The Continuing Scourge of Too Big To Fail

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I had the distinct pleasure of hearing Simon Johnson, an economist and professor of entrepreneurship at MIT's Sloan School of Business (and former Chief Economist for the International Monetary Fund) speak last night at a wonderful event produced by Zocalo Public Square, a local LA non-profit public affairs forum.  Johnson also is the author (with James Kwak) of the recently published 13 Bankers, about the financial crisis and how to stop another crisis from occurring again, and blogs at the Baseline Scenario, a blog I've been following for months and have linked to several times previously.

Johnson spoke quite emphatically about the need for fundamental financial reform, not as a partisan of any stripe (indeed, he claims to be a free-marketer more than anything else) but because the current financial system we have is not actually "capitalism" per se.  Why is that?  Well the phrase "too big to fail" (TBTF) signifies the problem at the center of our financial crisis, and within TBTF lies the potentiality for a future crisis even larger than the current one.  

First of all, what is "too big to fail"?  While we've certainly all heard the term bandied about since September 2008, I imagine there is some confusion out there.  The concept is that the financial institutions that were bailed out through the Troubled Assets Relief Program (TARP) instituted by former Treasury Secretary Hank Paulson, Federal Reserve Chair Ben Bernanke, and President Bush, among others, simply held too many assets in our economy, and were too interconnected, to be allowed to declare bankruptcy.  If the financial institutions (banks, such as Bank of America, and investment houses, such as Goldman Sachs) were allowed to fail, as Lehman Brothers was, then those failures would lead to an unprecedented breakdown of the global financial markets.  Furthermore, due to the interconnectedness of the various players in the markets, the thinking goes, the failure of one of the financial institutions could lead to the failure of others.  Why the institutions were all so interconnected is perhaps beyond the scope of what I'd like to say here today (in interests of length), but suffice it to say that AIG is one of the primary sources of the interconnectedness, and Goldman Sachs is another.

How did we get to this point where the banks were so big and interconnected that they could not fail without bringing down the global economy?  Well, I could try to explain, but I think I'll let Prof. Johnson explain, with the help of Steven Colbert:

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Simon Johnson
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Prof. Johnson raises a few points that are worth elucidating in that segment; first of all, the idea that the TBTF banks have an incentive to act recklessly and to take foolish risks with their investors' money.  This concept is known in economics terms as "moral hazard," and is essentially the idea that if you have a guarantee that the risks you face have been either eliminated or severely reduced by another party, then you will be inclined to take larger risks than you would without that guarantee.  Take, for instance, driving a car without auto insurance versus driving with auto insurance; you're likely to drive far more slowly and carefully without insurance than you would with insurance, because with your insurer's guarantee that they'll pick up any financial losses you incur through poor driving, you are not "on the hook" for your mistakes in the same way you would be without insurance.

The implicit backing of the government that came with the TARP bailouts of the largest financial sector players creates a moral hazard scenario in just the same way.  If a TBTF investment firm received a government bailout, then the individual managers and employees at that firm will be liable to take risks that they would not otherwise, as whatever they do, the government will ensure that their poor decisions don't cause the firm to go bust.  So, far from reducing the incentives of financial firms to reduce their exposure to risky investments, the bailouts in fact increased the incentives of firms to take massive risks, and to leave taxpayers to foot the bill.

A second point to discuss that is a corollary to the first (and which Johnson spoke at length about last night) is that the TBTF firms, with their implicit government backing, are receiving preferential treatment in the financial markets that are creating advantages for the banks to become even larger.  Essentially, because the government will not allow the TBTF firms to fail, they receive reduced interest rates when borrowing from private lenders.  Because the lenders perceive the TBTF firms as "safer" investments than firms that don't have government backing, they are willing to reduce the interest rates they charge the TBTF firms compared to other firms.  Naturally, this situation distorts the market's functioning, and gives the TBTF firms an advantage over their competitors that allows them to gain even larger market shares.  Hence, the failure of capitalism due to government intervention in the marketplace.  Johnson estimated the interest rates of the TBTF firms were reduced by approximately .7-.9% compared to their non-TBTF competitors, which may not sound like much, but when applied to loans and trades of billions of dollars at a time, those fractions of percents add up to large sums of money.  

