Goldman Sachs

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Who Knew There Were Banks?

Economists sure as heck didn’t.

“Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves.They did not bother to put financial markets and the banking sector into their models. This is a major flaw.” Professor Paul De Grauwe, a macroeconomist in today’s Financial Times.

It is one of those oddities that I am certain most of you are blissfully unaware of, but text book economic theory has no place for banks. Go on read that again just to make sure you understand: there are no banks in the realm of economic theory. None. No Goldman Sachs, no Citibank, not even JP Morgan Chase whose eponymous founder was an economic powerhouse and involved in national economic policy for years. And, no, I am not exaggerating. If you pick up any standard text book you will find no references to finance in the models of an economy.

Yes there is a whole subject now called financial economics, but that deals with valuation of assets not with institutional structure. The notion of intermediation, which is the central essence of banking, is entirely absent from econ 101, or econ 909 for that matter.

So it always a little disconcerting to watch a panel of economists opine about the banking system. It’s a bit like having bird watchers build airplanes: they can describe what’s needed, but have no idea about what it takes to implement, execute, or actually do anything.

Nonetheless here we are: bank reform is back on the table and Congress is having its normal self-indulgent ‘fact-finding’ sessions with ‘experts’. Most of whom turn out to be economists.

No wonder bank regulation is a mess.

With that said, there seems to be some clarity appearing around what should be done to prevent a recurrence of the recent melt-down in banking. With Barney Frank leading the charge even hearings on bank reform can be fun.

First what’s the problem?

  1. Some banks [and insurance companies like AIG!] are simply too big. If they run into difficulty we are forced to bail them out because we cannot afford to have them fail. A few of our largest banks now have assets approaching 10% of GDP. That’s an enormous figure and shows how much is at risk in just one of them.
  2. Bailing out banks is really, really expensive, as we have just learned. So avoiding a repeat seems urgent.
  3. Banks all operate with a government guarantee of sorts: FDIC insurance provides protection to deposit holders up to a limit, but that means banks can afford to be foolish safe in the knowledge that their depositors are relatively safe. No ‘market discipline’ there. Worse: now that we have shown we will bail out the ‘too-big-to-fail’ banks they can operate with complete abandon – they can be totally reckless and maximize their payoffs to employees and management knowing full well that the taxpayer will pay for the collateral damage. This is not a good idea.
  4. Banking is hopelessly interconnected. Regulators presumably were aware of this but did nothing to examine bank safety from a systemic perspective. This interconnectedness was the reason AIG had to be bailed out: no one – literally – had any clue as to the consequences of an AIG failure, so the regulators had to play it safe.
  5. Banks have exploited legalese to such a degree that few if any consumers know what they are signing up for when they purchase a bank service. A credit card, which is about as generic a product as can be, should not come with fourteen or fifteen pages of tiny font sized, jargon laden, and incomprehensible caveat riddled ‘terms and conditions’. Consumer protection from this ridiculous and often exploitive legalese has become vital. If you don’t believe me: try modeling the true cash flows of an option Adjustable Rate Mortgage with only the data given on the application form. You won’t get it right.

So those are the main topics we find our economists talking about. What are the solutions?

