American Unemployment Rate Approaches 10%

[DGuller]

I was reading an article in Forbes a few weeks ago about a smallish Texas bank that refused to go along with the subprime mess and maintained conservative lending pracices.  For that they were constantly harrassed by Gov't regulators for failing to expand lending to risky low-income groups.

The bank is sitting quite pretty now (which is why they wrote an article about them), but it makes clear how central pressure by gov't regulators to expand lending was to creating this crisis.

Again, this is a deliberate attempt to misdirect perpetrated by the same people who started or enabled the crisis.  Even if you buy into the fairy tale that the explosion in popularity of subprime mortgages was solely the creation of the government and no one else, they still were not the cause of the meltdown.  What set off the meltdown was the reckless leveraging upon leveraging upon leveraging by Wall Street.  The losses from the financial products absolutely dwarf the losses from the actual subprime mortgages. 

[Palisadoes]

Yeah. In Europe we widely accept it is the banks fault, though we still like to blame our politicians for letting them screw up as they did.

[Neil]

I still can't find the charts but there's a few which may do.  Unfortunately I couldn't find them online so I've had to save these and attach them to posts.  Hopefully this'll work.

First a map of bank crises since the late seventies:

So it seems that the only places that have avoided banking crises are desperately backwards or are so tiny as to not really be independent.

[DGuller]

Yeah. In Europe we widely accept it is the banks fault, though we still like to blame our politicians for letting them screw up as they did.

In way, it's extremely unfortunate that this bubble came to be known as "subprime mortgage crisis".  It makes people think that it was the subprime mortgages that did the economy in, even without the WSJ-created misdirections like the CRA.  This bubble should really be called the "financial instruments bubble".

[alfred russel]

The biggest part of misaligned incentives is precisely the conversion of investment banks into public companies.  This played a big part in investment banks becoming less prudent.  The bonus structure rewarded short-term rewards at expense of long-term viability.  Getting a big bonus out of a bunch of shareholders is a lot easier than getting a big bonus out of Mr. Goldman and Mr. Sachs.

Investment banking bonuses went way up, but so did investment banking profits--much like private investment bankers and hedge funds. My understanding has always been that comparably sized private companies offer management compensation that is similar and in some cases exceeds that of public companies (they can quietly bid as much as they want for an executive team without the sparking public outrage). I just don't think that argument (investment bank goes public --> bonuses go up because no one cares about shareholders --> stupid decisions and bankruptcy) works.

[Barrister]

I still can't find the charts but there's a few which may do.  Unfortunately I couldn't find them online so I've had to save these and attach them to posts.  Hopefully this'll work.

First a map of bank crises since the late seventies:

So it seems that the only places that have avoided banking crises are desperately backwards or are so tiny as to not really be independent.

Which is Canada?

[DGuller]

Investment banking bonuses went way up, but so did investment banking profits--much like private investment bankers and hedge funds. My understanding has always been that comparably sized private companies offer management compensation that is similar and in some cases exceeds that of public companies (they can quietly bid as much as they want for an executive team without the sparking public outrage). I just don't think that argument (investment bank goes public --> bonuses go up because no one cares about shareholders --> stupid decisions and bankruptcy) works.

When it comes to investing, it is short-sighted to talk of just profits.  There has to be some sort of risk-adjustment done to those profits, due to the inherently stochastic nature of the markets.  Any idiot can earn good profits with 50:1 leverage ratio and a little good luck.  It's not going bust in the long run that's going to be problematic.  Unfortunately, executive compensations neglected that kind of risk-adjustment, and all financial types were paid as if they were making something from nothing.  Heads they won, tails someone else lost.

[alfred russel]

When it comes to investing, it is short-sighted to talk of just profits.  There has to be some sort of risk-adjustment done to those profits, due to the inherently stochastic nature of the markets.  Any idiot can earn good profits with 50:1 leverage ratio and a little good luck.  It's not going bust in the long run that's going to be problematic.  Unfortunately, executive compensations neglected that kind of risk-adjustment, and all financial types were paid as if they were making something from nothing.  Heads they won, tails someone else lost.

If I'm able to lever up at 50:1 with low interest rates and freedom to develop my own business plan, guess what I'm doing? I'm going to create a massively leveraged high risk structure that kicks off obscene profits in the good times, and implodes when things start to turn south.

That is a rationale decision making process for managing equity. That is not a good decision making process for the overall economy. I wouldn't put all the blame on the equity ownership structure: it seems to me more should reside with the debt markets.

