bailouts

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Bank Crisis Aftermath: Greenspan Speaks

For those of us who have nothing better to do than get immersed in the banking crisis and its aftermath, this week has presented some riveting television. The Financial Crisis Inquiry Commission has been grilling some of the key players – dare I say villains? – of the implosion that led us into recession. Some of the conversation and questioning is revealing. Quite what this will all lead to is anybody’s guess, but in the meantime we are being treated to a typically American gala of recrimination, self-congratulation, and, in some cases, of reputation defending.

Yesterday’s star was Alan Grenspan, who amongst all the key players is probably most culpable, both for the actions he took and for the many that he refused to take. His testimony provides us with an acid test for the problems we face as we reconstruct banking to make it less damaging to our economic health.

With that in mind let’s pick apart some of his key points.

First off he reminds us that sub-prime lending has been around a lot longer than simply the past few years. It was a small, and well functioning segment of the mortgage market for the previous decade as well. Sub-prime loans were a way of extending home ownership to people who would never have been qualified for a regular loan. It was always higher risk business than regular mortgage lending, but because it was so small a piece of the whole market that risk was eminently manageable.

Where the wheels fell of was when home prices began their bubble driven rise.

Once home prices began that rise, many people who would have qualified for a normal mortgage found themselves being squeezed out of home ownership opportunities. In a nation obsessed with home ownership, and with a conservative political regime dedicated to private property as part of its ideological platform, lenders who began to deploy sub-prime techniques more broadly were encouraged rather than discouraged. Add in the inherent profit advantage sub-prime loans present the lender – which is only reasonable given their higher risk – and a we lay the groundwork for the disaster of 2006/2007.

At least this is Greenspan’s view.

He may be stretching things a little, but by and large this much is correct.

In and of itself however this would not have caused the crisis, we needed more ingredients.

The next that Greenspan identifies is the role played by the quasi-government agencies – the GSEs – Freddie Mac and Fannie Mae. These two bodies fell under intense political pressure to accommodate and encourage the boom in mortgage lending during the 2000’s. This pressure was a manifestation of the ideological approach of the Bush administartion, which is why it odd to see so many Republicans listing the GSEs as prime villains rather than supporting cast players. Greenspan himself falls into this same trap. Yes, the GSEs we part of the problem, but they were not responsible alone for the crisis, and they were coerced at first to jump into the quagmire that they then enjoyed so much later on.

Crucially, Greenspan cuts his data short when he throws blame the GSE’s way. He leaves off the two years immediately prior to the collapse. These were two years when the GSE’s role was much diminished compared with the extraordinary excesses of the private sector.

The next villain Greenspan list is the boom in securitization, and the foolery – my words not his – of the rating agencies.

It was securitization that opened the door for the final orgy of self-destruction the industry indulged in.

By dint of incompetent math, incredulous management, and outright greed on the front lines, banks willingly destroyed their balance sheets in a two or three year epic of stupidity.

The trick was that they rushed to lend ever larger amounts of sub-prime loans, making what had been a small segment of the business into the largest segment in no time at all. They then off loaded the loans by packaging and selling them to investors the world over. These investors thought they were buying safe assets – after all the rating agencies had confirmed that by giving the packages the highest possible rating. We all now know, of course, that the magic trick that converted the market’s riskiest loans into its safest was just that – a trick. The math wizards who invented the trick still haunt Wall Street, but their incompetence and venality was exposed on the grandest of scales.

What they believd was that by bundling together enough bad loans the package as a whole becomes less risky. The idea was that not all bad loans will go bad all at once. So if there are enough of them the cash flow from those that turn out to be OK will be more than sufficient to offset the losses on the inevitable, few, duffers. Whoops. The idea that the entire national housing market could implode at once never entered the febrile brains of these dolts. To be fair the data they used to convince themselves supported their case. Post war America had never experienced a national housing debacle. All the post war problems in housing had been local. So bundling a bunch of loans from all over the country looked like the safest of safe bets.