  • Limit bank size. You can do this by ramping up capital requirements on assets over a certain limit – thus making those assets unprofitable. Similarly you could simply outlaw leverage of above a certain limit – leverage was a chief culprit in the meltdown.
  • Bolster anti-trust legislation so as to ‘break up’ banks deemed ‘too big’.
  • Develop an updated bankruptcy code that covers big financial institutions. Our current bankruptcy code is really designed for industrial companies and medium sized [or smaller] organizations. Unraveling Citibank with its labyrinthine corporate structure, counter-party risks, global presence, and derivative laden balance sheet cannot be doe within the current set of bankruptcy rules.
  • Create a Consumer Protection Agency to provide and improve standards of bank products for consumers. Don’t fall for the whimpering about the damage this will do to ‘innovation’. Adding pages of legal jargon to a boring and vanilla product is not innovation. The last true innovation in consumer banking were probably the ATM and extended opening hours, everything since has been designed to bulk up profit opportunities not to provide a genuinely new product.
  • Get some transparency into the arcane world of derivatives. My own view is that most derivative trading should simply be banished: it adds risk rather than mitigates it. The origins of derivatives were in the need for options and future trading for farm products like wheat. Securitizing and selling bad mortgages was not on that original list, nor were credit default swaps for sovereign debt [ a ‘bete noir’ of mine as you know!]. They either should be abolished or traded on open and fair exchanges, not behind closed doors where traders can rig bonus pools for each other’s benefit.
  • Finally, we need international regulation. Case in point: the unwinding of Lehman is taking place in several countries across the globe. Each has a slightly different bankruptcy code, each has different regulators, and each has national jurisdiction over the bits of Lehman domiciled in its territory. It is already a mess and will take years. There is no way the global community could dismantle Citibank or Goldman Sachs. Plus those different standards make it easy, and legal, for a global company to move assets around the world and park them in the most relaxed regulatory environment. They can thus dodge tough standards, bolster profits, avoid taxes, and still foist the damage on their home country. This is not a time for national sentimentality: the banks are exploitive and full of lawyers. They will rip us off if they can.

So they are few points that need fixing.

Most are on the table in Congress, so reform could be substantial.

Now. Back to economics: one of the great reasons that Keynesian economics should be the standard rather than the neo-classical fanciful rubbish that they teach you in school, is that it actually does acknowledge the role of finance in the economy. The neo-classicists tried to eliminate Keynesian thinking partly because of this: finance introduces the inherent uncertainty of an economy. The neo-classical model has no room for uncertainty as it assumes that all consumption will be paid for from wages or profits. There is no borrowing in that model. Hence there are no banks.

How they get involved in fixing the recent crisis I have no idea.

They need to get out a bit. And then fix their sill models.

‘Who knew there were banks?’ is hardly a defense for the errors the neo-classicists models made.

Keynes knew. That’s who. Look it up.

Addendum, 10:50 a.m. July 22:

No sooner do I write this than I find an article in the Financial Times that includes these words:

“How to resolve this crisis in macro-economics? The field must be revamped fundamentally. Some of its shortcomings are obvious. Before the financial crisis, most macroeconomists were blinded by the idea that efficient markets would take care of themselves. They did not bother to put financial markets and the banking sector into their models. This is a major flaw.” [My emphasis]

Well duh!

The article’s author,Paul De Grauwe,is professor of economics at the University of Leuven and the Centre for European Policy Studies. He’s a Keynesian, so I would expect him to call for the overthrow of the stupidity currently known as standard economic theory.

Anyway you can imagine my smug reaction when I read his words!

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End of the Week: Banks; Health Care; the Fed; and California

It seems that the entire week has drifted sideways: nothing of note occurred to suggest that the economy’s trajectory has changed. We are still declining, albeit at a slower rate. The problems remain the same: unemployment, high debt, and a very weak banking system. The next few weeks are crucial. If the recovery is to take hold later this year we must see definitive evidence of that change soon. In particular businesses have to stop contracting and restructuring, and consumers have to start spending. At the moment the only part of the economy preventing collapse is the government. But the cost is monumental: if other sectors don’t get involved soon our prospects dim markedly and next year will be grim.

“Let me leave you with one thought to ponder this weekend: should we nationalize California?”

Having said that most people, including myself, still think that the most likely course for GDP is a very modest improvement in the fourth quarter this year followed by slow to moderate growth throughout 2010.

