How Finance Goes, So Goes the Nation

House of cards

From the WSJ:

The Government Won on Financial Reform

The financial system is more regulated than ever, but also no safer.

‘Your No. 1 client is the government.” So former Morgan Stanley CEO John Mack told current CEO James Gorman in a recent phone call, according to a September 10 story in the Journal. He’s exactly right, which more or less sums up how American finance has evolved in the five years since the 2008 financial crisis. Far and away the biggest winner is the government.

This isn’t the conventional view in media and politics, where the spin is that Wall Street has triumphed. This is politically convenient because it maintains Washington’s self-serving fiction that the banks alone caused the crisis, and that after bailouts they have emerged richer and less regulated than ever. This leaves politicians free to bash the banks in perpetuity even as they constrain their business and fleece them at regular intervals.

The truth is that across the U.S. economy the government has far more power than it did five years ago, especially in finance. The same politicians and regulators who pulled every lever they could to force capital into mortgage finance have not only escaped punishment for their role in the 2008 crisis. They’ve also awarded themselves more authority to allocate credit. Consider some prominent realities:

• Most of the big banks survived, but at the price of becoming regulated utilities. A sensible reform would have been to require more capital as a bumper against losses, and to use a basic definition of capital that can’t be gamed. Instead, the regulators are requiring more capital while adding vast new layers of regulation.

The regulation micromanages bank decisions down to the kind and quality of loan. Regulators have ordered a top-to-bottom overhaul of foreclosure processes even after extorting more than $25 billion in payouts for exaggerated past offenses.

The Consumer Financial Protection Bureau can veto some products while all but dictating certain kinds of lending. The bureau already has 1,297 employees and an automatic budget tied to Federal Reserve System expenses, not to Congressional appropriations.

The Dodd-Frank Act’s great reform conceit is that the same regulators who missed the last crisis, and who tolerated Citigroup’s off-balance-sheet vehicles hiding in plain sight, will somehow prevent the next crisis. It won’t happen. Regulators somehow missed J.P. Morgan’s “London whale” trades even after they were reported in this newspaper. But they sure know how to punish ex post facto, extracting $920 million in a settlement with J.P. Morgan this week.

The policy of too big to fail has been codified and expanded. Dodd-Frank lets Washington’s wise men define “systemically important” institutions subject to stricter regulation, and they are dutifully expanding this safety net. Insurance companies are already in this maw (AIG, Prudential) or may be soon (MetLife). So are clearinghouses for derivative trades, which have emergency access to the Federal Reserve’s discount window.

Dodd-Frank’s second great conceit is that in a crisis these firms will be wound down without a rescue. They even have to provide “living wills” that are supposed to plan the funeral. But the law also gives regulators the freedom to protect creditors as they see fit, which they will surely do in a panic. The difference next time will be that more firms will be deemed too big to fail.

The government roots of the crisis are unreformed, especially easy credit and the bias for housing. The Federal Reserve keeps buying mortgage securities to lift housing prices. Fannie Mae and Freddie Mac continue as ever, even after losses resulting in $188 billion in bailouts. Taxpayers now guarantee close to 90% of all new mortgages either through Fan and Fred or the Federal Housing Administration, which may also need a bailout.

Now that Fan and Fred are making money again amid the housing recovery, political pressure is growing to release them from federal conservatorship. This would recreate the same toxic mix of private profit and public risk that made them so dangerous when we were warning about them a decade ago.

Dodd-Frank did mandate that credit-rating agencies be reformed, but regulators still haven’t finished the job. The same goes for money-market mutual funds, which continue to benefit from a government rule that lets them declare a $1 net asset value even if the value of the underlying assets has changed. This is systemic risk caused by government that government could but won’t fix.

Even the new Basel capital standards are suspect because they include a carve-out for sovereign debt. So the same regulators that claimed mortgage debt was AAA safe now say that debt from various governments is solid gold.

The simpler, better reform would have been to require much tougher capital standards for banks that take insured deposits, set clear rules that limit risk-taking at such institutions, and let other companies innovate and take risks knowing they get no taxpayer protection. Instead, five years after the panic we have a financial system that is more heavily regulated, and thus is less able to lend and innovate, yet is paradoxically no safer. The government won again.

Gambling with Debt and Leverage


This article explains the simple problem with the modern world of banking and finance: too much debt leverage promoted by misguided tax and regulatory policies. The root cause of every financial crisis is excessive leverage funded by cheap credit. The solution is more equity on the part of shareholder owners through higher capital ratios. The essence here is RISK and the proper pricing of that risk. This means more skin in the game for those who control the financial risks. Then they can absorb the rewards or the failures of risk-taking, not the taxpayers. Of course, less leverage also means less bang for the buck, which implies banking should become the boring business it was meant to be.

From the NY Times:

We’re All Still Hostages to the Big Banks


NEARLY five years after the bankruptcy of Lehman Brothers touched off a global financial crisis, we are no safer. Huge, complex and opaque banks continue to take enormous risks that endanger the economy. From Washington to Berlin, banking lobbyists have blocked essential reforms at every turn. Their efforts at obfuscation and influence-buying are no surprise. What’s shameful is how easily our leaders have caved in, and how quickly the lessons of the crisis have been forgotten.

We will never have a safe and healthy global financial system until banks are forced to rely much more on money from their owners and shareholders to finance their loans and investments. Forget all the jargon, and just focus on this simple rule.

