Sunday, July 05, 2009

Banks own the US Government

Please read the following article from the Guardian (UK). It is interesting because what the headline says is true, but the proposed solution is illogical because it will simply benefit the people he is railing against in the article.

Banks own the US Government

Last month, when the US Congress failed to pass a bankruptcy reform measure that would have allowed home mortgages to be modified in bankruptcy, senator Dick Durbin succinctly commented: "The banks own the place." That seems pretty clear.

After all, it was the banks' greed that fed the housing bubble with loony loans that were guaranteed to go bad. Of course the finance guys also made a fortune guaranteeing the loans that were guaranteed to go bad (ie AIG), and when everything went bust, the taxpayers got handed the bill. The cost of the bailout will certainly be in the hundreds of billions, if not more than $1tn when it is all over.

More importantly, we are looking at the most severe economic downturn since the Great Depression. The cumulative lost output over the years 2008-2012 will almost certainly exceed $5tn. That comes to more than $60,000 for an average family of four. This is the price that we are paying for the bankers' greed, coupled with incredible incompetence and/or corruption from our regulators.

Under these circumstances, it would be reasonable to think that the bankers would be keeping a low profile for a while. That's not the way it works in Washington. The banks are aggressively pushing their case in Congress and Obama administration. Not only are we not going to see bankruptcy reform, but any financial reform package that gets through Congress will probably contain enough loopholes that it will be almost useless.

In this political environment, the poor might get empathy, but Wall Street gets money, and lots of it. Even when the issue is global warming Wall Street has its hand out. The fees on trading carbon permits could run into the hundreds of billions of dollars in coming decades. A simple carbon tax would have been far more efficient, but efficiency is not the most important value when it comes to making Wall Street richer.

This is why it was so encouraging to see congressman Peter DeFazio's proposal to tax trades in oil options and futures. DeFazio proposed a tax of 0.02% on trades in oil futures and options as a way to make up a shortfall in the federal government's highway trust fund. This tax could raise billions of dollars each year in revenue and make speculation in the oil market a more dangerous affair.

The logic is very simple. For someone using these markets to hedge, the tax will be inconsequential. For example, a farmer that hedges a $400,000 wheat crop will pay $80 when selling a future. Similarly, airlines that hedge by buying oil futures will barely notice the higher cost. In fact, because trading costs have fallen so much in recent decades, a tax at this level would just be raising costs back to their levels of two decades ago, a point at which there was already a very vibrant futures and options market.

However, even a modest tax will make life much more difficult for speculators. Many of them expect to make quick short-term gains, often buying and selling the same day. For these traders, an increase in transactions costs of 0.02% would be a burden.

Of course, a modest tax will not drive the speculators out of the market altogether, it is just likely to reduce the volume of speculation. For this reason, even a modest tax can still raise an enormous amount of money in a market where tens of trillions of dollars of derivatives changes hands each year.

This tax can best be thought of as a tax on gambling. Gambling is heavily taxed in every state that allows it. DeFazio's bill is effectively a tax on gambling in the oil markets. It will not stop it, but it would discourage it, and in the process raise a huge amount of money that could go to productive purposes.

The bill faces an enormous uphill struggle in Congress. As Durbin said, the banks own the place, and they are not going to just step aside and let Congress impose a tax on such a lucrative business. But, it is important that people know about the DeFazio bill. First, DeFazio deserves a place on the honour roll for standing up to Wall Street.

Also, it is important for the public to know that there is a relatively low-cost way to make up the shortfall in the highway trust fund. When Congress raises some other tax and/or cuts a useful programme, people should know that there was a better alternative. It just didn't happen because, as we know, the banks own the place.

The author obviously has no idea how commodity markets work. There are two participants; hedgers (those companies who produce and consume commodities and are trying to eliminate price risk) and speculators (those firms or individuals who are willing to take on price risk that the hedgers are trying to offload). Let's take an oil company that is producing 100,000 barrels of oil at a cost of $40/barrel. That oil company wants to lock in a profit of 10% so it goes out into the futures market and sells contracts equivalent to $4.4 million to speculators who in turn absorb the price risk. This locks in a $4 per barrel profit to the oil company with no potential loss on the $4 because it has hedged the risk away. It does however have an opportunity cost of potentially losing out on any appreciation in price. The speculator has taken on that potential.

Now the opportunity cost of the hedger typically has a real price in the market. Let's take a look at the gasoline market, and the prices of the delivery months.

The current price of gasoline is higher than the future delivery price, which is called backwardation. This does two things:
1. It provides an incentive for the hedger to produce in the near term instead of putting off production to a later date. This indicates that supplies are best used now than in the future.
2. It provides an incentive for a speculator to take on price risk, with the expectation that prices will tend to rise back towards the current price over time.

You can see that the discount on October gas is about 5% compared to August gas. This is the opportunity cost that the gasoline producer is willing to pay to the speculator in order to smooth out earnings. The futures markets are very liquid because speculators are rewarded for taking on price risk that producers are willing to get rid of. Speculators provide liquidity in the market to those hedgers that want stability in earnings. This is why good speculators are paid very highly.

Let's take look at Crude Oil.

Here, prices in the front month are lower than the future, called a Contango term structure. The incentives here are reversed.
1. The hedger has an incentive to keep supplies in house and sell in the future because the profit potential is greater. The hedger will then sell December or January contracts
2. The speculator has an incentive to buy front month oil, hold on to it, and sell it in the future when prices are higher.

Now that this background has been explained, let's go back to the proposed "Solution" provided by the author of the Guardian article; the .02% tax on speculators. What the author doesn't get is the two components of a market, hedger and speculator. By punishing one, the speculator, with a tax, there will be fewer that are willing to take on price risk. How does this affect the market?

The first thing that will happen is that speculators will simply withdraw from that market. If it only affects oil, then speculators will add the .02% transaction cost to their cost of doing business, analyze what the cost/benefit to transacting in the oil market is, and determine at what price and frequency it is beneficial to partake in speculation. That price will be reflected in the bid/ask spread or the difference between what the seller is willing to sell for and the buyer is willing to buy for. This transaction cost is basically a tax on the producer and eventually the consumer, because the wider spread is a cost of business that the oil company has to take on to hedge risk. The cost is simply passed on to the consumer.

But who benefits from the higher bid/ask spread? The speculator who has priced in the spread to his/her cost of business. Who are the speculators? Usually market makers at big investment banks, commodity trading advisors, and hedge funds. There will be fewer speculators, but those speculators that stay in will make more money per trade.

So the author's proposed solution is bunk. It is a tax on producers and consumers that ultimately benefits speculators. To understand how a market works, you have to know the participants and the incentive system. This author obviously has no clue that a market needs hedgers and speculators to function with low transaction costs and low volatility. So beware the journalist who has no idea what he is talking about, because he is probably doing you a disservice. In this case, he wants you to pay more for anything that requires energy to make. You should be livid at the idiocy of this man, Dean Baker and the congressman Peter DeFazio, for not using their brains.

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