[DGuller]

If I'm able to lever up at 50:1 with low interest rates and freedom to develop my own business plan, guess what I'm doing? I'm going to create a massively leveraged high risk structure that kicks off obscene profits in the good times, and implodes when things start to turn south.

That is a rationale decision making process for managing equity. That is not a good decision making process for the overall economy. I wouldn't put all the blame on the equity ownership structure: it seems to me more should reside with the debt markets.

Well, I guess the answer is that people like you got the opportunity to do exactly that.  Investment bankers found themselves in a very lucrative position where they got to gamble with other people's capital and take enormous juice off their proceeds.  I think that's immoral, but certainly not irrational, they don't seem to be doing too badly even now.  I guess once we figure out how that situation came to pass, we'll have an answer for Yi's riddle.

[alfred russel]

If I'm able to lever up at 50:1 with low interest rates and freedom to develop my own business plan, guess what I'm doing? I'm going to create a massively leveraged high risk structure that kicks off obscene profits in the good times, and implodes when things start to turn south.

That is a rationale decision making process for managing equity. That is not a good decision making process for the overall economy. I wouldn't put all the blame on the equity ownership structure: it seems to me more should reside with the debt markets.

Well, I guess the answer is that people like you got the opportunity to do exactly that.  Investment bankers found themselves in a very lucrative position where they got to gamble with other people's capital and take enormous juice off their proceeds.  I think that's immoral, but certainly not irrational, they don't seem to be doing too badly even now.  I guess once we figure out how that situation came to pass, we'll have an answer for Yi's riddle.

Since going public, the investment banks have done fairly well for their shareholders. Even if you factor in that 3 of the 5 effectively went under, if you put in equal amounts to each of the 5's IPO's you would be doing quite well--Morgan Stanley has exploded with solid performance from Goldman Sachs which makes up for the loss of the other three.

From a public policy perspective, 3 of the 5 major investment banks going down the decade after going public was very bad. But from an investor perspective, it looks like the way the companies operated is paying off.

[DGuller]

Ok, I concede that the shareholders weren't the ones fleeced.  However, it seems like the fact remains, Wall Street going public created incentives that were perverse to the economy at large.  It created incentives for wealth destruction rather than wealth creation, on the whole.

[alfred russel]

Ok, I concede that the shareholders weren't the ones fleeced.  However, it seems like the fact remains, Wall Street going public created incentives that were perverse to the economy at large.  It created incentives for wealth destruction rather than wealth creation, on the whole.

In terms of the individual contributing capital, having employee/partners contribute the capital will generally produce less risk and lower returns, as they will be more conservative. But at the same time the firms will have a higher cost of capital, be less profitable, employ fewer people, and be less active in the economy.

At the end of the day, Morgan Stanley and Goldman Sachs have combined market caps of about $100 billion. You aren't going to get partners to contribute that much capital. The cat is out of the bag and these are public companies that are going to stay that way. I tend to think that reasonable regulation could prevent some of the problems we are having without privatizing the companies.

[Neil]

I still can't find the charts but there's a few which may do.  Unfortunately I couldn't find them online so I've had to save these and attach them to posts.  Hopefully this'll work.

First a map of bank crises since the late seventies:

So it seems that the only places that have avoided banking crises are desperately backwards or are so tiny as to not really be independent.

Which is Canada?

According to Sheilbh's map, it has suffered banking issues in the last 30 years.  There were a couple of regional bank failures in the mid-80s, which is probably what they're referring to.

[DontSayBanana]

In terms of the individual contributing capital, having employee/partners contribute the capital will generally produce less risk and lower returns, as they will be more conservative. But at the same time the firms will have a higher cost of capital, be less profitable, employ fewer people, and be less active in the economy.

At the end of the day, Morgan Stanley and Goldman Sachs have combined market caps of about $100 billion. You aren't going to get partners to contribute that much capital. The cat is out of the bag and these are public companies that are going to stay that way. I tend to think that reasonable regulation could prevent some of the problems we are having without privatizing the companies.

True, but when the firms were created, they didn't start with that much capital anyway.

What about a system where capital is allocated into a liquidity pool, a leveraging pool, and an operational pool, with allocations determined by the risk presented by officers within the firm?

[alfred russel]

True, but when the firms were created, they didn't start with that much capital anyway.

But they have that much now. To run them as private companies, you will either need that much capital, drastically reduce their size, or lever them up even more.

What about a system where capital is allocated into a liquidity pool, a leveraging pool, and an operational pool, with allocations determined by the risk presented by officers within the firm?

I have no idea what you are talking about.