But American economic history doesn’t begin in 1945. Prior experience completely contradicts the evidence used by the bankers. But I imagine few of them wasted their time in history classes.

So Grenspan has laid the table for the crisis. The major ingredients are all there. His testimony is excellent, if sometimes self-selecting in its memory.

The final and crucial piece of the puzzle, and one few people mention, was the international economic conditions. Greenspan nails this well.

The story is a bit complicated as these things always are.

The point is that during the decade running up to the crisis the international economy was buffeted by a string of imbalances. The most important of these was the inability, or unwillingness, of some countries to expand their domestic consumption fast enough. That sounds arcane, but please focus on it. The upshot of this under-consumption was that the world economy was flooded with savings. Cash was everywhere. And it all needed a home. Investors were hungry for places to park their money and make good returns.

Let’s repaet that.

Some countries grew so fast that their domestic ability to consume was outstripped by their population’s new found wealth: China and India are classic examples. Both generated cash for investment, but their was simply not enough opportunity at home either to spend or to invest. So the money went into the global economy. Other countries, Germany and Japan, deliberately kept a lid on domestic consumption, which had the same effect: their populations ended up with extra savings that needed to be invested somewhere.

Either way, during the mid-2000’s the global economy was awash with cash and had too few investment opportunities.

Into which breach stepped the American banks and all those securitized loans. Those loans were the biggest single asset class available for investors around the world to buy. Since the loans were rated so highly, investors, mainly foreign banks and insurance companies, stepped up and bought billions upon billions of them.

This cash abundance was the vector through which what was a peculiarly American disease infected the entire world.

So when the American bubble burst it took the world with it.

That in a nutshell is what happened. As told by Alan Greenspan.

His examination of the regulatory response and the improvements we can make is also revealing.

In many ways he becomes old fashioned really quickly.

He advocates much higher capital levels for the banks. His argument being that had Lehman been better capitalized it would have weathered the storm. I doubt this. Lehman’s problems were more than this. It was running a shoddy book of assets, that turned out to be worth far less than its balance sheet suggested. Indeed at the loss rates it suffered even Greenspan’s suggested capital level of 15% would have been swamped.

Plus Lehman, like most of its kind, had developed an unhealthy reliance on short term funding. Greenspan recognizes this as well and advocates a much more stringent oversight of liquidity requirements.

My issue with this is that liquidity is a property of the system not an individual company. By this I mean that markets are liquid and that companies access liquidity only so far as the market remains liquid. Were such a market to freeze up and lose it liquid properties, then all the participants in that market suffer together. No one company loses its liquidity, they all do.

Where liquidity becomes an individual company issue is when it overlaps with solvency: do the other players in the market believe the valuation of the company’s assets it uses for collateral? If not it suffers more than the others. Which is what happened to both Bear Stearns and Lehman. No one believed their balance sheets.

So building a regulatory regime for the future needs to recognize that defending liquidity is the central banks role. Defending solvency is the individual company’s responsibility.

So while Greenspan is probably correct in arguing for much higher levels of capital and renewed emphasis on protecting liquidity, I am not convinced that we can arrive at easily constructed answers as to what those levels should be. There will always be an odd circumstance when even the highest level fails to save the bank.

Which brings me to a final comment on Greenspan’s testimony.

He litters his comments and his answers to questions with statements about the instability of banking and the waves of euphoria that sweep through it periodically. His analysis is oddly similar to that of Hyman Minsky, whose name I have mentioned here often. Minsky, you will recall, was the inventor of the Financial Instability Hypothesis, which is a theory about banking and its role in the economy based upon Keynesian economics, and in particular upon Keyne’s insight that the economy is inherently unstable due to the existence of uncertainty.

Throughout Greenspan’s testimony I get the feeling of someone grappling with the failure of long held ideas, theories, or beliefs. Sometimes he sounds almost naive in his statements, as if no one had ever though about things like this before. Or that no one could possibly have predicted the outcome the string of events he so capably summarized.

