We've been plowing thru various aspects of the Finance Industry and it's outlook as well as the 
broader socio-political context since the end of January. Starting with a broad overview and then tunneling down into specific sectors outlook. The AIG firestorm led to or was associated with a look at the broader context. No business or other institution can exist other than on the sufferance of society, and if it does not contribute value to that society it will be changed - one way or another. That makes it a fundamental management responsibility of any business to be aware of broader socio-political trends and problems and to act proactively to intercept or correct them. If nothing else by anticipating problems and acting to support broader policy responses to problems beyond the industry's immediate ability to cope with. Judging from the remarks of the new Citi CEO the Finance Industry gives new meaning to phrase tone-deaf. Now that some of the details are leaking out we've found out that in the President's recent meeting with key CEOs he basically said, "we're the last thing between you and the pitchforks". We're tempted to put up the "Can You Hear the People Sing" graphic and URL again but hopefully the point is still relatively fresh in your minds, as it appears not to be in the minds of the industry.
The real question is now what ? Mike Mayo (cf. the readings) as well as Meredith Whitney came out yesterday and said in effect to short the Financials. Advice we heartily agree with because there is no function or aspect of the industry that doesn't appear to be broken. From internal execution capabilities to strategy to broader socionomic positionings. The really sad thing is that it doesn't have to be this way. During the 1980s we were all the beneficiaries of major value-creating innovations from money market funds to reasonable de-regulation to discount brokers to mutual funds. In the '90s that innovation evolved into internal financial engineering rather than value-creation and in this decade it clearly metastasized into value-destroying, on both the business, industry and social levels, "innovation". To survive, recover, return to profitability and restore it's place as a valued part of the system the Industry needs to realize these firestorms will rage and change everything.
Drucker Principles and Finance Futures
As we've worked our way thru an analysis and assessment of the broader impacts and consequences of the finance industry we've ended up depending quite a bit on Peter Drucker's insights on the major performance criteria for business value creation. The graphic at right is a summary of one interpretation combined with our earlier framework of the major sectors of the industry. But let's start by quoting Drucker (p. 369, "Management: Tasks, Responsibilities, Practices"):
"Essentially being a member of a leadership group is what traditionally has been meant by the term "professional". ...as a member of leadership group a manager stands under the demands of professional ethics - the demands of an ethic of responsibility. [A professional] is public in the sense that the welfare of his client sets limits to his deeds and words. And Primum no nocere, "not knowingly to do harm," is the the basic rule of professional ethics. There are important areas where managers still do not realize they have to impose on themselves the responsibilities of the professional ethic. The manager ho fails to think through the and work for the appropriate solution to an impact of his business because it makes him "unpopular in the club" knowingly does harm. That this is stupid has been said. That this always in the end hurts the business or industry more than a little temporary "unpleasantness" would have hurt has been said too. But it is also gross violation of professional ethics".
We trust Prof. Drucker's points are crystalline ? Just to compress and paraphrase them the actions of the industry are harmful, counter-productive and are going to lead to a massive social backlash that's entirely justified by the facts of the situation and the necessities of society. Remember if you do not create value society has NO reason to tolerate you. If in fact you destroy value and massively harm society it cannot even afford to tolerate you. In the graphic we've tried to depict the relative performance on the Drucker Principles of each of the major lines of business with the caveat that there is no multiple-red color to properly represent the behavior of the securities related business and the damage caused.
The Theory of the Case
When a logician or lawyer is looking for the core, fundamental argument that drives the entire rest of a complex chain of argument they talk about the "Theory of the Case". We've come to think that's a nice, powerful, description of how to think about a business. That is to ask "what is the theory of the case ?". In other words what's really going on here, what are you going to do about it and why are you convinced and convincing that value-creating performance will result. So far all we've heard from the Industry has been denial, rear-guard defensive actions and what can only be described as "forlorn hope" attacks. Nowhere have we seen anybody stepping up to present the theory of the case for the immediate crisis let alone for the necessary future timeframes. Instead they're leaving leadership to Washington, speaking for society. And Washington is indeed stepping in to fill the vacuum. But the policy-makers and politicians know they aren't experts and would more than likely welcome constructive engagement that looked to the greater good of society as well as the industry. Not just continuing defenses of egregarious compensation packages. 
Observations, Suggestions and Opportunities
We aren't so bold ourselves as to make detailed suggestions just yet but we would like to make some observations and suggest some trial balloons. Across the entire spectrum of banking and financial services, including banking per se, consumer finance, SMB finance, financial companies, investment services and advisory services we think the basic business model and strategies of the future will have to deal with several key factors:
1. The industry will be significantly de-leveraged.
2. A focus on customer service, putting the customer's interests ahead of the firm's, will create value and ultimately a differentiating competitive advantage.
3. Fariness and value for compensation need to be fundamental principles of operation.
4. Innovation in new value-creating services and capabilities needs to be the driving strategic manatra of the new industry.
5. Survival, recovery and effective innovation need to be based on effective and principled management systems.
Which leads to some strawmen suggestions for financial innovations just to get the ball rolling:
1. Hedge-like funds for small investors to be able to cope with a low-return, topsy-turvey world.
2. Non-opportunistic (i.e. non-exploitative and with non-exorbitant interest rate) consumer finance and credit cards.
3. Securitized business finance based on deep understandings of fundamentals AND loanee re-payment capabilities. For example trade finance could be greatly expanded and help out the growth of the global economy.
4. Micro-finance in the inner city.
5. Ratings mechanism reforms coupled with performance insurance and/or bonding.
6. Localization of financial services where branch offices and staff truly return to being local in their knowledge and connections. This could be coupled with a "franchising" approach to combine the economies of scale of large institutions along with superb local knowledge.
7. Merchant banking for small companies in the best, "ye olde English" sense of informed investment in serious business opportunities. For example in green energy, bio-tech, etc.
8. Operations-based investing based on business fundamentals for the Private Equity sector.
9. Macro-monitoring and advisory services to help with budgeting, capital planning, expense control and general business planning.
SEE CHANGES: Glimmers of Hope, Honesty and Re-Thinking
The industry is faced with some very stark choices: Cooperate (go along with unavoidable policy changes just to survive), Collaborate (become pro-actively involved in shaping that policy) or Cave (be plowed under and constrained for decades by the popular anger at the violations of the public trust). The financial firms you want to be investigating and investing in are the ones that satisfy the Drucker principles AND have clear responses on the "Theory of the Case" on all timeframes for all lines of business.
