Banks Hate Banks, Voters Hate Banks: Hear the People Singing!
We're going to stick with Financial Reform for a while because so much has happened in the last week, and even more importantly, because it's such an important, even critical, issue. In some ways, though not all, Financial Reform is the single most important domestic policy challenge after stimulating the economy. Healthcare Reform as well as Education, Energy and Innovation are probably more important in the long-run but to get there we need to have a healthy, reliable and effective Finance Industry. Setting aside the natural anger that almost all of us feel about the last two years, which should be counter-balanced by the fact that we all rode the gravy train for the last three decades, we've concluded that the policy and business cases for not reforming Finance do NOT hold up, and in fact are completely contradicted by the facts and the economic history. But, like almost every other major policy initiative, we're now having to pay the Piper for that three decades party, before he comes to collect with claymore in hand. 
Take a few minutes to listen to this BNN clip from the founder of a Canadian securities firm who sounds about like the rest of us on the banks, but starts with discussing his recent trip to Afghanistan and the level of public dedication displayed as well as the level of progress. Then close the loop....what a compare and contrast between the Financiers and those troops. You might also want to check out Andrew Sorkin on Charlie Rose (go to the site, go to the archives and scroll down) and this recent PBS Special on Brooksley Born and futures regulation. Among other things Sorkin uses a key phrase - "tone deaf". What's happening to the Industry is something that they refused to see coming because they figured it was business as usual. On that topic Ms. Born's history should give you a bit of the history involved.
The Vicious Cycle of Malfeasant Financial Engineering
The last post went into some length on why the business models are broken and why the case(s) for leaving the Industry un-regulated don't hold up as well as pointing to support from an interesting range of commentators, from Greenspan to Volcker to Mervyn King of the Bank of England. In the accompany graphic we've tried to summarize those arguments and put them into the context of the bigger economic picture.
The top box summarizes the key economic policy goals that we must succeed at, no ifs, ands or buts, if we're going to stabilized the economy, get it growing again and re-create a healthy long-term outlook for us all. A healthy and product Financial sector is vital to all of them, but is key to #6 and IS #7!
Continued ...
The righthand box summarizes several of the critical arguments we concluded the last post with on what a contributory organization has to do to be a constructive member of society. We are after all a large and complex society that would be unable to function without our large organizations. In other words effective organizations that make a positive contribution, are well-run and, at minimum, do no harm to society, are inescapable to our meeting those goals. How would you grade the Finance Industry on those topics (please feel free to review the last post again)? We'd offer up our grades but there's nothing below an F and somehow that seems inadequate for an Industry that almost collapsed Western Civilization.
It also seems in adequate for an Industry that's taking advantage of public funds and support programs to create giant trading profits to pay bonuses when there's no demonstrable positive contribution. In fact we could even argue that paying those bonuses when, at minimum, they should be used to shore up the capital of the banks is essential. The lefthand box summarizes our findings from the last post, and all the readings excerpted there, on where the Industry has failed us. The bottomline is that an argument for bonuses because it's essential to an efficient and effective industry doesn't hold up very well.
The Economic Outlook
Martin Feldstein was recently interviewed on BNN, the Canadian Financial News network, about his take on the industry and regulation in two parts. Wrapped around his comments in part two are his comments on the state of the economy and the outlook, and he's not very sanguine. In fact he sees a weak recovery with serious downside risks for another downturn without government support. Now as it happens he's NOT as strong on controlling bonuses and risk-taking as we are but we'd argue that he hasn't looked at those issues as carefully as we have, or in much depth. In fact it'd be interesting to have him or his team at the NBER take a look at the issues. You can see Part 1 of his interview by clicking on the highlights.
In fact while you're at it here are some other BNN interviews that are directly and specifically relevant on the state of the economy, the challenges we've still got ahead of us and the Industry reaction to regulatory reform. Rather than leave you entirely in suspense it struck as fascinating and encouraging that the industry business experts also supported reform. The sooner the better, too!
