Goldman Sachs

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Unstable Banking

What to do about the banks?

Those of you who have read my comments on health care know that I believe any proper regulation of a system -heath care or banking – requires a set of incentives designed to induce the desired behavior. This is the way in which we can align behavior with socially acceptable outcomes. I have discussed that with respect to health care ad nauseam, but have so far not talked about it in terms of banking.

So here goes.

Let’s start with the basics:

  • Banks areinherently risky. There is no way to have a bank system that is not riven through with risk. The whole purpose of a bank is to ‘mediate’ or translate short term deposits and liabilities into longer term assets like loans. The risks there are obvious: there is a risk of not being repaid, in which case the bank still owes its depositors but has no assets to turn into cash so it can repay them; and there is time dependent risk, this is when interest rates on deposits, because they tend to change frequently – they are short term don’t forget – end up being higher than the interest being earned on the assets, in which case the bank loses money on its assets even tough they end up being repaid. These are the two major risks banks undertake in the normal course of business.
  • Banks mitigate these risks by trying to understand the chances of default: they check credit scores, they model likely outcomes, and they go over the books of the businesses they lend to.
  • They also try to match the cash flows of their assets and liabilities on their balance sheets to reduce interest rate risk.
  • And they keep a pot of capital they can dip into in case of emergency so that they can write off bad assets rather than take a loss on their annual income statements.
  • In order to have this emergency pot of capital banks regularly set aside, from their annual income, a ‘reserve’ for potential loan losses. This reserve, plus the accumulated profits and shareholder capital, are the buffer that prevents a bank from losing money even when its assets go bad.

So that’s the essence of banking.

The problems get deeper when we realize that the ‘spread’ between the assets and liabilities, that is the difference in interest rates a bank pays its depositors and what it charges its borrowers, is normally very thin. Banking can be very expensive: all those branches are costly to run, the infrastructure to account accurately for all that money is very expensive because it has to be close to flawless, banking is people intensive, credit analysis and data gathering cost money, and so on.

To pay for all this overhead banks don’t simply lend out dollar for dollar what capital they have – that would never cover the bills. Instead they borrow even more and lend that money out too. In other words their liabilities are not simply capital owed to shareholders, but also a variety of creditors: depositors like you and me, other banks, the Federal Reserve Board, and bondholders etc.. This piling on of other liabilities in order to expand the pool of cash that can be lent out for profit is called ‘leverage’ in the US and ‘gearing’ in the UK. You ‘lever up’ the profit opportunity.

This is where things get dodgy. And this is where incentives come into play.

Before I go into the details let me recommend the academic paper that provoked my thinking on this. It is byLucian Bebchuk and Holger Spamann of the Harvard Law School. For those of you involved in bank regulation it is worth the time. Plus it’s free.

Back to incentives:

Shareholders sit at the bottom of the liability heap. If the bank simply uses its capital pool to generate assets it will make very little money. So the shareholders have every incentive to pile on as much leverage as possible. The more leverage the more profit and therefore the higher the ‘return to equity’ [‘ROE’] generated. Shareholders love high ROE’s because that’s what flows through to their pockets. And an easy way to pump up ROE is to have as little ‘E’ as possible per dollar of assets.

Let’s illustrate that: an income of $10 on $100o of assets provides a 10% ROE if there is equity of $100 supporting those assets, but 20% if there is only $50 of equity. In the first case there is a ten to one relationship between equity and assets in the second case twenty to one. Further: in the case of 20:1 leverage a bank with $100 of equity can have $2000 of assets whereas at 10:1 it can have only $1000.

So shareholders love leverage: it can make them rich.

They love it so much that before this last crisis many of our leading investment banks had leverage ratios in excess of 30:1. Their ROE’s were fabulous.

Bankers love leverage also.

They get paid for all the cash that the leverage produces. The income potential obviously goes through the roof if you are highly leveraged. that means the bonus polls go up too. As I said bankers love leverage just as much as shareholders.

Neither shareholders nor bankers have much downside in this leverage game. The shareholders have at risk only a small portion of the total liability base of the bank: their downside is limited at their equity stake. The creditors have far more at stake. In a bank with leverage of 30:1 for each dollar the shareholders stand to lose, the creditors stand to lose twenty-nine. The bankers themselves stand to lose their bonuses and, you would have thought, their jobs. While that may sound drastic it pales in comparison to the plight of the creditors.

