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Monday, April 26, 2010

BOOK REVIEW: 13 Bankers

13 Bankers -- Simon Johnson and James Kwak -- 222 pages (304 with notes and index)

There seems to be no shortage of books being published with the aim of explaining what transpired during the financial meltdown and how it occurred despite an alphabet soup of regulatory agencies nominally created to prevent such singularities. While many books have aimed at the target, few hit it more precisely and concisely than 13 Bankers by Simon Johnson and James Kwak. The pair is already followed widely via their blog entitled The Baseline Scenario.at which they provide running commentary on the financial and regulatory forces producing the instability in the market.

In 13 Bankers, they provide a thorough explanation of the mechanics of the practices involved, the end-runs by financial institutions around already crippled regulatory controls aimed at avoiding such frauds and -- most importantly -- the true cost to our economy of depending upon such a concentrated, fraudulent, inefficient banking system. Anyone assuming we've put the worst behind us really needs to read this book before jumping back into the pool.


The authors chose their title from a meeting held March 27, 2009 between the Obama White House and CEOs from the thirteen biggest banks in the country. The meeting was Obama's first chance to speak directly to them as a group and twist arms to gain their public buy-in for squelching outsized compensation packages that were raising the ire of voters and taxpayers at the time. The authors focus on the key talking point to emerge from that meeting -- "We're all in this together" -- and use it to emphasis the key flawed assumption behind the meltdown itself and any attempt to correct the systems that produced it.

In a nutshell, their point -- the correct point to make -- is that we NEED a financial system in place to

* handle payments,
* collect deposits for people needing a safe place to stash funds,
* identify and provide funding for business opportunities that produce new goods and services or improve productivity
* quantify the risks of such efforts through credit terms and interest rates and open markets

However, we don't need THIS PARTICULAR system. THIS PARTICULAR system we have, when properly understood and measured, isn't even particularly good at what it is supposed to be doing. As long as politicians and regulators remain trapped in the thinking that THIS PARTICULAR system and THIS PARTICULAR collection of big bank survivors is the only way to safely and efficiently meet the needs of the economy, nothing will change and nothing will prevent bigger meltdowns in the future.

In the meeting with the thirteen bankers, the new Administration essentially threw its backing behind the thirty year old principle that led to the collapse in the first place -- the idea that a variety of technical regulatory policies were primarily to blame, that a large financial sector is critical to our economy and big banks --- these big banks in particular -- were critical to the financial system and worthy of protection at any cost.


In the chapter Too Big To Fail, Johnson and Kwak provide what has to be the clearest, most concise summary of the cascading failures that produced the crisis, from summer 2007 through early 2009. Before providing those details, the book first recounts key events in the Asian crisis of the late 1990s and how those firms handpicked to survive Korea's meltdown (LG, Samsung, Daewoo and Hyundai) consolidated their position while recapitalizing with help from the IMF. The authors make a point of replaying the policy advice of key figures in world finance at the time -- an insistence on tighter monetary policy (no printing money to inflate yourself out of a collapse), tighter government spending controls (no stimulus plans to ease the blow on citizens), no write-down of loan amounts (okay, that part's similar…) and no restrictions on foreign capital to come in and control more of the Korean economy. The authors later point out multiple times the irony (or hypocrisy) of American policymakers' refusal to follow the same prescription domestically.

Many may be familiar with the events itemized below but after providing the background of the Asian crisis and its hand-picked winners and the history of deregulation and lax supervision, the summary within 13 Bankers drives the events home with particular clarity:

* summer 2007 -- Bear Stearns and BNP Paribas find problems with their hedge fund operations tied to subprime mortgages -- this triggers a liquidity crisis seemingly out of nowhere between August 9 to August 11 (see Financial Markets: Running on Empty #1)