Dallas Fed President Richard Fisher
The president of the U.S. Federal Reserve Bank of Dallas says he sees the beginnings of an "inventory correction" in the U.S. economy. But, Richard Fisher also says a recovery is going to be "tough slog". He spoke with BNN's Howard Green in this exclusive interview. Part 1 and Part 2
Reaction to Fed Statement on Compensation
The Obama administration's pay czar released a report calling for big cuts in executive pay at companies that have yet to repay TARP loans. Paul Bagnell reports and BNN speaks to Scott Talbot, senior VP, government relations, The Financial Services Roundtable.
The Optics of Executive Pay
BNN investigates executive pay with Christopher Chen, regulatory lead, executive compensation, Hay Group.
We trust from the opening clip to the Rose and PBS programs to our own arguments plus the BNN interviews and reporting we've made a sufficiently strong case for why this is critically important? Feel free to write your Congressman. In fact, please do!
Just in case we haven't you'll find a rather extensive reading except collection after the jump that is at least worth skimming IOHO, starting with an excellent Jim Jubak column on how badly broken the banks are in their traditional lines of business and where they're making their profits. Plus some stories that back up the "Malfeasant" part of the title, readings on compensation and some more on the need for structural reform. The final section on the readings is on Capitalism and its future - we particularly recommend them here. It turns out we're fighting another Cold War here.
Several years ago a Marine Archeology team explored Kublai Khan's "Divine Wind" fleet that invaded Japan in the 13thC. What they found is that many, if not most, of the ships were built to hugely sub-par standards. Partly because they were rushed but mostly because the Mandarins in charge grafted off the public funds for their own purses. Who says History doesn't repeat itself!================================================================
First Reading
Why big banks hate banking There have been no obituaries. No eulogies. No burial services. But this quarter marks the death of traditional banking at the big money-center banks. Yes, we've seen amazing earnings reports
from the likes of Goldman Sachs (GS, news, msgs) and JPMorgan Chase (JPM, news, msgs) this quarter, but their profits came from things like trading. From everything, in fact, but what you and I -- and certainly the preceding generation -- called banking. And it's exactly those huge profits from everything but banking that have put the final nail in the big banks as banks. Goldman Sachs and JPMorgan Chase and maybe Bank of America (BAC, news, msgs) and Citigroup (C, news, msgs), too, will survive as financial institutions. But they won't be banks. The model for what these big financial institutions will be is laid out in the most recent quarterly earnings reports from Goldman Sachs and JPMorgan Chase. Goldman Sachs, for example, blew through Wall Street projections when it announced third-quarter earnings of $5.25 a share, more than a dollar above the Wall Street consensus. Revenue climbed to $12.4 billion for the quarter, more than double Goldman's $6.04 billion in revenue in the third quarter of 2008.Not bad for a recession, eh?
Stories from the Bleeding Edge
If Lenders Say ‘The Dog Ate Your Mortgage’ FOR decades, when troubled homeowners and banks battled over delinquent mortgages, it wasn’t a contest. Homes went into foreclosure, and lenders took control of the property. On top of that, courts rubber-stamped the array of foreclosure charges that lenders heaped onto borrowers and took banks at their word when the lenders said they owned the mortgage notes underlying troubled properties. In other words, with lenders in the driver’s seat, borrowers were run over, more often than not. Of course, errant borrowers hardly deserve sympathy from bankers or anyone else, and banks are well within their rights to try to protect their financial interests. But if our current financial crisis has taught us anything, it is that many borrowers entered into mortgage agreements without a clear understanding of the debt they were incurring. And banks often lacked a clear understanding of whether all those borrowers could really repay their loans. Even so, banks and borrowers still do battle over foreclosures on an unlevel playing field that exists in far too many courtrooms. But some judges are starting to scrutinize the rules-don’t-matter methods used by lenders and their lawyers in the recent foreclosure wave. On occasion, lenders are even getting slapped around a bit.