So the basic incentive structure of banking is not just to take risks, but to take enormous risks. The payoffs are gargantuan while the losses are limited by comparison. Bankers and shareholders are playing with other people’s money. Inevitably this will lead some bankers to cross the line from judicious risk taking into outright gambling.

That’s fine when only a few rogues do it. It is disastrous when the entire system does it.

Unfortunately our entire system went on a gambling binge and lost.

Some of them lost their jobs, although not many – which I find outrageous, and the shareholders of the likes of Citibank and Bank of America lost their stock value. You and I lost billions.

Why?

Because the incentives are all screwed up.

The risks I mentioned at the beginning – of default and interest rate mismatching – pale in significance when compared with the risk introduced by excessive leverage. The problem is that while banks may feel obligated to manage the first two risks because they can’t earn profits unless they do, they have much less incentive to manage leverage risk. On the contrary they are impelled by the profit motive to let it rip. They are behaving entirely rationally when they have 30:1 ratios.

This leads us to a vital conclusion: financial markets are unstable. AsHyman Minsky taught us, or rather taught those who paid attention to him, financial markets are prone to regular disasters. It is an inherent property of finance.

Why is this?

Minsky’s hypothesis is that as bankers observe stable economic conditions, say during a boom, they will naturally feel able to take on more leverage: they are like gamblers on a roll at the casino, they keep upping the ante. The problem is that bankers, when they ‘up the ante’ are creating liquidity: they add to the economy’s store of money by making loans. Remember they are using the same level of capital to make more loans [or other assets like mortgage backed securities etc], so the economy itself becomes less secure: there is less capital backing a larger volume of business. Eventually, according to Minsky, this gambling will implode. Something will cause the edifice to topple over and all that leverage causes cascades of losses through the economy.

This is why Minsky talked of stability leading to instability. He was right.

Wait it gets worse:

Because banks lend to each other one bank’s problems with defaults becomes another banks problems. If bank ‘A’ – let’s call it Bear Stearns – has a problem and has borrowed tons of money form bank ‘B’ – let’s call that one Bank of America – then Bear Stearns inability to pay back its creditors now becomes Bank of America’s default risk. And since Bank of America borrowed from bank ‘C’ – let’s call that one The Royal Bank of Scotland – the ripple effects trickle through the entire system. Actually they don’t trickle they get amplified: banks behave in herds, they tend to do the same things at the same time. This is entirely rational because they are all reacting to the same information. An impending Bear Stearns implosion causes everyone else in the game to retrench. This simultaneous retrenchment causes them all to call on Bear Stearns for repayment, which creates a ‘run on the bank’ for Bear Stearns who then goes bust since it has nowhere to get funding.

Why can’t Bear Stearns go to the Federal Resere Board for funding?

Because it is not regulated as a bank. Deregulation, absence of regulation, and poorly enforced regulation have left vast financial organizations with trillions of creditors and assets sitting outside the banking systems: Goldman Sachs, Lehmann Brothers, Bear Stearns, GMAC, Countrywide, Morgan Stanley. A veritable rogues gallery of massive risk takers and gamblers, none within the system. None officially able to get backing from the Fed in times of crisis, and so none immune to a ‘run on the bank’ situation.

No problem you might say: let them go bust. The taxpayers are not on the hook because they are outside the New Deal era safety net.

Umm. Not exactly.

Those creditors. Some are within the safety net. If Lehmann is allowed to go belly up, heck the free market should be set free, then who cares?

Well apparently everyone. The entire system crashed. Welcome to another risk: systemic risk.

The entire world came close to an end.

Most of our big banks within the system lost their shirts. We had to step up and bail them out. Not just this, but we ended up bailing out organizations not in the system. Goldman Sachs got a free ride. We bailed it our even though it never had to conform to any rules. Lucky dogs. Welcome to yet another risk: the public guarantee risk which induces even more instability since we provide a nice net for the gamblers to fall into so they don’t hurt us too much when their gambling fails.

Worse yet: Goldman Sachs is on the brink of its most profitable year ever. Courtesy of taxpayer money that stabilized the financial system, and benefitting from the continued guarantee that no ‘too-big-to fail’ bank will be allowed to go bust – memories of Lehmann haunt us – it continues to play with other people’s money and will pay record bonuses this year. And many of its ‘top’ employees will moan and complain over their fancy drinks about the nerve of the administration bailing out GM.