* winter 2007-2008 -- investor concerns shift to the structured investment vehicles (SIVs) banks had rigged to further leverage bets on derivates while keeping the instruments off their books and avoiding increased capital requirements -- key banks attempt to create an internal credit facility to cover potential shortfalls but soon scuttle the idea, requiring investments from abroad to shore up Bear Stearns, Citigroup, Morgan Stanley and Merrill Lynch

* March 2008 -- continued concerns about the value of derivatives focuses attention on Bear Stearns which is nearly 100% dependent on overnight loans to fund daily operations -- once overnight funding dries up, Bear Stearns cannot meet its obligations without a sell-off of assets and is sold off to JPMorgan within inches of hitting the pavement of bankruptcy

* July 2008 -- continued worries over mortgage related derivatives drive down the holdings of Fannie Mae and Freddie Mac, putting them near insolvency -- the Treasury attempts to provide a more explicit public guarantee of Fannie / Freddie assets but both wind up under government control by September

* mid September 2008 -- solvency concerns move from the GSEs to the next weakest player, Lehman Brothers, and the government assumes the markets have assumed the Bear Stearns and GSE rescues were "it" and that market forces would have to figure out a Lehman collapse on their own -- in fact, the banks saw the system getting weaker and assumed the government WOULD step in -- when no rescue materializes, the Lehman bankruptcy within hours and days triggers ..

* the collapse of AIG

* the collapse of a major money market fund, which triggers a lockup in the commercial paper market affecting short term lending to hundreds of thousands of small, medium and large businesses

* the failure of Washington Mutual

* the collapse of Wachovia and its takeover by Wells Fargo

In eight pages (156 thru 164), Simon and Kwak do a better job of summarizing and tying together these events than nearly any other book or blog available.


Besides explaining the eerie similarities of the "Asian contagion" dry run to the most recent American meltdown, 13 Bankers also analyzes nearly forty years of regulatory changes that inexorably positioned our financial system and the economy perched atop it closer to the ledge. The summary chapter in the book summarizes "business as usual" for the megabanks as:

* using their TBTF discount in regular banking to subsidize higher leverage / higher risk gambles
* using consolidation to capture more market insight from trading to use for their own accounts
* inventing highly complicated "products" for consumers and businesses alike that generate higher fees
* using convoluted "structured finance" practices to hide leveraged investments to avoid higher capital requirements
* applying political pressure to regulators to ignore what few paper laws and regulations remain

The legislative and regulatory changes that produced this current state are analyzed in detail throughout the book. Here's just a partial list of the changes discussed: (all near direct quotes from the book)

* May 1, 1975 -- fixed fees on stock trades eliminated on the NYSE by ruling from the SEC, allowing major trading firms to profit from churn on higher trading volume from large institutional investors and mutual funds

* 1982 -- Garn-St. Germain act eliminated restrictions on bank / S&L mergers across state lines, beginning 20 years of consolidation and blurring of the regulatory boundaries (page 72)

* 1983 -- OCC lifts all restrictions on loan-to-value ratios, loan durations and amortization schedules, essentially permitting the types of mortgages that dominated during the bubble (page 72)

* 1984 -- Secondary Mortgage Market Enhancement Act is authored by Solomon Brothers' principle trader Lewis Ranieri and eliminated complexities of state regulations and tax laws making mortgage securitization operationally practical and profitable (page 73)

* 1996 -- Fed raises the upper limit on revenues derived from securities from 10 percent to 25, beginning the dismantling of Glass-Steagall (page 133)

* 1998 -- Federal Reserve Board of Governors unanimously vote to forego any investigations of complaints involving non-bank subsidiaries claiming no jurisdiction (page 142)

* 1999 -- Glass-Steagull restrictions on bank / investment bank separation completely eliminated after Citibank and Travelers merge and force the issue

* December 2000 -- Congress enacts the Commodity Futures Modernization Act which explicitly cordons off derivatives from any government regulation (page 136)

