bizzXceleration: Performance, Value and Profit

 

Where We're At: Impacts and Current Status

Let's start with some charts taken from Mark Zandi, of Economy.com, testimony. Zandi by the way is well respected on both sides of the aisle, was an advisor to McCain and has a reputation for even-handedness.  Starting in the UL corner he tell us that after a near-collapse that government intervention has stabilized the financial markets (under questioning he stated that the Stress Tests this last spring were THE major turning point). At the same time he also said that the markets are far from healthy, using (UR) the bond markets and the level of debt issuance as the critical indicator.

He then went on to point out that it was almost entirely the stimulus package that saved the economy per se from greater collapse and that many of the programs had large and beneficial effects, leading to an estimate of 4% GDP growth in Q4. Yet also worried that the as the impact fades the risks of a W-shaped outcome are serious and would recommend another $200B stimulus follow-on (again, this from a McCain advisor). He also pointed out that (LL) the labor markets were damaged and recovering poorly and would remain in trouble for a long time. Since all that lines up with everything we've been saying for months we thought it was profoundly insightful :)!

What Broke - the Analyst's Perspectives

Interestingly, despite differences in perspective (and one commissioner with an ideological axe to grind) all of the witnesses basically agreed to the same set of problems and breakdowns. Since one of them (Michael Mayo of Calyon Securities) was kind enough to provide charts to back up his diagnosis we borrowed a subset to create this composite. (all the exhibits can be downloaded from the FCIC's web site at www.fcic.gov) Starting in the UL corner he first pointed out that there was an explosion of securities in the 00's AND that the Asset/Equity ratios of the Banks and Securities firms exploded;i.e. they got themselves leveraged to a fare-thee-well (really interesting despite the roots lying in the 80s this didn't explode until this decade).

Moving down the left column that much of that issuance moved from secure instruments to structured products and that this financial engineering drove a huge surge in fees. No self-interest here of course. Moving to the righthand column we see the concentration of this new issuance in real estate trading in one form or another, in which btw, consumers, et.al. were complicit as well - since consumer debt also exploded. The real money chart is the last in the lower r.h. corner - which tells you what happened to compensation in the Finance industry vs. the rest of the economy. So there you have it - graphic testimony to malfeasant greed run amok taking the innovative technology of securitization and metastasizing it this decade to drive fees, profits and bonuses. And, oh yeah, almost collapsing the world. Again - in so many words - everybody including Blankfein, Dimon, Mack and Moynihan (BAC), basically conceded all these points (and a good thing it was the new guy and not Lewis testifying).

The Long-term Strategic Impacts

So what are the long-term consequences? Well if you read our year/decade outlook on the economy, markets and business you've got one set of answers. But we'll go back to Mr. Zandi for his take - remember this is under oath btw. 

Well Mark sees it pretty much as we see it - though if anything he's even gloomier, though he put it more simply and clearly perhaps; and talked more about long-term debt and savings. Nonetheless coming from very different directions we ended up with identical conclusions. 

First off (UL) Consumers took a huge shot to their Net Worth that they will likely never recover and which will cause fundamental long-term damage. Which you can see in the Confidence charts (UR) for businesses and consumers - which despite improvement are still worse than at any time this data shows (NB: the spokesman for regional/community banks said something similar in his own words).

The two really sad, scary and critically important factors are the long-term structural impacts. In the LR you can see the estimate of the long-term impact on GDP growth rates - we're going to be hamstrung for a long time. And in the LL you can what kind of debt financing problem we got saddled with and will take a long time to work out of.

In the readings below we have a very long accumulation of excerpts leading up to the hearings, setting out the background, some diagnosis and recommended resolutions and the impacts. The Commission is chartered to take the year to to reach its conclusions but this will indeed be the year of re-regulation in several forms or the other. 

The Hearings and the Assessment

There's been an enormous amount of criticism of the Administration and Congress for not moving faster on all this to quickly and magically fix it. Of course that's how we got into these problems and the original Pecora Commission didn't reach its end and see new legislation for almost four years. There was plenty else to do this year which should have and did preclude starting hearings on this matters. At the same time now people both have some perspectives and we've seen the Industry's true colors. All in all we don't think things could be better positioned for as good an investigation and re-think as we're ever likely to see. CSpan is carrying the hearings live and also putting them up on its web site. It's at least worth some of your time to listen to the openings (if the Chairman and Vice's statements are on this) but we felt encouraged from the get go, and more so as thing proceeded. This is as qualified a group of public servants as you're likely to get, even considering the political process that brought them there.

During the course of the hearings Zandi summarized the "root causes" in three points:

1) a worldwide excess of savings which created a sloshing surfeit of liquidity that drove down returns and caused people to go crazy looking for any advantage (something we remember saying a few times going back to '03).

2) the over-use and over-exploitation of securitization combined with absolutely terrible under-writing and diligence

3) and a failure of regulation.

