JP Morgan Chase

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The Crisis Commission: Day One

This is a week where news about the economy is scarce – the only notable data was the fact that the trade balance widened to $36.4 billion in November, which is both the worst since January last year and a fairly good sign that domestic activity is improving. So we learn nothing new even from this little piece of news.

So the focus stays on banking and, in particular, the proceedings of the Federal investigation of the financial crisis. Today is the first day of public hearings with notables like Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JP Morganm Chase in the hot seat.

Already we’ve had a tense moment: Phil Angelides, the commission chairman, got us off to a fun start when he lashed into Blankfein with questions about Goldman’s nasty habit of selling investments such as mortgage backed securities, and then immediately turning around and selling those same securities short. You would only sell something short if you were convinced it was going to go down in value. So the obvious question is: did Goldman let investors know it thought the assets it was selling were worth a lot less than the amount it was charging for those assets?

Naturally Blankfein dithered in his answer, before admitting that, no Goldman did not advise investors of such problems.

His defense, if one can call it that, was that all the investors were ‘sophisticated’ and ‘analytical’ professionals who knew full well the risks they were taking. So Goldman had a right to presume the investors had done their due diligence on the assets before they went ahead and bought them.

In the sordid and ethically challenged world Goldman apparently inhabits such a response seems perfectly reasonable. To the less jaded and less ethically challenged eye, however, the fact that a purveyor of investments immediately hedges against those investments suggests that the disclosure was less than transparent, and may well border on fraud. That is fraud in an every day sense, not in the legal, carefully protected, and suitably obfuscated world of ‘Goldmanian’ finance.

Blankfien’s defense is intensely revealing. It opens up to our view a world where supposedly slick professionals who are ‘sophisticated’ and analytical’ shovel toxic crap into each others laps in order to make a quick buck. This is called high finance. Since everyone knows the rules, no one takes due diligence that seriously – instead they hedge against losses. They sanitize their lack of care by palming the loss of on someone else. The end game is to be stuck with less rubbish than anyone else, and to make sure all the toxic stuff you may own is covered by some sort of insurance.

It is a world where the old meaning of words is perverted. Due diligence used to be a careful method of risk mitigation. Now it is a perfunctory pre-sales function diminished by the after sales function of insurance. I suspect that much, if not the entire, volume of derivatives trading has become infected with such perversion. Indeed I would wager that most of the volume of derivatives exists because of the manic need of the big banks like Goldman to dump what they know full well to be toxic waste into an unsuspecting lap before it explodes and damages the bank’s bonus pool. No one does proper due diligence because everyone is buying insurance.

Angelides himself gave an analogy for the benefit of the press: Goldman’s method of investment sales is, he suggested, like selling a car knowing it had no brakes, and then buying insurance ‘in case’ it crashed.

To add to the blatant sleaze of Goldman’s business practices is the asymmetrical nature of Blankfein’s claim. Apparently his firm is correct to foist garbage on someone else because that someone else is presumed to be as sharp as Goldman in evaluating the risk of the transaction. But what happens when it is Goldman supposedly doing the due diligence,when it is the buyer, not the seller of a transaction?

Aaah. Then the rules change. How odd. When, for instance Goldman is suckered by AIG,. and has bought completely useless credit default swaps, AIG should be ‘honest’ and make Goldman whole. Poor little Goldman Sachs surely should not take a loss on transactions that big nasty AIG knew were rotten. This is, of course, the position that Tim Gethner took when he allowed the reimbursement of AIG’s counter-parties using taxpayer money. Those slick, smart and world class bankers had been given a sucker punch. They had failed totally in their due diligence. But instead of laughing at their stupidity, Geithner felt sorry for them and wrote out billions of dollars worth of checks. AIG not able to pay out all those CDS contracts simultaneously? Who knew? . Welfare checks for the poor bankers of Goldman anyone?

Double standard? Cheap and sleazy? Venal?

All of the above.

