Goldman Sachs

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Consumer Downer

All of my warnings about the medium term outlook seem to be confirmed by today’s consumer sentiment survey results from the University of Michigan. This is the third, and most frequent, of the surveys that attempt to measure consumer confidence. The data released this morning suggests a modest uptick from early October – the index rose from 66.4 earlier this month to 70.6 presently. Unfortunately that rise didn’t manage to get us all the way back to the recent peak of mid-September when the index stood at 73.5.

Digging into the details reveals a theme that is now pervasive and, frankly, disturbing. Consumers are so concerned about job security and consequently their ability to pay their bills, that they rank saving and eliminating debt well above spending in their list of priorities. The cause for this pessimism is that a majority of those surveyed reported declining incomes for the thirteenth straight month – an unprecedented run of decline. Moreover the number reporting any kind of gain in income is now the worst for over sixty years. This is no ordinary cloud of pessimism, this is a veritable storm.

Without employers ceasing the incessant beat of layoffs I see no reason for this downbeat attitude to melt. That implies we are headed into a period of increased savings and lower consumption. That, in turn, is the very worst thing that could happen right now.

Now, I say repeatedly that one month’s data does not make a trend. So we will watch consumer confidence closely as we enter the ‘normal’ holiday spending season.

Interestingly yesterday’s GDP report had buried within it the news that consumers had increased spending across a broad front – evidently poor confidence didn’t hamper spending too much over that late summer. But, most of the impetus in sales came from the now defunct ‘cash for clunkers’ program. Car sales have plummeted since its end, which leads me to wonder just how robust consumption is without the boost given to it by government stimulus support. Also in the GDP data was the news that third quarter consumption ran well ahead of earnings. This means that consumers were forced, in the face of declining wages, to dip into savings or run up extra debt in order to be able to buy. That all took place earlier in the summer when confidence was growing from the depths it reached late last winter and in the spring. Since then the mood has shifted: even though the aggregate figures tell us the recession ended the average consumer still feels the chill of recession lingering on. Wall Street may be partying again as their government subsidized business booms, but Main Street is stuck in the cold waiting for something to trickle down from the financier’s table.

It won’t.

We now have two distinct economies: a Wall Street one, where bankers, accountants, and lawyers wheel and deal with each other gambling in dark pools and hidden beneath layers of obscure, high risk, and economically worthless activity; and a the real economy where employers relentlessly have to scale back, consumers lose homes, and most folks feel successful if they hang on for another month.

I have argued for years that this separation is both inevitable and harmful. Inevitable because a world governed by laissez-faire capitalism always produces small pockets of huge wealth – this is the lesson of history that advocates of free-wheeling unregulated market economics have yet to absorb. And harmful because rising inequality always produces a populist backlash, extreme politics, and ultimately unsustainable growth. This is the second lesson from history that the free-wheelers prefer to forget.

The economy we now live in is horribly split apart: the middle class is reduced to a feeling of siege – the consumer sentiment indices all tell the same story. The golden years of the recent past was between 1950 and 1970 which were the glory days of the middle class. The prosperity then was constructed on a firm regulatory foundation. The implicit contract was that the upper echelon of society behaved responsibly, banks were fiercely regulated, and allowed unions to prosper and protect wages. The lower echelon, in return for receiving a regularly increasing share of national wealth, saved, consumed, and was quiescent at work. It was a triumph of balance. The expanding middle class this balance produced provided the flow of workers and consumers business needed to build huge profits.

Unfortunately all this was destroyed in the 1980’s when complacency had set in sufficiently that we all imagined we could rise into that higher echelon. The American dream mythology sprang to the fore as a tool in the hands of the conservatives who wanted to undo the post war contract, especially its New Deal and Great Society aspects. The market worldview penetrated every aspect of our lives, the balance was swept away and anything smacking of regulatory limitation was eliminated.

We re-built the 1920’s. On purpose. And with gusto.

Why no one thought about what followed the 1930’s eludes me.

We did everything we could to build an economy bound to crash. We kept voting for policies discarded in the past. We re-invented theories proven false. We unleashed a mayhem our grandparents paid dearly to stifle.

We were fools.

But happy fools.

Now we face long dreary years of sensibility as we put away the Reagan illusion and rediscover the dullness of Eisenhower.

