Adam Smith® Says

Sometimes, only sometimes, the financial community comes up with an apt metaphor.  One that struck me recently from a Wall Street Journal conference on lessons learned from the Great Crisis of 2008 is that large banks should have “Living Wills.”

If you don’t personally have a Living Will, you should probably think about getting one.  A Living Will gives clear directions in case you are incapacitated.  Revive me, don’t revive me if I will be a vegetable, and so on.  And it names the people who will execute these powers.  I have my beloved Dr. Weld, my retired cardiologist.

If a bank had a Living Will, it would go through the same procedures.  In case of systemic failure — the financial equivalent of a heart attack — here’s what should happen.  If a bank prepares a living will in times of tranquility when there is time to thrash through all the possibilities that would be an excellent idea, especially if all the banks did it, and the information was checked with regulators and lawyers.

Mario Draghi, governor of the Bank of Italy, said, “We want to be in a position where we are free to let fail any institution without paying the exorbitant price we are paying.  Therefore, the most important point is to have a mechanism that gives power, ability and funding to allow whichever authority steps in to continue preseerving the core function of the failed institution.”

The public appetite for throwing money at big banks and having taxpayers pick up the bills is nil.  Wall Street firms kept alive by the taxpayers are getting ready to hand out enormous bonuses: what’s fair about that?

Living wills can be modified or tweaked as you go along.  But having a living will for a bank — and getting it done now — is not only a good metaphor but a sound idea.

Paul,

When I was at your house on Sunday, you said the stimulus was not going to be enough, and faulted Bernanke for not backing additional stimulus.

But additional stimulus would have to be voted by the Congress.  And all the political folk say there is “no political will” for more stimulus.  Furthermore I mentioned the Bernanke confirmation hearings, which are surprising in the intensity of their vitriol, Senators attacking th Fed chairman.

These Senators and Congresspeople are just reflecting what their folks at home are saying.  The constituents are feeling ripped off.  Their own standard of living is going down, but as taxpayers they bailed out the banks and investment banks because the “systemic risk” was so great, and now the partners and officers of those banks are about to get billions in bonuses.  No wonder there is no “political will” for more stimulus.

So we come back to these questions:

1) The economic heart attack last fall was a product of, among other things, excessive leverage — debt.  What has been done about that?

2) The peddlers of the mortgages now known as “toxic waste” were aided aided by the rating agencies, Standard & Poor’s, Moody’s, Fitch.  These rating agencies were worthless.  What is being done about the rating agencies?  They gave AAA ratings to the “toxic waste” because they get their fees — their livelihoods — from the people they are rating.  That’s a huge flaw in the system. They should either be nationalized and be an agency like the FDIC or be totally independent and get their fees from a broad-based assessment of all the partipants. They should not be paid for delivering AAA ratings.

3) The big banks were bailed-out because of “systemic risk,” because they were “too big to fail.”  Yet now, through attrition, forced mergers and the bailout, the big banks have gotten even bigger.  We can’t continue to have “too big to fail” institutions keep growing, and have the government guarantee them, and pay their leaders billions in bonuses. What is being done about “too big to fail?”

I could go on, but the point is, until people get the feeling that real reforms have been instituted, that the morass has been cleaned up, there isn’t going to be the”political will” to support an optimum strategy.  We will have an economy that slides as the stimulus wanes.

Don’t you agree that the financial sector needs a “New Deal?”

j

It has been only a year since we suffered a national economic heart attack, the nitroglycerin in this case having been hundreds of billions in cash pumped through the financial system to avoid a fatal event. There were no heroes in this story, although Ben Bernanke, having done his scholarly work on The Great Depression, knew how to stave one off at that moment, more a paramedic than a cardiologist. And now, just a year later, we are back to our old bad habits.

The last man standing who has any integrity, in my view, is Tall Paul Volcker. When he was Fed Chairman, he got death threats. Builders facing interest rates of 18 percent and 20 percent mailed in two by fours with impolite language to express their unhappiness. But Volcker broke the back of inflation and gave Greenspan an economy he could coast on for a while.

