Capital Offense

Forty years ago, when I was a banker, we made our money by paying depositors enough interest to keep them slightly ahead of inflation and by making loans to credit-worthy customers for mortgages and automobiles. The spread was just a few points and most of the work was done by hand, so the process was more expensive but our fees were lower. Since we kept the paper, instead of bundling it into tranches, we were careful. Specialized banks put together IPOs, helping finance start-ups and private firms going public. At that time, the finance sector was very small portion of the economy and my fellow bankers were a boring lot, even the investment bankers. But we were honest, straight arrow types.

Now, the finance sector reaps 42% of all profits, even small banks sell their paper, the dividing line between investment banks and others is gone, and the big banks make their money developing and selling derivatives, complex financial instruments, and placing bets. In my day, physicists and mathematicians worked for NASA or the newly developing Silicon Valley. Today, they develop models and financial instruments that make it possible to leverage excessively and next to impossible to evaluate risk.

Between December 2007 and 2008, household wealth fell 17%, more than five times the decline in 1929. Over the three decades ending in 2007, the top 1%’s share of the nation’s total after-tax household income more than doubled, from 7.5% to 17.1%. The share of the middle 60% of Americans dropped from 51.1% to 43.5%.  The Great Recession, which began in the Fall of 2007, temporarily halted the stratospheric advance of the rich but they, and they alone, have now largely recovered. The record level of income inequality in America is growing once again. Wall Street year-end bonuses for US hedge fund employees will rise by 5% this year – after increasing 15% last year.  Portfolio managers at larger funds will average $4.85 million. (FT, Hedge fund bonuses signal rosier times, 11/5/2010)

During the Depression, the financial sector was totally revamped. So far, during the Great Recession, Dodd-Frank makes only relatively minor revisions: higher capital requirements for banks, more derivative trades on standardized exchanges, walling off some swaps, etc. When I’ve gone to conferences, of such ICGN, there is a strong sense that although institutional investors have gotten religion about the need to better assess the risk of their own portfolios, little has changed in our financial markets. Few were marched off to jail. Wall Street remains the master of Main Street.

In his book, Capital Offense: How Washington’s Wise Men Turned America’s Future Over to Wall Street, Newsweek reporter Michael Hirsh writes a compelling tale that reads more like a novel than a well-researched history. Hirsh looks back at how the free-market zeitgeist hit what he thinks may have been its peak in the Fall of 2007, but I think maybe not. One could argue the results of the recent election signal a return to the policies of free-market advocates like Milton Friedman, Alan Greenspan, and Robert Rubin.

Hirsh traces the intellectual threads and individual personalities that lead to the financial crisis. When it hit, even Greenspan admitted the folly of his hands-off policies and called for a breakup of the biggest banks.

“If they’re to big to fail, they’re too big,” Greenspan said. “In 1911 we broke up Standard Oil — so what happened? The individual parts became more valuable than the whole. Maybe that’s what we need to do.”

We didn’t. How did it happen? Hirsh does a good job of laying the whole thing out. Much of it involves spinning gold from lead through mechanisms that hid risk used by those who manipulated a sacred belief in free markets, herding instincts, and a game of musical chairs based on so-called tail risks that seemed unlikely to occur, since they would result in catastrophic system failure.

Hirsh cites Martin Wolf of the Financial Times: “Just as Keynes’s ideas were tested to destruction in the 1950s, 1960s, and 1970s, Milton Friedman’s ideas might suffer the same fate in the 1980s, 1990s, and 2000s.” “Call me naive,” Paul Krugman wrote, “but I actually hoped that the failure of Reaganism in practice would kill it. It turns out, however, to be a zombie doctrine. Even though it should be dead, it keeps on coming.”

Too many have too much invested in the current system. Politicians and regulators who go along with the herd are rewarded. The business model remains intact with the same people or their disciples in charge. “By the end of 2009, over-the-counter derivatives trading had climbed back up to more than $600 trillion. Of that amount some $230 trillion was controlled by four banks: Goldman Sachs, JP MorganChase, Morgan Stanley, and Bank of America.”

Daniel Sparks, the former head of Goldman’s mortgage department, freely admitted in Senate testimony that their obligation was to act in their own best interest, not those of their clients. We now see the market was rigged, full of scams, much of it justified by aiding liquidity. However, even as reforms are contemplated we must recognize that Wall Street is global, government is not.

Joseph Stiglitz appears to be Hirsh’s hero in the wings. Stiglitz argues the rich have more money than they can possibly spend, while the poor — who would spend all they have — have little to nothing. Economic growth driven by demand has cratered, especially in developed countries like the US where the gap between rich and poor is rising. Stiglitz argues we need to reorder incentives to move financial engineers to more productive pursuits, like real engineering. Wall Street objects; that would deprive them of top talent but Stiglitz argues that is exactly the point. (read Freefall: America, Free Markets, and the Sinking of the World Economy)

Real reforms during the Depression didn’t really take shape until after Pecora delivered his report. The Financial Crisis Inquiry Commission, headed by Phil Angelides, has a report due in December 2010 but Hirsh doesn’t hold out much hope. He calls Angelides “well-meaning” but “out of his depth.”  Hirsh notes that Angelides used his first hearing to call in the biggest Wall Street CEOs. That made good press but, as one observer noted, it was like “making Richard Nixon the first witness in the Watergate hearings.” Better to start with those on the front line.

Hirsh ends on a bleak note. The U.S. has lost ground in our ability to achieve military victories in asymmetric warfare, in manufacturing, technological innovation, and now in our moral authority tied to a free-market fantasy. “The age of certainty is over” but Wall Street continues to dominate the U.S. economy. I’ve heard the same bleak assessment time and again, although not so coherently argued, at many money manager and director’s conferences during the last two years.

At a 1953 hearing before the Senate Armed Services Committee, GM president and Secretary of Defense nominee Charles Erwin Wilson was asked if he could make decisions adverse to the interests of General Motors. Wilson answered affirmatively but added that he could not conceive of such a situation “because for years I thought what was good for the country was good for General Motors and vice versa.” We now seem to be under the delusion that what’s good for Wall Street is good for the country, even though we’ve seen it ain’t necessarily so.

Also of interest:

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