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Saturday, May 12, 2012

Too Big To Fail

Remember how certain people (most of our politicians and all of their banking friends) were certain that Wall Street was too big to fail and everyone's retirement would be in jeopardy if Wall Street wasn't bailed out with TARP? Hindsight is 20/20, as they say. While we can never know how much would have been lost without TARP, what we do know is that our federal government, courtesy of the taxpayers of America, have bailed out an entity that would do it all again. JP Morgan just lost $2B in bad bets, risking their money knowing that they are too big to fail and the taxpayers would be forced to bail them out again!

The Business Insider's Henry Blodget reports, "And Now We Know the Truth About Wall Street: It's Just Kids Playing with Dynamite." First the recap of what JP Morgan said back then:
The idiocy of a handful of gamblers should not be construed as a problem with the system as a whole, institutions like JP Morgan said.
Well-run banks should be trusted not to be so colossally reckless and stupid. Well-run banks should be allowed to manage their own risks. Well-run banks should not be hammered with strait-jacket regulations that would stymie their marvelous money-making innovation. Well-run banks should be free to look after themselves, like responsible adults.
And the banking lobbying engine rushed this message to Washington and threw money around. And the lobby quickly persuaded Congress that Wall Street was fine, that the financial crisis was an aberration, that Wall Street should be left alone.
Well, as Henry Blodget points out, we should have known better. Next he points out the biggest flaws in the system.
There are two reasons for this, neither of which boil down to the "stupidity" that most people generally assume is involved. The bankers who place these bets are anything but stupid.
  • The first reason is that the gambling instruments the banks now use are mind-bogglingly complicated. Warren Buffett once described derivatives as "weapons of mass destruction." And those weapons have gotten a lot more complex in the past few years.
  • The second reason is that Wall Street's incentive structure is fundamentally flawed: Bankers get all of the upside for winning bets, and someone else—the government or shareholders—covers the downside.
The second reason is particularly insidious. The worst thing that can happen to a trader who blows a huge bet and demolishes his firm—literally the worst thing—is that he will get fired. Then he will immediately go get a job at a hedge fund and make more than he was making before he blew up the firm.
Meanwhile, if the trader's bet works—and the bigger the better—he'll look like a hero and collect an absolutely massive bonus.
 So what do we do about this? In my own opinion with no banking knowledge, I say we let Wall Street know in no uncertain terms that the taxpayers (federal government) won't be insuring their investments anymore. This is what Henry Blodget suggests:
Congress needs to:
  • Radically increase bank capital requirements, so even massive bets can't threaten the system
  • Once again, separate "banking" from Wall Street gambling. Glass Steagall worked very well for 70 years—let's bring it back.
  • Lay out a plan, in advance, to manage the failure of even the largest financial institutions—by stepping in, seizing the bank, firing management, zeroing out shareholders, haircutting bondholders, and then injecting new SENIOR capital (fully protected) and re-floating or selling off the firm. This will allow the entity to keep operating, and it will stick the losses where they belong—with the idiots who bought the bank's stock or loaned it money. Meanwhile, the systemic threat will be eliminated.
And if the people in Congress do nothing? We know where their allegiances lie, and that they don't want to change a thing. And we vote them out of office.

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