So far we haven't seen any. Let's hope that that's just our lack of information access and not the reality. Otherwise a vital and important industry will do itself and us irreperable harm !
UPDATES: Nothing like good timing. As we were putting up this post it turns out Lloyd Blankfein was giving a truly stunning speech in Washington that finally acknowledges the public responsiblities of the Finance Industry, in detail. In particular he supports almost point by point the major elements of the Geithner Plan as well as the call for greated worldwide regulatory over-sight coming from the G-20 meeting. His speech got widespread, rapid and, dare on say, shocked coverage from a wide range of the commentariats. You can find some of this in the readings as well as a a valuable assessment from Steve Perlstein of the WaPo highlighting the need for fundamental cultural change. Our collective bottomline is that we consider all the points we've been making in this post and it's predescessors to have been supported by perhaps the leading executive in the Industry !
There is, btw, an enormous collection of readings after the break that we highly recommend you at least skim. Judging from the readership stats that hasn't been the case but there's quite a collection surveying the evidence behind the points we're making !
UPDATE2: Just ran across a fabulous oped from the WSJ on Wall St. cultural breakdowns that both fits nicely with our overall theme and serves as the perfect counter-point to Blankfein's Mea Culpa. The point being this - external and internal structural changes are vital but UNLESS THE STREET CHANGES IT'S CULTURE....IT'S CULTURE WILL BE CHANGED.
Updates on Industry Trends & Sectors
Mike Mayo's Seven Deadly Sins(CNBC) Former Deutsche Bank analyst Mike Mayo says bank loan losses will exceed the Great Depression, reports CNBC's David Faber.
Brokerages Tighten Hedge Fund Financing Brokerage firms are reducing financing and other services to hundreds of hedge funds, in a move that could accelerate the shakeout among these heavy-hitting investors. Under financial pressure, securities firms are dividing their hedge-fund clients into lists of those they consider best able to weather the financial turmoil and those they're less sure of. The result is that more funds may have to merge, find other financing at higher cost or close. The squeeze, described by a range of brokerage-firm and hedge-fund officials, takes different forms. For instance, they say firms have reduced financing for the flagship fund run by John Meriwether, a founder of Long-Term Capital Management, the fund whose near-collapse caused a brief market crisis in 1998. The move has forced Mr. Meriwether's Relative Value Opportunity fund -- down 42% in 2008 -- to reduce its borrowing to finance trades, putting pressure on returns. Mr. Meriwether, whose firm is called JWM Partners LLC, declined to comment. But Wall Street banks have put 200 or more other funds on what might be called B-lists: funds seen as either too risky -- because they could fold -- or not profitable enough to the banks. The moves reflect a sharp reversal. For years, banks competed hotly to draw hedge funds to their "prime brokerages," which handle securities trading and lend clients money. Now prime brokers are in retrenchment as their parent banks reel from losses and take care not to take undue risk in lending out their cash. Hedge funds' short-term trading has made them a major force in financial markets, influencing prices of assets from stocks to oil, but their clout is slipping as some post big losses. Their assets have fallen to about $1.4 trillion from $2 trillion in mid-2008, according to the firm Hedge Fund Research. Hedge funds closed at a record pace last year, with around 1,300 liquidating, the firm says. The shakeout could lead to continued instability in the financial markets in the near term as troubled funds sell assets. Longer term, fewer hedge funds could mean lower financial-market volatility, since the funds tend to be such rapid traders.
January Hedge Fund Rally Is Short-Lived Hedge fund performance took a turn for the worse in February by reversing January’s gains last month, according to Hennessee Group, a hedge fund advisory firm. The Hennessee Hedge Fund Index, which tracks the performance of more than 3,500 hedge funds, dropped 0.78% after posting gains of 1.1% in January. Despite the reversal, the index outperformed the broader market indices; last month, the S&P 500 declined about 11% while the Dow Jones Industrial Average lost just under 12%. “Hedge funds were flat the first two months of the year, while equity markets have declined almost 20%,” says Charles Gradante, co-founder of Hennessee Group. “Hedge funds are doing what they do best—preserving capital in down markets and generating alpha by managing exposures and perceptive stock selection.” According to Gradante, hedge fund managers are increasingly seeking opportunities in the corporate and high yield credit markets in an attempt to bolster returns using less risk. "The pervasiveness of this credit theme in long/short equity portfolios is probably the most prevalent theme since we saw long/short equity funds buying credit default swaps (CDS) back in 2006. The CDS trade turned out to be one of the best performing trades for equity funds in 2007," he said in a statement. Hedge fund declines have been exacerbated by massive investor redemptions, which subsequently triggered many fund managers to impose gates, which limit the amount of withdrawals from a fund. The industry has been reeling from this cycle for months, and according to Gradante fund managers will continue selling to raise capital to meet some redemptions. Investors, however, are finding other ways to access liquidity. For instance, they have increasingly been turning to auctions where investors can purchase fund interests in the secondary market at a discount to NAV, Gradante says. The benefits, he adds, are that investors gain immediate access to liquidity and hedge fund managers have less pressure to sell securities to fund redemptions.
