THE ENRON BANKING SYSTEM & CANNIBALISTIC CAPITALISM
“Panics do not destroy capital – they merely reveal the extent to which it has previously been destroyed by its betrayal in hopelessly unproductive works”
- John Mills, “Credit Cycles and the Origins of Commercial Panics”, 1867
What happens when you take a boring little utility company, leverage it up, expand its business far beyond its original operations, give it a prop trading desk, take it public and put a few corrupt greedy men in charge? You get Enron.
What happens when you take a boring little bank, leverage it up, expand its business far beyond its original operations, give it a prop trading desk, take it public and put a few corrupt greedy men in charge? You get the U.S. banking system.
The U.S. banking system remains a vital component of the U.S. economy, but as we’ve seen over the preceding 18 months the risks these firms take not only put their own firms at risk, but put the entire well-being of the country at risk as well. As the banks have recovered Main Street continues to ask about their bailout. With 9.7% unemployment and U6 unemployment at 16.9% the U.S. consumer remains embattled and beleaguered. Even worse, nothing has been done to ensure that the banks won’t do this again. This is the ultimate slap in the face for anyone who has lived through the last 18 months. Even worse, the regulatory plan we appear on the path of passing is nothing more than a return to the status quo. Unfortunately, the status quo was the problem.
Of course, the banks weren’t the only culprits in this crisis (we’ve thoroughly covered the failings of the Federal Reserve and the financially incompetent US consumer already), but they played a pivotal role. This is not to imply that banks are inherently evil or do not provide a great deal of good for the economy, but the current regulatory structures and business model is clearly flawed. Banks are unique in the economy in that they serve as custodians of the majority of the assets the public owns and provide an absolutely vital role in providing liquidity. If these firms are able to fail due to their own incompetence, lack of proper regulation and excessive risks it creates a systemic threat to the economy.
I have no issue with banks attempting to make a profit in traditional banking businesses (3-6-3 comes to mind), but when we allow these firms to turn into effective casinos you put the entire system at risk. When we allow these corporations to risk their own capital in potentially disastrous transactions we risk the very stability of the entire economy. Letting these banks operate as if they are all Enron is exactly what helped get us into this financial fiasco and it will certainly happen again if we don’t fix the Enron banking system.
I don’t necessarily believe the problem here is one of too big to fail, but rather ensuring that all banks never take the risks that put them and their deposits at risk. A large Enron is no more unstable or dangerous than several hundred small Enrons running in the same grid. It’s allowing these firms to operate as if they are Enron that poses a systemic problem. We must make banks be banks. Of course, much of this would involve reversing the de-regulation that has occurred over the last 25 years and it appears unlikely that Congress has the gumption to do so.
I firmly believe that the near destruction of the U.S. banking system in 2008 was the free market imposing its will on this sector of the economy that has grown too large in comparison to its true productive output. Many of these firms do little more than shuffle money from one pocket to the next while shaving off fees inbetween. It is a sick sort of cannibalistic capitalism whereby many of our largest profit making firms rely on producing nothing while separating the engine of growth (consumers) from their savings (by indebting them). In the meantime we continue to funnel our best and brightest minds into these institutions which produce little, but take much. The recent panic did not only destroy capital. It also showed the banks for what they truly are – hopelessly unproductive works.
So what should we do? We should draw a distinct line in the sand between banks and diverse risk taking firms. There are always going to be Enron’s in the economy, but why should we allow our entire banking sector to mirror Enron? Taking a 30,000 foot risk management view I say something must be done to ensure these banks can never do this again. Turn banks into true banks. Hedging and exotic business models are fine. Just don’t commingle them under the same umbrella as a deposit taking “bank”. With that, a few ideas come to mind:
- Our banking system should be aligned with the goals of the nation to help “grease” the wheels of the economic growth engine of the United States. Banks should be more like utilities and less like hedge funds. Otherwise, banking becomes counter-productive and potentially destructive.
- Banks should not be allowed to exact onerous fees on the public or enact a business model which is inherently dependent on driving their customers deeper and deeper into debt. This undermines the entire goal of productive economic growth.
