Friday, November 27, 2009

Mort Zuckerman On "Too Big To Fail"

Mort Zuckerman wrote a good editorial in Wednesday's Wall Street Journal addressing the "too big to fail" phenomenon in US banking.

He lays out the situation that fostered super-sized financial institutions in the beginning of his piece,

"It is also true that the wisdom that led to the Glass-Steagall Act, which separated commercial banks from investment banking during the Great Depression, was discarded. In 1999, President Bill Clinton and Congress revoked the act, thereby accelerating financial consolidation through mergers and acquisitions. So we got huge firms whose failure would bring down the whole house of cards. The too-big-to-fail phenomenon led to bailouts with taxpayer money, provoking a deep-seated public anger that has been further aggravated by the recent pile of executive bonuses.
The too-big-to-fail firms, in short, lie at the heart of the current crisis. Some are now even bigger, in part because the government had to sponsor and support several mergers that made them larger. The presumption was that big meant diversified and sophisticated and, therefore, less risky. That presumption proved false.

The dangers posed by a too-big-to-fail financial firm surely must be dealt with by new legislation, and one change needed is that the price large banks pay for the privilege of size should be significantly increased. If they benefit from explicit or implicit protection from the government, they should not be able to ride free on the backs of taxpayers.

Their risk of failure should be reduced one of two ways: by increasing capital requirements or by providing the option for the banks to be smaller or less systemic. This can be done either by narrowing what businesses they can be in or by making them less interconnected. In the worst-case scenario, the final backstop has to be bankruptcy or dissolution through a series of well-ordered procedures that do not imperil the whole economy or adversely affect our market-based system of credit."

I think Zuckerman is correct. His recommendation echoes that of my friend B, who first, among people I know, or what I have read, first predicted the rise of financial utilities in a conversation with me in 1996. That is, the driving force has to be to refuse implicit government deposit guarantees to large, risk-taking financial service firms.

Since really large banks have to be in many businesses, there should be some sort of firewalls between any government-insured businesses, and the riskier ones, or, at such sizes, government insurance should simply be priced for the added risk.

What puzzled me, though, was Zuckerman's contentions regarding such large financial institutions,

"Moreover, it must be remembered that the size of many of our financial institutions, despite its role in bringing on the crisis, has also greatly benefited the U.S. economy. Size, for example, enables our big financial firms to compete against others in Europe and Asia.

The too-big-to-fail institutions operate around the world, participating with similarly large financial partners to execute diverse and large transactions. They offer a full range of products and services, from loan underwriting and risk management to local lines of credit, providing financing to states and municipalities as well as firms of all sizes.

Should we fragment and constrain the system and cap the size of banks, it would undoubtedly limit the competitive level of service, breadth of products, and speed of execution. Clients could turn to foreign banks that don't face the same restrictions. Ill-judged reform could undermine one of the most important ingredients of American global power: our financial know-how, intellectual firepower, and size."

I must say that I emphatically disagree with Zuckerman on this point. He may have been correct in the 1960s and 1970s. But certainly by the 1980s, when I was at Chase Manhattan Bank, the evolution of deep, broad global financial markets had pretty much negated the advantages of banks with global reach, offsetting the declining advantages with the headaches of managing such sprawling, multi-business entities.

How does Zuckerman explain the rise of standalone mortgage banking, M&A and credit card companies in the 1980s?

Further, those very financial utilities were the ones which required such expensive cleanup and, in the case of Citigroup, Wachovia and WaMu, went bust.

If these financial titans created such value, how did they manage to self-destruct? That's a rhetorical question. The answers are, they were either too complex to safely and profitably manage, or didn't really provide extra benefits, or both. And I think it's "both."

The capital markets and technology of the past two decades have given smaller financial firms with better people advantages over the Citigroups, Chases and Goldman Sachs.' The new breed of excellent financial service firms are, once more, privately held, i.e., the better hedge funds and private equity shops.

For some reason, many people, including Mr. Zuckerman, behave as if the latter don't exist, and only focus on publicly-held financial institutions. But the mere fact that such successful hedge funds and private equity shops exist ought to be evidence to intelligent observers that the financial utilities simply aren't so valuable and uniquely important, after all. The really good people already left those cattle pens for the greener, more flexible fields of privately-held financial companies.

Finally, Mr. Zuckerman ends his piece with lavish praise for helicopter Ben and his Fed,

"The central bank may have fumbled a bit in the evolution of the bubble economy. But once the crisis hit, it was the Fed, under Chairman Ben Bernanke, whose innovative, imaginative response to the crisis literally saved the financial world.

Should Congress undermine the Fed, we could face a world-wide collapse of confidence in the dollar that would inevitably lead to higher interest rates. Congress is always playing the blame game, but it would be irresponsible to undermine the Fed and its capacity to handle the new financial world that we will all be living in."

Again, I respectfully disagree. I continue to believe that Anna Kagan Schwartz was correct in diagnosing last year's financial panic as one of solvency, not liquidity. Because so many bondholders were rescued, real consequences for the failure to appropriately measure risk were never felt. Instead, global interest rates have fallen back to levels which engendered the crisis in the first place.

Were insolvent banks simply closed and merged, the system would have automatically stabilized. The US, and, for that matter, the globe, was over-banked. The reason such financial junk as mortgage-backed CDOs were pumped out is that profit margins on conventional financial instruments were so thin, due too excess capacity and competition. Fewer, more solvent remaining financial institutions would have been a better result, with any legitimate needs for financial services being filled by the remaining institutions, both publicly- and privately-held.

The only thing that would have truly vanished was excessive leverage. Instead, the Fed replaced that with publicly-supplied leverage, and we are suffering the consequence of that now- a suspect economic "recovery."

Mr. Zuckerman then, in my opinion, reasons incorrectly, opining that an undermined Fed would lead to higher interest rates. That's the reverse of what most believe, i.e., that a Congressionally-compromised Fed would be forced to hold rates too low in perpetuity.

But we already have that, as David Rosenberg recently noted. Bernanke, in his quest for renomination, opened the monetary floodgates, and we have zero interest rates and an unprecedented rise in the monetary base as a consequence.

How much worse could it get under another regime?

In sum, I believe Mr. Zuckerman, whose editorials I generally find well-reasoned and sensible, only got this partially right. He is correct to call for risk-based pricing of any sort of government-provided insurance to financial institutions, particularly large ones. But his estimation of the value of financial utilities, and the correctness of the Fed's actions last year, are, I believe, widely off the mark.

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