As a layman observer of the financial clusterfuck, it seems to me that a rational strategy for financial companies going forward is
[ol]
[li]Enmesh your company into the fabric of the entire economy (via mergers/acquisitions/other means), and ensure that it is “too big to fail”[/li][li]Take some insane risks, that provide huge returns[/li][li]Profit![/li][/ol]
Since your company is too big to fail, and its demise would cause problems to the worldwide economy, and possibly irreversibly damage the entire economic system we have in place, the government will step in and prop you up and help you get through any problems your risky behavior caused. We have seen that this is indeed the case.
So, why wouldn’t all companies go in this direction in the future?
Isn’t there a huge moral hazard created by the way AIG has been saved?
Perhaps the united states can declare them conspirators and take out a class action fraud case against them? We’d all get half a penny each, and they’d be destroyed.
I just checked this term on Wikipedia, and it does seem appropriate.
I also liked a relevant term I saw there: “Socialism for the rich and capitalism for the poor”, although I think this doesn’t quite capture what’s going on.
There is a more galling moral hazard that this creates and I am a part of it. A couple of weeks ago my wife and I decided we both needed more life insurance. For her the decision cam down to American General, part of AIG, and TIAA CREF. TIAA CREF has been among the most sane and stable financial companies through this mess. Problem is they were also a decent bit more expensive.
In a sane world I would have chosen TIAA CREF. I would have paid more to ensure that the company would be there to pay out when the time came. With the massive resources the government has invested in bailing out AIG I decided it didn’t matter. If AIG continued to struggle either the government would pick up the tab or would facilitate the sale of the policies to another company. They are simply in too deep at this point. Either way I wasn’t willing to pay a premium for safety because government policy had discounted that as a prime consideration. AIG got my business.
If you let AIG fail a couple of good things happen. First, the stable and secure companies are rewarded by an ability to demand a safety premium for their insurance products. All companies focus more on maintaining high ratings and strong reserves because the market demands it. Second, as AIG gets dismantled the strong companies with cash on hand buy up the viable units at fire sale prices. The well managed companies get stronger and pick on the carcasses of the failed ones. Capitalism doesn’t work without failure. The OP points out one consequence, but there are many more that we may not think about.
I would not have saved any of these companies because government is distorting the incentives that naturally regulate capitalism. That will have much deeper consequences than an ultimately temporary financial reordering.
Or, we have a cascade of failures that leads to a general economic collapse.
Letting the companies fail won’t create any incentive for success; the same people who are paying themselves bonuses with the government’s money would just loot the company’s remaining assets and go on to their next victim.
You won’t see better, more ethical, more competent behavior from the corporate leadership until they personally pay a price.
I worked in finance for one of the companies that was a spectacular meltdown through accounting fraud in the early 2000s. My entire department was “laid off” before the meltdown because we refused to participate in the criminal enterprise. The people who replaced us and went ahead and did as they were told, did get arrested. pled guilty and got either probation or short prison sentences (the CEO and CFO got longer ones) and were banned from working in accounting in a public company again. The two I know of personally who got probation were working in BETTER jobs in private companies even during the period of their probation.
The private sector values a “can-do” attitude more than anything else. Especially if what you “can-do” is illegal and you are willing to play along.
Obviously you are forgetting the fact that most of the top employees have a significant amount of their compensation in the form of stock, which is now essentially worthless. AIG was trading at around $70/sh in late 2007 and is now down to $1.38/sh. Citi was trading above $50/sh and is now $3.08/sh.
The reason the ‘insane risks’ affected the rest of us, is due to the practice of fractional-reserve banking that allows banks to lend money that they technically do not have.
That is why Bernie Madoff’s $50 billion Ponzi scheme did not affect you. Well, unless you were an investor of his. He took his investors’ money, he stole it, and they lost it. And that’s it. It’s largely confined to them.
Banks are allowed to lend out 10 times the amount of money to which their depositors have claim. This means they are technically bankrupt at all times. No other business in the United States is allowed to operate this way…it is illegal. Only banks are allowed to operate this way via a special dispensation of the government.
In addition, the government guarantees nearly all of that money that could potentially be lost. So if depositors put in $100 bucks, and a bank lends out $1000, and $500 of those loans go bad, the depositors are guaranteed their $100 back. You and I pay for that. No other business works like this, either. Well, it used to be that way. It seems like automobile manufacturing might be working in a similar way, these days.
Just a few facts to highlight that the use of fractional reserve banking, with fiat money, along with depositors’ guarantees, is completely and entirely a Rube Goldberg creation of government. The government allows no other business entity to operate this way. That is why it is regulated and overseen by government. And lately, it’s been regulated and overseen by geniuses like Chris Dodd and Barney Frank. And Maxine Waters. Don’t forget Maxine Waters.
