I have written extensively about how I believe the bank bailouts were the worst of all possible solutions – fixes that perpetuate too big to fail, moral hazard and crony capitalism.  That ship has sailed, but the questions still linger – in large part because the fix has not trickled down to common folk to better their lot.  Rising unemployment is but one demonstration of this.

Arnold Kling writes a post that goes beyond banking to AIG, mortgages and Fannie and Freddie. He offers real world solutions that don’t require creating special resolution authority, buying toxic assets or orchestrating bailouts.  While there would certainly be costs to these solutions as well, they would be far less than what we are paying now.

The interesting bit is he proposed them in the moment when the bailouts were ongoing. Don’t let anyone tell you that there weren’t other options available because there were in spades.

1. Existing Mortgages and home owners.

Actual policy: attempts to implement loan modification programs

My policy: pay the moving expenses of homeowners who default on their mortgages. But do not interfere with the foreclosure process.

2. Mortgage Markets

Actual policy: keep Freddie Mac and Fannie Mae going, and we now have 90 percent of mortgage loans made by federal agencies.

My policy: Limit Freddie Mac and Fannie Mae to their existing book of mortgage loans (I wrote this in September of 2008) and not allow them to purchase any new mortgages. Let banks take up the slack in mortgage lending.

3. AIG

Actual policy: creditors bailed out 100 percent.

My policy: Send in a "stern sheriff" to protect the liquid assets of AIG from creditors making "collateral calls." I was thinking of a government-suggested mediator, perhaps a former bankruptcy judge. If the parties did not like it, they could go to court. But my guess is that the parties would have preferred a mediated solution.

4. Big banks

Actual policy: bailouts of nearly all of them

My policy: Triage. Shut down the ones that have clearly failed, using FDIC procedures. Those that are clearly solvent should be allowed to proceed. Those that are neither clearly failed nor clearly solvent should be given forbearance, but with tight supervision to ensure that they do not use this forbearance to expand their risk-taking. Again, this was what I advocated in September of 2008.

Why proposals of this sort were not followed is the subject of much debate.

Source

Was TARP Necessary? – Arnold Kling

Related posts:

• Fannie, Freddie to get $15 Billion from U.S. government
• Federal takeover of GSEs now in the works
• A quick note on corporate bankruptcy and bailouts
• Treasury to Consider Further Measures to Halt Housing Slide
• Dean Baker: I saw this scenario in 2002

Video embedded below.

See also Democratic Rep. DeFazio Calls for Geithner and Summers to Be Fired – Yves Smith

Related posts:

• Geithner testifies before Congress on financial reform
• Weekend Video: A Conversation with Tim Geithner at CFR
• Geithner is open to suggestions
• Did Tim Geithner blow it?
• How did economists get it so wrong (parody version)?

The Jamie Dimon piece in today’s Washington Post is a must-read. Dimon, head of behemoth JPMorgan Chase makes the best case for not breaking up large too-big-to-fail financial institutions. His idea: set up a robust resolution process and let reckless lenders fail regardless of size.

Now, back in September, I attended a meeting at the Clinton Global Initiative where both Americans Sheila Bair and Jamie Dimon and British bank executive Peter Sands gave their ideas on the too big to fail idea. They all agreed that too big to fail must end. But, while Bair was arguing for shifting the balance of power toward smaller, community banks, Dimon was arguing, as he does in the Post, to keep large organizations intact.

Reviewing the exchanges, I wrote:

What I found interesting was the general agreement between Dimon, Sands and Bair that regulatory reform to date has been a bust…  the conversation made clear that Bair, Dimon and Sands all felt that the first and most important bit of financial reform must be to set up a resolution process in order to deal with too-big-to-fail institutions. Let me characterize Dimon and Bair’s remarks below.

Jamie Dimon. It is clear that Dimon believes JPMorgan Chase was never in any real jeopardy during the financial crisis. He spoke on several occasions about the lack of a resolution crisis to deal with large firms without mentioning any names, but clearly intimating that other beleaguered institutions like Citi and BofA were saved by this. He said that the financial crisis should not be used as an excuse to break up large institutions (like his) because the crisis was the result of bad lending as in any other crisis. He said, smaller imprudent lenders are being liquidated systematically by the FDIC. The only reason larger companies did not face liquidation is because no resolution mechanism was or still is in place to deal with them…

He said the present reform proposals are not heading in the right direction and used an analogy saying, “If we had a problem with our legal department, I would tell the guys to fix the legal department. If the government had the same problem, it would create a second new legal department.”  Over-regulation is not the answer. Smart regulation is.

Sheila Bair. Bair was in stunning agreement with Dimon on the core issues. She too said the first priority of any financial regulation must be to put a resolution mechanism in place to deal with too-big-to-fail institutions. She rejected the concept of the Federal Reserve as the main financial regulator, something even Ben Bernanke is now rejecting. But, she disagreed with Dimon. Instead she felt that the financial system had veered excessively into derivatives and other complicated financial products and that this was a major contributor to the financial collapse. She advocated regulating these and increasing the focus on traditional banking products typical in community banking. It was clear from these remarks that she favors community banks over too-big-to-fail institutions.

Both points of view make sense. Dimon is obviously advocating from the position of an interested party. Nevertheless, he does make good arguments. Note that he says management should be fired. Shareholders should be wiped out. Unsecured creditors should, if necessary, be wiped out too. This is a big deal.

Here are excerpts of what he had to say (bolding added).  The link to the full article is at the bottom.

Our company, J.P. Morgan Chase, employs more than 220,000 people, serves well over 100 million customers, lends hundreds of millions of dollars each day and has operations in nearly 100 countries. And if some unforeseen circumstance should put this firm at risk of collapse, I believe we should be allowed to fail…

But ending the era of "too big to fail" does not mean that we must somehow cap the size of financial-services firms. Scale can create value for shareholders; for consumers, who are beneficiaries of better products, delivered more quickly and at less cost; for the businesses that are our customers; and for the economy as a whole. Artificially limiting the size of an institution, regardless of the business implications, does not make sense…

Creating the structures to allow for the orderly failure of a large financial institution starts with giving regulators the authority to facilitate failures when they occur. Under such a system, a failed bank’s shareholders should lose their value; unsecured creditors should be at risk and, if necessary, wiped out. A regulator should be able to terminate management and boards and liquidate assets… We can learn here from how the Federal Deposit Insurance Corp. closes banks…

…It also requires effective international cooperation, as the implications of a major financial institution’s failure are global. This is challenging but worth doing…

As we have seen clearly over the last several years, financial institutions, including those not considered "too big," can pose serious risks for our markets because of their interconnectivity. A cap on the size of an institution will not prevent that risk. Properly structured resolution authority, however, can help halt the spread of one company’s failure to another and to the broader economy…

To understand the harm of artificially capping the size of financial institutions, consider that some of America’s largest companies, which employ millions of Americans, operate around the world. These global enterprises need financial-services partners in China, India, Brazil, South Africa and Russia…

…a fragmented banking system cannot always provide the level of service, breadth of products and speed of execution that clients often need. Capping the size of American banks won’t eliminate the needs of big businesses; it will force them to turn to foreign banks that won’t face the same restrictions.

Source

No more ‘too big to fail’ – Jamie Dimon, Washington Post

Disclosure: I have no financial interest in any financial services companies. Further, I have said previously that I do not favor re-imposing Glass-Steagall as a magic bullet solution given that most financial carnage over the past twenty-five years has originated in the regulated commercial bank sector. Like Dimon and Bair, I see a robust regulatory regime as critical. On the other hand, I am generally in favor of reducing bank size, unlike Dimon.

Related posts:

• The failure to address the looming too-big-to-fail issue
• Jamie Dimon on the economy
• Jamie Dimon: ‘we don’t need’ your money
• Quote of the day: “Jamie is always hanging around the hoop”
• Jamie Dimon: “If You Are Not Fearful, You Are Crazy”

A friend sent me the following presentation earlier in the week when I was feeling a bit ill. So I neglected to post it.  But, I want to return to it because it is in keeping with my recovery/depression theme. These are the issues that were complicit in the latest financial crisis and almost none of them have disappeared.  They will most certainly rear their heads again precipitating or worsening the next downturn.

We’re talking about:

1. Duration mismatches (borrowing short and lending long)
2. Accounting (Mark-to-market, deferred tax assets and a lot more)
3. Conflicts of interest (no Chinese walls, ratings agencies)
4. Regulation (especially given poor risk controls)
5. Risk management (is Meriwether a leading indicator?)
6. Investment Banking vs. Utility Banking
7. Too big to fail (they must be downsized)
8. Heads I win, tails you lose (socialization of losses is crony capitalism)
9. Quantitative easing (QE has costs)
10. Hedges instead of capital

My baseline thinking at the moment is that we are seeing the beginnings of a cyclical recovery built on the back of asset relation more than anything else. The underpinnings of this uptrend are tenuous. So, when this latest burst of reflation hits the wall, all of the aforementioned issues will re-appear and policy makers will again do the who-could-have-known routine we saw in 2001 and again in 2008/ But the broader public is increasingly wise to this song and dance. Hat tip Scott.

Jim Chanos Presentation at Darden, 22 Oct 2009

Related posts:

• Chinese officials warn banks about reckless lending
• European banks: still undercapitalised
• The U.S. financial system is effectively insolvent
• Lessons from Japan’s Bank Crisis
• Bank of Canada blames Geithner for financial mess

For those of us interested in seeing more robust and knowledgeable regulators in government service, the recent news that Rick Bookstaber is joining the SEC is quite welcome. While I disagree vigorously with much of recent economic policy, I view the Bookstaber news as a signal that the Obama Administration is serious about overhauling America’s regulatory infrastructure.

