naked capitalism

By George Washington of Washington’s Blog.

Preface: If you are a Christian or Jew, the importance of the Bible is probably obvious. If you are not, please consider passing this essay on to people of those faiths who you know.

If you are an atheist and believe that religion is crazy, please remember that some 85% of the American population identifies itself as Christian and millions more identify themselves as Jewish, and that most people make decisions and process information based on their beliefs and emotions.

The head of Goldman Sachs literally said he’s doing “God’s work” with his banking activities.

The head of Barclays also recently told his congregation that banking as practiced by his company was not antithetical to Christian principles.

Are they right? Is big banking as practiced by the giant banks in harmony with Christian principles?

Do Justice

Initially, the Bible does not counsel us to ignore the breaking of laws by the the powerful.

In fact, the Bible mentions justice over 200 times — more than just about any other topic. The Bible asks us to do justice and to stand up to ANYONE — including the rich or powerful — who do injustice or oppress the people.

There have been widespread, credible allegations that Goldman Sachs and other giant banks have broken the law (see this, for example).

Indeed, one of the first things God asks of us is to do justice:

He has told you, O man, what is good; and what does the Lord require of you but to do justice, and to love kindness, and to walk humbly with your God? (Micah 6:8)

While many churches and synagogues have become obsessed with other issues, many have arguably ignored this most important of God’s demands of us. As pointed out by a leading Christian ministry, which rescues underage girls trapped as sex slaves in third world countries:

In Scripture there is a constant call to seek justice. Jesus got upset at the Pharisees because they neglected the weightier matters of the law, which He defined as justice and the love of God . . . Isaiah 58 complains about the fact that while the people of God are praying and praying and praying, they are not doing anything about the injustice.

Should Christians just pray for justice and leave the rest to God?

That’s not what the Bible asks us to do. Instead, Hebrews 11:33 tells us that we are God’s hands for dispensing justice, and God uses us to “administer justice.”

We have to “walk our talk” and put our prayers into action.

God demands that we do everything in our power to act as “God’s hands” in bringing justice. And as Saint Augustine reminds us, “Charity is no substitute for justice withheld.”

Please reflect on the following Scripture:

The Lord looked and was displeased that there was no justice. He saw that there was no one, He was appalled that there was no one to intervene. (Isaiah 59:15-16)

This is the only place in the Bible where the word “appalled” is used for the way God feels — in other words, the only thing which we know God is appalled by is if people are not doing justice.

There are hundreds of other references to justice in the Bible, including:

• Blessed are they who maintain justice . . . . (Psalm 106:3)

• This is what the LORD says: Maintain justice and do what is right . . . . (Isiah 56:1)

• This is what the LORD says: Do what is just and right. (Jeremiah 22:3,13-17)

• Follow justice and justice alone. (Deuteronomy 16:19, 20)

• For the LORD is righteous, he loves justice . . . . (Job 11:5,7)

• Learn to do right! Seek justice . . . . (Isaiah 1:17)

So if the powerful players in the giant banks broke the laws, they must be held to account.

Manipulating Money

Moreover, there have been credible allegations that Goldman Sachs and other giant banks manipulate the currency and other markets.

As Ron Paul notes, the Bible forbids altering the quality of money (which, at the time and place, was entirely in the form of coins):

As Gillian Tett points out in the Financial Times today, clearing derivatives centrally has come to be viewed in policy circles as a magical solution. As a result, it has not gotten the scrutiny it deserves.

The reason for the enthusiasm is that, in theory, a clearinghouse would make sure all agreements were adequately backstopped, so that if customer defaulted, it would not produce cascading counterparty defaults. The clearinghouse would have enough margin and capital to absorb the loss. And observers take great comfort from the fact that no significant exchange (which also has central clearing) has failed in a very long time.

But that view is based on precedents that have limited relevance for credit default swaps, which is the product that is the biggest source of risk. First, the CDS market is dominated by a comparatively small number of very large counterparties. So the failure of any one would be a vastly more serious blow than any modern exchange has suffered.

Second, the cheery view of the safety of exchanges is based on the airbrushing out of a near failure. In the 1987 stockmarket crash, a large counterparty of the Chicago Merc had failed to make a large payment by settlement date, leaving the exchange $400 million short. Its president, Leo Melamed, called its bank, Continental Illinois, to plead for the bank to guarantee the balance, which was well in excess of its credit lines. The officer in charge said no,. It was only because the chairman walked in and authorized the backstop only three minutes before the exchange was due to open that the Merc kept going.

Melamed has said repeatedly that if the Merc did not open that morning, it would not have opened again, and the head of the NYSE has said if the Merc did not open that morning, the NYSE would not have either, and it might never have repoened either.

Remember that. One decision with three minutes to spare kept the two biggest exchanges in the US from collapsing in the 1987 crash. See Donald MacKenzie’s An Engine Not A Camera for details.

Third, a clearinghouse for credit default swaps is certain to be undercapitalized. That means it is an AIG, a concentrated point of failure. The reason is that the contracts will be undermargined. CDS are not true derivatives, but are the economic equivalent of credit insurance. When a “reference entity” has a “credit event” meaning a bankruptcy or default, CDS prices jump to default. That means they shoot up massively because a payout on the CDS is certain, the only item in question is the precise amount.

A large enough initial margin to allow for jump to default risk will make CDS uneconomic (that’s an outcome I welcome, but that is contrary to the motives for the clearinghouse). So dealers and counterparties will fight for a lower margin, meaning the exchange will be undercapitalized relative to the risks it faces.

Tett has some overlapping concerns:

And yet, as so often in the current regulatory debate, there is a crucial catch: most notably, that a clearing house can only offer that all-important sense of reassurance to investors, if it is always perceived to be absolutely rock solid – no matter what. And what is notable about the reform debate so far this year, is that there has been remarkably little public discussion among politicians – or even among regulators – about how to guarantee that any future clearing house will indeed be strong enough to withstand any future shocks….

