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Thursday, September 11, 2008

Too Big to Succeed?

Turmoil in the financial markets has produced a great deal of conversation among politicians, financial execs and the media about causes and solutions for the current problems. Most Americans are still tuning out the discussion but for those following the discussion, one can't avoid seeing a rather disconcerting blind spot in all of the strategies formulated by the Treasury and Fed to contain the damage and in the media's explanation of events.

All of the discussions about the impact of the latest bailout (whether it's Bear Stearns in March, the GSEs in September or ________) bring up the question "too big to fail?" Of course, the answer keeps coming up "yes" which means the solution keeps coming up "bailout" or "shotgun wedding with someone still showing profits".

Of course, this shell game prevents a major corporation from reaching outright bankruptcy in public which avoids spooking the herd in the very near term. The problem is that it continues the consolidation of decision making into fewer and larger surviving firms. The group think arising from 10-20 big banks all trying to out-do each other on an unproven business model is exactly what PRODUCED this problem in the first place.

The question everyone should be asking is "are these institutions too big to succeed?" The back-office efficiencies of collapsing 10 regional banks into one megabank are far outweighed by the risk of a few really greedy / dumb strategists in that one megabank making a really bad bet and tanking a megabank. This isn't theoretical or political philosophy. It's been demonstrated repeatedly as the banks have grown larger and as regulation has been weakened for 30 years.

For the moment, some of these banks playing the "savior" role may think they're picking up assets at fire-sale prices while taking advantage of back-office deals to dump the bad loans on the Treasury. That may appear to be true but they are still growing in size and doing little to eliminate the trouble-prone lines of business.

The September 15 issue of Fortune has a cover story (#1) on Jamie Dimon and his merry band of men/women who managed to keep JP Morgan out of the sub-prime mess. The story identifies a few key factors that led Dimon to avoid the segment despite the temptation of short term profits made by rivals:

1) Dimon's management style is very critical from a logic sense -- they actively look for numbers that reflect problems across their lines of business and ACT upon them
2) unlike many big banks, JMP operated an internal mortgage payment processing unit that began noticing increases in late payments on sub-primes in late 2006
3) Dimon also noticed that despite continued AAA ratings on virtually any sub-prime paper issued (implying high quality), the cost of credit default swaps (essentially insurance against defaults on collateralized debt obligations) was skyrocketing (if the risk is so small, why is the cost of protection skyrocketing?)

At first, the overall tone of the story can leave one with the impression that the megabank model CAN work, you just need the right level-headed, brilliant guy at the top who can pay attention, read the tea leaves and avoid "obvious", colossal mistakes. However, the story is about ONE BANK which managed to avoid a disastrous strategy. Clearly, the presence of level-headed, brilliant executives at the top of American mega-banks is not the norm but the exception. So why are we encouraging continued concentration in the industry at a time when the fruits (or lack thereof) of this strategy are becoming obvious?


#1) http://money.cnn.com/2008/08/29/news/companies/tully_jpmorgan.fortune/index.htm