The lesson to learn from all this is that incentives matter. They override all else.

If Minsky is correct, and I believe recent history proves he is, then stability does indeed lead to instability.

And since you and I end up underwriting the cost of the instability part – think ‘bail outs’, but don’t profit from the stability part – think bonuses, we have an incentive to limit the damage the bankers can do to us.

If, as I have tried to explain, the natural incentive structure of finance is to encourage wild eyed gambling on the part of bank shareholders and bankers, and if we feel the need to continue to maintain our guarantee of the gambling – which I feel we should to limit the damage these yahoos create – then we need to have rules that they should play by. That way we can take the toys away when we need to. We intervene and tilt the incentive structure towards socially acceptable behavior. You know: of the kind where these cowboys don’t scupper the entire economy in their quest for the next quarter’s big bonus payment.

So when we debate the upcoming reform of banking, we should all pay attention to the way in which its provisions compensate for the skewed and anti-social behavior that the incentive structure of the market produces.

That means addressing banker pay and bonuses, and the size of banks.

Unfortunately, even though the proposals acknowledge the role of both in creating the crisis, it leaves very vague what we should do about them.

That’s why I am not a fan of the administration’s efforts so far. They talk a good game, but are very tentative in action.

Meanwhile those incentives look set to cause us trouble again sometime soon.

Addendum:

A special nod to John Fleming for correcting the math in my little example. Perhaps silly math is why I liked banking?

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Lame Bank Reform

Allow me to rant:

We deserve better than this. We really do.

We have now reached that part of the Obama administration’s agenda where we can start to assess the reality of the intent to introduce change. The core of the next few months, and perhaps the entire first term, rests squarely upon the nature of the reforms being introduced for health care and banking. Is Obama shooting for FDR status and enduring legacy, or is he content with a more modest agenda.

It’s too early to tell with respect to health care, which is a subject that Obama must have been wrestling with for a long time. But as for banking reform: he is no FDR. The announcement today outlines a bureaucratic rather than robust response to the central cause of our crisis: the systemic failure of finance.

This is very disappointing.

“Most of the true innovations in finance occurred before this explosion: ATM’s, and debit and credit cards are obvious examples. They are actually useful. That other stuff? Junk. No use except to generate fees and bonuses. What Minsky would call Ponzi finance. Therefore not just rubbish, but dangerous rubbish.”

Let’s start by recalling what went wrong:

  • We walked away from the safety and soundness doctrines introduced after the Great Depression.
  • We substituted market forces for regulatory constraints.
  • We relied on ‘self-regulation’ and ‘personal ethical standards’.
  • We became lax in enforcing what rules were left.
  • We encouraged innovation in finance, but never monitored its value.
  • We ignored the concentration of power and influence in the major banks.
  • We allowed Wall Street to push aside the main street banks in core financial services.
  • We extended the government safety net into Wall Street activities.
  • We ignored asset price inflation.
  • We ignored the steady ratcheting up of risk and leverage caused by competition and lax oversight.
  • We ignored the absence of objectivity of the rating agencies.
  • We ignored the effects of a disconnect between performance and reward in Wall Street compensation.
  • We forgot all the lessons of the Great Depression.
  • We relied on false economic theories.
  • We forgot that extending a safety net to huge banks without constraining them produces moral hazard.

We became fat, happy, complacent and far too reliant on short term memory: we ignored history. Which as we all know condemned us to repeat it.

In short, we screwed up royally.

We had a self induced systemic melt down of historic proportions.

The upshot is that we tore apart the firewall FDR built around the financial system and replaced it with an odd combination of big government subsidies and safety nets to banks, reduced oversight, deregulation, and quiescent or benign attitudes towards obvious excesses. This was Big Government and NeoCon thinking all rolled into one. It is a sure sign of the extent to which financiers captured control of the legislative and oversight systems that no one noticed the contradictions. The wool was pulled firmly over our eyes, while to corrupting power of big money ‘free speech’ did the rest.

Ah! But the market is always beneficent. It is efficient. Rational. And so so special that we had better never get in its magical ability to innovate.

Like credit default swaps on treasury bonds. Or reverse convertible stocks. Or all that jumble of derivatives. Or sub-prime mortgages. Innovations one and all.