I suspect the silence may also reflect delicate political sensibilities. If politicians were to demand that a clearing house should be so utterly rock solid that it could withstand even financial Armageddon, the future members of any clearing platform would have to make massive financial commitments. That would necessarily limit membership, to a small cabal of ultra-powerful banks – not something that most politicians wish to encourage.

However, if a clearing house is made more accessible to a wider pool of members, then it will only carry real credibility if it is ultimately backstopped by the government itself, to ensure that trades are always settled, no matter what. And most politicians are not keen to highlight that option either, given the wider sense of public anger about the degree to which the government is bailing out the financial world.

Nevertheless, a few lone voices are now trying to stir up more debate, Gerry Corrigan, the former governor of the New York Fed, for example, recently declared that any future clearing house be placed under the supervision of central banks. More controversially, he also demanded that any clearing house for credit derivatives should have enough resources to withstand the failure of two large members on the same day and still keep trading. “I believe that the operational and financial integrity of such counterparty clearing facilities must be virtually failsafe,” he sternly declared*.

These strike me as sensible suggestions. And behind the scenes, some policy makers strongly support what Corrigan has demanded. Yet, thus far, it is still unclear whether such tough standards will be imposed – even though some clearing houses are now emerging. And that is precisely why men such as Corrigan are growing uneasy.

After all, one lesson that financial history shows is that the issues which blow up the financial system are not usually those which caused the last crisis. Instead, the biggest threats tend to come from the areas swathed in a lazy consensus, or where there is a strong political impetus to clutch at easy solutions. That might yet apply to the clearing houses. In theory, I still believe that clearing houses could – and should – make the derivatives world safer. In practice, though, they could also end up creating new dangers if they are not put on a sound footing, particularly if the fact that no clearing house has ever failed before creates a false sense of complacency

Clearinghouses are the wrong remedy for CDS, but that horse has left the barn and is already in the next county. And I must confess, they sound deceptively appealing (I was a proponent early on) until you dig further into how they would work for CDS. They need to be regulated intrusively, with the intent of shrinking the market considerably over time, and like insurance, with tough capital requirements and frequent examinations of the capital adequacy and claims-paying ability of the sponsor. But the real need is to cut off the air supply to CDS to reduce the size of the market so the product itself no longer represents a systemic threat.

.

OK, I have heard all the explanations, spreads are wider because there are fewer market makers, asset prices are rallying (market making firms are structurally long; it’s difficult and costly to go net short on that big a balance sheet), Goldman is currently the trading kingpin.

But I still find these factoids remarkable: Goldman lost money trading only one day last quarter and only two days the prior quarter.

Now maybe I am just hopelessly out of touch, or perhaps more accurately, the Fed has created such a ridiculously favorable environment for banks and traders that if you are moderately competent, making money is like shooting fish in a barrel. But a winning streak this consistent looks like a rigged game. Is this just, ahem, “information advantages”? Greater ease in pushing markets around that have fewer players? Just a function of those monstrously wide bid-asked spreads? I’m curious for a sanity check from people closer to the action.

The party line comes in the Financial Times:

The performance – revealed on Wednesday in a regulatory filing – compares with two losing trading days in the previous quarter and confirms that the authorities’ drive to revive markets after the crisis is yielding huge windfalls for some banks.

Before the crisis, banks regularly recorded trading losses on several days in a quarter.

Goldman made more than $100m in profits on 36 of the 65 days in the three months to September and recorded more than $50m in profit on more than eight out of 10 trading days, the filing shows.

These figures were down from the second quarter, when Goldman reported record trading revenues and had 46 days with $100m-plus in profits. The smaller number of days with $100m-plus profits in the third quarter partly reflects the bank’s decision to rein in risk-taking in areas such as interest rates and equities.

There is a suggestion here that banks like Goldman might be taking advantage of the Fed and Treasury (although that might be by design, yet another hidden subsidy), as has been intimated elsewhere:

Dealers say banks have made big profits by the timing of Fed purchases of government debt and subsequent Treasury debt sales, and by betting that the relationship between Treasury bonds and other fixed-income securities would normalise.

By George Washington of Washington’s Blog

Many people – including former analyst for the U.S. Treasury Richard Cook – argue that credit is too important a function to be left to the private banks.

Indeed, even after taxpayers have given trillions in bailouts, backstops, guarantees, and other gifts, the giant banks are still not lending out much credit to individuals or small businesses.

The talking heads say that real reform of this nature is not “politically feasible”. But not politically feasible doesn’t actually mean anything except that the powers-that-be don’t want it.

We have been throwing ourselves against a brick wall trying to force the giant banks into doing the right thing, but as Buckminster Fuller said:

You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.

A Better Model

So what is a better model?

Gold advocates argue for a return to a gold-backed standard. This would, in fact, be a vast improvement over the fiat currency system we have now, as it would help to stabilize the currency, add discipline and consistency, and reign in the funding of unnecessary wars and other imperial mischief which are funded by the unlimited printing of new fiat dollars.

But Ellen Brown argues that a gold standard restricts credit for the little guy, not just Uncle Sam. If Brown is right – and given that the too big to fails are refusing to lend to most little guys – public banking might be the only way to restore a healthy economy and ease the pain for the average American. (Brown also argues that it was actually the bankers – and not the populists – who forced the adoption of a gold standard in the 1890s, and that the true meaning of the “Cross of Gold” speech has been forgotten).

National Public Bank

AFL-CIO president Richard Trumka told Congress last week:

If the Federal Reserve were made a fully public body, it would be an acceptable alternative.

The American Monetary Institute proposes the following alternative:

Incorporate the Federal Reserve System into the U.S. Treasury where all new money would be created by government as money, not interest-bearing debt; and be spent into circulation to promote the general welfare. The monetary system would be monitored to be neither inflationary nor deflationary.
Second, halt the bank’s privilege to create money by ending the fractional reserve system in a gentle and elegant way.

