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Charlie Munger: Leash and Collar Wall Street

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The backlash is starting to get serious. It is one thing for the man on the street to fulminate about the excesses of financiers. And even those who try to harness that anger find themselves checked. John McCain, who has said that he is going to fix the economy by (among other things) going after “Wall Street corruption” is having difficulty filling his New York fundraisers.

But it’s when people in or close to the financial services start calling for reform that you know the tide is turning. In a Forbes interview, Jamie Dimon and Felix Rohatyn (storied top M&A banker for two generations, also led the restructuring of New York City’s finances in its fiscal crisis) do an able job of singing from the reform hymnal. But Charles Munger, long-standing partner of Warren Buffett, calls for root and branch reform. If other prominent Main Street executives fall in with Munger, we might see the banking industry restored to its proper role, that of a support function to commerce.

From Forbes (hat tip reader Steve):

Even more radical is Berkshire Hathaway’s vice chairman. Munger wants Wall Street balance sheets reduced by 70% and insists that the firms “be a market maker, a broker, an underwriter and a custodian of securities but not the hedge funds they have become.” He wants to restrict leverage to 50% on every securities transaction except for the Treasury trading desk where “you’re dealing with the safest securities around.”

That 50% margin level, incidentally, is the maximum that ordinary investors can obtain from their broker when they purchase common stock. Before their respective demises, Bear Stearns and Lehman Brothers were leveraged to the tune of $30 of debt for every $1 of capital.

To rid Wall Street of its Las Vegas tone, Munger suggests leveling the options exchanges in Chicago and New York, and banning completely all derivatives contracts, a rather impossible vision but one that’s true to his spirit. He’s also furious with the accountants, in particular for letting Wachovia report actual profits on accrued interest from risky mortgages when, in fact, the interest wasn’t paid but added to the principal amount due on the mortgages.

Derivatives are simply not going away, but there are ways to restrict OTC derivatives (for instance, forbidding any institution that has access to the Fed window from buying or selling them or lending to any entity that has non-exchange traded derivatives on its books) which pose the greatest danger.

The article concluded on this cheery note:

One thing is sure: The abhorrent excessive compensation on Wall Street is bound to be severely reduced. If Wall Street firms can only be leveraged 10 to 1 instead of 30 to 1, then the excessive gains made on borrowed funds will be reduced by two-thirds. So the path to $5 million to $10 million annual payoffs will be more reasonable but still in the millions. Hamptons summer homes will be reduced in price. Private jets will be out of range for many. Applications to law school should go up. The buyside will have their choice of the brightest business school graduates. And forever more we’ll all wonder what a meltdown would have been like with the attendant chaos.

There will be an international conference dealing with global finance that will place such restrictions in order to prevent such a close brush with Armageddon and systemic collapse ever again. It cannot be left to the free market.

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36 comments

  1. vlade

    I think banning all the OTC derivatives is a bit too far (IR swaps, for example, are not nearly as dangerous as the infamous CDSes), and I think it would be hard to enforce too. How do you define an OTC derivative? I’m pretty sure soon enough a smart chap would come up with a way to structure a legal contract so that it would avoid the law – whatever it would be. If the law was too generic, it would on the other hand probably kill even some of the private dealing (i.e. there’s nothing to restrict me to enter into an OTC-like derivative contract with another private individual, and there might be good reasons for doing it). Saying “Do it!” without looking at what might the (unintended) consequence be reminds me of an invasion of an unnamed country few years ago.

    Restrict any and all derivatives where you cannot statically hedge. (It’s easy to show what you can and what you cannot statically hedge), and require static hedging for at least a part of overall exposure.

    Force reduction in leverage, and make an accounting rule that only realised profit is a reportable profit (use MTM to price your assets, but do not use assets-liabilities as a measure of attributable PNL).

    Some derivatives are weapons of mass destruction (I’d say those which have infinite gamma), but some are really helpful – and not always well suited for exchange traded (i.e. very standardised) approach.
    If we do go exchange traded, then I suggest we do it wholesale, i.e. start exchange trade mortgages as well (i.e. instead of going to your friendly bank on high street, you go to an exchange and “buy” a mortgage there anonymously. Same for loans, savings, etc…). If you allow non-standard mortgages, and require things like hedging interest rates risk for the banks, then you have to allow for non-standard derivatives. If you stanardise mortgages, well, then you can move to exchanges.

  2. pd130

    If other prominent Main Street executives fall in with Munger, we might see the banking industry restored to its proper role, that of a support function to commerce.

    After, of course, we find some commerce.

    Sorry, I just couldn’t resist … Backed up to a wall I’d agree that “services” trade is commerce of a sort.

  3. a

    “Applications to law school should go up.”