Most of the true innovations in finance occurred before this explosion: ATM’s, and debit and credit cards are obvious examples. They are actually useful. That other stuff? Junk. No use except to generate fees and bonuses. What Minsky would call Ponzi finance. Therefore not just rubbish, but dangerous rubbish.

That’s the unfettered financial market at work.

Ugh.

The plain fact is that financial systems simply do not conform to the economics text book model of equilibrium seeking. In fact they have an ugly tendency to veer off course and spin violently into unstable and destructive mayhem.

Bankers need to be kept firmly in a box. We should never, ever, let them play with the matches of financial innovation without firm parental controls in place.

This observation is not new. Keynes, Minsky, and others like Mandelbrot and Roubini have talked about the inherent instability of finance before. We forgot or ignored their work. We had to learn or rather re-learn their insights for ourselves.

Which we just did.

Given the epic destruction of wealth that the financial system just wrought I would have thought that draconian efforts would be made to re-erect a wall around it so it cannot repeat itself any time soon, if ever. This is especially so given the sterling work of analysts who have studied the outcomes of financially induced recessions: all studies point to the massive devastation such recessions cause. Financially created recessions are far more severe, last longer, cut deeper, and destroy more wealth than other recessions. This should cause us to re-double our efforts to take the toys away from the superannuated children who prowl around Wall Street.

So. Is this what we got?

No.

Instead we have a financial regulatory reform proposal that plays lip service to some of the key things we need to eliminate.

But let me be fair. The paper has some merit. It attempts to throw a rope around ‘systemically’ dangerous companies. These are the ‘too-big-to-fail’ businesses that threaten to wreck the economy every time they sneeze. The good news is that the administration wants to place such dangerous firms under stricter control, with tougher capital standards and central supervision. It even wants, if I read the text correctly, to extend regulation to all financial firms, not just banks, who could wreck our economy. Don’t forget that it was in this ‘shadow banking’ part of the system that the really big problems cropped up.

Great. But if these businesses can really destroy us, which they just proved is the case, why let them exist at all? Why isn’t ‘too-big-to-fail’ simply ‘to-big-to-exist’? Why is it that we tolerate the cuckoo in our nest? Have we no say in this? Or have we lost control?

At least the proposal sets up a method for government seizure of these dangerous behemoths. It was because there was no law allowing such seizure that AIG was dealt with in the ad hoc way is was. Such a new power would be very useful: Citigroup needs to be seized. But the issue is not getting the power, it is having the will to use it. The tone of this proposal suggests we may have to wait a while for that will to pop up somewhere.

Next up. I like the idea of coordinated oversight. It’s about time. But why walk away from regulatory consolidation? Are we scared of our own bureaucracy? Make the oversight agency big enough and tough enough to stare down the big shots at the big banks we have admitted we can’t downsize. Put the entire thing under one roof and do away with the unseemly regulatory turf fights and public spats that have bedeviled recent efforts to get a coordinated approach.

As for derivatives. When folks like George Soros and Warren Buffet say that derivatives need to be either eliminated or severely reduced I take notice. So why just set up an exchange? Why just forbid trades by ‘unqualified people’? Given the performance of the geniuses who invented the mess I doubt whether any of them are ‘qualified’. Tell me: were the people who built the AIG book of credit default swaps qualified or not? These are the very clowns who destroyed our economy and we are restricting the derivatives business to them? That makes me feel a lot safer.

Don’t get me wrong: I am all for ‘transparency’. Which is essentially what’s being proposed as the cure for the mischief wrought by derivatives traders. But there’s transparency and then there’s transparently stupid. Much of the so-called innovation that Obama wants so dearly to protect falls squarely into the latter category. Market forces didn’t root them out in the past, what makes us sure that they will in future?

As for the Consumer Safety pieces of the proposal: good idea. But we need to extend product oversight beyond consumer protection. It was the professionals who sank the ship. They had no clue what they were buying either. We should keep the gunpowder from them too. I understand that consumers need better protection against all those terrible mortgage products that implode at the slightest interest rate hike, but what about credit default swaps? Will we see better standards there too? I suspect the administration thinks its new derivatives exchange will accomplish that. That market magic once again.

And I like the notion of making sure asset generators keep some ‘skin in the game’ when they package up and securitize those assets. But 5% is anemic. They should be forced to keep 10% or even more. One of the great mistakes the market made was to think that securitization spread risk. It didn’t it concentrated it. Plus it separated the ultimate asset owner from the debtor. Hence the problems in the mortgage market and trying to induce mortgage owners to renegotiate the loans rather than simply foreclose on them: they have no idea who the borrower is and they don’t have any expertise in mortgage lending. They merely own paper. This is another ‘innovation’ we could do well without.