Reckless strategies doomed WaMu On Sept. 10, 2007, Washington Mutual CEO Kerry Killinger stood before an audience of analysts and money managers and assured them the Seattle-based thrift would come out of the housing slump stronger than ever. WaMu, Killinger told the Lehman Brothers conference, had tightened its lending standards, could access plenty of cash, and was "picking and choosing carefully" when it came to making new loans. "This frankly may be one of the best times I have ever seen for taking on new loans into our portfolio," he said. But even as he spoke, WaMu was a dead bank walking. The company had plunged headlong into the business of making exotic, high-risk home loans, selling many of them to investors but holding onto others; now defaults on those loans were rising, and big investors had lost their taste for them. Almost a year to the day after the Lehman conference, Killinger was fired. Two and a half weeks after that, federal regulators seized WaMu's banking units, effectively euthanizing a 119-year-old institution that had survived the Great Depression and the S&L crisis. After its collapse, Killinger and other leading WaMu executives repeatedly deflected responsibility, saying the company fell victim to a housing slump turned global credit crisis that they foresaw but couldn't outrun. But interviews with former WaMu executives and employees, along with government and internal company documents, reveal a far different picture, one of executives charting a reckless course that doomed the bank:
Class Claims Lender Destroyed Records Bank of America and Countrywide Home Loans destroyed mortgage documents, and "recreate" them by "insert(ing) data as they see fit," to cover up their own failure to keep records - or their fraud - according to a federal RICO class action. "To cover up the servicing mistakes and fraud and misrepresentation in the servicing of a consumer escrow, Defendants 'recreate' letters, insert data as they see fit, and fail to produce the entire HUD complaint form. This way, a consumer is left in the dark about the fraud that occurred to them," the complaint states. Countrywide routinely responded to customers' requests for records by claiming they were "unavailable or destroyed," according to the complaint. Statutory law requires that such records be kept for 5 years, the plaintiffs say. Mortgage servicers have a "statutory duty to send consumers an annual escrow analysis and statement, advising the consumer of their escrow, monthly payment, and how it is calculated based on taxes," the class claims. The information is especially important with an escrow addition to a mortgage, which "throws consumers off," as principle and interest tend to fluctuate. The class is estimated at 10,000. They claim the documents they received from the subprime lender were "incorrect or incomplete." The records allegedly were tailored to cover up misrepresentations, and to "ward off lawsuits such as the instant one." BAC Home Loans is also named in the complaint.
Compensation
Who cares if 'talent' leaves? Critics warn that reining in pay makes it hard to keep talented employees. Hemmed in, institutions like AIG (AIG, Fortune 500),Bank of America (BAC, Fortune 500) and Citigroup (C, Fortune 500) could lose their best people. These firms would then perform even more abysmally, if that's possible, leaving them hard pressed to repay tens of billions of dollars of taxpayer-backed loans. Still, we say Godspeed to this "talent." After all, the traders and suits in the corner offices don't exactly have an unblemished track record. In 2008, Citigroup, BofA and Merrill Lynch (since acquired by BofA) posted a grand total of $51 billion in losses. Yet even as they were running themselves into the ground, the firms managed to pay out more than $12 billion in bonuses -- including 1,606 million-dollar-plus bonuses, according to a report from the New York attorney general's office. "Even a cursory examination of the data suggests that in these challenging economic times, compensation for bank employees has become unmoored from the banks' financial performance," the report said. Meanwhile, it's hard to imagine that defection-hit firms would have a lot of trouble finding qualified replacements in the current job market. And Goldman Sachs' (GS, Fortune 500) charm offensive notwithstanding, it looks like the official response to runaway pay is just starting. The Fed's plan to weigh big banks' compensation plans against their potential for undermining the economy could eventually put pressure on pay at all the big banks. "This could be a game changer," said Simon Johnson, an economist at MIT. "There will be a lot of pressure on them in Congress to stick it to the big firms." But maybe the best reason not to fret about talent flight is one familiar to cubicle dwellers everywhere: just because someone has a big, high-paying job doesn't mean they're good at it. Take Bank of America, for instance. The bank's longtime CEO, Ken Lewis, unexpectedly announced his retirement this month, while agreeing to give back his 2009 salary. Lewis didn't say why he was leaving, but it seems that criticism over his empire building, mishandling of the Merrill acquisition and outsize pay got to him. The Charlotte Observer reported he had grown tired of the "mud being thrown on him day by day." Another helping or two of that mud could be just what Wall Street needs.
