Bank Stocks: Proof Times Have Not Changed?

Breeze through the financial news and one item will stand out: just how well bank stocks are doing. Today’s headlines at Marketwatch, the perennially pro-business financial media site, are an example. Apparently bank stocks are rallying in expectation of a surge in mergers and acquisitions activity. The boys are back in town.

That the banks have all this money to splurge on buying each other, but not enough to lend to customers, is something we can discuss elsewhere, today let’s simply talk M&A.

The banking industry, through its enormous stupidity and greed, plunged the world economy into a hole from which it is only now tentatively emerging. That emergence is not due to the help of the banks, but to the crushing burden of debt that governments the world over had to take on in order, first, to bail out those incompetent bankers, and second, to fill the gaping holes in demand that the implosion in banking had opened up in their respective economies. In effect the banks are directly responsible for the rapid accumulation of debt loads that we will be paying off for decades.

So it becomes reasonable to ask whether the banks and their owners shouldered a fair share of the cost they created.

The answer is a resounding no.

Therein lies the cause of the current populist disgust of all things banking. Rightly so.

Back in the dark ages of the crisis bank stockholders had seen their share values plummet to near zero. There was much chatter of nationalization and the forced elimination of the old shareholders who had overseen the bank management teams with all the zeal of a somnolent, deaf and blind toad. Which is to say none. While the executives pillaged the shareholders, the latter basked lazily in the safety of the implicit guarantee extended to all banks by governments the world over. Being pillaged is easy to take when you can simply pass the cost along to taxpayers. In other words there is no need to exert oneself or ask hard questions. You just wait to be bailed out.

This dysfunctional syndrome is what we call moral hazard: banks know they will get help so they take extra risks. If those extra risks work out they keep the profit. If they don’t they offload the loss onto the gullible taxpayers.

But taxpayers are not innocent in this tawdry tale. They need the banks because they need financial intermediation – the translation of short term money into long term money, and they need a payment system to grease the skids of commerce. Banks are central to both these activities. Indeed it is what they are supposed to do. But intermediation is inherently risky. Mistakes will be made. Banks will fail. The failure of a bank poses a threat to the second of those activities, and thus could gum up the entire economy. So taxpayers have an enormous vested interest in keeping the banks afloat. Hence the willingness to bail them out when they screw up.

Finding the delicate balance between supporting the banks, and being suckered by them is the central financial policy issue of the past three decades. If taxpayers release the grip they have on the banks – that grip is exerted through tough regulation and oversight – without also relenting on the support, then they expose themselves to being double-suckered. That’s the net effect of the Reagan/Clinton/Bush deregulation. Taxpayers gave up the benefits of keeping control of the banks, but still extended the safety net.

This asymmetry was inevitably going to implode. As public policy it was a disaster. I cannot emphasize enough just how awful the policy was.

What’s worse, everything that happened was eminently predictable.

Released from strong oversight, and freshly freed from the New Deal laws that restricted their activities, the banks went on a destructive binge of acquisitions, growth, new product development, and risk accumulation. The first example of the destruction deregulation could bring was the now forgotten Savings and Loan crisis in the Reagan era. Anyone with sanity could see that such a collapse could be repeated, but such was the fervor of the free-market advocates that critics of deregulation were quickly rooted out and sent packing. As Alan Greenspan said: markets will deal with potential problems.

What market advocates always seem to forget is that the adjustment within a market can be disruptive. Sometimes it is downright apocalyptic. It is conveniently forgotten by the free-market folks that a market adjustment is simply a dry and clinical phrase describing mass unemployment, loss of homes, loss of wealth, and a swathe of social problems running from broken homes to huge income inequalities. Economists like to avoid getting their hands dirty in such nasty topics so they refer to these awful events as an ‘adjustment’. In their eyes if your heart stops beating it is simply adjusting to a new equilibrium condition. The rest of us call it death. But economists are not interested in the details of the new condition, they are only interested in whether it allows a new balance to occur.

Back to the stock market.

There is an adjustment now going on. Banks that are huge and flush with profits courtesy of the taxpayer bail out are now turning their greedy eye to expansion. Market share is all the rage. The problem is that, with the economy sluggish, the banks need new ways of stimulating growth. Conveniently for them their stock prices are rising on the backs of the moral hazard driven profits they are raking in from their high risk trading activities. This represents a problem though: the more profit they generate from their anti-social trading the more likely it is that legislation is put in place to re-regulate them. So what is more natural than to go and buy smaller banks who are loaded with all those old fashioned things like consumer loans and deposits? Not only does this diversify their profit sources away from trading, but it allows them to load up on cheap money from those consumer deposits. And it makes them even bigger and so even more needing of taxpayer bail out guarantees. It’s a win all round.

The more talk there is of M&A activity the more speculative the bank stock prices become. This is heady stuff for bankers. They love deal making, and what can be more sexy than M&A deal making?

The irony is, of course, that the banks are diverting their energies into M&A activity because the economy is so sluggish that ordinary growth – getting more customers for instance – is very hard to do. I am sure the bankers complain about the time and cost it takes to acquire new business the old fashioned way. And why is the economy so sluggish? Because the bankers trashed it.

So here we have a thoroughly irresponsible and anti-social group of executives eyeing up opportunities to enlarge and aggrandize their businesses even before the wreckage of their last party is cleaned up. The stock market, oblivious as always to the trials and tribulations of Main Street, is lapping up the speculative stock price play that always accompanies an M&A surge.

The big banks are about to get bigger. The industry is about to get more oligopolistic than it already is. Competition will be reduced. Consumers choices will be limited. Innovation will be stifled. Risks will be more concentrated. Jobs will be cut to pay for the acquisition premium paid in each deal. Executives bonuses will be enhanced – which as we know is the real reason banks exist. And moral hazard will be ramped up a notch.

Let me present an example of the mess this could presage: one big rumor in the market has Barclays of the UK buying a ‘large’ bank in the US. Barclays is already deemed to big to fail by the UK government. If it acquires a large US bank it will be even larger, and will embroil regulators in two economies in a mess of intertwined bureaucracy that would take years, if not decades, to sort out in the event the bank gets into trouble. Allowing such a deal cannot be good public policy: the implications for the cost of a future bail out are enormous. But so far I see no official trying to damp down the speculation.

So the stock market response to these M&A rumors is simply an indication that nothing has changed.

The big banks paid no price for throwing the economy over the edge. Their shareholders are as supine as ever, intoxicated as they are by the prospect of all those non-competitive profits. And legislators have clearly fallen way behind in any attempt to rein the industry in.

Yes, the boys are back in town.

Which means there is a crisis brewing.

Jamie Dimon, the CEO of JP Morgan Chase told us recently that he thinks financial crises are common and frequent, so we ought to get used to them. What he forgot to add is that the banks create the crises as a deliberate and predictable result of the way they behave.

When puppies mess on the floor we train them not too. When bankers trash economies they train us to pay up and look away.

There is something wrong with that picture.