If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control.
Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors. James Grant: Let the Bankers Fail
As the news of Wall Street's underhanded dealings goes mainstream thanks to the SEC's case against Goldman Sachs, the idea of letting the bankers fail never seemed so sweet to so many in recent history. Yet, failure might have nasty consequences. Just as one wouldn't want a skyscraper to topple over in a crowded city, one wouldn't want the TBTF banks to collapse. Better, I think, to effect a controlled demolition.
While he has been opining about finance more wisely and for far longer than I, Mr. Grant's ire may be somewhat misdirected (although the effect of his proposed renewal of the fear of God seems a wise idea) at shareholders, when senior bank employees are those whose behavior must be modified. They take the least risk and benefit the most.
Explaining the problem's emergence, Mr. Grant draws our attention to the FDIC, an institution ostensibly designed to benefit the man on the street whose limited life savings might be lost in a bank failure. An additional effect, however, was to shield bank owners from liability, at state expense.
Another key effect, particularly when the lender of last resort (in the US, the Federal Reserve) supports banks rather than credit markets more generally, was to dampen depositors' desire and hamstring their capacity to demolish a bank. It is no surprise that the vigor with which Big Finance worked to repeal Glass Steagle was not directed at FDIC or Federal Reserve legislation.
Banking is a curious business, as Louis Brandeis noted in Other People's Money: The goose that lays golden eggs has been considered a most valuable possession. But even more profitable is the privilege of taking the golden eggs laid by someone else's goose. Bankers, by which he meant bank shareholders, combined their equity capital with deposits, in 1929 at a deposit to equity ratio of roughly 10 to 1 and kept a majority of the profits thereof.
Prior to Fed support of banks, depositors had a significant controlling interest (whether they were aware of this is another issue). A bank run was the means by which they exerted this control. As noted, this control was greatly diminished (but not lost), and obscured by the Fed and FDIC.
Of course, what is good for the goose is good for the gander. Bank shareholders had it good for a while, but lately they too have been getting the shaft from senior bank employees, who may not have any investment in the bank. As noted here, (full article here) at the Big 4 US Banks (BAC, C, JPM, WFC) depositors were paid $25B on their investment of $2.5T, shareholders were paid $18B on their investment of $660B and employees were paid $111B for their time.
If shareholders realized they they are getting the same shaft as depositors a major impediment to true bank reform could be swept away. Senior bank employees are using complexity of operations (which is more myth than reality) to hobble shareholder control and progressive era legislation to hobble depositor control. Simon Johnson and James Kwak should take note. Explaining that shareholders' interests are aligned with depositors' might ignite the controlled demolition of TBTF.
Why should senior bank employees with the least "skin in the game" reap the largest benefits?
A controlled demolition of TBTF might proceed something like this:
1) Depositors could begin to reassert their lost control by withdrawing money from the Big Banks (there already is such a movement underway).
2) Minimally, shareholders could begin to reassert their lost control by wiser appointments to the Boards of Directors with the view that cost control includes direction as well as magnitude (to wit, why should shareholders pay for lobbying which enriches employees and not them). Preferably, sell the shares and reinvest the capital in various smaller banks, presumably some of whom might be the recipients of moved depositor funds and none of whom have significant derivatives' exposure. In a controlled demolition of TBTF, the numerous banks left standing should benefit significantly.
3) Depositors and shareholders could understand that institution size dilutes control and allows employees to usurp control leaving you (or the state) to deal with the risk.
4) If an aligned group of depositors (aka voters) and shareholders (aka those funding the lobbying) demanded action, change would come. One key change: The Fed would need to stop supporting banks and instead support markets mitigating collateral damage from the demolition. They should open lines of communication with the hundreds of banks with assets between $1B and $100B. They will also need to deal with foreign depositors at the TBTF banks and begin to unravel the nightmare of derivatives (admittedly a task easier said than done).
Instead of a full frontal approach, TBTF should be imploded from within. Those with "skin in the game" need to take back control.
It's your money, and only your wisdom (not the government's or bank employees') will keep it safe and perhaps allow it to grow. Concentration of money occurs when investment is passive. Move Your Money!
One might even consider moving one's money out of the banking system entirely during the renovation through the purchase of Gold.
Showing posts with label GS. Show all posts
Showing posts with label GS. Show all posts
Friday, April 23, 2010
Tuesday, April 20, 2010
IMF Power Play: Capital Controls or Failed States?
Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.
The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, but the sharp rise in government debt during the economic crisis from already elevated levels helped create what the IMF says is the newest threat to the financial system: growing sovereign risk. IMF (April 2010)
2. Yesterday, October 10, the G-7 met and agreed the following plan of action:
• "Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure
3. Today the International Monetary and Financial Committee strongly endorsed the above commitments IMF (Oct. 2008)
On Christmas Day, 800 A.D., Pope Leo III crowned Charlemagne Emperor of the Romans. While scholars' views vary as to the Pope's intent, and Charlemagne's prior knowledge thereof, that the Vatican had thereafter a large effect on national politics in Christendom is without doubt. Concerns about the Vatican's continued influence almost 1000 years later, inter alia, led the framers of the US Declaration of Independence and Constitution to declare their sovereignty from, not only the mother country, but also such supra-national institutions.
Of course, that was then and this is now. The US Government, now hobbled by the debt load, incurred, in part, to support TBTF financial institutions- a policy urged by the IMF 2 years ago- is now being urged, by the same IMF, to reduce sovereign debt risks, which are the "newest threat to the financial system."
As the saying goes, with friends like these...
For decades, admittedly with varying intensity, the IMF has, in general, urged open capital markets- a policy at odds with the IMF's original mandate. Two years ago, the inevitable result of such national sovereignty abdicating policies in the absence of vigorous supra-national regulation brought the world's financial system to the brink of disaster.
With the benefit of hindsight, from one perspective, the IMF could be seen to have loudly urged national governments to "take as much (debt) rope as you'd like," and whispered, "to hang yourselves with."
How times have changed.
The dilemma which, in large part, led to the creation of the IMF- how to have the cake of international capital mobility and eat the cake of national sovereignty (yes, it's a stretch, but go with it), was, according to Louis Pauly, in his Who Elected the Bankers? confronted directly by Bretton Woods negotiators: They could see no way around the fact that states, if they valued economic stability as much as they valued their political independence, would have to maintain the capacity to deploy capital controls.
In the event, capital controls fell out of favor and thus capital sovereignty in the largest states was greatly diminished but the costs associated with supporting the banks profiting the most from the open environment have been shouldered by these same states. This seems, borrowing a term for yesterday's post, asymmetric.
Why should the state pay for what it cannot control?
Why, if the IMF supported the use of all available tools to restore financial stability but 18 months ago, does its most recent report highlight the risks of growing sovereign debt, but not the risks of private sector financial institutions whose failure to pilot the open capital market seas successfully played such a large role in the "risky" debt growth?
Louis Pauly asked, "Who Elected the Bankers?" If the IMF is taking its cue from Pope Leo III and playing for power with TBTF institutions, we have an answer. The IMF didn't Elect the Bankers, It Crowned Them.
Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.
The question of who is in control begs an answer. If the states aim to retain sovereignty, they will be forced to use the tool of capital controls. Indeed, in the current battle with GS, the US may find, if capital controls aren't imposed, that GS leaves a shell company to bear the brunt of any penalties. More broadly, if the national states don't impose control, they may soon find themselves, like Greece, California or New York, overly indebted entities with no power to solve their own problems, and thus waiting for hand-outs from the new supra-national institutions they created.
Let the games commence!
The global financial system and the world economy are slowly regaining their health, thanks in large part to unprecedented interventions by governments, but the sharp rise in government debt during the economic crisis from already elevated levels helped create what the IMF says is the newest threat to the financial system: growing sovereign risk. IMF (April 2010)
2. Yesterday, October 10, the G-7 met and agreed the following plan of action:
• "Take decisive action and use all available tools to support systemically important financial institutions and prevent their failure
3. Today the International Monetary and Financial Committee strongly endorsed the above commitments IMF (Oct. 2008)
On Christmas Day, 800 A.D., Pope Leo III crowned Charlemagne Emperor of the Romans. While scholars' views vary as to the Pope's intent, and Charlemagne's prior knowledge thereof, that the Vatican had thereafter a large effect on national politics in Christendom is without doubt. Concerns about the Vatican's continued influence almost 1000 years later, inter alia, led the framers of the US Declaration of Independence and Constitution to declare their sovereignty from, not only the mother country, but also such supra-national institutions.
Of course, that was then and this is now. The US Government, now hobbled by the debt load, incurred, in part, to support TBTF financial institutions- a policy urged by the IMF 2 years ago- is now being urged, by the same IMF, to reduce sovereign debt risks, which are the "newest threat to the financial system."
As the saying goes, with friends like these...
For decades, admittedly with varying intensity, the IMF has, in general, urged open capital markets- a policy at odds with the IMF's original mandate. Two years ago, the inevitable result of such national sovereignty abdicating policies in the absence of vigorous supra-national regulation brought the world's financial system to the brink of disaster.
With the benefit of hindsight, from one perspective, the IMF could be seen to have loudly urged national governments to "take as much (debt) rope as you'd like," and whispered, "to hang yourselves with."
How times have changed.
The dilemma which, in large part, led to the creation of the IMF- how to have the cake of international capital mobility and eat the cake of national sovereignty (yes, it's a stretch, but go with it), was, according to Louis Pauly, in his Who Elected the Bankers? confronted directly by Bretton Woods negotiators: They could see no way around the fact that states, if they valued economic stability as much as they valued their political independence, would have to maintain the capacity to deploy capital controls.
In the event, capital controls fell out of favor and thus capital sovereignty in the largest states was greatly diminished but the costs associated with supporting the banks profiting the most from the open environment have been shouldered by these same states. This seems, borrowing a term for yesterday's post, asymmetric.
Why should the state pay for what it cannot control?
Why, if the IMF supported the use of all available tools to restore financial stability but 18 months ago, does its most recent report highlight the risks of growing sovereign debt, but not the risks of private sector financial institutions whose failure to pilot the open capital market seas successfully played such a large role in the "risky" debt growth?
Louis Pauly asked, "Who Elected the Bankers?" If the IMF is taking its cue from Pope Leo III and playing for power with TBTF institutions, we have an answer. The IMF didn't Elect the Bankers, It Crowned Them.
Coincidences abound these days. GS calls for derivatives clearinghouses, as does the IMF. GS, and in the not too distant future, presumably other TBTF institutions face civil suits enforced by national states from many parties. The IMF declares the debt load of these states the biggest risk to the financial system.
The question of who is in control begs an answer. If the states aim to retain sovereignty, they will be forced to use the tool of capital controls. Indeed, in the current battle with GS, the US may find, if capital controls aren't imposed, that GS leaves a shell company to bear the brunt of any penalties. More broadly, if the national states don't impose control, they may soon find themselves, like Greece, California or New York, overly indebted entities with no power to solve their own problems, and thus waiting for hand-outs from the new supra-national institutions they created.
Let the games commence!
Monday, April 19, 2010
GS Case Begs the Volcker Rules (and Blankfein a lesson in asymmetry)
The core of the SEC’s case is based on the view that one of our employees misled these two professional investors by failing to disclose the role of another market participant in the transaction, namely Paulson & Co., and that the employee thereby orchestrated the creation of materially defective offering materials for which the firm bears responsibility. Goldman Responds
Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Working Paper on Information Assymmetry
As Mark Thoma explains in a recent post, the SEC's case against Goldman Sachs (assuming a strict reading of the statute) rests on the issue of asymmetric information- did GS disclose enough information about the offering such that the collateral manager of the CDO "knew or should have known that Paulson was on the other side of the transaction."
There is another aspect of the case, in light of the implicit support of TBTF financial institutions, that begs the Volcker Rules of proprietary trading separation from government supported activities, namely commercial banking, to which I'll return.
Asymmetric information is one of those phrases that makes common people hate economists. Uneven, deceptive or lying captures the essence of the issue.
