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Thursday, October 13, 2011

Morgan Stanley: Systemic Mistrust or Bad Financials?

Morgan Stanley by any measure is a safe and solid investment bank. Except for one: The amount of trust people have in the whole financial and political system. It's just about zero,” according to Jesse Eisinger of The New York Times in October 2011. Even as there is undoubtedly an element of hyperbole in his conclusion—for zero trust in the financial system and governments would occasion far greater problems than the world faced at the time of Eisinger’s report—his broader point that bankers would be held accountable one way or the other for not having learned their lesson on derivatives (and risk more generally) is valid. The subtext is that even though banks like Morgan Stanley were in actuality in solid financial shape, they deserved the negative repercussions from the systemic skepticism that the banks themselves brought about by virtually ignoring risk analysis in preference to a run of profits and (not coincidentally) bonuses.

Eisinger points out that, at least as of October 2011, Morgan Stanley “has almost $60 billion in common equity, compared with $36 billion before September 2008, and its ratios are stronger. Its trading book - which is volatile and where any bank can take sudden, large losses - is smaller than it was. Morgan Stanley has more long-term debt and higher deposits, both of which stabilize its finances. The bank has more cash available in case there's a crunch and a smaller amount of Level III assets, which don't have an independently verifiable value and so must be estimated by the bank. Hedge funds have parked a smaller amount of assets at Morgan Stanley. That's good because in the financial crisis, they pulled them from the bank.” But because all of this could be easily wiped out by a run on the bank occasioned or fueled by a wider mistrust of the financial sector, Eisinger brings up the topic of derivatives as a way of showing that the bankers did not in fact learn their lesson (i.e., all the improved stats may be for naught). Accordingly, the bankers deserved the systemic mistrust even at the expense of any effort having resulted in added financial strength.  

According to the reporter, Morgan Stanley had a face value of $56 trillion in derivatives in October 2011. He notes that JP Morgan Chase had more: a face value of $79 trillion. This is the GNP of some countries. Even though the bankers insisted at the time that they had adequately hedged their long positions, the hedges themselves could fail, especially if the derivatives are positively correlated, as in September 2008 when AIG was completely overwhelmed due to the housing-based derivatives caving in virtually all at once.

In other words, those of us capable of learning lessons know that we should not trust hedges in so far as systemic risk is concerned; the system itself can be overwhelmed by the sheer momentum of a really big wave. So we are back to the issue of trust in the entire financial system, which is and ought to be a drag on even stellar financials until the broader lesson is learned. Unfortunately, that lesson may not be in the immediate financial interest of particular banks due to externalities occasioned by moral hazard (e.g., the possibility of being rescued while another bank, such as Lehman, fails).

Even though governments can step in to protect the broader system (unless captured by the regulated), legislators and regulators cannot force bankers to learn their lesson. A mentality to safeguard even one’s own bank as a going concern cannot be imposed; it must be felt and valued from the inside. All too often, bankers are engaged in “managing” regulations as impediments to be minimized rather than stepping back to ask why the regulations exist in the first place. They might exist for the banks’ own good. If so, the banking lobby trying to water down the Volcker Rule might have been working at odds with those institutions that the lobby ostensibly represents. Be careful what you wish for, Wall Street bankers. You might just get it, especially if you have the gold and therefore can make the rules. It would be ironic if the protesters rather than yourselves had your back, even as you ridicule the masses marching below your towering be-windowed edifices of greed.


Jesse Eisinger, “Between the Lines, Wall St. Banks Face a Deficit of Trust,” The New York Times, October 12, 2011. 

On the E.U. Banking Proposal: Comparative Context

“Under proposals outlined by the European Commission president, José Manuel Barroso, banks would be required to temporarily bolster their protection against losses. . . . Extra capital for European banks should be raised first from the private sector, then from [the state] governments, according to the proposal. Only when those avenues have been exhausted should a euro zone bailout fund be tapped, it said. Banks should not be allowed to pay dividends or bonuses until they have raised the additional capital, according to the proposal” (NYT 10/13/2011).

After Lehman Brothers failed in September 2008, the U.S. took “swift action to ensure its banks had a strong cushion of capital,” according to The New York Times. The same logic is said to be in the European proposal. Perhaps in general terms this is true, but a major difference is worthy of note. Specifically, the American banks receiving TARP funds were allowed to pay dividends and bonuses. To be sure, executive compensation faced limitations, but this constraint pales in comparison to that in the E.U.’s proposal, wherein no dividends and bonuses would be permitted. Also, the U.S. Treasury allowed banks to pay back the funds earlier than perhaps advisable because the bankers wanted to be free to pay whatever bonuses they saw fit to sanction for themselves (assuming they controlled their boards, which generally holds, given the separation of ownership and control).

The difference on whether dividends and bonuses should be allowed at troubled banks reflects a rather basic cultural difference between the E.U. and U.S. concerning whether economic liberty ought to be limited even at the extreme. The difference also reflects a different historical experience (and thus value-set) with respect to comfort and convenience.