That’s my problem.

Plenty of people could. Anyone familiar with Keynes or Minsky for instance. Anyone who was not beholden to the market magic thinking that dominated Greenspan’s actions for is entire tenure at the Fed.

In other words: while Greenspan is to be congratulated for his revelations and his concise and accurate rendering of events, and, perhaps, for his latter day conversion away from market magic, he still bears responsibility. He could have listened. Instead he continud to drink from the same poisoned well as the bankers.

Instead of acting as a bulwark, he became a facilitator of their folly. He became a channel through which they spread the disease.

Unfortunately for him, that’s the way history will most likely remember him.

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Jobs: Do We Give Up Too?

Mark Thoma has caused quite a stir. Which you probably missed because he’s a fairly unassuming academic in his normal guise, and a regular, sharp, commentator on his economics blog. He is one of those economists who pops up now and again in the media with a non-orthodox view, and a practical approach. Along with notables like Brad DeLong, Dean Baker, and Paul Krugman he has done much of the heavy lifting necessary to orient economics towards a real world solution and away from the loony stuff preached by our friends in Chicago.

His presence within the economics blogosphere looms larger than most so when he announced that he was ‘giving up’ hope that the Obama administration would attempt a significant job creating effort his words carried a great deal of weight. And stirred quite a debate.

He is correct, of course, that all the stimulus efforts so far have been inadequate and lightweight. Had we done more, sooner, the economy would be much further down the road towards robust health, and we would not all be wringing our hands over the turgid pace of recovery.

The really sad part is that the administration knows all this and yet still falters whenever pressed by ideological foes of stimulus. The recent ‘jobs bill’ – it deserves quote marks because of its derisory amount of spending – was more slap in the face for the unemployed than a help.

Equally sadly, the talking heads of the media have fallen prey to the silly chatter from the world of finance that America needs to switch towards belt tightening sooner rather than later. The fear of a spike in interest rates and portentous blather about a downgrade of US bonds by the rating agencies, grip the media’s attention far more than long unemployment lines. It has become as if we are resigned to a jobless recovery because we cannot afford the cure.

Fear, in other words, drives our decision making, not a focus on a solution or a determination to make our economy well again.

This implies we have not learned from the japanese experience of the past twenty years.

The Japan has become the poster child of what not to do after a huge asset price bubble collapses. The Japanese failure has been analyzed up and down by a veritable army of economists. It is the seminal reason that Paul Krugman shook off his allegiance to orthodox economics and embraced the Keynesian way. Practically every step a whole sequence of Japanese leaders took had a perverse impact. Japan lost wealth a prodigious rate; it piled up debt; it has impoverished its future; and has settled for mediocrity in the present, all because of its misdiagnosis and then timid response to its crisis.

We are following much the same course.

The simple reason is not economics, it is weak kneed politics.

The economists around Obama know what to do. They just cannot get themselves to argue strongly enough that we should do it.

They fear the cloddish opposition the Republicans will throw up: as if Jim Bunning knew anything at all about economics. Beyond the simply cloddish, they fear the calculated cynicism of people like Romney who object to government spending as a vote catching position rather than a well worked out economic policy. The procession of GOP leaders decrying big spending is long and shameless. Their position has instinctive appeal to a large number of voters. After all it seems intuitive that we should tighten our belts when money is scarce.

Wrong. Wrong. Wrong.

It is extraordinarily disappointing to realize how little attention many of our erstwhile leaders pay to history. It is even worse to realize that those who have learned the lessons of history are too weak to implement the knowledge they gleaned from that study.

Our one and only hope for a strong recovery is a demented spending spree, with the government printing money and handing it out to anyone willing to spend it.

Period.

Everything else condemns us to a Japanese experience, and the deliberate reduction of our children’s wealth.

But we have reached the point in our discussion of policy that folks like Thoma now give up. Publicly.