To indulge a fantasy occasioned by the Goldman fraud, and explain the issue, let's imagine I found out that Mr. Blankfein liked to play a bit of ice hockey from time to time-nothing too strenuous, just for fun. Imagine, upon hearing the news, I invited him up for a skate with my spring hockey crew. "It's just a pick-up, no refs, no checking, lots of fun," I could tell him- "for us," I might say to my friends after hanging up the phone.
Imagine he comes up, suits up and hits the ice. At that point (or as soon as the first puck whizzes by his head), he'll realize that he's on the ice with 1-2 ex-Pros, quite a few ex-College players and we all play all year round, 4-5 times per week in the winter. There's no checking (well, almost, it gets you 2 minutes in the box), but there's quite a bit of contact. Slap shots are coming anywhere from 60-90 mph.
That's a little lesson in asymmetry I'd like to give Mr. Blankfein. Of course, there would be nothing sportsman-like about it. He'd be outclassed (but it would be fun). It also would be entirely legal, as we may find to be the case with GS.
Getting back to reality, GS will argue that the collateral manager knew or should have known what he was getting into. We'll have to wait for the evidence to be presented to see if that claim is true.
The second issue I raised about such dealings begging the Volcker rules may prove quite important in the financial regulation debate. Currently, all public markets for finance are open to all, and, apparently, deserving of government support. Even if the collateral manager should have known the security was designed to fail, that such a security could be created strongly suggests to me that such dealings have no place in publically supported markets.
All participants in my men's hockey league sign waivers taking personal responsibility for injuries caused on ice. We cannot sue the rink, or the town, etc. We all love the game, so it's not a problem. Imposing costs on the rest of society for the risks we take would not be fair. It would be assymmetric (if hockey players used such language).
Equally, it seems to me, trading activities such as are detailed in the GS case, should never lead to increased social costs. Not only, in my view, does socializing the costs of such trading activities negate their social virtue (price discovery becomes state sponsored price enforcement) such support drifts ever closer to tax funded gambling. What's next, tax credits for the losers in next year's World Series of Poker?
When a security can be designed to fail, it's time to separate the financial markets into socially protected and unprotected divisions. Just as I play socially unprotected hockey, I'm all in favor of socially unprotected trading- I just don't think my neighbors should have to pay when the risks become real. Nor should the rink be shut down because we made a mistake.
I'll close with an ice hockey tip for the boys at Goldman: Keep Your Head Up Out There, Boys!
Using methods from theoretical computer science this paper shows that derivatives can actually amplify the costs of asymmetric information instead of reducing them. Working Paper on Information Assymmetry
As Mark Thoma explains in a recent post, the SEC's case against Goldman Sachs (assuming a strict reading of the statute) rests on the issue of asymmetric information- did GS disclose enough information about the offering such that the collateral manager of the CDO "knew or should have known that Paulson was on the other side of the transaction."
There is another aspect of the case, in light of the implicit support of TBTF financial institutions, that begs the Volcker Rules of proprietary trading separation from government supported activities, namely commercial banking, to which I'll return.
Asymmetric information is one of those phrases that makes common people hate economists. Uneven, deceptive or lying captures the essence of the issue.
To indulge a fantasy occasioned by the Goldman fraud, and explain the issue, let's imagine I found out that Mr. Blankfein liked to play a bit of ice hockey from time to time-nothing too strenuous, just for fun. Imagine, upon hearing the news, I invited him up for a skate with my spring hockey crew. "It's just a pick-up, no refs, no checking, lots of fun," I could tell him- "for us," I might say to my friends after hanging up the phone.
Imagine he comes up, suits up and hits the ice. At that point (or as soon as the first puck whizzes by his head), he'll realize that he's on the ice with 1-2 ex-Pros, quite a few ex-College players and we all play all year round, 4-5 times per week in the winter. There's no checking (well, almost, it gets you 2 minutes in the box), but there's quite a bit of contact. Slap shots are coming anywhere from 60-90 mph.
That's a little lesson in asymmetry I'd like to give Mr. Blankfein. Of course, there would be nothing sportsman-like about it. He'd be outclassed (but it would be fun). It also would be entirely legal, as we may find to be the case with GS.
Getting back to reality, GS will argue that the collateral manager knew or should have known what he was getting into. We'll have to wait for the evidence to be presented to see if that claim is true.
The second issue I raised about such dealings begging the Volcker rules may prove quite important in the financial regulation debate. Currently, all public markets for finance are open to all, and, apparently, deserving of government support. Even if the collateral manager should have known the security was designed to fail, that such a security could be created strongly suggests to me that such dealings have no place in publically supported markets.
All participants in my men's hockey league sign waivers taking personal responsibility for injuries caused on ice. We cannot sue the rink, or the town, etc. We all love the game, so it's not a problem. Imposing costs on the rest of society for the risks we take would not be fair. It would be assymmetric (if hockey players used such language).
Equally, it seems to me, trading activities such as are detailed in the GS case, should never lead to increased social costs. Not only, in my view, does socializing the costs of such trading activities negate their social virtue (price discovery becomes state sponsored price enforcement) such support drifts ever closer to tax funded gambling. What's next, tax credits for the losers in next year's World Series of Poker?
When a security can be designed to fail, it's time to separate the financial markets into socially protected and unprotected divisions. Just as I play socially unprotected hockey, I'm all in favor of socially unprotected trading- I just don't think my neighbors should have to pay when the risks become real. Nor should the rink be shut down because we made a mistake.
I'll close with an ice hockey tip for the boys at Goldman: Keep Your Head Up Out There, Boys!
Friday, April 16, 2010
Goldman Goes For The Jugular With Derivatives' Control
"Given that much of the financial contagion was fueled by uncertainty about counterparties' balance sheets," Goldman Chief Executive Officer Lloyd Blankfein and President Gary Cohn wrote in a letter at the beginning of the annual report, "we support measures that would require higher capital and liquidity levels, as well as the use of clearinghouses for standardized derivative transactions." Washington Examiner
I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.
When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.
I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.
Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.
Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.
Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn. That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.
Death by regulation.
If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.
It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.
Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.
One coup de grace deserves another.
Disclosure: No positions in GS, JPM, BAC, or C
I've spent countless hours taking Goldman (GS) "to the woodshed" for underhanded dealings (and I'll end this article that way) but they have always been astute traders. Their recent request for derivatives clearinghouses seems to me like a coup de grace administered to all other derivatives dealers.
When I was trading FX Options at Chase, J. Aron (owned by GS) was rightly regarded as one of the best derivatives dealers along side First Chicago (which was eventually swallowed up by UBS). They had the best models, and were religious about hedging away their risk.
I assume the past few years taught them that their biggest risk lies, not in the market, but in their counterparties. Their book might be well hedged, but if their counterparties default, they are doomed.
Thus, it seems to me, the request for clearinghouses. GS will force other dealers to use their models and risk mitigating tactics.
Let's assume they get their way. Other dealers, like JP Morgan (JPM), Bank of America (BAC) and Citibank (C), will likely find they haven't properly valued and hedged their books. The government, in its zeal to enact reform will likely be forced to pick up the cost of reducing these other banks' risk, and the banks themselves will likely find that GS is the last player standing.
Let's be cynical and assume that GS expects it will be the spring from which derivatives' regulators will be drawn. That would be one way to avoid embarrassing fraud charges from the SEC, (the coincidence is striking) and a way to watch what other dealers are doing, in the bargain.
Death by regulation.
If I were sitting at the negotiation table I'd be willing to give GS what it wants, with one proviso, the government will pick up the tab of reducing sector wide risks in derivatives if and only if size limits on banks, and separation of commercial banking from proprietary trading activities (i.e. the Volcker rules) are part of the bargain.
It might not hurt to later impose some strict limits on the revolving door between GS and the public sector.
Without such a bargain, the creation of clearinghouses will only further concentrate pricing control of these instruments, in the hands of GS. However skilled the GS boys currently are, monopoly control of derivatives will beg abuse down the road.
One coup de grace deserves another.
Disclosure: No positions in GS, JPM, BAC, or C
Tuesday, April 13, 2010
The Big School and Convertibility Lost
As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!"
Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost
There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.
Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.
As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?
In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.
I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"
Big School Rules.
In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"
The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.
I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:
The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?
All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion
There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.
Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.
A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.
Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.
In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.
Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;
While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.
Big School means Big Problems
Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.
My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.
Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.
Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China
Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.
As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.
This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.
I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.
In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading. Markets to spend one's $s, even if one never shops there, engender a sense of stability.
Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)
The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.
What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS. An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.
GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.
One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.
Global US$ reserves have done nothing but rise since, at an increasing pace.
In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.
Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.
How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.
Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.
Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?
How will the US respond if an economy as large as China's needs a boost in international liquidity? How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction? Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?
What if Japan needs IMF support?
How far off might such events be?
Big Questions for the Big School
Why then was this forbid? Why but to awe,
Why but to keep ye low and ignorant,
His worshippers; he knows that in the day
Ye Eate thereof, your Eyes that seem so cleere,
Yet are but dim, shall perfetly be then
Op'nd and cleerd, and ye shall be as Gods
Milton: Paradise Lost
There are, it may seem to a new student of economics, more schools of thought in the field than stars in the sky. I sometimes wonder if David Bohm, author of, inter alia, The Qualitative Infinity of Nature, might have felt more comfortable as an Economist than a Physicist. While the physical sciences, according to Thomas Kuhn, exhibit totalitarian tendencies with violent revolutions, Economics is far more democratic, tolerating, albeit not without disputes, multiple coincident schools of thought.
Of late, however, one school of economic thought has become increasingly dominant in policy making circles. The Big School holds that the larger a financial institution becomes the more protected it should be, and vice versa, the smaller a financial entity is, the less protection it should receive.
As an example of this (somewhat) facetious claim, consider the views of JPM's David Lowman: Like all loans, mortgage contracts are based on a promise to repay money borrowed. Importantly, there is no provision in the mortgage contract, express or implied, that the lender will restore equity or reduce the repayment amount if the value of the collateral – be it a home, a car or a stock market investment – depreciates. If we re-write the mortgage contract retroactively to restore equity to any mortgage borrower because the value of his or her home declined, what responsible lender will take the equity risk of financing mortgages in the future? What responsible regulator would want lenders to take such risk?
In other words, the same bank (there were, of course, others) whose inability to meet its contractual obligations a few years ago was such that it needed loans from, and preferential swapping of toxic for performing securities with, the Fed, equity support from the Treasury, and a release from the onerous task of marking securities to market, NOW thinks contracts, regulations and agreements are sacrosanct.
I wonder if the issue up for debate was deriviatives regulation or marking toxic assets to market, would any person from a bank end a paragraph with "what responsible regulator would want lenders to take such risks?"
Big School Rules.
In a Jonathon Demme film appropriately (for our purposes) titled "Stop Making Sense", the Talking Heads' David Byrne asked, "Well, how did I get here?"
The Big School took its cue from Kuhn and engaged not in democratic debate, but totalitarian revolt. They appropriated Walter Bagehot's views on the Central Bank's Lender of Last Resort facility in times of crisis but perverted them in the process. Instead of the outline presented in Lombard Street of "very large loans at very high rates" which, in modern times, became, "lend freely at a high rate", the Big School preaches the doctrine of "lending freely (to the banks) at a very low rate" thereby relieving the Central Bank of its responsibility to enforce prudence.
I may, however, be wrong in assuming the Big School appropriated their "lend freely (to the banks) at a very low rate" doctrine from Bagehot (they may simply have thought "lots of free money would sure be nice"), because this implies a reading thereof. If they had read Lombard Street they would have found these lines of concern about big banks, and management practices obscured from review:
The second misgiving, which many calm observers more and more feel as to our largest joint stock banks, fastens itself on their government. Is that government sufficient to lend well and keep safe so many millions?
