From the Vault: Yves Smith on How Banks Extract from the EconomyMarch 19, 2012
This podcast was originally recorded in January 2012.
With Dylan off this week, we’re looking back at some of our favorite podcasts from the last few months that you might have missed. This one digs into a term that we talk about a lot in Dylan’s book Greedy Bastards — extractionism.
Joining us to discuss the concept of “extractionism” is Yves Smith of nakedcapitalism.com. She is author of ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. She opened my eyes to some radical stuff going on in the capital markets.
Big Banks are extracting capital for themselves with such power that investors are actually afraid to go to the courts for redress — a perfect example of institutions that like to create one set of rules for themselves, while preferring that everyone else play by another set of rules, solidified and supported by a stunning lack of transparency in certain sectors of the markets.
The examples of that reveal themselves over and over. But first, what is extraction, and how is it the opposite of capitalism? How can extractionist systems have all the characteristics of capitalism, while hiding the elimination of productive resources over time?
Greedy Bastards like to call themselves capitalists, but what they’re actually doing is the exact opposite: it’s extractionism: taking money from others without creating anything of value; anything that produces economic growth or improves our lives.
Under an extractionist system, we find lose value at a faster rate over time, while we need to be creating it. Instead of giving people incentives to make good deals where both sides can benefit, extractionist systems rewards those who take and take some more, and give nothing in return. Sadly, extractionism has crept its way into every aspect of our economy — it’s everywhere, from trade to taxes to banking.
Let’s take a look at banking as an example. As Yves Smith explains, financial firms do provide valuable services to our economy, like establishing stable and reliable methods of payment for goods and services, and selling bonds and stocks to help raise new money to fund big projects. There are more than that, of course, but those are two basic examples of valuable services that our banking and financial sector provides.
Now, let’s look at how they can also be extractive — almost always going back to the lack of transparency in the financial markets.
Yves identifies two main extractive techniques of our financial industry. The first is charging too much for goods or services. “Even fairly sophisticated customers can’t know what the prices are of many of the products, so it’s difficult for them to do side-to-side comparisons,” says Yves.
The second method is producing products that are so complicated –like in the swaps market – that clients can’t see hidden risk in them. “This has unfortunately become extremely common now that we have a lot more use of derivatives. Many of the formulas that are used they are disclosed by they are extremely complicated, and then on top of that, the risk models that are commonly used for evaluating the risk actually understate the risk,” says Yves.
So what is the Greedy Bastards Antidote to extractionism? Here’s what Yves would like to see:
1. A small tax on all financial transactions. This would “discourage customers from engaging in so many transactions. And the reduction in the number of transactions would mean less opportunities for banks to trade the risk and lay-off the risk so quickly, so the fact that they would have trouble turning around and laying off risk would make them… more cautious because they would have more trouble with their own risk management and would have to be more conservative in their own strategies,” says Yves.
2. Give financial institutions a bigger financial responsibility when they knowingly recommending bad products or dubious strategies. Yves believes that we need to have a better way for customers to hold financial institutions accountable when they sell bad products. “The problem is that that’s in theory a good solution; in practice, a lot of these – and we see this in the mortgage crisis — that the customers are so afraid of the banks that they are not willing to sue them. They are afraid of the power that the big banks have, they are afraid that either the banks will cut them off directly and that the banks have so much power that the government would go after them… If you can’t use courts for redress, you kind of have a problem because then it means it falls to regulators and we have a very weakened regulatory apparatus, too,” says Yves.
And that brings us to the next point.
3. We need increased political pressure for an effective and robust Securities and Exchange Commission.
Yves believes we need “the sort of SEC that was actually feared in the 1970s. People seem to forget that. When they had an effective enforcement director, Stanley Sporkin, who really did – and he was not only willing to try cases, he was willing to lose cases. You have to be willing to lose a few to perfect theories. The SEC has become so risk averse it’s not even willing to lose cases, which means it’s only going to do ones that are slum dunks like insider trading cases,” explains Yves.