Bank pay crackdown Washington launched its biggest offensive yet against Wall Street pay practices Thursday, taking aim at everyone from senior executives to high-flying traders of complex securities. Leading the charge was the White House, which outlined a series of drastic pay cuts for 136 top executives at the nation's biggest bailed-out companies, including AIG (AIG, Fortune 500), Citigroup (C, Fortune 500) and Bank of America (BAC, Fortune 500). Separately, the Federal Reserve proposed a review of pay practices at 28 of the nation's largest banks to make sure employees are not tempted to make the kinds of risky bets that helped sink firms such as Lehman Brothers.
Range of Firms Alter Pay Policies Companies as diverse as Polo Ralph Lauren Corp. and Sysco Corp. are adopting executive-pay plans that echo principles laid out by government regulators, potentially signaling a broad shift in compensation practices. The changes at these non-financial firms aren't a direct response to moves by Treasury pay czar Kenneth Feinberg and the Federal Reserve, which apply to banks and big recipients of government bailout funds. The recession, more than government regulation, is driving some of the moves. But companies for a while have been seeking ways to reward executives' long-term performance and limit excessive risk-taking, according to compensation consultants. "We are at the tipping point" for eliminating big annual bonuses, outsized severance agreements and other traditional pay practices, said James F. Reda, managing director of his pay consultancy in New York. Among the changes: more stock-based compensation, with longer waiting periods before it can be sold; higher performance hurdles for bonuses; and limits on perks, severance and supplemental pensions. The shifts are far from universal. Some experts say bank-pay limits are having little impact elsewhere in corporate America. "I don't see any trend in that direction," said George Paulin, chairman and chief executive of Frederic W. Cook & Co., a pay consultancy.
Why Do Bankers Make So Much Money? A tenet of economics is that in competitive markets there are no economic rents. That is, people get fairly paid for their efforts, their capital input, and for bearing risk. They are not paid any more than is necessary as an incentive for production. In trying to understand the reason for the huge pay scale within the finance industry, we can either try to justify the pay level as being a fair one in terms of the competitive market place, or ask in what ways the financial industry deviates from the competitive economic model in order to allow economic rents. No one expects competitive levels of compensation when there are deviations from a competitive market. In what ways might the banks – and here I mean the largest banks and those banks that morphed over the past year from being investment banks – fall away from the model of pure competition? One way is through creating inefficiencies to keep competitive forces at bay. Banks can do this, for example, by constructing informational asymmetries between themselves and their clients. This gets into those pages of small print that you see in various investment and loan contracts. What we might call gotcha clauses and what the banks call revenue enhancers. And it also gets into the use of complex derivatives and other “innovative products” that are hard for the clients to understand, much less price. Another way is to misprice risk and push it into other parts of the economy. The fair economic payoff increases with the amount of risk taken. If a bank takes on more risk it should get a higher expected payoff. If the bank can get paid as if it is taking on risk while actually pushing the risk onto someone else, then it will start to pull in economic rents. The use of innovative products comes up again in this context.