He and several others added a fourth multiple times thruout today's hearings as the real root of the root - HUBRIS!

But we'll add a fifth that is the Alpha and the Omega, the ultimate AUM (OM): the failure of corporate governance and performance management. In legal doctrine there is the notion of last clear chance to avert a disaster - well the people who had the first and last chances and who had the fiduciary duty to do so were the executives in charge. And the man who stepped up to that admission was Jaime Dimon, strongly seconded by John Mack.

There were lots of factors, lots of mechanical breakdowns, a triumph of greed and some really terrible regulatory decisions. But the ultimate failure was a mangement failure - opting for malfeasant choices, in both the private and public senses, in the service of greed. Synthetic derivatives were merely the enabler, or one among many.

The results of these hearings are going to frame your life and those of you descendents for decades, just as the originals did. And just as the failures of Financial leadership already have. Like we keep trying to say - the Industry as people keep trying to analyze it ain't coming back!

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Level-setting: Heading into the Hearings

For Top Bonuses on Wall Street, 7 Figures or 8? The bank bonus season, that annual rite of big money and bigger egos, begins in earnest this week, and it looks as if it will be one of the largest and most controversial blowouts the industry has ever seen. Bank executives are grappling with a question that exasperates, even infuriates, many recession-weary Americans: Just how big should their paydays be? Despite calls for restraint from Washington and a chafed public, resurgent banks are preparing to pay out bonuses that rival those of the boom years. The haul, in cash and stock, will run into many billions of dollars. Industry executives acknowledge that the numbers being tossed around — six-, seven- and even eight-figure sums for some chief executives and top producers — will probably stun the many Americans still hurting from the financial collapse and ensuing Great Recession.

• How should Goldman Sachs cover its ass this bonus season?

No Seat for Wall Street at Tea Party Could all those populist pitchforks currently pointed at Washington be turned toward Wall Street instead? That's the question that ought to worry Wall Street executives as they prepare to pay themselves nice bonuses this month, hard on the heels of a government bailout of the financial system, and amid continuing job losses around the rest of the country. Financial firms know they're in for heat on bonuses; they've already been chastised on national TV by President Barack Obama's chief economist. The more searing heat, though, might come not from Washington's corridors of power but from the streets, where disjointed populist armies are starting to organize in the so-called tea-party movement. It's a movement dominated for the moment by mistrust of big government and big government health-care plans. But it's also animated by mistrust of big institutions in general, and a tendency to see those institutions secretly working in tandem to the detriment of the little guy. So it's a short leap from anger at Washington's spending of taxpayer dollars to anger at Wall Street executives saved by those same taxpayer dollars -- and then taking home big bonus checks. Right now, Mr. Phillips notes, Wall Street bonuses aren't the top item in the broad tea-party tent. Most available oxygen is being sucked out by anger over health care. But talk of more economic-stimulus measures surely would revive anger over financial bailouts, he adds. Indeed, anger over Wall Street bailouts was in many ways the spark that brought the tea-party movement to life.

• Populist Anger Is Fueling Bid to Charge Banks
• Cuomo Seeks Data on Bonuses
• Banks Face Fees for Bailout
• Tax on Investment Income Is Weighed

The Other Plot to Wreck America What we don’t know will hurt us, and quite possibly on a more devastating scale than any Qaeda attack. Americans must be told the full story of how Wall Street gamed and inflated the housing bubble, made out like bandits, and then left millions of households in ruin. Without that reckoning, there will be no public clamor for serious reform of a financial system that was as cunningly breached as airline security at the Amsterdam airport. And without reform, another massive attack on our economic security is guaranteed. Now that it can count on government bailouts, Wall Street has more incentive than ever to pump up its risks — secure that it can keep the bonanzas while we get stuck with the losses. It’s against this backdrop that this week’s long-awaited initial public hearings of the Financial Crisis Inquiry Commission are so critical. This is the bipartisan panel that Congress mandated last spring to investigate the still murky story of what happened in the meltdown. Phil Angelides, the former California treasurer who is the inquiry’s chairman, told me in interviews late last year that he has been busy deploying a tough investigative staff and will not allow the proceedings to devolve into a typical blue-ribbon Beltway exercise in toothless bloviation. He wants to examine the financial sector’s “greed, stupidity, hubris and outright corruption” — from traders on the ground to the board room. “It’s important that we deliver new information,” he said. “We can’t just rehash what we’ve known to date.” He understands that if he fails to make news or to tell the story in a way that is comprehensible and compelling enough to arouse Americans to demand action, Wall Street and Washington will both keep moving on, unchallenged and unchastened.

