Today’s press is constantly filled with bluster about “new” regulatory regimes, Executive Pay Czars and other gripping topics stemming from 20/20 hindsight and populist zeal. Sadly, they all miss the point. Wall Street’s weakest link, it’s super-leveraged capital structure and reliance on overnight funding, was laid bare in the depths of the financial crisis last fall. If not for the wide-open purse strings of the US Government, institutions ranging from Citigroup (NYSE: C) to Goldman Sachs (NYSE: GS) would have gone down. No doubt. This was the moment in history when smart minds could have gotten together and projected – really projected – what a better, safer, smarter Wall Street might look like, a Wall Street that wouldn’t have collapsed like a house of cards so completely in the face of the mortgage crisis and credit derivatives melt-down. Rather than mindlessly shoveling liquidity in the system to prop up a broken model and failed institutions, a concerted effort could have been made to call time-out, not with respect to the markets but with respect to the institutions whose functioning had just been shown to be dangerously fragile. Needless to say, this is not how it was handled and we are suffering the aftermath today.
What we have is a return to business-as-usual. Except it’s worse than that. The US taxpayer has been systematically looted out of hundreds of billions of dollars, yet the press is focused on Andy Hall and his $100 million payday. Whether this is too much pay for Mr. Hall misses the big picture. Yes, the Wall Street pay model is messed up, and I recently provided an alternative approach. But how about the fact that Goldman Sachs is posting record earnings and will invariably be preparing to pay record bonuses, not nine months after the firm was in mortal danger? Whether anyone will admit it or not, without the AIG (read: Wall Street and European bank) bail-out and the FDIC issuance guarantees, neither Goldman nor any other bulge bracket firm lacking stable base of core deposits would be alive and breathing today.
Goldman is a great firm with a stellar culture, and in most circumstances it’s risk management and funding practices have been second to none. Except when the crisis hit. It stood with the rest of Wall Street as a firm with longer-dated, less liquid assets funded with extremely short-dated liabilities. And while it had a massive cushion of collateral, it would likely have been inadequate if the Treasury and the Fed hadn’t come to its rescue. In exchange for giving the firm life (TARP, FDIC guarantees, synthetic bail-out via AIG, etc.), the US Treasury (and the US taxpayer by extension) got some warrants on $10 billion of TARP capital injected into the firm. While JPMorgan Chase (NYSE: JPM) CEO Jamie Dimon prefers to poke a stick in the eye of the Treasury, seeking to negotiate down the payment to buy back the TARP warrants, Lloyd Blankfein smartly paid the full $1.1 billion requested. He looked like a hero for doing so, a true US patriot repaying the US Government in full for its lifeline, thanking the US taxpayer in the process. $1.1 billion… $1.1 billion…Hmm…something doesn’t seem right. You know why it doesn’t seem right? BECAUSE THE US TREASURY MIS-PRICED THE FREAKING OPTION.
There is not a Wall Street derivatives trader on the planet that would have done the US Government deal on an arms-length basis. Nothing remotely close. Goldman’s equity could have done a digital, dis-continuous move towards zero if it couldn’t finance its balance sheet overnight. Remember Bear Stearns? Lehman Brothers? These things happened. Goldman, though clearly a stronger institution, was facing a crisis of confidence that pervaded the market. Lenders weren’t discriminating back in November 2008. If you didn’t have term credit, you certainly weren’t getting any new lines or getting any rolls, either. So what is the cost of an option to insure a $1 trillion balance sheet and hundreds of billions in off-balance sheet liabilities teetering on the brink? Let’s just say that it is a tad north of $1.1 billion in premium. And the $10 billion TARP figure? It’s a joke. Take into account the American International Group (NYSE: AIG) payments, the FDIC guarantees and the value of the markets knowing that the US Government won’t let you go down under any circumstances. $1.1 billion in option premium? How about 20x that, perhaps more. But no, this is not the way it went down. I thought the best way was to impose Good Bank/Bad Bank restructurings on troubled institutions, making plain the value of the assets, hiving off the most troubled and letting the healthy institutions live on and thrive with a healthier capital structure and significant US taxpayer ownership that would eventually be re-offered to the marketplace. An alternative would have been a more accurate and representative pricing of the option inherent in the bail-out given to Wall Street firms. But the US Government elected to pursue neither approach.