One thing is for sure: no one should ever respect the ethical standards of Goldman Sachs. There aren’t any. Which is a terrible shame, becasue when I did business with Goldman, years ago, their reputation was for being smart and slick – sharp in a good sense. Not simply sharp. The difference between the old Goldman and the current sleaze version is that it is no longer a private bank, and yet still pays as if it were. The risks are dumped onto shareholders, while the returns are kept inside for the employees. With that basic relationship severed the bank’s ethics went overboard and making a quick buck became the only thing that mattered.

Clearly customer relationships and reputation don’t count.

Too bad.

Break it up.

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Two Americas

There are ominous signs emerging within our nascent recovery: one part of America is seemingly well on the way to a prosperous 2010, while the other remains stuck in a fear filled, jobless, and decidedly unprosperous mess.

This week’s release of bank earnings highlights this divergence.

“it is reckless and extraordinarily bad public policy to be as oblivious to the rent seeking activities of Wall Street as the current administration appears willing to be.”

One one side we saw Goldman Sachs and JP Morgan Chase announce with all their usual swagger that they have earned record, or near record, profits last quarter. Their speculation and gambling goes on unabated and in what is now effective a government sustained oligopoly they have been able to make hay. This is less a testimony to their skill or financial acumen than it is to the inefficiency of the markets within which they gamble and the weakness of their counter-parties. Of course they still benefit from the no-cost insurance that we taxpayers offer them: they remain too big to fail and so can gamble their hearts away knowing that their risks are tacitly underwritten not by their own shareholders but by the US Treasury.

That this offensive free ride is still tolerated by the public baffles me.

Were Goldman to have to underwrite its own risks through the purchase of private insurance its profits would be severely diminished. There are few, if any, insurers with the balance sheet strength to cover the enormous and complicated risks that Goldman undertakes. Thus there is only one effective recourse: us. That Goldman uses our backstop with impunity for the private gain of its employees is a moral stain on every single employee of that institution. The hubris is astonishing.

More astonishing is the complete lack of will within the corridors of power to rein them in.

Nor only was Goldman – and I should add the others: JP Morgan Chase and Morgan Stanley – too big to fail last year, but it has now become ‘even-more-too-big-to-fail’. It is simply arrant nonsense to argue that the benefits of Goldman’s size is worth the massive burden we all bear.

Those benefits are supposed to be the efficient allocation of capital within the economy. Remember: the underlying social purpose of banking – the reason we provide it more protection than any other sector of activity – is that we need capital to be allocated for optimum use. This should ensure that the economy at large grows most effectively and thus we all benefit from the increase in wealth thus ensured.

That the banking system obviously and egregiously failed seems to have slipped past our leaders. Instead of steering capital into long term projects that increased our national competitiveness and raised productivity – the ultimate and most certain source of future wealth – the system poured trillions into specious real estate deals, totally irrelevant risk management derivative products, and securitization of things that no one had a clue as to the underlying value of. The entire process was focused exclusively on short term gains for the benefit of the managers and staff of the banks involved. they gained while the economy lost. Economists call this kind of anti-social behavior ‘rent seeking’: it is the exaction of above market ‘rents’ based upon a biased or asymmetrical distribution of power or information. Every single absurd bonus paid out within the financial sector represents an exaction or tax on the rest of the economy.

The shame is that this rent seeking goes on unabated. Why? Because the authorities are shamelessly abetting it. The big banks have stormed the halls of power and co-opted the regulatory process. In another country we would deride this activity as corruption. America has a long history of forcing regulatory reform on other countries who have experienced legislative capture in this way. The very often brutal policies enforced by the IMF and World Bank as part of the bail out of smaller nations – those policies are referred to as the “Washington Consensus” – are designed to rid those places of the corruption that allows personal rent seeking at the cost of public welfare.

Apparently the Washington Consensus is too tough for Washington.

So one America continues its happy rent seeking ways and its Guilded Age extravagance.

On the other side the second America flounders under the weight of the first.

The results of the two other big banks – Citicorp and Bank of America – highlight the difference.

I have no sympathy for either of these two behemoths. They too should be cut down in size. They were horribly mismanaged and followed extraordinarily stupid business practices not least within their evidently inept risk management departments. Nonetheless their portfolios of assets are a better reflection of what banking is supposed to be: less about gambling and more about making loans to business and individual borrowers.