The effort to get the administration to do the right thing seems a hopeless cause. So Thoma quits and DeLong chimes in that he agrees.

So do we give up too?

Heck no.

We need more stimulus. Now.

Addendum:

Those of you who like pictures in order to understand things – I am with you believe me – should all rush to this chart on Brad DeLong’s site.

He shows the shortfall in economic activity, which he notes is about $1.3 trillion at the moment. Two points to note: that the gap is between current activity and projected activity as if the recession had never taken place. The idea being to put a number on the damage done by the downturn. The second point is to note that this loss is permanent. There is nothing we can do to recoup that lost spending. This is what I mean when I talk about impoverishment: we lost a ton of spending and, by extension, all the wealth that such spending implies, during this crisis. That lost activity is far greater than the cost of the bail-outs and the stimulus combined.

And it is to mitigate that loss, to shorten the period of loss and to lessen its amount, that we deploy government spending. In a vernacular sense we fill the void that the gap represents through artificial spending. We plug the hole.

By so doing we prevent much of the permanent loss. The cost is that we have to repay the amount we deploy. But that cost is a smaller burden on the future than the unfilled gap, because we kept ourselves on, or close, to our historic trajectory.

Pictures are helpful.

More stimulus. Now.

OK.OK. I know that we won’t get more stimulus. But it won’t be because we didn’t shout for it.

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Bank Reform: Contingency Planning

A couple of days ago I gave the thumbs down to the Dodd bank reform proposal, but in the past couple of days it has become clear I wasn’t sufficiently open about why.

One reason: bank behavior is not our only problem. Bank size is too.

Maybe one way to get at why this is so important is simply yo return to aspects of the crisis. There was no explicit taxpayer guarantee of AIG, but we bailed it out anyway. We allowed Bear Stearns to be pushed into a merger, yet we allowed Lehman to go out of business altogether. In short there was muddle and confusion everywhere, with ad hoc decisions being the order of the day rather than the execution of a well known and well rehearsed rescues plan.

Plus, and this is where I am most adamant, the crisis revealed the extraordinary size of the contingent liability the government has.

I find it odd, no positively annoying, that people who decry the use of off balance sheet accounting by the banks would then condone off balance sheet accounting by the government. Yet that is exactly what our continued guarantee of the banks amounts to. The way I see it is that the extension of a taxpayer safety net is a liability that taxpayers take on, and so should be added to the sovereign debt burden of the country. When a government bails out a bank it is converting a private debt into a public debt. Naturally it only does this in the event of a bank crisis, so the obligation is contingent. It is a real debt nonetheless.

Setting aside for the moment the efficacy of such a conversion – and the moral hazard it involves – the existence of a huge potential debt obligation needs to be factored into the risk profile of the national debt.

Why does this matter?

Because we are piling up liabilities at a prodigious rate. The national debt is growing rapidly as the result of our need to prime the economy, and our need to fund entitlement payments even while government revenues suffer a cyclical decline. This growth is causing consternation in the more right wing elements of the financial media because there is a fear we may eventually be charged more for the debt we issue. So far there is no sign of that happening: the government seems to have easy access to a large enough flow of funds, which indicates that the debt fear argument is more ideological than economic. Nonetheless it goes on.

My point then becomes this: our debt burden is growing and is making fiscal policy difficult over the medium term. We will no doubt have to resort to a combination of tax increases and spending cuts to get the budget back in line. Crucially: this adjustment period will be a highly sensitive one. We will have little room for maneuver should another crisis erupt. This lack of wiggle room is the basis for my continued criticism of the Reagan/Bush strategy of starving the government of revenues. No one is seriously going to slash spending on entitlements in the midst of a crisis – cutting them would exacerbate the drop in demand, and the existence of entitlements adds a huge ballast to the economy offsetting the volatility of the private sector. One overlooked aspect of the crisis is the value social programs play in keeping cash flowing in the face of a freeze up of private spending.

