I am frequently asked to comment on the Goldman Sachs controversy and the pending financial reform legislation.
The legal discussion about Goldman seems to center on whether Goldman had a conflict of interest. Goldman doesn’t HAVE a conflict of interest. Goldman IS a conflict of interest. They are not unique among major financial institutions. They are in the spotlight because they are widely respected as the most intelligent and influential financial market player. They create markets, they move markets, they short markets and they participate heavily in the regulation of these markets through an influential network of past, future and wannabe employees. I am not suggesting that Hank Paulson acted illegally, but the basic facts of his transition from Goldman to Treasury are mind boggling. He ran Goldman during the build-up of the bubble, earning $38.5 million in 2005. In 2006, he went to Treasury as the bubble was peaking. He was “forced” to redeem his ownership in Goldman before becoming Treasury Secretary. He therefore sold his stock for $485 million on a tax free basis saving over $100 million in taxes because he was entering “public service”. We will be assessing his actions for many years, but it is very clear that he was presiding over the resolution of a crisis his firm played a pivotal role in creating. There is nothing illegal about any of this, but there is a lot wrong with it.
We should be more concerned about legal than illegal malfeasance. The seamless flow of people from the private to the public sector is profoundly troubling, but it is an inevitable consequence of the highly centralized approach we take toward financial markets. The modern model of banking is essentially broken and the regulatory apparatus both reflects and causes this outcome. For investors, managers and regulators the purpose of the firm is not really understood to be to serve the customers’ interests. Rather the customer is necessary for the firm’s market positioning, which is thought to be the real wellspring of employee compensation and investor return. While regulators do have concerns about exploiting customers, financial market regulation is clearly viewed primarily as a vehicle for implementing economic and social policy. The basic discipline for management is to anticipate market trends and position the firm’s resources ahead of the market. As the real estate bubble shows, it is really not necessary for the market trend to make fundamental sense. All that is necessary is to gather financial momentum around a market thesis. Early profits draw more financial flows and the market maker just needs to get to the short position in time. The easiest way to short a maturing bubble market is to retail out the position to the public including, but not limited to, the firm’s customers. Michael Lewis’ recent book The Big Short does a masterful job of capturing this dynamic. The major financial firms all follow this same approach. They aren’t as hated as Goldman, because they aren’t as good at it.
The Too Big To Fail (TBTF) problem remains badly misunderstood by the public. TBTF worked great for some shareholders and badly for others. Lehman’s shareholders got the $0 they deserved. Bear Stearns shareholders did get a $10 per share gift from the US government, with Chase acting as the bag man for the Feds. Merrill shareholders were given their $17 worth of B of A stock thanks to an arranged marriage by Paulson and company. Goldman’s shareholders were spared their $0 by becoming a bank holding company at the hour of their doom. The investing public was spared enormous losses by the Federal government spontaneously insuring the money market funds that had competed with FDIC insured bank deposits for decades. The Fed’s balance sheet still holds several trillion dollars of investments of indeterminate quality. This likely represented an enormous undisclosed capital subsidy to the parties who sold those instruments to the FED. As the bubble peaked in 2006, the market movers were looking for a vessel big enough to absorb their need to short the market before it fell. AIG became the counterparty of choice for those wanting to short the market. Eventually the whole market was essentially “shorted” into the hands of the US government. When push came to shove, Hank Paulson, Ben Bernanke and Tim Geithner pretty much picked who the winners and losers would be. I would not have wanted to be in their shoes. I don’t doubt that they were doing their best to prevent a complete collapse.
Even when anger is justifiable, we must struggle to think clearly. Our goal should be to create the environment where no one may or must walk in Paulson’s shoes again. The goal must be to eliminate the systemic risk at the core of the problem. That is not the direction of the proposed bill. This bill further centralizes and politicizes finance and financial regulation. Centralization has proven politically and financially profitable for the winners of the game. Centralization of financial power and regulatory power is the cause of the problem, not the solution.
I am told the Regulatory Reform bill is about 3000 pages. I have not read it. Neither have most of the congressman preparing to vote on it. I don’t have to read it to know that the foundational premise is fatally flawed. I also haven’t read the bill because legislation that long isn’t written to illuminate, simplify and solve problems. In this environment, what passes for a public debate is a bunch of talking points spouted by people who don’t know finance and haven’t read the bill. The public fury over Goldman is the vehicle being used to ram through this reform bill of flawed intent.