All the past monetized private credit would be converted into U.S. government money. Banks would then act as intermediaries accepting savings deposits and loaning them out to borrowers. They would do what people think they do now. This Act nationalizes the money system, not the banking system.

Bloomberg News columnist Matthew Lynn writes:

The U.K. government needs to start thinking about what it will do with all the banks it now owns. The answer is simple: Hand them to the people…

Instead of selling the stakes it acquired in the financial system to other banks, or listing the shares on the stock market, it could create mutually owned societies. Royal Bank of Scotland Group Plc could be a people’s bank, owned by everyone.That would ensure more diversity, competition and stability, all goals just as worthy as getting back the money Prime Minister Gordon Brown’s government spent on bank rescues…

Sovereign nations such as the U.S. and England have the power to create credit and money (and see this, this and this). Taking the credit-creation power away from the banks and giving it back to the nation would ensure that credit is freed up for people’s use, and the stranglehold over the economy is taken away from the too big to fails.

State Public Banks

Many people argue that – given its actions – people don’t trust the federal government to create money.

Fair enough. Why not let the states do it?

Michael Moore recommends that the American people demand:

Each of the 50 states must create a state-owned public bank like they have in North Dakota. Then congress MUST reinstate all the strict pre-Reagan regulations on all commercial banks, investment firms, insurance companies — and all the other industries that have been savaged by deregulation: Airlines, the food industry, pharmaceutical companies — you name it. If a company’s primary motive to exist is to make a profit, then it needs a set of stringent rules to live by — and the first rule is “Do no harm.” The second rule: The question must always be asked — “Is this for the common good?” (Click here for some info about the state-owned Bank of North Dakota.)

As Moore notes, the state of North Dakota already has such a bank, and – because of that – North Dakota is just about the only state which is not running a huge deficit.

PhD economist and candidate for Florida governor Farid Khavari wants to create a Bank of the State of Florida, to create credit without burdening the state and its citizens with high interest charges by private banks.

See this for details.

Local Public Banks

An alternative to federal or state public banking is local public banks, as proposed by Edward Kellogg and others.

As summarized by Adrian Kuzminski:

During this time of financial and economic crisis, it is worth recalling that credible alternatives to our current financial system exist, if largely unrecognized, and deserve serious consideration…

The now-neglected 19th-century American proto-populist, Edward Kellogg … was a kind of godfather to the later populist movement on monetary issues. Perhaps the most profound of American writers on monetary issues, Kellogg advocated a decentralized but nationally regulated monetary system based on non-usurious, low-interest public loans to individuals. His vision inspired 19th-century century mutualists, greenbackers, populists, and others who sought to restructure the monetary system to redistribute wealth.

In our own day, when usurious credit in the form of private finance capital remains the dominant force in economic life, and is largely taken for granted even by educated people, the alternative Kellogg offers is more important than ever. Indeed, I suggest that Kellogg’s theory of money is the best monetary alternative we have to the baleful system under which we suffer…

Edward Kellogg (1790-1858) was a New York City businessman whose losses in the crash of 1837 led him to examine the business cycle, monetary policy, and debt. In a series of writings, Kellogg developed the idea of … having the government provide very-low-interest loans to the general public. These loans would have a uniform, fixed interest rate, established by law. They would be issued locally through a system of public credit banks he called the Safety Fund. Once issued, these low-interest loan notes would circulate as currency, replacing the privately issued banking notes of his day (which today take the form of Federal Reserve Notes)…

In his day Kellogg seems to have influenced even Abraham Lincoln who, according to historian Mark A. Lause, ” . . . had his own copy of Kellogg’s book, Labor and Capital [sic] advocating the government issuance of paper currency as a just means of redistributing wealth, and he corresponded with the author’s son-in-law.” Kellogg’s public currency was intended to end the monopoly over the discretionary issuance of money at interest, which was held then (and now) by the private banking and investment system…

Kellogg proposed to establish local public credit banks, and we might imagine one in each community. These local public credit banks would be part of the Safety Fund. Instead of money being issued (as it is now) through a privatized and centralized money-management system on a top-down basis, primarily as loans at increasing rates of interest from a central bank to major commercial banks, and then to regional and local banks, and then to the public, money in his system would be issued by local federal banks as loans directly to citizens at nominal interest on the basis of their economic prospects. Once lent out, Kellogg’s public credit notes would flow into circulation, providing the basis for a new currency backed by the assets of individual borrowers…

A centralized national currency would be replaced, in Kellogg’s system, by a locally issued currency. But that currency would everywhere be subject to common national standards, ensuring that each local public credit bank reliably issued equivalent units of currency. A dollar issued by one local public credit bank of the Safety Fund, Kellogg intended, would be worth the same as, and be freely interchangeable with, one issued by any other. The independence of local branches would be guaranteed by the discretionary power reserved to them as a local monopoly actually to loan money; the compatibility of their monies would be ensured under federal law by fixing the value of the dollar by law at 1.1 percent/year – that is, by lending money everywhere to citizens at that rate…

The goal is to establish and preserve economic decentralization. Amounts of money lent in Kellogg’s system would vary considerably from place to place, with some areas needing and creating more currency than others. The solvency of local federal public credit banks would be guaranteed by collateral put up by borrowers, and the money supply would be stabilized by repayment of loans as they came due. The interchangeability of public credit bank notes would ensure a wide circulation for the new money…

To achieve a stable currency, Kellogg insisted that this rate be fixed by law; perhaps today it would take a constitutional amendment.

What’s the Best Option?

People of good faith debate whether the gold standard, or national, state or local public banking is the best solution.

But they agree that the current fiat currency system where the creation of credit is controlled by the private banks has pushed us into an economic crisis and a credit crunch, with little hope of stability for the future.

Changing to a public banking system would clearly be a large change. But remember – as Buckminster Fuller pointed out – building a new model is often easier than fighting the existing one.

The time is right for a new model.

Afterword:  Is a Gold Standard Incompatible with Public Banking?