When Volcker talks, we should all listen. And he talked recently, this time to Congress. What to do about the financial system? Here are some points from Tall Paul’s testimony, available here.

“What all this amounts to is an unintended and unanticipated extension of the official ‘safety net,’ an arrangement designed decades ago to protect the stability of the commercial banking system. The obvious danger is that with the passage of time, risk-taking will by encouraged and efforts at prudential restraint will be resisted. Ultimately, the possibility of further crises — even greater crises — will increase.”

Our heart attack came from RISK and DEBT, from leverage gone wild.

One major Volcker point is to reinstate Glass-Steagall. That New Deal effort said the commercial banks had to stick to lending, and could not trade, like investment banks. But Glass-Steagall got blown away in 1999. Banks, as public companies, wanted to show earnings growing quarterly, and so took on more and more debt, and more risk. In effect, they became hedge funds with a window into the Fed, so instead of borrowing 7 to 1 or even 10 to 1, they could go to 30 to 1. They took the risks, pocketed the profits, and now the taxpayers have bailed them out.

So Tall Paul’s top point is to get the banks out of the casino. We should also, he says:

– regulate derivatives as a typical financial product

– encourage more prudent compensation practices

– register and establish reporting requirements for hedge funds and private equity

I can’t see a thing wrong with any of this. Derivatives are not going to go away, but they could be transparent and traded transparently. Leading up to the national heart attack, the derivatives got so complex that probably not a single bank CEO could explain some of his products. We taxpayers spent $180 billion — that’s billion with a “b” — to prop up AIG, and the whole AIG mess was done with complex derivatives (and large dollops of greed and stupidity).

As for “prudent compensation practices,” let’s not get hung up on the numbers. The basic idea, to me, is that when you run up risk and leverage and pocket the immediate profits where is the “clawback” when your firm goes so busted the taxpayers have to bail it out? Those AIG people KEPT THE MONEY. So did the Merrill people who lost $27 billion in a single quarter, and were given BONUSES of $3.5 billion. Some of them got a hundred million dollars for the worst disaster in Merrill’s history. That’s essentially our money. They KEPT THE MONEY, too.

In his testimony, Volcker said we have to coordinate with other countries to work on a global approach for oversight. Well, of course that’s not going to be easy.

We find ourselves saying, “of course, of course, why hasn’t this already happened?”

Where Volcker will have a harder time is in his arguments about “moral hazard.” Where is the punishment for the sinners? Did we have to let Lehman go to make sure some investment banks got the message? Will that message stick?

Tall Paul of course took the opportunity to underline the sanctity of the independence of The Federal Reserve, a passionate concern of his.

Here is Volcker doing some pen-to-yellow-pad thinking:

We threw all of this money at the banking system because of systemic risk. Your dry cleaner or your gas station can go four paws up in the air, but we have to float Citi — and AIG — because they present “systemic risk.” They are “too big to fail.” That just offends Tall Paul’s sense of how to run a financial system. Instead of throwing trillions at self-wounded entities, we should instead appoint a special “Conservator” to take control of a bank that’s clearly going to default. The Conservator would do just what Paulson and Bernanke did under such high pressure — arrange mergers or sales, or orderly liquidation, or negotiate debt for new stock. But can’t you hear the screams from the Limbaugh radio fans now? The government is already too big? Who’s to say what is a systemic risk? This works for me as long as I imagine Volcker as The Conservator. But this is what we had to do last year, and we improvised it.

We can’t go back to 2008. That was too close.

Tall Paul is not actually in the government. He is listed as an advisor, and I am sure some people will listen, just as some Congresspeople will. But for each item he has suggested, there is a militant constituency opposed, so it can keep its pockets full.

We ignore Tall Paul at our peril.

