More Fannie Maes & Freddie Macs To Come

Jonathan Koppell, an associate professor at the Yale School of Management, wrote a rather comprehensive piece in Monday's Wall Street Journal concerning the dangers of our current path to creating a group of "too large to fail" private sector, publicly-held financial institutions.

Citing the implosion of politically-protected and government-guaranteed Fannie Mae and Freddie Mac, Koppell argues that, in exchange for governmental backing, these banks will slowly, inexorably be drawn into political capital allocation. For example, he contends.

"Financial institutions will inevitably be beset by requests from members of Congress to "take another look" at rejected loan applications from favored constituents."

Further in his editorial, Koppell observes,

"The question is whether the marginal benefit of maintaining large integrated financial groups justifies the hazards that they introduce. There is scant evidence that financial giants make working capital more affordable or allocate credit more efficiently than smaller institutions. In fact, they may siphon capital away from lending activities that more directly expand the economy."

Amen to that.

I was a senior planning executive at Chase Manhattan Bank when it employed about 45,000 people. Now, the bloated financial utility has over 220,000 people.

Do you think smarter people are running Chase now? Don't bet on it. It's just an amalgamation of four old-fashioned money center banks which once did the same things in four different organizations scattered across Manhattan and the world: Chemical Bank, Manufacturers Hanover, JP Morgan and Chase Manhattan.

What you see now is simply the compressed remains of the four money center banks which weren't Citi, and didn't fail, like Bankers Trust.

I can vouch for Koppell's suspicions. Even in its smaller days, Chase Manhattan's scope and scale resulted in inefficient capital allocations among its businesses, "play it safe" lending and operating decisions by business managers, and far too much political maneuvering for career advancement.

I'm quite sure it's only worse now.

Add government guarantees, and you are looking at even worse problems. Think of Merrill's runaway mortgage finance unit of a few years ago, on steroids.

This time, any mess that some fairly innocuous business buried in the bowels of Chase gets into will be paid for by- you and me. As taxpayers.

Think this will result in more effective risk management at Chase? Not on your life.

Koppell finishes his piece by noting,

"To the leaders of financial powerhouses, the siren song of government backing will be nearly irresistible, particularly when irritants like federal pay czar Kenneth Feinberg can be tuned out. Unlike Ulysses, however, these captains of finance will never bind themselves to the mast. If we don't do it for them, we'll all end up on the rocks."

There's only one silver lining which I can see in all of this.

That is, my friend B's prediction from 1996 will come true among the ashes of exploded, government-seized banks whose activities were guaranteed. After the next blowup, they will probably be restricted from risky activities like underwriting and proprietary trading, as Paul Volcker has suggested.

In their absence, dozens of private equity firms and boutique lenders, traders and underwriters will flourish.

Nature and markets abhor vacuums where services need to exist to service demand. When the inept, gigantic financial utilities have been "guaranteed" out of the riskier financial businesses, new, more skilled ones will replace them.