All that the best board of directors can really accomplish [in the largest joint-stock banks] is to form a good decision on the points which the manager presents to them, and perhaps on a few others which one or two zealous members of their body may select for discussion
There is no more unsafe government for a bank than that of an eager and active manager, subject only to the supervision of a numerous board of directors, even though that board be excellent, for the manager may easily glide into dangerous and insecure transactions, nor can the board effectually check him.
Our great joint stock banks are imprudent in so carefully concealing the details of their government, and in secluding those details from the risk of discussion. The answer, no doubt, will be, “Let well alone; as you have admitted, there hardly ever before was so great a success as these banks of ours; what more do you or can you want?” I can only say that I want further to confirm this great success and to make it secure for the future. At present there is at least the possibility of a great reaction. Supposing that, owing to defects in its government, one even of the greater London joint stock banks failed, there would be an instant suspicion of the whole system. One terra incognita being seen to be faulty, every other terra incognita would be suspected. If the real government of these banks had for years been known, and if the subsisting banks had been known not to be ruled by the bad mode of government which had ruined the bank that had fallen, then the ruin of that bank would not be hurtful. The other banks would be seen to be exempt from the cause which had destroyed it. But at present the ruin of one of these great banks would greatly impair the credit of all. Scarcely any one knows the precise government of any one; in no case has that government been described on authority; and the fall of one by grave misgovernment would be taken to show that the others might as easily be misgoverned also. And a tardy disclosure even of an admirable constitution would not much help the surviving banks: as it was extracted by necessity, it would be received with suspicion. A sceptical world would say, “Of course they say they are all perfect now; it would not do for them to say anything else”.
A read of Lombard Street would not have led to the Big School's conclusion that the Lender of Last Resort should, in times of crisis, lend only to the banks, and even insolvent ones.
Bagehot advised differently: A panic, in a word, is a species of neuralgia, and according to the rules of science you must not starve it. The holders of the cash reserve must be ready not only to keep it for their own liabilities, but to advance it most freely for the liabilities of others. They must lend to merchants, to minor bankers, to “this man and that man,” whenever the security is good. In wild periods of alarm, one failure makes many, and the best way to prevent the derivative failures is to arrest the primary failure which causes them.
In other words, Bagehot argued the Central Bank's responsibility was to "the market", not the banks.
Further, he argued: the majority to be protected, are the “sound” people, the people who have good security to offer. He also speaks to the issue of unsound people, perhaps using a bit of wishful thinking: No advances indeed need be made by which the Bank will ultimately lose. The amount of bad business in commercial countries is an infinitesimally small fraction of the whole business. That in a panic the bank, or banks, holding the ultimate reserve should refuse bad bills or bad securities will not make the panic really worse; the “unsound” people are a feeble minority, and they are afraid even to look frightened for fear their unsoundness may be detected;
While the fraction of business which is unsound today is likely larger than in Bagehot's England, I suspect most is sound. Unfortunately, the unsound elements, while small in practical classification (derivatives, mortgage backed securities, etc.) are huge in terms of currency relative to the whole economy.
Big School means Big Problems
Why, I wonder, did the other schools of thought so meekly submit to the Big School's totalitarian revolution? Perhaps the question might better be phrased, what problem(s) deemed intractable by most other schools of thought did the Big School solve.
My best guess; one of the problems the Big School solved is Triffin's Dilemma. Alternatively, a previous (temporary) "solution" of Triffin's Dilemma, the London Gold Pool, was brought back to life, a la Frankenstein's monster which begat Big School thinking.
Triffin's Dilemma states that when a national money is used as an international medium of exchange and international reserve there will be trade-offs between the national and global effects of the reserve currency issuer's monetary policy. Moreover, the reserve currency issuer nation would soon find that it had to run increasing current account deficits to provide liquidity to the rest of the world. This, in turn, would erode confidence in reserve currency convertibility, eventually leading to international currency instability and potentially a break down in world trade.
Robert Triffin forecast the breakdown of the Bretton Woods system based on this dilemma. Of late, his work has been cited by the PBOC.
Issuing countries of reserve currencies are constantly confronted with the dilemma between achieving their domestic monetary policy goals and meeting other countries´ demand for reserve currencies. On the one hand,the monetary authorities cannot simply focus on domestic goals without carrying out their international responsibilities on the other hand,they cannot pursue different domestic and international objectives at the same time. They may either fail to adequately meet the demand of a growing global economy for liquidity as they try to ease inflation pressures at home, or create excess liquidity in the global markets by overly stimulating domestic demand. The Triffin Dilemma, i.e., the issuing countries of reserve currencies cannot maintain the value of the reserve currencies while providing liquidity to the world, still exists. Zhou Xiaochuan: hairman, Monetary Policy Committee of the People's Bank of China
Triffin, in the late 50s, called for the creation of a new global currency to act as international reserve, along the lines of Keynes' Bancor, or the IMF's SDR (deliberations for the creation of which were informed of his concerns), which, in my view, invites a whole new set of problems, but may still, barring a significantly large, in economic terms, country usurping the US$'s role, e.g. China (which invites similar problems, and leads to the US' loss of the exorbitant privilege), prove the best solution. A "free banking" system of competing moneys is another option.
As the US, not entirely without globally altruistic justification, did not want the Bancor in 1960 any more than it wanted it in 1945, the dilemma of convertibility fears was managed by illusion by way of intervention. The London Gold Pool was established in 1961 to keep the "market price" of Gold at $35 and thus reduce the incentive to demand promised convertibility from the Fed.
This worked until French demands for Gold were not satisfied. The cartel failed to maintain prices within the target and within a few years Nixon's closing of the Gold window ended US$-Gold convertibility.
I'll spare you the details of the 70s inflation and early 80s newfound stability. Suffice it to write that US$ reserves were accepted as semi-convertible- if not to Gold at a fixed price, at least to Gold and a basket of commodities with limited (until recently) fluctuations at new, higher prices.
In one (presumably easily accepted) respect, Big School banks that created and kept markets going in multiple new ($ based) investment vehicles helped sustain the sense of convertibility so long as those markets were trading. Markets to spend one's $s, even if one never shops there, engender a sense of stability.
Also coincident with this new found stability was the beginning of a business deal between J. Aron (purchased by Goldman Sachs in 1981) and Central Banks around the world. As described in The Partnership: The Making of Goldman Sachs: Coyne [CEO of J. Aron] learned that the central banks of many nations kept their currency reserves in gold bars stored in the vaults of the Bank of England in London or the New York Federal Reserve Bank. Taken together, all this great wealth of nations had what Coyne saw as one fascinating characteristic: It earned zero return. It just sat in the vaults. But Coyne knew that the time value of money always figured into any futures contract...so he called on the central bankers in one country after another and made what appeared to be a generous and innovative offer: "Lend me your sterile bars of gold bullion and I'll pay you a fee of one half of one percent every year!" (pg. 258)
The book goes on to detail that J. Aron was actually making 8% on the deal with no money down, "it produced a nearly infinite rate of return." The book suggests they pulled a fast one on the central banks.
What Coyne may not have known was that at least some governments may well have done the deal for nothing. J. Aron offered to do what the London Gold Pool had done, and was willing to take the risk itself- a risk passed on in the merger to GS. An added benefit, assuming the deal worked as described, no gold had to actually be sold on the market, paper gold would suffice.
GS was not alone in this game. By the mid to late 80s when I was at Chase (now JPM), our Gold desk (fortunately positioned right behind the options desk where I worked) was playing the same game. Paper gold flooded the market.
One of the reasons I began working with GATA a decade ago was my observation (shared by them) of Gold's stubborn reluctance to rise in price despite the rapidly increasing external US$ reserves. If Gold was, as Triffin asserted, undervalued in the early 60s, surely, I thought, it was a steal in 2000 at $275.
Global US$ reserves have done nothing but rise since, at an increasing pace.
In 1978, Triffin and Mundell were warning of a sudden collapse of the US$ due to the growth of those reserves. Back then they wrote in astonishment of US$ reserves in the few hundreds of billions. Now, such reserves are measured in the trillions.
Without concrete data I can only speculate as to the extent of Central Bank gold leasing, or its effect on the price. In the past few years, the price of Gold has risen above $1000. Interestingly the price broke above the early 1980s high of $800 when problems began appearing in large US banks. The mid 2008 dollar squeeze in international markets capped its advance at that time, only to bring the US banking system to the brink of disaster.
How causal the coincidence proves to be remains a mystery. What seems certain is that, if Central Bank gold leasing is a policy aimed at extending the life of the US$ as global reserve currency, the banks so engaged cannot be allowed to fail, or the game is over.
Thus, I wonder how much effect, if any, the Gold leasing practices of the big NY banks had on the decision to make them too big to fail.
Have we dodged Triffin's dilemma by trying to maintain the illusion of convertibility only to invite a banking collapse worse than Bagehot's worse nightmare?
How will the US respond if an economy as large as China's needs a boost in international liquidity? How large might an IMF rescue package need to be to keep China from suffering a disastrous contraction? Would the US, as is its wont, allow the current account to widen further to ensure China repaid the IMF?
What if Japan needs IMF support?
How far off might such events be?
Big Questions for the Big School
Thursday, April 08, 2010
Financial Regulation: Then and Now (Busting TBTF)
Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here and "restraint of trade" the lever. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.
Simon Johnson and James Kwak of 13 Bankers and The Baseline Scenario, urge President Obama, in a recent Washington Post Op-Ed, to channel Teddy Roosevelt’s defiance of Wall Street, exemplified by the break-up of Northern Securities in 1904 in order to clean up the US financial system.
I agree with Johnson and Kwak’s call to arms, and am sure their views are far more nuanced than a space limited op-ed can relate, however, my examination of the Progressive period in US history, of which the chapter on US financial regulation is but a part, suggests that repetition of that period is most unlikely, and hopefully unnecessary. While there are many similarities between then and now, both the context and issues of concern are, in certain key respects, different.
The Federal Government during the Gilded Age bore little resemblance to that existing today. As a financial entity, in the main, the government collected customs’ duties, which were more than half its receipts, paid interest on the debt, the bulk of which was incurred during the Civil War, and fought the Native Americans and Spain (wars were much cheaper then, additional Army and Navy costs for the 1898 Spanish American War came to $190M).
The malefactors of great wealth, as the industrial and financial titans of the day were known, controlled commerce and finance. They mined iron and made steel, connected the nation via railroads, telegraphs and telephones, and controlled the banks. They set prices and controlled the supply of money, credit and raw materials, which gave them the power to “shake down” people and firms of which they didn’t approve, competitors and frauds alike.
Unlike today, the leading banks which emerged at the end of the Gilded Age weren’t Too Big To Fail, they were Too Solvent To Fail. They owned much of the US gold stock, then the basis of money, and were seemingly immune from the Panics which shook the rest of the nation every decade or so, more often than not, it was claimed, at their instigation.
I’m confident if JP Morgan were running the Fed, credit growth would have been restrained long ago. There is some merit to having someone "own" an issue- unlike Greenspan, Geithner, Rubin et alios, who claim no responsibility. Thus, some believe we need more regulatory officials rather than better ones.
When the government was running dangerously short of gold reserves, in 1895, they went to Wall Street for help- call it a reverse bail-out- and had the Treasury supply replenished. A very small group of unelected men, in effect, owned the government.
This small group of men directed the transformation of America from a disconnected agrarian to a connected soon to be industrial society- from the states united to the United States. In the process, however, they paved the ground for the Progressives to use the power, not of money, but of public opinion, via the ballot box, to usurp their control.
The government that almost died in 1895, was reborn in 1901, when the assassination, by an anarchist (love the irony), of President McKinley, made Teddy Roosevelt President.
Teddy Roosevelt’s Trust Busting kicked off a vigorous 20 year period for the new government. Progressives, who had pushed potentially transformative legislation through Congress from 1885-1900 finally had an executive willing to use it, and his big stick, for change. The Rough Rider took the de jure power of the Interstate Commerce and Sherman Anti-Trust legislation, which had hitherto been used against labor, and prepared to make it de facto, against big business.
