“We have a once-in-a-lifetime opportunity to effect genuine change given that the general public is disgusted with the financial system and none too pleased with Congress,” says Jeremy Grantham, founder and chief investment strategist of the $100 billion GMO money managers. But unfortunately the new “administration, which came in on a promise of change, for heaven’s sake, is so determined to protect the status quo of the financial system at the expense of already weary taxpayers who are promised only somewhat better lifeboats.” Our current approach to financial reform, says Grantham, is like building Titanic II using the original plans. Here’s what’s behind this drama.
For months former Fed Chairman Paul Volcker (now head of Obama’s Economic Recovery Advisory Board) has been warning Washington that Wall Street’s “too-big-to-fail” banks are back to their old ways. Glass-Steagall should be reinacted. “The banks are there to serve the public,” Volcker told Congress, that’s “what they should concentrate on. These other [risky] activities create conflicts of interest. They create risks, and if you try to control the risks with supervision, that just creates friction and difficulties and will fail.” So Washington is helping Wall Street rebuild the Titanic.
House Financial Services Chairman Barney Frank is trying to keep Volcker’s proposal alive with a plan to “give a council of regulators the authority to reinstate Glass Steagall on a company-by-company basis,” according to MarketWatch. But Obama, Summers, and Geithner are siding with the big banks, marginalizing Volcker and his proposal. Since the 1999 dismantling of Glass-Steagall, banks and their lobbyists have fallen in love with their new free-market business model. They know how to manipulate regulators. And they also know Congress, Fed and taxpayers will bail them out next time they take too many risks, screw up again, trigger another meltdown. Worse, in a recent speech, Fed Governor Daniel K. Tarullo tried to kill off Volcker’s proposal, sounding like a Wall Street bank lobbyist: “One suggested approach is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with nonbank financial firms. This strategy would seem unlikely to limit the ‘too big to fail’ problem to a significant degree.”
Sorry, but that’s not the problem. It’s not that the banks are too big, they’re too greedy, they lack a moral compass, and they have no reservations about gambling with retail customers’ deposits. But Volcker’s right, if we don’t separate our “too-greed-to-fail” banks into low-risk commercial and hi-risk investment banking, we’ll face a bigger meltdown in a few years. In a recent letter to GMO investors, “Lesson Not Learned: On Redesigning Our Current Financial System,” Grantham captured the drama in a fascinating metaphor:
“Imagine the company representatives on the Titanic II design committee repeatedly pointing out that the Titanic I tragedy was a black swan event: utterly unpredictable and completely, emphatically, not caused by any failures of the ship’s construction, of the company’s policy, or of the captain’s competence. “No one could have seen this coming,” would have been their constant refrain. Their response would have been to spend their time pushing for more and improved lifeboats. In itself this is a good idea, and that is the trap: by working to mitigate the pain of the next catastrophe, we allow ourselves to downplay the real causes of the disaster and thereby invite another one. And so it is today with our efforts to redesign the financial system in order to reduce the number and severity of future crises.
“After a crisis, if you don’t want to waste time on palliatives, you must begin with an open and frank admission of failure. The Titanic, for example, was just too big and therefore too complicated for the affordable technology of its day. Given White Star Line’s unwillingness to spend, she was under-designed. The ship also suffered from agency problems: the passengers bore the risk of unnecessary speed and overconfidence in “too big to sink!” while the captain stood to be rewarded for breaking the speed record. No captain is ever rewarded for merely delivering his passengers alive. Greenspan, nearly 100 years later in his short-lived “irrational exuberance” phase, did not enjoy being metaphysically slapped by the Senate Subcommittee for threatening the then speedy progress of the economy. What is needed in this typical type of agency problem is for the agent on those rare occasions when it really matters, whether a ship’s captain or a Fed boss, to stop boot licking and say, ‘No, this is wrong. It is just too risky. I won’t go along.’
Wall Street failed miserably. But Washington lacks a backbone, has no strategy. So inaction and denial guarantees a new bubble-bust cycle soon. Here’s Grantham’s call to action.
“We have a once-in-a-lifetime opportunity to effect genuine change given that the general public is disgusted with the financial system and none too pleased with Congress. I have no idea why the current administration, which came in on a promise of change, for heaven’s sake, is so determined to protect the status quo of the financial system at the expense of already weary taxpayers who are promised only somewhat better lifeboats. It is obvious to most that there was a more or less complete failure of our private financial system and its public overseers. The regulatory leaders in particular were all far too captured and cozy in their dealings with reckless and greedy financial enterprises. Congress also failed in its role. For example, it did not rise to the occasion to limit the recklessness of Fannie and Freddie. Nor did it encourage the regulation of new financial instruments. Quite the reverse, as exemplified by the sorry tale of CFTC Chairman Brooksley Born’s fight to regulate credit default swaps.
“But, at least now, Congress seems to realize the problem: the current financial system is too large and complicated for the ordinary people attempting to control it. Even Barney Frank, were he on his death bed, might admit this; and most members of Congress know that they hardly understand the financial system at all. Many of the banks individually are both too big and so complicated that none of their own bosses clearly understand their own complexity and risk taking. The recent boom and the ensuing crisis are a wonderfully scientific experiment with definitive results that we are all trying to ignore. And, except for bankers, who have Congress in an iron grip, we all want and need a profound change. We all want smaller, simpler banks that are not too big to fail. And we can and should arrange it!”
Grantham’s one of America’s most successful money managers. He predicted the meltdown early in April 2007, when Paulson and Bernanke were in denial, dismissing it. And Grantham’s solution is exactly what Volcker’s says is essential to avoid another, bigger meltdown:
“Step 1 should be to ban or spin off that part of the trading of the bank’s own money that has become an aggressive hedge fund. Proprietary trading by banks has become by degrees over recent years an egregious conflict of interest with their clients. Most if not all banks that prop trade now gather information from their institutional clients and exploit it. In complete contrast, 30 years ago, Goldman Sachs, for example, would never, ever have traded against its clients.
Unfortunately, it looks like Goldman and the Wall Street banks will get their wish, because Obama, Summers, Geithner and Bernanke all back Wall Street’s strategy of continuing without Glass Steagall … so protect yourself folks, the next iceberg is bigger, and all the lifeboats are reserved to the first-class cabins.