So what is Prof. Johnson's solution?  To break up the TBTF firms into smaller, more manageable (and less economically dangerous) firms.  Johnson and a number of other significant economists estimate that a $100 billion limit on total assets under a firm's control is an ideal target to aim for.  What does that figure mean?  Well the current combined holdings of Bank of America, JP Morgan Chase, Citigroup, and Wells Fargo are approximately $7.4 trillion, and there are 23 institutions in the US that have assets over $100 billion.  Therefore, there will have to be a lot of division of these large institutions into smaller ones (simple arithmetic reveals that the $7.4 trillion of the four megabanks noted above, if divided into $100 billion sub-banks, would create 74 new institutions) and it is in the process of "breaking up" the banks that a lot of complication will occur, as in any complex transaction.  Furthermore, these firms are all multi-national, meaning that the US acting alone will not achieve any significant regulatory reforms unless those reforms are accompanied by international agreements.  It will be difficult enough for Congress to pass any semblance of meaningful financial reform (as evidenced by the Republicans' continued obstinacy) without having to deal with cross-border issues as well.  

I think I'll stop there for now.  There is still lots more to discuss about the financial crisis, as my understanding of the causes and the (proposed) solutions has been growing and evolving rapidly in recent months, and I'm eager to share what I've gained with you, my readers.  Despite not being a "finance guy" in the least, I believe that the simple fact that our financial sector has become such an integral part of the world economy requires that I attempt to understand what happened and how to prevent a recession of similar scale from ever happening again.  Any understanding I gain I'll attempt to pass on, since it's such a complex topic, but worthy of understanding by many.

In this posting I've focused only on the TBTF firms and the threats they pose to the financial markets and the world economy.  In future postings, I'll look at the political implications of such concentrations of wealth and power, as well as how it is that the financial sector got to have such power and influence as it does today.  If you have any further questions or a need for clarifications (or if I've totally bungled some facts in this posting) please comment on this piece below, or email me at generationalnavelgazing -at- gmail dot com (trying to protect my account from spammers, you know).

Additional programming note: I plan on returning to the subject of the Tea Party movement soon in an additional posting following up on my post from two weeks ago, so stay tuned for that.

UPDATED: Remember the Titans (of Industry are Not Friends of Yours)

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Allow me, if you will, to paint a layman's picture of the economic crisis and unbridled greed through the use of some headlines that have caught my eye in the last few days.

Headline 1: With Wall Street Shorting the Dollar, It is Time for Congress to Pursue Fundamental Change by David Paul, President of the Fiscal Strategies Group. This article provides some insight into how it is that Wall Street is managing to have one of its best years ever, despite the fact that the rest of the economy is in the grip of a major recession brought on largely by Wall Street's criminally risky behavior. Outrageously, after having been bailed out by US taxpayers, the banks are making their billions right now by shorting the US dollar and thereby effectively weakening the US' international position further than it would be otherwise. I won't excerpt from this article, as the entire piece is well worth a read, and has sadly been overlooked by the continuing popular outrage against the billion-dollar bonuses the banks intend to pay out this month, but suffice it to say that the banks are committing financial treason, if not outright treason, in pursuit of their profits at all costs.

UPDATE: Turns out that the Federal Reserve will allow the bet-against-the-dollar party to continue through the rest of the year by keeping the interest rate between 0% and 0.25%.  Sounds swell.

Headline 2: Obama Blasts Banks for Opposing Financial Reform: Here Obama comes out with some populist lines trying to get ahead of public sentiment against the excesses of the banks, and those banks ignore him, since he officially has no leverage over the banks' practices now that virtually all of them have paid back their TARP funds to the government. The banks are now free to continue to reduce business lending and to actively oppose any sort of reform that puts a damper on their radical activities. The lack of lending is slowing the economic recovery as businesses aren't able to hire workers as easily, and the banks know that they have the power to hamper any sort of recovery through cutting down on lending, effectively vetoing the President's initiatives from the private sector.

Headline 3: Bailout Banks Keep Tax Breaks As They Repay Loans: Yes, Citigroup and others are going to cash in on massive tax breaks, even as they repay the TARP funds that put caps on compensation practices early, to better engage in the type of compensation practices that preceded the economic collapse. The IRS appears, for all intents and purposes, to be in collusion with the banks on first glance, however by allowing for these tax breaks, the Treasury Department is actually increasing the value of the banks' shares, so that taxpayers get a better return on their TARP investments. Still, it's just an extremely sketchy way of going about increasing a company's worth, when the underlying fundamentals are still so weak. It is never a good thing for a company to rely on tax breaks to increase its value, rather than on sound business practices (say I who support tax breaks alternative-energy companies...)