Many people assume that a gold standard is incompatible with public banking.   But that might not necessarily be true.

An analysis of ways in which a gold standard might possibly complement public banking is beyond the scope of this essay, and I have not yet even thought it through myself.   But before ruling out the possibility, I invite financial experts to brainstorm on this issue to see if we can have the best of both worlds.

After all, when currency speculation is removed from the equation, money simply acts as  a yardstick to measure the exchange of goods and services so that barter is not necessary.  People may be able to create a money system which has the stability and discipline created by a gold backed system. with the credit availability of a public banking system.

Admittedly, the gold standard may at first blush be seen as more conservative than public banking, as the former limits money expansion while the latter encourages it. But as with all liberal-conservative dichotomies, it is important to get beyond labels and to determine what is actually best.  Indeed, public banking – especially if it is on the state or local level – would not create easy credit for the government to launch new imperial adventures.

McClatchy, the only major US news organization to question the Iraq war until is was obvious to all that it was a misguided exercise in neocon hubris, has started a series on Goldman’s famed “short subprime” exercise. While the timing and overall outline are not new (as to when and allegedly why the investment bank went short), it delves into some details that have heretofore not been examined, as to how much subprime paper it dumped onto investors during this period, whether this duplicity was permissible, and what sort of damage was visited on foolhardy borrowers.

Unfortunately, for my taste, the series does not appear to be getting enough into the nitty gritty (and it indicates clearly that Goldman has successfully kept mum about the details of how it executed its short). I am keenly interested, because my understanding is that any simple subprime index short would have blown out spreads and thus been very costly to execute.

Goldman used another route….and the road, not surprisingly, was through AIG. From an e-mail over the summer:

This also points out a *VERY* good nugget re: banks who used CDOs/AIG offensively as opposed to as a hedge. This is likely what bothered me most about the AIG debacle. The trades GS had on with AIG were generally *not* super senior CDOs GS was long simply because they had
underwritten CDOs and were “stuck” with the AAA risk as a result. Rather, GS had a whole program of issuance — something they called “Abacus” — which were deals they put together with the sole purpose
of getting short subprime/CDO risk. Their sole purpose in doing the deals was to get long protection/short risk on the underlying collateral. AIG was simply the vehicle they chose to moneitze that PnL. Call me crazy, but I put the AIG counterparties in two different camps: guys like SocGen, who bought bonds in good faith and then hedged the credit risk by buying CDS from AIG, and guys like GS, who used AIG as their lottery ticket for offensively constructed trades to capitalize on mispriced subprime risk. The former, to me, seem much more deserving of a bailout than the latter…

DeutscheBank had a broadly similar program called Start.

This of course makes complete sense. There simply was not enough insurance capacity (the monolines plus the volume on the Markit indexes) to account for the big names that went short (Paulson, Goldman, one other large but secretive player we are aware of). That road had to go through AIG as well.

And bear in mind another fact: asset backed securities CDOs (and the subprime kind were that type) were managed rather than passive. That mean when the collateral paid down, the manager would go and find new collateral. Again from an e-mail:

AIG got out of subprime in 2005/2006 – whenever – but it didn’t matter.  Why??  Because the same crappy borrowers that made it into 2005/2006 subprime RMBS refinanced and ended up in the 2007 vintage.  Guess who had to buy the 2007 subprime RMBS paper when the 2005/2006 paper repaid?  You got it – the 2005/2006 CDOs.  CDOs have reinvestment periods (4 yrs for SF CDO) whereby they have to continue to be fully invested rather than letting their liabilities get repaid.  The liability buyers don’t want their valuable paper to be repaid early – or, do they????

Readers who know the terrain, and Abacus and Start in particularly, are very much encouraged to comment or ping me at yves@nakedcapitalism.com.

Now to McClatchy:

McClatchy’s inquiry found that Goldman Sachs:

Bought and converted into high-yield bonds tens of thousands of mortgages from subprime lenders that became the subjects of FBI investigations into whether they’d misled borrowers or exaggerated applicants’ incomes to justify making hefty loans.

Used offshore tax havens to shuffle its mortgage-backed securities to institutions worldwide, including European and Asian banks, often in secret deals run through the Cayman Islands, a British territory in the Caribbean that companies use to bypass U.S. disclosure requirements.

Has dispatched lawyers across the country to repossess homes from bankrupt or financially struggling individuals, many of whom lacked sufficient credit or income but got subprime mortgages anyway because Wall Street made it easy for them to qualify.

Was buoyed last fall by key federal bailout decisions, at least two of which involved then-Treasury Secretary Henry Paulson, a former Goldman chief executive whose staff at Treasury included several other Goldman alumni.

The article continues here.

By George Washington of Washington’s Blog.

Preface:  Please read to the end to see the humorous quote.

I have previously debunked numerous false arguments used to defend the too big to fails. See this and this.

But the apologists for the TBTFs are now arguing that breaking up the beached whales … er, giant banks … will harm America’s ability to compete with foreign banks.

Joshua Rosner (managing director of an independent financial services research firm), has written an important essay debunking this argument:

Those who argue against a more proactive reduction in risk and size of TBTF institutions will, as always, revert to an argument that strikes a natural chord in every American’s heart: ‘Doing so would create an unleveled international playing field for our institutions relative to their international competitors’. Level playing fields are a worthy goal, but this is not a relevant argument. Instead, this tired bromide must be resoundingly dismissed on several counts:

• Those countries with the largest banks as a percentage of GDP (Iceland, Ireland, Switzerland) demonstrated that a concentration of banking power can cause significant sovereign risk and tilt global economic playing fields away from that country.

• The likely breakups of ING, Lloyds and KBC suggest that it is we who seek to support an unlevel playing field where we subsidize our TBTF banks while other nations recognize the policy failures of moral hazard. If we continue down this path we will likely be at risk of violating international fair trade regimes.

• When the “unlevel playing field” argument is cited, keep in mind this reasoning supports the disadvantaging of 8000+ community banks relative to our largest banks, all in the name of protecting big banks from governmentally- subsidized international competition.