That these two have now reported rising credit losses is a deep and disturbing commentary on where the economy stands. Main Street is plainly hurting. The rising tide of foreclosures and the persistent difficulties within business are creating a second wave of recession dependent loan losses. This is exactly as any analyst would have predicted: it is entirely normal for banks to suffer losses as the economy flounders. It happens in every recession. Loan losses rise as the economy sinks, and they continue to rise even after a recovery starts because it takes time for the banks to abandon hope of recovery on the loans. Later on, when the economy has returned to health, some of those loans will turn out to have been healthy and the banks typically benefit from a surge in reversals of the original losses. This is why bank profitability should always – absolutely always – be measured through an entire business cycle and not on a year to year basis.

It is also why financial industry bonuses should be tied to a cycle length performance and not to short term profits.

That B. of A. and Citi are entering another round of losses is, therefore, not a surprise. It is annoying that they were so astoundingly stupid to get involved in the yahoo gambling – something they clearly did not have a clue about – during the last few years that they lost billions in that gambling and thus were not well capitalized ahead of this predictable storm. But at least it is reassuring that they still have bank assets that relate to capital allocation.

The frenzy of bank profit and loss reports this week adds a gloomy cast to our picture of the economy.

Not only is the economy barely sputtering to life, but the divergence of the recovery will almost assuredly add a major threat to the recovery’s sustainability. The weakness of the major Main Street oriented banks will restrict their willingness and ability to lend. Meanwhile the robust profitability of the Wall Street gamblers will allow them to syphon off capital to bolster their activities – money will always flow to the profits no matter how anti-social the activities that produce those profits are. So the rent seekers will enlarge their grip on the capital flows, they will continue to flood it into ever more obscure and irrelevant securitization packages and derivatives [ of derivatives, or derivatives, of … ], and thus stifle the flow of money to that part of America still digging out from underneath the pile of rubbish the gamblers foisted on it last year.

As you can tell I am more than a little frustrated at the administration’s total inability to fight for the second of these two Americas.

This lack of fight is inexcusable and dangerous.

Let me give you two simple examples of the apparent extent of the capture of the government by the gamblers.

First was the recent hiring by the SEC of a new Chief Operating Officer for one of its enforcement units. The newly hired COO is 29 years old, has minimal experience, but has the only reference one needs: four years at Goldman Sachs. I find it incredible that the SEC could not locate a better qualified and more seasoned person. This COO may well be a boy genius. I doubt it, even so the taint of Wall Street should have been sufficient to render him inappropriate. When so much public money has been plundered by Wall Street for its own private gain, and while we continue to provide no-cost insurance to its activities there is no way in hell an ex-Goldman employee should have been hired for a serious job. That he has virtually no experience – he has an analytical not operations background – makes the move suspicious. At the very least it screams out the extent to which Wall Street has invaded the fabric of the institutions we rely upon to monitor its activities.

The second example concerns Geithner. His telephone records were recently made public under a Freedom of Information Act request. The pattern and timing of his telephone calls is telling: he had more conversations with the CEO’s of Goldman and JP Morgan Chase than he had with his own boss. He very often got on the phone to his Wall Street friends immediately after chatting with Obama. The volume of calls to his Wall Street connections vastly outweighs that of his calls to colleagues within the administration or to outside experts and economists. It seems his most important flow of advice and information acme from within the industry he was engaged in both bailing out and in shaping the future regulation of. I do not ascribe particular nefarious motives to this obvious bias in Geithner’s network. I will leave that to you. My purpose here is simply to note that our most senior economic administration leader is, apparently, guided mostly by those we need to control. Indeed they are the very same leaders who screwed the country’s economy. Their incompetence is demonstrated and very public. Why their advice carries weight is beyond me. But it does – to Geithner at least.

I offer these two small examples as evidence: there is no way that the second of our two Americas is getting the same treatment, the same deferential hearing, and has the same influence as the first.

That the gamblers are back to their old ways – announcing massive bonuses even as unemployment rises for everyone else – is a bad omen. As the economist Hyman Minsky taught us, finance is inherently unstable and thus needs to be heavily restricted so as not to spread its contagion. That we have so quickly forgotten last year’s lessons, and that we are apparently treating the gamblers excesses with indifference, tells me that we will have to suffer the consequences of their anti-social activities again. Probably sooner rather than later.