All that being said, there appears to be hope on the horizon in terms of financial reform. Yes, the House passed a reform bill last week, but that effort was weakened by bank-friendly Democrats, and as noted in the above link, the Senate will now be the main battleground over financial reform going forward, with bank lobbyists gearing up for a major fight. But the Senators may have some tricks up their sleeves, and a voice from the past may play a larger role in the reform movement still to come.

Hopeful Headline 1: McCain and Cantwell Want a New Glass-Steagall Law by Michael Hirsh for Newsweek. Glass-Steagall is a post-Depression-era law that worked to separate the investment arms of banks from the commercial lending sides (what we know as the regular bank you set up checking and savings accounts with, and that provide loans for cars to homes). The idea behind Glass-Steagall is that the investment sides of banks can take the risks, but the lending sides should be more well-regulated, and they will be provided for by the newly-created Federal Deposit Insurance Corporation (FDIC) with the government as "lender of last resort" should a bank fail. With the 1999 repeal of Glass-Steagall, the banks were allowed to merge their lending and investment arms, and some, such as Sens. McCain and Cantwell, believe that the risky bets the banks took with depositors' money, such as derivatives, laid the groundwork for the mess we're in today. While I'm no economist (I've only taken one micro class thus far) and I'm certainly not a financial market expert, it would appear to me that if the banks could get back to their core business of banking that would be a welcome return for many. Which leads me to my next point...

Hopeful Headline 2: Paul Volcker: Think More Boldly and interview with the Wall Street Journal's Alan Murray. Paul Volcker, former Federal Reserve Chairman under Presidents Carter and Reagan, argues that the "financial innovations" Wall Street has foisted upon the world in the wake of Glass-Steagall's repeal add nothing in the way of actual productivity or economic growth in the economy as a whole. The titans of Wall Street created fake profits, and the financial innovations of credit-default swaps and collateralized debt obligations simply "move around the rents in the financial system" meaning the complex transactions that played out between banks and insurers (such as AIG) to spread the debts out amongst many different players. Volcker goes on:

How do I respond to a congressman who asks if the financial sector in the United States is so important that it generates 40% of all the profits in the country, 40%, after all of the bonuses and pay? Is it really a true reflection of the financial sector that it rose from 2½% of value added according to GNP numbers to 6½% in the last decade all of a sudden? Is that a reflection of all your financial innovation, or is it just a reflection of how much you pay? What about the effect of incentives on all our best young talent, particularly of a numerical kind, in the United States?

In Britain, I was just talking to a high-tech company about the immense attraction to go into finance when both Britain and the United States are suffering from a basic inability to produce things competitively, to keep up with the new economy. Is this a result of financial innovation that we should be really worried about?

These thoughts intrigued me; how much have the outsize profits to be had in finance over the last decade shaped the job market in the US? How many of our "best and brightest" have gone on to huge-paying Wall Street jobs that would have otherwise gone into less, ahem, financially-motivated work? Look at these graphs of US job growth over the past decade; what does it say about our country when the investment sector grows from 2.5% of GDP to 6.5% over 10 years, but job growth drops to near-zero percent over that same period of time? Is there a link, a correlation, a causation? My limited economic knowledge at this point in my education leads me to admit that I cannot find an explanation for those two inverse movements of financial-sector activities and job growth, but I would be greatly interested if someone could explain them to me.

Let me take a moment to plug a wonderful website I've just recently come across, The Baseline Scenario, which, I must acknowledge, led me to the Volcker interview in the first place.  Some very esteemed financial market watchers and economists evaluate the current economic situation and provide some solutions, in very detailed form. I'll do some more investigating into the jobs/financial sector expansion connection and report back when I can. The main idea I've come away with is that the American people are being misled and misrepresented by our public officials and big businesspeople all at the same time, on many levels. It pains me that Obama has not been more of a force for true reform, especially when the plundering of our nation's economy and public coffers has been so widespread and rampant by the titans of industry. There's still time yet to make some fundamental changes, and Volcker seems quite confident that his views will prevail, so let's hope the situation changes soon.