I ask this question, becasue a wikileaks cable from the US Consulate in Toronto, in 2005, tells a story about how the Canadian withholding tax was preventing derivatives from coming to the Canadian banking market.
There is a lot of jargon involved, but it's really not that complicated. Start by asking simple, basic questions.
What brought down the US banks in 2008?
Derivatives, especially 'credit derivatives' like subprime mortgages and CDOs. And especially the Synthetic CDO, a bundle of derivatives based on other derivatives, which many people have described as flat out gambling (like Lawrence McDonald).
But why did the US banks have all these investments if they were so awful?
Because various bank executives made huge bonuses and imaginary short-term profits by selling these products to investors, to other banks, or to other departments in their own banks.
So why didn't the Canadian banks hold a lot of this stuff, when the US banks did?
This is where the Wikileaks cable is helpful.
Canada, basically, had taxes that were too high for these sorts of products to be profitable for bankers and investors and other parties, and so these sorts of products were not widely held by Canadian banks.
What do you mean?
Start with a mortgage on a house. You pay off the mortgage -- whoever owns it makes a profit, because your house cost $200,000 but you are gonna pay them back $200,000 plus interest. The interest is the profit.
This profit gets taxed. In the US it is taxed low, but if you were an American and got 'interest income' from a Canadian mortgage, the tax was much higher.
Ok so what does that have to do with derivatives that destroyed the US banks?
Well, the derivatives were made of products like mortgages. And the investors and bundlers and sellers, looking for profits from these products, wanted to do business where the taxes were lowest, because thats where the profits would be highest.
So that kept these CDOs and subprime mortgages out of Canada? The high taxes?
Essentially, yes, this is exactly the argument that the bankers made to the government in the wikileaks cable.
Look at the cable text:
(SBU) In late September, two CEOs and one senior
representative of Bank of America (Canada), Citibank
(Canada), and JP Morgan Chase (Canada) approached the
Consul General privately to complain bitterly about the
Canada-U.S. withholding tax on income paid to non-
residents. At issue is paragraph 212 (1) (b) of the
Canadian Income Tax Act (ITA), which deals with
withholding tax on interest paid to non-residents. The
U.S. bankers said current bilateral withholding taxes
on cross-border interest payments have a very
detrimental effect on liquidity and, therefore, a
correspondingly negative impact on the possibility of
establishing a strong Canadian secondary loan market.
They argued that they would be strong players in the
Canadian secondary loan market, if it were permitted to
become as dynamic as it is in the U.S. In practice,
the Canadian ITA keeps U.S. investors all but out of
the secondary loan market, hitting U.S. banking
interests, robbing the Canadian market of liquidity,
and adversely affecting the strength and depth of North
American integration in financial services.
. . .
(U) The withholding tax impedes the development of
a dynamic secondary loan market in Canada by
effectively shutting U.S. investors out. For example,
one of the deepest and most liquid markets in the U.S.
is the Public and Conduit Asset Backed Securitization
market. In 2002 this market represented approximately
US$730 billion of liquidity in the U.S. By contrast,
the Canadian Securitization market was some US$60
billion in 2002. According to the FBEC members of the
CBA, the withholding tax is one of the main reasons why
U.S. liquidity does not flow to Canada.
¶7. (U) Credit cards, auto loans, leases, and mortgage-
backed securities are some of the most actively
financed interest-bearing assets in this market.
Currently, a Canadian financial institution desiring to
boost its liquidity by selling a bundle of similarly
priced and timed interest bearing assets in this market
will find that U.S. banks, with deep pockets of
liquidity, are not interested in buying because the
interest earnings on Canadian assets will be too low to
make the deal fly once the withholding tax on those
interest earnings is factored in
. . .
But that's just a bunch of jargon. I can't understand it!
Sure you can. Break it down piece by piece. You know what a subprime mortgage is. Work backwards. Canadian banks wanted to sell alot more subprime mortgages, and even the products built on them like RMBs and CDOs, but they couldn't find US investors. Why not? Taxes were too high. US investors didn't want to buy. So what?
So, Canadian banks didn't do things like buy entire subprime-mortgage companies (Countrywide) or entire housing editions (Lehman Brother's McAllister Ranch), hoping they could 'flip' them to investors. If you saw 'Wall Street 2:Money Never Sleeps", think about Susan Sarandon's character , an ex-nurse buying and selling houses for a living. Imagine who her bankers were, and then imagine there was no Shia Lebouf to bail her out when the market tanked.
