Making Finance Easy to Fix, Not Hard to Break
Thursday, May 13, 2010
The initial winds of commentary over the Goldman Sachs affair have calmed down a bit, and a rough consensus of conventional expert opinion seems to be emerging that the Securities and Exchange Commission (SEC) case is thin, and Goldman will probably win or settle cheaply. Wall Street may be a brothel, but the players were adults and consenting.
Less noted are the long-term problems that winning creates for Goldman and for the banking industry as a whole, because any successful defense opens up an embarrassing question for the industry: “And just what is it that you do for a living, anyway?”
Starting in the 1990s, the financial sector’s share of total corporate profits began to soar, and in the 2000s its share became downright ridiculous. (And these profits are after the high salaries and bonuses paid to the employees.)
Banks make money borrowing short from the public and allocating capital for investment, a necessary and honorable occupation, but not one ever worth such a huge chunk of total returns to business.
So the question is, what new functions did the banks take on that promoted the overall weal of our civilization in exchange for such rewards? The defense that Goldman is making to the SEC, and that it and other financiers are making more generally in response to public anger over the crisis, is that the bankers are not responsible for anything because they were ignorant, fallible, and of only marginal value. How could banks have known that subprime mortgages were garbage when Moody’s attached high ratings, they say? How can the SEC claim that Goldman or other packagers misled their clients when their function was to introduce sophisticated, consenting adults who wanted to run offsetting risks, sort of like a financial eHarmony? Surely it was not their job to investigate whether any serial killers had logged on. They just played the piano while the clientele negotiated.
Clichés are clichés because they express truths, and another one is 'the cure is worse than the disease.'
These defenses look pretty good, to a lawyer, but performing these functions is not worth the rewards collected by the bankers. A reader of Moody’s can be replaced by an intern, or maybe a software program. Ditto for the eHarmony function; matching people with opposing views on the direction of the market is called a stock exchange, and these are all automated now.
The industry can say that putting together synthetic securities requires expertise, but why is this so if, in fact, the packager is exercising no quality control? Why not list the available offerings and throw darts? (Indeed, that would be better, because it would insure against negative bias.) Besides, the bankers are fighting hard against all efforts to standardize these new instruments so that they can be traded on exchanges at low cost.
So what do the bankers really claim as the business model that enabled them over the past decade to collect such a huge portion of all corporate profits? There are several possibilities, none of them flattering to the industry:
• That bankers actually did nothing and had no expertise, but clients thought, albeit wrongly, that they were getting something (no doing of the banks, of course—can’t imagine where the clients got this impression).
• That the government has created such market power in the financial world that anyone grandfathered in with a franchise can reap enormous rents.
• How about: “We aggregate the information we get from our blue-chip clients and use it to get an edge in our proprietary trading”? (Robert Samuelson: “In the first quarter of 2010, about 80 percent of Goldman's $12.8 billion in revenues came from its trading and proprietary investment accounts.”)
• Or, “We borrow from the government at low rates and lend back to the government at a premium, and for that we get paid a lot.” (From the investment analyst GaveKal, on the Greek bailout: “European banks should now make enormous profits by acting as a permanent conduit for ECB [European Central Bank] lending to various weak EMU [Economic and Monetary Union] governments. After all, borrowing money from the ECB at 1% to lend it back to EMU governments at 5% plus, while enjoying a permanent liquidity guarantee from the ECB, is not a bad business to be in!”)
Clichés are clichés because they express truths, and another one is “the cure is worse than the disease.” None of the business models sketched above would be illegal (well, the information point might raise some SEC eyebrows), so asserting them is tempting, especially for litigation lawyers, whose focus is narrow. The alternative would be for Goldman to say, “One of our guys hijacked our brand and screwed up; sorry, and here is a billion to make amends, even though we are not legally required to do this.”
‘The overarching principle I have is that we should try to make the financial system easy to fix. The more you try to make it harder to break, the more recklessly people will behave.’
This alternative course might be a good investment in brand equity, and Goldman knows it; so the failure to adopt it, and the decision to defend all-out, can and will be taken as indicating that the damage could not have been contained, and that any such confession could have resulted in the litigation equivalent of a run on the bank. So maybe Goldman has no choice but to take the its current stance.
