Thank goodness for emails! Now we know what was really going on at Goldman Sachs and Moody’s and Standard & Poor’s. How about Congress including in their bill on financial reform the requirement that all financial institutions and rating agencies and all other organizations having to do with finance (say the Federal Reserve and the Treasury and Fannie Mae and Freddie Mac…and Congress…and the White House) release all of their e-mails a week after they were written.
This would really provide the financial markets with transparency!
The thing that strikes me so much about the release of these e-mails over the past week or so is their humanity. These Wall Street villains talk like human beings, like you and me.
Gillian Tett, in my mind, has a terrific opinion piece in the Financial Times this morning titled “E-Mails throw light on murky world of credit” (http://www.ft.com/cms/s/0/a9da1aa4-508b-11df-bc86-00144feab49a.html). Her reflection on the e-mails is captured in the following sentence: “It is fascinating, almost touching, stuff.”
But, even more important she states that “Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working.” These people are just human beings trying to do their job.
The same can be said of those people that wrote the e-mails at Goldman. This is captured in an article by Kate Kelly in the Wall Street Journal titled “Goldman’s Take-No-Prisoners Attitude” (http://online.wsj.com/article/SB20001424052748703441404575206400921118356.html#mod=todays_us_money_and_investing.)
Kelly speaks of a world, which Tett describes as “so detached and rarefied”, in which betting applied to almost anything. The scene she presents in her article is one in which mortgage traders from Goldman Sachs “cast bets on a White Castle hamburger-eating contest” in December 2007. (Note that the problems in the subprime mortgage market were so severe at this time that the Federal Reserve announced the creation of a Term Auction Facility (TAF) on December 12, 2007 with the first auction being held on December 17, 2007.)
This behavior, Kelly reminisces, “resembled a scene out of ‘Liar’s Poker,’ a book (by Michael Lewis of the book ‘The Big Short’) depicting bawdy antics of (mortgage) bond traders at Salomon Brothers in the 1980s.” She argues that “It was a lower-stakes version of what went on ever day in the group: aggressive, take-no-prisoners trading.”
To Kelly, the world apparently didn’t change much between the 1980s and the 2000s!
Tett draws some conclusions from the picture present in the e-mails. She writes “by 2007 they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also a strange, geeky silo, into which few non-bankers ever peered.”
And, Tett goes on, “Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press, or that Goldman traders felt free to celebrate the mortgage market collapse.”
“Few expected external scrutiny or imagined their e-mails would ever be read.” They were just being human.
But, something was wrong! Something bigger than the traders or the raters had taken control and was driving the system.
And, this leads Tett to the first of two lessons she draws from the information in the e-mails: “what went wrong in finance was fundamentally structural, as an entire system spun out of control! It might seem tempting to lash out at a few colorful traders but that is a sideshow…”
She concludes: “what is needed is systemic reform that removes conflicts of interest.”
This is the only point on which I disagree with her. To me this whole “spinning out of control” was a result of the credit inflation that had been prevalent in the financial system for the past fifty years or so. The whole effort to inflate the American economy had resulted in the excessive creation of credit during this time period, the almost fanatical drive toward financial innovation (led by the federal government), and the assumption of more and more risk by the private sector in a search to sustain its returns.
The reference to the book “Liar’s Poker” is particularly relevant because the main story in that book is about the trading going on in mortgage-backed securities, something that did not exist until the early 1970s when the federal government created the instrument. Please note that the first mortgage-backed security was issued by the Government National Mortgage Association (Ginny Mae) in 1970. Before then mortgage-related issues were not traded on capital markets. By the time of the writing of “Liar’s Poker”, government-related mortgage-backed securities had become the largest component of capital markets.
As I have stated many times, the purchasing power of the United States dollar declined by roughly 85% between January 1961 and the present time. Although consumer price inflation was kept relatively low over the past decade or so, credit inflation permeated the asset markets as bubbles appeared in stocks and housing. House prices got so out of line with rental prices during this time that the collapse of the housing bubble became inevitable.
So, I agree with Tett in her statement that “what went wrong in finance was fundamentally structural, as an entire system spun out of control!”
But, human beings acted like human beings during this time. Again, to quote Tett: “they (the bond raters), like the bankers, had become tiny cogs in a machine that was spinning out of control.”
And, as Chuck Prince, former CEO of Citigroup, called it: as long as the music is playing, people must keep on dancing. This doesn’t excuse them, but it puts, I think, the behavior in perspective. This was not the well-thought-out plot of evil people.
Lesson: inflation creates incentives that can get out of hand. If the government wants to conduct economic policies with an inflationary bias then they must deal with the consequences at a later time.
I do agree with Tett on her second lesson learned: “the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense.”
Tett “welcomes the publication of these emails” but warns us to “keep braced for the next installment.” She “suspects that US regulators and politicians have not finished publishing all those damning e-mails yet.” I look forward to these revelations, as well.
Showing posts with label investment banks. Show all posts
Showing posts with label investment banks. Show all posts
Monday, April 26, 2010
Friday, October 23, 2009
Breaking up the Banks?
Mervyn King, Governor of the Bank of England, gave a speech the other night and set off somewhat of a storm…at least across the pond. It is a discussion that needs to be heard here in America. (For a full text of the speech: http://www.bankofengland.co.uk/publications/speeches/2009/speech406.pdf.)
Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see http://www.ft.com/cms/s/0/7056b56a-bda8-11de-9f6a-00144feab49a.html.
Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see http://www.ft.com/cms/s/0/0a8a6362-bf3d-11de-a696-00144feab49a.html). Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.
I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.
In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.
The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.
In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.
The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.
Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.
What changed?
Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.
This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!
Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.
Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.
Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.
As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.
The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!
Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.
Not only did it get a lot of play in the press, but it elicited an immediate response from Prime Minister Gordon Brown and Alistair Darling, his Chancellor of the Exchequer. Here is an example that appeared in the Financial Times, “King Calls for Break-up of Banks,” see http://www.ft.com/cms/s/0/7056b56a-bda8-11de-9f6a-00144feab49a.html.
Let me point up an excellent commentary, written by Martin Wolf, in this morning’s Financial Times, “Why Curbing Finance is Hard to Do” (see http://www.ft.com/cms/s/0/0a8a6362-bf3d-11de-a696-00144feab49a.html). Wolf emphasizes the “artificial” division in financial institutions between “utilities” and “casinos.” He then goes on to discuss how difficult it is—or would be—to distinguish between these two types of organizations so as to set up a regulatory framework that would work.
I would like to add a little more to the discussion so as to second the points that Mr. Wolf makes. Going into the 1960s here in America, the distinction between financial institutions that were considered to be “utilities” which dealt in “debt” and those that dealt in “equities” and, hence, were a lot riskier, was very clear.
In fact, there were many jokes over the next few decades that commercial bankers were “debt” people and could not mix with investment bankers because investment bankers were “equity” people. People laughed at commercial banks going into the venture capital business when they put a “debt” guy in to run an “equity” business. Many suggested that my success in bank turnarounds (I did three of them) was because I was an “equity” guy and understood what it meant to focus on shareholder value whereas bank “guys”—ugh, “debt guys”--didn’t have the foggiest idea.
The first of two common points of understanding about commercial banking early in the 1960s was that commercial banks needed to be a monopoly—or, at least, a part of an oligopoly—within a limited geographic area. (Monopoly is “local” in either a geographic sense or a “product space” sense: for more on this see “Competition Demystified” by Bruce Greenwald and Judd Kahn, (Portfolio: 2005).) The reason for this was that they needed to have market power to exist. (In more technical terms, the banks could not operate in markets where they were price takers.) Monopoly power allowed the banks to earn an interest rate spread between what they earned on the funds they loaned out and what they paid out to depositors.
In many areas of the United States, geographic limitations on banks were very important and a part of the local culture. So we had states that allowed a bank only one office. (My grandfather was a Missouri banker and Missouri only allowed one office per bank. I really didn’t understand this, but it was like a religious truth to the people in the region.) Other states allowed limited branching. (My first banking job was in Michigan—if you don’t include the work I did in my grandfather’s bank—and Michigan allowed limited branching.) Then other states allowed statewide branching—but, you could not branch over state lines.
The second common point was that commercial bankers could not be trusted to operate in a “safe and sound” fashion and therefore had to be closely regulated. That is, commercial bankers always pushed the edge in terms of trying to earn a little more money and would push themselves into riskier and riskier loans. In other words, commercial bankers had to be protected from themselves.
Commercial banks were public utilities: they provided social capital to a society, they were very needed, yet they were potentially very dangerous—not unlike nuclear energy plants.
What changed?
Commercial banks were highly constrained institutions. Their ability to grow was severely limited to the deposit base that could be generated within their “local” area. But, like all human beings, commercial bankers were problem solvers. (Yes, commercial bankers are human beings although a not very advanced subset of the species.) The bankers found a way to escape the constraints on branching, both within a state and between states. They developed a class of liabilities that they could use to fund their banks that was not limited to the geographic area in which they resided: liabilities that could be purchased or sold in the open market.
This asset class included Negotiable Certificates of Deposit, Eurodollar deposits, and Commercial Paper issued by a bank holding company, the funds of which could be distributed to the commercial bank it owned. Liability management at commercial banks came into existence. Now a commercial bank could not only manage its cash position with the use of these instruments, it could expand its balance sheet beyond the scope of “local” branching restrictions. Limits on branching across state lines were doomed!
Now, however, commercial banks became price takers. They could buy or sell all the funds they wanted to at the going market interest rate. Commercial banking changed in the late 1960s and the early 1970s.
Commercial bankers and regulators still gave voice to the idea that the commercial banks were utilities, but, this was only lip service. It was no longer true.
Commercial bankers became “traders” and lived more and more off of arbitrage transactions. They still had markets they operated within in which they were not price takers, but, as the 20th century progressed, the number of these markets declined as a proportion of the whole. You look at bank balance sheets now and the vast majority of assets and liabilities come from markets in which the banks are price takers.
As financial innovation progressed and bank spreads narrowed, commercial banks spent more and more effort trying to generate “fees” on services that did not depend on spreads, increased financial leverage (achieved as a price taker), and greater mis-matching the maturities of assets and liabilities. The second common point mentioned above still applied: bankers always pushed the edge to earn a little more.
The “Age of Financial Innovation” changed everything. Financial innovators discovered that cash flows were just bits of information and information can be divided up in any way you like. Thus, financial instruments could be tailored to meet the specific needs of a particular investor. And, you could perform this service for a fee, meaning that you didn’t need to absorb the risk of the transaction and you didn’t need to finance it! Ain’t modern finance wonderful!
Two final points. First, financial innovation is going to continue to take place. The idea that finance is information is spreading to other markets (Information Markets) that deal with physical products, not just cash flows. As computer technology continues to advance and the idea that information can be traded spreads it becomes quite obvious that regulation cannot be put into the boxes or categories we used in the past. It just isn’t going to happen. Second, we are moving into a world in which the idea of regulation may become silly. We used to regulate, somewhat, pornography. With the Internet, control of the availability of pornography is ludicrous. Possible solutions for bank regulation: that is for another post.
Subscribe to:
Posts (Atom)