Plenty of things could derail the recovery, but here I want to focus on the ‘big issues’ still facing us as we clean up our mess:

  • The banks. We now have three kinds of banks. Those that are dead in all but name. Those who are alive, but too small to be bailed out. And the behemoths who could destroy us all any time soon. Citibank and Bank of America are the obvious examples of ‘dead’ banks. They exist at the whim of the taxpayer. Neither is making much money, and both are very vulnerable to any sort of new credit default increase stemming from the economy’s intractable unemployment outlook. Both will remain effectively nationalized for some time: it was revealed only this week that B of A has been operating under Fed ‘Memorandum of Understanding’ [‘MoU’] for a while. An MoU is a very severe form of regulatory censure that essentially forces a bank to take steps to remedy problems – presumably the regulators thought the bank was moving too slowly to rectify its more glaring issues, like the inadequacy of its management. As for ‘poor old Citi’ – well enough said. The sooner they tear that place apart and make it manageable once again the better.
  • I feel bad for the medium sized financial firms. No cares about them anymore. We seem to have run out of both patience and money, so any smaller bank that gets itself into trouble will most likely have to go through bankruptcy. Ultimately I think that’s a healthy situation: the sooner banks have to behave sensibly and manage risks with a view to absorbing the consequences of failure, the better off we will all be. Banks are an essential part of a capitalist economy, but they cannot be allowed to exploit taxpayer fear of a banking system collapse to feather their own nests. They have to understand that our guarantees come with strings: like really intrusive regulation.
  • And I mean intrusive. Which gets us to the big question: is anyone going to rein in the behemoths? Right now it appears not. There is now a ‘big two’: Goldman Sachs and JP Morgan Chase, both of whom are taking full advantage or our largesse in order to lard their own pay. I find it astonishing that these two organizations are so socially insensitive that they announce record bonus awards while millions of regular Americans are being fired as a direct consequence of the ineptitude and greed of the big banks. And let’s be clear: the banks were right in the center of the collapse. Their folly and obscene risk taking was a root cause of our crisis. For these two banks to profiteer so openly and greedily at trough of public fiscal and bail out cash is a horror to watch. It simply reinforces my thought that bankers at these places are too arrogant to be trusted: they are willfully exploiting their status as ‘too-big-to-fail’ to game the system and privatize all the gains while shoveling the losses our way. It has to stop.
  • But it won’t. The reason these two behemoths survived as well as they did was not simply skill. They are also incredibly well connected politically. Both have their fingerprints all over the administration’s reactions to the financial crisis: Bear Stearns, and AIG are the prime examples.
  • The lesson? We will not achieve long term GDP stability with our current economic and regulatory framework – the big banks must be tamed, at whatever the cost. Otherwise they will have captured us in true ‘oligarch’ style. An example? The ‘Sovereign Credit Default Swap’ market. Sovereign CDS’s are a stupid concept: they are insurance policies against the default by a national government. They make sense only in emerging world economies. But the market that has ‘recovered’ is that for US and UK CDS’s. There can be nothing more indicative of the speculative nature and gambling tone of the big bank trading desks. My question is this: if the US government defaults on its debt – which what some of these traders are insuring against – which bank will be liquid enough to make good on the insurance? By the time the US government goes down the entire credit system is most likely gone before. The only reason to buy this rubbish is to gamble. This is just one example of the folly that pads the profits of the behemoths. They are taking huge bets, knowing we will clean up after them. As I said: this has to be stopped.
  • My suggestion? Enforce huge capital requirements against all derivatives. In some cases really marginal derivatives should carry a capital requirement of more than 100%. I am all for financial innovation, but these schoolyard yahoos are not innovating they are playing games with our money. So we should put a burden on them: innovate all you want, but some of these products are beyond the pale. Some should be publicly ‘non-guaranteed’ – meaning a failure in its market would not be seen as as reason for bail out. Or they should be covered by huge capital burdens. Preferably both. Only by deliberately withdrawing our guarantee of the gambling can we impose discipline on the children on those trading floors.
