What I Read on the Beach

While most people spend beach vacation reading page-turning fiction books, I spent my winter vacation reading Andrew Ross Sorkin’s Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves and Charles Gasparino’s The Sellout: How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System.
Sorkin’s book was an almost day-by-day, blow-by-blow account of what happened from 2006 to 2009 on Wall Street from Bear Stearns’ failure to Post-TARP events; specifically it details the Government’s attempt to save Wall Street (I joked with Aly it was a cliff-hanger where I knew how the story ended). Gasparino’s book, on the other hand, traces Wall Street’s troubles from the 1970s onward.

What became crystal clear, especially in The Sellout, is that my prior observations on this blog (here, here, and here) about the transformation of the investment banks were largely correct: that investment banking model as agent and advisor to clients is long gone; their problems stem almost exclusively from their transformations into hedge funds. As documented in both books, these firms became just ordinary, but astronomically large and highly leveraged hedge funds. Virtually all of their profits and all of their profit growth in the 2000s came from investing their own capital in mortgage bonds and mortgage-related securities. Gone were the days where the vast majority of the profits came from advising clients on M&A transactions, underwriting and selling stocks and bonds, and trading for client accounts. Like some actual hedge funds, these firms quickly became wildly profitable (at least on paper) and just as quickly blew up. Even scarier, firms such as Citibank, which have FDIC protection, engaged in these same activities. Gasparino also confirmed what I had suspected since these events transpired (described here): that these problems can be laid at the feet of just a handful of employees at each bank. For example, Gasparino details how less than 100 Citigroup bond traders almost brought down a company with over 375,000 employees worldwide.

The events described in both of these books lead me to the same conclusion: the only real solution that will prevent this from happening again is to prohibit investment and commercial banks and broker-dealers from investing their own capital, like their clients, for gain. They should be limited to provide “agency” services to their clients. What is evident from these books is that restrictions on pay, in the form of forcing executives and employees to be paid overwhelmingly in stock, so that their incentives are aligned with shareholders’, has largely failed. The two banks which had the highest employee ownership as a percentage of total ownership, Lehman and Bear Stearns, both failed, and failed spectacularly. While aligning the incentives should work in theory, it has not worked in the real world. As for hedge funds, the Government should limit the amount of leverage they can have. Going back to the 1970s through Kidder Peabody, Salomon Brothers, LTCM, Lehman and Bear Stearns, the most common link between those financial firms that blew up is their excessive use of leverage. It is like a kid who keeps putting his finger on the stove, each time thinking he won’t get burned.

PS—The group of people who comes out looking the best, at least in Sorkin’s book, is Treasury Secretary Hank Paulson and his team at Treasury. While his actions as CEO of Goldman Sachs helped get us to where we were in 2007 and 2008 (he pressed successfully for the SEC to permit banks to leverage themselves from what had been 12:1 up to 40:1), when he got to treasury in 2006, he foresaw many of the problems that occurred, and tried to avert them as best he could, given the political climate he acted in. This is hard for me to admit given my political leanings as a liberal democrat who saw nothing the Bush administration did as good. But, if Sorkin is correct, these government employees deserve high praise.

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