Two weeks ago I went on an itsy, bitsy, teeny, weeny rant: Come the Revolution.
I took issue with an email from an Investment Banker (also Emini Trader). Sine then, we’ve emailed quite a bit – and as it turns out, we agree on many issues and I misinterpreted some of his original email.
However, on the issue of bank bailouts and TBTF, we disagree. I am still adamant that it is not the job of Government to use taxpayer money to bail out risk-taking capitalists. Systemic risk is only increased (in the long term) when you do so.
Nor do I think insolvent banks should be allowed to just fail or declare bankruptcy. They should be taken over and “resolved” – just as the FDIC does every weekend with failed commercial banks. I also don’t agree with “shot gun weddings” with the taxpayer underwriting the deal.
The FDIC bank deposit insurance is designed to stop runs on retail/commercial banks and the Glass Steagall Act (repealed in 1999 to accommodate the illegal merger of Citibank and Travelers Group) was designed to insulate lending from capital markets risk taking.
Ultimately, the lack of confidence in the investment banks was brought about by their own doing: for years, they had engaged in deliberately obscuring their balance sheet and playing off-balance sheet games. In 2008 the investors/analysts suddenly realized they had been relying on CFO assurances but the investors/analysts themselves didn’t understand what exactly was on the balance sheet. From then on the game was up.
Anyway, since that rant generated so many email comments I though it would be right to close the loop and give the Investment Banker the last word. So with his permission, here is his (unedited) response:
Having listened to your video response (to my mail about trading bank risk profiles and bank failures), a couple of clarifications and reiterations. That being said, when defending bank bailouts, I have an image of myself as a deranged cartoon character trying to dig himself out of 10 foot hole with a miniature spade, digging deeper and deeper … but will try one more time.
I mentioned protecting commercial/retail bank depositors ‘fully or near fully’. ‘Near’ because I think it should be at least debated if an institution cap should apply and if interest should continue to accrue AFTER bankruptcy. i.e. during the weeks/months it takes to return funds back to savers.
I still maintain that banks with complex trading risk profiles need special consideration. Letting a bank fail with billions of $ of outstanding OTC derivative contracts (with a web of global counter-parties) can be very volatile. We don’t let nuclear power plants shut down overnight and the same applies to these (overly?) complex trading outfits. Their sudden closure can cause a seizure of the financial system as OTC counter-party confidence evaporates which I think happened when Lehman went bust. After that event, the interbank lending markets became very close to being dysfunctional (and the stock market plunged) and banks without short term funding go bankrupt, even if they are solvent. Rather a forced merger (e.g. Merrill and BoA) or temporary bailout (e.g. Citi) can ultimately be less costly (to the tax payer) and less damaging to the financial system.
During the extremes of the crisis (a good couple of years ago) I recall the financial system being in near meltdown. Without regulators/governments stepping in, it could be argued that Goldman/Morgan Stanley/JPM/Citi could have ended up like Lehman. Clearly not all of them would have gone, but even one more full bankruptcy could have tilted the markets into a tail spin and triggered runs on commercial/retail banks deposits.
How did banks get themselves into such a mess in the first place? The common answer being: the banks bet big and wrong. I think it is more complex than that, i.e.: excessive leverage, gross risk modelling errors (on multiple fronts), insufficient and wrong kind of capital, trading when they should not have been (AIG), over reliance upon short-term funding, lopsided focus on trading staff/systems/remuneration with little regard to controlling teams (i.e. risk/accounting/counter-party/settlements) who only incur overhead costs without revenue generation, off balance sheet vehicles, financial alchemy in creating AAA-rated CDO/MBS instruments which were stuffed with underlying sub-prime garbage the list could go on.
But these failures are not just market bets (i.e. long/short ES or equivalent) gone wrong rather these are pervasive failures of the operating/regulatory environment. Trading banks should never have been allowed to operate the way they were. External regulators were asleep at the wheel and internal regulators woefully under-appreciated and under-funded. It was all about make $ without incurring costs. The same goes for commercial/retail mortgage lenders which lost all sense and sensibility in terms of lending criteria (i.e. with the underlying loans that go into a CDO/MBS creation).
Additionally, the below summarised points should be factored in:
- Ultra-interventionist monetary policy by the Fed, that kept overzealously stepping in whenever growth slowed or the stock market fell, creating complacency amongst investors and fuelling asset bubbles.
- Global imbalances, mainly Chinese cheap exports (engineered by the Chinese government FX rate intervention) and their trillion $ purchases of Treasuries pushing down yields to artificial levels (thus flooding the world with cheap credit) vs the US consumption debt binge, i.e. buying goods with ‘paper profits’ (i.e. via mortgage equity withdrawals) and borrowing at artificially low rates giving banks an endless customer base hungry for debt.
- Both bondholders of bank debt (which in most cases is held by other banks!) and depositors thought their investments were 100% safe in all circumstances (e.g. a UK saver investing in an Icelandic bank!) which implies full state backing, thus enabling banks to borrow artificially cheap, as if they were a state funded operation but without corresponding risk taking restrictions.
- Mark-to-market accounting of OTC instruments that are highly structured (i.e. individualistic, not standardised Exchange Traded contracts like the ES) and became completely illiquid with no trading taking place, except forced mass liquidations at fire-sale prices due to bankruptcy avoidance or sudden bankruptcy, and thus there was no orderly let alone active market, making it impossible to do a mark-to-‘market.
- Wall Street ultimately stuffed CDO/MBS with dodgy sub-prime mortgages, but this lending process was originally started by politicians (Clinton administration), who to win votes promoted homeownership amongst the financially illiterate and then was embraced by Wall Street once given governmental/regulatory approval, indeed directive.
- Credit rating agencies providing a ‘health check’ service (based upon flawed model methods and assumptions) of CDO/MBS, which was paid for by the financial instrument constructor (i.e. banks).
Even if one dismisses the above, and reverts back to the rather simplistic ‘blame the betting banker’, I still don’t believe retribution is achieved by bankruptcy (and the resultant mayhem in the markets which clearly happened post Lehman and hurt so many retail investor/pension savings pot). Even if it feels like justice is done, the underlying causes for the mess are not fixed by bankruptcy. For me that would be: cut off the nose to spite the face. Rather, protect the greater good, i.e. the financial system. This is done by temporary bailouts/forced marriages and then once the dust has settled putting in place the appropriate safeguards to ensure there is no repeat, and clearly this includes a rethink of the lax regulatory environment trading banks were allowed to operate in.
With the situation in Japan and market volatility it feels trivial to be debating this topic any further so will cordially rest my case. Thanks for listening!”
So, as far as I’m concerned, this closes the discussion. I hope the balance has been redressed a little and no feelings have been hurt.
Enjoy the rest of your weekend and good luck with your Emini trading next week.