Tuesday, May 25, 2010

The Goldman Sachs hearings missed the point - PART 5

Okay...sorry for another extended delay. It's been difficult knowing when to jump into the mix here when the financial reform package was still being hashed out. It has now passed the Senate and will be molded together with the House bill in the next few weeks. But before I talk about that at all...let's discuss this issue of 'Too Big To Fail'.

As I mentioned in the last post, I see two major categories for reform: 1) Increasing the transparency of financial transactions from the credit-card consumer-level to the hedge fund-level, and 2) breaking up the "Too-Big-To-Fail" banks. In my mind, both are absolutely critical and one is nearly useless without the other.

I know the phrase 'Too Big To Fail' has been thrown around A LOT lately (almost to the point of becoming cliché) but what exactly does it mean? Again, let's go to my current favorite book (13 Bankers):
Certain financial institutions are so big, or so interconnected, or otherwise so important to the financial system that they cannot be allowed to go into an uncontrolled bankruptcy; defaulting on their obligations will create significant market losses for other financial institutions, at a minimum sowing chaos in the markets and potentially triggering a domino effect that causes the entire system to come crashing down.
No one in their right mind would ever argue for the existence of financial institutions that are Too Big To Fail. Fixing this problem was the rallying cry from nearly everyone in the financial world (both financiers and regulators) at the time of the near-collapse in late 2008. The reason that everyone appeared on the same side was because the problem caused by Too Big To Fail institutions was such a blatant affront to the very foundation of the free market that no one in their right mind would argue for their existence. And the consequences of bailing out Too Big To Fail banks was clear as day to everyone in late 2008: the mega-banks get the benefits of all of the risks that they took over the preceding years and the taxpayer bears the enormous cost of these risks once they exploded. It is privatized gains and socialized losses. Essentially...if you think Obama's health reform plan was socialistic, then this is even at another level beyond that (at least in a socialistic system, the taxpayer gets the gains as well as the losses).

And once an institution realizes that they are Too Big To Fail, they now have the perverse incentive to take more risks because they are implicitly backed by the federal government. This gives them an enormous competitive advantage over smaller banks who do not have this implicit government backstop. It is completely unfair and antithetical to everything that capitalism stands for.

One of the big rallying cries of the right during the financial reform debate has been to get rid of Fannie Mae and Freddie Mac (the government-supported entities that create liquidity in the housing market). And I completely agree with that argument for the reasons I discussed above. Fannie and Freddie are Too Big To Fail. But in order to stay intellectually consistent, those same people who argue for the dissolution of Fannie and Freddie should also be for breaking up the mega-banks for the exact same reason. Essentially, Fannie and Freddie are explicitly backed by the federal government and the mega-banks are implicitly backed by the federal government. There is zero difference when it comes to their power to corrupt our economic system.

This is why this is so frustrating. This should not be a left vs right issue. This is clearly not an example of the free market working as planned. But those against reform are buying the completely bogus piece of propaganda from those interested in keeping the status quo: "This is a government takeover of the financial sector!" Good sweet Lord...it's just amazing to see and hear the financial sector make this argument. The mega-banks have been holding the American government and taxpayers hostage for years and they are the ones crying about being taken over? Give me a friggin' break.

Another way to address the Too Big To Fail issue is through a re-implementation of the Glass-Steagal Act which was enacted during the Great Depression in 1933 to formally separate the plain-vanilla commercial banks (like the one where you have your checking or savings account) from the speculative and inherently riskier investment banks. The idea is to have the safer commercial banks backed up by the federal government [through the Federal Deposit Insurance Corporation (FDIC)] to protect against a bank run and conversely have the riskier investment banks not backed up by the government. However, this perfectly reasonable separation provision was quietly repealed back in 1999 as the market for complex financial products was just starting to go into full swing.

Along the same lines, another proposal is to eliminate proprietary trading, which is when banks use their own money for trading financial products to gain profit as opposed to using their customers money. This is better known as the Volcker Rule. More details can be found here.

So why do we need hard and clear rules on the size and type of banks instead of just relying on regulations?