Bookstaber is a market veteran who has a long and storied history of achievement. He worked at Bridgewater Associates, ran the Quantitative Equity Fund at FrontPoint Partners and was in charge of risk management at Moore Capital Management amongst other things.

Here is how Rick put it at his website:

I will be working in the SEC’s new division of Risk, Strategy and Financial Innovation as Senior Policy Adviser to the Director. Here is a brief article and the SEC announcement. We are facing a critical time for defining the future of the financial system; an opportunity for financial reform that comes only once in a generation (if that), and I am excited to be part of this.

I will still be able to write posts from time to time, but obviously with limits on topics and with appropriate disclaimers. How much free time I have to do so, though, remains to be seen.

I won’t be able to publish comments for this post related to the SEC.

Congratulations to Rick. Let’s wish him success is in this important role.

Related posts:

• Guest post: Regulation in Defense of Capitalism
• Guest post: Why do bankers make so much money?
• Bhagwati: The U.S. is underestimating inflation risk
• Ken Lewis is out as Chairman of Bank of America
• Tonight’s US Presidential debate

I was reading Kid Dynamite’s account of the recent Treasury – Finance Blogger meeting after having read a bunch of others (see them all in Abnormal Returns’ Nov 4th links). And I was struck by his characterization of the thinking at Treasury in regards to the financial crisis. I want to highlight two points and ask the question: didn’t the Treasury plan work as designed?

I will try not to editorialize and let you draw your own conclusions based on my (hopefully neutral) narrative of their goals.

Here is point #1 I want to highlight:

The first point that caught my ear was the description of the stress tests as having been designed to restore a level of confidence in the banking system.   The STO mentioned that the focus was now on reducing the footprint of economic intervention cautiously, quickly and prudently…

a number of STO’s present in the room, who quickly banded together to clarify that no one knew the results of the stress tests before they happened, and that they were designed to restore confidence by identifying the levels of capital needed by the banks, and requiring them to raise such capital.  I said that if they wanted to restore confidence, they should require banks to mark assets to market, and depict the true financial situation.

As I read it, Treasury wanted to show that it had a credible plan to identify any capital shortfalls amongst our biggest banks and to take corrective action.  Their belief is this would restore confidence.

Here is point #2 to highlight – why the need for secrecy:

I [Kid Dynamite] mentioned that the problem was that even if we had a "Counterparty Risk Czar" who somehow managed to magically quantify the exposures of each firm (which may be quite a difficult task in itself), we’d see the same problems we saw when the government went to give out the TARP funds. The government didn’t want to "bail out" select firms (ie, BAC and CITI) because they feared that the stigma attached to such assistance would create panic and runs on the bank – so they asked a large pool of financial institutions to take the money to hide the truly sick cows.

I read this to say that Treasury feared identifying ‘loser’ institutions would have a negative impact and cause bank runs (think Washington Mutual). therefore, they had to hide the ball, so to speak.  The same philosophy is behind the Fed’s refusal to release more information to Bloomberg on the Fed’s emergency lending counterparties.

The overall gist of the strategy was that Treasury wanted to identify the weak, give them time to grow stronger, and, in so doing, allow the panic phase to subside so that corrective action could be taken in a more normal economic environment.

Wasn’t the plan wildly successful? Blogger Accrued Interest thinks so.

Now, before you give a knee-jerk response, please read the following from a post I wrote in April called “Channeling my inner Larry Summers,” which was my attempt to read the intentions of Obama and his economic team (in the voice of Larry Summers). I think it dovetails nicely with what Kid Dynamite says were the actual goals of Treasury.

the question is how do we deal with this crisis.  The first priority must be  to forestall a deflationary spiral because that induces a dead-weight loss and extracts a cost of incalculable consequences.  The best way for government to end the spiral is to temporarily increase spending or temporarily induce more private sector spending.  Is this re-flating the bubble?  No, because deflationary forces will continue to extract a price even with these measures in place.  The key is to avoid a negative feedback loop, a spiral downward, and the easiest way for government to do this is to increase spending.

But, spending alone won’t get it done.  Ultimately, we will need to increase credit availability.  Just because people are spending more, does not mean the economy will grow.  Growth depends critically on increasing credit in line with the growth of the economy.

I am not one for nationalization of banks or other coercive, non-market based mechanisms of getting lending flowing.  The concept that nationalizing banks and re-privatizing them should be a first port of call for a government imperiled by a weak banking system is contrary to the need for limited government.  What we need to do is put a number of government-assisted programs into play — cognizant of that healthy tension between limited government and necessary government — and get credit flowing this way.

Let me enumerate some mechanisms:

• First we should try bank re-capitalization.  Our first priority must be to have an adequately-capitalized banking system. Absent that, increases in lending are impossible and the system will continue to be doubted. So that’s number one. We can do this through preferred equity so that the government is senior to common equity and receives some compensation for taxpayer money.  What’s more is it limits government interference. Remember – most of these institutions are having temporary problems.  With enough capital, they can weather the storm.  There is no need for heavy-handed government interference.
• If re-capitalization proves inadequate because of depreciated legacy assets, we will need to remove those assets from banks’ balance sheets in a way that promotes price discovery, increases asset liquidity and respects the tension between government involvement and government’s limitations. The PPIP and TALF can help achieve this.
• Moreover, by allowing financial institutions to borrow with a government guarantee, we can ease the funding liquidity constraints as well.

Ultimately, the jump start from stimulus and quantitative easing will start to kick in while all of this is ongoing. The result will be a growing economy and healthier banks. Nevertheless, we should implement some stress tests on institutions to gauge how much capital each institution would need in a worst-case scenario. Those banks faring poorest will need to take remedial action as soon as possible. However, under no circumstances should we ever imply that any individual institution is insolvent. This creates doubt and during times of stress it is not the wisdom of crowds, but the panic of crowds that is on display. Doubts about one institution are likely to have knock-on effects for others creating a systemic problem. This must be avoided at all costs.

So have Geithner and his team not avoided the pitfalls and accomplished their goals?

Related posts:

• The less optimistic view of Treasury’s handling of the crisis
• Will banks exiting TARP take back their toxic waste now?
• Bank by bank breakdown of stress test results
• Ackman and Stigliz talk Stress Tests with Charlie Rose
• GMAC has been nationalized

Nils Pratley’s piece at the Guardian on RBS and Lloyds is very good.  Two quotes sum up the situation quite well.

First, in regards to Lloyds, Pratley says:

Royal Bank of Scotland’s shares down almost 20% in two days; Lloyds’s shares an oasis of tranquillity. Those market reactions tell the story of the banking bailout part 3, or part 2(b) as the government would probably prefer. Lloyds has performed a great escape, but RBS has been clobbered…

Lloyds is being forced by the European commission to surrender 4.6 percentage points of market share but will retain 25%, probably more than any bank has ever enjoyed in the UK.

This is the statistic to remember when Alistair Darling trumpets the government’s commitment to greater competition. When one institution is so big in retail banking, actions like encouraging Virgin and Tesco to enter don’t amount to much.

In regards to the horrors brought to us by Sir Fred Goodwin at RBS, Pratley has this to say:

About 10 months after Lloyds started saying the worst was over, the claim looks semi-credible. It is relatively easy to see how – in time (a critical phrase) – taxpayers could earn a profit on their Lloyds shares.

The same hope is still alive at RBS but Stephen Hester’s task is far trickier. RBS, said Lord Myners today, was the "worst managed bank this country has ever seen," a claim that is supported by the sheer scale of taxpayer support. The capital ratios have had to be inflated to unheard-of levels to absorb the losses that are expected to arrive when the toxic rubbish from the Goodwin era washes up in the next few years.

The difference between the two banks is striking and goes entirely to management of the two firms.

The full article is linked below.

A tale of two banks at RBS and Lloyds – Nils Pratley, Guardian

Related posts:

• Lloyds to raise 21 billion pounds in biggest rights issue ever
• The FDIC to get credit from banks even while banks restrict lending
• Lloyds has a decent first half
• RBS reports a record loss of 24 billion pounds
• UK: Darling confirms government to break up too big to fail banks

Lloyds are looking to avoid the embrace of government by going to existing shareholders to raise capital and sidestep the draconian break-up solution foisted upon RBS by Neelie Kroes. According to Bloomberg, this is the largest rights issue ever for a British company and equates to $34 billion.

All of this must be excruciating for Lloyds shareholders, as Lloyds was not a reckless lender during the bubble years. It was HBOS which nearly went to the wall and was subsequently foisted onto Lloyds.  At the time (late September 2008), I certainly thought the deal was in the best interest of all concerned given how little Lloyds was paying for HBOS:

The fact that government were so involved in the negotiations makes clear how important it was that this deal get done. It appears to have been the best outcome for all parties concerned: HBOS, Lloyds and Labour. The British Government has been pilloried for having squandered the good times and leading the UK into a major downturn with no room for fiscal stimulus. Both Gordon Brown and Alistair Darling should be worried about getting the sack. The last thing either they or the Labour Party needed was a failure of an institution like HBOS. HBOS was too big to fail.

The HBOS crisis was a perfect example of how liquidity concerns become intertwined with solvency issues in a time of panic. With the HBOS crisis now at an end, one wonders whether RBS will come under attack next, or whether we can breathe a sigh of relief until the next round of writedowns or share price losses. We will have to wait and see.