We are all aware of the dictum that those who ignore history are destined to repeat it. It just seems a little silly to repeat it so soon.

I will go further: it is reckless and extraordinarily bad public policy to be as oblivious to the rent seeking activities of Wall Street as the current administration appears willing to be.

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Lessons of Lehman

Were there any?

This past week we have been treated throughout the press to a barrage of post-mortem articles about the significance, and otherwise, of the collapse of Lehman Brothers. That collapse produced the largest bankruptcy in American history and will provide a healthy living for attorneys worldwide for years to come.

The major thrust of the media attention follows two avenues: first, was the bankruptcy avoidable; and two, what have we all learned from it.

My take on the first point is that, yes, the collapse could have been avoided. At the moment of its disaster Lehman had a book of business very similar to those of its fellow investment banks – there was nothing uniquely stupid about Lehman. Moreover it had capital in the run up to crisis of around 11% – way above what the regulators consider sufficient even now. So on the surface there was nothing to single out Lehman for its role in the financial implosion last year.

So what did happen?

Lehman was unfortunate. It was unlucky enough to be the center of rumors about liquidity. It’s failure was precipitated by a liquidity crunch more than a fear of insolvency. It was a classic ‘run’ on the bank.

And such runs are the bread and butter of the regulators: so why did the ‘authorities’ not step in and provide support?

The answer appears to be twofold: they felt constrained by what they thought was the limited scope of their legal ability to act; and they, ultimately, wanted to avoid the impression that they could save all the banks. Remember, they had already driven Bear Stearns into a shotgun marriage with JP Morgan Chase earlier in the year, and they had muted pushing Lehman into Bank of America, only to be rebuffed in that effort. Other potential ‘deep pocket’ saviors like Barclays withdrew their interest as the crisis built towards its climax: no one had any idea of the consequences of taking on Lehman’s portfolio, and worried as they were about their own precarious balance sheets, no one wanted to add more risk just at a time when it seemed risk was impossible to measure.

So letting Lehman go became the only option.

My view has changed somewhat over the past year. I have hardened my opinion somewhat. On reflection I think it was correct to allow the bankruptcy. I have been stunned by the response of the banking industry: its sense of entitlement is extraordinary. This is a direct manifestation of the ‘moral hazard’ created through the years by the repeated bail out of failing banks. The impression in the banking industry is that no matter how stupidly they behave the public will always clean up the mess. After all banking is essential to the economy. By occupying this privileged and protected position banks feel safe to pursue practically any strategy they like, no matter how dumb it is. Management skills are not valued in the industry, trading and deal making skills are. Banking is a safe haven for those who want to play with other people’s money and make a personal fortune – or at least a very nice living – along the way.

My own experience in the industry was one of profound dillusionment: no one wanted to make strategic decisions and ‘thinking’ was devalued in favor of a macho ‘ability to do stuff’. that is to say to ignore risk so as to make short term profit. This I found especially odd because my employer had been at the epicenter of the real estate crisis at the end of the 1980’s – an event that cost many of my fellow managers their jobs and reputations. Yet we failed to learn anything at all. It has taken all this time for me to realize that this failure was not just in the bank that employed me, but was endemic to the entire industry.

It is a failed industry.

Yet the people who work there and conform to the ‘shoot first’ philosophy make a great deal of money. They are rewarded for amassing short term profits even if they end up destroying value in the long run.

You and I then are called in to pick up the pieces.

So: letting Lehman go down was supposed, in my mind, to force the bank’s attention on their innate vulnerability.

Did it?

Not at all.

For all the talk about the panic and the freezing up of the ‘credit markets’, nothing truly fundamental seems to have changed. Even most of the players are the same. Most of the Lehman people who drove the ship onto the rocks were quickly absorbed back into the industry where they are now, no doubt, replicating that driving skill they so amply demonstrated. But we should not pick on them too much: every single bank is trying to get back to the same activities. There doesn’t seem to be much of a change at all.