• There is no longer any evidence that, beyond a cost of capital advantage that comes with implied government support, there are sustainable and tangible economies of scale arising from being the largest. The financial supermarket concept has been proven a failure. The only ones who benefit are the high-level executives.

• We must demand that our legislators no longer allow unelected officials at the independent Federal Reserve to sign international accords created by the TBTF banks through supra-national bodies like the Basel Committee.

• Are we to believe that if we did not have such large and globally dominant firms, US borrowers might be paying more that the 29% interest that several of the TBTF firms are now charging on their card accounts? Perhaps we should think about what advantage our population has gained as a result of our financial institutions being such a large part of our economy or being globally dominant.

• Since when did we accept a national strategy of following rather than leading? When we do what is right, others follow. As example, consider the bank secrecy havens – they made money for a bit. Now, even the Swiss and the Cayman authorities are coming around to our view.

• We are already at a disadvantage given that the largest foreign banks operate in the US without any tier one capital requirement and yet mostlarge foreign banks have not built a bricks and mortar presence here. Nobody screams about their undercapitalization nor has that undercapitalization caused deposits to migrate to foreign banks.

What fake excuse will the apologists for the TBTFs throw out next?

That breaking up the giants and letting small and mid-sized banks, credit unions and state public banks compete fairly will shift the Earth’s gravitational field as deposits shift away from the money centers?

Note: Rosner has a funny and potentially effective idea for putting pressure on Congress. He suggests that we all call our representatives and ask how much the lobbyists have paid them to destroy America’s economy by propping up the too big to fail banks.

Rosner’s actual language is somewhat over-the-top:

By George Washington of Washington’s Blog.

I have repeatedly pointed out that big banks are not more efficient than smaller banks.

For example, I previously noted that an article in Fortune concluded:

The largest banks often don’t show the greatest efficiency. This now seems unsurprising given the deep problems that the biggest institutions have faced over the past year.

“They actually experience diseconomies of scale,” [Celent analyst Bart] Narter wrote of the biggest banks. “There are so many large autonomous divisions of the bank that the complexity of connecting them overwhelms the advantage of size.”

Now, James Kwak has done some sleuthing and discovered that even Fed economists don’t buy the bigger-is-more-efficient argument. Kwak points out that New York Fed economist Kevin J. Stiroh found that most of the increase in efficiency during part of the time in which banks were consolidating was due to the increased use of information technologies:

His main explanation for the productivity growth is not consolidation, but information technology: “The finding of steady productivity growth, in particular, is important since it is consistent with the idea that the massive investment in new technology is working to improve the performance of the banking industry.” This is not proven in this paper, but Stiroh went on to write a bunch of other papers on the link between information technology and productivity. For example, this paper (on the entire economy, not just banking) concludes:

“IT-producing and IT-using industries account for virtually all of the productivity revival that is attributable to the direct contributions from specific industries, while industries that are relatively isolated from the IT revolution essentially made no contribution to the U.S. productivity revival. Thus, the U.S. productivity revival seems to be fundamentally linked to IT.”

Stiroh also wrote a paper on banks in Switzerland, concluding:

“We find evidence of economies of scale for small and mid-size banks, but little evidence that significant scale economies remain for the very largest banks. Finally, evidence on scope economies is weak for the largest banks that are involved in a wide variety of activities. These results suggest few obvious benefits from the trend toward larger universal banks.”

The kicker is that Stiroh is the main source cited by those claiming that bigger banks produce greater efficiencies.

The bottom line is that there is absolutely no reason not to break up the too big to fails.

The New York Times published an edited extract from Andrew Ross Sorkin’s Too Big Too Fail (man, that book is so large, they can release a ton in advance and still have a book and a half of reading left over). This section is on some of Dick Fuld’s efforts to save Lehman.

The Japanese tell their children, “You should hear one thing and understand ten.” Sorkin’s snippet reveals quite a lot.

It was obvious to even outsiders in the late stages of the unravelling of Lehman was that Fuld missed possible deals because he set his price targets too high. One of the cardinal rules of dealmaking is everything can be solved by price. He probably could have unloaded Neuberger Berman and limped along for a while. He could have sold a stake to the Koreans. Would these moves in August have rescued the firm? As an independent player, no, but a sale of all or part of the firm still would have been a better outcome, and realistic conversations might have led to a sale of more operations, and saved more jobs. Bear’s employees did get something for their stock holdings, and a minority kept their jobs. Now Bear did get a government backstop, but that was after the investment bank was clearly terminal.

But three things are striking about the Sorkin-provided details:

First, Fuld (and presumably the underlying business) was desperate as of early July. Sorkin has Fuld arranging for contacts to be made to possible buyers like Bank of America on a Saturday. Huh? He was clearly flailing about, yet not offering a price or deal terms commensurate with his obviously panicked state.

Second, Paulson and Geithner were aware of Fuld’s desperation. The Wall Street Journal reported earlier that Fuld was calling Paulson almost daily (and suggested Paulson was somewhat puzzled). The Sorkin excerpt shows Fuld petitioning the Fed via Geithner to become a bank holding company:

Mr. Fuld’s outside lawyer, Rodgin Cohen, chairman of Sullivan & Cromwell, had recently suggested an idea to help stabilize the firm: to voluntarily turn itself into a bank holding company. The move, Mr. Cohen had explained, would make it easier for Lehman to borrow money from the Fed “just like Citigroup or JPMorgan.”

Mr. Cohen, a 64-year-old, mild-mannered mandarin from West Virginia, was one of the most influential and yet least well-known people on Wall Street. Pacing in his hotel room in Philadelphia before the wedding of his niece that night, he joined the call between Lehman and the New York Fed.

“We’re giving serious consideration to becoming a bank holding company,” Mr. Fuld started out by saying. “We think it would put us in a much better place.” He suggested that Lehman could use a small industrial bank it owned in Utah to take deposits to comply with the regulations.