Banks will inevitably find loopholes and ways to have their activities exempted because of their enormous and unrelenting power over the political world. If you don't believe me, just look up the source of campaign contributions for nearly every politician with any significant say in financial legislation. That's one of the benefits to running a Too Big To Fail firm; you have lots and lots of money just lying around to pay lobbyists to push legislators to do just about anything in order to fund increasingly expensive re-election campaigns. This political power is also quite potent with the regulators (known as regulatory capture). All in all, it has really turned our political-economic system into something more resembling an oligarchy.

So the only way to play ball with the mega-banks is to implement clear and decisive rules that would essentially break them up into smaller less politically powerful institutions.

But what about the argument that we need big banks to compete in an international market full of other enormous banks? Well, it turns out that, yes, we are not the only country with enormous financial institutions. Some countries have banks that are better dubbed Too Big To Bailout (this is part of the reason that Europe is in their current economic crisis). But even with that admission, there is still no credible evidence to suggest that we (as a country and as players in the market) need Too Big To Fail financial institutions. The megabanks are currently at such a bloated size that the usual economies of scale no longer apply. They really only got uber-huge (relative to GDP) in the last 15 years and back then they could still compete quite well. Also take this argument from Simon Johnson:
Even the biggest nonfinancial companies do not, under any circumstances, want to buy all their financial services from one megabank.  They like to spread the business around, to use different banks that are good at different things in different places – in part to prevent any one bank from having a hold over them.  Playing your suppliers off against each other to some degree is always a good idea.
There is just no evidence for having these megabanks around. They are enormous liabilities!

Okay, so what about the financial reform package? Well, I think I'll save more of a discussion on it after it passes both houses but things do not look all that great. It is still largely a technocratic fix...i.e., they really are only addressing the regulation side of things and nothing really structural (e.g., the size of banks...Too Big To Fail). I'm afraid that we really missed a huge political opportunity in early 2009. Some of the new rules will surely help but we are still poised for another situation where a future President decides between two awful choices: A) another massive bail-out of Too Big To Fail banks or B) collapse of the financial system leading to another Great Depression.
UPDATE: Just so everyone is clear on what exactly a megabank is, Johnson and Kwak would like to start with a limit of 4% of GDP for all banks and 2% of GDP for investment banks. That would make the following banks "mega-banks" and definitely Too Big To Fail:

  • Bank of America (16% of GDP)
  • JPMorgan Chase (14%)
  • Citigroup (13%)
  • Wells Fargo (9%)
  • Goldman Sachs (6%)
  • Morgan Stanley (5%)

Thursday, May 13, 2010

The Goldman Sachs hearings missed the point - PART 4

Sorry for the delay. I have waited to finish these last few posts on the financial crisis (for a while at least) until I finished the book 13 Bankers. And by the way, I just cannot possibly recommend it more to those interested and willing to take the plunge head-first down the rabbit-hole that is our broken financial system. It is a fascinating and well-written book by some really brilliant guys.

Okay...so here's a short, convenient summation of what I went through in the last 3 parts (quoted from 13 Bankers):
The end result was a gigantic housing bubble propped up by a mountain of debt - debt that could not be repaid if housing prices started to fall, since many borrowers could not make their payments out of their ordinary income. Before the crisis hit, however, the mortgage lenders and Wall Street banks fed off a giant moneymaking machine in which mortgages were originated by mortgage brokers and passed along an assembly line through lenders, investment banks, and CDOs to investors, with each intermediate entity taking out fees along the way and no one thinking he bore any of the risk. 
So, as we all know, the bubble did end up bursting and today we are continuously faced with the consequences in the form of high unemployment, cuts in government services, etc. But you might ask yourself...didn't we learn our lesson? Well, I wish that I could say 'yes' but I'm afraid we, as a country, are not even close to learning the larger lessons of this crisis.