Today’s confidence numbers hint, but only hint, that most folks sense this. We need a little of that old fashioned Yankee spartan life. We need to stop spending above our means. We need restraint. We need to limit the wildness of business. We need to rein in the gamblers who profit from our demise.

All this will take time.

During that time I expect our economy to grow less rapidly than it has in the past. That’s a good thing. Much of the growth we registered in the last thirty years was built on sand. It was false. We have revealed the extent of the fallacy and now need to exert ourselves in the cause of sobriety.

Continuing with two economies won’t do. Income inequality breeds anger and resentment such as that we see in reaction to the bonuses that flow on Wall Street. Bonuses that are returning even while the vast majority struggle. The CEO of Goldman Sachs revealed his opinion about the plight of Main Street just last week: he defended inequality and bonuses on the basis that the wealth will trickle down to the masses eventually. He declined to define just when ‘eventually’ is. Presumably after he has retired. He evidently hasn’t studied the last thirty years. He, equally evidently, doesn’t want to. If he did he would see the living disproof of his statement.

Inequality matters.

The economy of the next few quarters depends upon getting the middle class out of the mire. That involves taxes on wealth and profits in order to re-establish and shore up safety nets. It implies slowing growth at the top so as to make the opportunity broader lower down.

The economy is neither zero-sum nor totally open, it is in the middle. Today’s reading on consumer confidence shouild sober up that Goldman CEO: no one believes him. He represents the thinking that caused all this. He’s very old hat, and he needs to wise up.

We need to re-balance. Quickly.

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Banking: Lessons From Goldman

It’s a slow day for economic news, especially since I think we’re all waiting for the GDP announcement later this week when we’ll learn the extent of the recovery now underway. With that in mind I want to extend my recent run of comments on banking by taking a very quick look at Goldman Sachs, the bete noir of progressive bloggers.

First off: in my dealings with investment banks I would always rank Goldman as the class of the group. They invariably were brighter and more innovative than the others. So I consider myself to be a Goldman Sachs fan.

Having said that they are currently behaving badly and need to be boxed in. And that’s me being kind.

How do I square these two statements?

Easily: the Goldman Sachs I dealt with was the one that existed before it went public in 1999. The whole nature of Goldman’s business changed after the initial public offering. The two organizations share very little in common other than the name.

For instance: back before going public Goldman was owned by a fairly large number of partners – between 200 and 250 of them. The personal wealth of these partners was predominantly locked up in Goldman’s equity and was available as a distribution usually only at retirement. Partners were expected to keep their cash in the company to help fund its activities. This is a very familiar situation for a partnership. A natural consequence of this practice was that the bank’s activities were heavily monitored and administered by the partners – they stood to lose their own wealth if the bank lost money. Thus the bank’s income streams were varied and balanced to prevent catastrophic losses. A good example is the income from securities trading which provided about one third of total income in the years just before the banks went public.

So the bankers who I was dealing with had their own money at stake. That meant their advice had a weighty feel to it: you could trust the fiduciary responsibility embedded within it since it flowed from the partner’s own position.

After the IPO the bank changed totally.

It is now about 80% owned by retirement funds and other investment managers who are not necessarily long term investors and do not have day to day control over risky decisions.

The consequence of this passive management is entirely predictable – except if you’re a fan of neo-classical economics and its ‘agency’ theory variations.

The income from riskier businesses like trading has ballooned and now accounts for almost 80% of all income – up from that 33% I mentioned before. The entire bank is now much more dependent upon the vicissitudes of volatile financial markets than it ever was when it was a true partnership.

So the loss of personal oversight has unleashed a willingness to take more risk and indulge in more leverage than was conceivable when the people managing the bank were at personal risk of loss. Goldman is significantly diminished a as result.

The problem is that the bank’s pay structure was not altered. It is a fine thing for partners to pay themselves whatever they want from the profits of their business – it’s belongs to them after all. It is absolutely not fine for a public company to persist in that same habit. The cost of management in a partnership is no one’s business but the partners. They can pay out the entire profit to themselves if they want. There is no public or external constraint in a private company like the old Goldman Sachs. But after going public that scenario changes completely. The cost of managing the company – including the cost of paying the employees – is now a burden on the shareholders who have a right to expect that burden to be minimized. In my own theories of management that’s why I focus on what I call ‘management cost’.

Allow me to explain.