- “Banks” should be true lending institutions. Non-traditional banking operations and products such as CDS, “off balance sheet” finance, derivatives as collateral and such would be deemed illegal unless performed only by non banking/lending institutions (such as hedge funds) so as to insulate the public and true lending institutions from the risk taking, “hedging”, and “financial innovation” of firms such as Lehman Brothers.
If none of this is done we’re destined to repeat the mistakes of the past and we all know how Enron ended up. Unfortunately, this is looking more and more like a crisis wasted….And the next time we have a banking crisis the public will have zero pity or tolerance for the banking system. It’s necessary that we work with the banks to be proactive and best serve the future productivity and well-being of the U.S. economy before there is a “next time”.
I don’t see how your solution would change much. Any giant fund that borrows short and lends long is going to be prone to crashes and pose a systemic risk to asset prices. Consider LTCM for example – they would still be allowed to do what they did with your rules in place.
I don’t think the purpose is to prevent LTCM, but to prevent LTCM from bringing down the whole system. If you separate true banking from higher risk businesses then we’ve done a lot to reduce overall systemic risk. I think thats what TPC is getting at.
Exactly.
I think you’re underestimating the degree to which everything would be correlated. Every bank essentially invests in the same assets at the same time and it has always been that way. Break them up all you want but you will still have a systemic problem when they all need to liquidate assets at the same time. Breaking up will only give the illusion of stability. If i invest in 30 large cap mutual funds instead of the SPX have I really made things any better?
As for deposits, most savings are in the money markets these days. Same problem as the govt cannot let them go to 0.
I find it hard to believe that we couldn’t substantially reduce the risks these firms take. Reduce their leverage, regulate the kind of products they can invest in, etc etc. If everyone is borrowing from the Fed at 0 and lending at 4% then what is the big risk? It’s the borrowing at 0 and lending at 10% that gets these guys in hot water, the exotic hedging, etc.
You can’t tell me that banks absolutely have to be these highly complex effective hedge funds….
no more stars to agree/disagree with?…i kinda liked them
also it doesn’t give u very long to edit your post when u go that route.
your banking rules sound like a good start.
need to do something……its every 20 years its a bust….they figure out how to steal/make money….i remember the savings and loan robbery of 87′
Excellent commentary TPC. Very much aligned with my thoughts on the subject. Unfortunately I don’t think we’ll get there without the whole thing truly imploding beforehand. And I don’t think they’ll let that happen, and therefore instead of the banking system imploding it will be our whole nation’s fiscal/monetary situation and our economy. Beautiful, just friggen great.
TPC,
I’d have to say this is much fairer treatise than I’ve seen from you in the past. Kudos for that.
Unfortunately, we have issues here though. In order for the banks to provide liquidity and hedging, either they must fall under the umbrella of consumer deposits OR they must increase the limits that investment banks are allowed to take (while re-implementing Glass-Stegall). The problem is not so much that they put consumer assets at risk; the problem lies in “punting” as they call it – betting. Banks aren’t supposed to bet, we’re not SUPPOSED to be in the business of gambling. Banks should be providing liquidity and immediately hedging the majority of that risk – at a minor profit (rather than a major one). With access to every global market, every data field, massive computing power and tens of thousands of people working on 24/7/365, this should still be (and is) a very profitable business.
Trust me when I say that the much larger business involved with derivatives are those providing ESSENTIAL services to every private (and often public) business. Its this way because the largest business require services which only banks (or pools of banks) can provide. Take syndicate loans – these are loans so large that they require multiple bank participation and piles and piles of legal agreements to get done. This is how cars are manufactured before people buy them, how bridges are built before being funded, and how basically every innovation starts before knowing whether or not it will succeed. However, banks are supposed to (whether morally or legally) be a sort of exchange where each liability is offset within minutes or hours. In some cases, this is possible, in other cases its a stretch, and in many cases – it cannot be done. I guess in the cases that it cannot be done, well, perhaps it SHOULDN’T have been done – but Banks are fallible just like all the people that work in them and much of this is not known. In a business that spans tens of countries, its hard for the left hand to know what the right hand is doing, despite both being informed of “the rules”. The same phenomenon exists in government except somehow the blame never falls on any single or small group of individuals.