The Federal Government, as we know it today, was born. It was a small child about to battle grown men. US Federal Government receipts totaled $670M in 1900 (JP Morgan bought the Carnegie Steel Company around that time for $487M). In 1904, Northern Securities, a railroad trust owned by JP Morgan, JD Rockefeller et alios, was ordered to break up. The precedent, after appeal, was set and many other trusts followed. In 1911, after more than a decade of court battles, the Supreme Court dissolved Standard Oil, making JD Rockefeller, according to some, the richest man in the world, in cash.
He and the other Titans got rich, but lost control of their businesses. Like the Titans of Greek Mythology, they are, for good or ill, only going to appear once.
The child was growing quickly. In 1913, the Federal Reserve was created and the 16th Amendment, which made income taxes Constitutional, was ratified. Four years hence, the US entered World War I. At war’s end, the child had given way to the man. By 1920, receipts had grown to $23B. The Federal Government was now the biggest guy in town.
On one level, this growth of government is like that of Gilded Age business-built on the destruction of competition. There are, however, two key differences: 1) government didn’t “swallow” competitors, they dissolved them into smaller pieces, diluting their control 2) Gilded Age businesses were dynastic and decision-making was concentrated into few hands, government officials were (and are) popularly elected, operate within a system of checks and balances, and change more frequently.
The context in which Progressives operated was, as I’ve hopefully made clear, very different from today. The Federal Government then was, at least in a critical mass of minds, like a Deus ex machina, come to save the day. It didn’t tax the average citizen, but was likely to tax the wealthy and promised to not only break up the trusts, but also to open the credit spigot much wider. One hundred years hence, the bloom is off the Federal Government's rose. Increased taxation to fund another government expansion seems most unlikely.
Back then, the “money question”, as the debate between those who favored deflation or inflation was called, was one which brought people to the ballot box (I can’t imagine President Obama giving a Cross of Gold type speech). Elastic money seems to me the deciding factor which cemented Woodrow Wilson’s support of the Fed’s take-over of financial regulation.
Before turning to the present period, a few words about the Fed’s creation. There were two competing visions for the proposed central banking system, the Aldrich plan, which kept bankers in control, but allowed banks, at their discretion, access to government created liquidity (thus the need, under either vision, for the government, as financial entity, to grow, via increased taxes), The Bryan plan wanted government totally in control of a Central Bank which regulated the banks, and, at its sole discretion, could also supply liquidity.
The creature, as some call it, which emerged, was a compromise: government top down control of some key board members, banker control of others, the controlling board would be in D.C., thus demoting NY bankers, banks had access to liquidity, but the national liquidity level was at the board’s discretion.
Fortunately, unlike Johnson and Kwak, I’ve had the luxury of virtually unlimited internet space to flesh out the history. Unfortunately, I’ve probably lost most readers in this exercise of pedantry.
For those few that remain, let’s soldier on.
A Progressive solution, for our era, would involve for the creation of an empowered, taxing, global government with its own central bank, empowered with regulating all banks. This is, in a sense, the Nietzsche solution, fight monsters by creating bigger monsters. The United Nations (which replaced the earlier League of Nations) could be seen, in a Progressive dream, as the US Federal Government during the Gilded Age, an institution that, under direction of charismatic individuals, should become the biggest monster on the block, and maintain world order.
In my view, such a solution would but buy time in the same way that, 100 years from the empowering of the US government, many of the old problems remain. Ideas and conviction, not power, seem to me the missing elements. Further, the newly empowered Federal Government of a century ago was battling individuals, not national governments with armies, which would be the objects to be brought under control of any world government. If national governments begin to collapse, or fail to restrain growth of their internal monsters, however, I wouldn’t be surprised to see this “solution” emerge.
Supporters of continued US sovereignty within our borders, and the big bankers themselves, who might win the battle against US regulation only to risk eventually losing the war to world regulators (as the NY banks won the battle against state regulator but lost the war to the Feds) should take note. Men like Rockefeller and Carnegie, who ultimately submitted to government restraint, financed legacy institutions like the Trilateral Commission and its ilk to lay the basis for these bigger monsters. For a preview, consider: The IMF and the EU are currently battling for control in Greece, which seems willing to trade sovereignty rather than restrain its appetites via default.
Today, as then, the issue of size is key in one sense. Our regulators were seduced by “economies of scale” arguments and allowed a few financial institutions to grow beyond the ability of an indebted government to restrain. The 1895 analog is striking and, in that sense, Johnson and Kwak’s call to channel Roosevelt seems right on the mark. Terms like charisma and force of personality are often used to explain Teddy Roosevelt’s ability to bend people, ostensibly possessed of more power, to his will.
In the event, it took more than Roosevelt’s charisma to beat Morgan and his crew (or his charisma, and fear of popular backlash, was such that he bent a critical mass of the Supreme Court, to his will). US vs. Northern Securities was decided 5-4, with Chief Justice Fuller and Justices White, Peckham and Holmes dissenting. From a financial perspective, David, in the form of the US Government, had slain Goliath, a Trust whose capitalization was almost 2/3 of US revenues.
The basis of the decision, which, after appeal, and modification, became unanimous, however, was not bigness, but restraint of trade, via the stifling of competition. As Justice Holmes wrote in his dissent, “Size has nothing to do with the matter.”
Justice Harlan, writing in the affirmative: The Government charges that, if the combination was held not to be in violation of the act of Congress, then all efforts of the National Government to preserve to the people the benefits of free competition among carriers engaged in interstate commerce will be wholly unavailing, and all transcontinental lines, indeed the entire railway systems of the country, may be absorbed, merged and consolidated, thus placing the public at the absolute mercy of the holding corporation.
Adding: it need not be shown that the combination, in fact, results or will result in a total suppression of trade or in a complete monopoly, but it is only essential to show that, by its necessary operation, it tends to restrain interstate or international trade or commerce or tends to create a monopoly in such trade or commerce and to deprive the public of the advantages that flow from free competition;
Having read both sides, I understand the dissenting view; until trade is restrained, monopoly, per se, isn’t a crime, and might even lead to reduced consumer costs. Should there always be at least two rail options for every possible route? I assume, however, that the objects sought by President Roosevelt were a precedent, and distributed control and profits, not a strict reading enforcement.
I dwell on the decision to suggest a legal challenge to the current concentration of financial control into very few hands. Contrary to the above, financial concentration has already restrained trade, and imposed additional costs to all. Financial support (and even the expectation thereof) of TBTF firms also restrains trade in that potential (and actual) competitors who avoided (or even profited by) the declines in certain asset markets were restrained in gaining increased market share. Surely one of the benefits of competition is the weeding out of the short-sighted.
Fortunately, I don’t think we need new legislation, we just need to enforce what’s already on the books.
Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.
The need for redundancy would become more apparent if we held as self-evident the belief that there is no magic cure for financial overextension (bubbles) and their dissolution (busts) in a fractional reserve banking system. It will happen, again and again. Mitigation, as should now be clear, is not just an issue of additional liquidity but also a financial industry comprised of smaller, and more numerous, competing firms. It might also help to examine the books of any firm (including the Fed) which promotes the notion that “this time is different.”
I hold no illusions about being the sharpest knife in the drawer, as the Brits say, and thus assume others have considered similar legal arguments against financial concentration. Given the obvious trade restraining effects of TBTF, why isn’t the Supreme Court hearing arguments?
Like the Federal Government in 1895, ours too needs a bail-out. While the big financial firms can no longer provide such support, they can keep the Feds afloat by selling bonds as Primary Dealers, and, if needed, increase their own holdings thereof (particularly after the Fed has graciously relieved them of toxic mortgage, et alia, assets). If the Federal Government is ever to restrain finance, they need to break this dependency, and prepare to take their lumps, so to write, for poor fiscal management. If they were crafty they would blame the firms they were about to break up…just a thought.
This will require either skillful diplomacy or a good deal of charisma from some in power, and a good deal of conviction that this problem cannot be fixed without radical solutions, and will only worsen if left to fester. The "break-up" strategy from the early trust busting days may well prove effective today, and increase the number of balance sheet managers in the bargain. It will also, I suspect, require inflation ($ debasement) as a self-administered bail-out. President Obama might need to channel William Jennings Bryan, as well as Teddy Roosevelt to get the US out of this mess.
Perhaps President Obama can deliver a Cross of TBTF speech at the next Democratic convention.
Simon Johnson and James Kwak of 13 Bankers and The Baseline Scenario, urge President Obama, in a recent Washington Post Op-Ed, to channel Teddy Roosevelt’s defiance of Wall Street, exemplified by the break-up of Northern Securities in 1904 in order to clean up the US financial system.
I agree with Johnson and Kwak’s call to arms, and am sure their views are far more nuanced than a space limited op-ed can relate, however, my examination of the Progressive period in US history, of which the chapter on US financial regulation is but a part, suggests that repetition of that period is most unlikely, and hopefully unnecessary. While there are many similarities between then and now, both the context and issues of concern are, in certain key respects, different.
The Federal Government during the Gilded Age bore little resemblance to that existing today. As a financial entity, in the main, the government collected customs’ duties, which were more than half its receipts, paid interest on the debt, the bulk of which was incurred during the Civil War, and fought the Native Americans and Spain (wars were much cheaper then, additional Army and Navy costs for the 1898 Spanish American War came to $190M).
The malefactors of great wealth, as the industrial and financial titans of the day were known, controlled commerce and finance. They mined iron and made steel, connected the nation via railroads, telegraphs and telephones, and controlled the banks. They set prices and controlled the supply of money, credit and raw materials, which gave them the power to “shake down” people and firms of which they didn’t approve, competitors and frauds alike.
Unlike today, the leading banks which emerged at the end of the Gilded Age weren’t Too Big To Fail, they were Too Solvent To Fail. They owned much of the US gold stock, then the basis of money, and were seemingly immune from the Panics which shook the rest of the nation every decade or so, more often than not, it was claimed, at their instigation.
I’m confident if JP Morgan were running the Fed, credit growth would have been restrained long ago. There is some merit to having someone "own" an issue- unlike Greenspan, Geithner, Rubin et alios, who claim no responsibility. Thus, some believe we need more regulatory officials rather than better ones.
When the government was running dangerously short of gold reserves, in 1895, they went to Wall Street for help- call it a reverse bail-out- and had the Treasury supply replenished. A very small group of unelected men, in effect, owned the government.
This small group of men directed the transformation of America from a disconnected agrarian to a connected soon to be industrial society- from the states united to the United States. In the process, however, they paved the ground for the Progressives to use the power, not of money, but of public opinion, via the ballot box, to usurp their control.
The government that almost died in 1895, was reborn in 1901, when the assassination, by an anarchist (love the irony), of President McKinley, made Teddy Roosevelt President.
Teddy Roosevelt’s Trust Busting kicked off a vigorous 20 year period for the new government. Progressives, who had pushed potentially transformative legislation through Congress from 1885-1900 finally had an executive willing to use it, and his big stick, for change. The Rough Rider took the de jure power of the Interstate Commerce and Sherman Anti-Trust legislation, which had hitherto been used against labor, and prepared to make it de facto, against big business.
The Federal Government, as we know it today, was born. It was a small child about to battle grown men. US Federal Government receipts totaled $670M in 1900 (JP Morgan bought the Carnegie Steel Company around that time for $487M). In 1904, Northern Securities, a railroad trust owned by JP Morgan, JD Rockefeller et alios, was ordered to break up. The precedent, after appeal, was set and many other trusts followed. In 1911, after more than a decade of court battles, the Supreme Court dissolved Standard Oil, making JD Rockefeller, according to some, the richest man in the world, in cash.
He and the other Titans got rich, but lost control of their businesses. Like the Titans of Greek Mythology, they are, for good or ill, only going to appear once.
The child was growing quickly. In 1913, the Federal Reserve was created and the 16th Amendment, which made income taxes Constitutional, was ratified. Four years hence, the US entered World War I. At war’s end, the child had given way to the man. By 1920, receipts had grown to $23B. The Federal Government was now the biggest guy in town.
