• An editorial in Mint.
• Tamal Bandyopadhyay in Mint.
• Gautam Chikermane in the Hindustan Times.
• Jayanth Varma in the Financial Express.
• K. P. Krishnan in the Economic Times.
• Monika Halan in Mint.
• Monika Halan in Mint
• Monika Halan in Mint

One feature of the ULIPs crisis which has not been widely appreciated is the role of the banks. While much opprobrium has been
directed at insurance companies and insurance agents (both individuals or specialised financial distribution companies), banks
are big players in selling insurance products. Their misconduct in selling represents a failure of RBI supervision. Most major banks are part of this scandal. The few customers who have protested have been sorted out, with a no-media clause in the resolution agreement that prevents the story from getting out.

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Looking at these matters in turn, the ordinance raises serious concerns about regulatory arbitrage. Today, ULIPs act as ‘endowment policies’ where the premium paid by the insured on a what is nominally a life insurance contract is invested in the stock market. Under these contracts, if the insured dies before the maturity of the policy, there is an insurance payout. After a fixed period or maturity, the investments in the stock market are liquidated and returned to the insured minus charges. Under these conditions, insurance companies cover the risk of premature death for only a short period of time (between entering into a contract and maturity). As such, the insurance component of these policies (the money which the insurance company must keep with itself to meet its contingent liability) is very low. The rest of the money can easily be invested and payouts depend upon the stock market.

Mutual funds are similar in all aspects to ULIPs except for the small component of insurance that an ULIP carries. However, mutual funds must comply with tough regulations imposed by SEBI and are severly limited in the forms of fees they can charge. Financial firms faced with the choice of registering as a mutual fund and complying with SEBIs regulatory framework or providing a small component of insurance in their product structures, registering as a ULIP, and charging open-ended fees, will rationally choose the latter.

Second, as many others have commented, the ordinance does not address misselling. (See recent articles by Monika Halan, Deepak Shenoy and Jayant Thakur). The ordinance does not include any provisions to deal with misselling. The ordinance also does not address IRDAs lack of enforcement capabilities vis a vis SEBI. The ordinance does active harm and removes provisions that previously protected investors. By amending the Securities Contract Regulation Act, insurance instruments are now not considered securities for the purposes of the Act. Section 27 A and B were one of the few statutes in the country addressing misselling. These two sections gave investors in collective investment schemes and mutual funds limited investment protection, namely rights to income under collective investment scheme. These small provisions will now not apply to insurance products, weakening investor protection for the time being.

Third, the provisions of the ordinance raise concerns about what matters the joint committee would actually consider. The dispute settlement mechanism in the ordinance specifies the securities which can be referred to the joint committee. We wonder: could the ULIP controversy have been the first matter submitted to the joint committee? In any case, since new types of securities are constantly being developed by financial firms, the joint committee would need frequent legislative interventions to be operable. For example, the joint committee in its current form, does not include the Forwards Markets Commission (FMC). If a product were to be launched which consisted of a hybrid of steel futures and steel companies futures (not an absurd proposition to the extent that steel prices play a significant role in the profits of the steel industry), the FMC would not be allowed to approach the joint committee as the Commission is not a recognised regulator under the ordinance.

To take up a different example, the joint committee is also limited in its jurisdiction to “hybrid” or “composite” instruments. Certainly many disputes could arise between regulators that do not involve an underlying hybrid or composite instrument. An instrument governed by one regulator that has a negative effect on the market regulated by another regulator, as with the regulatory arbitrage hypothesis suggested above, could not be referred to the joint committee. Neither could issues which bring instability to multiple markets, unless, of course the underlying instrument is hybrid or composite.

Fourth, the structure of the joint committee points to problems of institutional design. The ordinance is largely silent about the procedures the joint committee would follow. This is not simply a technical matter. How would differences of opinion in the board be settled? By majority vote? Consensus? Would there be staffing? Who would be responsible for expenses? No doubt, to a significant extent disputes would be settled by reference to soft norms and existing hierarchies in government. The culture of deference by IAS officers to other IAS officers of a senior class provides one example. The unlikely possibility of agency regulators going against the deeply held preferences of a strong finance minister provide another. Yet these are not simply mundane questions and impact, materially, how extensively the committee could study and resolve matters before it.