Bank Profits Tripling Leaves Stocks Cheapest With 15% Discount to S&P 500  No U.S. industry has faster profit growth than banks and brokers, and no group is more hated by investors. Analysts say earnings at financial companies rose 120 percent in the fourth quarter, accounting for all of the income increase in the Standard & Poor’s 500 Index, and will triple by 2011, climbing four times as fast as the market. Should the estimates prove correct, the shares are trading at a 15 percent discount to the index, data compiled by Bloomberg show. That’s not enough for money managers burned by the 84 percent drop in the stocks from February 2007 through March and more than 160 U.S. bank failures in the past two years. Financial companies are the least-favored equities, according to a Bank of America Corp. survey of investors with $617 billion in assets that showed 38 percent of 123 money managers are holding fewer shares than are in benchmark indexes. Net interest margin, the difference between what banks earn from loans and pay to depositors, may widen to 3.54 percent in 2010, the highest level since 2003, according to forecasts for the 173 lenders followed by New York-based KBW Inc. That may not last, according to Baring Asset Management Inc.’s Hayes Miller, who recommends holding fewer shares of U.S. banks before Fed Chairman Ben S. Bernanke winds down emergency programs to damp concern inflation will accelerate as the economy picks up.

Bank CEOs: We Underestimated Crisis Wall Street executives said Wednesday they underestimated the severity of the 2008 financial crisis and apologized for risky behavior and poor decisions. They also defended their bonus and compensation practices to a skeptical commission investigating what caused the collapse. Americans are furious and "have a right to be" about the hefty bonuses banks paid out after getting billions of dollars in federal help, the commission's chairman told chief executives of four major banks, all survivors of the deepest and longest recession since the Depression. As the hearings opened before the Financial Crisis Inquiry Commission, chairman Phil Angelides pledged "a full and fair inquiry into what brought our financial system to its knees."The panel began its yearlong inquiry amid rising public fury over bailouts and bankers' pay. "We understand the anger felt by many citizens," said Brian Moynihan, chief executive and president of Bank of America. "We are grateful for the taxpayer assistance we have received."

• Wall Street CEOs Admit Missteps  Wall Street's biggest banks acted like used-car salesmen knowingly selling lemons to consumers, the head of a commission investigating the financial crisis said Wednesday, as top bank executives came under fire on Capitol Hill. Former California State Treasurer Phil Angelides kicked off the first of two days of hearings with an aggressive exchange with Goldman Sachs Group Inc. Chairman and Chief Executive Lloyd Blankfein, suggesting the investment bank was not taking responsibility for its actions in the lead up to the crisis. Mr. Angelides said he was not trying to make Mr. Blankfein "say 'uncle,' " but the two clashed for roughly 10 minutes, frequently interrupting and speaking over one another. Mr. Blankfein at one point said, "Let me ask you a question"--a breach of etiquette in congressional hearings --before being drowned out by Mr. Angelides.

Bubbles and the Banks Why did the bankers take on so much risk? Because it was in their self-interest to do so. By increasing leverage — that is, by making risky investments with borrowed money — banks could increase their short-term profits. And these short-term profits, in turn, were reflected in immense personal bonuses. If the concentration of risk in the banking sector increased the danger of a systemwide financial crisis, well, that wasn’t the bankers’ problem. Of course, that conflict of interest is the reason we have bank regulation. But in the years before the crisis, the rules were relaxed — and, even more important, regulators failed to expand the rules to cover the growing “shadow” banking system, consisting of institutions like Lehman Brothers that performed banklike functions even though they didn’t offer conventional bank deposits. The test for reform, then, is whether it reduces bankers’ incentives and ability to concentrate risk going forward. Transparency is part of the answer. Before the crisis, hardly anyone realized just how much risk the banks were taking on. More disclosure, especially with regard to complex financial derivatives, would clearly help. Beyond that, an important aspect of reform should be new rules limiting bank leverage. I’ll be delving into proposed legislation in future columns, but here’s what I can say about the financial reform bill the House passed — with zero Republican votes — last month: Its limits on leverage look O.K. Not great, but O.K. It would, however, be all too easy for those rules to get weakened to the point where they wouldn’t do the job. A few tweaks in the fine print and banks would be free to play the same game all over again. And reform really should take on the financial industry’s compensation practices. If Congress can’t legislate away the financial rewards for excessive risk-taking, it can at least try to tax them.

