Last Tuesday, April 21, 2009, a hearing of the Joint Economic Committee was chaired by Congresswoman Carolyn B. Maloney. It was entitled "Too Big to Fail Or Too Big to Save? Examining the Systemic Threats of Large Financial Institutions." Please find the testimony of the invited experts - Nobel Laureate Prof. Joseph Stiglitz of Columbia University, Prof. Simon Johnson of MIT (author of The Quiet Coup, The Atlantic, May 2009) and Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City - at the link above.
Their testimony indicates that so far, the answer is yes. Who, you may ask, is their opponent? Who have the banks won against and what have they won? The banks have won against the administration and you, the tax payer. What they have won so far is the capitulation of the administration and your money to recapitalize themselves and ensure their survival. It's not entirely final yet. Speaker Nancy Pelosi has expressed interest in having investigative hearings of the type chaired by Ferdinand Pecora in 1932 following the crash of 1929. As Prof. Stiglitz testified, we need to emerge from the crisis with a new financial system that is more resilient to systemic failure. To do so, we need to understand how we got here.
Both the Clinton and the Bush administration held the view that US capital markets and the US financial industry was a source of innovation (in finance) and consequently, an enabler of the engine of entrepreneurship and the vitality of the US economy. In the 1980s, financial engineering brought mathematicians to Wall Street, giving new-fangled products the aura of academic legitimacy. Thus, in addition to money and power, Wall Street projected intellectual superiority onto the executive and legislative branches of government. The revolving door between Goldman Sachs and past administrations is indicative of the sway that Wall Street has held over government. The current administration is comprised of people who are also similarly under the sway of the financial industry, some of whom (Larry Summers and Timothy Geithner for example) were directly imported from past administrations.
In 2008, after several previous failures (Long-Term Capital Management or LTCM in 1998 and the bursting of the dot-com bubble in 2000 to name just two,) banks managed to convince the Bush administration that systemic failure was imminent without government handing them a bailout. Congress appropriated $700 billion towards the TARP in a hurry, with Ex-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke holding a gun to their heads. Paulson and Bernanke made adhoc decisions with a lot of back-room dealing, which is now coming to light (cf., The Atlantic, April 23, 2009.) From a psychological perspective, it should seem obvious that intervention usually tends towards preserving the status quo, which at that point, has typically proven to be unsustainable already. As research shows, government intervention usually results in prolongation of the crisis. Every whiff of a crisis has resulted in the Fed flooding dollars into the system. The side effects of intervention are usually opacity in pricing and an increased possibility of inflation.
Thanks to the TARP, banks are currently pretty well collateralized in the US. The issue is not about whether they are collateralized, but rather about how they are collateralized. Collateral comes in primarily two forms - debt and equity. Banks are excessively collateralized by debt instead of equity. Banks are using TARP monies to service their debt, i.e., paying interest on it, which has allowed them to continue operating a failed business model. What needs to happen for banks to be restored to good health is for the creditors to take at least partial losses and assume an ownership stake in the banks, by converting some of the outstanding debt to equity. Creditors are resisting this as well, via influence peddled by K Street, and pushing the problem onto the backs of taxpayers. It is entirely odd that the administration has not pushed back on this, since this merely postpones the denouement. If the business model does not bring in revenues, as it surely won't, given that the financial industry is doomed to shrink, more bailouts will be required to service the unending debt. This will eventually require raising taxes.
The so-called stress tests are proving to be a thorn in both the industry's and the administration's sides. Results will not be credible if everyone passes. Yet the most likely bank to fail is Citibank, which is "too big to fail," and if it is officially known to have failed the stress test, that could engender a tailspin in financial stock valuations. We will see how the administration deals with this dilemma. The results are due in the next week or two.
For those of you invested in the market currently, you should know about a Bloomberg article informing us that insider selling is at its highest level since 2007. The recent rally definitely seems to have run into strong headwinds. For disclosure sake, I am out of the market entirely, and have been for a while. The outlook is negative for a simple reason: Even if economists exclusively ran the country, they would have a fairly tough time getting us out of this mess. With politicians involved, I can only conclude that our chances of making it are dimmer. For perspective on historical returns and the likelihood of reaping investment returns in the current environment, read this article published in July 2008, and also a more recent article published today. Of course, if we did have proper recognition of the full scope of the problem, and a solution that does not attempt to return us to status quo ante, things may turn out to be very different in the coming years. However, the odds are stacked against it.
Moving on, let's think about how our financial system could be made more resilient. What are some of the things we want from our future financial system?
- If you have an institution that is "too big to fail," it poses systemic risk, and therefore, should be broken up. This amounts to enforcing anti-trust laws against financial institutions. So far, however, banks have been able to resist this. Paul Krugman in his New York Times blog has called for splitting up banks into low-risk (aka boring) banks that serve as financial utilities, and high-risk entities that are more speculative.
- The financial industry must inevitably shrink. This means more job losses in New York, and a reduction in its clout in Washington.
- Some have called for labeling of financial products akin to consumer product labeling with buyers being provided information on the risks associated with the products.
- Transparency in accounting is paramount. Banks have pushed for suspension of mark-to-market accounting. On March 10th, Ben Bernanke suggested there should be some leeway in interpreting the rules. Perhaps this will convince the already skeptical creditors and public that banks are indeed solvent.
- Finally, we need to eliminate the conflict of interest that is so rife in the industry and in government. In emerging economies like India and most of the poorer rest of the world, we would tend to call this corruption. Here in the US, we indulge ourselves with euphemisms like "lobbying."
We need to understand that a public company's CEO is a shareholder's fiduciary. If a company is going down, its CEO would most likely not hasten its demise by admitting that fact openly. A CEO will necessarily attempt to make the company survive and protect shareholders from loss. What we need is for stakeholders to be true to their interests, which should be divergent. A conflict of interest arises when multiple parties serving as fiduciaries to counterparties with divergent interests find their own interests converging or when a single party serves as a fiduciary to multiple counterparties with divergent interests. We need excellent analysts to discover what the CFO is trying to finesse through on the balance sheet and income statement. This is also why we need short-sellers - for the same reason that we need vultures to pick the flesh of carrion - to enable, as Joseph Schumpeter put it, "creative destruction."