Another good part of the proposal is that it shoots at the silly notion being promulgated by right wingers that somehow the Community Reinvestment Act [‘CRA’] created the sub-prime mortgage debacle. This is scurrilous nonsense. The sub-prime market was built mainly by businesses not covered by the CRA. More to the point the CRA had been around for almost three decades prior to the invention of sub-prime mortgages. It is an absurdity to try to pin the disaster on CRA. At least the proposal acknowledges that.

Finally: why no word about compensation? I suppose that’s become taboo already. The plain fact is that the incentive structure in finance drove anti-social behavior. Short term gains were paramount. Long term losses were left to the taxpayers. By offering unlimited guarantees to the entire industry we let them gamble with our money. They set up their compensation to benefit, while shareholders and ultimately taxpayers were assumed to carry the losses. There are very few impoverished bond traders, even today, but there are tons of regular folks paying a huge price because the boys had no limits set on them. At a minimum bonuses should be limited to stock payments and spread over very long terms. No trader should ever collect an annual cash bonus again. Incidentally I have argued this one before: the whole thing unravelled even faster once the old time partnerships converted into public companies. They kept their partner style pay methods but no longer had any significant personal risk. They pretended to be partners still, but they were actually bureaucrats. Entrepreneurs and equity partners can gamble all they like: it’s their money. Bureaucrats should never gamble the way the managers of Bear Stearns, Lehmann Brothers, Goldman Sachs, Morgan Stanley did. So compensation is a big deal. Getting the incentives aligned should be a major legislative priority. This proposal fails on that count.

Obama was careful in his introduction of the proposal to pay homage to market forces. That’s all we need to know. The administration’s heart simply isn’t in this one. The bankers still have too much influence , and the administration is littered with market apologists.

The proposal is being presented as a major effort. But it seems more window dressing than profound course change. It certainly pales in comparison to the sea change that emerged form the New Deal era.

Perhaps this is all politics: the hope is that the regulations will emerge tougher once Congress gets involved. Perhaps Obama fears that he cannot get tougher laws passed. He may be right: already even some Democrats are taking pot shots at the proposal. But that merely makes my case: bankers can pour tons of money into politics. They have legislative muscle. They have captured the system to prevent a loss of power. Which is why stronger reform is needed.

My prediction:

If this is all we get, then there will be a new bubble. All we are doing is putting the boys on a short term probation. We are not stopping the game.

We deserve better than this.

So ends my rant!

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Banks To Repay TARP Money

The Treasury Department has approved the plans of ten banks to repay the TARP money they received as part of last year’s bailout of the banking system. The total cash going back is $68 billion, which can either be lent out again if the need arises or simply be used to reduce the government’s need to borrow from somewhere else.

In one way this is a good sign. Obviously the administration has more confidence in the banks than it did even a month or so ago. The names of the banks has not been released officially but reports suggest that JP Morgan Chase, Goldman Sachs, American Express, and Morgan Stanley are among them. Citigroup, Wells Fargo and Bank of America are not.

The banks have wanted to repay the government since they all passed the stress tests performed a month or so ago. Continued use of TARP money meant that they were subject to restrictions on the way they conducted themselves. All the banks chaffed at the notion of government scrutiny of their activities, and in particular, at the limits placed on pay scales. Bankers like to pay themselves big bonuses, and while they were on the government dole political pressure and legal straight jackets stopped them from making significant payments to ‘key’ people.

“The cost in cash and human misery that the bankers created is epic. They should pay for it.”

The government was adamant that the banks demonstrate an ability to raise capital from private sources before it would allow repayment, hence the frenzy of debt and equity issuance by the healthier banks over the past month. Now that most have managed to restore their access to the capital markets the regulators are satisfied that this first group can be weaned off taxpayer assistance.

But is this a good thing?

I am not so sure.

The banks who are now allowed to repay TARP cash all passed the stress tests. As you know I thought the stress tests were none too stressful. In fact I thought them to be easy. Not only that, but the banks all indulged in a period of negotiation subsequent to the tests, so the image created was not one of severe oversight but of indulgent cooperation. The regulators simply didn’t have the stomach to impose strong standards, and so the banks were required to rebuild themselves only up to fairly lenient levels of capital. And the ‘worst case scenario’ they all supposedly passed looks a lot like the most likely outcome for this year’s economy rather than a severe further downturn.