No other comment here. Wanted to lay the groundwork for the inevitable claim that ‘laissez faire’ economics or ‘libertarian’ policies or ‘greed’ were at the root of this. I would offer that a good place to start looking might be on Capital Hill.
They are obviously not technically bankrupt at all times unless you have some other definition for bankrupt than is commonly used.
Also, I don’t think you understand fractional reserve banking. It is not that they are lending out ten times the amount to which their depositors have claim. It is that they are only required to maintain reserves equal to essentially 10% of the deposits on hand and are allowed to lend out the other 90%. Logically what you are saying wouldn’t make any sense because they wouldn’t have the liquidity to lend out dollars that they don’t have. Banks borrow (usually in the form of collecting deposits but not entirely) and then turn around and lend out a portion of that at higher spreads than they borrow at.
Thanks for your post. It’s good to see another poster with banking knowledge kicking in.
I understand fractional reserve banking very well. I’m trying to explain it to a layman’s audience in as simple as terms as possible.
They are bankrupt because the vast majority of depositors have legal claim to their money on an instantaneous (or ‘demand deposit’) notice. Not a time-deposit notice.
The banks do not have enough cash on hand to satisfy all of those potential claims. This is evident by looking at any balance sheet of any major bank. Therefore, they cannot satisfy their legal claims and are bankrupt. That is why a run on the bank can force them to the wall, or drastic action like a merger.
The courts have ruled that other companies using other commodities (grain, for example, in grain elevators) cannot operate this way.
I look forward to more of your posts. Perhaps we can educate some of the Dopers on a subject (banking and regulation) in which a lot of them have strong opinions. I know I’ve been educated on other subjects on this Board.
I still wouldn’t use the term bankrupt to describe the business model of commercial banks. Certainly there is a potential timing problem between the assets and liabilities of banks as most assets are unable to be liquidated quickly and most liabilities are, as you say, in demand deposit accounts. Nevertheless, decades of experience have proven that model to be sustainable. Most banks have enough liquidity to withstand any reasonable amount of customer withdrawals. Additionally, replacement liabilities are fairly easy to come by.
Other companies face similar timing problems between their assets and liabilities and they depend upon liquidity in the capital markets to maintain their solvency. Think about any companies that finances itself with debt. Usually bank debt has a maturity of somewhere around 3-5 years whereas cash flow generated by some random company’s assets may not show an ability to repay debt in that time frame. They depend upon being able to extend the maturity date of their existing debt, refinance it, or raise some other form of capital. If the capital markets dry up, they are insolvent.
Maybe, but this is far easier said than done. More importantly, very few companies are too big to fail absent some extraordinary external circumstances. The reason why the government has taken such great lengths to avoid bank/company failures is largely because there is too much systemic risk out there due to the overall fragile state of the economy and the interconnectedness of the banks.
Typically, if a huge company goes down, there are other companies that can buy them, or take over their business. This is less likely when we are in such a down economy, and the credit market has dried up. It seems unlikely to me that we would encounter such a perfect storm in the near future.
The reason why it affected us all is because we collectively did the same exact thing for the very similar reasons; because they need to fulfill societal expectations. Banks are expected to become more efficient and profitable every quarter. People are expected to live in bigger and bigger homes, and to buy flashier and flashier toys.
People borrow money to buy houses, go to school, and buy shit they can’t afford. People take about bank leverage (understandable), but they gloss over the fact that you have college grads coming out of school with some multiple of their expectant yearly salary in school debt, ready to take on more debt to buy and house and have kids. Damn near everyone these days is taking “insane risks” in terms of money. That’s the problem. We finance our lifestyles on debt. Even worse is the fact that most of us are getting an increasingly small part of the pie as wages stagnant, and costs go up; and capital becomes more valuable than labor.
I think it affected everyone. Plenty of “normal” people lost money, and plenty of others lost confidence in the market. More importantly, you didn’t have to have lost money on Enron, AIG, or Lehman to have been affected by them. The Tylenol poisonings in 1982 only killed 7 people, but damn near everyone at the time was a little uneasy about taking Tylenol. Your chances of getting HIV during heterosexual sex as a male is vanishingly small, but most reasonable people still wear a condom due in part to fear of contracting the disease. The same idea applies here.
But the basic question is what would prompt them to do this? It’s one thing to be allowed to make dumbass bets, it’s an entirely different thing to do it on a regular basis. The real question is what prompted these people to want to take such risks? I can go to Vegas and bet my house on a poker hand, but I would never do that. Most people are pretty risk averse despite having the ability to take such risks. What makes bankers so different?