Market followers, politicians, and economists are accustomed to measure the output of a country by GNP, the gross national product, or GDP the gross domestic product.  What goes into those initials is, of course, a value judgment.  Environmentalists used say, cut down a grove of ancient sequoias and the cost of cutting, and the dead sequoia become part of GDP, leave it standing for hikers and visitors to enjoy, and it has no value.  Both President Sarkozy of France, and Nobel prize winner economist Joe Stiglitz have suggested “happiness” ought to be part of a national measurement, as it was to our founding fathers (”life, liberty and the pursuit of happiness.”)

Actually, the first country to use the concept, to my knowledge, is the small Himalayan kingdom of Bhutan, tucked up between China and India.  In 1972, King Jigme Singye Wangchuck coined the term “gross national happiness” and ordered his administration to construct such an index.  I have not attempted to run down the 72 variables in the Bhutanese GNH (gross national happiness), but Bhutan has universal healthcare coverage, high literacy rates, the purest air in the world and, according to a Belgian correspondent of the Financial Times, no Blackberry coverage at all.

To me, Tall Paul Volcker ought to get a permanent lifetime achievement award for integrity.  He didn’t flinch when he got death threats for raising interest rates to 15 percent in the early 80s to break the back of a virulent inflation.  When he says the way things ought to be, I pay him heed because I know he has no agenda but the public good.  (Revelation of possible conflict:  Paul used to be on the board of my television company, where he restricted his role to advising who might or might not be a good guest, and sometimes his secretary, Anka, would supply a phone number.  Also, my office mate, Craig Drill, and Paul have occasional  weight losing contests.  Paul is six-eight and Craig close to six-seven and they have both been known to hit 300 pounds, so the contest is to see who can get to 275, loser to buy dinner).

You would think, after the disaster we had in the nation’s financial system last year, that everyone should pay rapt attention, then, to Volcker.  Paul says a bank should be a bank, loaning money to clients.  It should not be making bets with units that act like hedge funds.  ”Extensive participation in the impersonal, transaction-oriented capital market,” Paul said in a speech in Los Angeles, “does not seem to me an intrinsic part of commercial banking.”  In that speech, which I am sure he will repeat before Congress when asked, he said banks should be banned from “sponsoring and capitalizing” hedge funds and private equity firms.  Further, strict supervision “with strong capital and collateral requirements should be directed toward limiting proprietary securities and derivatives trading.”  Paul is chair of the White House’s Economic Recovery Advisory Board, and he was asked, in Los Angeles, whether his comments were a break with the administration.  ”Nothing I said should be a surprise,” he said.

Considering the depths of gloom just a year ago, and how the Fed and the Treasury had to bail out the banks, and how the head of the British banking authority says that a year ago the entire world was less than 24 hours from a slide into a Great Depression, you would think that Paul’s statements border on the obvious.

What is eerie is how quickly people forget, and how eager they are to pretend that nothing really happened.   Derivatives never went away, big bets are back, hundred million dollar paychecks are hatching, and what is worse, there seems be the implicit assumption that the government will bail out  the system again if there is systemic risk.

I would say if you want to take your own money and borrow 40 to 1 against it, fine.  But a public, or even quasi public,  institution has no business doing  anything remotely like that, because it’s easy to make big bets if you can socialize the risk. That is, if you can hand the bill to the taxpayers and walk off to play again.

In my blog on Paul Volcker, I said not much had changed in the financial markets since last year, amazing considering what a heart attack to the system that was.  That wasn’t quite true. Money market funds, which came close to causing a bank run just by themselves where they “broke a buck,” are now guaranteed by the government.  Credit card companies can’t market to people under 21, and have to tell consumers before raising rates.  Short selling has been clipped.  And, of course, some major players on Wall Street, Bear Stearns and Lehman Brothers, are gone.  So are 95 commercial banks.  But what needs doing most hasn’t been done.

The financial press has been hung up on executive compensation, where one bill has passed the House.  And of course, investment banks that would have died, like Goldman Sachs, are now commercial banks, where they have access to the Fed, but can only borrow at 12 to 1 instead of 35 or 40 to 1.

The Group of 20 met in Pittsburgh and said yes, they needed some international rules.

