Perhaps the FDIC is reading this blog.
It took a week, but yesterday Sheila C. Bair, the new head of the FDIC, re-stated the argument our argument on banks: Instead of stepping in to support institutions "too big to fail," the government should not allow firms to get that big in the first place. Ms. Bair testified to Congress that current regulation places too much risk on the financial system, and that the Congress proposed idea of a "systemic risk regulatory" will be inadequate to change that level of risk.
The other concern is that Congress' current proposal will lead to the creation of a massive regulatory body which will increase beauracracy and red tape, but no fundamental change in the nature of the risks. Not everyone in her audience got it - hopefully they will soon.
Go Sheila - we are with you.
See today's article in the NY Times:
http://www.nytimes.com/2009/03/20/business/economy/20regulate.html?dlbk
Friday, March 20, 2009
Friday, March 13, 2009
Too Big To Fail
Sometimes, albeit rarely, politicians get it right. Such was the case yesterday, when Senator Bernard Sanders, Vermont independent, stated:“If an organization is too big to fail, it is too big to exist.”
Some background: In trying to prevent a financial meltdown, the previous Secretary of the Treasury, Henry Paulson, encouraged and in fact forced certain mergers to occur: JP Morgan took over Bear Sterns and later Washington Mutual, Wells took over Wachovia, and Bank of America took over Merrill Lynch. After absorbing these dwindling businesses, each of the previously strong firms needed to take down significant funds from the government to stay afloat. The government had determined that these financial behemoths, as well as AIG and others, were "too big to fail," i.e. the repurcussions to the economy were too great to allow one of them to default on their many obligations.
The argument previously for allowing combinations of large financial institutions had been that competition among financial institutions had become global, and to compete globally you needed to be big and have the ability to deliver every product. So banks merged, merged, merged until they could deliver all these products and underwrite huge sums. But as they became more competitive globally, they spread the risk of their failure throughout the world. Now, if Citibank fails, it affects not just the US but also Europe, Asia, and Latin America in a meaningful way.
Further, until the early 1990s the businesses of banks and investment banks were quite separate. With the fall of Glass Steagle, a depression era law requiring those businesses to remain apart, the lines distinguishing the two businesses fell away. Banks became investment banks, investment banks became banks. The consequences, as we know now, were disastrous.
The answer is simple - these firms are too big, they need to be broken up. Just as there are limits on the market share of broadcast companies and cable tv companies, there needs to be limits on banks. Also, the lines of business need to again be separated. This is the only way that the failure of a single institution or a single market will have less impact on the economy and financial markets as a whole.
So score one point for Senator Sanders. It may be a long time before another politician gets one right again!
Some background: In trying to prevent a financial meltdown, the previous Secretary of the Treasury, Henry Paulson, encouraged and in fact forced certain mergers to occur: JP Morgan took over Bear Sterns and later Washington Mutual, Wells took over Wachovia, and Bank of America took over Merrill Lynch. After absorbing these dwindling businesses, each of the previously strong firms needed to take down significant funds from the government to stay afloat. The government had determined that these financial behemoths, as well as AIG and others, were "too big to fail," i.e. the repurcussions to the economy were too great to allow one of them to default on their many obligations.
The argument previously for allowing combinations of large financial institutions had been that competition among financial institutions had become global, and to compete globally you needed to be big and have the ability to deliver every product. So banks merged, merged, merged until they could deliver all these products and underwrite huge sums. But as they became more competitive globally, they spread the risk of their failure throughout the world. Now, if Citibank fails, it affects not just the US but also Europe, Asia, and Latin America in a meaningful way.
Further, until the early 1990s the businesses of banks and investment banks were quite separate. With the fall of Glass Steagle, a depression era law requiring those businesses to remain apart, the lines distinguishing the two businesses fell away. Banks became investment banks, investment banks became banks. The consequences, as we know now, were disastrous.
The answer is simple - these firms are too big, they need to be broken up. Just as there are limits on the market share of broadcast companies and cable tv companies, there needs to be limits on banks. Also, the lines of business need to again be separated. This is the only way that the failure of a single institution or a single market will have less impact on the economy and financial markets as a whole.
So score one point for Senator Sanders. It may be a long time before another politician gets one right again!
Saturday, March 7, 2009
Why Banks Failed
I see pundits using lots of jargon, charts, and ratios trying to determine why banks failed. Some argue that leverage ratios of the investment banks are largely unchanged from those of the mid 1990s, and those of commercial banks actually declined, so are puzzled as to why we have the problem that we have now.
The bottom line is that banks (no distinction between commercial or investment) did not adhere to strict mortgage underwriting policies, largely because either a) they did not intend to hold the mortgages, or b) in the case of banks that held mortgages, they felt they had to in order to compete with the big conduit players.
Banks and investors relied on Loan To Value (asset value) as first way out - which as we know is always a mistake. Assets are only worth what someone will pay for them - unless they are cash flow generating, assets do not have inherent value.
The other issue, which often goes undiscussed because it is difficult to track statistically, is the impact of the CDS debacle. There are roughly $20 trillion in corporate and mortgage backed debt securities outstanding. Yet there are $56 trillion in Credit Default Swaps - or 2.8x the entire traded debt market. The counter party risk of such a pervasive, mispriced, and unregulated market is staggering, and we will feel its effects for years to come. Leverage ratios of banks and I-banks do not accurately reflect this risk - and therefore are grossly understated. This is a market that really only took off starting in 2002 - so comparing recent leverage levels to that of the 1990s is non-meaningful.
Our current market failure is also misunderstood - but is quite simple. Liquidity has been driven by both the issuance of $20 trillion in traded debt and $56 trillion in CDS, not to mention the untraded loan markets. There is zero net new issuance in any of these markets - in fact there is contraction. A contracting liquidity market means a contracting economy. Period.
As Bette Davis famously said in "All About Eve": "Fasten your seatbelt - its going to be a bumpy night."
The bottom line is that banks (no distinction between commercial or investment) did not adhere to strict mortgage underwriting policies, largely because either a) they did not intend to hold the mortgages, or b) in the case of banks that held mortgages, they felt they had to in order to compete with the big conduit players.
Banks and investors relied on Loan To Value (asset value) as first way out - which as we know is always a mistake. Assets are only worth what someone will pay for them - unless they are cash flow generating, assets do not have inherent value.
The other issue, which often goes undiscussed because it is difficult to track statistically, is the impact of the CDS debacle. There are roughly $20 trillion in corporate and mortgage backed debt securities outstanding. Yet there are $56 trillion in Credit Default Swaps - or 2.8x the entire traded debt market. The counter party risk of such a pervasive, mispriced, and unregulated market is staggering, and we will feel its effects for years to come. Leverage ratios of banks and I-banks do not accurately reflect this risk - and therefore are grossly understated. This is a market that really only took off starting in 2002 - so comparing recent leverage levels to that of the 1990s is non-meaningful.
Our current market failure is also misunderstood - but is quite simple. Liquidity has been driven by both the issuance of $20 trillion in traded debt and $56 trillion in CDS, not to mention the untraded loan markets. There is zero net new issuance in any of these markets - in fact there is contraction. A contracting liquidity market means a contracting economy. Period.
As Bette Davis famously said in "All About Eve": "Fasten your seatbelt - its going to be a bumpy night."
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