The analysis of a #FATCA battle – US has no natural allies in this game of brute force

The above tweet references an interesting comment at the Isaac Brock Society. I reproduce it in full. It  reveals an aspect of FATCA games that has not been sufficiently considered.

@muzzlednomore – consider a simple example.

Bank of Montreal (Toronto) enters into a swap agreement with Bank of America (New York) under which BMO agrees to pay BofA interest on a fixed sum at a floating rate while BofA agrees to pay BMO at a fixed rate. This is a bog standard hedge transaction enabling one bank to hedge the risk of floating rates – banks do transactions like this in billion dollar increments every day in order to keep their risk profile exactly where the number crunching quants tell them it should be (leave for another day the role such instruments played in the crisis of 2008; these ARE fairly normal and standard transactions). Variants on the theme will involve different currencies – I’ll pay you fixed rate in C$ and you pay me floating rate in US$, etc. Now imagine that US Treasury declares BMO to be a recalcitrant financial institution and thus directs BofA to withhold 30% of all payments to BMO and send those payments to the US Treasury. Ask yourself – what payments do you think BMO is going to make to BofA on its end of the deal? I vote “nil”, or at least a 30% withholding to compensate. Thus, when the dust settles, the Bank that ended up paying the US Treasury is…you guessed it, B of A. My example is a little too simple since BMO has an office in New York, but I don’t believe that would stop its Toronto branch from retaliating against B of A for withholding if indeed it didn’t seize upon the excuse to terminate any transactions with B of A that it didn’t like because the market had turned against them. BMO as PAYER might find itself in BofA’s shoes were it to have a deal with Bank of Brazil out of its NY branch. That is a more exotic twist, I admit.

The point being that the US – and US law – does not control both sides of every transaction in the financial world and just because the Treasury tells an FI to withhold does not mean that the withholding is not a breach of the agreements of the FI’s in question with counterparts all over the world. When the US Banks are serially in default of thousands of agreements because they are trying to follow US law which does not necessarily govern both sides of their transactions, chaos breaks out and the US is not a winner in that scenario. Jatras has written about the prospect of the US Government defaulting on T-bonds – could happen, but I rather doubt it. If I were a Russian or Chinese bank with some of those bonds in my portfolio about to receive a payment, I’d just swap them out with my friendly neighborhood, FATCA exempt state-owned bank and avoid the trouble entirely at nominal cost. That much is child’s play, if a bit awkward and bothersome. Canada’s ties with the US are likely too complex for such a simple work around to impact more than the margins, however.

I’ll make it a little more interesting for you – a great number of these types of contracts have clauses in them according to which a payer is bound to pay MORE if there is an adverse change in tax law. In other words, many agreements require the obligor to indemnify the payee if there is a change in law that would alter the economics of their agreement. Therefore, were there to be a 30% withholding on payments out of America, Americans might in some cases be obliged to increase their payment to compensate. Again, Treasury 1, American business 0.

In my humble opinion, people have not thought this thing through far enough to realize that in many cases, the US has aimed the gun at its own head in an outrageously silly Blazing Saddles bluff moment. Faced with the Sheriff pointing his pistol at his own head, the rest of the world seems to be standing still saying “OK, don’t pull the trigger”.

I don’t want to minimize the fall out to the rest of the world – there would be plenty as well. I’m just pointing out that the victims will be on all sides and it would take a pretty detailed review of the economics of world trade to conclude exactly where the greater number would lie. I can guarantee you that US Treasury conducted no such review when FATCA was dropped into the HIRE Act in 2010 in the dead of night. I see no reason to assume that US financial casualties would be slight and that is before world governments get imaginative and create retaliatory measures to defend themselves by holding hostage US investments overseas in proportion to US attempted hostage-taking of foreign investment in the US (a great deal of which is in the financial services industry given the predominance of that industry in the US and the predominance of the US in that industry).

As well, while the shift away from the US dollar as reserve currency will not take place overnight, do not think that this episode is not putting the movement into high gear. The US inherited that role in 1945 because its undamaged economy was almost half of world GDP and no other economy could come close to fulfilling that role. In the 70 years which have followed, the US share of global GDP has steadily slipped (as it was bound to) while its currency has retained a broadly similar level of predominance in world trade. That can and will change and regress somewhat closer to the mean. Between Fed printing presses and inadvertent but stubborn Congressional bone-headed fiscal imperialism, the world is no longer seeing the US as a bastion of stability and rule of law upon which world commerce might be based. Its currency is debased routinely and its laws are increasingly erratic, chauvinistic and unreliable. These are slower processes to unfold, but the cost to the US of this misadventure will be large and will be paid over decades, long after FATCA is forgotten.

FATCA is like the Austrian ultimatum to Serbia. The world’s options are not limited to World War I or allowing Austria to all but annex Serbia and, the US has no natural allies in this game of brute force. I actually think Canada has a chance to play a very positive role in helping save the US from itself by gutting this beast cleanly. By protecting its own tax residents – if necessary by Court ruling – Canada will give the US an opportunity to recognize that their blind defence of CBT is doing much, much more harm than good. Their choices will be to abandon it (not likely, I’m afraid) or retreat to the world of ten years ago which was effectively “don’t ask; don’t tell”. They would collect CBT and make half-hearted attempts to enforce it only when they tripped over it. US Treasury has been gloating over their “agreements” with the rest of the world, implying they have “set the new global standard”. The new global standard – if there is going to be one world Big Brother out there (another topic) – will be based on RBT not CBT and Canada may help the US climb quietly on board if they want to (I doubt they do – the US is not exactly setting records in implementing reciprocity because they make a good living gathering in money from “fat cat tax evaders” in less stable countries).

Sorry for the essay – at least this one was passably on topic!


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