Where we are left today, dear taxpayer, is a lot poorer. Unless you are a major shareholder and/or bonusable employee of Goldman Sachs. Brains, ingenuity and value creation should be rewarded in all fields, Wall Street included. But when value created is the direct result of the risks borne by others for your benefit, the sharing of benefits needs to be re-allocated. This has not and apparently will not be done, and we, dear taxpayer, are the worse for it. Further, such a crisis could have provided the opportunity and the impetus for a re-look at capital markets risks, getting CDS users to support a central credit derivatives exchange and revised capital rules to incentivize better gap management. The banks lobby like hell against these changes, because it cuts into their fees, notwithstanding the systemic benefits such changes could have on the global financial markets. Banks now lobbying with US taxpayer dollars against changes that could protect the US taxpayer from more harm in the future. Something is terribly wrong with this picture, yet all anyone wants to talk about are executives getting paid too much. It’s called missing the forest for the trees, and it is a fixture of both those trying to sell newspapers (get clicks) and run our Government, and it pisses me off.
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Roger,
totally agree. Our governments simply bailed out the bond holders and replaced short term debt with long term debt (financed by us).
Very little else has changed. The root cause flaws that have led to all this are still in play:
– The interest rates are still ridiculously low. central banks are to blame.
– Governments still want everybody to own their own house and I am sure this will never change. I bet you that within a short period of time, we will be extending credit to people who are not credit-worthy, so that they can buy/keep their own house.
– I see no restrictions enforced on overall corporate/financial institution leverage anywhere. Borrow 20x your own capital? I am sure many institutions still operate like that right now. There appears to be no change to this at regulatory level. Why are banks allowed top operate like this?
Overall, I don’t get it. Shareholders of most banks should have been completely wiped out. Bond-holders should have taken a massive hit. We all should be owning substantial parts of the equity in all banks at present. We should have vetoed all bonuses in all financial institutions that we own as a matter of principle, until the banks are recapitalized to the level where they need to be.
I think what we need is the government’s ability to ‘squash down’ equity and bond holders in all institutions that are deemed to be ‘system relevant’ when they are unable to meet their obligations. Wash out the equity holders, reduce the debt owned to the debtors, assume control of the equity position, refinance the debt.
Totally agree.
Thanks for this article. I’ve been pissed off about the bank bailouts since I first heard about TARP. I could not believe that Obama lobbied for TARP last September (I voted for him anyway, although I was starting to feel queasy), and of course all the rest that has happened since. This cannot be an accident. He could have, and should have, given the banks the coup de grace they deserved when they were on their knees. But everyone was saying, without any proof, that to do so would destroy the economy or the financial system, which seems to be interchangeable these days. I wanted to see the blood-sucking parasites destroyed. My gut tells me the financial sector should be pared down about 60-70 percent. After all, “finance” now represents 40 percent of all income in the U.S. and most of that adds no value to the real economy. Bailouts should have gone to the real wealth creators: the American people. And now, having given all of our wealth away, there is no leverage left for getting the banking regulations we need. You’re also the first person that I’ve noticed, besides me, who’s railing about the focus on bonuses. In March of this year, I wrote to Obama – I’m sure he read my email – “We keep hearing about the bonuses, which are shocking, but also a red herring. If the banks were allowed to go through bankruptcy, as they should, contracts [with employees] would be a non-issue. The real issues, which we’re of course not hearing about, are restoration of bank regulations and breaking up the banks, so that they’re small enough to fail (instead of using our money to get bigger!)…” You get the drift. To my knowledge, this is the first time in American history that we have bailed out speculators and gamblers. There used to be a time when, to get money from the government, you had to agree to regulation. This quid pro quo was the right and fair thing to do for the American people. Now we have dispensed with all such formalities. The government is a hollow shell run by corporations. Ever seen who sits on the Council of Economic Advisors? And, of course, all of the so-called regulatory agencies, and the White House and Congress. For the Republicans, the paymasters were the oil companies. Under the Democrats, it’s Wall Street. Nothing fundamental has changed since GWB. It really is more of the same. America: R.I.P.