Firestorm Flaring up: Finance Reform, Compensation Wars & Sausages (Update)
Not to rush you along too fast but we thought we'd re-visit our previous posts on regulatory reform
of the Finance Industry. Understanding the state of play AND the business performance of the Industry per se are important for their own sake. In fact this post should be considered as another deep dive into the state of the industry and as a case study. It's also important for several other reasons. One of course is the question of how viable investing in the Financials is. But because the industry is the ecology of the Markets it is systemtically important and influences how the entire economy does. It also controls how well you own investment does. This is particularly important, as we've been covering in multiple posts, because the old ideologies of Efficient Markets and Asset Allocation are being fundamentally re-visited. The long and short of it is that discussing reform touches Business Performance, Markets and Investments and the Economy! We will observe however that this famous painting, "The Scream", originally done to express the anxieties of the early 20thC, pretty well captures most folks feelings about the Industry. Which means, of course, that the pressures for reform are mounting. Which we'll discuss but pay attention!
Market Performance as Indicator
Let's start with a benchmark by looking at the stock performance of the Industry and its sectors YTD. We use the XLF ETF as a proxy for the industry as a whole while SPDR ETF's for various sectors including Banks, Regional Banks, Capital Markets, Insurance and Mortgage Finance are also shown.
As you can they all moved pretty much together into, through and after the March Madness when everybody thought the world was collapsing and the Financial Sector was going to end. Thank goodness for the Stress Test - it's called Animal Spirits, as in the world's not ending. The recovery continued for everybody thru mid-May on the back of earnings surprises (told you we'd close the loops) that turned out on examination to be a lot poorer quality than you'd hope.
Then things changed. The Regionals and Mortgage guys took some big hits as the size and scope of the CRE problems became more apparant. And as the up and downs of Housing optimism waxed and waned as well, though they both climbed back in the ballpark to keep playing with tre other teams. Since then the Regionals have re-deteriorated a bit as reality starts to set in.
The other important differentials ae with the Big Banks, the Investment Houses and Insurors. Strangely enough the Banks did relatively well but the real differential performer has been the Insurance Sector. Oddly enough the Investment folks haves slightly under-performed - it looks like performance actually matters a bit and some horses run faster than others. Of course which ones are important questions.
Continued ....
Financial Reform and Reactions
For a while there with the news that bonuses were going to be paid but would be extremely large there were multiple stories per day in the business press. Given that some of those bonuses were as large or larger than those paid during the decade of the leveraged financial boom that's pretty surprising. One might even use the word outrageous - lots of folks have.
Now we've covered the elements of reform several times in multiple posts as taking repeated deep dives on the financial business as a business over the last couple of years. So many times that we've collected all the prior posts into essay collections which, taken as a whole, are a pretty complete portrait, assessment and diagnosis of the industry. Pointers to the URL addresses for those collections are in the readings. If you're in the Industry, an investor or just concerned as we all should be we strong suggest getting them and reading them. The net net is that the old business models are broke and not coming back. But the business doesn't believe that, thinks business as usual is coming back and is pushing as hard as possible against reform. AND the culture is still locked into the last three decades view of bonuses and excess compensation. It'll be interesting to see what happens.
As it happens both the House and Senate, with strong support and enouragement from the Administration, are moving huge bills forward as we speak. One of the best surveys of the consensus views of what needs to be done is one Geithner gave at a recent SIFM conference, during an interview by Charlie Rose. Rose also interviewed Dimon who was, overall, very supportive of those arguments but pushed back where his ox was being gored. Rose has changed his web site so you just go to www.charlierose.com and scroll the exclusive archives to find them.
The Case For Reform
We think the case for reform is overwhelming on several counts. But if you cast your minds back to the late '90s there was an interesting situation where Brooksley Born, of the CFTC, tried to change te rules of the game to level the playing field. She was squashed by some major players, including folks who are again in the arena, because they were all drinking they Koolaid. They have since recanted, as has almost everybody. Except Lloyd Blankfein who thinks they are still doing "God's Work" of course. We'll see how this ends up but we're going to get something, it's going to be big and a bigger change, comprehensively, than anything we've seen since the 1930's. And let's not forget the Pecora II commission that's busy beavering away in some back rooms.
