For smart reform, leverage needs to be reined in
Posted: March 09, 2010
All financial markets are driven by two core human emotions - greed and fear. In the 1990s and 2000s, greed ran amok in large part because too little fear was present. Our regulatory system failed in its primary purposes — to temper greed with fear in order that the markets can be trusted. How is Washington currently responding to this breakdown?
Recent Congressional hearings, the Angelides Commission and White House proposals all are aimed in the same direction: They excoriate the Wall Street executives (ironically, in particular Jamie Dimon of JPMorgan and Lloyd Blankfein of Goldman Sachs who led their firms most successfully through the crisis) and propose regulations that would punish the survivors. Little or no regard is being given to learning the differences between those who survived and those who failed for lessons to incorporate into regulatory reform.
Similarly, none of the current proposed reforms reflect a deep understanding of historic successes from our regulatory past. In order to restore the proper balance between fear and greed, in order to restore trust in Washington and eventually Wall Street, any regulatory reform must address the consequences of excessive leverage and inadequate enforcement.
Solutions are being proposed with little apparent regard to addressing the issues that caused the crisis. Washington's initial response to a cure was to cap bonuses at financial institutions that received TARP bailout funds. So what happened? The institutions responded by raising salaries-the fixed, guaranteed portion of compensation. When American Express earlier this year raised the salary of its CEO by 60 percent, a permanent bonus of 60 percent was locked in. Washington inadvertently had increased the fixed costs at the institutions in which it had invested taxpayer funds — not a great step toward restoring profitability — and at the same time lowered the motivation for the executives to achieve success by reducing the relative importance of incentive-based compensation.
Currently, there are proposals to limit the size of financial institutions by capping or taxing their assets, their liabilities, or both; prohibit banks from proprietary trading or ownership of hedge funds; once again split banks into risk-taking investment banks and more cautious, deposit-taking commercial banks (a la Glass Steagall); and copy what has already been done in the U.K. and France by placing a high income tax on Wall Street bonuses.
Each of these proposals has serious flaws. We live in a globalized world. Reforms implemented solely for their short-term effects within the U.S. will inevitably fail. Neither Europe nor Asia has shown any inclination to limit the size or activities of their banks. If American banks were arbitrarily restricted in size, the competitive disadvantage that our banks would be placed in would result in higher interest rates for loans to their American customers and lower interest rates to their depositors. Executives are mobile and, as London is already seeing, high taxes on bonuses drive the "best and brightest" to other locales, resulting in a loss of jobs in your own country and creating jobs in the new locations. Diversity in revenue sources dampens cyclicality. Prohibiting participation in certain revenue streams could very well have the unintended consequence of increased volatility. As flawed as each of the proposals is on their own merits, they all share one flaw in common — they do not address the causes of the crisis!
Neither hedge funds nor proprietary trading desks caused our problems; nor did big bonuses; nor did the biggest institutions. Creating narrower, less well-compensated, smaller institutions very well could leave us uncompetitive with foreign banks and more, not less, vulnerable to another crisis. None of the proposals, for example, addresses excessive leverage, a major cause of the near collapse.
In 2004, the SEC eliminated the net capital rule that had been in place since 1974. This saw a leveraging of Wall Street balance sheets to the hitherto unfathomable (and previously illegal) levels of 25 or 30:1. Excessive leverage was not universal across all of Wall Street. The firms with highest leverage ratios (Bear Stearns and Lehman Brothers) disappeared, while the firm with the lowest ratio (JPMorgan) came through the crisis the best of any Wall Street firm.
Excessive leverage was not limited to Wall Street. It was also present on Main Street in the bubble years of the mid-2000s. Increased credit card and home mortgage debt resulted in the savings rate of the average American becoming negative during the same time frame — a clearly unsustainable number.
Washington joined party
And, yes, Washington also joined the party. In the 1950s, William McChesney Martin wisely observed that his role as Federal Reserve chairman was "to take away the punch bowl just as the party gets going." His successors, Messrs. Greenspan and Bernanke, disagreed. As the real estate bubble grew, they kept interest rates low. With low interest rates, the demand for mortgages grew. To meet this demand Federal government-sponsored enterprises (GSEs) such as FNMA that support the mortgage market saw their leverage ratios increase to more than 50:1, with the full knowledge and, in some cases, active encouragement of their Congressional overseers.
Wall Street, Main Street and Washington all were playing with more and more of "other peoples' money" (OPM). The narcotic effects of this other form of opium were equally as dangerous as and eventually more lethal to our economy than that which comes from poppies.
The path to restoring trust in our credit markets lies in dampening the incentives for greed in our system by addressing the underlying causes of the crisis. The response thus far has not fundamentally reduced the leverage in our economy; we have only shifted it from the private sector to the public sector. The individual savings rate has moved into positive territory, which in the long term is a step in the right direction. Wall Street has materially reduced the leverage in its balance sheets, another very positive development. These reductions in leverage, however, have been more than replaced by the leverage now found in our national balance sheet. Our annual federal budget deficit has tripled since FY 2008. Our national debt load as a percentage of GDP is at a level not seen since World War II.
Reducing the leverage in Washington as our economy recovers will not be easy, but it is vital to a restoration of trust in our national government.
Posted March 9, 2010