4. More inspection of what the banks are doing in their over-the-counter businesses. “Particularly in terms of disclosure,” says Yves. “One of the classic examples is infrastructure deals. You will have a government that owns some sort of asset — the classic example was the Chicago parking meter deals, where they get revenues from it and because they are a bit broke, they decide that they are going to sell the family china when they are still going to have to rent it back and use it. And what happens is that these investors will have so many fees in these deals, there are multiple fees. Not only do the investors want to earn a return in the 15% to 20% range, but then you also have a lot of fees in putting together the deals because they are extremely complicated. And there is a fee for managing the asset on top of that… Literally in the case of the Chicago meter deal, they marketed to investors at twice the price they paid the city because they knew they are going to ramp – they planned to ramp their fees aggressively,” says Yves.
- Meg Robertson is a digital producer for DylanRatigan.com.
EPISODE 5 - EXTRACTION
GREEDY BASTARDS ANTIDOTE
YVES SMITH - NAKED CAPITALISM
DYLAN: Welcome to another episode of Greedy Bastards Antidote. Today, we are talking, or I’m looking for, the antidote to systems that encourage extraction. What is extraction, and how is it the opposite of capitalism? And how can systems that are based on extraction or extractionism become almost like a mirage in that they can show the characteristics of capitalism through money moving around while they are actually hiding the elimination of productive resources over time. And joining us today to learn a little bit more about the difference in extraction and extractionism and capitalism is Yves Smith, her website, of course, nakedcapitalism.com. She is author of ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism.
There is a lot that goes into this, the most obvious from of extraction I guess that people understand is if I stick a pipe in the ground and suck minerals out or if I cut down trees and I’m literally harvesting natural resources, but as we are learning, Yves, there are financial mechanics and tax policy mechanics and all sorts of other mechanics that go to effectively extract future capital from societies by pulling it forward in a way that is none productive or is in fact destructive. Can you give us a –what is your perspective on where the lines are drawn between what’s extraction and what’s actual creation and capitalism and how manageable that really is.
YVES: Well, I think it really boils down to two different forms although they overlap. One is when, because remember finance you know ultimately is, can, and often does provide useful services. I mean, for example, we look to financial firms for things mundane as a payment system. You know, banks process checks and credit card payments and what not, they provide, as you eluded, financing of various sorts, you know, people go – you know, big companies go to the market and sell bonds and stocks to raise new money for projects. And then investors trade on secondary markets to try to get the portfolio mix they like for their retirement or their insurance company to match against their expected insurance pay out.
So there are useful things that these firms in theory do. The two ways that things become extractive is first if you charge too much for the service or you find away to charge too much. I mean this is one – this is the, for example, either people like to grumble about lawyers, people need lawyers, you know? If you – now I am just using these as rough numbers but costs, you know, if it costs the law firm $500 to set up a corporation, you need a corporation and maybe they charge another $500 for the trouble, people will regard that as reasonable. If the law firm, if it only costs the law firm – if it’s only $500 in expenses and they decide to charge you another $20,000 and you don’t know that $20,500 is not the going rate, you’ve been had. So that’s sort of one way extraction takes place, is people being charged prices that are excessive and that can happen in some of these markets because they are over-the-counter and nobody knows what the price really is.
You know if you go and you are a customer and you go to buy a bond and you don’t have a Bloomberg screen that even gives you indicative prices, you have no idea if the dealer is taking you on the price or not, if you are getting a market price because that’s an over-the-counter at the market. Unlike stocks, you don’t have the prices reported in a way that people can get them on a reasonable real-time basis.
DYLAN: You were taking about the importance of being able to see and the customer’s ability to understand the marketplace and the cost. We have a regulatory apparatus and a western financial apparatus, even though we claim to be a capitalist country and we claim to have all these aspirations towards equity and equality and all this, how much does the lack of transparency in the financial markets actually help to encourage extraction?