  • Now: health care. There has been a lot of discussion about the costs of reform. Most of the information I have seen quoted is simply right wing rhetoric. The Congressional Budget Office has now ‘scored’ the proposed legislation and come up with a cost of about $1 trillion over ten years. In my view that’s cheap. The Bush tax cuts cost us about $1.7 trillion. The difference between the two is not just that health care is cheap by comparison, but that we are actually getting something for our money! The Bush tax cuts went predominantly to the top 5% of taxpayers – a very small number of citizens – whilst the CBO estimates that about 35 million people will benefit from health care reform.
  • I have mentioned this before, but rationing is a red herring in the health care debate. We already ration health care. All we are discussing is how to alter the way in which we ration it. In this vein I highly recommend Peter Singer’s recent New York Times article on rationing. Singer is a philosopher who deals with ethics and all the complications associated with making ethicalchoices. His article cuts away the garbage from the ‘rationing’ canard.
  • Getting health care reformed is essential not just from a public policy perspective, but from a GDP perspective. We allocate way too much of our annual wealth to health care. In order to re-establish our competitive position and in order to be able to invest in future oriented and wealth generating assets like education, we need to disinvest in health care. So cutting costs is vital to our economic health. The first step towards cost cutting is to get a viable public option in place to break up the health insurance pricing cartels that exist in most states.
  • Finally in todays round-up: the Fed. Next week will provide a big moment in this crisis. Bernanke is going to testify before Congress about his plans to undo some of the massive and highly unconventional things the Fed was forced to do in order to stave off depression. Unwinding the Fed’s balance sheet is primary within that.
  • Under ‘normal’ circumstances the Fed has a very small balance sheet. This recession it was forced to ramp up its assets so it could pump reserves into the banking system. The problem is that these reserves could result in inflation once the economy gets going again – don’t forget that I don’t think there is any danger of inflation just yet because the economy is so far below capacity. At some point, hopefully not too far off, the economy will be growing and those extra reserves will need to be drained back out. Since the pumping-in process was so unconventional and unprecedented there is huge doubt about the Fed’s plans to reverse course: both from a timing and practical point of view. So Bernanke is scheduled to explain how he proposes to do that ‘draining’. But, and please mark my words, he will absolutely not be talking about when the draining will take place. I am sufficiently skeptical about the ability of the media to differentiate between the ‘how’ and ‘when’ questions that I expect a flurry of articles on Thursday next week expounding on disappointment or confusion about what Bernanke has just said. Right now all we sensible folk need to know is how he can roll back his monetary support. As long as he explains that we will be happy.
  • Lastly on the Fed: There is significant opposition brewing towards the administration’s plan to give the Fed a much larger role in the new financial regulatory set up. This opposition is led by people like Paul Volcker. I am on the side of the opposition in this one. One of the few inarguable facts to emerge from this crisis is that the Fed’s ability to analyze, let alone regulate, the big banks and financial markets was flawed. the analysts there are exceedingly bright people, but they are of the same mindset as those in the banks. They all believe that same economic theories and the technologies that rely upon those theories. Consequently there is no renegade view and no heterogeneity of opinion. Or not enough. In contrast the Fed gets very high marks for its monetary policy in the crisis itself. So my vote would go to a reform that reduces the Fed’s regulatory role and which leaves it to focus on monetary policy. This is not what the administration is pressing for. Like so much of what the Obama team proposes their reform is a ragbag of bureaucratic kluges. It is not reform. Let’s hope the opposition wins on this count.