On one level, this growth of government is like that of Gilded Age business-built on the destruction of competition. There are, however, two key differences: 1) government didn’t “swallow” competitors, they dissolved them into smaller pieces, diluting their control 2) Gilded Age businesses were dynastic and decision-making was concentrated into few hands, government officials were (and are) popularly elected, operate within a system of checks and balances, and change more frequently.
The context in which Progressives operated was, as I’ve hopefully made clear, very different from today. The Federal Government then was, at least in a critical mass of minds, like a Deus ex machina, come to save the day. It didn’t tax the average citizen, but was likely to tax the wealthy and promised to not only break up the trusts, but also to open the credit spigot much wider. One hundred years hence, the bloom is off the Federal Government's rose. Increased taxation to fund another government expansion seems most unlikely.
Back then, the “money question”, as the debate between those who favored deflation or inflation was called, was one which brought people to the ballot box (I can’t imagine President Obama giving a Cross of Gold type speech). Elastic money seems to me the deciding factor which cemented Woodrow Wilson’s support of the Fed’s take-over of financial regulation.
Before turning to the present period, a few words about the Fed’s creation. There were two competing visions for the proposed central banking system, the Aldrich plan, which kept bankers in control, but allowed banks, at their discretion, access to government created liquidity (thus the need, under either vision, for the government, as financial entity, to grow, via increased taxes), The Bryan plan wanted government totally in control of a Central Bank which regulated the banks, and, at its sole discretion, could also supply liquidity.
The creature, as some call it, which emerged, was a compromise: government top down control of some key board members, banker control of others, the controlling board would be in D.C., thus demoting NY bankers, banks had access to liquidity, but the national liquidity level was at the board’s discretion.
Fortunately, unlike Johnson and Kwak, I’ve had the luxury of virtually unlimited internet space to flesh out the history. Unfortunately, I’ve probably lost most readers in this exercise of pedantry.
For those few that remain, let’s soldier on.
A Progressive solution, for our era, would involve for the creation of an empowered, taxing, global government with its own central bank, empowered with regulating all banks. This is, in a sense, the Nietzsche solution, fight monsters by creating bigger monsters. The United Nations (which replaced the earlier League of Nations) could be seen, in a Progressive dream, as the US Federal Government during the Gilded Age, an institution that, under direction of charismatic individuals, should become the biggest monster on the block, and maintain world order.
In my view, such a solution would but buy time in the same way that, 100 years from the empowering of the US government, many of the old problems remain. Ideas and conviction, not power, seem to me the missing elements. Further, the newly empowered Federal Government of a century ago was battling individuals, not national governments with armies, which would be the objects to be brought under control of any world government. If national governments begin to collapse, or fail to restrain growth of their internal monsters, however, I wouldn’t be surprised to see this “solution” emerge.
Supporters of continued US sovereignty within our borders, and the big bankers themselves, who might win the battle against US regulation only to risk eventually losing the war to world regulators (as the NY banks won the battle against state regulator but lost the war to the Feds) should take note. Men like Rockefeller and Carnegie, who ultimately submitted to government restraint, financed legacy institutions like the Trilateral Commission and its ilk to lay the basis for these bigger monsters. For a preview, consider: The IMF and the EU are currently battling for control in Greece, which seems willing to trade sovereignty rather than restrain its appetites via default.
Today, as then, the issue of size is key in one sense. Our regulators were seduced by “economies of scale” arguments and allowed a few financial institutions to grow beyond the ability of an indebted government to restrain. The 1895 analog is striking and, in that sense, Johnson and Kwak’s call to channel Roosevelt seems right on the mark. Terms like charisma and force of personality are often used to explain Teddy Roosevelt’s ability to bend people, ostensibly possessed of more power, to his will.
In the event, it took more than Roosevelt’s charisma to beat Morgan and his crew (or his charisma, and fear of popular backlash, was such that he bent a critical mass of the Supreme Court, to his will). US vs. Northern Securities was decided 5-4, with Chief Justice Fuller and Justices White, Peckham and Holmes dissenting. From a financial perspective, David, in the form of the US Government, had slain Goliath, a Trust whose capitalization was almost 2/3 of US revenues.
The basis of the decision, which, after appeal, and modification, became unanimous, however, was not bigness, but restraint of trade, via the stifling of competition. As Justice Holmes wrote in his dissent, “Size has nothing to do with the matter.”
Justice Harlan, writing in the affirmative: The Government charges that, if the combination was held not to be in violation of the act of Congress, then all efforts of the National Government to preserve to the people the benefits of free competition among carriers engaged in interstate commerce will be wholly unavailing, and all transcontinental lines, indeed the entire railway systems of the country, may be absorbed, merged and consolidated, thus placing the public at the absolute mercy of the holding corporation.
Adding: it need not be shown that the combination, in fact, results or will result in a total suppression of trade or in a complete monopoly, but it is only essential to show that, by its necessary operation, it tends to restrain interstate or international trade or commerce or tends to create a monopoly in such trade or commerce and to deprive the public of the advantages that flow from free competition;
Having read both sides, I understand the dissenting view; until trade is restrained, monopoly, per se, isn’t a crime, and might even lead to reduced consumer costs. Should there always be at least two rail options for every possible route? I assume, however, that the objects sought by President Roosevelt were a precedent, and distributed control and profits, not a strict reading enforcement.
I dwell on the decision to suggest a legal challenge to the current concentration of financial control into very few hands. Contrary to the above, financial concentration has already restrained trade, and imposed additional costs to all. Financial support (and even the expectation thereof) of TBTF firms also restrains trade in that potential (and actual) competitors who avoided (or even profited by) the declines in certain asset markets were restrained in gaining increased market share. Surely one of the benefits of competition is the weeding out of the short-sighted.
Fortunately, I don’t think we need new legislation, we just need to enforce what’s already on the books.
Like the internet, finance would benefit from redundancy, and competition, not just in the sense of distributed shareholdings (which is already the case) but viewpoints (which is not helped when directors merely “rubber stamp” CEO opinion, and Fed, Treasury, and other financial regulatory officials are always on loan from GS and the rest of Wall Street). Like minded-ness, if you will, is the issue here. TBTF engenders the myopia which leads men like Greenspan to argue, “nobody saw it coming.” Quite a few did, but they were, in a sense, crowded out of the market.
The need for redundancy would become more apparent if we held as self-evident the belief that there is no magic cure for financial overextension (bubbles) and their dissolution (busts) in a fractional reserve banking system. It will happen, again and again. Mitigation, as should now be clear, is not just an issue of additional liquidity but also a financial industry comprised of smaller, and more numerous, competing firms. It might also help to examine the books of any firm (including the Fed) which promotes the notion that “this time is different.”
I hold no illusions about being the sharpest knife in the drawer, as the Brits say, and thus assume others have considered similar legal arguments against financial concentration. Given the obvious trade restraining effects of TBTF, why isn’t the Supreme Court hearing arguments?
Like the Federal Government in 1895, ours too needs a bail-out. While the big financial firms can no longer provide such support, they can keep the Feds afloat by selling bonds as Primary Dealers, and, if needed, increase their own holdings thereof (particularly after the Fed has graciously relieved them of toxic mortgage, et alia, assets). If the Federal Government is ever to restrain finance, they need to break this dependency, and prepare to take their lumps, so to write, for poor fiscal management. If they were crafty they would blame the firms they were about to break up…just a thought.
This will require either skillful diplomacy or a good deal of charisma from some in power, and a good deal of conviction that this problem cannot be fixed without radical solutions, and will only worsen if left to fester. The "break-up" strategy from the early trust busting days may well prove effective today, and increase the number of balance sheet managers in the bargain. It will also, I suspect, require inflation ($ debasement) as a self-administered bail-out. President Obama might need to channel William Jennings Bryan, as well as Teddy Roosevelt to get the US out of this mess.
Perhaps President Obama can deliver a Cross of TBTF speech at the next Democratic convention.
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....
click for larger version
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?
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....
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?
Tuesday, March 30, 2010
It's Good to be a US Banker (for now)
I remember the first time I saw a fellow trader get fired from Chase Manhattan. Sitting down at my desk in front of the green screens (this was before the invasion of computer terminals) I had my coffee in one hand and a phone in the other when a buddy sitting behind me whispered, "check out the security guards."
I looked around and saw two guys in uniform standing at attention near the elevators. I hadn't noticed them when I arrived, as I was reading the newspaper. "What's up with that?," I asked.
"Someone's getting fired," he responded.
The 35th floor of Chase was very quiet, I suddenly noticed.
A few minutes later another trader walked in, nose buried in his newspaper, on the way to his desk. The guards, one of whom carried a cardboard box, followed him and just before he reached his desk told him to pack his things in the box and come with them. He reached for a phone but the guard was quicker. "No calls," he said, "pack your stuff and let's go."
It was a scary scene, but on reflection, as I still had a job (I was later to be on the other side of this issue), it made me feel as if banking (at least on the trading side) was a place where Capitalism reigned. Perform and you get very well paid. Screw up, and you're fired.
Or so I thought.
I've spent much of the past 2 days downloading data from the FDIC (more on those details in my next post) and was amazed to discover the best uptrend in the financial markets is banking salaries and employee benefits. One look at the graph below and I realized Lloyd Blankfein must be right. Bankers are doing God's work (or at least being compensated as if).
the data is skewed somewhat higher from the late 90s on by the repeal of Glass Steagall
You might think, if Bank employees are doing well, the owners must be doing even better. If these banks were more privately owned I would agree, but they aren't. It's apparently much better to work for a big bank (smaller banks don't pay even their top guys that well, as I found drilling down in the data) than to own it, just ask the gang at Goldman. The graph of cash dividends isn't nearly as pretty (but you can't argue with any dividend for 2008 or 2009, given the recent crisis, if you're an owner).
If you aren't a bank share owner but simply a taxpayer hoping the Fed won't let the currency in which you're remunerated shrink in value, you can argue plenty.
Recent news headlines proclaiming the wondrous profit (of $7B, not enough to pay salaries and bonuses of the top men at the big 5 US Bank holding companies) ready to be realized by the government with the sale of Citibank (brokered by these same bankers) miss the point. The Fed's balance sheet exploded to ensure that the Bankers who approved the loans which fomented the crisis could provision (inadequately, I suspect, as I'll discuss next time) against the losses and get paid handsomely for their shoddy work.
We'll all pay the price for that down the road and it may not be that far ahead. Irish banks have gone back to their government for yet another infusion of capital. Back here in the US, Elizabeth Warren of the TARP Congressional Oversight Panel is warning of an impending commercial real estate loan crisis.
When the next crisis hits, (not too long now, I suspect) the Bankers won't need a TARP, they'll need some flak jackets.
As Paul Volcker said today, the banks must face a credible threat of closure. Ultimately the failing firm should be liquidated or merged. In all... it is a death sentence, not a rescue at the hospital.
I looked around and saw two guys in uniform standing at attention near the elevators. I hadn't noticed them when I arrived, as I was reading the newspaper. "What's up with that?," I asked.
"Someone's getting fired," he responded.
The 35th floor of Chase was very quiet, I suddenly noticed.
A few minutes later another trader walked in, nose buried in his newspaper, on the way to his desk. The guards, one of whom carried a cardboard box, followed him and just before he reached his desk told him to pack his things in the box and come with them. He reached for a phone but the guard was quicker. "No calls," he said, "pack your stuff and let's go."
It was a scary scene, but on reflection, as I still had a job (I was later to be on the other side of this issue), it made me feel as if banking (at least on the trading side) was a place where Capitalism reigned. Perform and you get very well paid. Screw up, and you're fired.
Or so I thought.
I've spent much of the past 2 days downloading data from the FDIC (more on those details in my next post) and was amazed to discover the best uptrend in the financial markets is banking salaries and employee benefits. One look at the graph below and I realized Lloyd Blankfein must be right. Bankers are doing God's work (or at least being compensated as if).
the data is skewed somewhat higher from the late 90s on by the repeal of Glass Steagall
You might think, if Bank employees are doing well, the owners must be doing even better. If these banks were more privately owned I would agree, but they aren't. It's apparently much better to work for a big bank (smaller banks don't pay even their top guys that well, as I found drilling down in the data) than to own it, just ask the gang at Goldman. The graph of cash dividends isn't nearly as pretty (but you can't argue with any dividend for 2008 or 2009, given the recent crisis, if you're an owner).
