Four years and still million miles away from safety

There is simply a total lack of critical changes needed to fix the regulatory spinal cord of the financial markets. This subject is being ignored at the highest levels and, at times, I find myself waking in a cold sweat, unable to conceive what a dangerous course they tread!

We often hear about President Obama’s intellect, how well read he is, how well spoken, how utterly polished. But after all we’ve been through the last four years — as close to the brink as we came in 2008 — why he is not leading the charge to fix a massive web of confusion over responsibility and accountability in our financial regulatory infrastructure, is the $10 trillion question. His performance thus far has been nothing short of unconscionable in this regard. In fact, his administration and Congress have exacerbated the problem, and today the system is far more convoluted than ever. 

It’s either the height of foolish, blind ignorance of systemic risk or an agenda as dark as you could imagine, and nothing in between. 

 A ticking time bomb

If you look back over the great financial panics in the last 50 years, we had the savings and loan (S&L) Crisis in the late 1980s, the Long Term Capital Management crisis in the late 1990s, and the biggest bankruptcy in the history of the universe in 2008 with Lehman Brothers. They come at us every 10 years, like clockwork. And yet each one is larger than the last, and quite disturbingly so, relative to GDP. Take a look at the global systemic risk, Long Term Capital Management was systemically 10 times bigger than the S&L crisis, but Lehman was 100 times the size of LTCM.

In the S&L crisis, after banks repaid loans through various procedures, there was a net loss to taxpayers of approximately $124 billion by the end of 1999, according to the book The Cost of the Savings & Loan Crisis: Truth and Consequences. Yet, because financial institutions in the 1980s were about 40% to 80% less leveraged than those in the 1990s and 2000s, there was dramatically less systemic risk. The birth of credit derivatives was still years away, and banking collapses were more isolated, with the dominos being miles apart.

According to the financial classic, When Genius Failed: the Rise and Fall of Long-Term Capital Management, at the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of over 25:1. But it wasn’t the size of LTCM, it was the fact that the firm had amassed off-balance sheet derivative positions with a notional value of approximately $1.25 trillion. Counterparty risk was born. This threatened many financial institutions globally in one way or another, a stage in history where the dominos were moving ever closer together.

In 1998, the year Lehman first teetered on the brink of collapsing, the firm had a balance sheet of about $38 billion. By 2007, it had grown to over $700 billion. But again, it wasn’t Lehman’s size and 40 times leverage that was the systemic problem. It was their $7 trillion of counter-party derivative risk, exposing banks across the world to incalculable destructive forces; this time the dominos moved only inches apart.

At the time Lehman failed in 2008, the size of the world stock market was estimated at about $36.6 trillion. Today, the world derivatives market has been estimated at about $791 trillion face or nominal value, 11 times the size of the entire world economy. It’s simple math. If you look at the size of these explosive monsters as measured by systemic risk over the last 50 years compared to GDP, we are on a collision course with a $10-12 trillion problem, enough to engulf the Federal Reserve. 

Bottom line: in the history of the planet, there’s  never been a more important time for our regulators to focus precisely on systemic risk. The question is, how many of them have ever actually taken risk, been in the game? As most know by now, 15 years ago, the combined assets of the six biggest banks in the US totalled 17% of GDP. By 2006, that number was 55% and by 2009, it was 63%. The government created these mega-giants. Thanks in part to acquisitions of Countrywide Financial Corp and Merrill Lynch, the assets of Bank of America have jumped 36% from before the financial crisis to $2.34 trillion. JP Morgan bought Bear Stearns and Washington Mutual and has assets of $2.14 trillion, up 37%. The top four banks now have 40% of the nation’s deposits, according to the FDIC, Cleveland Fed & NCUA and Simon Johnson, professor, MIT’s Sloan School of Management.

Even more disturbing, the European banking system is still over $46 trillion in size, three times total EU GDP. Imagine the Swiss nationalising just UBS and Credit Suisse, whose assets are 500% of the Swiss GDP.

A meteor is heading at us as we do nothing

The banking industry has become more concentrated since the 1980s. Today’s 6,291 commercial banks are less than half the number that existed in 1984, according to the Federal Deposit Insurance.

One would logically conclude with a problem this big and this deadly that modern financial reform would be laser focused on getting to the root of the problem, and protecting our capitalist system from catastrophe. With so much on the line, with all the cries from the Occupy Wall Street crowd, it is almost gross negligence that President Obama, Elizabeth Warren and many other Left wing politicians are using the financial crisis to shotgun financial reform into areas of the financial system that had nothing to do with the crisis. The stakes are just too high in 2012 not to attack this problem with precision solutions. Giant bureaucratic silos that don’t share critical information with one another, that aren’t run by proven risk takers, are the number one threat in the world to our capitalist system.

What is the problem and why hasn’t it been fixed?

Our regulatory system has not kept pace with the speed and sophistication at which 21^st century financial products have grown, not even close. Why is so much time spent on insider trading cases? They pose zero systemic risk to society. If insider trading is so important to prosecute, then why did it take until 2009 for the Securities and Exchange Commission (SEC) to try its first case involving credit default swaps? Don’t even get me started looking at the number of insider trading cases involving stocks versus corporate default spreads. Modernisation of finance technology has moved at the speed of sound, and the regulatory ecosystem is stuck in the
breakdown lane. 