The premise of the bill is that systemic risk must be managed by more and tougher regulators. The systemic risk of the TBTF institutions is not a naturally occurring market phenomenon. It is the unintended consequence of the conflicting goals of federal financial policy. Fannie, Freddie, the Fed and Goldman all played a role in this, but the problem is both more simple and more challenging than an angry public would like to believe. We already have a large and complex regulatory apparatus. This is designed to protect depositors (the FDIC), implement federal monetary and fiscal policy (the FED), maintain the safety and soundness of the system (the Fed, the FDIC, the OCC and the state regulators), stimulate low income housing and community investment (Fannie and Freddie and the all the regulatory agencies), provide funding mechanisms (the FED and FHLBs), protect investors (the SEC) and to provide consumer protection (multiple agencies). Understanding and navigating this regulatory complexity has displaced credit underwriting as the most important core competency in finance. This regulatory dynamic is what drives centralization and causes systemic risk. This centralizing dynamic tilts the competitive landscape away from community based players using local financial resources to responsibly serve people in the decentralized manner personalism requires.
Regulatory complexity favors the large players in any industry. The big firms have the volume over which to spread the fixed costs of compliance and they inevitably provide heavy input into the formation of regulatory policy and practice. They have the resources to hire the lobbyists necessary. No one is going to stop the seamless flow of people between the public and private sectors. The bill does not eliminate any agencies and may create new ones. This direction is all but guaranteed to produce a less satisfactory outcome. Finance will be more centralized and more politicized. We are all sickened by the current state of affairs. The proposition on the table is that, if we just further centralize financial markets under Washington’s control, they will fix things for us. The notion that people in the Midwest will be helped and protected by more powerful smart guys in Washington has no reasonable basis in practice. We don’t want systemic risk managed. We want it eliminated. The best way to eliminate systemic risk is to stop using the policy approaches that create it. In can be eliminated very simply by imposing higher capital standards on those institutions which pose systemic risk. Taxation of systemic risk would also reverse the implied public subsidy that creates it.
Financial markets have essentially functioned as a theme park play ground for the masters of the universe. Anyone doubting this should read some of the excellent journalistic accounts of the crisis that are now coming available. In addition to Michael Lewis’ book, I highly recommend Andrew Ross Sorkin’s, Too Big To Fail. The existing security guards have proven unequal to the task of controlling those gaming the system. Centralized finance is too profitable for politicians to want the nonsense stopped. Goldman has earned the PR beating they are taking. Merrill, Citicorp and the rest are just as corrupt as Goldman, just less competent. Fines will be levied and a few bad actors driven from the industry. Goldman will pay fines that sound big to the public (like $100 million dollars), but the cost to the public has been trillions. Perhaps the firm’s position will be diminished and a new power player will emerge. We will have a modified version of the same game with some different names. Financial Disneyland will reopen with more and tougher security, but the fundamental dynamic of centralized and politicized finance will be even stronger. Security will talk tough and penalize a few players, but the games will resume. The primary impact of enhanced security will be to keep small players off the field of play.
The financial machinations on display in the current congressional hearings have caused enormous economic pain. Politicians have successfully harnessed the public anger at New York to support a more muscular Washington. The public has to be blinded by rage to support this at a time when trust for Congress has never been lower. The public fury at Congress presumes that they don’t accurately represent our desires. I think our democracy really works and that Congress accurately reflects our wish for painless social and economic solutions. We really want to believe that there is a financial demi-god like Al Greenspan or Warren Buffett who can reconcile our conflicting economic desires with the right technical monetary fine tuning. Before retiring to Mt. Olympus, Greenspan visibly fostered and relished this role of the Fed Chairman as the god of the economy. We want to support low income housing for many good reasons. We just want to believe that low income housing not only won’t cost us anything, but can generate wealth instead of consuming it. This was the dominant financial thesis for much of the last ten years. The current financial thesis is that transferring private leverage to the public sector where it can be more effectively managed will fulfill our financial fantasies. False gods are powerful for as long as people adore them. We are like the poor obese guy buying starch blockers when only diet and exercise can cure our misery. We hate Congress because we don’t like what we see in the mirror, but we refuse to recognize it as our image. We have the political and economic representation we deserve and we desire.
We can have a much healthier and more stable outcome. We just need to grow up and process our anger like adults. We are currently allowing our anger to be used against us.