* 2001 -- federal regulators issue new capitalization rules allowing banks to base capital required for pools of securitized assets upon third party ratings rather than the prior more conservative rules (4 percent for mortgages, 8 percent for commercial loans) (page 139)

* August 2003 -- Office of the Comptroller of the Currency issues ruling negating efforts in several states (New Jersey, North Carolina and Georgia) to limit sub-prime lending abuses (page 144)

* April 28, 2004 -- SEC agrees to let biggest banks use their own internal models for calculating capital requirements (page 140)

The single most fascinating (in the trainwreck sense) observation made in the authors' description of the distorted regulatory and political framework supporting the current system involves the concept of "regulatory capture." In finance, the normal idea of regulatory capture doesn't remotely begin to describe how dysfunctional the system has become. The normal revolving door problems all apply but banking has its own twists. Here's a direct quote from page 96:

But banks also had a more direct means of putting pressure on their regulators -- the market for regulatory fees. The Federal Reserve makes the money for its day-to-day operations from its banking activities, and the FDIC makes its money from insurance premiums levied on banks. But the other major regulators, including the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS), are funded by fees levied solely on the bnaks that they regulate. And while each regulator nominally had its own sphere of jurisdiction -- bank holding companies for the Fed, national banks for the OCC, and so on -- financial institutions that fell under multiple regulatory agencies were allowed to select their primary regulator. As a result, regulatory agencies had to compete for funding by convincing financial institutions to accept their regulation, which created the incentives for a "race to the bottom," in which agencies attract "customers" by offering relatively lax regulatory enforcement.

The authors then point out that OTS seemed bent on winning in the worst way -- AIG wound up "choosing" OTS as its regulator after opening an S&L, Countrywide Financial actually converted itself from a bank holding company to an S&L to switch to OTS roughly one year before its collapse.


A quick poll of Americans on the street might find a relatively large percentage could cite $700 billion as the "cost" of the banking crisis in 2008. Some might also cite several trillions in lost value in homes, stocks and 401ks. A much smaller percentage might take the next step and cite the drops of quarterly GDP in real 2005 dollars of -2.7, -5.4 and -6.4 percent in 2008Q3, 2008Q4 and 2009Q1 (#2) and estimate another $430 billion or so in lost economic activity.

In 13 Bankers, Johnson and Kwak raise more subtle but potentially more important points about the true cost of our outsized financial sector and the most recent collapse. First, they tackle the combination of "moral hazard" and the risk subsidy provided to "TBTF" banks by implicit (now explicit) government backing. After nearly 20 years of consolidation, big banks enjoyed a TBTF discount of 0.29 percent when borrowing money over their smaller competitors. That comes from direct resources such as access to the Fed's discount window and pricing in the larger open market resulting from depositors and investors accepting lower interest rates from big banks versus small banks. After the bailouts of 2008, that TBTF discount widened to 0.78 percentage points. How material is that advantage? The book cites a study by Dean Baker and Travis McArthur indicating the value of that subsidy in 2009 produced $34 billion in profits for the eighteen biggest banks -- nearly HALF of their profit. (#3)

The authors also address the misallocation of resources caused by the combination of lax regulation and flawed monetary policy with a series of insightful points:

Home ownership not only isn't a sure thing as a savings vehicle for individuals, for many with little savings elsewhere, putting much of their available savings into a home not only puts all of their assets in one sector (housing), it puts it all in one specific ASSET in one fixed LOCATION, arguably one of the dumbest things one can do in investing.

Lax financial regulation in the 1990s and 2000s actually DISCOURAGED businesses form using tax cuts and low interest rates to invest in productive assets and instead ENCOURAGED deployment of those savings in areas with the most leverage but highest risk. As a result, actual INVESTMENT went DOWN in the 2000s meaning we not only misallocated capital into McMansions but crippled future economic growth and incomes by not properly funding improved manufacturing capabilities and basic infrastructure.