RBS did come under the government umbrella and both RBS and HBOS have proven major sinkholes for the UK taxpayer, with more money still coming.

What Lloyds are looking to dodge is the government’s Asset Protection Scheme, which Bloomberg estimates will cost the bank 15.6 billion pounds in fees and easily raise the government’s stake to a majority at 62 percent.

Below are the defining paragraphs of the scheme:

1.1 Under the Scheme, in return for a fee, the Treasury will provide to each participating institution protection against future credit losses on one or more portfolios of defined assets to the extent that credit losses exceed a “first loss” amount to be borne by the institution.  It is intended that the Scheme will target those asset classes most affected by current economic conditions.

1.2 The Treasury protection will cover the major part but not all of the credit losses which exceed this “first loss” amount.  Each participating institution will be required to retain a further residual exposure, which is expected to be in the region of 10 per cent. of the credit losses which exceed the “first loss” amount.  This residual exposure will provide an appropriate incentive for participating institutions to endeavour to keep losses to a minimum.

1.3 The Treasury currently expects that the fee will usually be satisfied by the issue of capital instruments of the participating institution.  These instruments are not expected to include ordinary shares, but will include a range of alternative capital instruments.  The Treasury will be open to consider other forms of fee, including cash.

Nevertheless, Lloyds are being forced to flog off assets , effectively deleverage, in order to escape the APS. Insight Investment management was sold to Bank of New York Mellon for 235 million pounds on Monday. The Intelligent Finance business, Cheltenham & Gloucester accounts and mortgages, and a number of Lloyds TSB branches in England & Wales will be gone within four years. The TSB brand is also history. No mention of plans concerning the Halifax or Bank of Scotland brand has been made.

It is unclear what kind of reception such a large rights issue will receive. Lloyds is down almost 2% in heavy trading so far today.

Sources

Lloyds to Raise $34 Billion to Avoid Control by U.K. – Bloomberg

Sale announcement of Insight by Lloyds – Lloyds TSB website

Related posts:

• RBS reports a record loss of 24 billion pounds
• Lloyds gets HBOS for a song
• Nils Pratley: A tale of two banks at RBS and Lloyds
• HBOS to raise new capital
• $467 billion in writedowns and counting

At the weekend I wrote about Alistair Darling’s about-face on breaking up to big to fail financial institutions. Apparently, this was not a case of labour changing tack and finding regulatory religion, but rather of the European Union imposing its will on the British government. The EU is also dictating policy in Germany, the Netherlands and elsewhere.

The Telegraph reports:

RBS said in a statement on Monday it was in the final stages of talks with the European Commission about "some divestments not initially contemplated" to get EU approval for the billions of pounds it has received in state aid.

Selling Citizens, which has 26,000 employees, is said to be one of the options raised by Neelie Kroes, the EU competition commissioner.

She is also said to want the sale of the Churchill, Green Flag and Direct Line insurance businesses, more than 312 RBS branches in England, Global Merchant Acquiring, a card payments processing arm, and a reduction of the investment banking operations.

And RBS shares were down as the effects of the EU’s dictates became clear for that institution. Job losses were the most negative storyline and unions are expected to resist these moves vigorously. But asset sales were also part of the equation.

The Guardian reports:

Royal Bank of Scotland’s woes deepened tonight after unions condemned 3,700 branch job cuts as "absolute madness" on the eve of an announcement of a dramatic restructuring of the bank imposed by Brussels.

RBS is tomorrow expected to admit that it is being forced by the EU to make major commitments to cut back the size of its balance sheet and sell off some of its highest profile businesses in return for more than £40bn of state aid.

The bank acknowledged for the first time today that the EU was demanding more draconian measures than it had first envisaged, driving RBS shares down sharply. They closed at 38.65p, down 8%, giving the taxpayer a paper loss on its investment which breaks even at 50.5p share.

Analysts were concerned that the new chief executive, Stephen Hester, would need to redraw his business plan which is only eight months old, and that the profits of the bank could tumble by as much as £1.5bn a result of the EU’s intervention.

As the Treasury prepared to admit it was putting another £25bn into RBS to take the taxpayer’s stake up to 84% to help it participate in the government’s toxic asset protection scheme, unions reacted angrily to the front-line job cuts.

So, far from appearing forward-looking, Labour look quite reactionary here. Not only are they having to bend to the will of Neelie Kroes in Brussels, they also are being forced to top up their stakes in the banking black hole even while job cuts are being made. This is not the sort of thing that is likely to lead to more votes at the ballot box. (By the way, why do the British media insist on always using this picture of Darling in articles. I find it pretty comical.)

The UK is not the only country coming under pressure for state subsidies (a weak form of protectionism). In the Netherlands, ING was forced to break in two and reduce its balance sheet because of the EU’s policy on subsidies. In Germany, Commerzbank (in large part because of sick child Dresdner) is also going to have to reduce the size of its balance sheet. Commerzbank reported more than 1 billion euros in losses today, a sum which was a negative surprise (thinking back to Halloween, it was more trick than treat). Expect asset sales here too. I know that Fortis and Natixis are other institutions with problems. What is the EU doing there?

The situation is very fluid right now and many details are expected to emerge in the coming days.  Expect the EU actions to put pressure on the U.S. which is also subsidizing its banks in an anti-competitive way.

Related posts:

• European banks have hands out for more capital
• European banks: still undercapitalised
• $5 trillion to go on balance sheets again?
• No one gets a bonus at Commerzbank and no dividend either
• The Germans get tough with the state banks

In a clear break with US economic policy, the UK government have decided that too big to fail is too big to exist. As a result, three large financial institutions now owned at least in part by government are to be dismantled. Moreover, talk of Tesco’s or Virgin getting the assets is yet another momentous shift in the British banking landscape.

The BBC reports:

Chancellor Alistair Darling has confirmed that Lloyds, RBS and Northern Rock will be broken up and parts sold to new entrants to the banking sector.

He said there could be three new High Street banks in the UK over the next three to four years as a result.

But the chancellor said he would only sell parts of the banks when "the time is right", to ensure taxpayers get their money back.

There is speculation that buyers might include Tesco and Virgin.

One should not understate the importance of this decision. This is a game-changing move by the UK government. One year ago, it was the U.K.’s decision to recapitalise its banks which changed the economic policy landscape. U.S. policy makers were forced to switch TARP policy from buying up dodgy assets at inflated prices to injecting capital (see my post “Recapitalising Britain” from 7 Oct 2008).

Yet again, the British are leading the way in reform. If you recall, just two weeks ago Mervyn King, the Governor of the Bank of England, made a blistering attack on government policy and advised breaking up too big to fail banks. At the time, Prime Minister Gordon Brown publicly rejected this idea.

However, it seems Labour were not as against King’s ideas as Brown’s comments suggested. The move last week by the Dutch to break up the bankassurance giant ING may have been the impetus. The Chancellor, Alistair Darling, suggested an increase in competition on Britain’s high streets was uppermost in his mind.

Mr Darling said this was the best way to ensure "proper competition and choice". He said having just "half a dozen big providers was not acceptable".

Why Bradford & Bingley was not mentioned with the other three banks under government control is unclear. Tesco’s and Virgin have been two of the more innovative financial service providers on Britain’s high streets and we should look on their ability to compete at scale as something which will shake up financial services in Britain. Tesco’s bid to compete in the banking sector is particularly noteworthy because of its enormous presence on high streets and immense customer base.

I reckon this move will put pressure on the US where the Obama Administration has been completely unwilling to break up the large banks, which are now even more dominant than before the crisis.

Related posts:

• Nils Pratley: A tale of two banks at RBS and Lloyds
• German deposit guarantee sets up a German-British row
• Irish government unveils plan to recapitalise banks
• The EU driving changes in European banking
• Einhorn: Break up too big to fail financial institutions

Josh Rosner, a Managing Director at Graham Fisher & Company, an independent research for institutional investors in financial service assets, has some pretty strong words for the reform legislation proposed by the Obama Administration and now making its way to Congress. On Bloomberg, he said it favors large too big to fail institutions and hurts smaller community banks. In sum, he calls it “the single worst not-yet passed piece of legislation” he has ever seen in financial services. Pretty harsh words.

Tim Geithner defended the proposal to a skeptical Congress yesterday, saying that we need large institutions to compete internationally and that the companies should be regulated rather than broken up. When asked why Obama is not proposing that systemically dangerous firms be broken up, Rosner says it’s regulatory capture (something Arianna Huffington and Eliot Spitzer have argued for months).

Rosner also notes that the proposal increases the power of the executive branch giving them “unlimited authority,” which Congress pushed back on during Geithner’s testimony yesterday.

The most worrying charge that Rosner levels has to do with what he sees as an implicit government subsidy for TBTF institutions that puts them in a situation akin to Fannie and Freddie before the crisis. This gives them a large funding advantage over smaller firms, allowing them to generate excess profits and/or take higher risk.

See also “Guest Post: Conservatives and Liberals Agree: Proposed Bank Oversight Bill Will Make Things Worse” on Naked Capitalism.

Rosner’s video is below.

Related posts:

• Video: Geithner calls for single agency to oversee systemic risks
• Obama caves to pressure on consumer financial protection
• Why not protect the homeowner?
• Greenspan: “If they’re too big to fail, they’re too big”
• The U.S. financial system is effectively insolvent

Robert Johnson, director of the Economic Policy Initiative of the Roosevelt Institute, has been extremely critical of the US Government’s handling of matters related to financial services.