But derivatives, the instruments of leverage, are still unregulated.  Sheila Bair, the chair of the Federal Deposit Insurance Corporation, says “the off exchange derivates market is still the Wild West.”  She, and other regulators, want to see derivatives traded openly, on an exchange.  That would mean that banks could not hide money losing positions, and would have to put up more money if the bets moved against them.  Some banks oppose open derivatives trading because it might cut their profits by making pricing more visible and competitive.  So nothing has happened.  And some people who see the big picture fear that, as the crisis fades, so will the momentum to do something.  Robert Shiller, the Yale economics professor who predicted the housing bust, says “people will accept change at a time of crisis, but we haven’t managed to do much.  Maybe complacency is coming back.”

The government had to put up $180 billion of our tax money to save one firm, AIG.  That’s a lot of schools and roads.  (And while General Motors is not a bank, the government owns it, too.)

Nassim Taleb, who wrote “The Black Swan” about long-odds events happening, thinks the possibility of an even bigger bust could be in the making because people believe the government will bail out the risk takers.  Sheila Bair says investors in financial institutions must believe they will lose their money if the institutions fail.  ”You need to send a very strong, clear signal to restore market discipline,”  she says.

All of this scares me.  Not for this year.  I suppose Congresspeople will say, well, if we are going to change it, we have to get it right.

But will we waste the opportunity, and learn nothing from the experience of 2008?

Well, let’s see.  It paid back all the government money it got last fall, and became a bank holding company.  Warren Buffett put in $6 billion during the crisis, and he’s already made $2 billion.  The stock has tripled from its November low.

Only months after the Great Crisis, Goldman has had the most profitable six months in the frim’s history.  It has set aside $11.36 billion in compensation and benefits for its 29,400 employees, and we know that last year, the great Crash year, it paid 953 employees at least $1 million, and 78 got more than $5 million.

That’s enough to make everybody else hate you.

Lehman is gone, Merrill is a shrunken division of Bank of America, only traces of Bear Stearns are left, and there’s Goldman, called by Rolling Stone “a great vampire squid wrapped around the face of humanity”.  Now, “great vampire squid,”  applied to a venerable Wall Street house, is gonzo writing, a nice job of it, you look to it to enjoy its daring and excess.   You do not expect to find some nuance, some new truth that helps you frame recent history.  “Retire, go do some public service,” used to be considered a good thing.  Now, to critics, it looks like seeding the government with pals who can help you make even more money.

http://www.rollingstone.com/politics/story/28816321/inside_the_great_american_bubble_machine

Certainly some of the ill will can be traced to the previous Secretary of the Treasury, Hank Paulson, who had been the CEO of Goldman Sachs.  Why did Paulson - and Ben Bernanke - let Lehman Bros fail, and then step in to save AIG?  It was said that Goldman held AIG liabilities that would have badly crippled it.  The current CEO of Goldman, Lloyd Blankfein, says, “If AIG had defaulted, guess what? We would have kept the collateral from AIG and the banks we’d bought protection from.  The government’s decision to bail out AIG was about the risks to the system.  It wasn’t about Goldman Sachs”.  But AIG was so intertwined with the whole financial system, Goldman would have suffered along with everybody else.  However, you could say that if Goldman had been truly Goldman, it might have figured out some nimble way to make a profit in the disaster.

In the era leading up to the Crash of 2008, Goldman, like others, had sold toxic, leveraged mortgage backed securities.  But Goldman left the party early, in 2006.  Ripeness is all, said Shakespeare.  Then Goldman shorted various mortgage securities indexes, betting that prices would fall, at a time when other firms were still reaping profits from selling the junk rated AA by the corrupt or inept ratings agencies.

Something feels unfinished about this whole story.  In America, where comic book heroes are iconic, we want the evildoers punished, and the good celebrated.  We want Batman triumphant.  What would it look like if The Joker reigned supreme?

In the 1920’s, Goldman Sachs had a leveraged fund which went broke in the slide into depression.  The radio comedian Eddie Cantor was among those stung, and he used Goldman Sachs as a trigger for anti Wall Street jokes.  That made everybody feel better.