Unfortunately, this cannot occur and though I would love to say its the fault of government – they cannot be completely blamed (well at least not for fixing the mess, but definitely for allowing it to get this way). You cannot simply break apart the consumer arms from the investment banking arms now that both are tied together. You can perhaps legislate future business (to some degree) but who wants to put laws in place that wouldn’t have impact for decades to come – and be held accountable for it?
The sad part is that SOME banks work on this behavioral reward/punishment system. Others actually look at what works and what doesn’t and adjust accordingly. Slow and steady wins the race but even businesses that have been around for 150 years haven’t learned that lesson. IMO, if someone had to save me, I’d make damn sure it didn’t happen again – solely for the sake of pride or affirming a victory over past hubris. Unfortunately, not all are created equal…
I’m painting with pretty broad strokes here, but I don’t see why the banks can’t be broken down into more simplistic businesses or separated so that there is reduced risk of contagion.
I’ve read the Lehman examiner’s report and it is chock full of operations and balance sheet deception that would never occur under a modern day Glass Steagall.
http://lehmanreport.jenner.com/
I get the impression that you think – “the banks have grown into these behemoths and rewinding them is impossible”. Am I wrong?
I am not a banker so you might very well know more about this than I do, but many of these products appear like nothing more than fancy ways of gambling without stringent rules (CDS come to mind). Are these really “essential” hedging operations?
I understand that these firms want to hedge their bets, but why do the so-called “hedges” appear to be the destructive forces at work here? I hedge every day and I know I can’t blow up. It boggles my mind that these firms have even allowed such poor risk management. It almost doesn’t compute with me….
Well, externally it may appear that way. Especially when you look at the mind boggling notional value on some of these derivatives (interest rate swaps are unbelievable…). However, technically speaking, yes – many are hedges.
Let me give you an example. If Bank A enters into an OTC Fixed/Float interest rate swap with Bank B, that’s a swap of cash flows. However, a swap (like a forward and unlike a future) is not guaranteed by an exchange (except in the case of Cleared Swaps where the exchange itself is the counterparty to the swap). Now that cash flow becomes a liability in so far as the counterparty’s risk of default is plausible. How then does one then hedge such a transaction (and remember, we want to hedge because there’s a risk here). Well, this gave birth to the credit default swap. In this case, Bank A then goes to Bank C and does another OTC transaction where the agreement is X premium paid for insurance on Y assets to be paid in full by Bank C in case Bank B defaults. Again, this being OTC is executed by the exchange (in most cases) but is not tracked. Now the big problem comes when Bank D, Bank F, Bank G, Bank H, etc. all go to Bank C for the same sort of hedge. None of them “officially” know the amount of CDS “insurance” Bank C has written – all they know is they’re getting a great rate and the legal work looks sound. Bank C is AIG, and Y assets = 500 bln (all issued from one group of 350 employees working in London). Well, the market turns, and risk of default starts rising and rising – and so does the premium on the CDS’ that Bank C has written. It goes so far to the point that even with the absurd capitalization rules in place (read – way too lenient), Bank C is approaching default, or at the very least a credit downgrade. Uh oh, now the cards start stumbling. The credit downgrade triggers certain payout or escape clauses for Banks A,D,E,F,G,H,etc. However, Bank C has nowhere near enough capital to actually pay these out. Thus what was thought to be a risk reducing instrument now becomes a risk INDUCING instrument. Banks A,D,E,F,G,H, etc now have to mark down their cash holdings/mark up their liable assets – themselves now undergoing a credit downgrade. As you can see, a storm thus ensues and then the government has to ride in to the rescue and backstop all that insurance to prop up the credit rating, pay out those contracts which have been triggered, and hope the market rebounds (or prop it up…). This is an ugly scenario that played out, except it wasn’t so much Interest Rate swaps that were being hedged with CDS, but CMOs and CDOs. And why not trust AIG, they were one of the biggest companies in the world, 200 bln market cap(ish) and have been in business for over 100 years. Except they were gambling. They weren’t going out and hedging their own CDS exposure, or shorting ABX (Asset Back Securities index) – thus multiplying their risk many times over. AIG wasn’t the only one – all the investment banks had a play in both purchasing and selling CDS coverage because it paid well for a long time. And though “officially” it was unknown what their actual exposure was, some shops did have an idea (via various channels – including government). Thus they started buying CDS like one would buy put options because they KNEW someone was going to blow up. They were right, and they ended up not only hedging their risk, but making a profit via the taxpayer.