This past October 7, he gave testimony at the House of Representatives financial Services Committee expressing some of his concerns.  Not only was his testimony cut short, but his prepared remarks failed to be entered into record (hat tip reader Tom). This is outrageous and a deliberate attempt to expunged his testimony from record. Read the excerpt from Harper’s below (emphasis added):

Predictably, witnesses at the hearing trotted out positions urging caution in regard to the matter of reform…

[Robert] Johnson, who came last, offered the only serious critical viewpoint, saying that the American public had been “quite demoralized by…the bailouts that we experienced last fall.” After about five minutes of his testimony, Congresswoman Melissa Bean—another industry-funded committee member who chaired the hearing because [Barney] Frank was absent—had heard enough. “I’m just going to ask you to wrap up because we’re running out of time,” she told Johnson.

Johnson gamely continued. “When I hear the testimony today that are largely financial institutions and end users, I believe that I represent a third group that comes to the table, which is the taxpayers, the working people of the United States,” he said.

“I do need a final comment,” Bean interjected seconds later.

That put an end to Johnson’s testimony. “I was just called to this hearing last night, so I will provide detailed comments on your bill and a statement for the record that will finish my comments,” he concluded.

About five days later Johnson submitted his full testimony to the committee, to be included on its website along with the statements of the other eight panelists. When it wasn’t posted, Johnson asked Lynn Parramore, editor of the Roosevelt Institute’s blog, to see what was up…

Finally, she was informed that the committee’s general counsel would not allow posting of the testimony because Johnson had not submitted it during the hearing. (Of course, since Johnson had been invited at the last minute it was impossible for him to fulfill this pointless requirement.) So you still can’t read Johnson’s prepared testimony at the committee website, but you can check it out on the Roosevelt Institute’s blog.

Meanwhile, Frank’s committee has put forth its “reform” bill. “Too tepid, too weak, too late,” Johnson says of the legislation. “Very industry influenced. We had a crisis and they are pandering to the perpetrators.”

Read the full gory details below.

Source

An Object Lesson in Governmental Failure: Derivatives reform – Harper’s

Note: this post originally erroneously stated it was Simon Johnson and not Robert Johnson whose testimony was at issue.

Update: the testimony is now also embedded below for you to read.

Robert Johnson Financial Services testimony: 2009-10-07

Related posts:

• Obama caves to pressure on consumer financial protection
• A conversation with Robert Caro on Charlie Rose
• S.E.C. complicit in Madoff fraud, whistleblower says
• Geithner testifies before Congress on financial reform
• Simon Johnson: Too big to fail is “too big to exist”

I am listening to Treasury Secretary Tim Geithner answer questions before the House Financial Services Committee and he seems to be talking the talk, but his Administration is not walking the walk. 

The bill he is aggressively defending calls for putting a resolution process in place which ostensibly allows the cost of the failure of a too big to fail to not be passed on to taxpayers or the wider economy.  The sentiments he expresses are the right ones. But, he is rightly being questioned about whether this proposal gives the executive branch power which it could abuse.

Meanwhile, just in the last 24 hours we learned that GMAC was effectively nationalized and non-government equity was inexplicably not wiped out.  The testimony and the actions are in direct contradiction with one another.

Congress is fully aware of this dichotomy. They seem to have a bit of bailout fatigue. That makes them mistrustful of Geithner’s intentions. As a result, he is facing some tough questions from Democrats and Republicans alike.

Related posts:

• Rosner: Financial Stability Act “single worst not-yet passed piece of legislation”
• Chanos: I warned Brown and Geithner of financial calamity
• Weekend Video: A Conversation with Tim Geithner at CFR
• My initial reactions to President Obama’s financial regulation proposal
• Is Bernanke Toast? If he is, Summers is a shoo-in

This comes via the FT:

Saudi Arabia on Wednesday decided to drop the widely used West Texas Intermediate oil contract as the benchmark for pricing its oil, dealing a serious blow to the New York Mercantile Exchange.

The decision by the world’s biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world’s most heavily traded oil futures contract. It is the main contract traded on Nymex.

Before anyone tries to spin this as an anti-dollar move, you should read what else the FT article says:

In January, WTI, which usually trades at a premium of $1-$2 a barrel to Brent, fell sharply, leaving it at a discount of almost $12 – a record gap. This dislocation in the market continued well into the summer. 

From January, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company.

The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon.

The point of this move is not to undermine the dollar but to get away from the WTI contract where prices have been artificially inflated due to storage shortages at Cushing.

A friend familiar with this market also indicated that big bank punters active in this market will like this move as well as it helps them evade the position limits and regulation of the CFTC. He says, “In fact, the lack of transparency and regulation on the Dubai Merc was one of the reasons why you had such successful speculation in the oil market during the spring of 2008.”

I see a spike in oil prices as a risk to any sustained recovery. Anyone with more insight into why the Saudis made this move, do comment.

Related posts:

• Peak oil: it’s all about the Saudis
• Blame Bernanke, the dollar and oil
• Evidence that governments are underplaying peak oil
• Abu Dhabi sovereign wealth fund loses $125 billion
• Oil price rise is accelerating

Every time I hear the word ‘bureaucrat’ used to make a point for or against government’s role in the economy, I cringe. I see this label as unfair and dehumanizing.

I grew up in Washington , D.C. where my parents and their friends rose through the ranks of government, often to the very managerial positions which are being used to characterize government employees as bureaucrats. So I have a lot of insight into what goes on in and around Washington that affects the decisions made by these so-called bureaucrats.

I bring this up because of my recent post “Why you won’t hear me using the word bankster” in which I talked about a similar rhetorical tool used to label bankers. I see these labels as cheap, underhanded tactics meant to elicit an emotional response rather than a logical one and bias the reader against one’s preferred whipping boy. It is akin to invoking Adolf Hitler as an analogy in any debate – something sure to elicit a reptilian response instead of a well-reasoned one.

The question I was actually looking to have answered with the bankster post was more of a philosophical one: should we assign collective guilt when we see ‘moral’ or system-wide failures of the sort we have just witnessed in the financial services industry? It is the sort of question that I am asking myself due to the five recent posts here related to greed and morality in our capitalist system.

• Greed is not good
• More on greed, regulation, Lehman and the financial industry
• Guest post: Why do bankers make so much money?
• Keep your hands off Goldman’s bonuses
• Guest Post: Did Gordon Gekko inspire Wall Street or the other way around?

Here are the questions I have been asking myself: Is “individual greed but collective progress” the underpinnings of laissez-faire ideology? Is greed ever good? Are bankers greedy? If so, should government cap their pay or is that a violation of their liberty? Is market failure a sign of collective guilt?

I think these are fundamental philosophical, political, even moral questions that cannot be divorced from the conversation about economics and markets. They go to the core of our value system and, hence, to the fundamental nature of how we want our system of capitalism to function. It seems to me it is a major cop-out to say in effect “these issues are irrelevant because individual decisions of morality are swamped by the collective whole. Large systems are inherently amoral and thus we individually can be as well.” That’s what extreme forms of laissez-faire capitalism suggest.

As far as collective guilt goes, Wikipedia has a workable definition:

Collective guilt, like guilt, is the unpleasant emotional reaction that results among a group of individuals when it is perceived that the group illegitimately harmed members of another group. It is often the result of “sharing a social identity with others whose actions represent a threat to the positivity of that identity”.[5] Different intergroup inequalities can result in collective guilt, such as receiving unearned benefits and privileges or inflicting more extreme forms of harm on an outgroup (including genocide). Individuals are generally motivated to avoid collective guilt in order to maintain a positive social identity. There are many ways of decreasing collective guilt, such as denying harm or justifying actions. Collective guilt can also lead to positive outcomes, such as promoting intergroup reconciliation and reducing negative attitudes towards the outgroup.

The WaMu example I cited is a good one to think about:

The White House is pushing for a new consumer regulatory agency to end these sorts of abuses, but the banking lobby and even federal banking regulators are opposed. Banks say more regulation would kill innovation.

"I hated that loan," said Mary Kay Morse, a 20-year veteran at WaMu whose job was to persuade independent brokers to make option ARM loans. "It’s just not a good loan. It wasn’t good for the borrower."

That loan affected her opinion of WaMu.

"I always felt like I worked for a really honest industry that cared for the borrowers they dealt with," she said. The corporate culture changed to: "We just want to do the most we can to make money for the bank."

What blame could/should an individual like this bear for alleged predatory lending at Washington Mutual (I hate to pick on the employee in this example as her instincts seem to be in the right place)? If we individually make the wrong moral decisions, do we collectively risk a market failure like the one we saw in the recent spate of predatory lending?  I think the answer is yes. But I also think it is difficult for one individual to make a difference in a system where the incentives go against doing the right thing. This is a major argument in favor of regulation.

I would love to hear your comments on these issues as I have made mine.

As for the terms ‘bankster’ and ‘bureaucrat,’ I am looking to bring a bit more civility and logic to the debate about government, regulation, the banking industry and their roles in our capitalist system. Cheap shots and emotional pandering have no role in a mature discourse about these important topics.

Related posts:

• Why you won’t hear me using the word bankster
• WaMu: Mr. Smith goes to Washington and turns predatory
• Quote of the day: Gordon Gekko – greed is good
• Intent and motive
• Deregulation as crony capitalism

This comes via the NYTimes:

To the Editor:

Re “Volcker’s Voice, Often Heeded, Fails to Sell a Bank Strategy” (front page, Oct. 21):

As another older banker and one who has experienced both the pre- and post-Glass-Steagall world, I would agree with Paul A. Volcker (and also Mervyn King, governor of the Bank of England) that some kind of separation between institutions that deal primarily in the capital markets and those involved in more traditional deposit-taking and working-capital finance makes sense.