If you aren't a bank share owner but simply a taxpayer hoping the Fed won't let the currency in which you're remunerated shrink in value, you can argue plenty.
Recent news headlines proclaiming the wondrous profit (of $7B, not enough to pay salaries and bonuses of the top men at the big 5 US Bank holding companies) ready to be realized by the government with the sale of Citibank (brokered by these same bankers) miss the point. The Fed's balance sheet exploded to ensure that the Bankers who approved the loans which fomented the crisis could provision (inadequately, I suspect, as I'll discuss next time) against the losses and get paid handsomely for their shoddy work.
We'll all pay the price for that down the road and it may not be that far ahead. Irish banks have gone back to their government for yet another infusion of capital. Back here in the US, Elizabeth Warren of the TARP Congressional Oversight Panel is warning of an impending commercial real estate loan crisis.
When the next crisis hits, (not too long now, I suspect) the Bankers won't need a TARP, they'll need some flak jackets.
As Paul Volcker said today, the banks must face a credible threat of closure. Ultimately the failing firm should be liquidated or merged. In all... it is a death sentence, not a rescue at the hospital.
Sunday, February 21, 2010
The Mask of Solvency
On reading the news of Goldman Sach's involvement in the Greek Government's heretofore successful plot to negatively obscure their fiscal position from the rest of the world (with the notable exception of Goldman Sachs, it seems worth noting) a vision sprang to mind. In it, a group of Greek Finance Officials are seated on one side of one of those over-long conference room tables found in the upper floors of modern office buildings facing two people from Goldman Sachs- Europe's Chief Institutional Derivatives Salesman and his mid 20s blond bombshell assistant.
After the obligatory pleasantries are completed the assistant distributes folders to the Greek Officials, bending over slightly in front of each man in the process. "As I was saying on the phone, Gentlemen," the GS salesman interjects, interrupting the not well concealed ogling, "we at Goldman Sachs can structure a portfolio of derivatives to hide your true fiscal position from both potential investors and the prying eyes of the European Central Government. We call it, 'The Mask of Solvency' portfolio."
Fade out.
What an interesting name, and notion; The Mask of Solvency- a means for the insolvent to appear to all but the most discerning observer as solvent as the best AAA credit, e.g. the US Government (irony intended).
The invented-but-still-possibly-accurate name of the GS ploy reminds me of a book on Psychopaths by Psychiatrist Hervey Cleckley, The Mask of Sanity. The depiction of Psychopathology seems to me a most useful prism through which to view current financial affairs.
To wit (from the book): It must be remembered that even the most severely and obviously disabled psychopath presents a technical appearance of sanity, often one of high intellectual capacities, and not infrequently succeeds in business or professional activities for short periods, sometimes for considerable periods.
More often than not, the typical psychopath will seem particularly agreeable and make a distinctly positive impression when he is first encountered. Alert and friendly in his attitude, he is easy to talk with and seems to have a good many genuine interests. There is nothing at all odd or queer about him, and in every respect he tends to embody the concept of a well-adjusted, happy person. Nor does he, on the other hand, seem to be artificially exerting himself like one who is covering up or who wants to sell you a bill of goods. He would seldom be confused with the professional backslapper or someone who is trying to ingratiate himself for a concealed purpose. Signs of affectation or excessive affability are not characteristic. He looks like the real thing. Very often indications of good sense and sound reasoning will emerge and one is likely to feel soon after meeting him that this normal and pleasant person is also one with high abilities. Psychometric tests also very frequently show him of superior intelligence. More than the average person, he is likely to seem free from social or emotional impediments, from the minor distortions, peculiarities, and awkwardnesses so common even among the successful.
The idea of a mask of solvency must have seemed like a stroke of genius to those whose masks of sanity had faded as far from conscious awareness as breathing. Successful arbitrageurs, after all, are well practiced in accepting the facsimile of a thing as the true thing itself. Thus, for most, the S&P 500 future is seen as identical to a portfolio of those 500 stocks, even though it only delivers (or takes) cash on settlement. As with the psychopath itself, only careful observation of behavior in all facets of life distinguishes the arbitraged facsimile from the true thing.
Usually, the distinguishing characteristics only manifest, i.e. the masks slips, as seems the case with Greek debt, when the damage has been done.
Or is damage done? Is there a difference in experience between merely the appearance of a thing, or quality, like solvency or sanity, and that thing or quality in truth?
It seems man has been pondering this question for Millennia, which is to write that it is a question each person apparently needs to answer for his or her self. In Plato's Republic Socrates asks if there is a difference between a man who appears Just but is not and a man who is truly Just. Athens too, it seems, had its share of Psychopaths in positions of influence inspiring such questions.
In our modern, financially centered system, Solvency, not Justice is the issue. Recasting Socrates' question, Is there a difference between a financial entity which appears solvent but is not, and one that is truly solvent? Would it not be better, as Socrates' listeners asked (about Justice) in the Republic, to enjoy the extra consumption afforded those who can mask their insolvency?
Socrates argued against such a view, while admitting that those so masked might reap temporary benefits. His reward for such truth-seeking views was death ordered by an Athenian Government which was in the process of devolution from the core of a great empire to a city with little sovereignty.
Whether the question has been answered accurately is up to everyone to individually decide.
One wonders if any of the Greek Finance Officials recalled Socrates' views when offered the Mask of Solvency. Regardless, I suspect Socrates' wisdom is now evident to them.
After the obligatory pleasantries are completed the assistant distributes folders to the Greek Officials, bending over slightly in front of each man in the process. "As I was saying on the phone, Gentlemen," the GS salesman interjects, interrupting the not well concealed ogling, "we at Goldman Sachs can structure a portfolio of derivatives to hide your true fiscal position from both potential investors and the prying eyes of the European Central Government. We call it, 'The Mask of Solvency' portfolio."
Fade out.
What an interesting name, and notion; The Mask of Solvency- a means for the insolvent to appear to all but the most discerning observer as solvent as the best AAA credit, e.g. the US Government (irony intended).
The invented-but-still-possibly-accurate name of the GS ploy reminds me of a book on Psychopaths by Psychiatrist Hervey Cleckley, The Mask of Sanity. The depiction of Psychopathology seems to me a most useful prism through which to view current financial affairs.
To wit (from the book): It must be remembered that even the most severely and obviously disabled psychopath presents a technical appearance of sanity, often one of high intellectual capacities, and not infrequently succeeds in business or professional activities for short periods, sometimes for considerable periods.
More often than not, the typical psychopath will seem particularly agreeable and make a distinctly positive impression when he is first encountered. Alert and friendly in his attitude, he is easy to talk with and seems to have a good many genuine interests. There is nothing at all odd or queer about him, and in every respect he tends to embody the concept of a well-adjusted, happy person. Nor does he, on the other hand, seem to be artificially exerting himself like one who is covering up or who wants to sell you a bill of goods. He would seldom be confused with the professional backslapper or someone who is trying to ingratiate himself for a concealed purpose. Signs of affectation or excessive affability are not characteristic. He looks like the real thing. Very often indications of good sense and sound reasoning will emerge and one is likely to feel soon after meeting him that this normal and pleasant person is also one with high abilities. Psychometric tests also very frequently show him of superior intelligence. More than the average person, he is likely to seem free from social or emotional impediments, from the minor distortions, peculiarities, and awkwardnesses so common even among the successful.
The idea of a mask of solvency must have seemed like a stroke of genius to those whose masks of sanity had faded as far from conscious awareness as breathing. Successful arbitrageurs, after all, are well practiced in accepting the facsimile of a thing as the true thing itself. Thus, for most, the S&P 500 future is seen as identical to a portfolio of those 500 stocks, even though it only delivers (or takes) cash on settlement. As with the psychopath itself, only careful observation of behavior in all facets of life distinguishes the arbitraged facsimile from the true thing.
Usually, the distinguishing characteristics only manifest, i.e. the masks slips, as seems the case with Greek debt, when the damage has been done.
Or is damage done? Is there a difference in experience between merely the appearance of a thing, or quality, like solvency or sanity, and that thing or quality in truth?
It seems man has been pondering this question for Millennia, which is to write that it is a question each person apparently needs to answer for his or her self. In Plato's Republic Socrates asks if there is a difference between a man who appears Just but is not and a man who is truly Just. Athens too, it seems, had its share of Psychopaths in positions of influence inspiring such questions.
In our modern, financially centered system, Solvency, not Justice is the issue. Recasting Socrates' question, Is there a difference between a financial entity which appears solvent but is not, and one that is truly solvent? Would it not be better, as Socrates' listeners asked (about Justice) in the Republic, to enjoy the extra consumption afforded those who can mask their insolvency?
Socrates argued against such a view, while admitting that those so masked might reap temporary benefits. His reward for such truth-seeking views was death ordered by an Athenian Government which was in the process of devolution from the core of a great empire to a city with little sovereignty.
Whether the question has been answered accurately is up to everyone to individually decide.
One wonders if any of the Greek Finance Officials recalled Socrates' views when offered the Mask of Solvency. Regardless, I suspect Socrates' wisdom is now evident to them.
Tuesday, October 13, 2009
Will Goldman Sachs "Do It Again"?
The key to the game is your capital reserves, If you haven't got enough, you can't piss in the tall weeds with the big dogs. Gordon Gekko
Sidney Weinberg must be rolling in his grave at the news that Goldman Sachs, according to press reports, intends to pay its employees bonuses totaling some $23B. Mr. Weinberg, if you're unfamiliar with the name, was the man who brought Goldman Sachs back from the brink of disaster after the Crash of '29. One key aspect of his management approach was capital retention. Like the mythical Mr. Gekko, Mr. Weinberg knew the key to the game.
Admittedly, the game has changed. The former partnership went public in 1999 and become a bank holding company last year. I wonder how many owners (direct or indirect) of GS are aware that their holdings help finance these big payouts. The shift to bank holding company and consequent access to the Fed's discount window also facilitates the shift from Weinberg's capital retention mode to the current capital distribution mode.
These days, Goldman Sachs (GS) is on top of the world. GS men like Mr. Rubin and Mr. Paulson became US Treasury Secretaries, and many others seems to find opportunities in the state effortlessly.
What a recovery for a firm that was almost brought to its knees in 1929.
Last weekend I flew to Chicago and read The Partnership: The Making of Goldman Sachs, which I highly recommend, if you can manage to stomach the all too frequent claims of absolute integrity wrapped around some very dodgy activities (like getting caught forcing Penn Central to buy back its commercial paper while it was selling same to the public right before the railroad went bankrupt in June, 1970).
From the Court Record of the Case of Welch's et. al (who got stuck with the bankrupt paper) vs. GS:
Question: Were you aware that on Feb. 5, 1970, Wilson [a GS partner in the CP division] asked Penn Central to buy back $10M of its commercial paper from the inventory position of Goldman Sachs?
Gus Levy [GS Managing Partner]: It was in the memorandum, so I knew about it.
Question: Was that nonpublic information?
Levy: That was definitely nonpublic information.
Question: Did you instruct disclosure of that fact?
Levy: I did not.
The above, however, is not the "meat" of what I sat down to convey today. By "do it again" I refer to the Goldman Sachs Trading Corporation, about which, Seeking Alpha opines here (GSTC), the disastrous failure of which required 30+ years of diligent effort from Mr. Weinberg et. al. to repair.
In the latter half of the 19th Century, Goldman, Sachs & Co. was a mercantile (commercial) paper finance company started by Marcus Goldman. His son, Henry, expanded into investment banking before siding with Germany in WWI which led to his resignation. He eventually relocated to Germany and ran into Hitler in the 1930s (in case you thought their senior partners never made bad calls- what a horror that must have been).