It's well worth listening to the entire PBS Special on The Warning, or so we think. You can find the web page for the whole effort HERE. If you want to take a deeper dive on the political sausage-making and the state of play, as well as the big picture implications and debates may we point you to: The Beginnings of a Great Debate: People Singing, Politicians Making Sausage.
Here the People Singing
In the essay collections plus previous posts digging into the Industry, its performance as a business and its influence and impact on the overall health of the economy we go into some detail about the business case for business as usual. So let's just summarize our findings:
1) Financial Industry malfeasance almost destroyed the economy, brought on Great Depression 2.0 and might have collapsed Western Civilization.
2) The collective and cumulatively losses of the last couple of years wiped out most of the last decades's profits, even though they were all funny money in the first place. In other words the Industry almost destroyed itself. It's in their own best interests since obviously they can't be allowed to play without adult referees.
- NB: the bonuses that the Industry started paying itself grew exponentially starting in the '80s, accelerated in the '90s and turned into a bubble in the '00s. And put compensation completely out of line. There is no evidence that those bonuses contributed positively to the health of society. In fact all the evidence is the other way.
3) Post de-regulation in the '80s we began almost three decades of wild indulgence in debt and over-consumption that loaded up the Industry, the consumer and business with leverage that we couldn't sustain.
4) That debt caused savings to drop to nothing and severely retarded investment and economic growth.
5) The lack of economic growth led to a relatively stagnant economy with poor job creation and flat to declining wages and benefits. And that, in turn, has led to an increasingly stratified society where the top 1% of earners, strangely enough somewhat concentrated in the Finance Industry, to garner all of the gains of the last three decades.
When a society, historically, spends more effort on rent-seeking and power elites focus their careers on rule manipulation then it eventually succumbs to sclerosis and dies. Just ask the farmers and peasants who harvested all the wood on Easter Island and destroyed the ecology just to keep making giant statues for the Chiefs.
Sadly though the mood of things is pretty well captured by the song "Here the People Singing" from Les Miserables. The real problem is that the Industry had an opportunity to both fix itself AND to collaborate on re-shaping the regulatory framework in a constructive fashion. But has refused to do so. The evidence for helmet laws and adult referees to make sure the game is played according to the rules seems to be overwhelming.
UPDATE: an interesting summary of the last "Lost Decade" and the triumph of a terrible culture and the consequences for the rest of us:Farewell to Wall St.'s decade of hubris
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Table-setting Pieces
Inside the Meltdown BNN gets a behind the scenes analysis of the U.S. economic meltdown with Andrew Ross Sorkin, columist, New York Times, and author, "Too Big Too Fail". Part 2
Farewell to Wall St.'s decade of hubris As 2009 winds to a close, we bid good riddance to a decade on Wall Street that we can sum up with just one word: Hubris.Hubris is defined as haughty behavior by people who are arrogant enough to think they might rank up there with the gods. It's a bad attitude that inevitably leads to a fall.It's the perfect word for a decade in which Wall Street experts and company chiefs told us they knew what was best for our money while proving they knew very little.And that's giving the benefit of the doubt to many titans of profitless dot-coms, CEOs of shell companies such as Enron and WorldCom, and the Wall Street geniuses who engineered the credit crunch. No doubt more than a few of them knew exactly what they were doing to us. A decade ago, historians debated what to call these years -- the '00s, the Oughts or the Zeros. For investors, it's been the less-than-zero decade.It kicked off at the most boisterous phase of the tech bubble, just before the Nasdaq Composite Index ($COMPX) reached a dizzying peak of 5,132 in March 2000. In 2002, the index bottomed at 1,114. Nearly a decade later, it still sits almost 3,000 points below the peak. In between the busts, investors saw a steady stream of collapses and scandals:
Goldman Says "Sorry" And The World Moves On In recent months, Goldman Sachs made a good run at becoming The Most Hated Company In The World. How? By nearly going bust last fall, getting a cash bailout from the taxpayer, immediately denying that it ever needed any help, and then minting so much money over the next twelve months that it will pay 2009 bonuses in excess of $20 billion. A couple of weeks ago, Goldman CEO Lloyd Blankfein then compounded the problem by going on a PR offensive in which he said Goldman was doing "God's work." Goldman does provide a lot of valuable services, but it's hard to imagine in what universe they would deserve that description. First, Lloyd Blankfein thanked the government publicly for its help. And then, yesterday, he apologized for some of Goldman's actions in recent years. In addition, Goldman - with a helping hand from Warren Buffett - announced a $500 million charitable project to assist 10,00 small businesses. Americans are very forgiving. As long as public figures (and firms) express gratitude for help and contrition for perceived wrongs, Americans are happy to move on. Americans also love winners--and Goldman is a major winner. So we--and our guest Howard Lindzon, CEO of StockTwits--expect that the Goldman hatred has passed its peak and that the world will now move on.