But the lack of wiggle room is made much worse by the continued contingent liability we have to bail out the banks. The implied addition to our debt load overhangs any ‘on the books’ policy decisions. Put another way: the bank bail out liability could serve as pressure to cut social spending in order to free up debt room for the banks.

In that light I wanted to see strong measures in the reform that would cut back the contingency.

One way, which is included in the proposal, is to force the banks to pay an up front fee that is set aside as a ‘rainy day’ fund for the government to dip into when it needs bail out cash. I am skeptical about this fund, not because it will not exist, but because it looks insufficient at $50 billion. This insufficiency stems from two weaknesses in the reform proposal: the sheer size of the industry dwarfs $50 billion so a systemic failure would flow straight into our debt burden; and even if the problems were contained to individual banks, those banks are still behemoths, each quite capable of absorbing $50 billion – the cost of saving AIG was much more than that.

And this is my central criticism of the proposal. It leaves the banks too large. It contains fine words about establishing a process to dissolve big banks, and to suggest limits on them. But this puts the burden of change on the shoulders of the regulators, a group prone to capture and intimidation by the industry.

Proper reform, in my view, would have included some form of cap on bank size, backed by the Volcker rule to eliminate over-entanglement and unmanageable complexity.

The contingent liability implied by ongoing taxpayer support should have provided a rallying point for fiscal conservatives to support the establishment of size limits – one way to reduce future budget deficits and limit the fiscal risk of the country is to limit the size of our banks.

Such is the power and importance of the banking industry that we need to take both its instability and incompetence into account as we manage our way out of the hole it dug for us in this crisis. Which is why any reform has to have a harder edge than the Dodd proposal has. So far at least.

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Bank Reform

Well here we go. Lest you have forgotten, we had a bank crisis a while back and such was its ferocity that the economy stalled and approximately 8.5 million of our fellow citizens lost their jobs, while millions of others lost homes. So much for the little details. Now let’s get on with the grown up stuff: how do we avoid this happening again? We need swift, decisive, and deep surgery on our financial system in order to re-align it with socially acceptable goals.

Yawn.

What seems a lifetime later, Senator Dodd sends us his proposal. The only criterion we need apply to it is a simple one: would these reforms prevent a similar crisis.

Umm. Well no, actually.

And therein lies the rub.

The problem I have with the proposal is that it has become a long list of fudged responses. It looks as if it gathered dust over the last year, and that the delay gave enemies of reform plenty of time to soften its blow.

Let’s take a look at it.

First up is the Consumer Protection aspect. On the surface the reform delivers the goods: an agency dedicated to protecting consumers from the kinds of exploitation and misdirection that swamped us with sub-prime mortgages. The new agency would extend its reach into parts of the system that were beyond regulation before and would be adequately staffed and financed to keep up with the legal road blocks thrown in its way by the banking industry. The proposal litters the word ‘independent’ all over the place which is our first indication that all is not well. The good news is that the new agency would take over in a central location all the various consumer related efforts now scattered across the regulatory landscape. The bad news – really bad news – is that this so-called independent agency would sit inside the Fed. This is the same Fed that was clueless as the sub-prime tsunami rose up a few years back.

Having the head of this ‘independent’ agency report to the President does nothing to hide that fact that the Fed has won a decisive battle here. For the new agency to have teeth it needed to stand alone. Dumping it into the Fed’s lap doesn’t fill me with confidence.

Second: having said all that the reform proposal has good things to say about the Fed itself. Good in the sense that it seeks to alter the Fed’s make-up. Currently the Fed banks, and especially the New York Fed which is the key player in the system, are riven through with nasty conflicts of interest. The banks themselves appoint many of the governors and there are far too many career paths that crisscross between the Fed and the banks. This interconnection may not be illegal, and it may not, necessarily, bring about conflicts of interest that have damaging consequences, but it does produce a remarkable homogeneity of thought on the larger banking issues. It allows the skeptics like myself to wonder out loud about the way in which policies were arrived at: why, for instance did the New York Fed seemingly bend over backwards to get Goldman and others that AIG cash? Was it because the chairman of NY Fed at the time was an ex-Goldman executive who still had large Goldman shareholdings? Maybe not. But the conflict was potentially there. In a good system it would not.