Given this, I don’t think that we truly know just how healthy these supposedly healthy banks are. They are all still sitting on substantial portfolios of toxic assets of doubtful worth. They will no doubt need to keep raising capital just to offset future losses on those portfolios. Which means that the amount of capital available to be deployed as loans is still limited.

So the flow of credit into the economy is by no mean assured even though we now have a slew of ‘healthy’ banks.

Meanwhile we now have two types of banks: those who have repaid their TARP money, and those who are still tethered to the Treasury Department. Clearly the latter are now at a significant competitive disadvantage. The credit markets will differentiate even more strongly between the ‘strong’ banks and the ‘weak’ banks which implies higher interest rate costs for the weaker ones and possibly even more difficulty in their capital raising efforts. Private investors will take the repayment green light as a government ‘seal of approval’ and thus channel their investment into the strong banks and away from the weak ones. This will make it harder for the likes of Citi to rebuild itself to the point that it, too, can be allowed to repay TARP.

The market has, of course, been drawing its own conclusions as to relative bank strengths, so all of this may not change the environment for capital raising very much. But it cannot be welcome news for shareholders of Citi, Wells, B. of A. etc that their organizations are still considered too weak to come off life support.

In broader terms there are very clear signs that the credit markets have settled down from their crisis levels of last September and October. Risk spreads are much lower, funds are flowing, and investors are willing to lend to banks gain. So there is a semblance of normality slowly returning. The recent spate of better news in the ‘real’, i.e. non-financial, economy has helped lift the mood of investors too.

But we should take great care not to declare the crisis over. The banking system remains very fragile and large losses on commercial real estate and credit card portfolios loom in the near future. Plus the banks are as opaque as ever in their activities. Nothing substantial has changed in the system except for the reduction in competitors and the new two tier system of good and weak banks that results from this TARP repayment. The biggest of our banks remain ‘too big to fail’ and can thus indulge in extravagant risk taking for the benefit of their bonus payouts knowing full well that the taxpayers will pick up the pieces.

This privatization of profit and socialization of loss is an anathema to the long term health of the economy. It has to stop. Bankers have to be made accountable for the losses that their excessive risk taking produces. It was failed bank management, and, in particular, a cavalier approach to risk, that brought the nation’s economy to its knees. The cost in cash and human misery that the bankers created is epic. They should pay for it.

This means radical and structural reform of the banking system.

There are proposals already floating around as to how this should be done. So far none are adequate, although some regulators are agitating for strong action. The latest salvo to be fired came from Federal Reserve Board Governor Dan Tarullo just this week who focused especially hard on the banks considered to be ‘systemic risks’. He advocates a fairly hard line to restrict the damage that rotten bank management and failed bank business models can do to us in the future. As of now though the debate is only warming up, and time is slipping by.

But for now the big banks will remain ‘too big to fail’ and thus we can expect them to retain control over public policy. This is the most important point we must confront. The banks have ‘captured’ the legislative process and thus can ensure that legislation is always modified in their favor. Even in these times of evident failure they have been able to push back against bankruptcy law changes that would have allowed easier mortgage payment modifications for borrowers. I am thus not expecting the administration to introduce the kind of stringent re-regulation I see as needed to prevent further banking mischief.

The banks, even in their currently impoverished state, still flood the electoral system with cash and other forms of largesse. In any other nation on earth this flood would be called corruption. Here we call it free speech. It is the sort of free speech advocated by the Mafia. I doubt whether our doughty legislators will be able to resist the suggestions of their local bankers, let alone those of the big Wall Street banks and the various trade associations that inhabit the shadows of Washington.

So while we applaud the repayment of TARP money, we may regret the continued power of the banks. They are not fixed yet. And the odds of getting them fixed, as in becoming socially acceptable and reliable institutions, is waning. As the immediacy of the crisis fades and the attention span of Congress shifts its focus somewhere else our window of opportunity for reform diminishes.

I wonder whether we have lost the chance to restore balance to the economy even though the debate is only now beginning. I hope not.