Top Hedge Fund Managers Do Well in a Down Year The financial crisis may have turned much of Wall Street’s wealth into dross, but a select group of hedge fund managers has managed to maintain a golden touch that might make King Midas blush. As major markets and economies careened downward last year, 25 top managers reaped a total of $11.6 billion in pay by trading above the pain in the markets, according to an annual ranking of top hedge fund earners by Institutional Investor’s Alpha magazine, which comes out Wednesday. James H. Simons, a former math professor who has made billions year after year for the hedge fund Renaissance Technologies, earned $2.5 billion running computer-driven trading strategies. John A. Paulson, who rode to riches by betting against the housing market, came in second with reported gains of $2 billion. And George Soros, also a perennial name on the rich list of secretive moneymakers, pulled in $1.1 billion. Of course, their earnings were not unscathed by the extensive shakeout in the markets. In a year when losses were recorded at two of every three hedge funds, pay for many of these managers was down by several million, and the overall pool of earnings was about half the $22.5 billion the top 25 earned in 2007. The managers’ compensation, which was breathtaking in the best of times, is eye-popping after a year when hedge funds lost 18 percent on average, and investors withdrew money en masse. “The golden age for hedge funds is gone, but it’s still three times more lucrative than working at a mutual fund and most other places on Wall Street,” said Robert Sloan, managing partner of S3 Partners, a hedge fund risk management firm. “But this shouldn’t pop up on the greed meter. They made money. That’s what they’re supposed to.” In an interview, Mr. Paulson — whose lofty 2008 earnings were down from the $3.7 billion that Alpha estimated he earned in 2007 — said his pay was high in large part because he is the biggest investor in his fund. In fact, he said he receives no bonus. The pensions, endowments and other institutions that invest in his fund do not mind the hefty cut of profits he and his team take, he said. Even as the spotlight intensifies, these hedge fund managers and others who made it through last year with cash on hand are the sort of investors the federal government hopes will step in and buy troubled assets from banks. The richest managers are also in the best position to take advantage of the distressed environment to build their wealth. “The guys who own the future are the guys like John Paulson and the others on the Alpha list,” said Keith R. McCullough, the chief executive of Research Edge, a firm in New Haven that provides trading analysis for hedge funds. “Ironically enough, we’re going to go beg for capital from the very people we’ve been trying to vilify.”
Mezzanine Debt Loses Its Shine With Investors In the fading years of the commercial real-estate boom, mezzanine debt was all the rage among yield-chasing private-equity firms and hedge funds like Fortress Investment Group LLC, Fillmore Capital Partners LLC and Petra Capital Management LLC. Today, for most, mezz is a four letter word. Firms made an estimated $50 billion to $75 billion in mezzanine -- dubbed "mezz" -- loans, debt that fills the gap between the borrower's equity and the first mortgage. Billions of dollars already have been lost and the figure is likely to balloon as the steep downturn in the commercial-property market deepens. The losses are sending shock waves through the rough-and-tumble world of office buildings, shopping centers, hotels and other commercial properties, which are only now facing the full brunt of the recession. Mezz debt was one of the biggest culprits that enabled commercial real-estate investors and developers to participate in the broader speculative binge on Wall Street. Now mezz investors are suffering a massive casualty rate with some mezz funds facing total losses. Almost all the firms that specialized in the once-promising investment are spending their days fighting with borrowers to salvage some of their loans while defending themselves against creditors who financed their operations.
Absolute return shortlist is very short The private banking industry may have come in for criticism in the past year, but a high-profile awards committee has still managed to find a series of UK wealth managers it believes worthy of merit. However, Ermitage Global Wealth Management, the winner in investment performance: absolute return category of the annual Pam awards, was the only firm to be shortlisted in this field. James Anderson, chairman of the panel, said the category, introduced to take account of the increased use of hedge funds and other “so-called alternatives” in portfolios, had been a “major disappointment” in 2008. “These so-called non-correlated assets turned out to be perfectly correlated by leverage,” he said.
Laggards Get the Boot Small investors aren't the only ones fuming about the poor performance of stock pickers at mutual funds. So is the U.S. life-insurance industry, and it isn't just fuming -- it's boosting the role of index-based investing in the funds it offers to buyers of variable annuities. Insurers offer a menu of funds to investors in variable annuities, a tax-advantaged form of investing that has been popular with baby boomers in recent years. Many of those funds have underperformed the major stock indexes, at great cost to the insurers. That's because over the past few years, life insurers increasingly have sold these annuities with minimum-return and other performance guarantees that kick in when the stock market falls. The insurers use risk-management programs, including hedging, to mitigate their exposure to market declines, but costly gaps surfaced at many insurers as stocks slid last year -- and poor picks by fund managers made a bad situation worse. The bottom line: Industrywide, issuers of performance guarantees took charges against earnings totaling $1 billion to $2 billion in the fourth quarter because of the weak performance of actively managed funds, according to the companies, consultants and analysts. That's just a piece of the overall cost of the minimum-return guarantees to the insurers. All told, the several dozen insurers who sell the guarantees had to boost their reserves and capital last year by more than $15 billion, analysts say, to show regulators they can make good on their promises to investors should markets not rebound. But it's a piece the insurers can control -- by ditching some funds run by stock pickers and offering investors more funds with index-based strategies, including exchange-traded funds, analysts and consultants say. While stock pickers try to outsmart the markets, managers of index funds and most ETFs aim to match the performance of broad markets or their sectors, by building portfolios of the stocks that make up the various indexes.
Off Balance For years, the financial advisers at Bingham, Osborn & Scarborough LLC have religiously followed the age-old tenet of "rebalancing" for their clients. But last year, they gave it a pass. Rebalancing basically involves trimming investments that have run up in price and adding to those that have declined, thus bringing a portfolio back to its target asset allocation. By doing so, the investor ideally is selling high and buying low. So, in declining stock markets, it means buying stocks, and maybe trimming bonds or other investments that have gained value. That is what the advisers at Bingham, Osborn & Scarborough did in the bear market early this decade. But after the market caved last autumn, advisers felt that, by adding stocks, they would be catching a falling knife, as the Wall Street term goes. Since December, "we've made an active decision not to do that," says Bill Urban, the 56-year-old co-managing principal at the firm. Mr. Urban typically rebalances client accounts when allocations drift more than five percentage points away from their targets. But by last summer, he was already letting some client portfolios drift further. In the fall, he and his colleagues became concerned about where stocks were headed. And clients were becoming very nervous about rebalancing. So, the advisers made a firm-wide decision to hold off. Jennifer Ellison, 37, a principal at the firm, says that in order to go back to adding stocks, the advisers would first need to see signs of stabilization in the housing market and in the financial sector, as well as more clarity about where company earnings are going. The portfolio has a 3% allocation to a commodity fund, Pimco ChommodityRealReturn Strategy fund. The advisers started investing in commodities about two years ago, with the goal that it would provide a hedge in an economic downturn. "But they didn't," Mr. Urban says, referring to the fact that commodity prices went down in 2008 just like stocks and some bonds. "We're going to have to revisit the use of that," he says, "because it didn't do what we would have hoped it would have done in this down market."