Economic theory tells us that firms should not exist at all. This is because all transactions should be mediated – conceived and executed – within the ambit of a ‘free market’. And, as I have said here before, a ‘free market’ is one where no one has any long term advantages over anyone else. There can be no profits under these circumstancesand no firms – production is undertaken in the open market through the cooperation of equally skilled and funded partners.

Obviously this is a utopian vision. That’s the problem with economic theory – it simply doesn’t speak to real world economies.

But there is a kernel of truth in that vision: any cost associated with setting up and running a company has to come out of someone’s pocket. Rational people only tolerate that expense if they are going to get something they otherwise would not.

In the case of the average customer the benefit of that expense is the availability of products too complex or rare for the consumer to construct or locate for themselves. In this case the expense adds value.

For the shareholders there is a different benefit: the profits from a set of activities that they do not have the expertise to oversee themselves. There are very few investors who have the know-how to run their own bank or to build automobiles, so they hire managers to oversee the process, and those managers acquire the workers and machines etc to get the job done. This is the ‘agency’ I mentioned earlier: the managers act as agents for the shareholders. These agents cost money and must be governed correctly so as to prevent them defrauding the shareholders, that’s why businesses have boards of directors and so on.

So both customers and shareholders, for different reasons, look at the cost of running a firm as a burden they’d like to minimize. For customers that minimization should bring lower prices for the firm’s products. For the shareholders it should produce higher profits. Either way management has a duty to lower the cost of its own existence.

This is patently not occurring at Goldman Sachs. On the contrary: management cost is proudly inflated as if it were a sign of success.

The bank acts as if it were still a private company. It sets aside an obscene portion of its revenues for the benefit of its employees – either as base pay or as bonuses. The employees act as if the shareholders and customers did no exist. In fact they openly divert money from those two groups into their own pockets. This is called rent seeking in polite circles. In less polite circles it is dammed near fraud. The employees who owe their jobs to the capital invested by the shareholders and to the ongoing business thrown their way by customers skim an inordinate amount of the cash flow from their activities and hoard it for themselves. To the tune of about 50% of gross revenues. That is obscene.

And it reflects the extraordinarily twisted and self-serving sense of entitlement that pervades modern finance.

No self-respecting business analyst would advocate buying the stock of a company whose management cost was as inflated as Goldman Sachs is. We ridicule GM for having fallen into a situation where its employee costs are as high as they have become: that’s called bad management and is the subject of mirth amongst the traders who consequently sell GM short all the time. Yet they think nothing of their own excessive pay. Apparently its OK to pay a banker ridiculous amounts, but not a car worker.

The odd thing is that the investors who own Goldman’s stock don’t resist this open pillaging of their profits. Passive investors are the bane of capitalism. By overlooking the theft of their profits they diminish the returns they could be offering to the participants in their products – usually retirees. So the ludicrous pay structures of Wall Street end up impoverishing Main Street folks via the back door represented by passive investment managers.

Why would these investment managers tolerate this situation?

Because they’re in on the act. The Wall Street pay structure is mimicked by the pension managers, insurance companies, and other ‘fiduciary’ businesses. The top executives of these firms are extremely well compensated and want to keep it that way. they see nothing wrong with skimming half of a firm’s revenues for a bonus pool – as long as that firm is in finance. In manufacturing … not so much.

The common thread running through all this is that once clever people start to play with other folk’s money they need to be boxed in quickly. Otherwise they’ll rob you blind.

The old Goldman knew this. The partners were active and relatively risk averse. It is only in the last ten years or so that robbery became respectable – the current Goldman Sachs is flat out robbing its customers and shareholders.

We will never fix wall Street as long as this goes on.

If Wall Street types – and those pension managers – want to be paid like capitalists of yore, let them act the same way. Put your own capital at risk: all of it, every day. No cash bonuses. Just a lifetime stake in the capital of the company you work for.

I have said this before: one of the characteristics of old time recessions, and especially the Great Depression, was the frequency of bankruptcy amongst bankers. Those folks lost their own wealth: when the bank went bankrupt so did they. It was personal. Today’s yahoos are a far different crowd: they can run the ship aground and still expect to get paid. That’s why they’re a joke.

But the joke’s on us while we tolerate it.

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Break Up The Banks: Part 2

My my.

The heat has turned up around this issue. Maybe there’s something in it.

As I wrote yesterday I am a firm believer in reducing the scale of our banks. In a nutshell my view is premised on the ability big banks have to destabilize the economy and on their associated ability to exert undue influence on our legislative process. in short I see mega banks as anti-social and anti-democratic.