Addendum:

Clearly the Congressional Oversight Panel [‘COP’], led by Elizabeth Warren of Harvard University, agrees with me about those stress tests. The panel’s June report contains a critique of the tests written by two Berkeley professors. They conclude that the tests are too lenient given where unemployment already is [the tests worst case assumed an unemployment rate of 8.9% as an average for 2009]; that they don’t extend far enough into the future, while much of the commercial loan losses will occur in 2011 and beyond; and that they have been deliberately obscured so that understanding how they were carried out is very difficult. The COP concludes that the stress tests should be run again to adjust for these problems.

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The Results Are In!

And the winner is? Well that depends on your point of view. The early winners seem to be Goldman Sachs and JP Morgan Chase who flew through the tests with flying colors. The losers include Bank of America and Wells Fargo, the latter of whom must be particularly peeved having been lauded by no less an authority than Warren Buffet just a few days ago. Following up the rear is GMAC who seems to be the only tested bank who pulled the equivalent of an ‘F’.

So. Now what?

The banks that have been told to get capital have until June 8th to present a plan showing how they intend to do so. They then have until November 9th to raise the cash.

What if they don’t? We’ll see about that later.

Now that the whole charade is over and the dust settles what have we learned?

The tests indicate that the Treasury Department expects this group of banks to suffer a further $600 billion in loan losses through the rest of this credit cycle. Those losses are expected to stem from such things as the effects of rising unemployment and the ‘normal’ cycle in commercial real estate. This estimate is on the low side. Other organizations, most notably the IMF have forecast losses much worse than this.

In part the difference between the IMF and the Treasury may flow from the fact that the Treasury allowed the banks to do the predicting by using the banks own risk assessment models. This involvement of the banks would naturally skew the expected losses down. After all these are the same risk models that helped create the mess in the first place.

As you know I have been highly critical and skeptical of the entire testing process. I find it odd that the banks were involved so deeply in the process – it sounds more like a self-assessment than a rigorous audit. And the fact that they were negotiating the results seems just absurd. These two factors fed my naturally cynical nature, and resulted in my conclusion that the tests were run as a ‘misdirection’ play to make it seem as if we were facing the banking crisis rather than actually doing anything about it.

Be that as it may.

The tests are now done and we must all face the new reality.

So the discussion now shifts to the next few months and the consequences of the testing process.

Are the banks safer?

Well not yet. Some like Goldman and JP Morgan Chase are already chaffing at the bit to repay TARP money so that they can get on with their business without government interference. I don’t blame them. We should all recall that the banking landscape has been re-written over the past few months. There are far fewer major players and some of those left standing are ineffective players at the moment. I can imagine the guys at the healthy banks want to get stuck into the game: they will make hay over the near tern while their weak competitors do lazy eights as they raise capital. Expect profits to rise sharply among the healthy. Not only is the competitive landscape ripe for profit making, but loan spreads are high, the yield curve has been twisted in favor of lenders, and cheap government bailout money is lowering the cost of doing business. In short if you are a ‘healthy’ bank things are truly looking up. The government is doing all it can to give those banks a leg up.

Meanwhile: the weak banks will wallow around. Their spreads and so on will also improve. So their profits will be better. Loan losses will cripple any efforts to expand lending, but that has become secondary. Public policy, which at the start of this crisis was focused on getting lending going again, is now more focused on keeping the weak banks alive long enough that they can thrive on their own. The second objective is to keep the out of pocket cost to taxpayers as low as possible.

An interesting problem may emerge later in the year when, and if, one of the weak banks fails to raise the capital the government has ordered it to. Right now the Treasury Department is indicating that it will forcibly inject more capital at that point. I doubt it. One of the administration’s goals in the test process was to punt the problem forward. By November with banking conditions slightly improved and the economy gradually rising from recession, both of which are certainly possible, the politically smart move would be to punt again. Since the administration seems to have been driven by politics rather than economics so far I would bet on another punt.

Plus I expect lost of discussion to surround that part of a bank’s capital called Tangible Common Equity [‘TCE’]. As I have said here many times that ratio can be fixed more easily than broader measures of capital such as Tier 1 Capital. Geithner has been hugely successful in switching our attention to TCE so there is no reason to change now.