Henry Goldman was replaced, in a sense, by Waddill Catchings, who promised The Road to Plenty in 1928 with William Foster. Despite early trepidation about the bull market of the 1920s he "caught the bug" and decided to launch GSTC. The book relates a quote on this decision from Walter Sachs which may prove quite ironic (again) in a few years time, "All would have been well had the firm confined its activities to the type of business which had been done over the years."
Launched in 1928, GSTC jumped out of the gate rising from its IPO price of $104 to $226 quickly and an eventual high of $326. Although already owning 10%of the shares, and contracted to receive 20% of the trust's net income as manager, GSTC bought another $57M of its shares in the first few months. In a few short years GSTC would trade down to $1.75.
What sin did GSTC commit, and Walter Sachs notice? GSTC (and via the ownership thereof, GS) stopped being an intermediary and took a position. The "boring" choice of simply being a financial intermediary was not enough for GS in the final stages of the 1920s US equity bull, and, it seems to me, the equally "boring" choice of being simply a financial intermediary in the final stages of the US's bull market has been eschewed by current GS management.
There's an interesting anecdote from the book which highlights this choice:
[Fischer, of Black and Scholes fame, then an employee of GS] Black was quantitative to a fault. The rigor of his logic and his infallibility to be anything but entirely logical led him to state some positions that were so perfectly rational that they were really very irrational. For example, one day he stopped everyone's clock with his conclusion that Goldman Sachs should go short- ten million dollars worth short- in financial futures. "If we are intellectually honest with ourselves, we will go short futures by enough to fully hedge our exposures to the cash markets, instead of always being net long. That way, we will be operating the firm with zero net exposure to market risk."
......
"For Fischer," [recalls Silfen] "it was completely rational." But that was the theory, and the pragmatists of Goldman Sachs-with less than one billion dollars in total capital- simply couldn't imagine establishing a "simple" short position that was ten times as large as the firm's total capital. For them, Black's idea might be academically valid, but it was so totally irrational that it was insane.
In the years since Mr. Black made his suggestion, GS' capital leverage has only grown. Long ago they decided to not simply be intermediaries, but to be players. You can't make big profits, as Mr. Catchings likely advised in the late 1920s, without exposure.
This time it isn't just stocks which seem to drive profits. GS, in particular relative to other BHCs, seems to make money when US liquidity is rising and US yields are falling- as I noted in From Black Scholes to Black Holes. This is a bet on a continuation of the "exorbitant privilege"- the ability to force as many US$s down the rest of the world's financial throat as they wish- which one might construe as yet another Road to Plenty. Someday in the not too distant future, former Nixon Treasury Secretary Connally's quip might prove false- we (and GS) might discover that our currency is, in fact, our problem.
I suspect when the dust settles we'll discover that GS "did it again"- got leveraged in the wrong market at the wrong time. Hopefully, as occurred in the 1970s, the failure of GS won't be seen as tantamount to a failure of the US, because it isn't. In the 1970s the US courts handed GS a string of defeats related to Penn Central and, to the best of my knowledge, never worried if the company would fail. Ah, the good old days.
Sidney Weinberg must be rolling in his grave at the news that Goldman Sachs, according to press reports, intends to pay its employees bonuses totaling some $23B. Mr. Weinberg, if you're unfamiliar with the name, was the man who brought Goldman Sachs back from the brink of disaster after the Crash of '29. One key aspect of his management approach was capital retention. Like the mythical Mr. Gekko, Mr. Weinberg knew the key to the game.
Admittedly, the game has changed. The former partnership went public in 1999 and become a bank holding company last year. I wonder how many owners (direct or indirect) of GS are aware that their holdings help finance these big payouts. The shift to bank holding company and consequent access to the Fed's discount window also facilitates the shift from Weinberg's capital retention mode to the current capital distribution mode.
These days, Goldman Sachs (GS) is on top of the world. GS men like Mr. Rubin and Mr. Paulson became US Treasury Secretaries, and many others seems to find opportunities in the state effortlessly.
What a recovery for a firm that was almost brought to its knees in 1929.
Last weekend I flew to Chicago and read The Partnership: The Making of Goldman Sachs, which I highly recommend, if you can manage to stomach the all too frequent claims of absolute integrity wrapped around some very dodgy activities (like getting caught forcing Penn Central to buy back its commercial paper while it was selling same to the public right before the railroad went bankrupt in June, 1970).
From the Court Record of the Case of Welch's et. al (who got stuck with the bankrupt paper) vs. GS:
Question: Were you aware that on Feb. 5, 1970, Wilson [a GS partner in the CP division] asked Penn Central to buy back $10M of its commercial paper from the inventory position of Goldman Sachs?
Gus Levy [GS Managing Partner]: It was in the memorandum, so I knew about it.
Question: Was that nonpublic information?
Levy: That was definitely nonpublic information.
Question: Did you instruct disclosure of that fact?
Levy: I did not.
The above, however, is not the "meat" of what I sat down to convey today. By "do it again" I refer to the Goldman Sachs Trading Corporation, about which, Seeking Alpha opines here (GSTC), the disastrous failure of which required 30+ years of diligent effort from Mr. Weinberg et. al. to repair.
In the latter half of the 19th Century, Goldman, Sachs & Co. was a mercantile (commercial) paper finance company started by Marcus Goldman. His son, Henry, expanded into investment banking before siding with Germany in WWI which led to his resignation. He eventually relocated to Germany and ran into Hitler in the 1930s (in case you thought their senior partners never made bad calls- what a horror that must have been).
Henry Goldman was replaced, in a sense, by Waddill Catchings, who promised The Road to Plenty in 1928 with William Foster. Despite early trepidation about the bull market of the 1920s he "caught the bug" and decided to launch GSTC. The book relates a quote on this decision from Walter Sachs which may prove quite ironic (again) in a few years time, "All would have been well had the firm confined its activities to the type of business which had been done over the years."
Launched in 1928, GSTC jumped out of the gate rising from its IPO price of $104 to $226 quickly and an eventual high of $326. Although already owning 10%of the shares, and contracted to receive 20% of the trust's net income as manager, GSTC bought another $57M of its shares in the first few months. In a few short years GSTC would trade down to $1.75.
What sin did GSTC commit, and Walter Sachs notice? GSTC (and via the ownership thereof, GS) stopped being an intermediary and took a position. The "boring" choice of simply being a financial intermediary was not enough for GS in the final stages of the 1920s US equity bull, and, it seems to me, the equally "boring" choice of being simply a financial intermediary in the final stages of the US's bull market has been eschewed by current GS management.
There's an interesting anecdote from the book which highlights this choice:
[Fischer, of Black and Scholes fame, then an employee of GS] Black was quantitative to a fault. The rigor of his logic and his infallibility to be anything but entirely logical led him to state some positions that were so perfectly rational that they were really very irrational. For example, one day he stopped everyone's clock with his conclusion that Goldman Sachs should go short- ten million dollars worth short- in financial futures. "If we are intellectually honest with ourselves, we will go short futures by enough to fully hedge our exposures to the cash markets, instead of always being net long. That way, we will be operating the firm with zero net exposure to market risk."
......
"For Fischer," [recalls Silfen] "it was completely rational." But that was the theory, and the pragmatists of Goldman Sachs-with less than one billion dollars in total capital- simply couldn't imagine establishing a "simple" short position that was ten times as large as the firm's total capital. For them, Black's idea might be academically valid, but it was so totally irrational that it was insane.
In the years since Mr. Black made his suggestion, GS' capital leverage has only grown. Long ago they decided to not simply be intermediaries, but to be players. You can't make big profits, as Mr. Catchings likely advised in the late 1920s, without exposure.
This time it isn't just stocks which seem to drive profits. GS, in particular relative to other BHCs, seems to make money when US liquidity is rising and US yields are falling- as I noted in From Black Scholes to Black Holes. This is a bet on a continuation of the "exorbitant privilege"- the ability to force as many US$s down the rest of the world's financial throat as they wish- which one might construe as yet another Road to Plenty. Someday in the not too distant future, former Nixon Treasury Secretary Connally's quip might prove false- we (and GS) might discover that our currency is, in fact, our problem.
I suspect when the dust settles we'll discover that GS "did it again"- got leveraged in the wrong market at the wrong time. Hopefully, as occurred in the 1970s, the failure of GS won't be seen as tantamount to a failure of the US, because it isn't. In the 1970s the US courts handed GS a string of defeats related to Penn Central and, to the best of my knowledge, never worried if the company would fail. Ah, the good old days.
Tuesday, October 06, 2009
Who's Afraid of Naked Short-Selling?
The real significance of the naked short-selling issue isn’t so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies — and that has been significant, don’t get me wrong — but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it. Matt Taibbi
Naked short selling, or the sale of a security you don't already own, has been an issue of concern for corporations for many years. According to those affected, the practice allows traders to drive a stock price lower than it "should be" if the practice was restricted.
This is, no doubt, true. Beyond the equity markets, this activity has been common practice in the foreign exchange markets for decades, and has inspired similar complaints. Ex-Malaysian PM Mohammed Mahathir heaped scorn on George Soros and other speculators for attacks on Malaysia's Ringgit and other currencies during the Asia crisis. Before that Mr. Soros became infamous as the man who broke the Bank Of England, driving the GBP and ITL out of the European ERM bands.
While I see the point of those affected, and agree that naked short selling run amok could stifle corporate IPOs and young businesses- which might not be a bad thing at certain times- there is a way to avoid a good deal of the damage this type of trading can unleash. Keep your financial house in order.
On the national level, it seems worth noting that Soros didn't try to short the DEM or the CHF, he chose the GBP and ITL for a reason. Those currencies were mispriced within the ERM.
More to the point, due to the guarantee of the ERM (which aimed to keep bilateral exchange rates within a trading band) long before Mr. Soros decided to short the GBP, speculators had bought it at the bottom of its trading rage against the DEM to pocket the interest rate spread between Britain and Germany. Mr. Soros' sales may have upset the balance, but it was the weight of "free money" investors who got, justifiably, spooked and ran for the exits, which crashed the GBP.
In other words, if the price of the security is not too high- say, as a result, in the equity arena, of too much debt and too little profit- short sellers will likely not find your security a profitable sale. Yes, there is a lot of gray here and I don't doubt that currencies or securities that might eventually justify their price could fall prey to naked short-selling. However, a company with a strong balance sheet and highly profitable capital stock might enjoy a round of short selling, to buy back their own stock.
What I found most interesting about Mr. Taibbi's excellent reporting is the increased Congressional interest. As the big banks in the US increasingly realize that they, given their extremely leveraged position, are prime candidates for naked short selling they will be caught in something of a dilemma. On the one hand, they either engage in the practice themselves (after all what is the bet in a credit default swap) or finance hedge funds who do, while on the other they will (much more slowly I imagine) see themselves as potential victims. I'm probably only half joking when I suggest that naked short-selling will surely be outlawed when Goldman Sachs, as one of the last banks standing, finds its stock under attack.
Karma can be a b!tch.
Naked short selling, or the sale of a security you don't already own, has been an issue of concern for corporations for many years. According to those affected, the practice allows traders to drive a stock price lower than it "should be" if the practice was restricted.
This is, no doubt, true. Beyond the equity markets, this activity has been common practice in the foreign exchange markets for decades, and has inspired similar complaints. Ex-Malaysian PM Mohammed Mahathir heaped scorn on George Soros and other speculators for attacks on Malaysia's Ringgit and other currencies during the Asia crisis. Before that Mr. Soros became infamous as the man who broke the Bank Of England, driving the GBP and ITL out of the European ERM bands.
While I see the point of those affected, and agree that naked short selling run amok could stifle corporate IPOs and young businesses- which might not be a bad thing at certain times- there is a way to avoid a good deal of the damage this type of trading can unleash. Keep your financial house in order.
On the national level, it seems worth noting that Soros didn't try to short the DEM or the CHF, he chose the GBP and ITL for a reason. Those currencies were mispriced within the ERM.
