Lessons Learned?

Thursday, August 9, 2018

Throughout much of American history, financial crises have slapped us around at least once every 20 years—about the same time it takes for a new generation of bankers, traders, speculators, Wall Street executives and government officials to forget all about the calamitous mistakes made previously and to start making them again. (The lone exception, the long stretch between the Great Depression and the stock market crash of 1987, saw the capital markets mostly quiescent for reasons that no longer apply.)

On the tenth anniversary of the collapse of Lehman Brothers—the event that marked the start of the Great Recession—the question is, are we due, or overdue, for another financial crisis? It seems hard to fathom, doesn’t it? Despite wobbles in the Dow Jones Industrial Average since it hit its January all-time high of 26,616, inflation is at low levels; the unemployment rate, 3.8 percent, is at a 20-year low; and annual GDP growth seems poised to break out of the 2 percent rut it’s been in for a decade.

We appear to be squarely in the long-desired Goldilocks Economy—not too hot and not too cold, just about right. Even the New York Times editorial board had to grudgingly admit in June that the current economy was “if not shining, certainly sunny.”

But it might be wise to worry that the next financial crisis is something like what you see in a side-view mirror: closer than it appears. While there were many causes of the Great Recession, four of the most virulent remain problematic today, suggesting that it is only a matter of time before they conspire together again to shake the confidence that is essential to the proper daily functioning of our capital markets.

And that’s before we factor in Mr. High Beta himself, Donald Trump.

In the years leading up to 2007, when the first cracks began to appear in the mortgage markets, there was what people on Wall Street referred to as “light touch” regulation from Washington. There were a variety of different regulators—among them the Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Commodity Futures Trading Commission—but none were particularly vigilant about monitoring what was going on at the big Wall Street banks or at their smaller counterparts across the country. For instance, the S.E.C., then Wall Street’s chief regulator, rarely showed up inside a Wall Street firm. This, of course, was just the way the banks wanted it.

That changed dramatically after the financial crisis and the passage of the monumental, and monumentally complicated, Dodd-Frank Act. Suddenly, there were new rules about how much capital big banks were required to have and how

much risk they were allowed to take. The Federal Reserve took over from the S.E.C. as the “prudential” regulator of Wall Street. Daniel Tarullo, then the Federal Reserve Board governor charged with overseeing Wall Street, was especially vigilant about trying to make sure what happened on Wall Street in the run-up to the financial crisis would never happen again. A new era of regulatory diligence had dawned. Since then, regulators have been swarming around Wall Street firms, often establishing offices on-site at the banks, as well as expecting regular access to their loan portfolios and their boardrooms.

Donald Trump is dismantling all that. Tarullo is long gone, replaced by the far more accommodating Randal Quarles, a former private equity investor. In May, Congress rolled back parts of Dodd-Frank and dramatically changed the size of the banks—those with $250 billion or more in assets—that must remain under its purview. To accommodate Wall Street, the Federal Reserve is now considering eliminating the parts of Dodd-Frank—known as the Volcker Rule (after the former Fed chairman who came up with it)—that regulates how much risk firms could take. The Fed has proposed that the banks themselves be the final arbiter of their own risk-taking, rather than regulators. We haven’t quite returned to the days of “light touch” regulation, but they don’t seem that far off anymore.

That’s only problem number one.

Problem number two is the fact for most of the last decade, thanks to the Federal Reserve’s so-called “zero interest rate policy,” risk in the credit markets has been badly mispriced. What does that mean? Shortly after the onset of the financial crisis, and for the next eight years or so, former Fed chairman Ben Bernanke instituted a policy known as “quantitative easing,” which had the effect of pushing long-term interest rates to their lowest levels in decades. At the same time, the Fed pushed short-term interest rates to near zero, too. Bernanke’s idea was to make borrowing money so cheap—with interest rates close to zero—that demand for loans would go up and cheap capital would be available to jump-start a moribund economy. It worked pretty well, too, especially for borrowers with pristine credit ratings.