This, in conjunction with more demanding capital requirements, would go a long way toward building a more robust financial sector.

John S. Reed
New York, Oct. 21, 2009

The writer is retired chairman of Citigroup.

Interesting.

Related articles

John Reed on Glass Steagall: Then & Now – Real Time Economics

Related posts:

• Was repealing Glass-Steagall the cause for the present Depression?
• How globalisation led to universal banking in America
• More on why big capital markets players are unmanageable
• Obama caves to pressure on consumer financial protection
• Is Citi being forced to downsize by Obama?

It seems that not a day goes by when you don’t hear about some asset sale in Citigroup’s far-flung empire. Of all the major too-big-to-fail institutions, it is easily the most troubled: the poster child for everything that is wrong in finance in America.

But, when President Obama’s Pay Czar Kenneth Feinberg stepped in to limit pay at Citi and six other failed institutions living off of taxpayer largesse, I noticed something that made me wonder if there was more going on than meets the eye at Citi.  I am starting to think Citigroup is being forcibly dismantled by the Obama Administration as a condition of its bailout. Could there be some bailout strings of which we are not yet aware?

Why is WFC not getting pay caps?

The thing I noticed was Wells Fargo’s name missing from Kenneth Feinberg’s list. The seven companies now subject to pay caps are: Citigroup, GMAC, American International Group, General Motors, Chrysler Group and Chrysler Financial. But, last time I checked, Wells Fargo was suckling from the government breast via a $25 billion TARP payment. What gives?

The only logical conclusion one can make is that the Obama Administration has excluded Wells Fargo because it is a healthier institution than the pay-cap seven. I agree with that assessment despite a downbeat post on Wells earnings last week. The headwinds from Wachovia are significant. But the underlying earnings power of Wells Fargo’s franchise is of a different caliber than Citigroup’s. If you saw Citi’s earnings report, it was a disaster in banking, credit cards, trading, you name it.  Everywhere, Citigroup was getting killed.

So clearly, in looking at the too big to fail banks, something quite awful is still amiss at Citi (and at BofA to a degree) that is not at Wells Fargo or JPMorgan Chase (Goldman and Morgan Stanley are not really banks).

Remember those stress tests?

The question then is: what do you (the government) do about the problems at Citi, and, to a lesser degree, Bank of America? Well, we have answer number one: pay caps for executives. And don’t think Ken Lewis left Bank of America on his accord, despite his huge golden parachute. We could be seeing some of his cash clawed back. I suspect, however, there is more for these multi-bailout offenders.

Think back to the bogus stress tests from this past spring and summer. I was pointing the finger at Citi and BofA then, saying these stress tests were just a cover-up to buy these organizations more time. If they weren’t able to make the grade in that time, more draconian action would be warranted. My logic was as follows:

The leaks about who failed the stress tests are already starting.  Who got a big fat ‘F’?  Apparently, Citi and BofA for starters.  But is that any surprise?…

See, the stress are just a scheme to make us think the Federal government is actually doing something about the under-capitalized banking system in the U.S.. In reality, the Obama Administration is just buying more time in order to let us grow our way out of this problem…

Based on what Summers is saying, the stress tests are not designed to really test anything. They are designed to make it seem like the government has things well in hand so that we can grow our way out of this crisis with the help of government stimulus and debt.

Now, Summers and Geithner are not stupid. They do have a backup plan here. As I said in a recent post, not everyone is going to pass, and indeed, some banks have failed. What does that mean? It means these banks will be given some time to come up with the capital necessary to be adequately capitalized. If they cannot do so, the government will have to explore other options. This Plan B could include debt-for-equity swaps, nationalization, and FDIC seizure.

So, Geithner and Summers are hoping FDIC-subsidized funding, toxic asset removal, fiscal stimulus, quantitative easing and all the other measures now in place will kick in and provide a recovery – and solve the banking problem. However, if the problem is not solved, there is plan B – debt-for-equity swap, nationalization, or asset seizure.

In my view, we should be going to Plan B right from the start rather than going through this jerry-rigged sham of a stress test.

Everyone beat the clock… except Cit and BofA

Now, time is up. All of the big banks raised boatloads of capital months ago. If Citi and BofA aren’t ready to hand back TARP funds yet… then they may never be. It is time for Plan B.

Remember back in May when all the big banks ‘passed’ the tests and immediately went to the capital markets for more capital after their share prices had doubled, tripled and quadrupled? That whole process was by design. We were supposed to have some ‘stress tests,’ followed by a clean bill of health, all in an effort to get those stock prices up so the banks could sell shares to shore up their capital base (the exact same thing has just happened in Sweden, by the way. See here and here).

Every bank CEO which could escape TARP, ran as fast as he could away from the government and the TARP facility. Only the truly capital-constrained remained under TARP, namely Wells, BofA and Citi. Wells is going to earn their way out of this one (which George Soros feels is exactly what should happen). Obviously, Citi and BofA are a different story. Hence the pay caps. But, I suspect there is a lot more.

Citi pullback and asset sales

Let’s concentrate on Citi because I have written a lot about their asset sales over the last year. They are the big bank which is truly deleveraging the most. They are selling everything they can to raise cash. Here’s a short list. Please tell me ones I have missed.

• Sale of German retail bank (Jul 2008)
• Morgan Stanley-Smith barney deal (Jan 2009)
• Lending halt in Denmark (Feb 2009)
• Sale of Brazilian assets (Feb 2009)
• Sale of Japanese business Nikko (May 2009)
• Potential disgorgement in Mexico (Oct 2009)

I am sure there is a lot I am missing here. Nevertheless, it is clear that the Citigroup of 2011 or 2012 will be a shadow of its former self. I suspect the same is true for Bank of America as well.

But, it strikes me as likely that these sales – at least the ones in 2009 – are being dictated by the Obama Administration. Citibank may not be selling purely because they need the capital and it makes strategic sense to do so. The coercive power of government may be standing shotgun over this.  All of the chatter between big banks and government is being done behind closed doors, so we can’t know what the true pre-conditions of the BofA or Citigroup bailouts were.

My operating assumption to date is that the government recklessly gave the banks all of the bailout money and backstops, asking next to nothing in return – all largely because they are captured by the financial services lobby. But, I would like to think there were at least some strings attached and that we are now beginning to see what those strings are.

Related posts:

• JPMorgan has record revenue and $2.7 billion in profit
• Stress tests reveal Citi and BofA need more capital, but you knew that already
• Ten big banks receive approval to repay TARP funds
• How is Citi going to deal with $38 billion in deferred tax assets?
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

In the months since I began this website, I have had some fairly harsh things to say about economic policy in the U.S., the U.K. and elsewhere. I have consistently condemned what I think is a captured government promoting an unstable financial system and a bloated financial sector. But, I have made a conscious effort to not use the word ‘bankster’ because I find it unfair and dehumanizing.  Other bloggers may disagree, but allow me to tell you why I have made the choice I have.

I look more to government and its regulators as the problem than the banks. As an example, my post “Forget about Goldman” is about why it is government at fault when Goldman Sachs gets preferential treatment.  I make much the same point in my post, “Why is Goldman allowed to game the system?”

Wall Street, indeed the financial services industry globally, employees hundreds of thousands of people. These people do not magically transform into ‘banksters’ looking to steal grandma’s pension when they start working on the Street or the City. They are no different than you or I.

The problem is government. Our policy makers are the ones who allowed easy money and lax regulation to become the status quo. They are also the ones who gain power through the political patronage of special interests as we have seen not only in banking, but in healthcare and oil and gas.  Government has created a lawless environment in which far too many individuals have committed fraud and far too few have been prosecuted. But the vast majority of people in the financial services industry are hard-working honest individuals who do not deserve to be labeled banksters.

Take the recent Washington Mutual expose that I linked to in an earlier post. There was a telling few lines involving a veteran WaMu employee that goes to the heart of the problem. It says regarding a predatory loan product at WaMu:

The White House is pushing for a new consumer regulatory agency to end these sorts of abuses, but the banking lobby and even federal banking regulators are opposed. Banks say more regulation would kill innovation.

"I hated that loan," said Mary Kay Morse, a 20-year veteran at WaMu whose job was to persuade independent brokers to make option ARM loans. "It’s just not a good loan. It wasn’t good for the borrower."

That loan affected her opinion of WaMu.

"I always felt like I worked for a really honest industry that cared for the borrowers they dealt with," she said. The corporate culture changed to: "We just want to do the most we can to make money for the bank."

How could she have changed anything when the whole force of the system was working against her instincts? Should she have quit her job, left the industry, or blown the whistle? And to the degree she participated in getting these option ARMs out to consumers, is she complicit in the whole web of deceit?

To me, these are important questions which go to the concept of “collective guilt,” where people go along to get along while crimes are being committed in their midst. What got me to thinking about this issue was a BBC Documentary podcast called “Assignment – Protecting Britain’s Children” which I listened to this morning. The issue was social services in Britain and their complicity in the horrible death of an infant called Baby P at the hands of his parents in Britain. The incident caused shock and outrage, much of which was directed at Britain’s social workers, who were seen as complicit in the death.

Some social workers felt ashamed of who they were. Others left the field. Many more felt besieged by the public as a whole. I listened to all of this thinking of the parallels to the banking industry, which was crystallized for me when I read the Washington Mutual article. I see both episodes as related to some sort of collective guilt.

