recover their losses.

This week, we end our first-ever trilogy of blog columns by exploring a recent counter-argument that is gaining traction among supporters of the global banks. Namely, some industry veterans are asserting that the scandal did little to harm borrowers …

… and may have actually helped them!

Interest Payments

The essence of their argument appears to focus on the direction in which the bankers at Barclay’s appear to have manipulated the Libor interest rate. Namely, they appear to have understated their rate quotes, as other banks purportedly did as well during the depths of the financial crisis in order to maintain the impression that they were strong and stable institutions.

The Washington Post recently quoted several industry experts who asserted that, by understating interest rates, the banks actually assisted borrowers by minimizing their interest payments. And Bloomberg quoted a representative of British mortgage lenders who claimed that “it’s very unlikely that Libor-fixing will have had any material impact at all on consumers … if anything, a downward impact on Libor (was) advantageous overall to the wider influence on rates …”

From a narrow perspective, this argument is indeed true. Borrowers with fixed rate loans, for instance, would not be affected at all by Libor rate manipulations. And borrowers with variable Libor-based loans would indeed enjoy reduced payments when the rate is manipulated downwards.

But from a broader perspective, would these conclusions remain valid?

Interest Rate Swaps

Let’s consider an example of a debt arrangement that is far more complex than a single variable rate residential home mortgage. Let’s ponder the plight of a municipal government entity, for instance, that agrees to a primary fixed rate debt instrument with a secondary variable interest rate swap.

Huh? How would such a transaction work?

Well, the borrower would pay a fixed interest rate on its primary debt outstanding, and then would purchase an exotic secondary derivative that would provide varying levels of reimbursement in proportion to fluctuations in market interest rates. The two opposing cash flows, when netted together, would be designed to generate net interest payments that would reflect changes in the variable Libor rate.

Unfortunately, though, this strategy backfired for many government borrowers (as well as for investors in debt instruments) when Libor rates declined, purportedly as a result of understatement manipulations. Such declines minimized the variable cash inflows received on the derivative transactions, but did not affect the cash outflows paid on the primary fixed rate obligations. That is why the City of Baltimore, the New Britain Firefighters’ and Police Benefit Fund, the California Public Employees Retirement System, and others are now contemplating legal actions.


There is also a macro-economic perspective that should be considered when assessing whether any borrowers have benefitted from the Libor scandal. To consider this perspective, let’s assume that the global banks were indeed fixing variable rates at inappropriately low levels.

Because other lenders “peg” their variable rate loans to Libor as well, they would have also received lower interest payments from borrowers. In other words, the revenue streams of relatively small competitors would have been damaged as severely as those of the global banks by such manipulations.

But which institutions may have benefited from revenue declines that affected global banks and smaller competitors simultaneously? The global banks, by nature of their sheer market size, their implicit (or explicit) access to bailout programs like TARP, and their thicker capital cushions, undoubtedly would have been better positioned to survive such circumstances.

In other words, like any dominant industry player that launches a price war with the intention of driving smaller competitors out of business, the global banks may have enjoyed a macro-economic advantage by forcing market interest rates lower. In the long run, the elimination of competition cannot be beneficial for consumers.

The Public Trust

There is one final perspective, perhaps the broadest one of all, to consider when assessing whether any borrowers actually benefitted from the Libor manipulations. Namely, can any member of society ever benefit, in the long term, from scandals that fundamentally damage the public trust in our global financial system?

If public cynicism about the system permanently depresses demand for variable rate loans in the United States, for instance, can any one truly benefit? Likewise, if citizens in Greece and other struggling European nations rebel in disgust against the austerity measures that are needed to repay the government debts held by global banks, can the system ever heal?

In the broadest sense, it is difficult to argue that any deceitful manipulation scheme can create “winners” among borrowers. In the long run, if there is no public trust in the global financial system, we are all inevitably “losers.”

Managing The Curse of Wealth

Just a few days ago, Citigroup revealed that it is experiencing an unusual new problem. It appears to be earning too much money … albeit only in its Phibro trading unit.