Yes there are surface changes: Goldman and Morgan Stanley are now registered as bank holding companies, which sounds arcane, but is a fairly important shift. Everyone focuses on this shift as as sign the ‘old days’ of rogue trading are over. They are not. I think the shift was driven more by a cynical need by the banks to get more securely under the bail-out wing of the Fed than it was an attempt to change their activities. Sure their leverage is down: but will it stay down? I have no confidence at all that it will. All it takes is for a new, and no doubt ‘innovative’, product to emerge and the pressure to pump up the balance sheet will be unavoidable.

Nothing has changed.

Given the devastation wrought by the ineptitude of the banks you would have thought that legislators and regulators would be clamoring to pile on the chains and lock the industry up as tightly as possible.

Not so.

The ‘reforms’ being touted in Congress are entirely superficial. The basic incentives for anti-social behavior are still in place. Which means we are headed, already, into another bubble of some sort.

So what have we all learned?

Not much apparently.

You and I were exposed, briefly, to a blizzard of jargon and obscure things like CDS’s and LIBOR spreads etc, so we can say that we learned a little about the games being played down on Wall Street. But the people who we need to have learned: those in the industry and those who regulate it, appear to want to return back to ‘normal’ as soon as they can.

I attribute this lack of learning to laziness and self interest. it is simply too much effort to impose restrictions on an industry that provides so much campaign money to politicians. The inherent corruption of the American political system is never more evident than in the legislative approach towards banking – conflicts of interest abound, and money talks, I doubt that the invective will produce a proper limitation on the industry. Let’s hope I am radically wrong.

Nor does there seem to be any recognition of the international scope of the problem. The banks are hoping against hope that there is only limited international cooperation: they especially hope that the US and UK act to water down attacks emanating from mainland Europe. Not that the European banks were innocent – they indulged in pure fantasy too by buying CDS’s to cover risk on their balance sheets rather than carrying the far more expensive basic capital. European banks were more thinly capitalized than many of their ‘gangster’ American cousins.

So here we are a year later. Plenty of words have been spilled about the Lehman debacle. And not much has been learned despite all the effort.

I think a major problem is that our leadership – worldwide – suffers from such a collective ‘group think’ on economic and financial matters that little originality is tolerated. And it is weak. No one wants to disrupt the hallowed market. So the market, embodied on the trading floors of the big banks, continues to corrode the fabric of the economy.

As you contemplate all this let me leave you with the advice I give myself when I try to think about banking: bankers are truly stupid people. They may be extremely bright. They may be clever as all heck. they might have degrees from top universities and they may know how to run wizard like models for risk management. But collectively they are stupid. They destroy shareholder wealth with a monotonous regularity. They rely on us to bail them out with equal regularity. They use our money and pay us nothing for it -our guarantees are offered up free of charge. And they aggrandize themselves through a wickedly perverse reward system that enriches most those who loose the most.

On second thoughts: it isn’t the bankers who are stupid.

We are.

Will that change?

Addendum:

Joe Stiglitz makes a good point: the big banks are now even bigger. They gobbled up failed rivals and now are emerging as ‘even too bigger to fail’ institutions. Yet no one in the administration has made a credible response to this greater concentration of finance. This issue: the size of the big players and their implied ability to tear the economy down, is key to getting the industry back under control. Until we have smaller banks that can be allowed to go into bankruptcy without destroying us all, we will be under their thumb. Don’t hold your breath for a solution however – the Obama administration’s watchword appears to be appeasement.

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Wall Street Bonuses – The Abomination Continues

Do not think that this story will go away. Andrew Cuomo has just submitted another fascinating report of Wall Street bonuses and the manner in which they no longer reflect anything remotely connected to reality. Here’s a quote:

“Thus, when the banks did well, their employees were paid well. When the banks did poorly, their employees were paid well. And when the banks did very poorly, they were bailed out by taxpayers and their employees were still paid well. Bonuses and overall compensation did not vary significantly as profits diminished.”

“We have set up a massive, expensive, and never ending welfare program for rich, complacent, and arrogant bankers.Why?”

How true.

The problem with the bonus structure in the financial industry is that it now no longer rewards excellent work or above the average contribution to businesses profits: it is expected.