Let me leave you with one thought to ponder this weekend: should we nationalize California? The parallels with GM are extraordinary. Years of bad management. Horrendous financial outlook. Total lack of willpower to resolve its own crisis. And now it has been forced to issue IOU’s to ‘pay’ its creditors. the place is a terrible mess. I have no idea about how we do this: but yes, we should nationalize California.

Enjoy the weekend everyone.

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    Bank Profits: Fair Game For a Special Tax?

    The record revenues and profits being reported by JP Morgan Chase and Goldman Sachs ought to have made you think a little about the nature of the banking industry.

    I applaud anyone’s ability to make profits – that’s why these folks are in business – but its a little unfair that they are doing so well on the backs of the taxpayers. So I suggest we all start lobbying for a special tax on these profits by way of clawing back the cost we have all borne providing both these giant organizations with a risk free zone for money making.

    Risk free? Well sort of.

    Neither Goldman Sachs nor JP Morgan Chase is as smart as they would have us believe, and those massive bonuses they are getting set to pay out are not as deserved as all that.

    This is because we taxpayers have removed the downside risk by guaranteeing that banks as large as these two are will never fail. So both are free to go about their business in the most carefree fashion and take as much risk as they like. They can foul everything up and yet know they will survive. There is no market discipline on them despite the fact that both constantly laud the free market system and beat the drum for competitive capitalism. The truth is that neither is doing business in the world they describe. They are coddled and protected oligopolists who have been able to gobble up weaker competitors and have thus grown to become not just ‘too big to fail’ but even bigger than that.

    Case in point: JP Morgan Chase’s earnings jumped in part becauseof the contribution made by the business lines added after the absorption of the old Washington Mutual.

    Any CEO can look really smart if the regulators avert their eyes to the kind of industrial concentration we have just gone through.

    And: those great trading and speculation profits? They are inflated by the same kind of process. The industry lost two of its largest players last year when Lehman and Bear Stearns imploded. That has left easy pickings for the survivors who are benefitting not just from the lack of competition, but also from the incredibly easy monetary regime we are having to sustain in order to pull the economy from the wreckage the banking industry created. Wide spreads and risk guarantees are the stuff trader’s dreams are made of. We are providing them a feather bed equivalent set of trading conditions: if they weren’t making record profits I would be concerned about their ability.

    So: if we taxpayers are underwriting the world in which these banks are making such profit, and if we only doing that to save the economy from the mayhem these same folks created last year and the year before that, I see no sensible reason why we shouldn’t say ‘well done guys’ and then ask them to ante up an appropriate compensation for our continuing assistance. After all we are essentially partners with them. We deserve a return on the risk guarantee we are providing.

    If you are skeptical think of it this way: were the risk guarantee to have been provided by an insurance company – let’s call it AIG – none of us would be surprised to learn that the insurance company demanded a fee for such a service. That’s good business. And very normal in a financial market. So why not us too? If the word ‘tax’ puts you off, then let’s just call it a ‘fee’.

    They are making record profits because we are creating the conditions in which that is possible. Further we have let it be known that they can take inordinate risk, and thus make extra profits, because we will not let them fail. That’s about as explicit a risk guarantee as it can be.

    What makes it even more urgent that we get paid for our help is that these people are about to reward themselves record bonuses – I demand that we get our bonus too.

    So are those record profits fair game for a special tax fee?

    Absolutely.

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    Uncertainty, Uncertainty, Uncertainty

    Well I think it’s safe to come out now. The threat of another depression has passed. Phew. Now comes the hard part. The odd thing about where we’ve just been is that in the depths of the last few months it was easier to act: thinking too far ahead was pointless and formulating proper reforms or corrective policies was just not appropriate. There was simply too much uncertainty.

    “Without a fix for the banks we will absolutely be headed back into dangerous gambling soon, but this time without the resources to fix it. That way lies the road to depression.”

    Now, from my point of view, uncertainty is the dominant theme in any economy. It is concern over the unknown that compels us to save and to form businesses that can undertake long term projects. Indeed from a theoretical perspective a business firm is simply a ‘hedge against uncertainty’ – as described by the economistBrian Loasby. Money is also such a hedge: we use money as a way to avoid having to barter and as a way to store value for future use. Money has no intrinsic value other than what it can be exchanged for, so keeping or setting aside a cash store in savings etc can be viewed either as a way to postpone current consumption for the future, or, alternatively, as a measure of the uncertainty we have about our ability to pay for future consumption.

    So everywhere we look uncertainty affects the way we construct our economic lives.

    I mention this because as we emerge from the storm of the past year one key factor seems to stand out: the dramatic drop in confidence, or conversely the dramatic increase in uncertainty, that has settled in on the economy.