Oh, So That Is God's Work Today's New York Times has an encouraging article about the things that Goldman Sachs is doing to cleanse its image as a greedy and destructive force in the U.S. economy and society. Apparently Warren Buffett is teach their senior team a bit of humility, or at least how to feign it. This is all old news, but I can't stop thinking about the comparison between how the Rolling Stone described Goldman versus how CEO Blankfein did (a statement that got him in big trouble, by the way). I am really trying to avoid the temptation to engage in mindless bashing of Goldman Sachs as I have met many people from the company I admire and in many ways it is splendidly managed company. But the thing that gnaws at me can be gleaned from the Kurt Vonnegut poem that was published in The No Asshole Rule and that I have reprinted on this blog, called Joe Heller (read it here). When people act if no matter how much money, status, goodies, and other material goods pile-up, it is never enough for them, I start to squirm. I am glad that Goldman is reaching out to help small business , offering some 3% of their 16.7 billion in bonuses to do so. That is a start. My gut feeling is that something closer to 50% would be more appropriate --- especially for the top 100 or so people in the firm. But I think they ought to read Vonnegut's poem, as it is a message they need to hear -- especially at a time when over 10% of the U.S. workforce is unemployed, most of whom shelled-out tax money to help save Goldman and their ilk from their own greed, arrogance, and misleading statements -- a new government report rebukes their claim that they didn't much benefit much at all from the massive AIG bailout (see this story in the Wall Street Journal). I am glad that Goldman is starting to grovel a bit and is giving a bit more back after their arrogance failed them, but I would I think they owe their fellow Americans more than a lousy 3%. I know they will be paying whopping taxes on all this money, but for me, they need to do more to help all those people who saved their ass.
Pathology of a Crisis The coroner’s report left no doubt as to the cause of death: toxic loans.That was the conclusion of a financial autopsy that federal officials performed on Haven Trust Bank, a small bank in Duluth, Ga., that collapsed last December.In what sounds like an episode of “CSI: Wall Street,” dozens of government investigators — the coroners of the financial crisis — are conducting post-mortems on failed lenders across the nation. Their findings paint a striking portrait of management missteps and regulatory lapses.At bank after bank, the examiners are discovering that state and federal regulators knew lenders were engaging in hazardous business practices but failed to act until it was too late. At Haven Trust, for instance, regulators raised alarms about lax lending standards, poor risk controls and a buildup of potentially dangerous loans to the boom-and-bust building industry. Despite the warnings — made as far back as 2002 — neither the bank’s management nor the regulators took action. Similar stories played out at small and midsize lenders from Maryland to California.What went wrong? In many instances, the financial overseers failed to act quickly and forcefully to rein in runaway banks, according to reports compiled by the inspectors general of the four major federal banking regulators. Together, they have completed 41 inquests and have 75 more in the works.Current and former banking regulators acknowledge that they should have been more vigilant.Many bank examiners acknowledge they were lulled into believing the good times for banks would last. They also concede that they were sometimes reluctant to act when troubles surfaced, for fear of unsettling the housing market and the economy.Then as now, banking lobbyists vigorously opposed attempts to rein in the banks, like the 2006 guidelines that discouraged banks from holding big commercial real estate positions.