I realize the difficulties that surround rewarding top performing employees: even in a loss making year there may have been many employees whose own contribution should still be rewarded as exceptional. And in an organization as large as, say, Citibank not every employee is associated with the loss making activities – no one in the entire branch system can be blamed for booking those obscenely stupid derivatives that blew up the balance sheet.

Yet I doubt – I have no direct evidence – that many of the big bonus payouts find their way to the branches. They mostly end up in the hands of the fools on the trading floor. Which is Cuomo’s point.

Banks like Citibank have been captured, almost literally, by investment bankers who have no experience of or knowledge of the hum drum ordinary banking that remains the ballast of that organization. The executive team is populated more by investment bankers and finance attorneys who are deal makers not bankers. They know the world of trades. Not the world of small business lending. They treat everything as if it is for sale. Their short term profit mentality is coupled with a false sense of security derived from overly complicated, and now proven wrong, set of risk management principles.

They don’t manage a business, they manage a portfolio. The notion of creating a long term structure is abhorrent to them. If it’s not now, it doesn’t exist.

They are traders.

So, inevitably, they have set up reward processes that mirror their own outlook on the world. They think it normal that a trader would be paid enormous sums even though that trader is using someone else’s money.

I have no problem at all with huge profits being made from banking. My point is that if you want to be rewarded that way play the game with your own money. Put your own wealth on the line. Not anyone else’s.

That is the fundamental disconnect on Wall Street: most of these millionaires are playing with someone else’s capital: they start by gambling away their shareholder’s stake, then they come running to the taxpayer and use our money.

In days gone by investment bankers who made bad bets went bankrupt. Personally. Their errors cost them their own wealth. Yes the central banks, as in Britain even in the mid 1800’s, or some major financier, JP Morgan in the US in the early 1900’s, stepped up to stabilize the system. But the bankers paid a personal price.

Nowadays there is no such connection between the trader and the loss that might accrue from his or her mistake. They make a bonus on the upside and shovel the losses off onto the shareholders or the taxpayers on the downside.

That is abominable.

It is a major distortion of the free market these folks worship. It is ludicrously unethical. It just plain stinks.

So I give Cuomo credit for pressing on with his ‘outing’ of the greed.

Traders who are not personally invested in their own trades should not be receiving egregious bonuses. Incentives, yes. Fortunes, no.

No one should be able to make a fortune working as an employee – the shareholders are being taken to the cleaners if that happens.

The word is ‘tunneling’. That’s is what happens when a group of employees extract an extraordinary amount of reward for themselves and leave the shareholders to hold the losses. It is a common practice on Wall Street. It should be illegal.

Just for the record and your amusement here is a list of the number of people getting million dollar bonuses:

  • Citibank: lost $27.7 billion; paid over a $1 million in bonus to 738 employees
  • Merrill Lynch: lost $27.6 billion; paid over $1 million to 696 employees
  • Bank of America: 200 bonuses over $1 million
  • Goldman Sachs: 953 bonuses over $1 million; 212 over $3 million
  • JP Morgan Chase: 1,626 bonuses over $1 million; over $3 million to ‘over 200’ employees
  • Morgan Stanley: 428 bonuses over $1 million; 101 over $3 million
  • Bank of New York Mellon: 74 over $1 million
  • Wells Fargo: 62 over $1 million
  • State Street: 44 over $1 million

This, of course, is not an exhaustive list. Foreign banks with branches on Wall Street pay the same kind of wages in order to attract ‘talent’ – even when that talent is exposed as rotten.

What’s really notable is that none of these banks would be afloat without our help. Not one. They would all have faced bankruptcy, or at least massive decline and eventual failure, had it not been for the efforts of the taxpayer.

They play in a safe arena clearly delineated by our guarantees. And they luxuriate in the flow of cash they splash about for themselves. The shareholders may lose everything: that could be your retirement money. The taxpayers wade in with a massive safety net to catch the losers. But they still keep their money.

We have set up a massive, expensive, and never ending welfare program for rich, complacent, and arrogant bankers.

Why?

Addendum:

The Financial Times has supplied us with a nifty table of the bonuses, plus the relevant bank losses or profits from last year. The numbers still are annoying.

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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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