I contend that dividends and bonuses are inherently “extras.” Admittedly, the bonus system on Wall Street has made its way into calculations of standard or basic compensation. However, if a bank itself is at risk, the need to increase reserves should trump any compensation that depends on the bank’s performance. Otherwise, the implication is that large profits in the short run are to be sought even at the expense of ignoring the impact on systemic risk.

I suspect that the culture of Wall Street has come to embrace surfeit compensation as an entitlement regardless of performance. The aspect of entitlement is particularly disturbing, even if it has become akin to an ingrown toenail (i.e., difficult to eradicate once it has become ensconced—like a house-guest after a week or so). A similar mentality inheres in the dynamic wherein private companies profit while the taxpayers are presumed liable in covering any losses. An entitlement exists, in other words, to enjoy the benefits without having to face the risk of suffering a loss. As the generation that lived through the Great Depression undoubtedly knows, this sunny-side up mentality is a manifestation of being too accustomed to comfort (i.e., having it too good for too long).

The bloody twentieth century in Europe gave Europeans a more realistic perspective on the entitlement of comfort at the turn of, and even a decade into, the next century. Accordingly, European officials have an easier time saying no to dividends and bonuses as long as the banks are at risk. It is a pity that the Americans have such a hard time with this; they unwittingly fall into the hands of the vested interests on Wall Street that have had it too good for too long (especially as investment bankers are “paper entrepreneurs” or middlemen rather than producers).


Stephen Castle, “Europe Tells Its Banks to Raise New Capital,” The New York Times, October 13, 2011.

Wednesday, October 12, 2011

Wall Street Writing the Volcker Rule

On Columbus Day 2011—pretty much a non-holiday by the second decade of the twenty-first century—The New York Times observed that the regulations known as the Volcker rule, “intended to limit trading when the bank's money is at risk, a sweet spot for banks, is seen as a centerpiece of the sprawling financial overhaul of the Dodd-Frank Act of 2010. In anticipation, the nation's biggest banks, like Goldman Sachs and Bank of America, have already shut down their stand-alone proprietary trading desks.” OK, but hold on—the long and tortuous route by which any regulation is written was leaving its own mark in the sense that promising loopholes were finding their way into the rule.

Regulators were leaving room for “significant changes,” according to the Times. Wall Street was “lobbying furiously to tame the Volcker Rule, holding roughly 40 meetings with various regulators, warning that the changes will eat into profits at a difficult time for banks.” Those banks were undoubtedly threatening to charge more to their customers if the rule weren’t weakened. “In essence, the [rule] would upend the banking industry's lucrative, yet risky trading system, forcing powerhouse investment banks to resemble sleepier brokerage firms.” It is difficult to see Morgan Stanley and Goldman Sachs readily becoming mere market-makers and deposit and loan banks without a fight. To be sure, Lloyd Blankfein did insist that his bank was only a market maker when he testified before Sen. Levin’s Senate committee after the credit freeze of 2008.

At the time the Volcker Rule was being proposed, it was already apparent that there would be some wiggle-room for the banks. "Unfortunately, this initial proposal does not deliver on the promise of the Volcker Rule or the requirements of the statute," said Marcus Stanley, policy director of American for Financial Reform, an advocacy group. In the proposal, “a number of controversial exemptions emerged. While the regulation prevents big banks from placing bets on many stocks, corporate bonds and derivatives, it exempts trading in government bonds and foreign currencies. The proposal also provided a path for getting around the ban, for instance, when banks hedge against risk that comes from carrying out a customer's trade. Market-making and underwriting are excused, too, though the line is often fuzzy between these pure client activities and proprietary bets.” Lastly, the proposal would allow “banks to hedge against theoretical or ‘anticipatory’ risk, rather than just clear-and-present problems.” Armed with their lawyers and astute financial wizards, Wall Street banks could conceivably continue with business as usual.

Trading in government bonds and foreign currencies, and hedging even theoretical risk presumably with anything constitute an obstacle course that any Wall Street banker could run without breaking a sweat. With so much on the line and public scrutiny less potent at the regulatory stage, the financial-sector lobbyists could be expected to achieve just enough and then some. Once again, systemic risk would not be a factor, and history could repeat itself.


Ben Protess, “Banking Industry Revamp Moves Step Closer to Law,The New York Times, October 12, 2011. 

Slovakia Stands Up, Caves to the E.U.