Fifth, the process by which the ordinance was passed is worrisome. As suggested by the Economic Times, regulators were not consulted on a ordinance that amends 4 major acts of parliament. What does this say for consultativeness and democratic process? What does this say for the legitimacy of the proposed solution? Is the failure to consult and rush to promulgate this solution reflected in the drafting and policy flaws of the instrument suggested above?

Sixth, the ULIP dispute has been presented as a contest between SEBI and IRDA. Implicitly, one regulator had to win, and the other, lose. This is misleading. One scenario would have each regulator govern the portion of ULIPs which fall within their domain. IRDA would govern the insurance component of these instruments and SEBI would govern the investment component. Some might suggest that this would lead to too much complexity. Yet, we are more used to dealing with complexity than we realize. A person driving a vehicle who causes damage to property could be liable for damages under rules of the Motor Vehicle Act, tort law and possibly the Indian Penal Code. That the net zone of freedom of action in driving a car would be limited to the conjunction of the areas prescribed by these laws seems hardly remarkable. The government would never declare that all motor vehicle drivers are immune from civil or criminal laws. The more complex the transaction, the more regulation might apply. Financial firms are as well-equipped as any actor in society to handle this complexity.

Another scenario would involve crafting a mechanism for joint regulation of ULIPs. As Monika Halan suggests, this proposal has precedent in the arrangements between the banking and capital markets regulators and could lead to the harmonisation of regulation to the benefit of investors and the marketplace.

Yet another scenario would involve actively fostering or allowing some measure of regulatory competition. The heightened regulation of ULIPs as a result of this controversy is itself a salutary case in point. We do not suggest that the government allow this issue to fester but feel confident that serious scholars and practitioners of administrative law and institutional design could develop interesting ways of promoting regulatory competition given time and a mandate.

Hurried solutions lead to poor law with implications that will be felt by investors and markets down the line. Ordinances are intended for use when Parliament is out of session and the President perceives a need for immediate legislation. Ordinances may be amended. The conflict between SEBI and IRDA is also only one small piece of a larger problem of financial sector legislation that is fragmented, at times duplicative and at times inadequate. We can only hope that Parliament revisits this matter in a more thorough fashion, either independently or through the efforts of the proposed Financial Sector Legislative Reforms Commission proposed in the Finance Ministers budget speech of 2010-11.

END THE FED

Murray Rothbard argues in The Case Against The Fed that because depositors are entitled to demand their deposits at any time and because by its nature fractional reserve banking cannot sustain all depositors demanding their deposits at the same time therefore fractional reserve banking is fraud.

Because of the inherently fraudulent nature of fractional reserve banking bank runs were a common occurrence before the FDIC and Federal Reserve system.  However, because of the cartel nature of the FDIC and Federal Reserve system individual bank failures are no longer to be feared by depositors because of the implicit guarantees.

These implicit guarantees have been turned into actual guarantees with the $100k limit being increased to $250k, which returns to $100k on 1 January 2010, the FDIC’s reserve fund being depleted and the Treasury extending a $500B line of credit to help placate owner’s of $13T+ of FDIC insured funds.

This has introduced tremendous moral hazard.  Moral hazard is the economic principle that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk.  As a result, people do more due diligence on the movies they watch than the banks they deposit their currency in.

For example, with FDIC insurance the moral hazard occurs often without conscious or malicious action.  Depositors have been trained to seek out the highest yields without regard to the underlying stability of the bank because when there is a bank failure the losses are socialized through increased FDIC insurance premiums, inflated away by the Federal Reserve through increasing the currency supply or a myriad of other fraudulent, deceitful, immoral or often illegal means.  The lynchpin of the current banking system, which is inherently unstable and will fail, is the Federal Reserve.

Consequently, the Federal Reserve is built on a fraud and the attendant effect on the rest of the economy is to distort normal market operations through both the supply and cost of currency.  This is illegally and unconstitutionally perpetuated through legal tender laws which violate the Constitution in regards to the monetary provisions in Article 1 Sections 8 and 10, the 10th Amendment and confounded the definition of a dollar and serve to centralize power.

But this immoral system, conceived in iniquity under cloak and dagger as explained by G. Edward Griffin in The Creature From Jekyll Island, has been perpetuated for nearly 100 years and despite humanity doing just fine for thousands of years many cannot conceive of an economy should the Federal Reserve be razed.  Nevertheless, because the system is built on fraud and because sunshine is the best disinfectant therefore the Federal Reserve has strongly challenged any type of public audit, accountability or oversight despite it being in the best interest of American citizens.