But the question left hanging is, “Then just why do you deserve your fat profits?” and the brand destruction that results from a lack of good answers is a serious problem for the industry.
The question is also a serious one for both political parties, but especially for Republicans. We all know where the Democrats are—they are using the scandal to juice a “reform” bill that will increase government power, favor large incumbents, and increase the profits from government-derived franchise, while injuring small business, angel investing, hedge funds, Main Street, and everyone less connected. As Peter Wallison wrote:
Provisions [of the financial reform bills] will substantially restructure the financial markets and the U.S. economy by favoring large financial institutions over their small competitors. This makes sense only if the administration is pursuing an ideological objective instead of striving to ensure a healthy and competitive U.S. financial system in the future.
The performance of Goldman’s CEO in using a chief Democratic fixer as his mouthpiece to complain about these scurvy politicians who are trying to make its market position even better deserves at least a Tony Award, and it would take someone considerably less cynical than I to believe that the criminal investigation will go anywhere.
The Republicans are a puzzle. Many reflexively leapt to Goldman’s defense, on the theory that if the administration does something, then Republicans must oppose it. On financial reform generally, the Democrats’ proposals would indeed institutionalize “too big to fail,” and the Republicans are resisting, at the risk of being skewered for it. In the Bizarro world of Washington, the narrative labels it "anti-reform" to oppose a bill that would further entrench the people largely to blame for the financial crisis. The administration has captured the narrative because it knows a crucial secret—most reporters are lazy and rarely read beyond the title of a bill.
On other issues, Republicans lecture on the virtues of free markets, but, as unkind liberals note, most of their financial reform proposals are not all that different from the Democrats’.
Liberal columnist Ezra Klein said:
So if you basically liked the Dodd bill but were looking to give regulators just a little bit more discretion, then the Republicans are here for you (for a more comprehensive side-by-side comparison, head here). But what if you think that the financial sector itself is broken, and even good regulators can't fix a broken sector?
Klein concludes, with some surprise, that he is actually with Arnold Kling and his eight-point program on this issue.
The Republican position does not impress the Tea Party crowd, who are far more interested in an answer to why bankers deserve their pay. So far, they have not gotten an answer, and, as noted, the defenses the industry is now mounting lead to the conclusion that there is no good one. In the Internet era, information systems are much better, too, so the Tea Partiers can readily learn the realities of reform provisions.
So the Republican spin that it too hates the financial industry is thin, and reinforces the Tea Party concern that the Republican establishment is more interested in looting the Special Interest State than reforming it. If you Bing the old slogan "not a dime's worth of difference," you get 11.3 million hits. (Interesting sidebar: Google produces only 69,000 hits.) And MIT Professor Simon Johnson’s argument that the financial sector has bought the government is resounding with the Tea Partiers, not just with the Left.
The logical step for the Republican Party is to turn populist, and to portray the bankers as co-conspirators with the administration, not victims of its regulatory zeal. The Washington establishment regards this as hopelessly déclassé, but I am with Kling:
The overarching principle I have is that we should try to make the financial system easy to fix. The more you try to make it harder to break, the more recklessly people will behave.
If we have to go the populist route to get to this goal, another cliché is applicable: “Politics ain’t beanbag.”
To further quote Mr. Dooley: "Never steal a doormat. If ye do, you'll be investigated, hanged an', maybe, reformed. Steal a bank, me boy, steal a bank." The Tea Partiers fear, with reason, that the bankers have adapted this advice to their own situation: “Never steal a doormat [when you can buy] a government.”
James V. DeLong is vice president and senior analyst of the Convergence Law Institute, and a visiting fellow at the Digital Society.
FURTHER READING: DeLong recently discussed “Supreme Climate Folly” and "Opening a Can of Worms: Government and Climate Change Data." He also outlined the failure of Congress and the administration to encourage biotech investment in "Bleeding Biotech," and "The Coming of the Fourth American Republic" after America's special interest state decays. Peter Wallison dissects “Crisis and Ideology: The Administration’s Financial Reform Legislation,” while Philip Swagel explains “Ironing Out the Kinks in the Dodd Bill.”
Image by Darren Wamboldt/Bergman Group.