Mr. Geithner, who was joined on the call by his general counsel, Tom Baxter, was apprehensive. “Have you considered all the implications?” he asked.

Mr. Baxter, who had cut short a trip to Martha’s Vineyard to participate, walked through some of the requirements, which would transform Lehman’s aggressive culture, minimizing risk and making it a more staid institution, in league with traditional banks.

Regardless of the technical issues, Mr. Geithner said, “I’m a little worried you could be seen as acting in desperation,” and the signal that Lehman would send to the markets with such a move.

Mr. Fuld ended his call deflated. Later that evening, Mr. Fuld called Mr. Cohen, finding his lawyer in the waiting room of a hospital, attending to a cousin who had become ill at the wedding.

Yves here. If Geithner and his colleagues didn’t get that Fuld was at the end of his rope, they were choosing to ignore an elephant in the room. Now they may have been completely unwilling to consider the petition and this was the easiest way to signal their opposition (taking Fuld through a long list of requirements, some of which presumably would have been pretty painful, was another message).

But this speaks to a question we have raised again and again: why was there no serious assessment of what a Lehman bankruptcy would mean? After Bear went down, everyone knew Lehman was next on the list, with Merrill and UBS also known to be wobbly. Why didn’t the Fed, Treasury, and SEC together demand certain types of information from all big US regulated capital markets players (including JP Morgan and Goldman, perceived to be the healthiest, so as not to be singling out the weaker members of the herd?). This is a massive oversight. Relying on luck, which is what assuming all would be well after the Bear debacle, is no substitute for having a strategy. There was clear urgency in July. Even a month of assessment and evaluation of options (it probably would have taken two weeks to orchestrate the information requests among the agencies) would have been better than nothing. But the Freddie/Fannie unwind was moving to front burner, that probably consumed a lot of available bandwidth.

And we have the third, and peculiarly most obvious point to anyone who has had some exposure to deals, but one that Sorkin does not bring forward: what the hell was Fuld doing trying to negotiate his own deals? This is a mistake CEOs make all the time, and it never ceases to amaze me.

Now why is it a bad idea for a CEO or for most principals to negotiate their own deals? Most people are terrible negotiators. And I have to tell you, most people in M&A are not as good as they think they are. They don’t really negotiate all that much. They structure deals, value them, sell, but a lot of the negotiating takes place through the lawyers (many of the key points are negotiated in the negotiations over reps and warranties and the details of the definitive agreement). Most M&A transactions do not have that much negotiating, relative to all the other stuff that goes on in a deal, for most professionals to get that much practice.

But CEOs on average are FAR less practiced at negotiating, and Fuld is by temperament and experience particularly poorly suited for that role. He comes out of commercial paper (which is a very simple “placement” business; negotiating was never a skill he had to develop), he was known for being hyper aggressive and surrounding himself with yes men; he’d have even less give and take on a daily basis than most top executives.

There are other reasons not to negotiate your own deal. Even if I were a good negotiator (and I’m not, but I am a good transaction tactician), I’m loath to negotiate on my own behalf, and many good negotiators I know try not to. You have too much at stake, you lose the detachment you need to be effective.

Another crucial reason is you have FAR more leeway going through a negotiator. They can explore ideas with the other side with far less of a sense of commitment than if principals deal directly.

The one exception to this rule is industries where people negotiate all day. I’ve have some clients in the media business (cable) and they are frighteningly good, since horse-trading is a much bigger part of the fabric of their business than in other fields.

Back to Fuld. I’m simply gobsmacked at how he carried on. For instance, why did Fuld speak to Geithner and Baxter? This was completely nuts, a display of ego and utter stupidity. Fuld has the best connected, most trusted (by the Fed, anyhow, which is what counts) BANK regulatory lawyer in the US in Rodg Cohen. I’m personally not a fan of the man (long story involving a client here, won’t bore you with details) but Cohen would be the guy to broker a deal like that. If anyone could have pulled it off, he could have. If Fuld felt he had to be on the call, he should have let Rodg lead and kept his bloody trap shut as much as possible. But instead he conducts the call with no Cohen, apparently not even any Cohen laying of the groundwork.

Now it may be that Sorkin has this wrong, that Cohen served up the idea only under duress and didn’t want to carry the message. That’s unlikely, since lawyers often are asked to serve up low-odds ideas. But given that Fuld made all the calls on all the deals Sorkin discusses here, it appears he insisted on making his own pitches.

And again, while Sorkin may have had to streamline to keep his very big book from tuning into a three volume saga, the number of proposals Fuld made in a short succession also suggests that Fuld was winging it, throwing out ideas to see what might stick. Yes, it’s a good idea to start with an elevator pitch, and then elaborate if you get an initial positive or at least neutral response, but there seems to have been NO thinking, no detail beyond the high concept. Again (and this is just common sense), there seems to have been little consideration of “what’s in it for the other side,” as in some concrete discussion of fit/synergies, at least an indication of an awareness of possible structural/organizational issues, etc. These all seemed to be seat of the pants with NO backup! Check this out:

Mr. Fuld decided to call his old friend John Mack, the chief executive at Morgan Stanley…Mr. Fuld asked candidly: “Can’t we try to do something together?” It was a bold question and Mr. Mack had suspected it was the reason for the call…

“We’ll come over to your offices,” Mr. Fuld, clearly anxious, said.

“No, no, that makes no sense. What if someone sees you coming into the building?” Mr. Mack asked. “We’re not going to do that. Come to my house, we’ll all meet at my house.”

…There was Walid Chammah and James Gorman, the firm’s co-presidents; Paul Taubman, the firm’s head of investment banking; and Mitch Petrick, head of corporate credit and principal investments.

Bart McDade, Mr. Fuld’s new No. 2, showed up next, dressed in a golf shirt and khakis. Skip McGee, the firm’s head of investment banking, was running late; his driver got lost.

As the group took their seats on sofas around a coffee table, an awkward silence followed; no one knew exactly how to begin.