On October 11, 2011, Slovakia’s Parliament failed to approve the expansion of the euro rescue fund, a development, the New York Times reports, that “brought down the government.” Although the vote makes good copy, it was not at all as dire as the headline suggests. According to the Times, the state’s “leading opposition party said after the government fell that it would be willing to discuss support for the fund, pointing to the eventual approval of the deal. European officials in Brussels were counting on a political solution, but also weighing the possibility of some kind of messy workaround if Slovakia failed to pass the measure.” In other words, the vote had to do with state politics as well as resistance to bailing out a richer state. Once the state government fell, pressure from the E.U. and the new politics in the state government quickly coalesced by the next day to produce a deal in support of expanding the bailout fund. According to the Washington Post, "opposition leader Robert Fico, head of the Smer-Social Democracy party, announced he had struck a deal with the remnants of Radicova’s coalition, promising to back the fund in exchange for early elections that analysts say Fico’s party is well positioned to win." Doubtless that pressure from the E.U. was also in the mix, as E.U. officials were already hinting that the bailout fund could be expanded over the tiny state's objection. “We call upon all parties in the Slovak parliament to rise above the positioning of short-term politics and seize the next occasion to ensure a swift adoption of the new agreement,” European Council President Herman Van Rompuy and European Commission President Jose Manuel Barroso said in a joint statement, according to the Washington Post. In other words, hey guys, get your act together over there in Slovakia or else.

The full essay is at "Essays on the E.U. Political Economy," available at Amazon.

Tuesday, October 11, 2011

Wall Street and the Populists: A Disconnect

In October 2011, Gerald Seib observed that political and economic pressures were “pushing business leaders into the public cross hairs.” From the corporate standpoint, the time was ripe for the field of business and society, whose topics of corporate social responsibility, corporate citizenship, and stakeholder management had emerged as means by which managers could interface with the broader society. The fundamental matter to be “managed” or assuaged could be said to be divergent norms or values, which in turn can eventuate in antithetical perspectives. Seib was essentially noting that the societal populists and corporate executives were not on the same page. In being geared to creating the impression that the values espoused in a given corporation are in line with societal norms, the field of business and society may not have been equipped to deal with divergent talking points that are grounded in antipodal social realities. Indeed, being invested in one social reality can prevent someone from even being aware of threats from another social reality. Under that scenario, the cues for value-congruence are missed by boundary-spanning managers on the corporate side, which in turn solidifies the discordance between the two social realities. In other words, the pressures mount from the outside, and the validity of the corporate social reality is itself in the cross hairs. To effectively “unwind” this dynamic, the field of business and society must deepen to include the basics of how to see things from a very different perspective without discrediting it from the outset. Value-congruence, and thus the continued legitimacy of the corporate form in modern society depend on this rather-basic yet arduous ability as a precursor.

In the context of the “Occupy Wall Street” protests spreading across the U.S. in the fall of 2011, Seib pointed to the existence of “a radical disconnect between the picture populist critics paint from the outside, and the one business leaders describe from inside.” This disconnect went back to September 2008, when bankers viewed the collapse of the CDO market as a result of over-reaching, dishonest and languid mortgage borrowers and the wider society saw greedy and fraudulent mortgage originators and investment bankers behind the liars loans. This disconnect infuriated the general public, as the business perspective meant that expected contrition would never come from the bankers. In fact, the latter would engage in mass foreclosures without a hint of guilt even as the general public was dumbstruck that people could be so clueless as to inflict injury on insult without realizing it. In short, pressure actually builds from such a disconnect.

In the populist protests, the crowd saw American companies with enough profit and cash to create jobs on-shore yet inexplicable without the will to do so. In the first decade of the new century, American corporations had cut their work forces in the U.S. by nearly 3 million, while increasing employment abroad by almost 2.5 million. In the fall of 2011, Standard & Poor predicted corporate earnings growth of 13.5% for the third quarter, which suggested “to Wall Street protesters that companies were hoarding profits without creating work.” Seib goes on to observe that business leaders saw the inverse. From the business perspective, third-quarter expectations were less than expected. The managers pointed to the benefits of an artificially weak dollar that had already strengthened at the expense of exports. More broadly, businesses were looking at weak consumer demand and increasing costs with government regulations, which make augmenting the domestic work force more costly. Seib juxtaposes this view of a hostile business environment with that of unpatriotic and greedy corporate chieftains.

Debating the respective variables misses the point (or does not go far enough). The underlying disconnect may itself be a threat to American corporations. Indeed, the perspectival disconnect could mean that corporate capitalism could itself be the target of popular angst and dissatisfaction. While the field of business and society has been geared to the corporate “unit of analysis,” it is not clear that the managerial tools used to assuage perceived differences concerning norms (and thus values) will suffice when the corporate form itself has a target painted on its ass. In other words, the bastards may not see the arrows coming until it is too late, due to the rather basic disconnect in perception. Of course, it could be argued that the mega corporations have so much potential power that even a few arrows wouldn’t do much damage that could not be repaired. In other words, corporate capitalism may be so entrenched that it could easily survive being made a target without having to change the way managers view their refined domain of excellence and the broader society of sore-losers.  Even so, it couldn’t hurt to deepen the field of business and society to address the disconnect and how to manage it. Foremost, I would advocate the development of a skill-set that is devoted to being able to see things from a very different perspective without immediately falling over in supercilious laughter that only makes matters worse.


Gerald F. Seib, “Populist Anger Over Economy Carries Risks for Big Business,” The Wall Street Journal, October 11, 2011.