Breakdowns, Reactions, Breakages and Consequences

Bubbles & Banks & Zero Lending Standard Loans I disagree with many of my colleagues as to where the bubble actually was. I believe we did not have a national Housing bubble; rather, what we had was a national Credit bubble. (Understanding the difference becomes important, as you shall see shortly). And while much of the country had a housing boom, only a few areas — notably, SoCal, Las Vegas, Arizona and S. Florida — were full blown housing bubbles. But that is a relatively minor quibble. Without the explosion of subprime, but with ultra low rates, we very likely would have seen a rise in housing prices, followed by a plateau. But it would not have been nearly as severe relative to historic price relationships (as an example, median income to median home price). What the newfangled lend-to-securitize subprime model did, however, was to bring millions of previous non-buyers — people otherwise known as renters — into the housing market. On top of the rise in prices caused by 1% Fed Funds rates (~6% mortgages), this added an additional level of pricing destabilization to the Real Estate market.This is evident in the charts I’ve shown again and again: Median income to median home price; cost of renting to ownership; Housing stock as a percentage of GDP — all of these showed a housing market  several standard deviations above its historic pricing mean. With that in your mind, consider how this sub-prime driven boom played into the securitization market, and eventually the Derivatives market (CDOs, CDSs, etc). Look at the 10 steps detailed here on Monday regarding the forming of the credit crisis. The inevitable conclusion is that sub-prime was a major driver of not only the Housing boom and bust, but of the entire financial crisis and credit freeze, and the subsequent bailouts . . .Could it have been prevented? Only if the Fed would have enforced traditional lending standards, i.e., the borrowers ability to service the mortgage. They should have regulated those non-bank lenders whose model was based not upon the borrowers ability to service these loans, but upon the lender’s ability to subseqeuntly sell the loan off top securetizers on Wall Street. So, the answer is yes, appropriate regulation could have prevented the entire mess . . .

• Bernanke Still Does Not Understand Credit Crisis

The U.S.–and the rest of the developed world–is near the point where debt takes a big bite out of growth So exactly when does a lot of debt for a country such as the United States, Japan, the United Kingdom, Greece or Italy become too much debt? The threshold is when government debt rises above 90% of national GDP, economists Carmen Reinhart and Kenneth Rogoff argue in a paper headed for publication in the American Economic Review. After looking at data from 44 countries spanning 200 hundred years, they’ve concluded that at ratios of debt to GDP up to 90% there’s not much correlation between government debt and economic growth. Above 90%, however, median economic growth rates fall by one percentage point and average economic growth rates fall by about four percentage points. That makes the 90% level a kind of make-or-break point for countries that are hoping to grow their way out of debt. If the government debt load climbs above 90% of GDP, economic growth slows so much that growth is no longer a viable solution to reducing government debt. Above that 90% level, governments serious about reducing their debt load have to increasingly rely on “solutions” such as reducing wages and depreciating their currency that might over time increase global economic competitiveness enough to give a boost to national economic growth. In the short to medium term, however, these “solutions” inflict real pain on the citizens of the country since they reduce standards of living. The scary thing about Reinhart and Rogoff’s conclusion is how close the United States and other major developed world economies are to the 90% cut off thanks to the global financial and economic crisis.

• The next financial crisis has a name and it’s the United Kingdom
• Japan’s huge budget gamble will push up global interest rates
• Is Japan betting its future on a new weak yen policy?

So where’s the growth supposed to come from? People who don’t have jobs don’t run up their credit card balances. Not much of a surprise. But in November it added up to a record 14^th straight monthly drop in credit card debt. Today, January 8, the Federal Reserve reported that credit-card debt fell by $13.7 billion in November. Total seasonally adjusted consumer debt fell $17.49 billion. That’s equal to an 8.5% annual rate of decline. The drop in total consumer debt was far larger than the $4 billion that economists had been expecting.The consumer debt numbers lag behind such economic indicators as unemployment by about a month. But the December unemployment numbers, also released today, argue that the December consumer debt numbers will continue to show that consumers are cutting back (or that banks are cutting back for them by reducing credit lines.) Nonfarm payrolls fell by 85,000 in December. Official unemployment held steady at 10%, average hourly earnings climbed by 0.2%, and average weekly hours worked held at 33.2. The “real” unemployment rate, which counts discouraged workers and those working fewer hours than they want, rose slightly to 17.3% from 17.2% in November. Most of the job loss came in the goods-producing sectors of the economy where construction employment fell by 53,000 and manufacturing jobs dropped by 27,000. Jobs in the service sector fell by just 4,000.The bad news in these two reports is obvious. The consumer sector of the economy, which makes up about two-thirds of all economic activity, isn’t showing signs that it will produce strong growth in 2010. And manufacturing activity, which had looked strong in recent surveys, suddenly seems suspect.