Perhaps the more interesting analysis about the impact of growth in the financial sector involves its impact on the allocation of intellectual capital in the economy. The authors cite studies indicating financial sector jobs accounted for roughly 4 percent of Harvard graduates in the 1960s but grew to 23 percent in recent years. Like bees to honey (or flies to ____), compensation in the financial sector helped attract new graduates. Based on data from the Bureau of Economic Analysis, average wages in banking were in line with the rest of the economy until 1979, at which point they began growing to a point where now the average banking employee wage is twice that of workers in the rest of the economy, even when factoring in similar educational backgrounds.


The most effective aspect of the entire book lies in the final pages of the technical narrative at the point where results of the "stress tests" were announced in May of 2009. Everyone remembers the snickering that accompanied the formal announcement of results that -- VOILA! -- not a single bank analyzed turned out to be undercapitalized and in need of new taxpayer assistance. Johnson and Kwak pronounce the stress tests a failure for that reason, but also a success -- for the TBTF banks. The tests failed to instill any confidence in the wider financial community or the voting public that the megabanks wouldn't face another crisis. However, by publicly stating the banks passed the government's "rigorous" analysis and had shored up their balance sheets to the government's satisfaction, the government explicitly provided its backing to the institutions as TBTF. At that point, the banks achieved an even stronger position of leverage because any remaining regulatory pressure to write down the toxic assets on their books that produced the uncertainty and instability in the first place vanished while their TBTF backing became explicit instead of implicit.

In other words, we went through a multi-trillion dollar crisis only to come full circle with trillions of bad assets still sitting on the books of a smaller set of even bigger banks with the explicit support of taxpayers. The final chapter of the book, entitled The American Oligarchy, sums up the key lessons to take away from the crisis to date in very clear terms.

1) The bailouts of 2008 may have stabilized the system in the short term but they increased concentration in banking. This has allowed the survivors to further exploit their TBTF benefits while exposing the entire system to more risk, not less.

2) Solutions involving highly complicated technocratic measurements and regulations will be completely ineffectual. Banks can hire armies of accountants to adjust books to satisfy any arbitrary rule for capital ratio, etc. As the authors state, both Lehman Brothers and Bear Stearns were healthy on paper by any common measurement, yet both collapsed within days.

3) Continuing to allow TBTF institutions to operate while providing "resolution authority" to regulators ignores the politics of existing regulatory conflicts of interest and the public politics that would result from the government or Federal Reserve attempting a takeover of a struggling TBTF while the bank itself protests in public that it is perfectly healthy and the government is just taking over for political gain.

4) The use of resolution authority as a solution is virtually useless for large multi-national banks since such authority would not be able to impose controls on the valuations and handling of assets abroad. Without multi-lateral agreements, countries that impose the strongest limits first in response to a crisis will minimize local damage while transferring it to other countries with weaker rules.

5) Despite any claims made during merger press conferences, the TBTF banks achieve ZERO economies of scale as they grow larger. The authors cite a study by Kevin Stiroh which found all of the improvements in efficiency in the banking sector during the 1990s were due to modernization of information technology systems, not the size of the firms per se. In other words, if the individual banks had made the same investment in IT, the same efficiencies would have resulted. Getting gobbled up by NationsBank or CitiBank or countless others didn't produce ANY efficiency.

With the entire book and these points in particular, Johnson and Kwak make a convincing argument for the only change likely to actually address the problem from TBTF banking -- breaking up TBTF banks and enforcing rules to prevent any banks from exceeding a TBTF thresholds. What would those be? They recommend a limit of 4 percent of GDP for depository institutions and 2 percent for investment banks. Would such limits take us back to the 19th century? Hardly. More like the mid-1990s, hardly an era of economic decline.

In summary? Get this book. Read it.


#1) http://watchingtheherd.blogspot.com/2007/08/financial-markets-running-on-empty.html

#2) http://www.bea.gov/national/xls/gdpchg.xls

#3) http://www.cept.net/documents/publications/too-big-to-fail-2009-09.pdf