    Is this supposed to be good? The same aggressive, ambitious personality, who turned to finance to screw things up (and be rewarded handsomely), returns to law, where he will screw things up (and be rewarded handsomely).

  4. Anonymous

    After, of course, we find some commerce.

    Better define what “commerce” is first.

    I see absolutely no reason real unemployment rates can’t soon equal or exceed the last Great Depression.

    “Excess capacity”, you know. This time the excess capacity is in the consumer and services sector that grew to 70% of the economy.

    No one need worry about “triage” for dead banks and thrifts. Before the Feds can start a euthanasia program for the terminally ill they have to open mass graves for the bodies.

    That’s what the recapitalization of the Big Nine is about. Once that’s done they can begin moving smaller dead institutions’ accounts. And also “downsize” the excess capacity staffs to join the unemployed mortgage brokers, car salesmen, real estate agents and hedge fund managers. And drop the excess facilities onto the commercial real estate market.

  5. Anonymous

    “To rid Wall Street of its Las Vegas tone, Munger suggests leveling the options exchanges in Chicago and New York”

    I’d add the NYSE to Munger’s proposed urban renewal program. I’d also allow any qualified person (i.e. owner of stocks or cash) to directly buy and sell on an expanded NASDAQ.

    At this point in time and technology there is no further socio-economic justification for the NYSE’s specialist system and physically concentrated exchange facilities.

    It simply facilitates a toxic local culture of cronyism and self-dealing.

  6. Anonymous

    “Applications to law school should go up.”

    When applications to engineering, engineering technology and hard sciences programs go up we’ll be on the road to real economic recovery.

    As opposed to the recovery of virtual reality bull markets against a background of declining real incomes.

  7. wintermute

    Throughout all the carnage two classes of derivatives have been well behaved: futures and options.

    Surely it is not beyond the wit of regulators to bring all other OTC derivatives into the same exchange framework, margin requirements, settlement cycle, transparency of trade/volume reporting etc.

    Coupled with rigorous control on bank-leverage – and including off-balance sheet SIVs, subsidiary companies into the capital adequacy requirements (or banning them altogether) would go a long way to preventing similar credit crisis.

    Ultimately governments need to all run balanced budgets too – to get rid of boom/bust cycles.

  8. Independent Accountant

    I have long favored subjecting banks and Wall Street firms to the same margin requirements retail customers have.
    I have a better balance sheet than any major bank. Why should a bank get cheaper funding than I can get or be more highly leveraged than I could be? Smash the banks. We need another Andrew Jackson!

  9. luther

    “Once that’s done they can begin moving smaller dead institutions’ accounts.”

    2 cents crystal ball: watch for the regionals to start dropping like flies after election day.

    Comerica, Nat’l City, 5th 3rd, SunTrust, etc.

    one of the big 9 will be there in a flash to swoop them up (in the public interest of course) to make sure the depositor accounts will suffer no blip for Christmas.

    wonder if they got a US map out yesterday and played a game of Gobble?

  10. dearieme

    If company law could be changed so that shareholders had more power over directors and executives, it might become much harder for those miscreants to loot the companies.

  11. That thing you do

    “Real” leverage is linked directly to fractional reserve banking, and needs to go. Synthetic leverage (options) is okay, because you can’t lose more than you put into the system. Options traders don’t destabilize the system, but 30:1 leveraged investment banks surely do.

    But I could live without options (even though it would screw me over) if banks got out of the markets. I question the necessity of much of our financial system in this age when a $2000 PC can serve as an exchange for billions of shares a day. But I think Wall Street is not going to go out voluntarily.

    The right way is to quietly replace the current system with an alternative system, and let everyone migrate over of their own accord. I wish the open source guys would tackle this problem instead of writing new skins for MP3 players.

  12. Anonymous

    watch for the regionals to start dropping like flies after election day. Comerica, Nat’l City, 5th 3rd, SunTrust, etc. one of the big 9 will be there in a flash to swoop them.

    Yup. Now drive to your nearest mainstreet intersection and see how many of these face each other on different corners. And then count the thrifts located further down the block.

    Most of that soon to be consolidated “infrastructure” represents overhead supply for the local labor and commercial real estate markets. Plus additional house foreclosures.

  13. Anonymous

    On Reform:

    ‘Too Big To Fail.’ Change the phrase to ‘Too Connected to Fail’

    The purpose of corporate license is to produce goods and services and employ people.

    The right to raise capital offers the public opportunities to ‘speculate’ on unpredictable results.

    There are no guarantees.

    Tying corporate compensation to share performance is a conflict of interest. No? Not obvious yet?

    The corporate executives of an older generation knew little to nothing about the stock market. They were busy running their companies. Ask them.

    The license to raise and ‘distribute’ capital for the growth of the economy has been misappropriated for the growth of stock prices.