• Consumer Credit Declines for Record 10th Straight Month
• More on Gross Purchases (and China)
• Hours Worked per Civilian (per Week)
• Debt, Wealth, Finance & Outlook: Sixty Years of Bubbliciousness
• Jobs, Debt & Growth: Level Setting the New Normal

Shift Seen in Investment Banks' Revenue Investment banks stand to earn up to a fifth less in fixed income, currencies and commodities revenue this year than they did in 2009, as the conditions that allowed them to book record profits in the aftermath of the financial crisis dissipate and lower-margin advisory work returns to the fore. Analysts at Citigroup are predicting banks' revenues from FICC will fall by between 15% and 20% globally in 2010 from around $190 billion last year to between $150 billion and $160 billion. As a result they estimate FICC will contribute 16% of total revenue this year, compared with 21% last year. Banks with strong FICC platforms benefitted from unusually benign conditions in the aftermath of the financial crisis, but declining volatility, tightening bid/ask spreads and increased competition are forcing profitability back to 2006 levels. Among big banks, UBS AG made 13% of its revenue from FICC in 2009, Credit Suisse Group AG was at 35%, while Goldman Sachs Group Inc. was at more than half, according to the Citigroup report. Citigroup analysts predict banks' revenues from currencies business will be down by a quarter, as will revenues from interest rates, while revenues from mortgages will be down by a fifth. In credit, tighter bid/ask spreads will be largely offset by greater opportunities in high yield, distressed and structured credit, leaving income likely to remain flat or slightly down. Commodities could enjoy a 5% to 10% improvement as investor appetite for risk assets returns. On the flip side, revenues from advisory and equities work are expected to pick up as confidence creeps back to the market. Ironically, banks that came in for criticism for failing to gear up and capitalise on the FICC boom, could be among the major beneficiaries of the expected shift.

Repaying U.S. and Reaping Bounty in Fees Here comes another payday on Wall Street, just in time for the holidays. No, I’m not talking about the big bonuses you’ve been reading about already. I mean a new one, courtesy of companies like Citigroup, Wells Fargo and Bank of America returning their federal bailout money and raising new capital to replace it. And that means big fees for all the banks that will hawk these new shares for themselves and their rivals. More than $50 billion of new capital was raised as part of the effort by the biggest banks to repay the money from the Troubled Asset Relief Program and get out from under the thumb — and pay caps — of Washington. All told, December was the biggest month in history for offerings, according to Thomson Reuters. Here’s what the post-bailout bonanza means for all the banks that helped find investors for the new shares: Bank of America’s $19.3 billion offering generated $482 million in fees; Citigroup’s $17 billion offering resulted in $425 million in fees; and Wells Fargo’s $12.2 billion offering led to $275.6 million in fees.

Why Aren’t Banks Lending? They Are Being Rational  President Obama met with a dozen small banks yesterday, urging them to keep lending. He did not have to tell that to this group — about 6500 mostly AAA rated, regional and community banks — who have been happily lending away. Its how they earn their money. The larger banks, on the other hand, are the ones who have cut back lending dramatically. This is especially true of the 10 biggest banks. Why? Its the rational thing to do. These banks STILL have to much debt, too little capital. They books are festooned with bad loans, which, thanks to our corrupt Congress, they no longer have to disclose appropriately. Thanks to Mark-to-Make-Believe, they can pretend these assets are worth near what they paid for them. In reality, they cannot sell them even at 50% off. Lending money is a risky business; there is the possibility of loss. Under-capitalized banks cannot take that chance. By not lending, their capital base goes up. IT is the rational thing to do from their perspective. Rather than engage in traditional money lending, these banks have decided to simply borrow from the Fed at 0%, and make risk free loans to the Treasury at 3%. And, these banks are not lending because the way the Fed/Treasury bailouts were structured, they are encouraged NOT TO LEND. Why? They need to rebuild their capital levels after 30 years of declining safeguards and capital ratios. This is yet another unintended consequence of bailing reckless bankers from their folly. Theior oplace in the economy is so distorted, as to become nearly economically meaningless.

Banks Bundled Bad Debt, Bet Against It and Won As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits. Goldman’s own clients who bought them, however, were less fortunate. Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm. Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment. Profits in a Crisis: Graphic

A Bank Idea, With Ancient Roots, for Helping Small Businesses To this day, Bart Mitchell is not entirely sure he knows what a merchant bank is. “I guess I think of it as the old-fashioned banker who takes the time to listen to his customer’s needs and help them solve their problems,” he said. (Actually, that is not far off.) One thing he is certain about is that if not for Next Street, a four-year-old, 22-employee merchant bank with offices in Boston and New York, his development company would have been in big trouble. It is a common refrain for Next Street clients, by and large established businesses with $5 million to $50 million in annual revenue. The chief executives of these companies, which include a Boston-area moving business with as many as 400 seasonal employees, a major supplier of refurbished toner cartridges, and a manufacturer of truck batteries that meet California’s stringent new idling restrictions, report that Next Street fills a vital role for their organizations. More than one has said that its blend of Fortune-500-level advice and access to sophisticated financing could be a solution to the small-business credit squeeze threatening to derail the economic recovery. That is what makes Next Street intriguing: It may be the only small-business merchant bank in the country.