Mr. Fuld looked at Mr. Mack as if to say, It’s your house, you start. Mr. Mack imperturbably glared back, You asked for the meeting. It’s your show.

“Well, I’ll kick it off,” Mr. Fuld finally said. “I’m not even sure why we’re here, but let’s give it a shot.”

“Maybe there’s nothing to do,” Mr. Mack said in frustration as he noticed the discomfort around the room.

“No, no, no,” Mr. Fuld hurriedly interjected. “We should talk.”

He began by discussing the possibility of selling Neuberger Berman, Lehman’s asset management business and one of its crown jewels. He also suggested that Morgan might buy Lehman’s headquarters on Seventh Avenue — the same building that had been Morgan Stanley’s until Philip Purcell, the firm’s former C.E.O., sold it to Lehman after 9/11. The irony would be rich.

“Well,” said Mr. Mack, not entirely sure what Mr. Fuld was proposing, “there are ways we can, you know, there are ways we can work together.” ….

But the meeting ended with no agreement and what seemed like no incentive to keep talking. “Was he offering to merge with us?” Mr. Mack asked after the Lehman executives departed.

“This is delusional,” Mr. Gorman told his Morgan Stanley colleagues.

Yves here. By virtue of having had Japanese clients, I have probably seen more offensively overpriced turkeys than the average person. But even with people peddling utter rubbish (which they no doubt knew to be utter rubbish), and the Japanese occasionally being so bold as to say so (Kansai Japanese do that) I cannot recall a meeting going every remotely as poorly as this one did. This is clumsy and embarrassing, and it is unfortunate that Sorkin either did not appreciate that, or that he felt that the narrative style he chose prevented him from saying so directly.

But it still makes for very voyeuristic reading.

Actually, despite the somewhat churlish headline, the story “Bailout Helps Fuel a New Era of Wall Street Wealth,” by Graham Bowley at the New York Times, is a solid job of reporting and does not tiptoe around the issue of the big bennies that the financial services industry is enjoying and their role in creating outsized profits. It also makes a distinction, which has escaped many writers, that the firms that are doing really well are the big capital markets players, not conventional banks (or firms like Citi and Bank of America, that are capital markets firms with very substantial commercial banking operations). It was the markets that the powers that be were panicked to save (debt is now heavily intermediated on over-the-counter credit markets, vastly less on bank balance sheets than it once was). And with the subsidies directed mainly at shoring up credit markets and the firms that own and operate the crucial trading infrastructure, it should be no wonder that the players that were most deeply involved are showing the greatest gains.

The reason for the tart headline is that this view should be conventional wisdom by now (well, it is among folks who understand financial services, but not in the wider world). And it should have been widely commented on when first and second quarter bank earning came out,. Instead the meme was “isn’t it wonderful those banks we thought were dead are actually making money!” No one wanted to look to closely and ascertain that the pretty profits were the result of government props, not sounder fundamentals. The one who came closest to saying the truth was Meredith Whitney, who described the earnings as “manufactured” (recall the role of AIG swaps unwinds in 1Q results) but added that the banks could keep it up for another quarter or two.

The New York Times story warm up indicates that comparatively few are in on the role of the government support in the supercharged profits. The price provides a short recap and notes that the Federal aid is contributing to lofty bonuses:

It may come as a surprise that one of the most powerful forces driving the resurgence on Wall Street is not the banks but Washington. Many of the steps that policy makers took last year to stabilize the financial system — reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institutions’ debts — helped set the stage for this new era of Wall Street wealth.

Titans like Goldman Sachs and JPMorgan Chase are making fortunes in hot areas like trading stocks and bonds, rather than in the ho-hum business of lending people money. They also are profiting by taking risks that weaker rivals are unable or unwilling to shoulder — a benefit of less competition after the failure of some investment firms last year.

So even as big banks fight efforts in Congress to subject their industry to greater regulation — and to impose some restrictions on executive pay — Wall Street has Washington to thank in part for its latest bonanza…

Not all banks are doing so well. Giants like Citigroup and Bank of America, whose fortunes are tied to the ups-and-downs of ordinary consumers, are struggling to turn themselves around, as are many regional banks.

It is admittedly a high level treatment (for instance, it does not enumerate the various types of support, but does make clear it extends well beyond the TARP) but delivers its message in a clear, matter-of-fact, and unqualified fashion.

Some economists and bloggers have been on this theme (the extent of the subsidies and the lack of quid pro quo for the taxpayer) for quite some time, and their drumbeat continues. One salvo comes today from Jesse in “How Goldman Sachs Leveraged $70 Billion in Government Money For Record Profits.” While this is admittedly close to conspiracy theory, most investment professionals I know regard the latter phases of the stock market rally with great suspicion (too much end of day tape painting, too many heavy handed short squeezes, continued thin volume, and suspicious moves on indexes when they near levels that are significant to technicians). That of course begs the question, “If the market is being manipulated, how and by whom?” When I worked with the Japanese, it was widely known that the Japanese securities firms manipulated the markets and the politicians were tipped off early and bought stocks the brokers were about to ramp (look, if I as a mere gaijin heard about it, it was hardly secret). Yet when it came out in the Japanese media years later, it was treated as a huge scandal. I was and am perplexed that a widely-known practice could be treated as such a remarkable event. I regard much of this rally as a similar open secret, except how this is being carried out is a mystery (is this mere trader opportunism and brute force that looks like collusion, with the perps secure in the knowledge that the government won’t act against rule violations, since the outcome serves their interests, or something more deliberate?)

On the wonky/policy end of the spectrum, Willem Buiter continues to be Not Happy about the wondrously bank-friendly regimes that have been put in place. He provided some commentary from János Kornai on one of his ideas, that of soft versus hard budget constraints (Buiter had invoked the idea in a post earlier in the week).