In what way? It seems to me that most of the money that has “vanished” has not come from accounts that are FDIC insured. Hasn’t most of the lending not taken place via commercial B&M banks, but rather investment banks, hedge funds, and other less-regulated entities?
There is plenty of blame to go around, but I think you are focusing on the wrong things here. IMO, a lot of it has to do with greed (from the ground up).
The thing that I think most people gloss over is the fact that few people can really thrive in a highly capitalistic society. It seems to me that most people are just not built that way in this country anymore (or maybe ever). Nobody really wants to really compete, so they rig the game by asking for government intervention, and special dispensations. They don’t like the increasingly winner-take-all nature of the economic activity in this country. They don’t like the bubbles and depressions/recessions that naturally occur, and would continue unabated, in a loosely regulated capitalistic environment. They don’t like CEOs making 1000x the pay of the average worker. And they aren’t envious of places like Hong Kong where the average people lives in a government subsidized shoebox.
Our system isn’t bad (relatively), or irreparable, but it needs serious work. As more and more people recognize there is a disconnect between the work they do and the results they see, you will see far fewer people wanting to enthusiastically play a rigged game. In 2007, John Paulson made $3.7 billion largely by betting against us. By betting that Joe six-pack won’t pay his mortgage, and that Suzy Soccer mom’s health problems would force her into bankruptcy. His astute and accurate prediction of economic disaster made him billions while we all suffered. These types of dealings are all too common. People would rather watch the shit hit the fan and make a profit, than to compromise their position by warning people and fixing systemic flaws.
It’s important to have a society where that type of genius is recognized and encouraged, but the reward system we set up needs to adhere more closely to our value system. Most people won’t begrudge another person money or success so long as they feel it did not come at their expense. The problem is it is harder and harder to come to that conclusion these days when people who can’t afford decent health insurance are financing bonuses for reckless CEOs.
Fractional reserve banking has nothing to do with anything. It’s been around since people were hoarding gold. It’s not some invention of modern banking, for Eris’s sake.
All true insurance companies are subject to pretty substantial regulation and are separate subsidiaries that should not be swamped even by a bankruptcy of a parent entity–these regulations set capital levels/permitted investment limits that are designed to assure that insurance companies are able to pay on their policies. State insurance regulation is a traditional and one of the original consumer protection type laws. AIG’s insurance subsidiaries are probably solvent–it’s the non-insurance financial services piece of AIG that needed to be bailed out. In the industry, I have not seen insurance and reinsurance companies back away from dealing with AIG’s regulated insurance entities, but I have seen them unwind swaps they had with AIG financial services entities.
This came up on Marketplace Money. AIG’s traditional insurance is solvent, and has the reserves required by state regulators. Regulation works, just the way it did for the regulated banks, which for the most part have no issues. Some have failed, have been taken over by the FDIC, cleaned up and will be resold, but there is no crisis in that sector of the industry, except as created by that which started in the unregulated sector.
You don’t even need the too big to fail part. CEO bonuses depend on short term profitability, which increases with increasing risk. People do get away with risk for a long time. If you choose a cautious approach for a year, and a competitor does not, the competitor will out-perform you, make more money, and you will get a lot of pressure from your stockholders to copy them. If you decide to take on more risk, you will do better, and the process repeats.
That is, until the risk catches up to everyone. Sure everyone loses, but in time a new generation will forget, will convince themselves that this time it is different, and the process repeats.
Even with the bailouts, hardly anyone is unscathed, remember. No one bailed anyone out 80 years ago, but it’s not like we learned anything.
The only way out of the mess you identified is regulation. If the government requires reserves for the worst case scenario it is convenient for a company to ignore, it puts the brakes unsafe risk taking. The companies yell about it being anti-competitive, and it is, in the sense that it prevents a company from getting a jump on others by assuming more risk. But it is good for the long term, which unfortunately only the government seems to care about.
Are you complaining that there is insufficient regulation, and that banks should be further restricted in how much money they lend out? It seems like it, but that doesn’t make sense in the context of the rest of your post, which seems hostile to regulation. Could you clarify? What would you recommend as an improvement over this?
If you do feel that banks should be able to repay all the depositors instantly, obviously that implies that they should not be allowed to lend out any of that money. In that case, what do you envision as the role of a bank? It doesn’t seem to me that it would be able to pay any interest. It also seems that with a vastly reduced amount of credit available, we would have to live with a far smaller economy, and consequently a lower standard of living.
Anyone else feel free to jump on these questions as well. I am by all means a layman when it comes to banking, but I am interested in learning new things!