Now we have come through the crisis.  But, we still have a mountain of debt, a threat to the dollar, and a perilous journey ahead - and yet we have not really had an outlet for the rumbling populism you can feel like a thunderstorm over the horizon.  Goldman has the right CEO for a Lenten atmosphere, not the All American lineman, like Hank Paulson, but Lloyd Blankfein, who was born in the South Bronx, grew up in a housing project in Brooklyn, and went to the predominantly black Jefferson High School.  His father sorted mail at night in the post office, his mother worked as a receptionist at a burglar alarm company, “one of the few growth industries in my neighborhood”, Blankfein says.  Scholarships and financial aid took Blankfein to Harvard, where he was a classmate of Ben Bernanke, and then to Harvard Law School.  On the way to Goldman, he left the law for a job selling gold at J. Aron & Co.  Blankfein had a good sense of when to push traders to take more risk.  He told FORTUNE, ” the best traders are not right more than they are wrong, they are quick adjusters, better at getting right when they are wrong.”

So far, the populist rumblings have been seen in the “town meetings” about health care, and in Obama’s falling ratings.  Obama was once thought to be out ahead of the populist surge, not behind it.  Blankfein has a chance to present a self deprecating, soft spoken Wall Street.

Given its history, and its diminished competition, Goldman could make money in jagged and down markets, as well as in its traditional ways.

That’s not going to make the rest of us feel better, especially when we read about rising unemployment or commercial real estate heading south, or whatever negative news is being broadcast.  Whatever Goldman is going to do, we might do ourselves, if we only knew what it will be, but we don’t.

Many economists, like my neighbor Paul Krugman (see video elsewhere in this blog) believe that once the current stimulus has come to an end, the economy will tip back into recession.  Or stands a good chance of doing so.  That is because their numbers tell them the normal engine of the US economy, the consumer, is still tapped out, still in debt, still struggling.  Industry is not likely to spend a lot on expansion with demand under par and more than enough capacity everywhere.  So they were urging the Obama team to ready a second stimulus. 

The collective wisdom of our office is, ain’t gonna happen.  First, the stimulus voted is only just beginning to engage.  That is, it takes time to get the money to the states, as one example, and to call the contractors, decide on which roads and bridges, and get the money flowing.  With stimulus funds still unspent, the appetite in Congress to vote more isn’t there.  Congress has a very short term span of attention.

Second, there is finally an impact on the public from the “million billion trillion” language amplified by “town meetings”, Fox News, right wing radio, and lack of clarity in mainstream (and shrinking) media.  George Lakoff, the Berkeley linguistics professor, (”Don’t Think of an Elephant”) writes that the Obama team, which controlled the language so well in the 2008 election, hasn’t maintained that control.  The health care reform discussion has been complex and wonkish, leaving the field open to the “million billion trillion” voices that say, we have to stop spending so much money.  Nevermind that, in the credit contraction, that money evaporated out of the private sector and had to be replaced by public spending.  The appetite for such action comes from language, not computer models, and it won’t be there.

I attended an annual breakfast this morning with Henry Kissinger at The Four Seasons.  While everybody else wants to know about North Korea and Iran and nuclear proliferation, I wanted to know what happens if we don’t bring off a financial recovery?

Most of Kissinger’s remarks were addressed to the broad foreign policy question of containing nuclear proliferation, and what to do about North Korea.  KIssinger said that North Korea had a history of negotiating about the negotiating, and then negotiating, and then junking the whole process, and the message other would-be nuclear powers (like Iran) are getting is that the world does nothing about it. Continue Reading…

I’m angry, and I am not alone.  I am angry that $180 billion of tax money — some of it mine — has been spent to prop up AIG, because a bunch of greedy AIG idiots in London, apparently unsupervised by anyone at all, wrote some contracts that weren’t hedged or reserved for anything.  Why didn’t we let AIG just go four paws up in the air, just like we would if the corner grocery store overextended itself?.  Because AIG was too big.  Systemic risk, meaning the whole system comes apart, look what happened with Lehman. Continue Reading…