YVES: Well, I think you can argue quite a lot. I mean the fact that customers – because then there’s sort of two levels. One is that they – even fairly sophisticated customers can’t know what the prices are of many of the products so they can’t do – it’s difficult for them to do side-to-side comparisons, you know. Literally, in the days when I was young on Wall Street, people would bother to get simultaneous quotes from multiple dealers.
I don’t know that anybody bothers going to that hustle anymore. But the second way that people get extracted – so, you know, it’s significant and precisely because no one knows what the real, except the dealer himself, what the market price was versus what the price the customer was charged, we don’t really know.
You know we have some evidence of the level of abuses because we see, for example, these – now there are a number of suits being filed about overcharging of foreign exchange transactions and those are very significant lawsuits.
So you know there are some moves to try to – and these again are being charged to major institutional investors. So we are seeing some moves to try to recover some of these charges, but the fact that you see overpricing in foreign exchange, which is a very liquid market. You know, it’s not as if the dealers –it’s not as if there is a big risk assumption argument for any kind of egregious charges in those markets.
The second way that extraction – a second way that extraction takes place is that customers are sold overly-complicated products with hidden risks in them. This has unfortunately become extremely common now that we have a lot more use of derivatives. It would be a lot more difficult to pack extra risk into the sort of products that you have the financial markets pre the early 1990s when the use of derivatives became really common place. And again, most customers just aren’t in any position to understand the risks. You really need to have an intuitive understanding of calculus, an intuitive grasp of calculus to understand the risk properly. Many of the formulas that are used they are disclosed by they are extremely complicated, and then on top of that, the risk models that are commonly used for evaluating the risk actually understate the risk.
This has been a big theme of the work of you know Nassim Nicholas Taleb in his book Black Swan, that the conventional models underestimate what is called “tail risk”, which is the risk that really bad stuff will happen that will blow you up. And the experience of the crisis shows that. You know, dealers were using similar risk models and they blew up on mass. And on top of that you’ve got other ways to measure.
DYLAN: Well is it – one thing on risk management, how much of it is under-pricing or undervaluing the risk and how much of it is the appropriate diminished pricing of the risk because they know that – because they are too big to fail, they have transferred the risk to the state. I don’t know if that was maybe too complicated, not for you per se, but for the audience.
YVES: Well, there are cases where the banks under-priced the risk. I mean the biggest one was in the credit default swaps market running up to the crisis. But they – but in most of the cases, the banks really weren’t the ones taking the risk; they sort of dumped it on third parties. I mean in the end, some of them did wind up taking the risk because they didn’t understand the risk of the collateralized debt obligations and traders were engaged in bonus gaming. So they did wind up – and that was one of the big reasons for the crisis, but my take on that is they just really weren’t paying attention and really didn’t care. But to your point, the fact that they could be so inattentive about it points to another pricing of risk. You know when I was, -- I mean I worked for Goldman in the early 1980s when firms on Wall Street were partnerships and you’d never see firms engaging in risk if they didn’t understand it or weren’t highly confident that they understood it. And the partners would have been all over it.
So the fact that you’ve got risk managers who really aren’t that powerful, even though they may have like a C level title like Chief Risk Officer, they really are second-class citizens if there are serious fights with the traders. And you’ve got these groups that – the very fact the chief risk officers aren’t as powerful as they should be is kind of testament to this phenomenon you are talking about.
DYLAN: So what’s the antidote?
YVES: Well, one would be…
DYLAN: To extractionism or to those characteristics.
Yves: Well, first thing, one would be a Tobin tax, which is the name of the tax, you put a small tax on all financial transactions, that discourages customers from engaging in so many transactions. And the reduction in the number of transactions would mean less opportunities for banks to trade the risk and lay-off the risk so quickly, so the fact that they would have trouble turning around and laying off risk would make them, even though we did talk about the too big to fail issue, it would still make them more cautious because they’d be more – they would have more trouble with their own risk management and would have to be more conservative in their own strategies. I mean even though they blow up, they’re only supposed to blow up every five to ten years—blowing up on an annual basis is not acceptable then people don’t get their bonuses.
