THE BEAR'S
LAIR Wall St greed to feel the
squeeze By Martin Hutchinson
The Bear Stearns bailout was not quite
unprecedented; Continental Illinois Bank in 1984
and Citicorp in 1991 were both beneficiaries of
Fed-orchestrated rescue operations. And
notoriously, the hedge fund Long Term Capital
Management was not allowed to fail in 1998.
However since the mortgage crisis is by no means
over, and further financial difficulties seem
likely to appear as the US recession deepens, it
raises the interesting question of what kind of US
financial system we can expect to see in 2013,
after the storm has passed.
Economically,
we can expect to be climbing out of the current
unpleasantness by 2013 - it may be prolonged, but
probably not quite that prolonged. This is not
Japan, and given the choice of a short sharp shock
or 15 years of stagnation, most US
voters
would
choose the short sharp shock. In any case, capital
spending has been depressed since 2001 and
corporate balance sheets have markedly improved;
thus we are to some extent already seven years
into the process of recovering from the dot-com
bubble.
Nevertheless, the financial system
in 2013 will have a memory of a debt crisis,
followed by a sharp decline in housing prices,
followed by inflation, followed by a decline in
stock prices. It will not have been a pleasant
five years, and financial market participants,
both institutional and individual will have been
scarred by the experience.
Financial
market structure in 2013 will probably be very
different from today. How different depends on the
degree of pain suffered by market participants in
the intervening five years, and the actions taken
by the authorities in their attempts to clean up
the mess and return markets to an even keel. Those
matters are intrinsically unknowable; while one
can forecast with some assurance the general shape
of an economic downturn, one cannot be sure of its
depth, nor of the order in which traumas occur,
nor of the political position, economic resources
and sheer basic competence of the authorities
attempting to deal with problems.
It is
just possible that the impending downturn will be
relatively mild, in which case the financial
market structure and ethos will be only modestly
changed, as it was by the 2001-02 downturn. That
outcome is however fairly unlikely given the
apparent scale of impending losses. In what
follows I have assumed that serious and repeated
losses will have provided Teaching Moments for
market participants and regulators, and will have
pushed the market structure beyond the "tipping
point" at which fundamental change occurs and a
new equilibrium structure shakes itself out.
In that event, of a recession and
financial crisis that takes Wall Street beyond the
"tipping point" at which a new structure appears,
the risk-tolerant, even risk-seeking culture
prevalent on Wall Street for the last generation
will be gone. In addition, government will have
stepped in with new regulations, some of which,
like the Glass-Steagall Act of 1933 that separated
banking and investment banking, will decades later
prove to have been counterproductive.
Too big
to fail In all probability the most
structurally significant of those regulations will
involve the "too big to fail" doctrine that has
repeatedly brought the Fed to rescue of ailing
behemoth banks and investment banks. If an
institution is too big to fail, so that taxpayers
are ultimately at risk for its actions, then
well-designed legislation would also prevent it
from taking excessive risks.
The ludicrous
structure of the hopefully now moribund Basel II
bank capital regulations allowed large banks to
take more risks than small ones, while relying on
their own dodgy risk management systems to monitor
the mess. The huge checks that taxpayers will be
forced to write in the downturn will bring huge
political demands for legislation forcing "too big
to fail" banks and brokers to act in a highly
conservative manner in order to preserve their
"too big to fail" status.
Under this new
legislation, banks and brokers with more than a
certain volume of deposits, capital or total
assets will be compelled to register as
"mega-institutions". They will benefit from an
automatic Fed bailout, but in return will be
compelled to submit to very strict capital ratios
and restrictions on the businesses they will be
permitted to carry out.
In particular,
they will be permitted to carry out new businesses
to a total principal amount of only 10% of their
assets, until those businesses have been
registered with and approved by the Fed for
mega-institution activity. Thus credit
derivatives, for example, would not have been a
permissible business for mega-institutions except
in small amounts until the Fed on behalf of the
public was completely satisfied their risk
management problems had been solved.
With
these restrictions, the mega-institutions would be
neither risk-seeking nor innovative. They would be
conservative in outlook and their management would
be paid respectably but not lavishly, perhaps
somewhat above the level of Federal civil servants
of equivalent responsibility. Fannie Mae and
Freddie Mac, which by 2013 will probably have
received at least one taxpayer bailout, will be
registered as mega-institutions, and compelled to
follow the stringent capital regulations for "too
big to fail" banks. (If this put them out of
business, tough; the home mortgage market would be
the better if it lacked their quasi-public
participation). In that event they would probably
pay their top brass like the GS-15 civil servants
they truly are.