AUDIT THE FED

As the wretched vampire squid is dragged into the sunlight and revealed for the parasite it is then increased political pressure will be brought to bear on the immoral institution.  Ron Paul’s bill, which received a full committee hearing, is the first major step in this direction in a long time.

During the hearing testimony was heard from both Austrian economist Tom Woods, author of Meltdown, and Scott Alvarez the general counsel for the Federal Reserve.  As the general public becomes aware of the tremendous damage this institution and those on Wall Street have done hopefully they will adopt the spirit of the Founding Fathers.

Mr. Alvarez, or should we say Chicken Little, decides to terrorize those who advocate in favor of H.R. 1207.  He testified:

These concerns likely would increase inflation fears and market interest rates and, ultimately, damage economic stability and job creation. … Higher long-term interest rates would further increase the burden of the national debt on current and future generations.  Adoption of H.R. 1207 also could disrupt the nation’s relationships with foreign central banks and governments, relationships which are helpful in supporting the Federal Reserve’s efforts to fulfill its statutory missions, and erect barriers to official cooperation among central banks and governments.  Foreign central banks and governments likely would be less willing to engage in financial transactions with the Federal Reserve if these transactions were subject to policy review by the GAO as H.R. 1207 would allow.  These transactions, such as the deposit of international reserves and bilateral currency swap arrangements, help support the role of the dollar as the worldwide reserve currency

For example, first comes the audit of the Federal Reserve system.  Next comes the legislation to end it.  Then comes a reenactment of legislation like the Coinage Act of 1792 to prevent future similar behavior which reads:

SECTION 19. And be it further enacted, That if any of the gold or silver coins which shall be struck or coined at the said mint shall be debased or made worse as to the proportion of fine gold or fine silver therein contained, or shall be of less weight or value than the same ought to be pursuant to the directions of this act, through the default or with the connivance of any of the officers or persons who shall be employed at the said mint, for the purpose of profit or gain, or otherwise with a fraudulent intent, * * * every such officer or person who shall be guilty of any * * * of the said offenses, shall be deemed guilty of felony, and shall suffer death.

APPORTIONMENT

Bicameralism is the practice of having two legislative or parliamentary chambers.  The United States Congress is modeled after the British system which was composed of the House of Lords and the House of Commons.  The United States Senate is composed of 2 Senators from each state while the House of Representatives is under Article I Section 2 to be “chosen every second Year by the People of the several States”.  Under the doctrine of apportionment the House is to grow as the population grows and it did for the first 130 years of the Republic except in 1840.  But the Reapportionment Act of 1929 limited the size of the House to 435.

Currently, Congress Critters have a constituency of about 700,000 instead of about 50,000 like they did before the Reapportionment Act.  This has served to consolidate power and make the Congress Critters less responsive to The People.  The 17th Amendment was ratified in 1913, the same year the Federal Reserve Act was passed, and provided for the direct election of Senators.  The eviseration of these two checks and balances in the American political machenirey has made it easier for special interests and lobbyists to influence elected officials.

With the House often gridlocked with 435 members imagine the chaos of getting everyone aligned if there were over 1,300?  Ironically, increasing the number of Congress Critters through proper apportionment would likely have the effect of greatly decreasing the size of government because special interests would have much less influence and control with politicians likely much more accountable to their constituency.  Therefore, I find this order by Judge Jones for a hearing on the apportionment issue to be extremely interesting and a positive development regarding the decentralization of power.

CONCLUSION

The auditing of the Federal Reserve system would be very beneficial for the powers of truth and justice.  The Federal Reserve system should be viewed as counterfeiters because they enjoy a legalized counterfeiting franchise and are able to engage in creating new fiat currency with legal tender status and doing so amounts to confiscation through inflation which is a form of taxation without representation or due process of law.  Unmasking these costumed terrorist counterfeiters will bring to light and the conscience of The People the degree to which they are being stolen from.

Likewise apportionment could result in Congress Critters being more responsive to their constituency who could demand the repeal of the Federal Reserve Act and the implementation of legislation like Section 19 of the Coinage Act of 1792.  Humanity has survived and thrived for thousands of years without a Federal Reserve.  Consequently, auditing and abolishing the Federal Reserve will be a great development for humanity and reduction in the centralization of power.