I have a problem with assigning this collective guilt to so-called ‘banksters.’ Yes, we should want regulators to do their jobs and prosecute people for fraud. We have not seen any prosecutions I know about from the alleged predatory lending at Washington Mutual or Countrywide Financial. This is yet another example of the permissive and destructive regulatory environment which created this mess.

But, we should stop well short of making blanket accusations of blame. The notion that there is collective guilt here is something we need to examine and address. I, for one, do not support it. I see captured and weak government as the problem.

Blame the government for setting up a rigged and corrupt system without adequate checks and balances. Vilify regulators for encouraging fraudulent practices that ripped off and bankrupted ordinary Americans and led to a fantastic crisis. Reserve your enmity for a system which encourages greed and naked self-interest at the expense of the broader economy and financial stability. And demand action.

Don’t hate the player, hate the game.

Related posts:

• On so-called bureaucrats in Washington and the morality of capitalism
• Consolidation through merger over bankruptcy
• WaMu: Mr. Smith goes to Washington and turns predatory
• WaMu on the brink of disaster: has agreement with regulators
• Anecdotes on reckless lending at WaMu from the Seattle Times

Source

Stuart Carlson – Uclick

Related posts:

• The failure to address the looming too-big-to-fail issue
• Einhorn: Break up too big to fail financial institutions
• Too big to fail?
• Greenspan: “If they’re too big to fail, they’re too big”
• Regional banks: Zions falls

This contribution from Daniel Berger is a letter to Michael Smerconish in response to a commentary Smerconish wrote on 10 May 2009 in the Philadelphia Inquirer “Head Strong: Did Hollywood inspire the meltdown men?” A shorter version of Berger’s piece appeared at New Deal 2.0 in July.

Given my recent two posts on greed (“More on greed, regulation, Lehman and the financial industry” and “Greed is not good”), Berger’s remarks bear posting.  What I find most interesting about this commentary is the tie between the belief in market forces and greed – which on an individual level is defined as selfish and excessive. The question is whether greed, which has historically been viewed as a negative on a personal level and condemned by most major religions in the past, can actually be beneficial on a society-wide level.  Berger says no and I agree. Markets are not self-correcting. As a result, regulatory oversight is necessary to prevent harm from excessive risk taking.

Michael:

I read the May 10 column in the Inquirer and, while I disagree with the ultimate conclusion which you imply, you, nonetheless, deserve credit for raising a provocative subject: whether people on Wall Street were influenced by Oliver Stone’s film “Wall Street” in engaging in beyond risky, reckless behavior which has brought down almost the entire edifice of modern American finance and has threatened an economic calamity akin to that of the 1930s.

In my view, your column actually raises two interesting issues: First, do the arts and popular culture (including film) influence society, or is it the other way around; and, second, what do attitudes expressed in Stone’s film say about professionals working in financial markets, the America financial elites and the financial system as a whole? In quoting the memorable words in the film of Stone’s character Gordon Gekko that, “greed is good,” you really are raising a larger question of whether unethical behavior was primarily responsible for the current crisis. Indeed, lack of ethics – - which undoubtedly was rampant on Wall Street in the period leading up to the crisis – - is a popular explanation for what happened. So it is interesting to explore the role of ethics, as well as Stone’s film, in the current crisis. Recently, Howard Jackson, your editor, wrote that the purpose of the Inquirer’s Commentary section is to stimulate debate and an exchange of ideas on important subjects of public interest. It is in that vein that I write to you.

Starting with the influences of film, I think that, upon reflection, you have gotten the role of art (and film) exactly backwards: Life rarely imitates art; but rather just the reverse. The general proposition is that art (including film) holds up a mirror to life and society – - which is a good thing. In holding up a mirror to life (to culture, society, the political system, the family, human nature and so on), art has the capacity to discover and communicate significant truths about these subjects, even ones which are inconvenient and from which conventional wisdom shrinks.

So what is the message – -the inconvenient truth – - of Stone’s film and how does it relate to the current crisis?

In considering the meaning of Stone’s film, it is important to consider certain aspects of the film with which you might not be familiar and some of which Stone was apparently not aware, either. The back story to Stone’s movie was not the leveraged buy-out craze of the 1980s – - as you allude – - but rather the insider trading scandals of that period. Moreover, the model for Stone’s protagonist, Gordon Gekko, was not a reputable figure (like those mentioned as being responsible for the current financial crisis), but was more of a Bernie Madoff type, Ivan Boesky. Boesky was simply a low-life stock trader who was thought to be uncannily adept at stock picking, but who was, in reality, paying people off for inside information and who got caught by the authorities.

Rudy Giuliani did not either uncover or prosecute Ivan Boesky, but rather it was the SEC who discovered the illegal activities of another rogue trader, Dennis Levine, who turned Boesky in to the SEC. Boesky, in turn, informed the SEC about his passing involvement with Michael Milken, a true financial visionary of the 1980s who both was a major figure in the leveraged buy­out field and who single-handedly created an entirely new field of finance, the market for “non-investment grade” securities (”junk bonds”). It was Milken who Giuliani prosecuted and whose prosecution made Giuliani’s career.

Had Stone’s film dealt with the complex motivation and actions of Michael Milken which were at once heroic and dishonorable, the film could have courted artistic greatness. However, Stone failed to take advantage of a golden opportunity to achieve possible film immortality and focused on Boesky which limited the scope and power of the film.

Additionally, Gekko’s striking (even iconic) remarks about greed and finance were not original to Stone. In fact, Stone (or his researchers) must have learned of them from a speech that Boesky gave at Brandeis or Yeshiva University. (Because of his unexpected success in the market, Boesky – who, in his own irony, had become an observant Jew – - was also a philanthropist of Jewish institutions.)

And, in yet an additional irony, the phrase “greed is good” was not original to Boesky, either. Boesky’s speech-making, like his trading, was also phony – - plagiarized from others. Interestingly enough, Boesky’s source for his provocative statement about greed and finance originated from none other than the much reputed economist and pundit, the late Milton Freidman ( a fact of which Oliver Stone was apparently unaware).

It is in the context of Milton Friedman’s words – not Ivan Boesky’s – - that Gekko’s stark view of actions on the Wall Street takes on the potential for real insight, even wisdom – - but not for reasons which ever occurred to Stone or to which you alluded to in your column.

Because of the importance in conventional thinking in attributing the excesses of Wall Street responsible for the current crisis to unethical behavior, it is worth pondering both the origins and meaning of Freidman’s views involving greed and finance. Milton Freidman was a leading economist and public intellectual in the United States in the early to middle post – World War II period. Freidman was the principal exponent of the so-called Chicago School of Economics and what has become known as the signature idea of the Chicago School pertaining to finance and the financial markets, the “efficient market hypothesis.”

Freidman was also the leading advocate in the U.S. of the free market system and market capitalism, believing in an extreme form known as laissez-faire capitalism (which has also become known as free market fundamentalism) and which postulated that markets were both self-regulating and self-correcting and that government intervention in the market system (including government regulation) would cause economic inefficiencies and harm the economy. In so far as financial markets were concerned, laissez-faire capitalism took the form of the efficient market hypothesis which postulated that the most efficient allocation and use of capital came about by the unfettered operation of financial markets and that open, unregulated markets perfectly established the economic value of financial assets.

According to Freidman, the market and its vaunted efficiencies came about as a result of competition among market participants, so-called “market forces” and sometimes referred to as the “invisible hand” of the market. Because of the presence of competition, the self-interest of market participants cancelled itself out and was an engine of economic progress.

Freidman argued that not only was economic self-interest not to be feared, but was a force for social good, because the effect of competition was to drive the system toward efficiency. Thus, Freidman argued the more unrestrained self-interest the better – - indeed, the greater the degree of naked self-interest exhibited in the market place, the greater the level and intensity of competition.

Naked self-interest is just another term for greed, as Freidman recognized, leading him to conclude that, “greed is good.” According to Freidman, the one and only worthy economic objective of corporations or individuals trading, not just in financial markets but in the economy as a whole was “to make as much money as possible,” to “maximize profits,” i.e. be as greedy as possible. In this way, the economic system would supposedly realize economic efficiency and maximize the economic welfare of society as a whole.

Freidman’s views on capitalism and greed epitomize the current state of an extremely prominent economic philosophy in the U.S.: the laissez-faire, unregulated free market school of political economy. From an economic policy perspective, free market fundamentalist views amount to endorsing a form of economic organization (market capitalism, so called “free enterprise”) based on acknowledged immoral motives and promoting or acquiescing in immoral activities in economic decisions and policy making. Supposedly, for policy reasons, society as a whole is better off with the free enterprise system than it otherwise would be, because – - not in spite – - of its reliance on the unrestrained exercise of self-interest (i.e. greed) in the market place. The reasoning is that the greatest good for the greatest number will result from the adoption of naked self-interest as the basic driver of the economic system.

Alas, while there is substantial social scientific evidence supporting the general functioning of markets in accordance with a rough approximation of the tenants of neoclassical economic theory, there is no empirical validity to the broad, sweeping assumptions of free market fundamentalism and laissez-faire capitalism. The competitive free enterprise system (as a system) is neither self-correcting of market mistakes or changed circumstances, nor self-regulating against abuses and excesses. In fact, the apparent near instant replay of 1929 et. seq. with which we are currently contending demonstrates just the opposite.

Nor is the efficient market hypothesis empirically true. Similarly, self-interest, or even competitive forces which it may generate, are not always engines of social good. Indeed, greed (or unrestrained self-interest) is usually just that – - and in need of restraint in economic decision-­making, as in life generally.