    This might appear odd in the context of the revival of the credit markets which is one of the clear signals that the storm is abating. It is true that the financial world has lost much of the panic feeling that gripped it over that past few quarters. Banks have been able to issue equity; spreads are returning to more normal levels; bank profits are rising; and capital ratios are not declining, but are fairly stable. None of this implies that the system is repaired, but it is on its way to recovery. The banks are back to having fun. We are left to clear up their mess. Confidence is creeping back on Wall Street. That’s not our issue just yet.

    No. The uncertainty that has risen is on the consumer’s side of the economy. There has been an enormous shift in private savings. Looked at as the difference between private incomes and private expenditures, savings have gone through the roof. This implies an enormous contraction in consumption. And I mean enormous. Were it not for the extremely large increases in government spending we would most definitely be in the grips of a full depression at the moment. The contrast with the 1930’s is extraordinary: the rise in savings back then was less than our current shift. This means that we were on course for a worse depression than the Great Depression. It was, and still is, that bad.

    I say ‘still is’ because the shift towards savings, which has been advocated by many of us for a very long time, has been so sudden, and violent, that it risks completely dampening the recovery. There is no doubt that we need to unwind the overhang of debt that we gorged on over the past few decades. One of the reasons I regularly harangue the Reagan/Bush era is that the economy was encouraged to rush into indebtedness in order to mask underlying weaknesses. The moment Reagan filled the country’s imagination with hazy visions of yesteryear he led it away from fixing its issues. Those rose tinted glasses created an illusion that prevented a proper understanding of long term problems then emerging. And so a very imbalanced economy was created: loss of long term competitiveness and growing foreign oil dependency were ignored; stagnating wages and rising health care costs were glossed over; and the fact that many people had to borrow to stave off a declining standard of living was seen as a sign of optimism about the future, rather than a sign of something going badly wrong.

    The final nail in the Reagan/Bush coffin came when massive inflation in home prices was seen as a source of wealth rather than as a destabilizing social force. The prevailing, and hopelessly wrong, economic thinking that pervaded the whole Reagan/Bush era missed the danger of the real estate bubble precisely because it saw no bubble, just ‘exuberance’.

    The consequent implosion, which contrary to the opinions of many in the media, was foreseen by many of us, has now manifested itself in the shift towards savings I mentioned earlier.

    Uncertainty indeed abounds.

    Couple the huge blow to confidence that a 30% to 40% drop in home prices has dealt, with a bleak long term employment outlook and it easy to see why consumers are saving at the rate they are. Who knows what could happen next?

    The bad news is that the total debt level of the private sector is down only a couple of percentage points from its high back at the beginning of 2007. That implies we are likely to experience this rate of savings for a while longer as de-leveraging continues.

    The conclusion I come to from all this is that the recovery will be long and very slow. Unemployment will stay high, and most likely increase over the next few months.

    And the hard part is just beginning: we still have not dealt with the insanity of the banking system, which, if Goldman Sachs performance is anything to go by, is about to head straight back to the recent past and try to replicate its bad habits for huge private gains. There are no signs of lessons being learned there, just rampant opportunism safe in the knowledge that the taxpayers will pay the bill for the next catastrophe the banks heap on us all.

    Plus the epic fiscal effort we have had to make to stave off total disaster has left us with a Federal deficit problem that will need urgent attention in the medium term.

    Without a fix for the banks we will absolutely be headed back into dangerous gambling soon, but this time without the resources to fix it. That way lies the road to depression.

    As I said: uncertainty, uncertainty, uncertainty.

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    Do Not Trust the Big Banks

    Amid the clamor over health care and all those green shoots the fate of the big banks has faded from the public glare. This has led to a complacency in the analytical and media: the general feeling seems to be that the banking crisis has abated and that we can ‘check it off’ our list of things to worry about.

    Not so fast.

    Do not trust the big banks.