The current proposal wins points for eliminating the possibility for conflicts of interest by getting rid of the bank influence on appointments and preventing career jumping back and forth. The Fed will thus be a more independent institution. Whether it will still suffer from finance industry group think is another story.

Third, and this is a major point, the proposal punts on ‘too big to fail’. It recommends a new central committee to oversee ‘systemic risk’ and gives it the power to suggest action against firms deemed dangerously large. The problem is in the details. For instance, the reform would allow this committee to take action against a dangerously large firm, but ‘only as a last resort’. Huh? What does that mean. In the cautious and litigious world of regulation those words: ‘only in the last resort’ signal that the power is never to be used. Who would determine when the last resort had arrived? This is unnecessarily contentious. It shows a weak hand. It is almost as if the writers of the proposal wanted to check off all the big issues and make it appear as if they had dealt with them, and then they backed away in fear of rocking the boat too much. This systemic risk committee smacks of bureaucratic gridlock even before it gets set up. The big banks will be able, I imagine, to thwart anything intrusive coming out of such a cumbersome and purely ‘suggestive’ body.

Fourth, likewise, the reform hedges much too much, on other aspects of the overly complex nature of our big banks. Yes the proposal sets up a center of expertise to gather and analyze the data necessary to understand the dangers the big banks pose to us. But much of that data already exists elsewhere in academic studies. We already know that they are dangerous. We already have tons of data to tell us that financial systems are inherently unstable and need heavy regulation and strong limits on behavior. We do not need more studies, we need to act on the studies that already exist.

The good news on bank complexity is the inclusion of the Volcker Rule, which would go part way to reducing the damage the banks can do. But it is insufficient. We need to reduce the banks in size so that they can be exposed to market discipline.

Nothing in this proposal implies smaller banks. The words are all there, but the action is not. The reform backs away from setting hard limits on size, and relies far too much on soft methods to contain the damage.

Chief amongst these soft methods is the heavy reliance on improving the way in which banks can be wound up through bankruptcy. One of the big problems in the depths of the crisis was the feeling within the Fed and other regulators that they did not possess the power to force a wind up of a defunct bank. Nor are the bankruptcy laws amenable to a swift dissolution – as the ongoing legal battles over the carcass of Lehman attest. It is absolutely vital that a bank can be wound up within a day or so. That way the potential for a cascade of panic and the resultant bank run is eliminated. The point is to limit the damage a rotten bank can do to the system. Unfortunately having any number of good plans and intentions doesn’t always produce the decisive action needed in the heat of the moment. Policy makers and regulators will still be loathe to wind up something as large as Citigroup, no matter how awful its balance sheet has become.

Which is why I am an advocate of taking the action up front: limit the banks in size, so that if they are toxic they can fail without intervention. I am too skeptical of the willingness of regulators to forces a major bank into bankruptcy for me to see much value all the elaborate ‘funeral planning’ that the proposed reform offers up as a bulwark against future bail outs.

And the notion that the banks will be taxed so that a bail out fund can be established up front – to the tune of $50 billion – in order to avoid future TARP like crises is window dressing. The cost of that tax will find its way into customer prices. So we pay either way.

Fifth, the proposal tackles the tangled web of regulation. Or tries to. It reduces and cleans up the mess of regulators we have But it leaves the Fed at the center dealing with the big banks. Which is a bad idea. The Fed failed before in it regulatory role, and shows no sign of strength since the crisis. It still is ‘suggestive’ rather than ‘enforcing’, it still deals with the big banks from a weak position, and it still suffers from that group think I mentioned earlier. So while the reform goes part way to establishing better regulation, it has this basic flaw – in my view – at its core.