The AIG report Big financial institutions are a small club, with a shared interest in sustaining the system. Ever since the days of JP Morgan it has been standard practice, in times of crisis, to get major players together in a room and get them to forgo short-term profit maximization on behalf of the industry interests. It happened in the Panic of 1907; it happened in the Latin American debt crisis of the 80s; it happened in the LTCM bailout, which was financed by private firms, not the feds.Also, individual banks are in a long-term relationship with the public and the government. They have an interest in preserving that relationship. The Epicurean Dealmaker offers an imaginary speech that Tim Geithner an anonymous government official could have given:
[T]hose people and institutions in this room which did not help us, which put their own narrow personal and corporate interests before the interests of this nation and its people, will be remembered as well.And let me tell you something, gentlemen, banker to banker: you do not want to be on that list. That list will be a world of pain. That list will be Death.
Indeed. Bear Stearns famously refused to participate in the rescue of LTCM — and it’s widely believed that the lingering bad feelings from that exercise in free riding had a lot to do with the firm’s demise last year.So could the feds have negotiated a haircut? Yes. It might not have been that much money, but it would have had a lot of symbolic importance. And that matters. Brad DeLong says that the loss of public trust due to the kid-gloves treatment of bankers has raised the probability of another Great Depression, because the public won’t support another round of bailouts even if it becomes desperately necessary. I agree — but I think the bigger cost is that we’ve greatly increased the chance of a Japanese-style lost decade, with I would now give roughly even odds of happening. Why? Because bank-friendly policies have squandered public trust in all government action: try talking to the general public about stimulus, and it’s all confounded in their minds with the deeply unpopular bailouts. By itself, the AIG story would be damaging enough. But it’s part of a pattern — and that pattern has ended up undermining the economy’s prospects, big time.
Comp and Reg Wars: Finance vs Society
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?
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.
Re-thinking Compensation and Culture
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.
Record Bonuses Return to Wall Street as Big Three May Award $29.7 Billion Goldman Sachs Group Inc., Morgan Stanley and JPMorgan Chase & Co.’s investment bank, survivors of the worst financial crisis since the Great Depression, are set to pay record bonuses this year. The firms -- the three biggest banks to exit the Troubled Asset Relief Program -- will hand out $29.7 billion in bonuses, according to analysts’ estimates. That’s up 60 percent from last year and more than the previous high of $26.8 billion in 2007. The money, split among 119,000 employees, equals $250,400 each, almost five times the $50,303 median household income in the U.S. last year, data compiled by Bloomberg show. The three will award more in stock and defer more cash payments under pressure from regulators to tie pay to long-term results, compensation experts said. They may still face public wrath over the size of bonuses after the government injected capital into all the major financial institutions following Lehman Brothers Holdings Inc.’s collapse in September 2008. “Wall Street is beginning to resemble Clark Gable as Rhett Butler in the film ‘Gone With the Wind’: ‘Quite frankly, my dear, I don’t give a damn,’” Paul Hodgson, a senior research associate on compensation at the Portland, Maine-based Corporate Library, said in an e-mail. “It doesn’t seem as if even political threat, disastrous PR, envy, rising unemployment rates and home repossessions is enough. Bonuses for employees in fixed income will likely jump the most, 40 percent to 45 percent, while employees in asset management may see no growth in their year-end bonuses, according to a report from Options Group, a New York-based executive search and compensation consultant firm. Average bonuses for employees at financial firms worldwide will rise about 35 percent to 40 percent this year, according to the annual report, which is set to be released this week. They will still remain below 2007 levels after dropping an average of 40 percent to 45 percent last year, the report said.
Regulatory 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.