The second issue, a second way would be to put – have more areas where the banks have fiduciary responsibility or at least heightened responsibility so that if they recommended a bad product or a dubious strategy that the customer would have a better way for – a cleaner path for going back and suing them. Now, the problem is that that’s in theory a good solution; in practice, a lot of these – and we see this in the mortgage crisis that the customers are so afraid of the banks that they are not willing to sue them. I literally was on a conversation today with a lawyer with a lawyer that is representing investors in one of the larger suits against one of the banks, and he said that he knows investors who he said if [indiscernible 11:02] came into somebody’s house and killed the children of these people, he said they would be afraid to call the police.
YVES: They are afraid of the power that the big banks have, they are afraid that either the banks will cut them off directly and that the banks have so much power that the government would go after them. I mean it sounds paranoid but this is – I am literally replaying this from a lawyer that that’s how the investors – the investors are afraid to sue the banks and I don’t really have a good solution for that one. I mean if you can’t use courts for redress, you kind of have a problem because then it means it falls to regulators and we have a very weakened regulatory apparatus, too.
DYLAN: There is, however, absent the aspects of intimidation and corruption, there are tools, there are ways to stop this. In other words, if someone wanted to or had the policy courage or had the intellectual courage to do this, this is achievable.
YVES: Oh no, I’m saying exactly right, I mean if you had sort of – if we had the sort of SEC that we had – the SEC was actually feared in the 1970s. People seem to forget that. When they had an effective enforcement director, Stanley Sporkin, who really did – and he was willing to take, not only willing to try cases, he was willing to lose cases. You have to be willing to lose a few to perfect theories. The SEC has become so risk averse it’s not even willing to lose cases, which means it’s only going to do ones that are slum dunks like insider trading cases. But so, you know…
DYLAN: So political pressure for a real SEC?
YVES: Yeah, would make a big difference, and more inspection of what the banks are doing in their over-the-counter businesses, in particularly in terms of disclosure. I mean, for example – and then there are other practices which would just, again, which are sort of very disturbing in terms of – you know, you mentioned early on the use of debt to – in basically an extractive manner. I mean one of the classic examples is infrastructure deals. I mean, fortunately, those are beginning to get a bit of a bad name. But, you know, you will have a government that owns some sort of asset like the classic example was the Chicago parking meter deals where they get revenues from it and because they are a bit broke, they decide that they are going to sell the family china when they are still going to have to rent it back and use it.
And what happens is that these investors will – they have so many fees in these deals, there are multiple fees. I mean I could go through it, but basically not only do the investors want to earn a return in the 15% to 20% range, but then you also have a lot of fees in putting together the deals because they are extremely complicated.
YVES: And there is a fee for managing the asset on top of that. And the deals are set up to be a heads I win, tails you lose kind of deals where, for example, in Chicago if they clean the streets, they have to pay the parking meter consortium for the loss of revenues. And they have jacked up the parking charges so much that its hurting local merchants. So you know – and literally in the case of the Chicago meter deal, they marketed to investors at twice the price they paid the city because they knew they are going to ramp – they planned to ramp their fees aggressively.
DYLAN: Right. So the technique basically is very well established.
DYLAN: Yeah. Well, they’ve done a fine job, they went to school, they worked hard, and they got it done, which means that if we do the same thing I suspect we can fix it. I appreciate ALL of your, not just your work but the accessibility and the benefit that I think so many of us, myself included, have had in advancing this conversation because you have invested so much in helping folks understand the conversation itself. It is a pleasure to talk with you and thanks for the time today, Yves.
YVES: Thanks so much, Dylan. I really appreciate it.
DYLAN: Naked Capitalism is the blog, the book is ECONned, and the antidote is apparent although money and politics and intimidation maybe the barrier. We might need a 28th amendment before we can deal with this particular one, we will talk to you next time.