More to the point, due to the guarantee of the ERM (which aimed to keep bilateral exchange rates within a trading band) long before Mr. Soros decided to short the GBP, speculators had bought it at the bottom of its trading rage against the DEM to pocket the interest rate spread between Britain and Germany. Mr. Soros' sales may have upset the balance, but it was the weight of "free money" investors who got, justifiably, spooked and ran for the exits, which crashed the GBP.
In other words, if the price of the security is not too high- say, as a result, in the equity arena, of too much debt and too little profit- short sellers will likely not find your security a profitable sale. Yes, there is a lot of gray here and I don't doubt that currencies or securities that might eventually justify their price could fall prey to naked short-selling. However, a company with a strong balance sheet and highly profitable capital stock might enjoy a round of short selling, to buy back their own stock.
What I found most interesting about Mr. Taibbi's excellent reporting is the increased Congressional interest. As the big banks in the US increasingly realize that they, given their extremely leveraged position, are prime candidates for naked short selling they will be caught in something of a dilemma. On the one hand, they either engage in the practice themselves (after all what is the bet in a credit default swap) or finance hedge funds who do, while on the other they will (much more slowly I imagine) see themselves as potential victims. I'm probably only half joking when I suggest that naked short-selling will surely be outlawed when Goldman Sachs, as one of the last banks standing, finds its stock under attack.
Karma can be a b!tch.
Thursday, October 01, 2009
From Black Scholes to Black Holes (part 4- Finance)
Were a modern-day financial Rip Van Winkle to awake today having slumbered for the past 20 years, he would observe a capital market vastly different from the one he knew. Introduction: From Black Scholes to Black Holes
It's been 16 years since the above noted book-a collection of essays explainging how one models the risks associated with certain derivative securities- was published and the introductory statement is more true now than then. In 1992, the notional amount of interest rate derivative exposure in US banks was about 77% of GDP. The graph below shows the growth since.
I begin this 4th look at the US economy from a flow of funds perspective with derivatives to "cut to the chase." This isn't to diminish the still currently intractable problems of mortgage finance, but that topic has been ably covered by many others. Further, as hard as it may be to believe, the problems associated with mortgage finance pale in comparison to those associated with derivatives. Warren Buffett famously called these securities financial weapons of mass destruction, but I think he understated the problem. These securities are far worse- a Ponzi scheme even Carlo wouldn't have dreamed of. We can choose to fire a WMD, but these securities have taken on a life of their own and they will, in my view, drag everything financially tied to them into oblivion- into a black hole.
The intent of the book From Black Scholes to Black Holes, to cloak these securities in an aura of cool, is quite ironic in its, apparently unintended, prescience. Black Holes are singularities in Einstein's space-time continuum which swallow, for want of a better term, everything that comes near. They are the Charybdis-es of space. Derivatives are the Charybdis-es of finance. They are creating their own ever stronger gravitational field that has already swallowed 3 of the 8 major US players since 1998. The 5 banks which remain are increasingly linked together.
Last night, after perusing the derivatives data from the BIS and Office of the Comptroller of the Currency (OCC), I was wondering what the end game would be, happened to glance at my book shelf and the book title jumped out at me. "It's a Black Hole," I realized. In the end the remaining banks will merge into one and money, instead of light, would never be able to escape as the fallacy of netting benefits- the assumption that they are all similarly valued- is exposed.
In the OCC Report on Derivatives, the benefits of netting are explained: For a portfolio of contracts with a single counterparty where the bank has a legally enforceable bilateral netting agreement, contracts with negative values may be used to offset contracts with positive values. This process generates a “net” current credit exposure (NCCE)
I had some experience with this fallacy of netting when I was trading FX derivatives for Chase. When Drexel Burnham collapsed I had to "net out" - put on the opposite trade with the same counterparty- the exposure of my option portfolios with Drexel's. While this seems easy to describe there was a problem. They didn't value their options at the same values we did. In some cases I was short low delta (far out of the money) options I had marked to the (lower) at-the-money value. Who should take that revaluation loss? In other cases, I might have to net out a position I needed only to find that replacing it was far more expensive than our agreed upon price.
Fortunately, markets I was trading at that time were not excessively volatile, which would have made the procedure even more difficult. Even more fortunately, the notional amounts were orders of magnitude less than currently carried by US banks.
50 basis points (a fairly trivial change in an option value, or, if you prefer, an aggressive post Volcker Fed tightening) on $100M (roughly the size of trade back then) is $500K. 50 basis points on $7Tln (or 1/5th (5 banks left) of the notional exposure in interest rate derivatives with maturities between 1-5 years) is $35B (7 times the total net income for JPM in 2008).
Why has interest rate derivative exposure grown so much over the past few years? The search for profits in an ultra low interest rate environment seems, in part, a good answer as the graph below depicts.
The other answer is that, as I discovered, the easiest way to make money from a derivatives portfolio is to grow it. Increasing risk in the far dates that is mispriced in your favor can cover many sins as derivatives mature.
Warren Buffett describes the pain of going in reverse on (winding down) such portfolios: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.” General Re's derivatives exposure was orders of magnitude less than that of GS, C, or JPM.
The OCC seeks to assure us that they have things under control: While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report. Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives.
In addition to the assumed virtues of netting, the OCC seeks to calm you with VaR (value at risk analysis) analysis (about the shortcomings of which, more here). The average VaR in 2008 relative to 2008 net income according to 10K and 10Q SEC reports is roughly 3% for JPM, C, and BoA and higher for GS. In the event revenues from interest rate derivative trading for Q1 2009 was $9B. Those tails sure seem to be fatter than assumed. If you can make it, as all traders eventually learn, you can certainly lose it.
Perhaps now we can see why the Fed is being so tentative with talk of removing stimulus and raising rates. 50 basis points can wipe out a bank. Imagine if the Fed is faced with the situation of a full blown currency crisis- the Scylla near the Charybdis- and needs to lift the Fed Funds rate 200, 300 or 500 basis points swiftly- a policy response chosen by the Fed in the late 70s/early 80s and many other Central Banks since.
In that event, the black hole becomes operative and another type of derivative, the credit default swap starts sucking the financial life out of the remaining big banks.
Since Q3 2007, credit default derivatives have generated $28B in losses. As of Q2 2009 there were still some $13.44Tln in notional exposure or 95% of GDP. What happens if only 1 bank is left? even if that bank has successfully bet on the collapse of the other 4? Who pays?
From Black Scholes to Black Holes indeed. In my view, the sooner, the better. If Warren Buffet's experience is any guide, an implosion of the 5 biggest banks seems a better alternative to an attempt to wind down these portfolios.
It's been 16 years since the above noted book-a collection of essays explainging how one models the risks associated with certain derivative securities- was published and the introductory statement is more true now than then. In 1992, the notional amount of interest rate derivative exposure in US banks was about 77% of GDP. The graph below shows the growth since.
I begin this 4th look at the US economy from a flow of funds perspective with derivatives to "cut to the chase." This isn't to diminish the still currently intractable problems of mortgage finance, but that topic has been ably covered by many others. Further, as hard as it may be to believe, the problems associated with mortgage finance pale in comparison to those associated with derivatives. Warren Buffett famously called these securities financial weapons of mass destruction, but I think he understated the problem. These securities are far worse- a Ponzi scheme even Carlo wouldn't have dreamed of. We can choose to fire a WMD, but these securities have taken on a life of their own and they will, in my view, drag everything financially tied to them into oblivion- into a black hole.
The intent of the book From Black Scholes to Black Holes, to cloak these securities in an aura of cool, is quite ironic in its, apparently unintended, prescience. Black Holes are singularities in Einstein's space-time continuum which swallow, for want of a better term, everything that comes near. They are the Charybdis-es of space. Derivatives are the Charybdis-es of finance. They are creating their own ever stronger gravitational field that has already swallowed 3 of the 8 major US players since 1998. The 5 banks which remain are increasingly linked together.
Last night, after perusing the derivatives data from the BIS and Office of the Comptroller of the Currency (OCC), I was wondering what the end game would be, happened to glance at my book shelf and the book title jumped out at me. "It's a Black Hole," I realized. In the end the remaining banks will merge into one and money, instead of light, would never be able to escape as the fallacy of netting benefits- the assumption that they are all similarly valued- is exposed.
In the OCC Report on Derivatives, the benefits of netting are explained: For a portfolio of contracts with a single counterparty where the bank has a legally enforceable bilateral netting agreement, contracts with negative values may be used to offset contracts with positive values. This process generates a “net” current credit exposure (NCCE)
I had some experience with this fallacy of netting when I was trading FX derivatives for Chase. When Drexel Burnham collapsed I had to "net out" - put on the opposite trade with the same counterparty- the exposure of my option portfolios with Drexel's. While this seems easy to describe there was a problem. They didn't value their options at the same values we did. In some cases I was short low delta (far out of the money) options I had marked to the (lower) at-the-money value. Who should take that revaluation loss? In other cases, I might have to net out a position I needed only to find that replacing it was far more expensive than our agreed upon price.
Fortunately, markets I was trading at that time were not excessively volatile, which would have made the procedure even more difficult. Even more fortunately, the notional amounts were orders of magnitude less than currently carried by US banks.
50 basis points (a fairly trivial change in an option value, or, if you prefer, an aggressive post Volcker Fed tightening) on $100M (roughly the size of trade back then) is $500K. 50 basis points on $7Tln (or 1/5th (5 banks left) of the notional exposure in interest rate derivatives with maturities between 1-5 years) is $35B (7 times the total net income for JPM in 2008).
Why has interest rate derivative exposure grown so much over the past few years? The search for profits in an ultra low interest rate environment seems, in part, a good answer as the graph below depicts.
The other answer is that, as I discovered, the easiest way to make money from a derivatives portfolio is to grow it. Increasing risk in the far dates that is mispriced in your favor can cover many sins as derivatives mature.
Warren Buffett describes the pain of going in reverse on (winding down) such portfolios: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.” General Re's derivatives exposure was orders of magnitude less than that of GS, C, or JPM.
The OCC seeks to assure us that they have things under control: While market or product concentrations are normally a concern for bank supervisors, there are three important mitigating factors with respect to derivatives activities. First, there are a number of other providers of derivatives products whose activity is not reflected in the data in this report. Second, because the highly specialized business of structuring, trading, and managing derivatives transactions requires sophisticated tools and expertise, derivatives activity is concentrated in those institutions that have the resources needed to be able to operate this business in a safe and sound manner. Third, the OCC and other supervisors have examiners on-site at the largest banks to continuously evaluate the credit, market, operation, reputation, and compliance risks of derivatives.
In addition to the assumed virtues of netting, the OCC seeks to calm you with VaR (value at risk analysis) analysis (about the shortcomings of which, more here). The average VaR in 2008 relative to 2008 net income according to 10K and 10Q SEC reports is roughly 3% for JPM, C, and BoA and higher for GS. In the event revenues from interest rate derivative trading for Q1 2009 was $9B. Those tails sure seem to be fatter than assumed. If you can make it, as all traders eventually learn, you can certainly lose it.
Perhaps now we can see why the Fed is being so tentative with talk of removing stimulus and raising rates. 50 basis points can wipe out a bank. Imagine if the Fed is faced with the situation of a full blown currency crisis- the Scylla near the Charybdis- and needs to lift the Fed Funds rate 200, 300 or 500 basis points swiftly- a policy response chosen by the Fed in the late 70s/early 80s and many other Central Banks since.
In that event, the black hole becomes operative and another type of derivative, the credit default swap starts sucking the financial life out of the remaining big banks.
Since Q3 2007, credit default derivatives have generated $28B in losses. As of Q2 2009 there were still some $13.44Tln in notional exposure or 95% of GDP. What happens if only 1 bank is left? even if that bank has successfully bet on the collapse of the other 4? Who pays?
From Black Scholes to Black Holes indeed. In my view, the sooner, the better. If Warren Buffet's experience is any guide, an implosion of the 5 biggest banks seems a better alternative to an attempt to wind down these portfolios.
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