Why Should We Trust the Financial System?

Every day, it seems as if people are given more reasons to distrust financial institutions and the leaders of those financial institutions.

Lloyd Blankfein has become a joke!

Banks are not to be believed!

And, governments and members of governments have even lower ratings!

Finance is supposed to operate on trust and financial markets are said to function because people have confidence in them.

Well, if this is the case anywhere at the present time it must be in a parallel universe.

And, the stories continue. “It’s an open secret on Wall Street that many big banks routinely—and legally—fudge their quarterly books.”

“Window dressing is so pervasive on Wall Street…”

“The big question is the extent to which other banks (other than Lehman Brothers and Bear Stearns) used, and still use, creative financing, and whether they, like Lehman, broke any rules.”

These quotes are from the New York Times article “Crisis Panel to Probe Window-Dressing at Banks”: http://www.nytimes.com/2010/05/05/business/05repo.html?ref=business.

It is not just the big banks. It is on the public record that the Greek government lied to the world about its fiscal position. What other governments might be falsifying their records?

State and local governments in the United States are not forthcoming about their financial commitments and liabilities such as those connected with the funding of pensions and other contracts. And, many of these entities are facing the bankruptcy court these days.

Ponzi schemes come in many different flavors.

But, those that work in financial markets claim, at least in theory, that the markets are efficient, that the prices that exist in financial markets reflect all relevant information. They assume that participants in financial transactions are “sophisticated” meaning that the participants are canny professionals who have all the information they need.

That is why the executives at Goldman Sachs can, in good conscience, argue that their customers are “sophisticated” and are “big boys, fully capable of looking after themselves.” (See “Goldman and the ‘Sophisticated Investor” in the Wall Street Journal this morning, http://online.wsj.com/article/SB20001424052748703866704575224511672855990.html#mod=todays_us_opinion.)

What! The financial wizards claim that investors have all the information they need, yet they hide information from the public on a regular basis!

And, why does Lloyd Blankfein look silly testifying before Congress or on the Charlie Rose program?

Government officials hide information from the public on a regular basis!

And, then these same officials cry foul when financial markets sell off once the information on their lies becomes known.

Hello, Bernie Madoff…

We now know that Lehman Brothers and Bear Sterns used “shadow financial vehicles” and produced results that mislead investors and regulators. This seems to be the case most of the time in terms of companies that fail.

I know from the bank turnarounds that I was involved in, one of the first requirements of the new management was to open up the books and let the world know what actually was going on in the “troubled” institution. When this was done, the basic response I got from the investment community was one of “incredulity” and “disbelief.” The investment community could not believe that I was willing to make the books as open to them as I did. But, once they got used to this “openness” they began to trust me and what was being done at the troubled institution.

Secrecy, to me, is the worst thing the leadership of an organization can pursue. But, then, people tend to run to secrecy when things go wrong because they either were not capable of running the organization or because they made bad decisions.

As a consequence, my experience has made me a firm believer that openness and transparency, in all financial institutions…and governments…are a requirement for sound finance. Openness and transparency are a requirement for the building of trust in organizations and the system so that investors will have confidence in markets.

Openness and transparency should be one of the building blocks for any new financial reform and re-regulation that takes place.

Yet, the Obama Administration and the Congress seem to be focused on the past; they are fighting the last war. And, this means that any reform package they get will be out-of-date and irrelevant when it is passed. As the New York Times article reports “JP Morgan Chase and Goldman Sachs are examining how to use shadow vehicles to help them borrow money in the future.” The article points to such major players as BSN Capital Partners in London as one firm that has created such vehicles for banks in the past. Even the best seem to need secrecy!

International financial markets still don’t know all they need to know about the Greek situation…and the Spanish situation, and the Portuguese situation, and the Irish situation, and the Italian situation, and the English situation, and so on and so on. International financial markets still don’t know all they need to know about who holds the debt of these countries and how much of an impact would take place if the debt where to be substantially written down.

So we see that another financial crisis has taken place because the expectations of investors were surprised. (See my post http://seekingalpha.com/article/201382-greece-the-surprise-that-breaks-the-camel-s-back.) Maybe we are asking the wrong question, that question being “Why have investors lost confidence in these euro-zone securities?” May the question should be “Why did investors have confidence in them in the first place?”