Canadian banks were unable to partake of this particular form of financial 'innovation', because if they tried to slice and dice and resell mortages, the cross-border taxes would have been too high, so there'd be no buyers. No buyers for this trash, means no reason to create the trash in the first place, and no executives inside the bank trying to game the bonus system by holding onto the 'good bits' of the trash.
When the cable says this 'secondary market' provided 'US$730 billion of liquidity' to the US banks, what its really saying is that US financial markets were loaded with 730 billion dollars of garbage, while the Canadian financial markets only were loaded with 60 billion dollars worth of garbage.
Why does it matter how many garbage they were 'loaded' with
Because in 2008, people began to realize that the garbage existed and was truly garbage. Beforehand, the bank told everyone it owned 100 billion dollars of good quality 'asset backed securities'. People began to find out the 'good quality' bank assets were really garbage with a real value of 1/100th what was claimed. This caused a run on the bank. Everyone would pull their money out at once. The bank would collapse. That's a very short, condensed version of what happened to Bear Stearns and Lehman Brothers.
So the Canadian banks had some of this stuff too...
Right. But not as much. They were able to swallow the losses. A US bank like Lehman Brothers, though, was almost entirely built of garbage, so there was no way it could swallow it's losses.
But couldn't the Canadian banks just sell to Canadian investors? There's no 'border tax' if they do that
Yes. But the vast majority of 'investor money' at the time was in other countries. Especially the United States and it's mass of innovative financial markets, hedge funds, funds of funds, pension funds, retirement funds, etc etc etc, all of whom gobbled up these subprime 'investments'. Canada is kind of a small population country as countries go.
So that little paragraph 212 (1) (b) of the Canadian Income Tax Act basically saved their banks?
Well, that's what it looks like to me. Then again, I'm not an expert.
So... is that Canadian interest income withholding tax still in effect?
No. Actually they repealed that tax in 2008, but by then the US banks were already doomed - they had gorged themselves on the junk, and the Canadian banks, if the crisis had happened in say 2010, might have gorged on it too.
Aren't you leaving out huge parts of the story? Aren't some of your basic facts wrong, and your descriptions of financial relationships completely bogus?
I am not a super-experienced financial whiz. But I think the basic gist of my story is pretty spot on. I'm not making up the cable - the cable says quite clearly that the Tax prevented toxic assets, aka credit derivatives, aka "the secondary market", from becoming big in Canada. And many sources have pointed out that Canadian banks survived the crisis better than American banks.
As for the nooks and crannies of the story? Of course there is more to it! The motives for the Canadian government officials are probably myriad and diverse. The names of the CEOs and executives who lobbied for this are easily obtainable with a bit of research. I bet those backstories are fascinating. For example. Take Jessica LeCroy.
Jessica LeCroy is the alleged author of the cable. Her wikipedia article is full of dazzling accomplishments. But here is what she wrote in the cable:
Comment: Time to Ax this Tax
Thus, LeCroy, with several diplomas from the world's best schools, vast experience in financial companies and the government, wanted to 'Ax the Tax' that seems to have actually saved the Canadian banks, to some extent, from the certain doom of the CDO market, credit derivatives, subprime mortgages, etc. It seems like maybe, possibly, hers was a voice at one with the executives of the very same banks that would, 3 years after her cable, go belly up, bailed out by taxpayers in 2008. How did this happen? Why, in her cable, did she not present critical viewpoints? Why did she not analyze and dissect and ponder and examine? Maybe that was not her job?
By the way. She also helped Paul Bremer in his running the Coalition Provisional Authority right after the US Invasion of Baghdad in 2003. By most accounts, Mr Bremer left much room for improvement in his activities as a leader. PBS Frontline, and many others, have chronicled this story, which ends with Baghdad being covered in flaming pools of shit, truck bombs, and anarchy.
So, there are lots of things to dig out around this story. But I am not a professional journalist, I am a peon with no life, blogging in my underwear.
EConned, Yves Smith, 2010, published by Palgrave Macmillan
US govt cable: 10/12/2005 15:46","05TORONTO2634","Consulate Toronto", 2005, by LECROY, from wikileaks.
English Wikipedia: Jessica LeCroy, alot of which was originally copied from the US Consolate in Toronto.
Welcoming Jessica LeCroy, Eesti.ca , 2005