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Sunday, May 10, 2009

How much purging is required at the top of big American banks?

by JD.

As we come to the beginning of the end of the financial crisis, the calls for the blood of bankers have abated. There is universal agreement that the system overall was flawed, and it is unfair to burden a particular group with the full responsibility of our current sorry state.

The time has come to dispassionately step back and ask the tough question. It may or not be unfair, but is it incorrect?

Consider first the arguments for those who claim that the Bankers have suffered enough.

There was a sense of outrage that that the Bankers had not paid for their sins. This is simply not true. As a percentage of their wealth, Bankers have lost more than everyone else combined. Fully 40% of Lehman stock was held by its employees. When that stock was worth $85, the company was worth around the same, in billions of dollars. Every person in Wall Street has the right to claim that they could not foresee the collapse. The original argument was that it took mala fide intent, or stupidity to not have seen the risk. It turns out that stupidity was the right answer, since every idiot on Wall Street was in fact heavily invested in - you guessed it, Wall Street.

Which brings us nicely to point 2. The idiots could not be held responsible, since there was not deliberate fraud. There is today only a perplexing cloud of sub moronic decisions. How, is everyone asking, could we not have foreseen this ? Naturally, we forgive ourselves, and having done that, find it easy to extend the forgiveness to Wall Street. They could hardly be held responsible for the wrong decisions. After all, we made them too!

Finally, we all would like to look at who else we could hold responsible. There is a popular cry that Rating agencies should have done more, or that the entire process of Ratings is intrinsically flawed. Regulatory agencies are also very popular invitees to the whip-them-all parties. Finally, what about the consumer, the buyer of gas guzzling Hummers, the takers of sub-prime loans to purchase houses three sizes too big? Surely, some of the pie, humble or otherwise, belongs to him as well.

These arguments are not unjust, but unfortunately they miss the point. This is not a bad thing - it shows our intrinsic humanity. It takes a special kind of cruelty to turn away from justice for the past and coldly consider what is best for our future. But it must be done. "The greatest good of the largest number" is a disgusting motto, but we it does help in analysing the issues.

I will get to the inconvenient truths, but first let me speculate about why the Bankers lost so much money.

<nasty on>The reason that the Bankers lost so much of their personal money was that they were all overpaid, and behaved exactly like people do when they come into money that they know they haven't earned. They throw it into the riskiest earnings streams that they can find. That comforts them, because if they lose the money, well then, they did not do such a bad thing after all, since they didn't take the money home with them. And if they win, well then, this time the money was made by them, so that feels good as well! <nasty off>

Well, that was nasty, but my personal belief in this comes from the incidence of Wall Street Bankers in Las Vegas during the boom years. It really doesn't take too much intelligence to know that you are playing against the house, so why do such highly educated and well paid people - which probably means that they are intelligent - keep playing these games?

To come to somewhat more factual matters, the arguments for letting Ken Lewis and all the other CEOs "pursue other interests" are as follows.

The current incumbents cannot effect the change we need. It is sad but true that it is only after Obama won the presidency has it become acceptable to admit that it was a mistake to give Bush carte-blanche in Iraq. Only Senator Edwards had the courage to admit that he made a mistake, and in retrospect, it may be because it was one of his smaller ones :) The current lot will go right back to making original sin #1, forcing really intelligent people to think like idiots because of misguided compensation structures.

Which bring us to point #2. While it is probably correct to absolve the CEOs of fraud, it would be incorrect to absolve them of stupidity. One has to assume that they have blundered, and it would not be right to not hold them accountable for their blunders. In this case, by kicking them out.

The last and final point is simply a rebuttal of the desire to make major changes to the infrastructure, or to the nature of human beings at large. It may or not be feasible to make major changes to the infrastructure and social polity within which Wall Street operates. It is simply not the better answer. We don't need change around Wall Street, we need it in Wall Street. The best way to effect that change is change the players, not the environment within which Wall Street operates.

The last point is the coldest of them all, because it makes no bones about asking Ken Lewis to lose his job so that we can get on with our lives without having to wait 10 years for a new world order to come into place. But it is also the most important. It is simply the most practical decision to get a new broom to sweep clean.


  1. I fail to understand, you tried to reason everything except the crowd. Crowd is irrational. Period. It will always be. Period. You can't control, deregulate tax its irrationality.

    Nearly a century back, Charles Mackay wrote, Men go crazy in herds and return to senses often painfully and one by one.

    Seems that is the case. Remember tulip bulb craze? Dot com crazy? Railroad collapse of 1906?


  2. Ajay, from your conciliatory soothe speak it is clear you live in India, advocating Gandhian love for Messrs. Fuld, Thain, Lewis et al. (or is it a knee jerk sucking up to the well off...or a "chalta hai" attitude toward fait accomplis!)

    All Far removed from what happened in US.

    Tulip Mania? HA HA HA.
    The US inflated SUCH a bubble, it lead to SERIAL BUBBLES 1997-2008: DotCom, Telecom (fiber optics), Commodities, Oil (a particular nasty/ but separate subset of commodities in general), Real Estate, and Structured Finance Bubbles!

    This is FAR beyond one tulip mania!

    Then the Fed orchestrated hushed and rushed (without public debate) acquisitions of investment banks ("big swinging dick" type gamblers) with deposit taking banks where mom and pops keep their money. Thus bailing out the gambling in CDS/ Synthetic CDO and what not.

    As you know from economics 101, betting on shares/CDS/CDO/ABS is NOT counted in GDP. Capital Gains arisen from GAMBLING do not add to GDP! Yet, it has become central to US markets, affecting the REAL ECONOMY.

    Also, OIS Spread data showed clear gumming up of interbank lending starting in NOVEMBER 2007!

    But deals were struck in backrooms as to who will buy what gambling institution, then come to taxpayers for their money because it would now affect the depository banks, all to keep the gamblers afloat.

  3. Folks, this post is by JD and not by me.

  4. I agree that there are many people to be blamed for the current crisis. To that extent, I am in sympathy with both jumpup and rajan. Both the mania of the crowd for buying on credit and the Federal Reserve policy of easy money + constant bail-outs have brought us to this crisis. I want to look at the most practical way to break this cycle. I continue to feel that to emerge stronger from this crisis, we need to change many of the top players in Wall St, or we will soon see a recurrence to past behaviour.

  5. JD, being a card carrying economist, I have to say that the fault is not of the humans but of the incentives that they were presented with. I.e. that the same Ken Lewis would have behaved very differently if the world of rules and constraints surrounding him was different.

    But then that immediately leads you to the rating agencies. Okay, imagine a world where rating agencies were fundamentally changed. That would generate better incentives for Ken Lewis.

    My fear is that if you sack a few of the people at the top today, then others much like them will rise through the ranks, and you won't have achieved much.

  6. Though the draconian 90% tax bill did not go into law, the desire for compensation reform remains.


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