The problem is that the concept is important, but this (established) turn of phrase does not slip swimmingly off the tongue. A hard budget constraint means when you run out of something (dough, usually, but it could be other scarce resources) you are stuck. No magic fairy dust to rescue you. Kornai explains:

To simplify matters, a contrast is often made between the soft and the hard budget constraint. In fact there are grades between these two extremes. The budget constraint that corporate decision-makers sense may be very soft, moderately soft, quite hard and so on, depending on their subjective awareness of the probability of rescue….

Let us turn for a minute to the dawn of capitalism. A debtor unable to pay was threatened by the debtors’ prison. Business failure in the early period of capitalism was more than a fatal material blow, for it ruined the bankrupt’s moral reputation. The budget constraint in those days was still absolutely hard. The perilous results of loss and indebtedness forced entrepreneurs to be extremely cautious.

But the historical development of property relations and the credit system gradually brought essential changes. The principle of limited liability became legitimated, and joint stock companies based on that new principle appeared. At the same time, the hitherto close connection between the material and moral position of decision-makers and the financial state of their companies became weaker.

As property and management separated, so the relation weakened between the individual destiny, income and reputation of the managers making the practical business decisions on the one hand, and the presence or absence of financial destinies of their companies, on the other. Successive legislation on business failure provided some protection for firms caught up in a spiral of debt. These changes and others not mentioned here contributed to a steady softening of the budget constraint….Early capitalism rewarded success richly and punished failure fiercely. As time went by, the rewards not only remained, but in several countries increased dramatically, while the penalties became lighter. That disproportional change has weakened the incentive for business to pursue efficiency and adaptability to change. It encourages irresponsible decisions on borrowing, investment and expansion.

The one bit I find troubling with Kornai’s discussion is he conflates soft budget constraints with socialistic regimes, namely the sort he saw in Hungary in the late 1960s, when companies were urged to adopt “market socialism” but that meant that if the manager did well, the company got a bonus, but if the company produced a loss, no matter, the state would fund the shortfall.

But this is not a function of socialist systems per se; it took place in all the examples that George Akerlof and Paul Romer cited in their classic 1994 paper on looting, and included the Chicago School free market experiment in Pinochet’s Chile, which resulted in a plutocratic land grab. To put it more simply, “socialized losses” can occur under a socialist system (where the goal is to preserve employment), in looting (where lax regulation and accounting allow companies to report largely bogus profits and syphon out funds, either directly to the owners/managers, or to affiliated companies), or in Mussolini-style corpocracy.

Note that Korzai stresses that rescues per se are not bad things, provided they are made judiciously and infrequently:

Softness of the budget constraint cannot yet be said to apply in a singular case where a firm in deep financial trouble is bailed out. The syndrome appears if such rescues occur frequently, if managers can begin to count on being rescued. We face here a mental phenomenon, an expectation in decision-makers’ minds that strongly influences their behaviour.

It isn’t hard to imagine that with a clear “no more Lehmans” policy in force in the US, UK, and EU, that banks are very well conditioned by now to expect a rescue if they screw up.

Separately, even the Times manages to undercut the pointed message of its story on source of bank profits with another story today: “All This Anger Against the Rich May Be Unhealthy.” A cultural aside: since the early 1800s in England, there was a distinction between the deserving and undeserving poor. Someone who was able to work but didn’t was undeserving (there were other ways the line might be drawn, but that was one of the most consistent). We see that carried through today (when talking about those over their heads in debt, some readers like to demonize them all as profligate, while others jump in and point out how, for instance, medical expenses can push a lot of people who had lived reasonably within their means into debt pronto. Again, it’s a “deserving v. undeserving” distinction.

Given the row over the suspect level of pay in certain areas of finance, it may be time to apply that notion to the upper end of the food chain more formally. Most people have no problem with self made men and women making a lot of money; heck, that’s the American dream. The fact that the “if you are rich, you must be deserving” Calvinist assumption is beginning to be questioned is positive; we just need to be careful not to replace old stereotypes with new ones.

From Marshall Auerback, a fund manager and investment analyst who writes for New Deal 2.0:

As reported by Bloomberg:

Goldman Sachs Group Inc., one of the first banks to receive cash injections from the U.S. Treasury during last year’s crisis, doesn’t have an implicit guarantee from the government, Chief Financial Officer David Viniar said today.

“We operate as an independent financial institution that stands on our own two feet,” Viniar, 54, said in a conference call with reporters today after the New York-based firm posted higher third-quarter profit. “We don’t think we have a guarantee.”

That’s the quote from today.

Then see an excerpt from their last 10Q issued less than three months ago.

Note the footnote (3) that $20 billion was guaranteed via the FDIC (click to view full image).

Now tell me something, what if you have received FDIC guarantees in the middle of the crisis and had been able to borrow three year money at 100bp over 3 year notes or a whopping 1.5% interest cost.

Might you have taken up the opportunity?

Would that be an implicit guarantee or perhaps more than just implicit?

It is an outright lie to say that they “operate as an independent financial…..”

They should be held accountable for lying to their shareholders.

Where is the outrage in Congress and in the Obama administration?

FDR and Jesse Jones never ever would have tolerated this behavior just 8 months after the bank closings.

You need to look beyond the forest of debits and credits.

This goes to the very heart and soul of the democracy and what we have written about the corruption in the American polity.

Yves here. Ahem, and how pray tell does Goldman rationalize that it was allowed to become a bank in the crisis, which gives it direct access to the Fed? And the government has a clear “no more Lehmans” policy, with Goldman as a larger and therefore treated as an even more important to preserve player.

Another doozy from the conference call was that Goldman CFO David Viniar justified Goldman’s high profits by claiming it was justified by the valuable social role the firm was performing.

Organizations that perform valuable social functions are generally controlled by the state (police) or utilities and subject to heavy government oversight to keep them from abusing their crucial role. But Goldman, along with the rest of the financial services industry, has managed to get itself in the “heads I win, tails you lose” position of privatized gains and socialized losses. And then they have the temerity to act as if we don’t see the result, which is looting.