Structural Reform
Do not ignore the need for financial reform, The philosophy that has helped me both in making money as a hedge fund manager and in spending it as a policy oriented philanthropist is not about money but about the complicated relationship between thinking and reality. The crash of 2008 has convinced me that it provides a valuable insight into the workings of the financial markets. The efficient market hypothesis holds that financial markets tend towards equilibrium and accurately reflect all available information about the future. Deviations from equilibrium are caused by exogenous shocks and occur in a random manner. The crash of 2008 falsified this hypothesis. I contend that financial markets always present a distorted picture of reality. Moreover, the mispricing of financial assets can affect the so-called fundamentals that the price of those assets is supposed to reflect. That is the principle of reflexivity. Instead of a tendency towards equilibrium, financial markets have a tendency to develop bubbles. Bubbles are not irrational: it pays to join the crowd, at least for a while. So regulators cannot count on the market to correct its excesses. The crash of 2008 was caused by the collapse of a super-bubble that has been growing since 1980. This was composed of smaller bubbles. Each time a financial crisis occurred the authorities intervened, took care of the failing institutions, and applied monetary and fiscal stimulus, inflating the super-bubble even further. I believe that my analysis of the super-bubble offers clues to the reform that is needed. First, since markets are bubble-prone, financial authorities must accept responsibility for preventing bubbles from growing too big. Second, to control asset bubbles it is not enough to control the money supply; you must also control credit. The best known means to do so are margin requirements and minimum capital requirements. Currently they are fixed irrespective of the market’s mood because markets are not supposed to have moods. They do, and authorities need to counteract them to prevent asset bubbles growing too large. Third, since markets are unstable, there are systemic risks in addition to the risks affecting individual market participants. Participants may ignore these systemic risks, believing they can always sell their positions, but regulators cannot ignore them because if too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or a collapse. Fourth, financial markets evolve in a one-directional, non-reversible manner. Financial authorities have extended an implicit guarantee to all institutions that are too big to fail. Withdrawing that guarantee is not credible, therefore they must impose regulations to ensure this guarantee will not be invoked.
Bill in works to let US dissolve failing firms House Democrats and the Obama administration are preparing to introduce major legislation aimed at eliminating the devil's choice the government faced last fall, when officials felt forced to decide between spending billions of dollars to rescue some of the nation's most powerful financial firms or letting their failures sink the economy. The lawmakers and Treasury Department officials labored over the weekend to finish drafting legislation that would empower the government to seize troubled firms other than banks that are deemed "too big to fail." The legislation would set up the Federal Reserve to oversee the largest financial firms, and eliminate the agency that regulates thrifts. The officials said the measure could be unveiled as soon as Tuesday. The proposal comes as debate intensifies over how far the government should go in restructuring the financial system, and it follows House action last week toward creating a consumer protection agency to oversee lending practices. Republicans on the House Financial Services Committee have remained skeptical of granting the government power to wind down or bail out large, non-bank financial institutions. In July, they proposed creating a new chapter in the bankruptcy code to deal with such troubled firms, saying it would make for a smoother, fairer process. Concerns have also deepened in Congress, among Republicans and some Democrats, that the program could amount to a permanent bailout fund and reduce private market discipline by being too generous to creditors of failed firms. Despite such differences, the problem is clear to all sides: Banks got so big that federal officials could not let them fail without risking catastrophic consequences for the economy. During the crisis, the government arranged mergers that pushed troubled banks into the arms of more stable firms. Big firms got even bigger. Senior officials now worry that these financial behemoths could return to the reckless behavior that led to the crisis, reasoning that federal officials will clean up any mess. Frank has made clear that he expects the new proposals will be contentious. Last week, after his committee had voted to create the new consumer financial protection agency, he was asked whether the most difficult and divisive part of regulatory overhaul was behind him. Frank didn't hesitate. "I think the resolution authority is probably the hardest to do," he said.