Sixth: I support the proposal to bring all the shadow banking system under regulatory supervision. In particular systemically important hedge funds will now brought into the net of control. This is simply an extension of the old ‘if it quacks like a duck’ measure. If an organization could be eligible for public support then it should be subject to public scrutiny. That the proposal moves towards a more comprehensive regulatory regime is to be welcomed. I give this idea high marks.

Seventh, in a similar vein, tightening the net around the insurance industry is a long overdue reform. Right now the insurance industry falls outside of federal oversight. This is despite the size of some of the players in that industry and their potential to do enormous damage to the economy – think AIG. So getting them under control is something we need to do both for consistency’s and safety’s sake. The problem is that the reform doesn’t do this. It merely sets up a federal office of insurance oversight at the Treasury Department, with the remit to look into how to regulate the industry. Ugh. This is a total cop out. The problem is that the state insurance overseers have enormous political clout and will not give up their powers easily. Our chance of modernizing the insurance industry is near zero. Nice idea though.

Eighth, the rating agencies take a hit. Again the reform backs off making a strong move in favor of a list of suggestions and minor tweaks. Yes there is a new office of oversight at the SEC, but this is the same SEC that has perennially bent over backwards to avoid confrontation with a ratings industry riddled through with conflicts of interest. What would have been so hard to eliminate those conflicts? All we needed to do was to fund the rating companies from a tax on the transactions they rate. So rather than rely on the investment banks for fees the rating firms would be quasi-utilities funded from the pool of debt and equity offerings. This would help insulate them from the obscene tampering they were exposed, and fell for, in the go-go years of securitization.

Speaking of which, and last on our list, is the proposal to regulate and bring more transparency to the derivatives market. One of the biggest issues during the crisis was that so many of the toxic transactions were the result of murky and obscure deals done in private rather than through an exchange. This meant that the advantages of an exchange – open pricing, transparent trading, and market making – were lacking. The result was a mess of ridiculously complex and ill understood deals whose value was lost beneath mounds of smart legalese designed to prevent anyone knowing the value of what they had bought, and which masked the consequences of changes in the economic assumptions that made the deals profitable. One of the main ways in which the big banks manipulate the credit markets to their own advantage is through these murky deals. The very name they use for the space in which they trade is a give away of their intentions. They use the phrase ‘dark pools’ to describe it. So getting derivatives out of these dark pools and onto a public exchange is a very good thing. We can give the proposal high marks on this. At least for the attempt.

OK.

Let’s all come up for air.

What is the overall conclusion?

I come out this way: the reform proposal contains lost of good intentions and some good actions. But it falls way short of being decisive. The acid test, for me, is this: does it prevent a repeat of the crisis?

To avoid a repeat the reform would have to produce smaller banks, with simplified lines of business, with less ability to manipulate markets, and less able to exploit customers. It should also have put hard limits on the potential loss taxpayers would bear, and would have ensured that shareholders and creditors play an active role in monitoring executive management in order to prevent the kind of excesses – what we call rent seeking – that led to the misaligned incentive structures of the 2000’s.

Does the reform do all this.

No.

It tinkers. It suggests. It guides. And it starts us along the way. But it does not get us there.

The state of our leadership is such that this reform is being touted as strong. It is not. It is more jello than steel. But that si where we are as a nation. We accept weakness as a sign of pragmatism.

Jamie Dimon is right: we should all expect, and accept, regular financial crises. This reform does not forestall a repeat.

And it’s probably going to get watered down from here on, until something gets voted on. That prospect should galvanize us all into demanding better reform.

I doubt we will get it.

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Bank Stocks: Proof Times Have Not Changed?

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

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

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

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

The answer is a resounding no.

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

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

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

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

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

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

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

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

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

Back to the stock market.

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

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

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

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

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

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

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

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

Yes, the boys are back in town.

Which means there is a crisis brewing.

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

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

There is something wrong with that picture.

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