To begin with, it is now abundantly clear that the efficient market hypothesis about financial markets is invalidated on a daily basis. Ask yourself who is the most respected stock trader in America? By a wide margin, the answer would be Warren Buffet. Buffet is the principal advocate in the U.S. of the “value” investing approach to stock market investing. In value investing, investors look for companies whose stock prices are undervalued by the stock market and which will rise in absolute terms and relative to their industry sector and the market as a whole. Under and overvaluation of stocks by the market is routine and represents the antithesis of an “efficient” market which postulates that the price of a stock at any given time always reflects it true economic value. If the efficient market hypothesis applied, stocks would never be under or overvalued relative to the market.

In the 1980s, Michael Milken demonstrated that the exact same situation existed for corporate bonds. By establishing that the default rate on non-investment grade securities was relatively low, Milken showed that non-investment grade securities were grossly undervalued by the credit markets. By contrast, the recent sub-prime mortgage crisis has shown that mortgage-backed securities were grossly overvalued by financial markets.

Even more troublesome than routine mispricing of financial assets by the “unfettered” operations of market forces in financial markets, the assumption that the financial markets, or even the economy as a whole, represent a self-regulating, self-correcting system is also demonstrably false. In fact, financial markets – - indeed, the entire money economy – - are inherently unstable and experience cycles based upon the expansion and contraction of credit.

This phenomenon is dramatically illustrated by the current crisis which originated in unsound, speculative mortgage lending practices and which resulted in gigantic “asset bubbles” in real estate and finance, a crash and a paralysis of liquidity and a vast credit crisis leading to what you have described as a “financial melt-down.” A “melt-down,” “sell-off,” “freeze,” “panic,” “collapse” – - whatever it is called – - is the antithesis of a market “correction.”

In fact, but for the drastic and unprecedented actions by the Fed and the U.S. Treasury which have flooded the financial system with liquidity, made massive amounts of capital available to financial institutions, and even gone so far as to guarantee certain private financial obligations, the value of financial assets in the U.S. would have totally collapsed and the operations of financial markets would have shut down completely generating a 1930s – style Depression. Thus, the current behavior of the financial system is not – - and has not ever been – -self-correcting.

The financial crisis, in turn, has caused a collapse of the real economy, in a pattern eerily reminiscent of the Great Depression of the 1930s. An economy-wide contraction of economic activity has left the economy operating far below full capacity (including resulting in a massive increase in unemployment) where it would remain indefinitely, but for massive intervention by the national government to bolster and/or restart economic activity. Again, the current behavior of the economy is self-evidently not self-correcting.

In response to the economic crisis of the 1930s, an entirely new field of economics was developed to explain what happened called macroeconomics or Keynesian economics. Then, largely like now, the prevailing economic orthodoxy was represented by free market fundamentalism. Then, like now, the collapse of the financial markets leading to a genuine implosion of the real economy was viewed as highly improbable – - before the fact. It was also said, at the time, that the financial markets and the economy would self-correct and return to normal – - at least “in the long run.”

Keynes stunned the world of business and government with his brilliant explanation of the Depression as resulting from a collapse of aggregate demand caused by a financial market collapse stemming from a sharp, unexpected contraction of credit in response to unsound real estate lending by the banking system and financial speculation in real estate and stocks in the 1920s. Moreover and more importantly, Keynes showed that a pure free market system could stabilize indefinitely below full employment of its productive resources and, without outside assistance, would be unable to revive itself. Indeed, in response to the assertion of the then economic orthodoxy of a natural return to long-run full employment, Keynes responded, “Yes, but in the long-run, we’ll all be dead.”

Finally, it is equally obvious that unrestrained self-interest, i.e. greed, either by itself or in combination with competitive forces it may generate, is insufficient even to maintain stability in financial markets, let alone drive the financial markets to the efficient creation and use of capital. This has now been authoritatively acknowledged by none other than Milton Freidman’s intellectual successor and most recent high priest of free enterprise and laissez-faire capitalism, Alan Greenspan. In recent Congressional testimony and in response to the question of what went wrong in financial markets, Greenspan admitted to a “flaw” in his and Friedman’s “greed is good” logic: Namely, Greenspan had believed that self-interest would have prevented market participants – - both individuals and their firms – - from engaging in the risky, reckless financial speculation which imposed large losses on them and caused the current crisis. Self-interest and competition, far from disciplining the market, resulted in windfalls, either windfall profits or unanticipated, catastrophic losses.

However, neo-con free-marketers fear not. All is not lost for the private property-market -and-self-interest driven economic system. Markets have been proven to work across a wide range of economic conditions, to be relatively efficient and to have produced, at least cyclically, high levels of income and employment. However, as the above analysis demonstrates, they have drastic deficiencies and flaws which render them neither self-regulating nor self-correcting. Markets, particularly financial markets, need to be systematically regulated by the government to prevent excesses and abuses by market participants and to maintain stability.

Once again, we have learned that history will repeat itself, if society is uninformed or deluded enough to make the same mistakes of the past. We have also learned (once again) the heavy costs of free market fundamentalism and laissez-faire capitalism. It is, as they say, an expensive history lesson – - which was totally avoidable, and should have been avoided.

To summarize my main points:

First, art generally does not influence society, but it is the other way around.

Second, it was not greed that brought down the financial system, but deficiencies and failures in the system, as Greenspan put it, “flaws” in the theory of free market fundamentalism and laissez-faire capitalism. The collapse of the market is NOT primarily a matter of values, but of system dynamics. If it were the former, we would have to get rid of the free enterprise system which is based on unrestrained self-interest as an engine of prosperity, and as, inter alia, an immoral system. However, from a public policy perspective, it is not self-interest that is wrong, since self-interest and the market forces which self-interest generates work at least partially to self- regulate abuses and excesses of the system. Rather it is free market fundamentalism and the belief that markets are always self-regulating and self-correcting which is wrong.

Third, there undoubtedly was unethical (and illegal) behavior on a massive scale in the period leading up to the financial crisis and which was a contributing factor to its scope and magnitude. This type of behavior – - both in terms of negligence and intentional wrongdoing – -can and should be discouraged. But it was flaws in the market system, not the ethics of market participants, which was the principal problem. To quote the comedian Chris Rock in another context: “Don’t hate the player, hate the game.”

Fourth, the answer to the problem is to fix the system. Once again, experience shows that there is no such thing as a self-regulating and self-correcting economic system. As a result of the collapse of the financial system 70 years ago which resulted in the Great Depression, a mixed system of private markets and public oversight was instituted. Nor was the approach limited to the financial sector, but was extended to markets for labor (labor organizing, wage and hour, child labor, occupational health and safety, and anti-discrimination regulations) and goods and services (antitrust, environment protection, and consumer protection regulations and so on).

The “mixed” economy of private markets and government oversight/regulation was the correct response to the financial/economic crisis of the 1930s. And a return to the mixed economy is the correct response now. Indeed, if you consider the fundamental challenges to the country now, such as energy, environment and health care, they are problems which the private market does not deal with well and as to which market forces will not produce least cost, let alone optimal, outcomes.

Fifth, and finally, although it will be difficult for conservatives – - even moderate conservatives – - to accept, the overwhelming weight of historical evidence shows that the vaunted market system has flaws; that there is such a thing as the “public interest” which consist of the interest of society as a whole and which is greater than the sum all of the private interests in society; and that there is an important role for government – - particularly at the national level – - in protecting the public interest.

Anyone who tells you differently is either a deluded ideologue or ignorant of history – -or both.

Daniel Berger is an attorney in the field of complex litigation, including securities and anti-trust litigation, and has a broad-based knowledge concerning the structure and functioning of the US economy and US financial markets.  He practices in Philadelphia.

Related posts:

• Quote of the day: Gordon Gekko – greed is good
• Guest post: Why do bankers make so much money?
• Guest post: Regulation in Defense of Capitalism
• Greed is not good
• Public anger at Wall Street begins to boil over

John Gapper had a good piece in the FT yesterday called “Goldman should be allowed to fail.” His conclusion is that Goldman is allowed to game the system. It is a broker-dealer masquerading as a bank. It takes on much more risk than a traditional bank. It engages in different activities. It compensates its staff differently as well. And it is too big to fail. Gapper says this cannot be tolerated.

So, if Goldman Sachs took on more risk when its equity was held by outsiders than with its partners’ own money, what can we expect now that the government implicitly accepts that it is “too big to fail”? Goldman has an even bigger incentive to risk other people’s money.

This is the problem I identified last week, with the most powerful broker-dealer on Wall Street having the same privileges as the most mundane commercial bank. Not only does the fact that it may pay $23bn in bonuses this year upset people, but also its incentives are skewed.

Solving this requires two things to be addressed. First, Goldman’s intention to operate as a institutional Wall Street firm – complete with its own hedge and private equity funds – while having government and Fed support. Second, its tradition of setting aside half its revenues each year for employees.

Gapper also points out about Goldman Sachs is that the firm is very different than the one that went public in 1999.  Back then sales and trading was only a third of revenue, however by 2006 and 2007, the fixed income and currency divisions were up to two-thirds of revenue. This year, in the first nine months, those units have contributed nearly 80 percent of the firm’s revenue.

In Goldman’s defense, Gapper admits that the firm is the most partner-like of all the big Wall Street firms.

Goldman probably has one of the most partner-like pay structures for its managing directors. About two-thirds of bonuses are in restricted stock that vests over four years and its most senior partners have to hold 75 or even 90 per cent of the stock until after they retire.

Gapper doesn’t believe that is enough and suggests returning to a  system in which 90% of Managing Directors’ money is tied up in the firm until retirement.