Disclosure:  Long physical gold, silver and platinum and no position the problematic GLD or SLV ETFs.

All financial crises are either directly or indirectly caused by the Federal Reserve’s anti-market monetary manipulations. But the government can never blame itself or its central bank—it has to find scapegoats. And who better to blame than people and institutions who deal in private and voluntary financial exchanges outside of the government’s domineering and prosperity-killing regulatory scope?

It was the “speculators” who caused AIG to fail—or at least that’s the official government story. More specifically, it was the roguish brigands who deal in the unregulated market for credit-default swaps (CDS).

The Coming Political Shakedown

Credit-default what? The official story is all the more plausible since 99% of Americans (to be generous) have absolutely no idea what a credit-default swap is. And why would they? Most of them went to government-funded schools that teach statist myths about the cause of the Great Depression and the need for strong anti-trust regulation to thwart potential “robber barons.” The real robber barons, of course, have always been the men behind the curtain writing the very regulations allegedly intended to rein them in!

With this in mind, one has to wonder what financial interests are backing Senator Tom Harkin, the Iowa Democrat who has threatened that his party might not just increase regulation of CDSs but prohibit the market altogether. On October 14, Harkin—who is chairman of the Senate Agriculture Committee, which has authority over derivatives regulation—said that CDSs “increase the risk, the systemic risk, of the whole society.” Global warming, Islamic terrorism, and CDSs: mankind’s greatest threats.

CDSs: Among the Last Vestiges of the Free Market

What anti-capitalist congressmen hate most about credit-default swaps is that they’re completely unregulated. In the wake of the Great Depression, FDR’s New Deal added a backbreaking amount of new market regulations that have served to do nothing but provide investors with a false sense of security and, in some cases, discriminate against the non-affluent by making certain asset classes off limits for them.

Even if you believe we need an SEC and “Blue Skies” regulations to “protect the public,” a similar argument cannot be made for CDSs, which are private transactions between large financial institutions. The public only assumes liability for CDSs when the government steps in to bail out firms that made bad financial decisions. No bailout; no liability.

AIG made some bad bets in the CDS market. As a result, their stockholders were decimated and some of their CDS trading partners were left in the lurch too. That’s the way things work in a capitalist economy: every transaction carries its own risk. And financial markets cannot function when the government steps in to remove the element of risk—or more accurately, to socialize it.

How do Credit-Default Swaps Work?

A credit-default swap is a pseudo-insurance agreement made between two counterbalancing traders. The reason CDSs are considered “pseudo-insurance” instead of actual insurance—something AIG might have actually known something about—is in effort to avoid the onerous regulations the government puts on official insurance products. Regardless, anything that two consenting adults do behind closed doors is their business, and the same philosophy should apply to financial institutions.

An example of a typical CDS agreement would involve one firm (Company A) with a lot of money invested in the bonds of a third party (say, GM). Company B would offer to sell Company A insurance protection against GM’s default. Perhaps Company A would agree to pay $265,000 a year to insure its $10 million in GM bonds. The terms of the agreement would spell the circumstances under which Company B would have to pay Company A and how much, but typically, payment is triggered by formal bankruptcy or failure to pay bond interest. In such a case, Company B would buy the bonds from Company A at a premium or pay Company A the difference between the bonds’ current market value and their par value.

That’s not so confusing, is it?

How CDSs Make the Financial Markets Safer

What is so sinister about such an arrangement? Nothing. Credit-default swaps let companies shift risk and efficiently allocate capital. What’s more, they work to keep the credit markets honest and to expose fraud or negligence on the part of bond rating firms like Moody’s.

For example, if a company’s credit-default swaps are trading at a high yield, and yet the firm is still rated as being credit-worthy by Moody’s, there may be a problem. Typically, the market can better assess a company’s financial health than credit-rating firms. Banning the CDS market, as some Democrats would like to do, would be a lot like the recent short-sale ban—it would merely shield unsound companies from having the reality of their situation exposed to the average investor.

Credit-default swaps emerged from the free market to meet a demand. Banning them would, like all financial regulations, only punish the honest and responsible participants in the market. Let the fraudsters go bankrupt and let the responsible parties pick up the pieces. This is the system of capitalism that served us so well for so many years—now is no time to turn our backs on that which made us great.