Private Equity Difficult Period (CNBC)Buying opportunities are not yet overly attractive and investors should be more analytical when thinking about spending in the U.S., says Scott Sperling, THL Partners co-president.
Reflections and Strategic Responses
Michael Steinhardt Conversation Many people believe that hedge funds are villains and that they should be regulated. If you look back at the experience of hedge funds, they have not been responsible for any problems in the economy today. When the hedge fund genre started there was an unstated principle that the reason to invest in hedge funds was that they would achieve superior performance -- both pre- and post- their egregious fees. I lived my 29 years as a hedge fund manager in anxiety because I was one of the few people in the financial world who received such egregious fees and I felt that to deserve them I had to be the best or near the best performing money manager in America. Over time that feeling in hedge funds evaporated. You have said that there comes a time in business cycles when lots of people, fearful about investing, buy Treasury bonds and that then you could buy stocks with your eyes closed and make money. Is this cycle different? Yeah, I have to say I think it is. Because it seems as if this moment is a moment when the sins of the past are being paid for. The excesses of the last 10, 20 years are catching up with us. When you think about the innovations of the last 20, 30 years, one of them was something called private equity. I hear that [Treasury Secretary Timothy] Geithner is going to use private equity as one of the sources of money for his bank plan. But what is private equity? A wise guy getting some money and buying a public company and taking it private and doing all sorts of cutesy things and taking it public again. What does he do? I don't know. Something always seemed funny to me about that. There's something unholy about it. There is something somehow unproductive about the thing.
Manager’s long term philosophy pays off with soaring assets In the current bleak environment it is not unusual for fund management companies to pass the milestone of £1bn of assets under management. Unfortunately, most of these houses will be passing this barrier in the wrong direction as their assets are assailed by the twin forces of sliding markets and net redemptions.However, Veritas Asset Management, based in London and Zurich, has managed to buck that trend with its assets rising above the £1bn mark this year, thanks to a series of mandate wins. Interestingly, at a time when portfolio turnover in the fund industry has risen to unprecedented levels, as FTfm reported last week, Veritas partially attributes its success to its long-term investment philosophy.“High turnover, high volatility, following the latest momentum play, that is a very fast way of losing money,” says Charles Richardson, chief executive of Veritas UK and manager of its global equity income fund. Yet, according to Financial Express, a data company, portfolio turnover for UK open-ended funds has jumped from 30 per cent to 90 per cent in the past two years. “Unfortunately in today’s environment, practising genuine long-term investment has become extremely difficult. Speculation and short-term trading strategies have come to almost completely dominate as investment horizons have become ever shorter,” says Andy Headley, head of research and manager of the flagship Global Focus fund. “In the 1960s the average holding period of publicly traded US stocks was six years, in the 1990s it was slightly over two years whereas in the current decade it has declined to about one year. Not only do such short holding periods imply higher costs but they also imply that speculators now dominate markets. “Holding a business for one year is not aligning yourself with the long-term economic fortunes of that business but is purely speculation based on price movements and emotion.”
A chance for bankers to refocus their talents Take a look, for example, at some fascinating recent research by Thomas Philippon and Ariell Reshef, two US-based economists, on human capital and wage trends in the 20th century banking and non-banking worlds. This analysis suggests that between the 1930s and early 1980s, pay and skill levels in finance were roughly comparable to those in the rest of the business and professional world. However, from the early 1990s, pay and skill levels soared until by 2006 bankers were earning 1.7 times what other comparable business employees took home. No wonder graduates flocked to finance. But – more interestingly – the research also shows that an almost identical rise in the wage and skill levels of finance workers relative to other business spheres was also seen in the 1920s. It was only in the late 1930s, or after the Wall Street crash, that banking pay and skills fell to levels comparable with other industries (where they stayed for almost five decades). That has two intriguing implications. First, it suggests that the ability of finance to attract smart graduates this decade had little to do with the inherent challenge of the technology of modern finance. After all, CDOs – and “rocket scientists” – did not exist in the 1920s. Instead, Philippon blames extreme deregulation, or a bubble. But second, the data also suggest that if history now repeats itself – i.e. banking becomes a tightly regulated, low-margin business – then the relative skills and pay of bankers could stay low for years. The next decade, in other words, could look like the 1950s or 1960s, when bankers’ remuneration differed little from everyone else’s.
Fund industry must prepare for period of radical change Today's financial crisis is producing ever higher unemployment, investment losses, and home foreclosures. People now recognise that the unthinkable is thinkable, be it in the banking system or in the real economy. Yet some big structural changes, that are about to play out, have not as yet attracted sufficient attention - including the approaching shrinkage and consolidation of the industry that provides investment management services to individuals, companies, pensions, and governments round the world. Two distinct yet inter-related drivers are at work. First, collateral damage from the largely self-inflicted war within the banking system which, as I noted in an earlier FT column, is gradually transforming banks into "utilities". Second, the desire by governments to impose a peace by de-risking and re-regulating finance, lest today's crisis morphs again - and this time into a global depression that would negate the progress that the world has made in the last 10 years to improve living standards and alleviate poverty. These factors will inadvertently result in a considerable but uneven shrinkage of the investment management industry during 2009 and 2010. This unintended consequence will be felt most intensely in the levered (or "alternative") space dominated by hedge funds and private equity firms; but it will spread well beyond that to traditional investment managers, particularly in the equity space and among those that are part of declining banking conglomerates. The alternative sector faces a perfect storm. These once prominent pools of capital are finding it harder to secure financing lines from banks. It is also proving harder for them to raise longer-term funds through bond issuance and initial public offerings. The alternative sector's reputation has been harmed by the restrictions (or "gates") that some have placed on investors seeking to pull money out. Meanwhile, poor investment performance for some, and asset value erosion for many more, have shrunk collections from management and incentive fees. It would come as no surprise if at least half of the entities in this space were to disappear in the next two years, either through mergers or failures. What does that mean for investors? The implications go well beyond another phase of pressure on asset prices. As difficult as it already is, it is no longer sufficient for investors just to come up with the right asset allocation and responsive risk management; they must also undertake more rigorous assessment of investor managers to ensure investment and business models are sustainable. To do so, investors should look for firms that remain profitable and, equally importantly, are playing defensively upfront so that they can play offensively later in a sustainable fashion. They should also look for firms that are positioning their business to take advantage of some big strategic and human resource opportunities that will arise as others stumble.