Given the draconian
restrictions on mega-institutions, new financial
innovations would have to come from somewhere
else, as would the risk-seeking that has been so
successful in the last couple of decades. In the
latter area, current structures would probably
survive, to a limited extent, in hedge funds and
private equity funds. These would have difficulty
raising large amounts of capital, since the
mega-institutions would not be allowed to invest
in them, and would be very limited in their
lending. Moreover fiduciaries such as pension
funds will by 2013 have discovered the hard way
the legal dangers of subjecting beneficiaries’
money to the risks of hedge fund investment and
the Pharaonic remuneration standards of hedge fund
managers.
As at present, hedge funds and
private equity funds would be short-term in their
orientation and would continue to supply capital
to the riskier areas of arbitrage and venture
capital and psychic and occasionally financial
satisfaction to the greedier "bankers". Their area
of productive operation might theoretically be
increased by removing the competition from the
mega-institutions, but their profitability would
alas be severely affected by this elimination of a
class of enormously rich suckers.
Intelligence
demand There would then remain a need
for intelligence, to carry out true financial
innovation, profit from new product areas while
their volume is still relatively small and their
margins high, and advise on merger and acquisition
transactions and on financial re-organizations
generally. This business would be increased by the
elimination of many large "profit center" finance
departments in major corporations.
The
losses and indeed bankruptcies due to ill-judged
speculation by profit center finance departments
will have demonstrated to even the doziest boards
of directors that at best such departments are an
expensive, poor quality and unnecessary
duplications of Wall Street, while at worst they
are an invitation to ignore the firm's core
business and "make the numbers" through
value-subtracting speculation. Eddie Lampert, he
of the attempt to turn Sears Roebuck into a hedge
fund, will no longer be a revered name by this
point.
This intelligence will be provided
by much smaller houses, generally private
partnerships, living on their wits rather than
their capital, which will navigate between the
hedge funds and mega-institutions to make money
for themselves and provide service to their
corporate and wealthy individual clientele
(private banking is an intellectual-value-added
business only at the very top of the wealth
spectrum.) They will perform the functions of the
pre-1986 London merchant banks or some of the
pre-1975 Wall Street investment banks, and will
operate in the same way, living primarily on the
fees they earn.
By removing the temptation
to "principal investing" inherent in the current
behemoths, these institutions will eliminate a
huge conflict of interest and allow for the
reduction in the share of national income devoted
to financial services. Naturally, to deal
effectively with giant corporations and the very
rich they will have to have what the 1960s Bank of
England Governor Rowland, Lord Cromer called
"prestige and standing". As their market develops
they will quickly discover that they will not get
this by operating hedge funds, or by risking
scarce capital in speculation.
Finally,
there will be the "minnows", those banks and
brokerage houses not large enough to be
"mega-institutions" but still providing banking
and/or brokerage services to a limited clientele,
generally regionally. They will not be permitted
to grow beyond a certain point without registering
as "mega-institutions" but will otherwise operate
with fewer restrictions and more generous capital
ratios than the mega-institution fraternity.
Since regulation will have eliminated much
of the economies of scale from growing "too big to
fail" these entities will be highly competitive in
their limited markets, surviving by means of lower
capital costs, lower top management salaries and
better customer service. Indeed, since
securitization will have fallen largely out of
favor, they may find a profitable new line of
business in home mortgage lending, which they will
perform more efficiently than the Wall Street
machine. (Research has shown that the move from
direct home mortgage lending to securitization
between 1970-75 and 2000-05 added about 50 basis
points per annum (0.50%) to the cost of every home
mortgage in the United States - the new market was
pure rent seeking.)
The new Wall Street
will be less exciting for the greedy but provide a
better service for customers, while shrinking the
financial services sector back towards its
historic level and eliminating most rent seeking
behavior. As such, its emergence will be one of
the few unequivocal benefits of the miserable
recession ahead.
Martin
Hutchinson is the author of Great
Conservatives (Academica Press, 2005) - details
can be found at www.greatconservatives.com.
(Republished with permission from
PrudentBear.com . Copyright 2005-07 David W Tice
& Associates.)
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