    “… we can predict anti-social behavior. Proof: bumper pay checks even amongst banks still on taxpayer life support, and increased intensity of lobbying against reform. The big banks are back to their old tricks”.

    Their balance sheets are still rickety. More to the point: no one really knows what they’re worth.

    Let me recap:

    • The administration has adopted a passive approach towards big banks: the hope is that, given time, they can earn enough profit that capital ratios will gradually move back towards sensible levels and that the banks can repay TARP money.
    • Such an improvement will encourage private investors to buy whatever stock the banks decide to sell, and so capital will be restored even more quickly.
    • As proof of this approach: the banks reported generally good earnings in the first quarter; most have managed to raise extra private capital; and many are now repaying TARP money.
    • Couple this with the whole stress test process that supposedly gave an objective kick of the banking tires, with a publicly reported set of results and a standard set for capital and earnings soundness, and we are entitled to believe things are progressing nicely.

    Except that:

    • Much of the first quarter profit was specious: accounting wheezes and trickery helped boost ‘earnings’ at most of the big banks, so those results are not indicative of sustainable profitability.
    • Similarly some of the capital that has been raised has simply been through conversion of preferred stock into plain equity. To the extent this is the case the banks actually have no new capital, all they have done is to allocate existing capital to a bucket that looks more solid.
    • There are fewer banks. Let’s not forget the crazy days back last year when big banks like Bear Stearns and Lehman folded. The market is much more concentrated. The oligopoly is stronger. So spreads are wider. This is a positive for bank earnings, but it makes controlling the survivors even harder: if they were ‘too-big-to-fail’ before, they are certainly too big after.
    • That means we can predict anti-social behavior. Proof: bumper pay checks even amongst banks still on taxpayer life support, and increased intensity of lobbying against reform. The big banks are back to their old tricks.
    • While both Goldman Sachs and Morgan Stanley have ostensibly changed their ways and become Bank Holding Companies – and therefore regulated a such – their actual mode of operation is unchanged.
    • If anything the incentive to take extraordinary risks has been increased. The administration’s unwillingness to liquidate a large bank has emphasized the extent to which the big banks are beyond control. They now know for certain that they will not be allowed to fail, yet there is no limit on their activities. All the risk lies with the taxpayer and all the gains lies with the management and shareholders. This means there is another bubble in our future [emerging market debt looks as if it might be it].
    • And if this is not enough to scare you: those stress tests were a joke. The oncoming wave of commercial real estate and credit card losses will disrupt any earnings growth the big banks have. Much of the commercial real estate mess will occur out in 2011 – beyond the horizon for the stress tests. Plus the worst case scenario within the tests is beginning to look tame: unemployment seems headed higher than imagined.
    • Finally, those toxic assets are still lurking on the balance sheets of most big banks. They appear less toxic only because accounting rules have been relaxed which produces an aura of improvement without altering the underlying economic reality.

    So while its fun to be diverted from the annoying hubris of Wall Street and all the puffed up egos that still inhabit its trading floors, we should be acutely aware that not much has changed. It is still quite possible that credit conditions could worsen again. While each day that appears to be less the case there are serious potential sources of difficulty ahead. The aforementioned commercial real estate mess for one.

    Most of the big banks are now so large that they mirror the broader economic conditions. Their core earnings ebb and flow with the economy. In that regard they are fairly benign, except that the most likely economic scenario is one of very poor growth over a period of years. In that case the big banks are likely struggle to perform well and thus will take a long time to recuperate fully. This lingering and slow recovery will inhibit the flow of credit into the economy, and so our growth prospects will be even further diminished.

    The real problems, though, are elsewhere: it is their gambling trading profits that tend to make them lurch around like drunken sailors, so the goal of bank reform should have been to take the bottle away. But it won’t. As long as the taxpayer is dumb enough to pick up the pieces, traders will gamble to their hearts content. One day soon they will assuredly screw up again.

    As I said: do not trust the big banks.

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