Now, to be sure, Goldman has a huge cushion of $170 billion in cash for events like the ones we witnessed last Fall. It is commonly considered the best run firm on Wall Street. But it is still a broker-dealer.

One thing Gapper fails to mention is how a large balance sheet necessarily translates into bigger bonuses. A lot of people have made the argument that big banks are so big because they benefit from economies of scale in activities like derivatives and they need to compete in cross-border activities. But, the dirty little secret in corporations is that the larger a company is, the more revenue and profit it makes and this justifies much higher compensation for senior staff.

Imagine for a second you have eight firms on one side with revenue of $1 billion and profit of $100 million each and one company on the other side that is just as big as the eight collectively with revenue of $8 billion and profit of $800 million.  Who do you think makes more money, the guy running one of the eight companies or the guy running the large one?

Size matters not just in economies of scale or competition but in paychecks as well.

In any event, Gapper believes that Goldman should not receive the benefits of the federal reserves discount window unless it is a true deposit-taking institution which carries out a central function that carries responsibilities.  The suggestion is that Goldman should be stripped of its bank holding company status unless it takes on these responsibilities. And if it gets into difficulty in the future using this same broker-dealer business model, Gapper says Goldman should be allowed to fail.

Goldman should be allowed to fail – John Gapper, Financial Times

See also Goldman Sachs Is Too Big to Tell It Straight: Jonathan Weil – Bloomberg

Related posts:

• Goldman crushes earnings estimates
• Goldman loses $2.1 in the third quarter
• Why is Goldman allowed to game the system?
• Goldman looking to buy a bank
• Goldman and Morgan Stanley are now banks

If our response focuses only on the symptoms rather than the underlying causes of the crisis, then we shall bequeath to future generations a serious risk of another crisis even worse than the one we have experienced.

-Mervyn King, Governor of the Bank of England

The Bank of England head has come out unequivocally against continuing with the status quo.  He sees grave risks at large global institutions like HBOS and RBS, which lent recklessly and leveraged up to a point where they threatened collapsing the entire UK financial system. As a result, he is now calling for them to be broken up or we risk a more severe crisis down the road.

However, Gordon Brown has rejected this notion and is looking to move forward with a tweaked version of the status quo.

The Telegraph reports:

Mr Brown told MPs that "the difference between having a retail and investment bank is not the cause of the problem."

The Prime Minister added that "the cause of the problem is that banks have been insufficiently regulated at a global level."

Mr Brown was responding to Mr King’s fiercest attack yet on big banking in a speech he gave in Edinburgh last night. Mr King indicated the country’s high street banks should be separated from their risky investment banking arms.

"“It’s clear King’s not happy with where we are now,” Colin Ellis, an economist at Daiwa Securities told Bloomberg. “He said the regulatory structure was inadequate, and coming from the governor of the Bank of England that’s as damming as it could be."

Lest we forget, Mr. Brown is the architect of the present regulatory structure in the UK. It was under his guidance as Chancellor that the regulatory structure was divvied up into the tripartite authorities of the FSA, the Bank of England and the Treasury. As with any incumbent, Gordon Brown has a legacy to protect and this puts his interests at odds with ours. So, it should be a given that Brown is not going to break up the banks, especially since he was the architect of the Lloyds-HBOS merger to begin with.

But, it is disingenuous for Brown to claim that right-sizing these institutions means abandoning the Universal Banking model.  There are 100 different ways to downsize a bank as the forced downsizing at Citigroup demonstrates.

Below is a video of Governor King speaking on the subject, making his call for greater regulation and an end of too big to fail.

In related news, Goldman Sachs’ Vice Chairman Lord Griffiths has defended Goldman and their outsized bonuses with the unfortunate phrasing that Britons must:

tolerate the inequality as a way to achieve greater prosperity for all.

To make matters worse, he threatened Britain with a loss of tax revenue by explaining bankers will just move to Switzerland if the UK tries to take their money away.

Are we looking at “the biggest moral hazard in history?” That’s how the Mervyn King video ends.

To be continued.

Related posts:

• UK: Darling confirms government to break up too big to fail banks
• FSA: Gordon Brown complicit in credit bust
• Lloyds gets HBOS for a song
• The Last King of Scotland
• Quote of the day: Gordon Brown, get your bazooka

You are a teacher at a local primary school. Each school day you and some of your colleagues watch over the children at the school playground to make sure all of the children follow the rules and keep their hands to themselves. Your role is to keep the children safe. Mind you, this is a Montessori School where the philosophy is to let children explore within set boundaries.  But, if a child hurts another or a child’s behavior poses an immediate risk to others, you always step in.

In fact, one child, Charlie has been a bit of a problem recently. Charlie is one of the biggest kids at the school, a boisterous sixth grader who likes to push and play with matches. Last July 4th, it seems he got a hold of a video on the Internet blog Credit Writedowns on how not to use fireworks.  Contrary to the video’s intention, he rather liked seeing things blow up and courting danger. You see Charlie is a bit of a pyromaniac. You have repeatedly had to stop Charlie from bringing matches to the playground and lighting things on fire. But, recently you have had to confiscate firecrackers and suspend him from school.

But, one day a new headmaster comes to the school. He doesn’t believe much in the need for teachers to monitor the children. The children can monitor themselves. Unfortunately, Charlie has a bit of a following at school and before you know a lot of the kids are lighting firecrackers on the schoolyard. No one gets seriously hurt – just a few minor burns here and there. So Charlie ups the ante to M-80s like he saw in the video. There was a serious close call when he put the frog in a jar with the M-80, but self-monitoring has worked pretty well and there have still been no major casualties.

That’s when little John comes up to you and asks, “Ms. Watkins, why does Charlie have lit dynamite?”

In case it’s not obvious:

• Charlie is a too big to fail bank.
• The matches are debt, the firecrackers are derivatives, the M-80s are asset-backed securities and the dynamite is OTC derivatives.
• You (Ms. Watkins) are Brooksley Born
• The headmaster is Alan Greenspan
• Little John is another smaller community bank
• The other children are banks and citizens of the broader economy
• The frog-glass incident was LTCM’s collapse
• The lit dynamite incident was Lehman Brothers

In the past, I have likened regulators to referees or playground monitors to illustrate why the concept that markets are self-regulating is absurd. In the last post, “Frontline – The Warning: Who Knew About the Looming Financial Crisis?” Alan Greenspan was at war with regulator Brooksley Born over this concept of self-regulation. Born believed that regulation was a necessity in any financial market. Greenspan believed that markets are inherently self-regulating. Even fraud was self-regulating through market discipline in his view. I believe he has now repudiated this. However, Born lost that battle with ugly consequences when the market she wanted regulated, OTC derivatives, blew up via AIG.

Self-regulation is to regulation as self-importance is to importance.

Note: Even though, I am pointing to Buiter’s piece here, I am not a believer in regulation-heavy in the least. Nevertheless, his ideas do merit consideration.

Related posts:

• Deregulation efforts from the late 1990s were blocked
• A conversation with Richard Posner on Charlie Rose
• Greenspan: financial crisis ‘will happen again’
• A conversation about AIG on Charlie Rose
• Forstmann on Charlie Rose: easy money caused crisis

Watch the hour-long retrospective which aired tonight on PBS’s Frontline.  It should be very enlightening in regards to the seeds of the bubble and meltdown.  It examines who the players in the 1990s and 2000s were, what their attitude to regulation was, and how lax regulation created a bubble and a bust.

Also see the following posts for more background:

• 1987
• Freshwater versus saltwater circa 1988
• 1995
• Deregulation efforts from the late 1990s were blocked
• FRONTLINE: Inside the Meltdown of Sept. 18, 2008

(video embedded below; runs just under one hour)

Related posts:

• FRONTLINE: Inside the Meltdown of Sept. 18, 2008
• Greenspan: financial crisis ‘will happen again’
• Ms. Watkins, why does Charlie have lit dynamite?
• Deregulation efforts from the late 1990s were blocked
• Ten lessons from financial crisis investors will soon forget

David Einhorn delivered a speech at the 2009 Value Investing Conference that is creating a lot of buzz in the blogosphere. He said a lot of interesting things about the investing and political climate.  A surprising amount of it comes out of the playbook here at Credit Writedowns.

Below are the quotes I want to highlight for you. At the bottom is an embedded copy of his speech.

Enjoy.

On short-termism in politics and government

Winston Churchill said that, “Democracy is the worst form of government except for
all the others that have been tried from time to time.”

As I see it, there are two basic problems in how we have designed our government.
The first is that officials favor policies with short-term impact over those in our long-term
interest because they need to be popular while they are in office and they want to be reelected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions. Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.

On crony capitalism and regulatory capture

The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, “without banks, we would have no economy.” Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.

Like teenagers with their parents away, financial institutions threw a wild party that eventually tore-up the neighborhood. With their charge arrested and put in jail to detoxify, the supervisors were faced with a decision: Do we let the party goers learn a tough lesson or do we bail them out? Different parents with different philosophies might come to different decisions on this point. As you know our regulators went the bail-out route.

On misdirected anger on main street

And the neighbors are angry, because at some level, Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don’t know the particulars or how to argue against the “without banks, we have no economy” demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings. As I see it, the revolt over healthcare isn’t really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.

On breaking up too-big-to fail institutions

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.

There is MUCH MUCH more below.

Einhorn Vic Speech 2009

Related posts:

• UK: Darling confirms government to break up too big to fail banks
• Too big has failed
• Congressional response to AIG is mindless
• The failure to address the looming too-big-to-fail issue
• Lessons from Lehman