There are very legitimate hedges out their for these products. If we, for example, do an Cleared Swap for Natural Gas, we would then go out and hedge that with OTC swaps against other related products (ie. locational hedge, commodity hedge, a number of different names can be used here). The exchange obviously knows about the cleared swaps (and has strict limits of such) but does not know about the OTC trades. Thus, when near breach or in breach of a limit, we need to file for an exemption which is granted based on our hedge (so this is the point where we report our OTC positions). The exemption is on one side and applies only to the Cleared trades. SO, if you were stupid and wanted silly unbridled leverage, you’d go to the OTC market and get it.
Of course, THAT is what the CFTC is trying to work on (among other things). But the market is huge and the notion of a “hedge” is quite broad. Before this was nearly a sure thing but these days I’m hearing that a few of the panel members aren’t so interested any more. Banks like the one I work at use this methodology religiously and not just because we must abide by market rules; its done because it makes consistent money at fairly low risk. Beyond that, we have our own internal exposure limits and they’re actually very low (I’ve worked at a prop firm and I’m surprised sometimes to see what the allowed net exposure is but it makes sense consider the number of products traded).
Excellent and thorough comment. But the fact remains – if these banks (clearly yours is better at managing risk than the ones I refer to) can potentially bring down the whole system with faulty risk management then what can we do to ensure that this never happens again?
Surely the answer isn’t the following: “banking has become too complex to eliminate this risk”
Again, in the eyes of the individual banks, they have implemented risk controls correctly because they are unaware that their insurer is grossly underfunded to pay out in a “six sigma” event (or not even something like that – more like a “fat tail” according to the black swan). They’ve hedged their risks and even their VaR shows their risk is inline. They haven’t hedged their hedges, granted, but at what point do you stop? Well, the point where it isn’t profitable anymore obviously. And even though everyone acknowledges (now) that VaR has its flaws, they still say if you were on the spot and had to determine your risk, this is the best metric to do so – with institutions this large.
I wish I had a good answer for this, unfortunately I can’t say I do, though I will say that the government proposals for regulation will not do anything other than cost much more money and solve little if anything at all. However, I can also say the “too big to fail”/”bailout” model is really not working AND is blatantly unfair to the smaller institutions or the risk adverse institutions. Its not necessarily that “banking has become too complex” (though there are some issues when you look at a global level risk management strategy and try and untangle the mess of interrelated products) its more like “where do we put all this crap until it unravels itself in time”. Breaking off the consumer/retail arm of banks would mean immediate default for the investment banking arm in every single bank. Credit markets would freeze completely and make early 2009 look like a party.
One thing is for certain – you cannot hope to manage an industry in which you have little to no knowledge. Unless the government is willing to tap into the large portion of GDP obtained from the finance sector to get top talent analyzing risk (and cut the pork barrel spending elsewhere to offset), then they will always be outgunned. But they’re not even remotely going in the right direction. For the new Healthcare bill they hired like 19,000 IRS agents as most of the enforcement of the bill will be based around taxation (to avoid Supreme Court cases). The SEC is hiring maybe 1/10th of that number and not doing anything to train them to a greater degree. I mean, how many people explained Madoff to the SEC over how many years with such simplistic descriptions a 10 year old would understand (“The amount of money he is using in the method he is stating is larger than the market he says he’s participating in”). But now, the seas had to pull out before all the seashells became exposed and in the end, the investors all got fleeced.
Perhaps the best solution is to allow the banks to fail, but make the Central Bank the receiver of all assets and backstop them by the US Gov. Then instead of issuing credit via Treasuries, they issue these assets as well or instead. This way, no bank gets a free backstopped acquisition at rock bottom pricing, all banks that trade these assets are forced to take them and trade them (and price them correctly), and the market doesn’t get flooded with paper, dropping the floor out from the rest of us.
I hate to involve the government in something this large and complex but unfortunately, Uncle Sam is the only one with a big enough bank account. And a simpler solution is much more likely to work than a complex one.
Then again, I’m just an IT guy…
But the point is, why are they operating in markets that are risky enough to destroy them? Whatever happened to borrowing at 0 and lending at 3? When did it become borrow at 0 lend at 8, hedge at 4 and insure at 2? Bad example, but you get my point.