The way the current financial system is structured, a future president (regardless of ideology or party) will inevitably look over the edge into a dark abyss of economic chaos and face the same decision that the Bush administration faced in the fall of 2008 after an asset bubble burst (this last time it was housing, the time before it was dot-com's, the next time...who knows?):
  • let the mega-banks fail and cause a banking crisis that would lead to another Great Depression (many, many times worse than the current economic recession) OR 
  • pledge an enormous amount of taxpayer money to bail out the mega-banks.
Both of these ideas are horribly unsustainable. Another Great Depression would dramatically change the world's economic status. It would be absolutely devastating. Another Huge Bailout for banks would funnel more money away from taxpayers to the financial elite plus it would dramatically increase the government's debt burden (with the worst consequences experienced by future generations). So that's why we cannot let this moment just pass and say 'Boy...that was close...we sure did learn our lesson...that shouldn't ever happen again.'

We have not truly come to grips with this crisis as a country. Those that are unemployed or otherwise severely affected by this recession are undoubtedly hurting and very interested in solutions but, as a whole, we are poised to repeat this mistake again. (See this new data on the decrease in the savings rate for a taste of this idea). More people need to be told about how close we came to plunging into a Great Depression...how the commercial paper market (the short-term loans that companies depend on to cover payroll) momentarily froze in September 2008 (the This American Life episode on this is great...the very first story beautifully explains the commercial paper market). This is all poised to happen again.

Alright...splendid. What to do? Now...on to the actual financial reform ideas.

I think it's easiest to just break it up into two basic strategies: 1) Increasing the transparency of financial transactions from the credit-card consumer-level to the hedge fund-level, and 2) breaking up the "Too-Big-To-Fail" banks.

#1: Increasing transparency of financial transactions

A fundamental assumption of a fully-functional capitalist market system is that everyone has the correct information available to them and then they use that information appropriately and efficiently to make a "correct" economic decision. But the critical lesson of the crisis is that this assumption is totally bunk. People are irrational and information is conveniently and strategically hidden from those who are being duped.

This has been happening at all levels of the financial system but most people are much more familiar with the credit-card side of things. I think most of us would agree that credit card companies have become exceptionally good at deceiving people into high interest loans and charging for hidden fees. This has got to stop. But it's not at the heart of the crisis.

The other side of the system is where the huge problem is...in that maze of crazy acronyms that is the complex financial products for the "sophisticated" investors; a market that became a house of cards, which then imploded to trigger the meltdown. While greed was definitely a primary driver on both sides of each transaction, lack of information was surely another. As was argued recently, it is clear that some people knew much more about the complexities (and associated risks) of these financial instruments than others. Firms like Goldman Sachs manufactured these products, had contact with the individual lenders that fed into the products, and were able to "negotiate" (i.e., pay for) good ratings from the agencies responsible for assessing these products. Therefore, they are at a distinct advantage when compared with the average (even sophisticated) investor.

Some people will just say "buyer beware" and trying to fix a problem like this with government regulation would be equivalent to a nanny state but I think this is a case where overly deceptive (and sometimes illegal as we are seeing with Goldman and JPMorgan) practices are hurting the overall machinery of the economy more than helping.

That gets me to my main point here, as wonderfully summarized (again) by 13 Bankers:
The core function of finance is financial intermediation - moving money from a place where it is not currently needed to a place where it is needed. The key questions for any financial innovation are whether it increases financial intermediation and whether that is a good thing. 
I think it can be argued that these deceptive practices and overly complex products do not do anything to move money from a place where it is not currently needed to a place where it is needed (think greasing the gears of the economy). We are no better off as an economy because of these practices/products. It is squarely the opposite...our economy is much, much more susceptible to disaster as a consequence of them.

So I would recommend increasing regulations on the complex financial products (derivatives) market to increase transparency. The assumption of abundant information is so incredibly important in this market because of the enormous risks that get compounded and correlated together with each new bet on the same set of assets.

Currently, the proposal that claims to deal with exactly these types of regulations would be in the form of the recently proposed Consumer Financial Protection Agency. While I realize that another huge bureaucratic regulatory agency is rarely a good solution to anything, what else would you propose we do in the light of what I just discussed?

Okay, I have rambled on for too long again...I will save the Too-Big-To-Fail issue for next time.