    Common stocks are not appropriate vehicles, managed or otherwise, for retirement accounts where peace-of-mind approaching old age is its purpose. Current situation proof of this? Not yet?

    The problem throughout economic life today is a generational problem.

    The massive consumer power of the baby-boomer generation as it ripped through the economy lost knowledge of the basic humanistic principles upon which this country was founded.

    It will take a younger (Obama?) generation IN COOPERATION AND CONSULTATION with the Felix Rohatyns of the world to set things right.

    Deliveraging must include deconsolidation with an emphasis on breaking up corporate media conglomeration: radio stations, newspapers, TV, etc.

    Current abuses by Congress and the Executive branches in particular could not have happened with a functioning journalistic enterprise.

    Arline Stewart

  14. Anonymous

    correction: “journalism” enterprise. my thinking is slipping into ‘istic’ terms as in communistic, socialistic …

  15. Anonymous

    I have been forced to add nine financial institutions with dubious fogged balance sheets to my portfolio against my will and against my better judgment.

    At an absolute minimum I deserve what the Brits are getting for their money:

    1. Sack the current management
    2. Suspend all bonuses, stock options, corporate travel and 401k contributions
    3. Suspend dividends
    4. Purchase voting shares as opposed to non-voting so we can have a real say in preventing irresponsible business practices going forward.
    5. Require all banks who take a dime of taxpayer money to comply with usery laws limiting maximum charged interest rates to 18% and maximum fees to $20.

    Surely even bankers would consider it a little excessive to rape the taxpayer twice.

  16. mxq

    “…but there are ways to restrict OTC derivatives (for instance, forbidding any institution that has access to the Fed window from buying or selling them or lending to any entity that has non-exchange traded derivatives on its books)”

    Great idea…maybe also make OTC’s unenforceable or have laws that strongly favor arbitration that routinely reject enforcement of contracts, unless done/modified on an exchange.

  17. Anonymous

    the word ‘excessive’ no longer has meaning. this regime has proven repeatedly on every level of life, that the forces in power are in a race for the bottom and the end of American life as we have known it.

  18. Stephen

    Luther,

    Expect to see Canadian Banks pick off a couple of those regionals and/or smaller thrifts.

    I like Mungers point about leverage and its effect of supercharging returns and therefore bonuses. Limit the leverage and limit the bonus, except for the truely gifted, who likely will have to build their bonus over a longer time frame.

    As for Wall Street vs Vegas….Vegas HAS rules.

  19. William Mitchell

    Munger isn’t a recent convert. He practically started this religion.

    Charlie Munger has been calling for better regulation of the financial industry (mainly in the form of better derivatives accounting, which would force the balance sheet reduction discussed in this post) at nearly every public appearance since at least 2002.

    Munger and Buffett were alerted shortly after buying General Reinsurance in 1998. It took years for Berkshire to unwind GenRe’s derivative contracts, mostly at big losses to book value. Ever since, they have argued what everyone has suddenly discovered: these instruments are illiquid, create huge off-sheet exposure, and create conditions that make overstatement of value almost irresistible.

  20. doc holiday

    I guess Chuck and I are in 100% agreement, RE:

    “To rid Wall Street of its Las Vegas tone, Munger suggests leveling the options exchanges in Chicago and New York, and banning completely all derivatives contracts,”

    I just wish Chuck would take a look at that $33 Billion goodwill thing at Berkshire and re-think reform on those Level 3 Assets! Although in form and substance, Berkshire goodwill may not be the synthetic weapons of mass destruction that his buddy speaks of, but they sure as hell can leave a big hole in a balance sheet!

    It’s one thing to preach to the crowd about reform, but it’s also another matter to actually practice what you “frigg’n” preach!

    I trust me more than him!

  21. Anonymous

    Yves,

    Derivatives are simply not going away.

    Why?

    Simply make them unenforceable by law and treat them as gambling or fraudulent insurance.

  22. Yves Smith

    Anon of 3:26 PM,

    Commodity and foreign exchange futures play a vital role in commerce. Trade would be well nigh impossible without them.

  23. vlade

    Anon 3:26
    Because without things like futures farmers will not know what they get for their crop, without things like IR swaps companies will face huge uncertainties around their floating casfhlows and will be less able to plan and so on and so on.

    Derivatives can help real economy.

    If we do want to get rid of derivatives, but, as just about everything, they have “caveat emptor”, and must be used with care.

    Because some drugs have side effects, and overdose can kill, it doesn’t mean we should ban the drug entirely (or even all the drugs).

  24. vlade

    Oops, a posted before finishing the post.

    3rd paragraph should have been:
    If we do want to get of derivatives, we can, but they are quite a useful tool. Of course, as just about any tool, they have a “caveat emptor” and must be used with care.