But there were unintended consequences. Among them was what I call the Yield Hunger Games—investors’ unquenchable desire to find higher returns for their cash. With the Fed keeping interest rates intentionally low—warping the market, in fact—and with Treasury securities yielding around 1 percent or less, investors started bidding up the price of riskier bonds with higher coupons, or interest rates. Since bond prices trade in inverse proportion to their yields, as investors bid up the price of so-called high-yield, or “junk,” bonds, their yields went down. Whereas one rule of thumb would have high-yield bonds yielding around 10 percent annually—to reflect the credit risk of the company issuing them—in the world of the Yield Hunger Games such bonds were yielding some 5 percent or less. That’s how risk gets mispriced, when investors, desperate for yield, pay too much for bonds that would be worth less in an environment where risk is properly priced. When the real value of those bonds gets adjusted in the marketplace—as is inevitable at some point see the value of the bonds of the now liquidating Toys “R” Us as but one example)—lots and lots of money can be lost. Suffice it to say, that a similar version of the Yield Hunger Games occurred in the years leading up to the financial crisis—only this time, the Fed has kept interest rates even lower for even longer. Big underappreciated problem.

Problem three relates to the DNA of banking itself, the very nature of “fractional banking.” Banks of all stripes—whether big “depository” institutions such as JPMorgan Chase or Bank of America, or what were once known as Wall Street securities firms, such as the defunct Bear Stearns or Lehman Brothers—operate on the simple premise of “borrowing short” and “lending long.” In other words, our deposits—of which JPMorgan Chase has around $1.5 trillion—are part of the raw material that banks use to make loans to corporations, companies, governments and educational institutions that need the money to grow their businesses or to operate. Those loans generally are made on a long-term basis, of one, five or ten years. But our deposits are “on demand,” meaning that when we go to an ATM machine and put in our card, we expect the money we have deposited to come out of the slot. We don’t even think about it anymore.

The truth is our money is not at the bank, and never has been. Our deposits have been lent out on a long-term basis to borrowers all around the world. Banks make their huge profits—JPMorgan Chase made a stunning $8.71 billion in net income in the first quarter of 2018—lots of different ways, but one of the most lucrative is by taking the raw material we give them nearly for free—our deposits—and then lending that money out at much higher rates of interest, capturing the “spread” between one and the other. That’s fractional banking—which works just fine until people lose confidence in their banks, and worry that their money won’t be there when they want it. That’s when this kind of banking leads to disaster. Banks can fail very quickly. Bear Stearns collapsed in a week and Lehman Brothers seemingly over the course of a weekend. Needless to say, banks are still in the business of “borrowing short” and “lending long,” and this fundamental flaw remains little more than bone-dry kindling on the forest floor.

Which brings us to the match that can ignite the kindling: the compensation system on Wall Street that still rewards big risk-taking with other people’s money. Bankers, traders and executives get big bonuses—often in the millions of dollars—to generate revenue from selling whatever products they are told to sell, be they mortgage-backed securities, stock and bond underwritings or wacky derivatives. Once upon a time, when Wall Street was a series of undercapitalized private partnerships, where people with last names like Lehman, Goldman, Sachs and Morgan had their own capital invested in their firms, they also had their entire net worth on the line every day. Wall Street is a dangerous place, it’s worth remembering, and things often went wrong, with firms going out of business all the time. For generations, there was accountability for bad behavior on Wall Street where it mattered most: in the bank accounts of the partners at the firm.

But that ethic began to change nearly 50 years ago, when, led by the brokerage firm Donaldson, Lufkin & Jenrette, one Wall Street partnership after another “went public,” by selling a slice of their equity to investors. Where once the risk of the firm was borne by the partners in the firm, over time it has become a firm’s creditors and shareholders that bear the most risk, as was especially obvious when Lehman failed ten years ago (and would have been obvious too in the cases of Bear Stearns and Merrill Lynch but for government bailouts). Bankers and traders are rewarded for generating revenue, not for prudent risk-taking. 

Let’s face it, people are pretty simple: they do what they are rewarded to do. On Wall Street today, as in the years before 2008, people are rewarded to take big risks with other people’s money, with little or no accountability when it comes to bad behavior.

I could be wrong about all this of course. But most of the factors that caused the last financial crisis remain in play. My bet is that the next one is right around the corner.

Happy anniversary!


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