Addressing the Problem

When Greed Is Not Good When economists first heard Gekko's now-famous dictum, "Greed is good," they thought it a crude expression of Adam Smith's "Invisible Hand"—which is one of history's great ideas. But in Smith's vision, greed is socially beneficial only when properly harnessed and channeled. The necessary conditions include, among other things: appropriate incentives (for risk taking, etc.), effective competition, safeguards against exploitation of what economists call "asymmetric information" (as when a deceitful seller unloads junk on an unsuspecting buyer), regulators to enforce the rules and keep participants honest, and—when relevant—protection of taxpayers against pilferage or malfeasance by others. When these conditions fail to hold, greed is not good. Plainly, they all failed in the financial crisis. Compensation and other types of incentives for risk taking were badly skewed. Corporate boards were asleep at the switch. Opacity reduced effective competition. Financial regulation was shamefully lax. Predators roamed the financial landscape, looting both legally and illegally. And when the Treasury and Federal Reserve rushed in to contain the damage, taxpayers were forced to pay dearly for the mistakes and avarice of others. If you want to know why the public is enraged, that, in a nutshell, is why. American democracy is alleged to respond to public opinion, and incumbents are quaking in their boots. Yet we stand here in January 2010 with virtually the same legal and regulatory system we had when the crisis struck in the summer of 2007, with only minor changes in Wall Street business practices, and with greed returning big time. That's both amazing and scary. Without major financial reform, "it" can happen again.

Looking for Fairness In Wall Street Bonuses To put it mildly, it would not be a catastrophe if some of these people had to downsize, a fate they so readily inflict on companies they take private. But let's be realistic: they're not going to do it voluntarily. There are only three entities that have real power over how financial industry employees are compensated: the government, shareholders and customers. Reform proposals currently under consideration in Washington attempt to address structural issues that contributed to the recent financial crisis, but do almost nothing about Wall Street pay. I've written before about steps that, in my view, would address the worst sources of outrage (for example, banning guaranteed bonuses) while preserving incentives and competition. But now something potentially much worse might arise in Congress, which, in the wake of last year's American International Group payouts, demonstrated a willingness to impose a 90% tax on some bonuses (subsequently rescinded). With Britain and France pushing for draconian bonus taxes, pressure is building and a new fee levied on banks is under consideration. I believe such a step is heavy-handed, too simplistic and a potentially dangerous precedent for any other temporarily out-of-favor sector. Shareholders are a far more potent source of reform, since they own these companies, at least the publicly traded ones. Customers also need to exert their considerable leverage. This won't do anything about revenues from proprietary trading, where the firm is its own client. But they can certainly help rein in exorbitant fees. At the same time, reform is in everyone's interest. For bonus recipients themselves, it will quell calls for even worse sanctions. For shareholders, it should boost profits and share prices, which will also benefit all those employees being paid in stock. For the public at large it should restore some sense that people being paid large bonuses actually deserve them.

Financial Crisis Inquiry Commission set to Meet Maybe they will take suggestions and questions. My first suggestion is they start by interviewing - in private - the field examiners at the Fed, FDIC, OCC and OTS. There is no need to publicly embarrass any examiner. The various Inspector General reports on bank failures would provide a starting point (see Eric Dash's article in the NY Times: Post-Mortems Reveal Obvious Risk at Banks). Ask the examiners what they saw and when - according to the Inspector General's reports, the field examiners were warning about lending problems in 2002 and 2003. Follow the trail. Did this information generate warnings inside the organizations? If so, why wasn't action taken? Was the action blocked by political appointees? And how would the proposed regulatory reform lead to a better outcome? And a quote from Eric Dash's article: “Hindsight is a wonderful thing,” said Timothy W. Long, the chief bank examiner for the Office of the Comptroller of the Currency. “At the height of the economic boom, to take an aggressive supervisory approach and tell people to stop lending is hard to do.” If the lending was risky, telling them to stop was the regulators job. How does reform fix this? The good news is Brooksley Born is on the commission, and I think she will do an excellent job.

In 2010, Year of the Regulator If 2008 was the year an old era passed, 2010 will be the year the new one begins. In this new era, banking, insurance and trading are regarded as much as potential contagions as essential economic activities. A recently passed House bill and pending Senate proposal instruct the government to monitor the system for overall risk, essentially quarantining financial institutions that threaten others. After near-collapse and a taxpayer bailout, the financial industry has little public room to protest much of the changes designed to thwart systemic failure.

• Paul Volcker: The lion lets loose

Refocus the regulatory debate on essentials There are a variety of means by which a fundamental restructuring of banking can be accomplished. The aim is to ensure, on the one hand, that institutions enjoying access to central bank windows and where deposits are governmentally insured operate in the safest manner, in the full interest of those whose deposits they take and whose businesses they provide with credit; and, on the other hand, that institutions engaged in speculative trading are subject to the vagaries and risks of the marketplace, subject of course to a precautionary range of regulations. So far, politicians and regulators have ignored the fundamental issues, pursuing quick fixes rather than challenging the status quo. However, I do not believe it is too late to reopen the debate. We must start with fundamentals and the core interests of the public if we are to ensure that we will not stand condemned in the future for failing to learn from the mistakes of the past.