Mindful, perhaps, of the coming five-year anniversary, regulators have recently taken some actions along these lines. In June, a committee of global banking regulators based in Basel, Switzerland, proposed changes to how banks calculate their leverage ratios, a measure of how much borrowed money they can use to conduct their business.

Last month, federal regulators proposed going somewhat beyond the internationally agreed minimum known as Basel III, which is being phased in. Last Monday, President Obama scolded regulators for dragging their feet on implementing Dodd-Frank, the gargantuan 2010 law that was supposed to prevent another crisis but in fact punted on most of the tough decisions.

Don’t let the flurry of activity confuse you. The regulations being proposed offer little to celebrate.

From Wall Street to the City of London comes the same wailing: requiring banks to rely less on borrowing will hurt their ability to lend to companies and individuals. These bankers falsely imply that capital (unborrowed money) is idle cash set aside in a vault. In fact, they want to keep placing new bets at the poker table — while putting taxpayers at risk.

When we deposit money in a bank, we are making a loan. JPMorgan Chase, America’s largest bank, had $2.4 trillion in assets as of June 30, and debts of $2.2 trillion: $1.2 trillion in deposits and $1 trillion in other debt (owed to money market funds, other banks, bondholders and the like). It was notable for surviving the crisis, but no bank that is so heavily indebted can be considered truly safe.

The six largest American banks — the others are Bank of America, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley — collectively owe about $8.7 trillion. Only a fraction of this is used to make loans. JPMorgan Chase used some excess deposits to trade complex derivatives in London — losing more than $6 billion last year in a notoriously bad bet.

Risk, taken properly, is essential for innovation and growth. But outside of banking, healthy corporations rarely carry debts totaling more than 70 percent of their assets. Many thriving corporations borrow very little.

Banks, by contrast, routinely have liabilities in excess of 90 percent of their assets. JPMorgan Chase’s $2.2 trillion in debt represented some 91 percent of its $2.4 trillion in assets. (Under accounting conventions used in Europe, the figure would be around 94 percent.)

Basel III would permit banks to borrow up to 97 percent of their assets. The proposed regulations in the United States — which Wall Street is fighting — would still allow even the largest bank holding companies to borrow up to 95 percent (though how to measure bank assets is often a matter of debate).

If equity (the bank’s own money) is only 5 percent of assets, even a tiny loss of 2 percent of its assets could prompt, in essence, a run on the bank. Creditors may refuse to renew their loans, causing the bank to stop lending or to sell assets in a hurry. If too many banks are distressed at once, a systemic crisis results.

Prudent banks would not lend to borrowers like themselves unless the risks were borne by someone else. But insured depositors, and creditors who expect to be paid by authorities if not by the bank, agree to lend to banks at attractive terms, allowing them to enjoy the upside of risks while others — you, the taxpayer — share the downside. [Heads we win, tails you lose.]

Implicit guarantees of government support perversely encouraged banks to borrow, take risk and become “too big to fail.” Recent scandals — JPMorgan’s $6 billion London trading loss, an HSBC money laundering scandal that resulted in a $1.9 billion settlement, and inappropriate sales of credit-card protection insurance that resulted, on Thursday, in a $2 billion settlement by British banks — suggest that the largest banks are also too big to manage, control and regulate.

NOTHING suggests that banks couldn’t do what they do if they financed, for example, 30 percent of their assets with equity (unborrowed funds) — a level considered perfectly normal, or even low, for healthy corporations. Yet this simple idea is considered radical, even heretical, in the hermetic bubble of banking.

Bankers and regulators want us to believe that the banks’ high levels of borrowing are acceptable because banks are good at managing their risks and regulators know how to measure them. The failures of both were manifest in 2008, and yet regulators have ignored the lessons.

If banks could absorb much more of their losses, regulators would need to worry less about risk measurements, because banks would have better incentives to manage their risks and make appropriate investment decisions. That’s why raising equity requirements substantially is the single best step for making banking safer and healthier.

The transition to a better system could be managed quickly. Companies commonly rely on their profits to grow and invest, without needing to borrow. Banks should do the same.

Banks can also sell more shares to become stronger. If a bank cannot persuade investors to buy its shares at any price because its assets are too opaque, unsteady or overvalued, it fails a basic “stress test,” suggesting it may be too weak without subsidies.

Ben S. Bernanke, chairman of the Federal Reserve, has acknowledged that the “too big to fail” problem has not been solved, but the Fed counterproductively allows most large banks to make payouts to their shareholders, repeating some of the Fed’s most obvious mistakes in the run-up to the crisis. Its stress tests fail to consider the collateral damage of banks’ distress. They are a charade.

Dodd-Frank was supposed to spell the end to all bailouts. It gave the Federal Deposit Insurance Corporation “resolution authority” to seize and “wind down” banks, a kind of orderly liquidation — no more panics. Don’t count on it. The F.D.I.C. does not have authority in the scores of nations where global banks operate, and even the mere possibility that banks would go into this untested “resolution authority” would be disruptive to the markets.

The state of financial reform is grim in most other nations. Europe is in a particularly dire situation. Many of its banks have not recovered from the crisis. But if other countries foolishly allow their banks to be reckless, it does not follow that we must do the same.

Some warn that tight regulation would push activities into the “shadow banking system” of money market funds and other short-term lending vehicles. But past failures to make sure that banks could not hide risks using various tricks in opaque markets is hardly reason to give up on essential new regulations. We must face the challenge of drawing up appropriate rules and enforcing them, or pay dearly for failing to do so. The first rule is to make banks rely much more on equity, and much less on borrowing.