As I said above: I find it hard to believe that we couldn’t substantially reduce the risks these firms take. Reduce their leverage, regulate the kind of products they can invest in, etc etc.
You can’t tell me that banks absolutely have to be these highly complex effectively hedge funds….
My larger point is, if you aren’t credit worthy (and yes, the credit rating agencies played a large role in this) then you don’t deserve a loan. But banks are very loosey goosey in giving out loans in the name of fees. Anyone in America can get a credit card. Anyone in America could buy a $500K house a few years ago.
How is this not regulated? If you aren’t credit worthy, you can’t use other people’s money. It should be that simple. But these banks continue to operate in these highly risky markets in the name of profits….
TPC,
I will attempt to answer both questions to the limits of my knowledge – but keep in mind this started well before I (and probably even you) were on the scene.
Yes, banks do still lend in conventional ways. However, the housing boom wasn’t fueled by bank lending – it was fueled by market lending and low interest rates. You have the Countrywide’s of the world who are approached by a borrower for a home. This borrower is “sub-prime”, “Alt-A”, “Prime”, etc based on employment status, income, savings, home value, etc. They take the appraised value of the home (loophole alert: who says the appraiser is right and how does one really value a huge asset like a house in a fairly illiquid market) and do some calculation on the amount on interest that must be charged in order to provide the borrower with credit while mitigating the total amount lost in case of foreclosure (these are varied and broad formulas that as we now know, dont work all that well). Now the numbers don’t add up all that well, your classical bank/borrower relationship would end here and the buyer would walk off realizing he’s got some saving to do. But not these days; these days we have larger government mandates of how many sub-prime loans must be part of a lender portfolio (and of course, this is kicked off by the two biggest mortgage purchasers creating the market – Fannie and Freddy). However, even then, the rate is too high that you avg person can calculate he’ll be eating bread and water for 30 yrs in order to pay off the house. So, the ARM is born – starts at a nice low rate and is reset at set periods based on interest rate spreads (ie. LIBOR + 2). Now the hook is in because the buyer sees a low interest rate and incorrectly assumes his earnings growth with match that of his interest rate. Again, this is still risky business and Fanny/Freddy can only buy so much. So, next stop, securitization. Let’s take this high risk/high return mortgage and package it into a bond like instrument with 100 other mortgages (some just like it, some better), all underwritten by different entities, and lets sell it to the market. Now you have the brokers come in and say, high rate (forget the high risk part) instrument – hell yeah! I can sell, so I’ll underwrite this badboy and make a market where my great credit rating will insure that all sorts of “savy” investors pick it up. And so the Collateralized Mortgage Obligation CMO/Collaterlized Debt Obligation CDO comes to fruition. Well, this only works if the stuff looks good (loophole 2: who says the licensed credit agencies are actually looking into the instruments being sold rather than the companies selling them?), but with AA and even AAA ratings on “bonds” yielding 15-20%, well geeze – I missed my chance in the 80s on those US Treasuries and am still kicking myself so I’ll make up for it now. Again, there is lots of risk still floating around, but that can be plugged by a CDS! (loophole 3: who says the CDS writer can actually pay off in case the flavor of the week investment bank goes belly up? well, certainly the ratings agencies don’t have that kind of time…) And so the picture is oh so rosey and everyone coasts along locking in record profits and demand explodes causing a massive bubble. Even helicopter the nearsighted Fed chairmen Ben can see this one because it looks just like what was in his textbook. So rates start getting hiked. ARMs start getting reset. People start to miss payments because obviously working at McDonalds or Walmart is probably not going to make them a millionaire as fast as they thought (even if they play the lotto every day, or not, because 90% of them think they’ll win…). So they go to their trusty credit cards until those lines start to dry up – and unfortunately they actually charge interest too! Uh oh, this room is filling with water, let’s get just one more gust of air and everything will just blow over. Second mortgage, third mortgage – because now everyone is in this Ponzi knee deep and isnt really checking jack shit. Well obviously borrowing on credit card 1 to pay mortgage debt 1 wasn’t working, so this right here is a bomb – multiplied millions of times over. The rest of the story we know all too well..
