Friday, 9 January 2015

The CBO’s Bad Math: Putting $7 Trillion of Notional Value of Derivatives in Taxpayer-Backstopped Depositaries Will Cost Zero

So why did Elizabeth Warren lose her battle last month to stop banks from continuing to park $7 trillion notional value of risky derivatives like the credit defaults swaps in taxpayer-backstopped depositaries?

One of the less well-recognized reasons is that the CBO’s dubious analysis said it would not cost taxpayers a dime.

The Congressional Budget Office forecasts have enormous clout on the Hill. Yet as we’ve written, one of its most influential analyses, that of projected Medicare cost increases, was so rancid that two fiscal budgeting experts from the Fed roused themselves to write a lengthy academic paper demolishing it. That CBO work was so problematic on so many fronts, including that it violated CBO policies for the preparation of long-term forecasts in multiple ways, that it raises questions as to the intellectual honesty of the exercise.

In the case of the so-called swaps pushout rule analysis, the CBO came to a similarly dubious conclusion. We’ve embedded a report from the House Committee on Financial Services, which includes the CBO’s budget estimate on pages 5-6. The key bit is that “any impact on the cash flows of the Federal Reserve or the FDIC over the next 10 years would not be significant.” In budgetary terms, that is tantamount to saying it will have no cost.

This is absurd on multiple levels. There is an obvious subsidy to the banks here, otherwise Jamie Dimon would not have been lobbying personally to get the bill passed. FDIC insurance is widely acknowledged by banking experts to be underpriced, so increasing the risk held in depositaries, particularly of positions can and do go boom, makes the odds of going though the FDIC’s kitty even greater.

The CBO attributes no value to the de facto guarantee of these positions, despite the glaring contrary evidence of the $750 billion TARP in 2008 and a bailout of S&Ls in the early 1990s. Do they really have such a good crystal ball that their forecast period will manage to miss entirely one of our periodic banking system implosions? Trust me, if we have a meltdown, these positions will add to the cost. And with the Fed unlikely to be able to end ZIRP any time soon, it have less ability to use monetary tricks to levitate asset prices and thus reduce the fiscal costs of any salvage operation.

A post earlier this week by Occupy Wall Street’s Alternative Banking Group reminds us of how the last bank bailouts similarly undervalued the guarantees:
…even if we accepted the Treasury’s accounting and treated it like just another private trader, its returns are abysmal…it can’t properly count how much aid it gave — and continues to give — these businesses. Beyond the $426 billion of actual capital acquisitions the Treasury made, it provided guarantees and other support to these industries that experts have valued at more like $9 trillion. Calculate the $15 billion profit the Treasury is now bragging about using a $9 trillion base as the money that was put at risk and you start calculating minuscule returns like the 0.1 percent you’d see in a Chase money market. 
The fact that the Treasury did not have to make good on its promises to cover trillions of dollars of potential losses the financial industry had recklessly exposed itself to doesn’t mean the government did not give something of huge value. The mere fact of the government stepping in as a guarantor of things like toxic mortgage-backed securities kept the bank shareholders from being wiped out. This happened a lot as part of the bailout. But on Wall Street you can be sure to get paid for taking risks, regardless of whether the bad stuff you are insuring against happens. The Treasury, on the other hand, got paid basically nothing by putting all that taxpayer money on the line.
Let us not forget that Treasury conveniently omits a $35 billion of what Andrew Ross Sorkin called a “a tax benefit, er, gift, from the United States government.” So even on the raw numbers the “TARP made a profit” is questionable. And that’s before you get to three card monte, that the massive, ongoing subsidy to the banks via QE and ZIRP that goosed asset prices was essential to the Treasury being able to exit the TARP at all.

As derivatives expert Satyajit Das observed drily by e-mail:
The cost-benefit rationale is fascinating. I am impressed that people have determined enacting this legislation could affect direct spending and revenues; albeit not significantly. I would have thought not having to potentially bail out a depositary institution would have been a positive to public finances, not a negative. Clearly, I have been misinformed about how cost benefit analysis is done. 
It is an Alice in Wonderland view of markets.

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