naked capitalism

From Craig Heimark, a recovering derivatives trader

Perversely, what prompted me to read Lawrence Kotlikoff’s new book, Jimmy Stewart is Dead, was a review that described his proposal as forcing all banking to become mutual funds. That seemed both radical and naive, but coming from a well known economist, I thought it would be interesting to see if he could make a credible case.

On Style

Jimmy Stewart is Dead is both amusing and annoying. Kotlikoff gets on the bank-bashing bandwagon, calling the current industry structure corrupt. He goes name by name from Fuld all the way through Rubin describing them as technically incapable of running their firms,as con men as they clearly were peddling snake oil. It evoked Matt Taibbi’s Goldman Sachs as vampire squid article. I have mixed feeling about this style. It made Kotlikoff’s book easy and fun to read, but it often served to discredit the analysis. Just as when I read the vampire squid article, I was left with two feelings. One – it was far too much in the conspiracy theorist school of journalism to be taken seriously. Two – unfortunately its analysis was all too correct. Similarly, I took some guilty plesures in the gossipy snake oil accusations and anecdotes – frankly none of which are actually wrong, but this overblown style undermines and obscures what is actually a serious proposal (or at least the beginnings of a serious proposal) for fundamental reform

On Substance

As a post on Naked Capitalism earlier this year noted, Mervyn King, the governor of the Bank of England, gets it: the financial services industry needs to be restructured. So far the proposals are all about tinkering at the edges. What is actually needed is industry level reform. Yes, reform will cause real change – but again that is exactly what is needed.

Kotlikoff’s recommendations fall short of that standard. Essentially he is proposing a return to some of the thirties style reform. In that era, we separated securities from loans. Today that separation is impossible, due to the insertion of securitization (a desirable innovation) into all aspects of financial services. Proposals like Volker’s to focus on proprietary trading as the evil I think are right in a desire to return to a simpler, more transparent, more understandable system, but fatally flawed as trading IS the the problem, nor is any separation of “customer” trading from proprietary trading possible in a real world sense. Instead what Kotlikoff proses is separating financial intermediation from risk transformation. So he would effectively ban all prop trading from intermediation and place all risk transformation into general partnerships. He get there by focusing on the evils of leveraging. He is not opposed to leverage per se – though he goes to lengths to discredit Millier Modigliani as unrealistic as it ignores very real costs and no doubt has made a entire generation of manager inappropriately comfortable with too much debt. Rather his point in not that leverage is bad, but that YOUR leveraging ME (as either a shareholder in a fin services firm – or as a taxpayer) without my explicit knowledge and consent is root of all evil.

He feels – all too correctly – that this unsupervised leveraging of other peoples’ capital is both magnified and probably only possible by government actions, creation of moral hazard and explicit government guarantees. From my perspective he focuses too little on the x-efficiency argument (meaning traders and short term bonuses cause the management of public financial service firms to behave in a manner not consistent with long term creation of firm value) and too much on the sins of the government in creating moral hazard, exacerbating the too big to fail risk, and so on. But no matter – the essence of his line of logic is that financial risk transformation (whether yield curve or factor transformation) is risky and as such should be done in general partnership type structure that cannot take advantage of limited liability, By contrast, he arguest that financial intermediation does not require and in fact should not be allowed to make bets based upon leveraging their financial balance sheet.

The problem is he prattles on for 123 pages on gossip, government ineptitude, and many, many pages on virtues of mutual funds before getting to his specific proposals. And when he gets there he does not lay them out in the 5 or 7 bullet point they require but spreads them across a couple of chapters. Further his single chapter on transitioning from current structure to his desired future state is not thoughtful – and ironically for someone who criticized Miller Modigliani as misleading because it ignores transaction costs, make exactly the same mistake in his implementation chapter.

Nervertheless -the book caused me to think differently about the problems and the solution space and so I recommend it to those interested in fixing our financial system.