Extending this little bit: the big banks represent the only aspect of our economy where we, the people, have an interest in preventing failure as a matter of course. This aversion to failure does not flow through to all banks. On the contrary we allow small banks to fold up an a regular basis: nearly 100 small and medium sized banks have been allowed to fail this year and their assets have been dealt with by the FDIC according to well established and easily implemented guidelines. It is only the large banks who operate with carte blanche freedom to screw up royally and yet be bailed out. This is moral hazard writ large – egregiously large – and must end.

Why?

Because the banks know they will not be allowed to fail. So they can indulge in all sorts of gambling activities with impunity. The managers and traders can arrange to pay themselves vast bonuses safe in the knowledge that they have no ultimate responsibility for their actions. The behavior of Goldman Sachs and AIG should be adequate warning to us all in this regard. The one is larded with astonishing hubris – its CEO yesterday claimed that increased income inequality produces social benefits in the long run, to which I can best respond by paraphrasing Keynes: ‘in the long run we are all dead’. The second seems to be stuffed with an unreconstructed rentier class attitude which motivates its managers – that might be too generous a term given the obvious lack of management at the place over the past decade – to develop a sense of entitlement: they are aghast that we might find multi-million dollar bonuses for failed portfolio managers and traders somewhat galling.

As long as these organizations are allowed to persist they will always exert an extraordinary and disproportionate effect on policy makers. This means that monetary policy will be tilted towards avoidance of failure for these banks as a priority over other policy options that could benefit us all. Whilst policy makers live in fear of the results of the incompetence that seems to pervade Wall Street we cannot expect them to act on our behalf. they will protect the banks first. And the devil can take the hindmost – that’s you and me.

Which raises the non-economic issue: the very existence of private organizations large enough to wreck the way of life of all of us disturbs the balance of our democracy. They can, and do, act as oligarchs. They expect legislative bias in their favor. The flood the legislative process with cash – corruption by any other name. In times of crisis they expect to be at the front of the queue for government aid and bailouts.

This is decidedly unhealthy were it to persist for too long. My view is that it already has thus persisted.

So the question now becomes what to about anti-social and anti-democratic organizations.

My solution, as you know, is to get rid of them.

This is not an unknown or untried solution. Standard Oil is the obvious case in point. Economically the break up of Standard Oil was probably a wash: the resultant smaller organizations all did well for their shareholders and this gain offset any lost rent seeking that the larger quasi-monopoly can be presumed to have had. Socially America at large was much healthier subsequent to the break up: a huge source of political disruption was neutered and its corrupting influence watered down. More to the point, by breaking up Standard Oil we ended up with a more competitive and more vigorous oil industry – there were more players in the market so the public had more choice and costs were forced down accordingly.

Others are far more cautious and seem committed to protecting the banks integrity.

Daniel Tarullo, a Governor of the Federal Reserve Board, came out yesterday and opposed the ‘provocative’ idea of breaking up the banks. In particular he doesn’t see any advantage to splitting the gambling and lending activities apart in the way that the old Glasss Steagall Act did. His objections all seem very weak to me:

First, he argues that no one has offered up how we would break the banks apart, and so the idea remains a ‘provocative idea’ not a ‘solid proposal’. That’s bureaucrat speak for ‘we don’t have a plan yet so nothing exists’. Apparently only things that are planned for can be discussed. That’s just silly of course. The whole point of floating the idea is to elicit responses and start to planning process. the notion that the idea should be killed simply because we have no current plan is absurd. Let’s make a plan.

Second, he argues that separating the gambling and lending parts will not eliminate risk of losses. Duh. No one said it would. This is what we call a red herring. Of course it won’t eliminate lending risks. But it will isolate the two forms of banking risks from one another and prevent them from compounding each other. Moreover, since we are now acutely aware of the huge volatility in gambling risk, we should act fast to stop that volatility from undermining the capital base of the lending risk and thus freezing up the flow of credit into the economy. The objective of pulling the two risks apart – into what I call separate commodity and gambling banks – is to minimize the ability of the gamblers to stall the economy.