Geithner urges prompt action on financial overhaul Treasury Secretary Timothy Geithner is pushing Congress to move quickly in overhauling the nation's badly flawed financial rules, which he says is essential for the health of the economy. Both the House and Senate are making progress toward revamping the current regulations, but Geithner said a rapid conclusion is needed to keep the economic recovery on track. Both the House Financial Services Committee and the Senate Banking Committee are working on their own versions of sweeping overhaul plans. But the two panels are taking sharply divergent approaches in some areas. Both proposals also face sharp opposition from major sectors in the financial industry, casting doubt on how quickly Congress will be able to reach agreement and send a finished bill to the White House. Geithner said a key principal the administration wants to see adopted is ensuring that firms not be able to escape or avoid oversight by shopping for the most lenient regulator, a situation critics say contributed to the worst financial market crisis in seven decades. "The fact that investment banks like Bear Stearns or Lehman Brothers or other large firms like AIG could escape meaningful consolidated federal supervision simply by virtue of their legal form should be considered unthinkable from now on," Geithner said. Another key principle the administration wants to see approved by Congress is to make sure the financial system as a whole is more capable of absorbing shocks and coping with failures. Geithner said this will require putting a greater focus on the quality of capital that firms are allowed to hold.
Re-Thinkings: Capitalism RIP?
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."
Readings and References
The Broken Finance Industry: Credit, Crisis, Collapse and Broken Business Models The credit crisis of 2007-2008 that metastasized into a collapse and nearly caused Great Depression 2.0 was largely created by broken business models based on bad practices, malfeasance, excess leverage and synthetic, structured investment products. We've all learned the hard way that the Finance Industry is more than just another industry but impacts us all. By looking back, perhaps in anger and certainly in dismay and puzzlement, we can understand more about how this all came to pass. And, as a result, more about what to expect because all of these problems remain with us. If you'd like to get a better understanding of how broke the Industry is and what the consequences are this is a place to start.
The Broken Finance Industry II: Crisis, Adaptation, Innovation and Value? The Finance Industry brought itself and us to the brink of disaster thru bad practices and poor management. But effective capital markets are vital to the health of the economy. Now we need to consider what's broke, how to fix and how govern the Industry for its own benefit and the health of society.
Facing the Firestorm: Finance Industry, Popular Anger and Re-regulation The Finance Industry appears to have returned to profitability on the back of public funds and government support programs. Its refusal to acknowledge that debt is leading to a tidal wave of initiatives for regulatory and legislative reform which will be made worse by a refusal to constructively cooperate. Society needs a productive Finance Industry and will get it either voluntarily or otherwise. The Industry's refusal to see these pressures will make things more difficult than necessary, but are unavoidable without leadership and a sense of social responsibility.
The Corporation vs Society: Performance, Social Responsibility and the Win-Win The unfettered free market was supposed to bring enduring prosperity but recent history shows that markets and participants are not self-regulating. In fact markets require an institutional framework to work, publicly responsible behavior by participants and appropriate regulatory frameworks to balance private gain with public welfare. The results are better performing markets that are sustainable.
The Chinese Goldsmith, Finance and the Next Big Fight The last several months have seen partisan fight after partisan fight in Washington, often leaving us average citizens as innocent bystanders or even collateral damage, or so it seems to many people. Now we've been focused on the Healthcare Reform fight and the debate on Afghanistan. The big fight you may be missing is the one over Finance Industry Reform. It was back-burnered because of the urgency and importance of immediate business, e.g. saving the country from economic collapse, but is moving center stage. Like many of the stakeholders in HC Reform those in Finance have been fighting to water down the bill but in this case with less justification, if possible, more smoldering anger among the public and, with this week's announcements. The Industry argues that the last two quarters of monumental bonuses are right, proper, the way they do business, indicate a return to health and good for the economy and country. The country's mood is probably captured by the cartoon collage but just in case were wondering how angry people are check out this video clip from Dylan Rattigan's Morning Meeting. The question is who's right?