The classic strengths and weaknesses of the public and private sectors are moving capitalism full circle to its possible breaking point. I am at a total loss as to why the Obama administration has done nothing about this threat in four years. 

It’s not just the obvious failures of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The most serious problem of all could be addressed outside of the shortcomings of this legislation, but the president has not made it a priority. We still have a chance but we must do something now or all will be lost.

I’ll never forget Alan Greenspan’s Troubled Asset Relief Program testimony in front of Congress in 2008, almost three years after stepping down as chairman of the Federal Reserve. A humbled Greenspan admitted that he had put too much faith in the self-correcting power of free markets, and had failed to anticipate the self-destructive power of carefree mortgage lending.

It’s so clear to me why the self-correcting power of capitalism failed in 2008. Capitalism does not work without transparency of risk and, ultimately, our regulators simply did not have the financial acumen to fully grasp our most important problems.

Does President Obama have the back of the right person in the right spot today? Simple answer, no. The isolated silos within the regulatory machine in Washington are as disconnected as ever. And our capitalists system, our way of life, hangs in the balance.

Let’s all get real, please. In 2008, we had protecting us the Federal Reserve, the New York Fed, US Treasury, SEC, Commodity Futures Trading Commission (CFTC), Federal Deposit Insurance Corporation (FDIC), Financial Industry Regulatory Authority (FINRA), Office of Thrift Supervision, Comptroller of the Currency, State Insurance Commissioners, Department of Justice, the Office of Fair Housing and Equal Opportunity and the FBI. Some 60,000 people work for all these government agencies, but how many of them have actually taken risk?

How to fix the problem

Warren Buffett’s lifelong business partner Charlie Munger was nice enough to invite me to Omaha for the Berkshire Hathaway annual meeting and offered me a private one-on-one meeting. He’d read my book and wanted to discuss what went wrong in our financial system and how to fix it. 

I’ll never forget his words of wisdom, “It’s all about the incentives, Larry. Always follow the incentives as far as you can, and there you’d find solutions and truth.” Point being, in 2008 there were all the financial incentives in the world for talented people to join the ranks of Paulson and Co, Goldman Sachs and JP Morgan. Yet, how many incentives were there for those same talents to sign up with the SEC, CFTC and the FDIC?

It was Henry Merritt Paulson, the former Secretary of the US Treasury, who made the fateful decision to put Lehman to sleep and save just about every other bank, money market fund and insurance company in the Western world. Now, as much as I didn’t like Paulson’s selective god-playing role during the financial crisis, I must admit, we were lucky to have him in his seat during this incredibly important moment in American history. Of all civil servants in Washington looking over our financial system, he was one of a handful who’s actually played the game, taken risk at the highest level. He could play centre field in the Big Leagues of finance with the best of them.

A review of all the accounts, books and blogs covering those fateful days of the financial crisis, it’s very clear to me there was one man calling most of the shots — Hank Paulson. In the end, with everything on the line, the only person in Washington with real-world risk-taking experience was making most of the big decisions. And when The New York Times reviewed his phone log, most of his time was spent brainstorming with Goldman’s Lloyd Blankfein and JP Morgan’s Jamie Dimon, not bureaucrats who’ve never played the game. That’s a powerful statement of truth pointed towards what’s needed in the future.

Follow the Incentives

Why did Paulson make that fateful move to Washington in 2006? There’s no question, Time magazine’s runner-up 2008 Person of the Year was one of President Bush’s best decisions in his eight-year term. But why did he leave Goldman Sachs in 2006 to join the US Treasury? Sure, there was a flash of patriotic flare, give something back, but ultimately as Charlie Munger told me, it’s all about the incentives. 

The $183,000 annual salary for the treasury secretary position didn’t mean much to Paulson, who was used to earning almost $40 million a year. Thanks to a provision in the tax code, the former Goldman Sachs CEO got a colossal financial break for moving to DC. Over the years at Goldman, he amassed almost $700 million equity stake. In the end he was able to diversify a good chunk of those holdings without paying a dime to the Internal Revenue Service. By accepting the Treasury post, Paulson took advantage of a tax loophole that allows government officials from the executive branch to defer capital gains taxes on assets they have to sell to avoid a conflict of interest, as long as the proceeds are reinvested in government securities or a broad array of mutual funds approved by the government within 60 days.

Former Governor Jon Corzine of New Jersey, who later became US Senator, wasn’t so lucky. While serving on the Senate banking committee, he was pressured to sell off $300 million worth of his Goldman stock. But alas, the tax perk is only available to members of the executive branch.

We must expand the Paulson Tax Treat to regulatory offices outside of the executive branch. Think of it as a military-style draft, taking some of Wall Street’s best and brightest into new roles at the SEC, FDIC, CFTC, FBI and New York Fed. Bringing real-world players and risk-takers into our regulatory system will go a long way in protecting capitalism from its ever-growing threat. Is it really wise and necessary to have academics and bureaucrats running our regulatory nerve centres while the best risk takers in the world are on Wall Street running hedge funds and working on sell side trading floors? Four years is a long time, 1,460 days. Dodd Frank is a lazy man’s spray-gun approach at financial reform. We desperately need precise fixes applied to our most important challenges.