From Bubble to Depression? How can one crash that wipes out $10 trillion in assets cause no damage to the financial system and another that causes $3 trillion in losses devastate the financial system? In the equities-market downturn early in this decade, declining assets were held by institutional and individual investors that either owned the assets outright, or held only a small fraction on margin, so losses were absorbed by their owners. In the current crisis, declining housing assets were often, in effect, purchased between 90% and 100% on margin. In some of the cities hit hardest, borrowers who purchased in the low-price tier at the peak of the bubble have seen their home value decline 50% or more. Over the past 18 months as housing prices have fallen, millions of homes became worth less than the loans on them, huge losses have been transmitted to lending institutions, investment banks, investors in mortgage-backed securities, sellers of credit default swaps, and the insurer of last resort, the U.S. Treasury. What we've offered in our discussion of this crisis is the back story to Mr. Bernanke's analysis of the Depression. Why does one crash cause minimal damage to the financial system, so that the economy can pick itself up quickly, while another crash leaves a devastated financial sector in the wreckage? The hypothesis we propose is that a financial crisis that originates in consumer debt, especially consumer debt concentrated at the low end of the wealth and income distribution, can be transmitted quickly and forcefully into the financial system. It appears that we're witnessing the second great consumer debt crash, the end of a massive consumption binge.
Regulatory Re-structurings, Culture Change, Innovation
Global banking is in turmoil. The worst financial crisis since the second world war has not only forced governments across the western world to step in and rescue giant institutions. Amid the turmoil, there has also been a tectonic shift in banking’s centre of gravity. A decade ago, a list of the world’s largest financial institutions was dominated by banks from the US and UK. Today, just four of the top 20 have their headquarters in the US, still the world’s largest economy. HSBC, at heart an emerging markets bank, is Britain’s sole representative. After writing off more than $1,000bn (€734bn, £691bn) on complex debt instruments and raising hundreds of billions of dollars in fresh capital, many banks have watched their market value shrink to a fraction of its level at the peak of the boom. Looking back 10 years, the banking industry in early 1999 was still dusting off the debris of the previous autumn, when the Asian economic crisis and near-collapse of Long-Term Capital Management in the US left some banks nursing large losses. Though few recognised it at the time, however, the industry was at the beginning of an eight-year growth spurt that would ultimately bring the world financial system to the brink of collapse. The most striking are the fallen. Citigroup, which dominated the landscape for most of the past decade, now languishes at the bottom of the list and is in effect under government control. Lloyds TSB is now too small to register after its ill-judged rescue of HBOS. New names have meanwhile arrived as if from nowhere. This is partly a reflection of shifting economic power: China’s three big banks dominate the rankings after joining the stock market in 2006 and 2007. Australian and Brazilian banks have also risen to prominence. But the shifting composition also offers evidence of how well different countries have managed their financial systems. Canada, for example, has been praised for its risk-averse approach to regulation. A decade ago, no Canadian bank made the list. Now there are five in the top 50. Nevertheless, a comparison of the two snapshots masks the destruction of value since the crisis began. Even relative winners have not fared well: HSBC’s stock market value peaked at $234bn in October 2007. Today it is worth just one- third of that amount. China’s three largest banks have halved in value over the same period. Does the experience of the past decade offer any pointers for banks hoping to thrive through to 2019? On the face of it, there are few strategic lessons to be learnt. A decade of rapacious consolidation has made JPMorgan Chase the world’s largest bank outside China. But Royal Bank of Scotland, which was also aggressively acquisitive, is controlled by the British government and now valued at significantly less than the £20bn ($29bn, €21bn) in fresh capital that the state pumped into the bank last autumn. When the crisis eases and confidence returns, valuations are bound to recover. But regulation will be more muscular and governments more willing to slap down signs of excess.Banks may also be forced to become smaller and more domestic. Taxpayers, who have been shown to be the ultimate guarantors of the financial system, are bound to be less tolerant of global giants whose collapse could overwhelm their home countries’
Geithner to Propose Vast Expansion Of U.S. Oversight of Financial System Treasury Secretary Timothy F. Geithner plans to propose today a sweeping expansion of federal authority over the financial system, breaking from an era in which the government stood back from financial markets and allowed participants to decide how much risk to take in the pursuit of profit. The Obama administration's plan, described by several sources, would extend federal regulation for the first time to all trading in financial derivatives and to companies including large hedge funds and major insurers such as American International Group. The administration also will seek to impose uniform standards on all large financial firms, including banks, an unprecedented step that would place significant limits on the scope and risk of their activities. Most of these initiatives would require legislation. Geithner plans to make the case for the regulatory reform agenda in testimony before Congress this morning, and he is expected to introduce proposals to regulate the largest financial firms. In coming months, the administration plans to detail its strategy in three other areas: protecting consumers, eliminating flaws in existing regulations and enhancing international coordination. The testimony will not call for any existing federal agencies to be eliminated or combined, according to the sources, who spoke on condition of anonymity. The plan focuses on setting standards first, leaving for later any reshaping of the government's administrative structure. The nation's financial regulations are largely an accumulation of responses to financial crises. Federal bank regulation was a product of the Civil War. The Federal Reserve was created early in the 20th century to mitigate a long series of monetary crises. The Great Depression delivered deposit insurance and a federally sponsored mortgage market. In the midst of a modern economic upheaval, the Obama administration is pitching the most significant regulatory expansion since that time. An administration official said the goal is to set new rules of the road to restore faith in the financial system. In essence, the plan is a rebuke of raw capitalism and a reassertion that regulation is critical to the healthy function of financial markets and the steady flow of money to borrowers. The government also plans to push companies to pay employees based on their long-term performance, curtailing big paydays for short-term victories. Long-simmering anger about Wall Street pay practices erupted last week when the Obama administration disclosed that AIG had paid $165 million in bonuses to employees of its most troubled division, despite losing so much money that the government stepped in with more than $170 billion in emergency aid.The administration's signature proposal is to vest a single federal agency with the power to police risk across the entire financial system. The agency would regulate the largest financial firms, including hedge funds and insurers not currently subject to federal regulation. It also would monitor financial markets for emergent dangers.