So the lesson is that given loopholes 1-3 coupled with greed, baseless unrealistic hope, unlimited free market funding, and out of control inflation being reigned in – a market will snap back and wipe out everyone involved. You see now how its hard to just make “the banks” the enemy? Back when it was one bank/one mortgage, these never would have been done. But with 10s of thousands of mortgages and 10s of millions of investors, no one knows jackshit and it depending on someone else in the “chain of trust” (IT term used to define securing data through crpytography) to be doing their job correctly. And all of this because owning a home somehow changed from a privilege to a right – or at least that’s what the politicians wanted everyone to believe.
Again, I dont know how to dismantle this system. Frankly, its largely dismantled itself from functioning but just like a nuclear blast, there is still toxic stuff hanging around that can have impacts for years to come. The best we can do is not forget it and perhaps force all those participants in this ponzi to trade in their greenbacks for this junk at pennies on the dollar (much of which is going on as we speak). In the meantime, the government will restart the death spiral with low rates but hopefully not leave them that way for a decade or two. Inflation is already creeping into the Commodities markets. Anyone building NEW homes should be given cease and desist orders, but the Toll Brothers of the world continue to exist for some reason. What will happen next is very uncertain – but I will say the blaming/villifying of only a few participants is a sign of the ignorance surrounding the whole issue. From ignorant overly hopeful buyer, to credit rating agencies, to investor, to regulator – all deserve the blame. Unfortunately, of them all, the banks are the only ones who are expected to be holding cash at the end of the day while the rest of the leeches scurry away – scarred for life but still alive (and Im sure even that will be legislated away so that the innocent “victims” are allowed to borrow again in the future).
As for the comments of let them fail, its obvious these are fueled by emotions – rage, anger, sadness. However, people have minds and must overcome these emotions with thought. The people who you’ve directed your anger towards (and again, the party was a lot bigger before the police raided it) will not suffer a bit. Ask the ex-stooges from Lehman and Morgan and Bear and AIG and GM how bad they’re hurting with hundreds of millions already banked. Newsflash – if a bank fails, everyone who has money their gets crushed, not necessarily the people who work there and almost certainly not the top execs and board members. Too big to fail means John Q Public fails….because the only guarantor more underfunded than AIG was FDIC. They couldn’t print out money fast enough if these institutions went under. Meanwhile, see how easy it is to buy food and water while the government tell you to wait up to 2 years for your $10,000 in savings to get paid back.
This is the system we live in. Be realistic. Change is due but its not going to get accomplished with a swipe of the magic money wand while chanting “regulation, regulation, regulation”…
/soapbox
Great great comment banker. I always respect your opinion. I am not certain of the solution either, but it’s conversations like this one (and educated commentary like yours) that helps us get closer to a potential resolution.
Thanks.
TPC,
Thanks. I just like you, I feel its our “civic” duty to inform the public of the truth behind the mess because much of what is out there is simply FUD.
And as you can see, despite my earlier comments, I’ve been regularly visiting this site (and commenting when applicable). I myself am learning a lot and though perhaps we don’t always agree on everything, I certainly respect your opinion as well!
Cheers for keeping it up inspite of confrontational newbies like myself. At least some of us know better than to simply pursue and argument without knowledge of the matter. Like Socrates said, “The only thing I KNOW is that I KNOW nothing.”
Failure…..is the ONLY option. It is the only credible and fair choice. People who do stupid things deserve to FAIL. I am so sick of hearing that our entire system will freeze up, it will be the end of (thier) our world!, As if there aren’t 10,000 other smart young (and old) people out there just waiting to get into this pathetically rigged game, who could do it much better and with the right rules, without the crony crap we have now. But here we are with the same problems we have lectured Japan, THailand, Korea and countless other countries about for the last 3 decades. And with the same losers in charge, because they have the right names on thier Blackberries. Rewinding the TBTF’s is really pretty easy and effective, we just don’t have the guts or freedom left to do it. There I said it.
“Next time the public will not be tolerant of the banks”?
NEXT TIME?
Even BEFORE the GFC the public should have been outraged at fraudulant thieving banks – the GFC should have been catalysts for revolution – why the FUCK are we waiting for “next time”?
Jesus, the sheep are so pathetic!