The social purpose of banking has to be pre-eminent in our regulatory attitude. That purpose is to allocate scarce capital against competing end requirements. Banks are the mechanism that we have for that allocation. Privately owned banks are better than publicly owned banks – they are supposedly immune to political favoritism – and so our regulatory regime should ensure the safety and soundness of the private banking sector. But only insofar as it performs its social task well. Once it wanders off into other activities – gambling on securitized or obscure derivative products that do not assist the allocation of capital, but exist only to generate bank profit – then our regulatory interest should drop to zero. We simply shouldn’t care if Goldman Sachs blows itself up by taking too much risk – what they do mostly doesn’t touch regular people at all, so why should regular people bail it out?. But we should care if Citicorpscrews up and doesn’t keep making those credit card or small business loans. Pulling out the gambling bits of Citicorp and selling them off to private gamblers makes sense in this case.

So the defense of social purpose is a big driver of our need to limit banks to specific types of banking: that way we can limit the extent of our underwriting.

Third, Tarullo argues that hiving off the gambling would simply move the problem and not resolve it: there would still be ‘too-large-to-fail’ gambling banks like Goldman cluttering up the regulatory space.

Not necessarily.

Once we start untangling the web of counter-parties and deliberately convoluted subsidiary relationships that the banks have put in place to reduce their tax payments – nice corporate citizens that they are – I think we will find that the bulk of the bloat is fiction. All banks could be much smaller if they were prevented from trading at the pace they do. Current bank balance sheets are pumped up in size by the constant inter-bank trading of gambling products. This activity generates profits and thus bonuses, but doesn’t n=move capital into the real economy. It stays within the financial sector. By putting a fence around the gambling banks we can force them, to pay the full cost of the underwriting insurance of their gambling activities – we can withdraw our support completely. The margins on this churn of gambling products is usually wafer thin, if the banks then had to price in the underwriting cost – private bail-out insurance – the profitability would be eliminated and the volumes collapse back to those derivatives and securitized packages for which there is a social value: futures on commodities for example. So separating the gamblers from the lenders is just the first step I envisage. It enables the second: the elimination of any public support for the gambling activities.

The irony is that most defenders of the banks espouse free market principles. All I am arguing is that we should force the gamblers like Goldman Sachs, whose managers constantly spout their pride in being tough players in tough markets, to play in markets that are, in fact, free. In particular they should play in markets free of government support. If they do well, then great. If they sink, then great too. I love the democratic power of markets. What I don’t love is the hypocrisy of managers who talk tough and play soft – while paying themselves as if they were playing tough.

So Tarullo’s whole speech seems to me to be a hurried attempt to throw up a few ill thought through roadblocks. That he felt the need to do so is re-assuring. It means the break up argument is worrying the establishment.

Speaking of which: today’s Wall Street Journal carries an op-ed piece by Professor Charles Calomiris arguing against break up also – I doubt the WSJ would carry a pro-break up piece, but that’s another argument. As I would expect the professor makes a much more nuanced and better case than Tarullo’s more political version.

But he still misses the main point.

Calomiris focuses his defense of mega banks on their ability to operate and provide services across global markets. Breaking them up might jeopardize this ability. Plus, he says, the scope advantages of the huge banks enables them to mix products and package them attractively for those same customers. Finally he cites research that shows the cost of equity underwriting has fallen significantly since the abolition of Glass Steagall.

But none of these arguments defends against my main attack: the political power of mega banks to disrupt democratic determination of economic policy.

His preferred solution to the ‘too-big-to-fail’ problem – and he acknowledges that it is a problem – rests on our ability to legislate powerful restraints on bank activity – by adding capital requirements, raising transactions costs, limiting affiliations etc. Since all these regulatory actions would represent a threat to the personal gain of the managers now running the mega banks – profits would be reduced – the professor seems, naively in my view, to assume that the banks would not resist. Or that they could not derail such legislation. Or that they could simply re-locate enough of their operations to lax regulatory regimes and thus avoid the restrictions of American law. They already avoid tax laws this way, why not regulatory restrictions too?

I think the professor misses what has happened during the past year. The administration has trodden very politely around any strong regulatory measures. Regulators seem to ape the opinions of the banks. People like Geithner spend more time on the phone with top bankers than they do talking with non-bank experts. In short there is no evidence that the banks would fail to stop strong legislation.

Calomiris’ solution presumes a compliant industry. There is no evidence of such compliance. On the contrary there is ample evidence of corruption and undue influence. And that simply serves to support my claim that they are already disruptive and so need breaking up.