Kristín Pétursdóttir Conversation What do women hate about the culture of the financial world? The investment banking sector has ultra-masculine values. You have this excessive risk-taking and a short term focus. You have big egos. You have incentive schemes that make people think very short-term: results next quarter, my next bonus. It's a very narrow definition of profits. What about that strikes you as masculine? All of it. Feminine values are different. I'm not saying that it's about men or women; I'm very much saying that you need a balanced approach for long-term thinking. It's not only the financial returns that matter. You also have to think about society, the environment and people. There has also been a lack of transparency in this whole system. I think, in general, women like to have things more transparent. They have a wider definition of success. They place ethics high on the agenda. What do your male family members and friends think about this? People to a large extent agree with me. Women tend to be more risk aware. Not risk averse, but risk aware, meaning that they want to understand the risks they're taking. Do you think there will be a time when equal numbers of men and women go into finance? I hope so. But I doubt it. If that were to happen, we'd have to have some change in the culture. You founded Audur Capital with a female colleague. Do you have male employees? Yes. And the aim is to have good diversity in terms of gender, age and backgrounds. Are they different somehow from the men you used to work with? The men who work here tend to have the same values as we have and believe in the same things. There are a lot of men who agree with and understand our values. So this is not so much of a gender thing, it's more of a value thing. I think in the investment banking sector you tend to have alpha males, who dominate the culture. You have a lot of people who are not the same but somehow they do not go against the culture that's already there. You've said that your firm brings a feminine sensibility to finance. What does that mean? We talk about risk awareness -- that's very key for us. We don't want to earn a lot of money today at the expense of some others having a huge loss tomorrow. We believe in saying things as they are and in transparency. We also believe in the value of emotional capital. It's not only about financial capital. It's also about the human side of everything. You used to be on Iceland's national handball team. Are men and women different when it comes to athletic competition? I think women are competitive as well. I have been in sports a lot and I guess I'm a very competitive person. I think women are competitive but they are less aggressive and often more cooperative. Are you hiring equal numbers of men and women? Absolutely. I'm even hiring more men at the moment because I really want to balance things out, and we were women who started the company. That company, Audur Catpital, is named for a Viking woman. Actually, Audur (EYE-durr) is a female name in Iceland, and one of our foremost Viking women was Audur the Wise. She's a very well-known person. But Audur also means wealth and happiness. So it fits a company like ours. Were her qualities that different from the male Vikings'? I mean, they were all still Vikings, right? She was called Audur the Wise, she was known for her insights, not for her fights or killings. So that may say something.
Where’s the Plan, Wall Street? FOR the last several months, Americans have looked to Washington to lead them. But where’s the leadership on Wall Street? There is an enormous opportunity for a C.E.O. to come forward with a plan to reform the financial system and pledge a change from business as usual. Jamie Dimon, JPMorgan Chase’s chief executive, has been the most outspoken of his peers during the crisis — and has done an admirable job addressing the issues — but he has been more focused on helping instill confidence in the economy and the health of his own firm. John Mack, the chief executive of Morgan Stanley, has shown glimpses of public leadership, at one point apologizing for the crisis by saying, “We are sorry for it.” But the public could particularly benefit today from a forceful voice of reason and change within the industry, proposing how to remake the world of finance in a sensible way, driven not by populism but by practicality and a sense of fairness. It’s worth noting that most Wall Street C.E.O.’s are being advised by their legal and public relations teams to keep their heads down or risk provoking more public outrage. But there is the flip side to that coin: reasoned leadership may generate a reasonable response, helping the industry pre-empt what it fears most — additional government regulation. So in that spirit, here’s a five-point plan to refashion Wall Street. A plan that would be best sold by Wall Street itself.
Global financial crackdown is cost of G20 deal Gordon Brown and his fellow world leaders have pledged the biggest crackdown on tax havens, hedge funds and banks in modern history as the price to be paid for the multi-trillion dollar bail-out of the world economy."The era of banking secrecy is over", the Prime Minister declared, as the Group of 20 leading nations agreed to impose a new range of regulations on banks and non-bank financial institutions as a punishment for contributing to the crisis. Harsh fines and sanctions will be levied on tax havens that refuse to publish details of their accounts; hedge funds will have to provide more detailed accounts in the future; and bankers will have their bonuses more heavily controlled and taxed throughout the world, the communique pledged. The range of new regulations will be implemented by national governments in the coming months, officials said, after the G20 agreed on more significant and far-reaching reforms than had been expected. In what will be interpreted as a victory for the French and German factions, which had emphasised the importance of regulation over new fiscal giveaways, the G20 also ordered the creation of a new Financial Stability Board dedicated to monitoring leverage and inter-connectedness of international financial institutions. US President Barack Obama, who personally helped broker the deal by acting as a mediator between French President Nicolas Sarkozy and the Chinese delegation, said: "We made enormous strides in committing ourselves to a comprehensive reform of a failed financial system. We must put an end to the bubble and bust economy that [obstructed] sustained growth." Among the major agreements by the G20 on financial regulation were:
Greed and Stupidity The second and, to me, more persuasive theory revolves around ignorance and uncertainty. The primary problem is not the greed of a giant oligarchy. It’s that overconfident bankers didn’t know what they were doing. They thought they had these sophisticated tools to reduce risk. But when big events — like the rise of China — fundamentally altered the world economy, their tools were worse than useless. Many writers have described elements of this intellectual hubris. Amar Bhidé has described the fallacy of diversification. Bankers thought that if they bundled slices of many assets into giant packages then they didn’t have to perform due diligence on each one. In Wired, Felix Salmon described the false lure of the Gaussian copula function, the formula that gave finance whizzes the illusion that they could accurately calculate risks. Benoit Mandelbrot and Nassim Taleb have explained why extreme events are much more likely to disrupt financial markets than most bankers understood. To me, the most interesting factor is the way instant communications lead to unconscious conformity. You’d think that with thousands of ideas flowing at light speed around the world, you’d get a diversity of viewpoints and expectations that would balance one another out. Instead, global communications seem to have led people in the financial subculture to adopt homogenous viewpoints. They made the same one-way bets at the same time.Jerry Z. Muller wrote an indispensable version of the stupidity narrative in an essay called “Our Epistemological Depression” in The American magazine. What’s new about this crisis, he writes, is the central role of “opacity and pseudo-objectivity.” Banks got too big to manage. Instruments got too complex to understand. Too many people were good at math but ignorant of history.