• Fed’s Hoenig warns on too-big-to-fail, backs Glass-Steagall

How to make the bankers share the losses Bankers were paid when the risks they took paid off, but were not penalised when their bets went sour. Since it can take years to be certain that bank risks are profits or losses, it proved too easy for them to take the cash on short-term gains but to have no responsibility for the consequences of their actions years later. There has been a proliferation of plans to fix this structural weakness of the banking system. But politicians and regulators have overlooked a really simple solution. Why not design a limited-liability model, where bankers become personally liable for the cumulative amount of their bonuses? Bankers who wish to receive a bonus above a threshold (say £50,000, or twice average earnings) would become personally liable for the amount of the bonus for a period, perhaps 10 years. They would sit between equity holders and other creditors of the bank – and so would be called upon should any bank find that its equity capital is wiped out by losses. In practice, this would mean their liability would be triggered by a government or other (private sector) rescue. If there turned out to be no rescue, then they would be liable to the liquidator. If there were a rescue, the rescuer would pay over support monies, and then reclaim them from the limited-liability bankers. The bankers would be released from this liability over time, but of course with every new bonus payment they would incur a new liability. By this mechanism, all senior bankers would have a rolling portfolio of liabilities to the extent of the cash they had taken out of the bank in bonuses. The tax treatment would have to be dealt with; I suggest the liability should be the amount of the pre-tax bonus, but if called, the banker would receive tax relief on any repayment. Bankers would have to be prevented from transferring substantial assets out of their own names until the liabilities were expunged, and would also have some residency and other restrictions to prevent them escaping their liabilities.

Too Big to Jail MAYBE WALL STREET should open a casino right there on the corner of Broad, because these guys simply cannot lose. After kneecapping the global economy, costing millions their homes and livelihoods, and saddling our grandchildren with massive debt—after all that, they're cashing in their bonuses from 2008. That's right, 2008—when amid the gnashing of teeth and rending of garments over the $700 billion TARP [1] legislation (a mere 5 percent of a $14 trillion [2] bailout; see "The Real Size of the Bailout [3]"), humiliated banks rolled back executive bonuses. Or so we thought: In fact, those bonuses were simply reconfigured to have a higher proportion of company stock. Those shares weren't worth so much at the time, as the execs made a point of telling Congress, but that meant they could only go up, and by the time they did, the public (suckers!) would have forgotten the whole exercise. It worked out beautifully: The value of JPMorgan Chase [4]'s 2008 bonuses has increased 20 percent to $10.5 billion, an average of nearly $6 million for the top 200 execs. Goldman [5]'s 2008 bonuses are worth $7.8 billion. And why are bank stocks worth more now? Because of the bailout, of course. Bankers aren't being rewarded for pulling the economy out of the doldrums. Nope, they're simply skimming from the trillions we've shoveled at them. The house always wins. Indeed, 2009 bonuses are expected to be 30 to 40 percent higher than 2008's. And don't forget AIG [6], which paid the same division that helped cook up collateral debt obligations and credit default swaps "retention bonuses" worth $475 million, in some execs' cases 36 times their base salaries. As anyone who watches Dog Whisperer [7]knows, rewarding bad behavior produces more of the same—so it's no surprise that Wall Street is back to business as usual. Derivatives are still unregulated (thanks, Congress!), exotic sliced-and-diced securities are being resliced and rediced, and the biggest offenders in peddling subprime mortgages? They are raking in millions in federal grants to—wait for it—fix subprime mortgages. And the worst part? These fat-cat recidivists don't even have the decency to fake contrition. The New York Times' Andrew Ross Sorkin [8] says that whenever he asked Wall Street CEOs "Do you have any remorse? Are you sorry? The answer, almost unequivocally, was no."

• Moral Bankruptcy Moguls without morals: Time for a market correction.
• Thank You, Sir. May We Have Another? The bailout made Americans hopping mad. So why aren't we furious at the fat cats who caused it?
• Capital City  It's hard to kick the finance lobby off the Hill when they own the place.