Re-thinking Markets and Capitalism
Death of “Soul of Capitalism”: Bogle, Faber, Moore Jack Bogle published "The Battle for the Soul of Capitalism" four years ago. The battle's over. The sequel should be titled: "Capitalism Died a Lost Soul." Worse, we've lost "America's Soul." And, worldwide, the consequences will be catastrophic. That's why a man like Hong Kong contrarian economist Marc Faber warns in his Doom, Boom & Gloom Report: "The future will be a total disaster, with a collapse of our capitalistic system as we know it today." Has capitalism lost its soul? Guys like Bogle and Faber sense it. Read more about the soul in physicist Gary Zukav's "The Seat of the Soul," Thomas Moore's "Care of the Soul" and sacred texts. But for Wall Street and American capitalism, use your gut. You know something's very wrong: A year ago, too-greedy-to-fail banks were insolvent, in a near-death experience. Now, magically, they're back to business as usual, arrogant, pocketing outrageous bonuses while Main Street sacrifices, and unemployment and foreclosures continue rising as tight credit, inflation and skyrocketing federal debt are killing taxpayers. Yes, Wall Street has lost its moral compass. It created the mess, but now, like vultures, Wall Streeters are capitalizing on the carcass. They have lost all sense of fiduciary duty, ethical responsibility and public obligation. Here are the Top 20 reasons American capitalism has lost its soul:
Converting the Preachers "Large swaths of economics are going to have to be rethought on the basis of what's happened." So said Larry Summers, President Obama's chief economic adviser, in an interview in the weeks after the markets crashed a year ago. Yet to a remarkable degree, economic thinking hasn't changed very much at all. Now financier George Soros is announcing a $50 million effort to speed things along. This week Soros is gathering some of the leading practitioners of the market-skeptic school, who were marginalized during the era of "free-market fundamentalism," among them Nobelists Joseph Stiglitz, George Akerlof, Michael Spence, and Sir James Mirrlees. He's also creating an "Institute for New Economic Thinking" to make research grants, convene symposiums, and establish a journal, all in an effort to take back the economics profession from the champions of free-market zealotry who have dominated it for decades, and to correct the failures of decades of market deregulation. Soros hopes matching funds will bring the total endowment up to $200 million. "Economics has failed not only to predict and explain what happened but has also failed to protect society," says Robert Johnson, a former managing director at Soros Fund Management, who will direct the new institute. "That's what the crisis revealed. The paradigm has failed. There is no guidance." It might be tempting to dismiss all this as a war of words among brainiacs. It's not. The critical issues being discussed in Washington about the future regulation and control of the financial industry—the very nature of Wall Street and the health of the economy—depend on this battle of ideas. What led to wholesale deregulation in the '90s and '00s wasn't just Wall Street lobbying money. It was also that key legislators and policymakers, among them Larry Summers, persuaded themselves that deregulation was sound economics and good policy, and that markets and Wall Street institutions could take care of themselves. Many of those views have been discredited by the crisis. But in the absence of a new paradigm of economics, confusion still reigns in Washington. With no new concept of the proper role of government and regulation in the economy, of the proper balance between the markets and their minders, the old school still dominates. Exhibit No. 1: the late Hyman Minsky, a bushy-haired dissident at the University of California, Berkeley, and Washington University who saw into the heart of financial-market mania perhaps more deeply than anyone else. Minsky's "Financial Instability Hypothesis," which he developed in the '60s, held that success in financial markets always breeds its own instability. The longer a boom lasts, the less market players consider failure a possibility; as a result, careful borrowing, lending, and investment inevitably give way to recklessness and speculative euphoria. Margins and capital cushions come to be seen as unnecessary. At a certain watershed point—sometimes called a "Minsky moment"—the foreordained collapse begins. The most speculative bets crash, loans are called in, asset values plunge, and the downward spiral feeds on itself. That's what happened over the last two years. Minsky was in effect filling in many of the intellectual blanks left by John Maynard Keynes on the critical question of how financial markets affect the "real" economy. Nonetheless, an assessment of Minsky in 1997, a year after he died, concluded that his "work has not had a major influence in the macroeconomic discussions of the last thirty years."