The Four Horsemen Of The Athletic Apocalypse(NPR) Manny Ramirez. Terrell Owens. Stephon Marbury. Sean Avery.Each is a highly paid star in one of the four major team sports, and each is, on his own merits, a jerk of the first magnitude who is also locker room poison. Each has been banished by his team — the conclusion being: No matter how good he is, it ain't worth having him around. But, then, this too: Each has been brought back, given another chance to again be a highly paid star — and to again be a jerk of the first magnitude. There are, it seems to me, two lessons here. First, the fact that the teams were prepared to rid themselves of the malcontents, no matter what the cost, may indicate that teams have finally reached a point where the concern for clubhouse spirit and cohesion has been accorded due emphasis. And second: Notwithstanding No. 1, there will always be somebody prepared to hold his nose and write a check for talent. The cases of our Four Horsemen of the Athletic Apocalypse — selfishness, arrogance, narcissism and just-don't-get-it-ism — all at root have to do with how one Boston Red Sox teammate described what Ramirez was to the team: a "cancer."
Inside Obama's bank CEOs meeting The bankers struggled to make themselves clear to the president of the United States.Arrayed around a long mahogany table in the White House state dining room last week, the CEOs of the most powerful financial institutions in the world offered several explanations for paying high salaries to their employees — and, by extension, to themselves. “These are complicated companies,” one CEO said. Offered another: “We’re competing for talent on an international market.” But President Barack Obama wasn’t in a mood to hear them out. He stopped the conversation and offered a blunt reminder of the public’s reaction to such explanations. “Be careful how you make those statements, gentlemen. The public isn’t buying that.” “My administration,” the president added, “is the only thing between you and the pitchforks.” The fresh details of the meeting — some never before revealed — come from an account provided to POLITICO by one of the participants. A second source inside the meeting confirmed the details, and two other sources familiar with the meeting offered additional information. The accounts demonstrate that despite the public comments on both sides that the meeting was cordial, the tone in the room was in fact one of mutual wariness. The titans of finance — men used to being the most powerful man in almost any room — sized up a new president who made clear in ways big and small that he expected them to change their ways. There were signs from the outset that this was a business event, not a social gathering. At each place around the table sat a single glass of water. No ice. For those who finished their glass, no refills were offered. There was no group photograph taken of the CEOs with the president, which typically happens at ceremonial White House gatherings but not at serious strategy sessions. “The only way they could have sent a more Spartan message is if they had served bread along with the water,” says a person who attended the meeting. “The signal from Obama’s body language and demeanor was, ‘I’m the president, and you’re not.’” According to the accounts of sources inside the room, President Obama told the CEOs exactly what he expects from them, and pushed back forcefully when they attempted to defend Wall Street’s legendarily high-paying ways.
'Kind Of Scary': Congress Rewriting Rules Of Finance U.S. Rep. John Campbell readily admits something not often heard from politicians in this economic crisis. When it comes to rewriting the rules of the financial system, the California lawmaker says he's not sure where he stands. "I'm not sure even in my own mind," he says. "If I were king, I'm not sure what I would do at this point. And I don't think I'm alone. This stuff is not easy." Campbell, a Republican on the House Financial Services Committee, says that in many hearings, the Democrats pick their witnesses and Republicans pick theirs. You can ask friendly questions you already know the answers to, or pose hard ones to the witnesses for the other side of the aisle. Usually, he says, you know what you want to hear. Much of the new legislation for banking and investing will be written in the Financial Services Committee. That's prompted some soul-searching for Campbell. "I'm favoring some very tough regulation," he says. Last fall's credit crisis "scared the hell out of me — and I do not want to go through that again."
What the French revolution can teach America Eat the wealthy.” The ferocity of the words used by some demonstrators in London on the eve of the Group of 20 summit evokes the worst excesses of the French revolution. Anti-capitalist anger in the west is not confined to Europe. Alexis de Tocqueville’s The Ancien Régime and the Revolution is as relevant to understanding today’s America as his deep and eye-opening thoughts on the young American republic in his Democracy in America. Of course, America in 2009 is not France in 1788, the year before the fall of the Bastille (the prison that embodied the oppressive nature of the monarchical regime) and the symbolic beginning of the French revolution. The fall of Lehman Brothers in September 2008 has nothing to do with the fall of the Bastille; symbols of wealth should not be confused with symbols of oppression. There is no guillotine around the corner and it would take a lot of imagination to compare President Barack Obama to Louis XVI, or Michelle Obama to Marie-Antoinette. Yet as a European living in America – watching news on television every night, talking to friends, colleagues or my students – I sense fear, anger and a deep feeling of injustice reminiscent of the climate on the eve of the French revolution. Just replace bread shortages with foreclosures, aristocrats with bankers, and privileges such as the right not to pay tax with stock options. Add to that support for the king but rejection of many of his ministers, and the comparison looks less far-fetched. The explosion of populist rage that has accompanied the AIG scandal, amplified by an opportunistic Congress and by media that play to the tune of their audiences when not reinforcing their passions, reflects the depth of suffering in the US. Main Street, like much of France at the end of the 18th century, is outraged. Fear for its own present and future is combined with anger at those it considers responsible, and who are much less affected than they. Are not senior bankers today like the aristocrats of yesterday, their privileges no longer justified by their social functions – to serve the king with their swords or to contribute to the creation and dissemination of wealth? The problem with the economic team of the new president is that, like the court of the king of France in pre-revolutionary times, it has inherited all the bad reflexes of the ancien régime, mixing excessive sympathy for the outdated logic of the world of finance, which it helped to create, with insensitivity to the emotions of the ordinary people, which it tends to ignore. This sympathy is perceived to contrast with the harsh treatment of carmakers. Bankers and financiers have to reinvent not only their trade but also their way of life and, above all, their value system. In the Madoff scandal, just as shocking as the crime of an individual was the behaviour of many of his rich customers, who combined greed with a lack of financial common sense.