Monday, May 3, 2010

The Goldman Sachs hearings missed the point - PART 3

Okay...now that we have that little bit of background behind us, what about those hearings last week?

So Goldman Sachs was charged with committing fraud in the course of selling a synthetic, synthetic CDO to a group of investors that consisted of the German bank, IKB and which also led to a lot of money lost by the Royal Bank of Scotland (through, yet another big insurance deal/bet). The complex product was called ABACUS and it was put together by the "Fabulous Fab" at Goldman Sachs along with the close advice of a big-time hedge fund manager, John Paulson, who also, it turns out, was "shorting" (betting against) the synthetic, synthetic CDO. The SEC alleges that the company that originally packaged up the synthetic, synthetic CDO (their name is ACA) thought that John Paulson was on the long side of the bet...not the short side. Hence, Goldman Sachs was at fault for knowingly avoiding to clear up this misunderstanding with ACA and committing fraud in the process. Clear as mud, eh? (Try this timeline for a full rundown of this case)

But as I said in the opening post...the Senate committee really missed the point here. They didn't argue about the specifics of the fraud charge. Instead, they focused on the fact that Goldman Sachs was also on the short side of many of these mortgage-backed securities and other financial products that were implicitly backed by the mortgages of ordinary Americans. The senators emphasized that Goldman Sachs was essentially "betting against the American dream" and that's why they are such cruel people. In addition, they lambasted them for betting against the very products that they were selling to their investor clients. But as this great post from the Economist's Democracy in America blog points out, that's a pretty ridiculous thing to scold them over:

It's important to distinguish between the SEC allegations and the allegations being aired in Congress, which I believe some senators are intentionally trying to confuse. The SEC is alleging that Goldman broke the law in a very specific way. Binyamin Appelbaum of the New York Times explains, "Rather than asserting that Goldman misrepresented a product it was selling, the most commonly used grounds for securities fraud, the Securities and Exchange Commission said in a civil suit filed Friday that the investment bank misled customers about how that product was created. It is the rough equivalent of asserting that an antiques dealer lied about the provenance, but not the quality, of an old table." That type of misrepresentation or misleading is illegal, no doubt about it. On the other hand, the accusations emanating from Congress—that Goldman took the opposite side of its clients' bets on the housing market—are certainly not. As we say in our leader on the subject, "the idea of willing counterparties, with full and accurate disclosure, each seeking to profit from the other's inferior grasp, is central to financial markets."
This may not seem like an important clarification—in the eyes of many, the story of Goldman during the crisis is already written and the firm acted unethically whether it broke the law or not. That was certainly the mood on Capitol Hill yesterday. But at least consider the following. In his opening statement Mr Levin asked whether Goldman's actions in 2007 were "appropriate", not whether they were lawful. If we agree with him that Goldman's actions were indeed inappropriate, but also lawful, what does that say about the politicians who were tasked with making the laws?

So yes, the Senate committee did reveal the Goldman Sachs executives as exceedingly greedy people but what they did was largely within the confines of a very loose regulatory structure within the financial system...a structure that was created and supported by the very same body of government that was apparently scolding them for making incredible amounts of money only because of how that system was structured.

It's true that some of what Goldman Sachs allegedly did in the ABACUS deal (the center of the fraud charge) was truly illegal (willfully misleading their client into thinking that another big-time investor was actually betting on the same side as them when in fact that big-time investor, John Paulson, was on the opposite side of the bet and hand-picking the risky pools of mortgage-backed securities). For that they should definitely be brought in front of a court.

The whole point that I am trying to get at is that it is much easier for a government official to remedy a situation where a party committed an illegal act...you put them on trial and hope to find them guilty. But it's far more difficult for a government official to remedy a situation where a party committed an "inappropriate" act. The only way to remedy that situation in the financial industry is to change the regulations so that you make an "inappropriate" act against the rules (i.e., you get a big fine if you break them).

So that's where we are now...back to the question of government regulation...the dicey area where we are headed in Part 4. We will actually look at some of the elements of financial reform that include more regulations. What do you think should be the role of government in this situation?