Institutional Risk Analytics has an informative, engaging interview with Martin Mayer, who is a professional polymath (he is the author of 34 books, former banking columnist, art critic, film critic, and currently a guest scholar at Brookings). I very much recommend reading the entire piece and provide some tidbits below.
Mayer: What is happening on this LIBOR business? That is a very strange story that the five big banks are cooking their books on reporting LIBOR.
The IRA: Well, with many banks now struggling to fund themselves, the larger banks don’t want to be seen as aggressively bidding in the funds markets for fear of starting a reputational issue a la Bear, Stearns (NYSE:BSC) or Lehman Brothers (NYSE:LEH). LIBOR is a manifestation that global investors don’t want to lend to US or even EU banks…..
The IRA: Agreed. But despite the obvious logic of institutions like DTCC [Depository Trust & Clearing Corporation], we’ve still allowed our OTC markets to fragments and thereby become a source of systemic instability. How did this happen?
Mayer: One of the problems I have with the OTC markets and the arguments that we mustn’t cramp innovation is that a lot of what is called innovative is simply a way to find new technology to do what has been forbidden with the old technology.
The IRA: Yes, techno-regulatory arbitrage. What a lovely thought; using new technology as a means for committing financial fraud. It’s kind of like the affordable housing and innovative financing games.
Mayer: Yes. Innovation allows you to go back to some scam that was prohibited under the old regime. How can you oppose innovation? The fact that the whole purpose of the innovation is to get around the existing regulation never seems to occur to regulators or members of Congress…..
The IRA: Going back to your point about market structure, how do you explain to people outside the world of finance how we go it so badly wrong? You have a very wide circle of friends outside the markets. What do you tell them? How did Americans forget the lessons of the 1920s and 1930s to arrive at this sad circumstance?
Mayer: In part, it is theory, namely the strange conjunction of Susan Phillips, Wendy Graham and Alan Greenspan over a decade ago. Bill Seidman too, for that matter, when he was at FDIC. In an odd way, we became technologically backward regarding market structure because the people in charge of supervising financial institutions namely the Fed — did not know anything about it. Look at the Fed’s employment roster. There were people who were obsessed by monetary theory. And there were people whose chief responsibility was performing tasks like handling checks, namely operations. There were various models of equilibrium in circulation at the time which provided overall comfort. And Alan Greenspan really believed with religious fervor that markets cure their own ills. Remember Barry Bosworth’s warning that diversification devalues knowledge. So the notion that the technology made it possible to drive risk beyond any reasonable limit wasn’t in anybody’s head. As I said before, there are a certain number of tested Wall Street scams that have been forbidden by regulation. If you can find a way to use technology to revive one of these scams, then you are an innovator and you get paid extremely well for the five years these techniques work, and then you go away.
The IRA: How can other nations around the world take the US seriously when we show such a capacity for collective self-delusion?
Mayer: Yup. In addition to using technical innovation to evade regulatory limits, there was also a confusion of purpose at the Fed. The Fed really never wanted to exam banks. And it really didn’t want to be in a admonitory position vis-a-vis the banks. The commercial banks are the mechanism by which monetary policy is conveyed to the world. And the Fed needed them very badly. But beyond just monetary policy, what got forgotten was the reason why we separated commercial banking and investment banking in the 1930s. Obviously it got more and more difficult to enforce that separation as the technology changed. But that didn’t mean that there were not good reasons for the continued separation. The way I like to put it is that the commercial banker wants to know how am I going to be repaid, the investment banker asks how am I going to sell the paper. These two attitudes really do not coexist well together.
The IRA: Banks globally have been miserable failures when it comes to combining investment and commercial banking.
Mayer: Correct. It is a very different mindset. And historically, in terms of public policy, we have relied upon the commercial banks to keep the markets and the economy on an even keel. Greenspan’s observation was that, after all, the banks are going to protect us because they are lending their own money
The IRA: Yes, but in a market dominated by investment bankers, no such discipline prevails. The investment bankers rarely create value and, judging by their recent behavior, care nothing about the long-term health of the global markets or the economy.
Mayer: Well, of course that was inaccurate because commercial bankers lend other peoples money. But beyond that, the notion that people who gamble with their own money are more responsible gamblers than those who gamble with their Uncle Joe’s money was always very strange to me. People who are gamblers are gamblers and they will run through anybody’s money. The difference between their own money and other people’s money usually does not mean much to a gambler….
Mayer: [Ed} Kane is a very amusing guy and very sound. His coinage of the term “zombie thrifts” was one of the great features of the 1990s. But to go back to the thought, where all of this business with the Fed supporting Wall Street starts really with Continental Illinois. What happened was that in order to keep Continental Illinois going, the FDIC had to buy the billion dollars of notes the holding company had sold in Aruba. The FDIC was not willing to put up the money, so the Federal Reserve Bank of Chicago loaned money to the FDIC to carry Continental Illinois until they could sell it off. The Board of Governors of the Fed, remember, has no money. Silas Keehn threatened to call the loan. There was a congressional hearing which I quoted in my book The Fed where Seidman said in a jocular way that if the Fed wanted its money back they could close down the FDIC because he could not pay them! So you developed a situation where the lender of last resort to the banking holding companies was the FDIC. And the lender of last resort to the FDIC was the Federal Reserve. The Fed began to get into very non-standard situations after that, as in the case of the Bank of New England failure where the FDIC was again using the Feds money.
The IRA: Well, again, they did not have the liquidity. But the odd thing about both of these situations was that the FDIC did not first go to the Treasury via the Federal Financing Bank. By statute the FDIC has a credit line directly with Treasury, yet instead they went to the Fed.
Mayer: Correct. The FDIC had the reserves in both cases, but they did not want to use them. The FDIC insurance would not be as meaningful if the agency itself were seen to be in difficult financial straits.
The IRA: So these types of innovative financing techniques by and between the regulators are essentially the precursors of what we see today, albeit with the Fed now lending directly to the insolvent non-depository institutions like BSC and perhaps LEH.
Mayer: Yes, that is where I see this situation we have today with the Fed holding billions of dollars in junk paper starting, with Continental Illinois and the like. You see, one the problems that the FDIC had in Continental Illinois was that the bank had a billion dollars in offshore deposits. The FDIC had no legal authority to bail out these depositors. Another example was the National Bank of Washington….
Mayer: In the second edition of The Bankers, about two thirds of the way through, I promulgated three laws of financial derivatives. The first law is that when the whole is priced to sell for less than the sum of the parts, some of the parts are overpriced. Second law is that when you segment value you segment liquidity.
The IRA: So much for innovation.
Mayer: And the third law is that risk shifting instruments will tend over time to shift risk unto those less able to bear it because them what’s got want to keep and hedge, and them that ain’t got want to bet and speculate. Three laws from the 1990s and all three still true. This business about appetite for risk or ability to shift risk is all crap. The banks and funds own some of this junk, but not so much. They don’t seem to be howling nearly so much as the guy who packaged these assets and stupidly kept inventory.