FCIC (Pecora 2) Hearings and Implications

That 1930s show THE battle against the financial crisis may be ending, but the war over why it happened has barely begun. The most ambitious effort yet to settle the story begins next week with the first hearing of the Financial Crisis Inquiry Commission.Congress gave the ten-member bipartisan commission a sprawling mandate: to investigate at least 22 potential causes, from excess global savings to short-selling, and to explain why specific firms collapsed or needed bail-outs. The report, due by December 15th, is not supposed to contain recommendations but probably will. Though modelled on the body that investigated the attacks of September 11th 2001, the spiritual father of this venture is the Pecora Commission. This was named after Ferdinand Pecora, the chief lawyer on the Senate Banking Committee from 1933 to 1934. His cross-examinations brought forth revelations of widespread abuses on Wall Street: bankers selling stocks at preferred prices to powerful friends, or giving executives bonuses for dumping dud securities on the public. Within days of testifying, the head of National City Bank, the predecessor of Citibank, was forced to resign. The commission’s findings led to the creation of the Securities and Exchange Commission and the passage of the Glass-Steagall Act, which separated commercial and investment banking. Bankers could be in for another public stoning. The heads of JPMorgan Chase, Goldman Sachs, Morgan Stanley and Bank of America will appear at the commission’s first public hearings on January 13th and 14th. Regulators and independent experts will also testify. Tim Geithner, the treasury secretary, and Ben Bernanke, the Federal Reserve chairman, have already appeared before the commission privately and should do so publicly later. The commission, chaired by Phil Angelides, the Democratic former treasurer of California, is unlikely to make as big a stir as Pecora’s. Journalists, prosecutors and Congress have already produced a stream of exposés of the crisis. Most of the star witnesses have been grilled elsewhere already. The Obama administration hopes its own regulatory overhaul will be done before the commission even reports. Yet the commission seems bound to uncover some salacious wrongdoings that will shape future reforms. Mr Angelides was a perennial thorn in the side of business, using California’s state pension plan to browbeat bosses of firms he disapproved of, and he retains a dim view of Wall Street. “In 1929, people were throwing themselves out of windows; in 2009, they were lining up for bonuses,” he says. A staff of up to 50 will interview hundreds of witnesses. Reluctant ones will be subpoenaed. While national security required the 9/11 commission to keep private much of what it learned, Mr Angelides and his Republican vice-chairman, Bill Thomas, want to post their findings on the web immediately. If their final report is half as readable as the 9/11 one, it, too, should be a bestseller.

Pecora Commission

• 'Put Up or Shut Up': The Message the Financial Crisis Panel Should Send, Bill Black Says
• Panel Investigating Financial Crisis to Question Bankers
• What the Financial Crisis Commission Should Ask
• 10 Questions for the Financial Crisis Commission
• Financial Crisis Inquiry Commission Hearings Start Tomorrow
• Questions for the Big Bankers
• Mr. 'Fat Cat' Banker Goes to Washington

Top Risk No. 4: U.S. financial regulatory reform But the exception is in the process of financial regulatory reform. That's likely to be a tougher issue than people expect. The reform package that passed the House of Representatives is comprehensive, though it will be moderated in the Senate, where for the first time under Obama a serious bipartisan effort is being undertaken. Either way, substantial change is afoot -- more far-reaching than anything we've seen since the Great Depression. The result will be a structure put in place to monitor and address systemic risk, largely self-financed from the financial community, as well as changes on many other issues, ranging from derivatives regulation to the proper role of the Federal Reserve Bank. Unlike cap and trade or immigration reform, there's a very high likelihood that comprehensive financial regulatory reform will pass. But with mid-term elections approaching, it's likely to turn populist and lose a considerable amount of its bipartisan flavor. But while Obama's economic team will be wary of populist measures, Democrats in Congress and the president's own political advisors will see such measures as a necessary piece of "mobilizing the base" before mid-term elections. Big banks are an easy target, especially in the context of high profits and a strong recovery for the financial markets, but a weak overall economic rebound. The legislation should pass by late spring. Regulators will be given significant new discretionary powers, including some authority for breaking up institutions deemed a systemic risk. A key risk is that, depending on the political environment, the newly empowered regulators could use their capabilities to issue strict rulings that go well beyond what is specifically included in the legislation. Regulators will also likely issue proposals for revising capital requirements upward next year. Another key risk to watch will be efforts to impose further fees and taxes on the financial system. With the U.S. government running record deficits in the wake of the financial crisis, trying to recoup these costs from the financial services industry will be seen as a relatively low-cost political option. Executive compensation is one likely possibility; taxes on carried interest for hedge funds are another.

• Not All Banks Are Created Alike Any new regulation of the financial industry must distinguish between firms engaged primarily in speculative trading and lenders linked to the real economy of Main Street. The great danger is that regulation of the former might inadvertently strangle the latter.
• How Overhauling Derivatives Died Lobbying by Wall Street has blunted efforts to step up regulation on derivatives trading by carving out exceptions or leaving the status quo in place.
• Agencies in a Brawl for Control Over Banks In the darkest days of the financial crisis a year ago, Sheila Bair was hailed for having predicted the housing bust. Today, the chief of the Federal Deposit Insurance Corp. is fighting for her agency's future.Connecticut Democrat Christopher Dodd, the Senate Banking Committee chairman, has proposed revoking almost all of Ms. Bair's powers to supervise banks, as part of a sweeping financial-regulation bill now under consideration in the Senate.