Talk about a sudden mood change! This holiday-shortened week started out with all eyes on Massachusetts as referendum on health care reform but ended up being all about the Administration’s proposals to change up the rules for the banking industry. What seemed like applause for the swan song of Government-Issue Health Care quickly gave way to the rumble of investors heading for exits, swept along by their not surprising disdain for any such sudden thickening of atmospheric uncertainty. There has been a lot not to like about the populist trash talk that the Administration has directed at the “evil fat cats, et al” who by the way contributed so much to their political success, but I find it very encouraging that they seem to have tumbled to the understanding that was articulated in Musings few months back (Nov. 11) . That would be that something akin to the Glass Steagall Act, which separated deposit-taking banks from investment banks, needs to be re-imposed if we are going to make any sort of headway in managing down the “too big to fail” problem.
If this week’s reversal dented your net worth and dinged your sense of being on top of the ebbs and flows of Market sentiment, remember that it could be worse. You could be the Attorney General of the Bay State. One suspects that for years to come, any politician who suffers a really bad day can look in the mirror and say, “Well, at least I’m not Marcia Croakley!” Her candidacy was emblematic of corruption, the sort of decay that sets in when a “machine” is imposed and then goes for decades without an effective challenge. How else to explain the fecklessness that denoted both her campaign and career? Like an army that had been at peace for decades and no longer bothered to even drill, the gang that thought they had everything under control was no match for a no-name adversary they could not bring themselves to take seriously until it was too late. It all happened too quickly to know exactly what to make of Mr. Brown. Having been constantly reminded of the huge disparity that often exists between public persona and “what the family sees” (St. Elizabeth Edwards most recently comes to mind), it is quite premature to form much of an opinion about him, other than that he is hard working, a gifted politician and has a fetching family behind him. It struck me as bizarre when on the morning after there was speculation about him running for President, seeing as how six weeks ago almost no one outside of Wrentham, MA knew who he was. Then it occurred to me that “obscure State Senator jumped up to U.S. Senator and then commencing a successful run for the White House a few months later” has already happened. How often do you suppose he voted “Present”? He seems likely to be at least a modest net positive for the World’s Greatest Deliberative Body, but it remains to be seen whether he is even remotely qualified for the job of Chief Executive.
So the Market went from anticipating the death of Health Care-reform-as-an-exercise-in-imposing-Statism to withering under a gamut of uncertainties no one was thinking about during the three day weekend. I am skeptical about both the intentions of the Administration and the government’s collective ability to end up with something that actually does less harm than good, but I do like the essential thrust that recreates a “wall” akin to what Glass-Steagall imposed. That was a suboptimal fix as well, that had to be tweaked along the way, and not every tweak was for the good. We have a pretty good idea of its consequences, intended and otherwise. We also have viscerally memorable experience with the unintended consequences of that “wall” going away. How awful would it be if banks evolved back into boring businesses, like utilities or cereal makers or big drug store chains? Taking deposits and lending against them based on collateral that can be understood by anyone with a rudimentary knowledge of business (i.e., your typical bank examiner) might not be an exciting business, but it can be a not-bad business. Banks that want to offer insured deposits and have access to the Fed window should not be engaging in activities that even the Sage of Omaha finds incomprehensible. Investors seeking safety and relative predictability will migrate in that direction; if other investors want the kind of “excitement” that comes from the creation of “products” akin to alchemy and perpetual motion machines, we can be sure that the investment banks will provide them the opportunity.
What needs to happen is for banks to be given a window of time, five years would probably do it, to wind down or spin out their hedge fund-like activities. I would give them a year to affect either a wind down or a partial spin off, with a provision that their equity interest in such activities is permissible, but will be subjected to escalating “haircuts” re its value within regulatory capital as time goes by. My sense is that to the degree the world needs the kind of speculative activity they have been providing, it will be taken up by hedge funds, whose principals face an altogether more bracing set of risk/reward terms. We will probably end up with a bit less speculative activity, and that will be a good thing even beyond its role in rendering institutions less likely to be “too big to fail”. A moderate amount of speculative activity is a good thing, a lubricant for a vastly complex system that no one could design, but this does not mean that more such “lubricant” is necessarily a good thing. Sometimes, speculation becomes like the tail wagging the dog. It happened leading up to 2007, especially in the commodity markets, and its undue influence on commodity prices has not gone away. The really galling thing is that we all get to pay for it when excess speculation pushes commodity prices to extremes. Speculators don’t “cause” much of anything, and the world is better off with at least a few of them, but there is no doubt that speculation, egged along by perverse incentives (i.e., taxpayer funded backstops to failure) exacerbate things unto wretched excess whenever momentum becomes broadly discernible (like gasoline at $4/gallon).
One obvious roadblock to dialing down what is essentially money center banks impersonating hedge funds is that it will hinder badly needed economic recovery in the New York metroplex. That economy (down for the count, as I recall, in 1991) was given a burst of steroids by all that bonus money sloshing around for everything from shoe shines to summer places. It’s going to be a long slog back any way you slice it. (Insofar as the very idea of money center owes much to a now obsolete need for physical proximity entailed in the exchange of securities, i.e. certificates that got run across town during the day before the trade settled, recovery is not a foreordained outcome.) While the amount of speculative activity, as reckoned in the number of high earning traders, analysts, etc. will find a level in line with the need, the unwinding of the mega-casinos will ripple through a local economy that has already taken a terrible beating. Expect anyone who has a stake in the viability of that local economy to push back against reform harder than most of the rest of us are willing to push for a lasting semi-solution to “too big to fail”. Nonetheless, by acknowledging the root of this problem, that human nature is such that “bank” preceded by “investment” is the very antithesis of the safety and security that word is supposed to connote if its principals do not have copious quantities of the right kind of skin in the game, the Administration has given us the most hopeful signal we have seen in a very long time. The Market got its badly needed excuse to sell off, and rightly fears that there will be collateral damage even if the new regulations move us in a basically right direction (like the last time Mr. Volcker was calling the shots), but long term investors who are attuned to the global economy should not be dismayed.
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