As for the global arguments: on paper they seem strong. In reality they melt. Even a trimmed Citicorp could manage its global clients. And, surely, the increased competition represented by the existence of more banks, as would be the case after the break up of the mega banks, would add to and not diminish, the cost and innovative advantages that Calomiris attributes to the existing structure. It is contorted pleading to argue that advantages of scope and scale will inevitably outweigh the advantages of more free market competition. Economic theory – screwed up as it is – is not something we can cherry pick to support our arguments. It either works or it doesn’t, in its entirety. If this is true then the professor needs to explain why market forces – something he teaches about every day in his academic life – suddenly appear frail in the face of mega banking.

On the topic of theory: Calomiris sees fit to throw into the mix the work of Oliver Williamson who won the Nobel Prize last week. Williamson works on the theory of the firm and is particularly interested in the question of where the firm’s limits should be. In other words what determines a firm’s size? Calomiris argues that Williamson explains why firms get larger – it is cheaper than having smaller firms all contract with each other in the open market. But this is a superficial reading of Williamson. The deeper and more accurate reading is that it is cheaper for firms to grow only when the cost of information is excessive. Thus large organizations economize on information. Calomiris needs to explain why, in the modern electronic financial market place, where transactions costs are negligible, economizing on information costs automatically implies large banks. I don’t see in any of Williamson’s work an argument saying that such growth is automatic. On the contrary, Williamson seems to support the efficacious nature of markets and is simply seeking to explain the existence of business firms by highlighting the fact that ongoing uncertainty inhibits free markets from performing the way textbooks argue they should. In my mind Williamson hews more closely to New Classical orthodoxy than either his inspiration – Ronald Coase back in the 1930’s – or Calomiris’s interpretation would indicate.

Either way putting Williamson’s name into an op-ed about mega banks seems to be a tawdry effort to beef up his argument’s intellectual heft, rather than giving it actual substantive support.

Anyway: the break up the banks effort flows as much from the social and political argument about their disproportionate power as it does from pure economics. For far too long we have bowed down to the purist economics crowd: they are the ones who brought us the derivatives business in the first place, as well as the wonderful risk models that blew up last year. Their credibility is shot.

In the end this discussion comes back to our attitude towards the bank’s power.

I just cannot reconcile the existence of the concentration of such power in so few hands with the continued health and vibrancy of the American system of values and institutiuons.

That’s why this is important and discussion should not be restricted limited arguments such as either to Tarullo’s bureaucratic view, or Calomiris’ economics based view.

But at least there’s discussion. That’s a good start.

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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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Housing

I haven’t commented on the state of the housing market lately so this morning’s release of the monthly home price data compiled by the Federal Housing Finance Agency gives me a chance to rectify that.

The news, like so much of what we see and hear at the moment, is very slightly improved over that of earlier this year. Is that good? Well not great, but moving ever so slowly in the right direction.

The FHFA collects data only on homes financed through the agencies that comprise the government mortgage provider network: Fannie Mae, Freddie Mac, and the various Federal Home Loan banks. The data is useful because it based upon repeat sales – in this way it resembles the Case-Schiller Index – and so tracks prices for the same house through time.

On this basis the FHFA estimates that home prices rose 0.3% in July, which is the latest month for which it has compiled data. This follows an increase of 0.1% in June, and makes three consecutive months of gain. That’s the good news.

On the negative side I am concerned that the June number was revised down from 0.5%, and year on year prices are still showing a decline: this July’s figure is down 4.2% from last year’s and is 10.5% off the 2007 peak.

None of these numbers are as dramatic as those of the Case Schiller Index which shows a 15.4% decline in the last year alone.

Since the two indices are calculated on such different sets of homes they cannot be compared directly and we are left simply to remark on any similarities in trends.

Both are showing the same kind of slope: down sharply last year, continued down early this year, and now a noticeable ‘bottoming out’ effect with prices up and down month to month , but with a very small positive movement discernible.

So is the housing market on its way back to health?

That depends on what you mean by health.

I don’t see a way for the market to rebound with anything like the intensity of activity we saw during the height of the bubble. Those absurd days are gone – mercifully. With all the key market actors severely burned by the experience it will be a while before we return to the years of reliable double digit price increases – without strong re-regulation of the banks I cannot eliminate the possibility entirely, but I have to assume that even the banks are reticent to lose a ton more money on rubbish real estate loans. So funding will be less available and credit standards will, hopefully, return to something like respectability. This will limit the cash flowing into housing and so dampen all that Greenspan ‘exuberance’.