UPDATES: Blankfein's Speech and Commentaries
Goldman's Blankfein Calls for Pay Change Goldman Sachs Group Inc. Chairman and Chief Executive Lloyd Blankfein called for broad changes to how Wall Street pays employees and is regulated, saying "the loss of public confidence from failing to live up to the expectations that we created will take years to rebuild." In a speech Tuesday at a Council of Institutional Investors meeting in Washington, Mr. Blankfein said banks and securities firms should agree to basic compensation standards, such as paying "senior people" mostly in stock, meaning their compensation would rise and fall with the success of the firm. Mr. Blankfein also recommended that stock awards be held for at least three years before they could be collected, a move that would rein in excessive risk-taking. "We have to recognize a higher responsibility...to act like an owner responsible for the integrity of the system," he said. Compensation practices, particularly at firms that rapidly lost shareholder value, "look self-serving and greedy in hindsight." Many of the recommendations made by Mr. Blankfein are being adopted or at least considered by some Wall Street firms as they react to public ire over their culpability for the financial crisis and bonus payments that to many Americans seem out of touch with reality. But Mr. Blankfein suggested that lawmakers and regulators might need to force long-term changes in how investment bankers, traders and brokers are paid. "Fixing a systemwide problem, elevating standards or driving the industry to a collective response requires effective central regulation and the convening power of regulators," he said. Wall Street also needs to do a "better job of understanding when incentives begin to work against the social good," he said. Overly lucrative pay packages when times were good and during the times of losses and taxpayer bailouts that followed are "just the exact opposite of the way anybody wants it to be." Despite a conciliatory tone on compensation, the Goldman CEO said Wall Street should fight back on protectionist "salves," such as limiting foreign workers or forcing government-aid recipients to buy U.S.-made products. Regulations should get tougher in bull markets, he added, much like the Federal Reserve tries to keep the economy from overheating, he said.
Pearlstein: Not a Confession, but a Good Start For the past year, as the nation has engaged in a heated debate about how we got into the current financial mess and how we're going to get out of it, there's been one group noticeably missing from the conversation: leaders of the big Wall Street firms. With the exception of the occasional public floggings organized by congressional committees and the quiet off-the-record lunches with newspaper editorial boards, the titans of finance have remained hunkered down in their bunkers. In public, at least, they have declined to accept personal and institutional responsibility for what went wrong, to explain more fully how and why it happened or even to express a simple thank you for the government's extraordinary rescue efforts. At a time when it was most needed, industry leadership has been nonexistent. Until now. In a speech yesterday in Washington to the Council of Institutional Investors, Lloyd Blankfein, the chairman of Goldman Sachs, took the first trip through the public confessional, acknowledging that "the past year has been deeply humbling" for an industry that held itself out as expert but disappointed customers and shareholders by taking actions that "look self-serving and greedy in hindsight." There are some glaring factors, however, that Blankfein, like other Wall Street leaders, tends to overlook. The most important is culture -- in the case of Wall Street, a culture that not only tolerates but almost celebrates taking advantage of customers. Here is an industry in which brokers traditionally get their start making cold calls to strangers, offering bogus stock tips, and investment bankers cut their teeth peddling bad merger and acquisition ideas to corporate clients. It is an industry in which the majority of money managers consistently underperform the broad market averages, analysts and strategists are almost always bullish, and firms rarely run into a security that can't be brought to market. These days, Wall Street is a place where the trading culture has supplanted the investment culture and score is kept on the basis of how many securities a banker or a firm underwrites rather than whether those securities actually turn out as good investments. It's hard for anyone who grows up in an industry to see fundamental problems in its culture. But until Wall Street deals with this blind spot, it is likely to careen from one crisis to another.
New Update:
Twelve Years Down the Drain Anyone who toils in the legal-industrial complex -- better known as Big Law -- should be able to tell you how we got here. Corporate attorneys like me, even those with the eyesight and insight of Mr. Magoo, all should have been able to see this financial collapse coming.The market has lost a dozen years worth of wealth in a matter of months. Millions of hours of manpower put in by investment bankers on Wall Street and the lawyers who enabled them -- the kind that brought home those bright shiny bonuses that are now causing a populist uprising in the hinterlands -- have been wasted away by what is kindly called the credit crisis. And whatever lessons the powers that be might learn from this adjustment -- that salary structure should change, or that the billable hour is an anachronism -- it seems no one has stated the obvious: The whole system is warped. Perhaps money and mortality are all the same to some. But as a way of making the former, this hysterical ER-approach has proved futile. All those lost nights of sleep are now lost 401(k)s. So what was the point? Corporate lawyers could have been sunning in St. Bart's and ended up with the exact same result, plus a tan.The Wall Street atmosphere -- in both law offices and investment banks -- is not open to dissenting opinion. If you blow the whistle, it's only to hail a taxi to take you away, because complaining is just not tolerated. So anyone sharp enough to say that these deals were a bad idea in the first place didn't stay on long enough to make the point. And we all know that organizations that don't retain thoughtful opposing views are doomed by hubris. Hello, Lehman Brothers! Still, I don't believe any of the major players are re-evaluating their ethos -- only their decision to invest in subprime mortgages. And this is foolish, since the problem is not just that the financial instruments were bad bets, but that the corporate structure and the feverish rush of it all are fundamentally flawed.I would love to call the system despicable or detestable or something evil-sounding, but that would be giving it too much credit. It's really just the march of dunces.A dozen years worth of sleepless nights down the drain like dirty bathwater. Pity these people.
charts so you can re-orient yourselves. This is our version of the Great Circle of Life(Business Cycle) which we've taken apart a couple of times before. Consumption is the engine but people's decisions to buy are based on current income and their views on future income and wealth (that future evaluation happens in the black box we've named confidence, which ironically depends on credit - what it really is is a futures evaluation algorithim !). The result of current situation and future expectations is consumer spending, the primary engine of the economy. Business then goes thru a similar current and futures evaluation process, again involving credit decisions, and decides whether or not to invest and hire. In other words investment and employment are lagging variables that will keep going on down much longer until they begin to recover. But Consumers then factor hiring into their evaluations, looking primarily at real wages and employment changes to reach a judgment about prospects and future spending. Right now we're trapped in a vicious feedback loop where bad news begets more bad news. That consumer spending is getting less worse doesn't mean business will begin hiring and buying equipment or buildings any time soon. The real recovery won't start until those start picking up and that's a long...long way away. 