  25. Anonymous

    Tying corporate compensation to share performance is a conflict of interest. No?

    The problem is tying corporate compensation to short-term share performance. I think most compensation should be in the form of shares, but shares that must be held for 5 years.

    Do you think the Orange Man would have blown up CountryFried if his 500 million in stock was at risk? Possibly, but it’s much more likely. Even if he still blew up CountryWide, he would be punished through $500 million of worthless shares.

  26. Anonymous

    share price depends on many factors other than corporate performance. Corporate executives should be as diversified in the stock market as any individual employee, and not hav to keep an eye on the stockmarket while making corporate decisions.

  27. Anonymous

    Sorry about that:

    Long term has a way of becoming short. Just give it enough time.

    And while we are on the subject. Remember the dot.com bust. The young people took it on the chin when it went bust. And I didn’t hear a peep of complaint from them.

    Has anyone done a study on how many of the talent and otherwise them worked for nothing -axcept for
    stock options that became worthless in the bust?

  28. MT

    When I graduated from college, the top job coming out of business school was…Microsoft? Nope, Pets.com? Nope Wall Street? Nope, Real Estate Developer? Nope, it was….drumroll please…Proctor and Gamble. Pepsico, Nestle, and Gallo were the top jobs. These were all companies that produced things.

    My cousins that have graduated from college in the last 5 years have all ended up in finance, banking, or Real estate. All of them. Now they are all getting laid off.

    I guess it’s time to apply to law or MBA school now……

  29. Anonymous

    Dear Mt. Maybe everyone should not go to college. Whatever happened to good, hard work in this country. There is money to be made in the trades such as plumbing, roofing, electrical and other construction related work. It seems that if everyone has to spend thousands of dollars for an education that they will never have any use for that an answer is to just plaine do some hard work to earn a living. My Dad raised a whole family by doing ironwork for a living and we never wanted for anything.
    Why is it today in this country that we do not want to do any hard work? WE just want to sell stuff that people cannot afford to pay for.

  30. Anonymous

    After reading Jeff Matthews on Buffet/Munger, it’s easy to understand why Charlie feels the way he does. His idea of growth is to clip a coupon. Never has there been a greedier, less risk seeking, less entrepreneurial business person. You’re gonna love his world. Welcome to Scotland, circa 1750. Just don’t expect much innovation, unless you characterize a furniture mart or dairy queen as an important innovator in today’s society. But indeed, there won’t be much risk. Wonder how the rewards will work out?

  31. spare some change?

    Anonymous @ 7:26:

    The smart white kids are drawn to ponzi schemes because they’ve seen how companies in this country treat native engineers; an unavoidable expense during boom times to be ruthlessly culled in favor of H1-B slave labor as soon as expedient. Doctors get saddled with huge debts coming out of med school and with malpractice insurance the way it is, they don’t break even until middle age and that’s if they work like dogs and luck into the right specialty. Most blue collar workers are treated like crap also.

    The trades had a good run during the housing boom but now, unemployment is rampant. Let’s not forget that the trade masters enjoy the protection of a government that artificially restricts competition to keep fees high.

    Finance is the way out of the ‘hood for white kids. As Giovanni Ribisli observed in Boiler Room, “You’d better have a good jump shot or you’ve gotta sling crack rock. Wall Street is crack for white boys.”

  32. Anonymous

    7:26, Can we get away from those ridiculous arguments? Those 50′s-70′s generation got away with what they did (scrape through or drop out of high-school to become plumbers, car mechanics, miners etc) because there was no competition.

    A high-school dropout worker at GM has the same skill-set as a billion other Chinese/Indians/Brazilians etc on this planet. Those folks DO NOT live ‘middle class’ lifestyles comprising of heated/cooled big houses with yards, minivans, dogs and yearly vacations. The US workers of those decades managed to pull it off as the aforementioned countries were still struggling with defining themselves and gaining a foothold in this world. So forget those days. If Americans want to maintain a better lifestyle than most natives of those countries, they HAVE TO build up more skills that them. Dropping out and become a factory worker will only beget what it rightfully does in the world – cycling 20 miles to a factory and coming back to a shack.

  33. William Mitchell

    >> Never has there been a greedier, less risk seeking,
    >> less entrepreneurial business person. You're
    >> gonna love his world. Welcome to Scotland, circa
    >> 1750.

    What an odd choice of example. The Scots (and their diaspora) made modern industrialism during that period. See "How the Scots Invented the Modern World" by Arthur Herman.

    Guided by the two key features of the national character — naked avarice and fear of Armageddon — Scots were innovative without falling into mania.

    Coincidentally, we are currently being rescued by a Scot. Dour old Gordon Brown is not much fun at parties, but the closest thing we have to a global leader in the current effort at financial stability.

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