Just as important: buyers are now cramped. The tighter credit standards will inevitably limit the number of eligible buyers for each home, so with demand decreased another source of exuberance is eliminated. Buyers are also struggling with debt burdens accumulated during the silly season of earlier this decade. With wages flat lining for a long time now, and under pressure currently, affordability becomes critical. The significant drop in prices already has made homes much more affordable than they were, but I question whether we have made sufficient adjustment for the market to recover completely.

My suspicion is that prices have dropped enough to eliminate only the effects of the ridiculous financing – sub-prime mortgages being the obvious example – we saw during the bubble years. Those kinds of loans increased the ability for people to buy homes by expanding the number of ‘creditworthy’ buyers. The result was not just to enable more people to buy houses, which was the positive social effect that was touted by the de-regulators of the past decade or so, but it also drove prices way up beyond ‘normal’ levels of affordability. Add these two effects together and we produce a market glutted with demand and overpriced at the same time.

The next step in rounding out the picture is to understand that this state of affairs stimulated construction. In fact real estate construction became our biggest single source of job growth throughout the Bush era. When the bubble finally burst we ended up with a massive over-construction of homes – supply is way out of whack with demand. The inventory of unsold homes is slowly being whittled away, but it remains at historically high levels.

Adding all this together we can now answer the question about the health of the housing market: it is suffering from a humongous hangover. And like anything or anyone in that situation it is both turgid and volatile at the same time – it is very sensitive to loud noises. ‘Fragile but increasingly steady’ just about captures the picture.

Very slowly life is returning to normal. There are huge geographical differences: the prize for the worst hit locality has just shifted from California to Nevada: the mountain states are still seeing quite large price decreases, whereas the Pacific coats has begun to firm up a bit. Even Florida has hit bottom, but it could begin to fall some more if the overall economy doesn’t get going soon.

Sellers of existing homes seem to be in shock at the prices they now have to accept as reasonable. The prevailing price level is so far down from its peak that some sellers appear willing to try to wait for a rebound rather than sell now. This creates a kind of ‘grey’ inventory – homes that the owners would like to sell, but which are not listed as for sale officially. In Manhattan this problem is particularly acute – it almost doubles the inventory of homes for sale.

Then we have to add to inventory newly constructed homes that the builder is not listing for sale because to sell at prevailing prices would undermine the financing arrangements that underpin the construction. This effect has released a flood of condominiums in New York City as rentals rather than as sales, creating yet another distortion in the market that makes perceiving the market’s health very difficult.

Further: much of the ‘recovery’ in prices we have seen this year was driven by the tax incentives for new buyers: this helped arrest the decline in qualified buyers for a while. That effect will now fade away and thus reveal any underlying trend it may have masked.

Lastly: given the very difficult job and therefore income position that the population at large finds itself in, it becomes extremely hard to predict a sustained and steady recovery in prices. There will be pockets of strength: all those Goldman Sachs bonuses will inevitably continue to distort New York real estate prices, but the general trend will be one of very slow gains.

We are only now at the bottom of the cycle and there are no sources of strength that justify a bold forecast: affordability is still low; credit is less available; households are financially weak and risk averse; sellers are shell shocked over prices; foreclosures are high and rising – this puts downward pressure on prices; many owners are stuck with negative equity and therefore cannot sell – this reduces potential inventory for sale; builders are still sitting on piles of unsold homes; and the banks are evaluating their loans to builders – I foresee a burst in loan losses and commercial real estate bankruptcies that will distort the market next year.

As I said this is one heck of a hangover.

Prices will stabilize – I think they need to drop a little more [another 5% to 10%] for a solid rebound to take effect. Without a further decline things will have to wait for personal incomes to grow to bring affordability back into normal ranges, and that looks unlikely for a year or so.

All of which implies that this morning’s data is a very accurate reflection of the market: very weak price recovery coupled with big geographical variation and no real evidence of strength.

That’s the way I see real estate for a few quarters – maybe years – yet. I doubt we will return to the price peak of 2007 for many years to come: somewhere between 2015 and 2018 looks about right for that. Meanwhile housing will underperform as an investment, and there will be plenty of deals.

Buy a home certainly, but invest somewhere else.

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