Saturday, April 03, 2010

GoldiSachs and the TBTF Banks

GoldiSachs and her friend MorganStanley were tired (of worrying about insolvency) so they went upstairs in the Banks' home and found a bed labeled TBTF that was just right. In contrast to the children's story, GoldiSachs and MorganStanley were welcomed into the club.

In March of 2008, years of poor investment decisions finally caught up to Bear Stearns, forcing the firm to accept a $2 per share bid (later revised to $10) from JPMorgan (financed by loans from the NY Fed). A once mighty financial firm which had survived the Great Depression was no more. Adding insult to injury, its final 5 year stock price chart, which depicted a dive from over $150 to the single digits could easily have been mistaken for that of a dead Tech firm which never generated a dime in profits.

Coincidentally, the Federal Reserve announced the creation of the Primary Dealer Credit Facility (PDCF) which allowed any Primary Dealer not already authorized to borrow at the Fed's Discount Window, to, in effect, enjoy the privilege of discounting their securities if they were cash poor.

Despite the new access to Fed liquidity, however, stock prices of Primary Dealers, who, inter alia, sell US government debt, were under assault within 6 months. Lehman Brothers did not survive the assault, declaring bankruptcy on September 15.

Perhaps due to the thinning ranks of Primary Dealers (in the previous 2 years, 5 Banks, ABN AMRO, CIBC, Nomura Securities, Lehman Brothers and the aforementioned Bear Stearns, had left the club or died) or some other reason (more on that in my next post) the Fed and Treasury made the hitherto unsaid policy of Too Big To Fail (TBTF), explicit, and welcomed GS and MS into the club (which, according to Simon Johnson and James Kwak, numbers 13), declaring the new entrants Bank Holding Companies (BHCs), for emphasis.

A recent check of the Fed's NIC (a wonderful resource on BHC data) demonstrates that GS and MS fit into the BHC club about as well as I fit into the crowd on my first visit to Beijing many years ago. Their source and use of funds are quite different as are their arenas of profit.  They are investment firms, more closely related to Hedge Funds than banks.  I'm all in favor of investment firms, however, I don't agree that, if TBTF is wise policy (which, at this stage, I doubt) they should be included in the protected group.

I still, on the topic of sticking out from the crowd, remember being asked to join a picture of a Chinese family during a visit to the Great Wall, because, I suspect, this rural family rarely saw white people and wanted to show the folks at home their great adventure.

Banks, as I recently argued, always and everywhere earn their money lending. As the table below demonstrates, however, the meaning of the term "bank" is being diluted at roughly the same pace as the US$.  Admittedly, the banks themselves, in their desire to be more like Hedge Funds, are helping the dilution of meaning.  This makes me wonder if the next GS to join the club will be George Soros. Perhaps if he becomes a primary dealer....

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As you can see, GS and MS needed no help in provisioning against bad loans (one argument, with some merit, in favor of TBTF is that the banks provided more mortgage credit than they otherwise would have if the government wasn't promoting home ownership).  These investment houses earn money from, inter alia, Investment Banking, Brokerage and Proprietary Trading. 

Proprietary Trading is the arena one tends to find "rogue traders" like John Rusnak, Brian Hunter of Amaranth fame and this fellow from France.  A policy of TBTF might well bail out a "rogue bank"or the banks' creditors, perhaps it already has.  This isn't to suggest I'm against prop trading (it's one way I earn my keep) I just don't see the positives (if any) outweighing the negatives. 

A thoughtful reader at Seeking Alpha wanted a more explicit statement of TBTF effects which inspired the use of "scam" in my last post.

TBTF direct effects include, as he noted, creditors avoiding "haircuts" (reduction or total loss of investment), and, as I added, employees and owners equally avoiding "haircuts" (reduction in compensation and loss of investment).

I used the term "scam" in reference to the latter two effects.  Reductions in compensation and dividend outflow would go right to the bottom line, mitigating the need for equity and liquidity support.

TBTF rewards failure, which creates its own ill effects, and it will impose financial costs on families across the US as the effects of the changes in the Fed's System Open Market Account (latest data seen below) and growth in US Federal Debt manifest.  Further, supporting firms which failed to see the collapse coming, or minimally to adjust their exposure accordingly, removes from the list of positives the one social virtue of trading I needed to know to become licensed as a securities' dealer- price discovery.

While I agree with the reader that US financial authorities had trade-offs in mind (I didn't use "total" in my original title) when TBTF became explicit (some going beyond finance, as I'll discuss in my next post) some are taking advantage or "scamming" the public in the lax environment.

Take a good look at aggregated employee compensation in the first table.

The ultimate question of TBTF is not "if" it will end.  It will.  Such arrangements always end.  The Medici were known as God's Bankers, under the protection of the Vatican- the best shield going at the time- and they went under. Money, like water, eventually finds a way to flow around (or through) constraints. 

The question is, will we end TBTF or will it end us, in our current form?