Nevertheless, Phibro’s profitability is causing such a headache that Citigroup is seriously considering selling the division. Apparently, at Citigroup, excessive earnings are as much of a risk nowadays as excessive losses.

Interestingly, enterprise risk managers have long been cognizant of the problems that may arise in response to a sudden and significant increase in wealth. Although Citigroup’s problems with its Phibro unit may pose an interesting dilemma, they certainly shouldn’t have taken the banking colossus by surprise.

Money and Politics

In a sense, the Phibro situation is a natural example of the risks that are faced whenever money and politics are mixed together. Early last year, energy companies made huge fortunes when the price of a barrel of crude oil spiked past $147; politicians were then blistered by the angry howlings of American drivers bemoaning the era of $4 per gallon gasoline.

But then, late last year, the economy itself melted down. Crude oil prices plummeted as low as $33, and gasoline prices dipped well below $2. Then Citigroup received a massive, and publicly unpopular, $45 billion government bail-out with TARP funds.

Energy companies suffered during this period as well, but they have subsequently rebounded to profitability as crude oil prices have soared above $70. Phibro, as an energy commodities trading firm, is now once again raking in huge profits; that has meant significant profits for its corporate parent Citigroup as well.

So where’s the problem? What’s the risk? Well, Phibro’s chief trader Andrew Hall is now demanding a $100 million bonus for his superior performance, but Congress is no mood to watch firms that received billions of dollars of TARP funds hand out such compensation awards. So Citigroup may decide to sell the entire division, and surrender the future profits that can be expected from it, instead of risking the wrath of the United States government.

A Familiar Problem

Is this an unusual problem? Of course not! In fact, one doesn’t even need to be the direct recipient of government bail-out funds to experience it. Any organization that transacts directly with government should be concerned by the prospect of excessive profits as well.

Lockheed, for instance, was excoriated during the Reagan Administration for charging the Navy $640 per toilet seat for furnishing the bathrooms on its P-3 Orion aircraft. And state treasurers are often criticized for overtaxing citizens when they run budget surpluses and deposit excess cash receipts in rainy day funds. Such problems are common when dealing directly with governmental officials who are responsible for approving government expenditures.

Nevertheless, many firms maintain no government business and yet are roundly criticized for earning excessive profits. Oil companies, for instance, are often threatened with windfall profit taxes when their earnings soar during times of high energy costs. Health insurers and pharmaceutical firms, likewise, are often criticized for earning profits when Americans are struggling to obtain coverage and purchase drugs. And colleges and universities are often urged to increase tuition grants and fellowships when their endowments climb into the billions of dollars.

So what can be done? How can firms anticipate and manage the risk of earning too much money? This are not complicated questions; in fact, they can be answered through the simple application of enterprise risk management.

Keeping it Simple with Risk Management

How would that be accomplished? Well, the first major task of enterprise risk management is the anticipation and description of potential crises. Adroit consumer polling, coupled by astute lobbying, can help us predict how public annoyance over profits may grow into maelstroms of rage.

The second major task of risk management is an assessment of the likelihood that each potential crisis may occur, and the extent of the harm that would be experienced if it actually happens. Lockheed, for instance, may have blundered here if they believed that their $640 toilet seat would never become a public issue, or – if it did – that they could minimize the damage to their reputation by quietly discounting the price.

Finally, the third and fourth major tasks of risk management are the respective definitions of risk response and internal control activities, with the former designed to reduce likelihoods of occurrence and the latter designed to reduce extents of harm. Citigroup, for example, may have goofed here by overestimating the government’s delight at the prospect of Phibro profits and underestimating their chagrin at Hall’s bonus demands.

So what should firms do to manage the risk of excessive wealth? First, they should anticipate situations where this may occur. Second, they should prioritize and then focus on the highest risks. And third, they should implement plans to prevent and/or manage these high priority crises.

Perhaps Citigroup’s decision to explore a sale of Phibro has actually been a step in its master risk management plan all along. If so, then it may prove to be a very costly step indeed.