Congress’ Priorities versus the Financial System’s Needs: an exchange

Posted in Blog at 3:27 pm

Response to an article by Alan Blinder in the Wall Street Journal, “When Greed is not Good,” January 11, 2010:

Mr. Blinder’s well-considered analysis of the obstacles to financial reform is essentially a re-statement of why Congress needs leadership from the White House in order to accomplish anything worthwhile.  Instead of trying to extend the Welfare State in the U.S., President Obama should be doing everything he can to fix an actual problem currently facing the country.  No such luck:  part of the heritage of the Left’s myopic obsession with the failures of capitalism as a system is an inability to deal with a structural problem within capitalism.  They have been and remain too focused upon attacking our system in toto, and bringing the supposed benefits of social democracy to those relatively few currently outside the system, to even try to repair a malfunction that affects almost everyone.

Worse, a statist frame of mind makes them actually prefer to deal with a few CEOs of giant financial entities, rather than a broad assembly of participants in what the financial system should return to being:  a free market.  To this mindset, a centralized financial system they think they can command from Washington is actually better than a more decentralized system that responds to new information as a market should, by repricing risk.  Thus they probably prefer one of the chief current flaws to any solution that might fix those flaws.

As long as the American Left—or “liberalism” as we prefer to mis-name it here—remains mired in this essentially Marxist world-view, they will have no useful contribution to make to running the country.  The “Us versus Them” thinking that characterizes the current Democratic Party keeps attempting to divide the country into two polities that bear little or no resemblance to any meaningful picture of our society.  It is probably a waste of time to expect any worthwhile reform to come from the current crop of Democrats; the question is whether one can expect any better from the Republicans, when and if they return to power.

Conservatives currently reject any attempt at government intervention, even if that intervention has the object of restoring a free-market system that should ultimately function with less government intervention.  Winning conservatives over to the cause of reform is where would-be reformers should concentrate their efforts.

I received this rather tart note in response from one reader:

“even if that intervention has the object of restoring a free-market system that should ultimately function with less government intervention”

1. The government has proven itself to be absolutely unable to solve real problems.

2. Once the government gets its claws into something they can regulate and tax, they never let go.

To which I replied in turn:

Unfortunately, I don’t think we can abolish government. That leaves us only with the options of:

(a) trusting the financial system as it is now constituted to run itself without any supervision whatsoever, or

(b) trying to reform it, so that it can operate as a more-or-less free market, with a minimum of continuing supervision.

Having worked on Wall Street for thirty years, I would prefer the latter to the former. Empire builders make lousy investors, lousy traders, and lousy corporate advisors. About the only thing they do well is to negotiate special deals with governments. That’s the last thing we should want.

The same respondent came back with:

Had TARP not happened, what would have happened to the financial system? I’ll qualify my question by adding that I just pulled 100% of my cash out of the market because I just don’t understand what its doing.

My understanding is that the banks were fundamentally sound, it was their derivative positions that went south. I also understand that AIG took the double whammy of the 5 big banks plus the Fannie and Freddie portfolio.

So what would have happened if the big 5 filed for reorganization, AIG, Fannie, and Freddie filed for chapter 7, and the government stayed out of it?

I answered:

It’s impossible to know now, of course, but the most likely outcome is that the funding crisis would have continued to spiral out of control, as no bank was willing to lend any other the short-term funds necessary to continue operations. Investors would have sold everything in a desperate rush to get something out of the chain of bankruptcies, and share prices would have collapsed to almost zero. Without equity, every bank and almost every other corporation would have been worthless. The world would have stopped functioning for lack of cash: no one could even meet a payroll.

The banks weren’t so sound, either: many of them were levered to ten, twenty and even thirty times own capital, but that wasn’t the main problem: it was that cash must continue to circulate in the system or it dies rapidly. And no one will lend money to a bankrupt without holding collateral worth the full value of the loan. That collateral can’t be worthless equity or bonds that are likely to go into default. No bank can be truly solvent in the face of sudden massive demands to return capital, which is why one always needs a lender of last resort, and the power to shout, “Time, gentlemen,” when a run on one bank escalates to others. A totally unregulated capital market is almost a misnomer: it would be a black hole waiting to devour all its participants as soon as prices began to fall.

TARP was badly screwed up, of course, and kept changing its objective because events got out of control after Lehman was allowed to go bust. But something had to be done or the chain reaction would have continued to accelerate. This was what killed AIG: the CDS contracts they had written were suddenly all deep in the red (think of an insurance company that suddenly has claims against all of its policies.) Fannie and Freddie were the largest cause of the underlying bubble in real estate prices, and should never be allowed to loan money out like that again, but once the crisis got going they were almost irrelevant.

The question we face now is to decide whether to regulate banks to death so that they can never be in a position to take even unrecognized risks again, or whether to restructure the system so that no component of the system is so important and so interconnected with the rest that its failure would start the cascade of further failures. Or, we could wait until the next unpredicted event caused the chain reaction to begin again. I believe that a change in structure would be better than trying to regulate every single possible risk a market participant might ever take, and then discovering that there were new ones you hadn’t known about.

There should also be limits to how cautious you want to make the whole financial system, or perpetual stagnation will result. The Germans, who had the largest universal banks in the 1970s and ’80s, almost killed off their otherwise strong economy because these banks were required to be so conservative; industrial financing was largely done through the Euromarkets in London and elsewhere. If this is the price one has to pay for allowing enormous one-stop financial supermarkets, maybe we are better off without them.

(An hour later, having received a positive reply, I added:)

More and more support seems to be growing for some version of Glass-Steagall to be enacted. Paul Volcker, for instance, has recently been in favor. It wasn’t so long ago that everyone I knew was saying it was too late, that markets had evolved, that global corporations needed the outreach of global, universal banks, etc. Now, more and more observers of the markets are asking, ‘What, exactly, have all these innovations done for the corporate sector or for other users of capital markets?’ And so far, no one has come up with very much in support of them. Issuers love to have their underwriter buy the whole offering, of course: then, it isn’t the issuer’s risk any more. But they are beginning to realize they have to pay a lot in fees for the privilege of avoiding a day or two of worry. Derivatives are useful tools to manage risk, but only if they aren’t allowed to accelerate the destruction of a market. Institutional investors certainly haven’t benefited if, in exchange for lower transaction fees, they have to pay for more analysts, because they can’t trust the analysts on the Street any more.

I’d like to see a serious, independent study or studies of what it would cost to separate commercial banks from capital markets, and corporate finance from trading, and all three from money management. This is what we had before about 1985, and it seemed to be working just fine. What it bothered was the ‘vision’ of certain CEOs, who wanted their trading partnership to have unlimited capital to gamble—er, trade with, or their brokerage firm to be able to accept demand deposits like commercial banks could. The banks wanted to get into the sexier parts of corporate finance. But I never saw anybody actually ask their bankers for these services. And most commercial bankers learned to hate the variability of returns from capital markets activities, although they loved the much higher return on assets these sometimes gave them. But net net, I’d love to know who—other than the former partners or shareholders of smaller organizations who sold them for fancy prices—if anyone, came out ahead.

Of course, a re-division of the sector might happen de facto if salary caps and effective risk-taking limits are imposed on traders, deal-makers, and other risk-takers. They could gravitate to new and smaller organizations, and history could repeat itself. But there would still be the risk that a rising market in a few years could provide the capital for a new wave of consolidation led by new empire-builders who manage to find a way around commercial banking regulation. And there would still be the problem that even the riskiest activities were being funded by Someone Else’s Money. Re-thinking the architecture of the whole sector would seem to make more sense now, while there is still an opportunity and a need to do so.

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