One of my yardsticks for the testing process would have been the level of howls from the industry. Normally a strict audit will elicit predictions of dire consequences and imminent disaster. So far the reaction has been more one of confusion. The stock market has bid up then bid down the stocks of the weak banks, largely due to the flood of rumors we have suffered through. Now that the facts are before us the market should settle down. I would expect banks that are deemed healthy to attract investors, while those who are weak will have a harder time raising private funds: who would want to invest in an organization that the government has on life support? So an outcome of the testing is that the weaker banks, who need to find capital, may find it harder to do just that. The best avenue for capital growth will then be from the sale of subsidiaries and lines of business. Look for hedge funds and private equity funds as well as the healthy banks to attempt to bulk up by acquiring bits of their weaker competitors.

This really is a case of the rich getting richer and the poor getting poorer.

In the end I am glad the process is over. I am sure you are too, given all my venting over it.

But the concerns remain. We should be leery of declarations of success. The second wave of losses is coming, and the structure of banking remains the same. If anything there are some too big to fail banks that will now be much bigger.

Saving banks is one thing. Fixing them so they can’t screw us all up again is another.

So I will leave you with this:

My concern has always been with the structure of the industry: it needs to be reined in so that we are not exposed to its excesses again. As I watched the administration deal with the immediate issue of saving the weaker banks I used it as an acid test of their ability or desire to take what I perceive to be tough action to downsize or limit the power of the industry. The stress test process leaves me highly skeptical. The government seems to be unable or unwilling to face the banks down. Whether that results from hard nosed political calculation or from simple cowardice I don’t care. The result remains the same. Until the banking industry is severely restricted and its major players reduced so that they can fail without destroying everything around them our economy remains at risk: from the undue influence of financiers and from the very high prospect of another asset bubble resulting from easy credit.

So my confidence is high that the banks will be saved. And it is low that they will be fixed.

Too bad.

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Goldman Sachs: Connections Run Amok?

Here’s is a little reported story worth keeping an eye on: some people are concerned about the extent of Goldman Sachs reach into our regulatory and legislative process. I know that’s not real news. Anyone who followed the AIG debacle closely would have seen the apparent preferential treatment Goldman received from the Paulsen Treasury.

With all the sensitivities about proper behavior you’d have thought the bank would try to keep a low profile. At least by their normal headline grabbing standards.

Nope.

Now a juicy story emerges from last September.

Back then it was the New York Fed in the lead on banking issues. Among its actions was the fast track approval of Goldman Sachs as a bank holding company, along with the provision of $10 billion in capital. This is not to mention the hasty approval of the use of AIG bailout money to pay off it counter-parties, amongst whom Goldman Sachs was very prominent.

Now I am not going to cry foul on any of this because everything may well be above board.

But.

During that time the New York Fed’s Chairman, Stephen Friedman, sat on Goldman’s board. Which raises all sorts of red flags of potential impropriety especially since it would be the Fed that regulates a bank holding company.

Worse: in December Friedman bought a sizable number of Goldmans shares, which have since gone up $1.7 million in value.

This could all be proper. It could all be very well covered by all the necessary paper work. And it could also be that Mr. Friedman and Goldman are as honest as the day is long.

But, surely this situation is outrageous. It smells of a kind of preferential treatment that we need to rid ourselves of as quickly as possible. Much of the weakness in our economy right now stems from the actions of our large banks. Especially those deemed to ‘big to fail’. Goldman is one of those banks.

So why on earth is one of our top regulators sitting on its board? More to the point why is he buying more stock in one of the companies he oversees as a regulator?

It is situations like this that raise the specter of a potentially unhealthy relationship between our large banks and the government. The amount of personnel that swap jobs back and forth alone is dangerous because of its erosion of objectivity. But to have the most senior regulator sit on the board of a regulated bank under his jurisdiction is plainly absurd.

This is why I am skeptical of the administration’s ability either to understand or to resolve the banking crisis. Too many of its senior players are inextricably connected with Wall Street.

Add this story to the unseemly amount of coziness surrounding the stress tests and it is no wonder that some of us suspect the fix is in before the game starts.

Bankers like those at Goldman are out for themselves. Good for them. But they should be kept at a distance from the levers of regulation and legislation. In fact the bias should be against them.

Remember who brought the economy down and who has the most at stake. And who could profit the most from tilting the playing field.

That’s what makes this story about Friedman so terribly upsetting. The regulators constantly harp on about the risks of banks being too ‘interconnected’. I has always assumed they meant interconnected in a financial sense.

Maybe we should be more concerned about interconnectedness of the influence peddling kind.

Who’s running the show?

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