In defense of the TBTFs, or the true originators of moral hazard

Written by Naufal Sanaullah (University of Michigan) & Mohammad Ali “Qasim” Khan (Duke University)

There is a certain increase in comfort in defending one’s more controversial beliefs after events transpire that vindicate one of these non-mainstream opinions. Contrarians and conspiracy theorists have used the financial crisis as “proof” of every theory, belief, and emotion under the sun, and as a testament to derailing the entire notion of conventional wisdom.

Surely, asset bubble unwinds expose the pervasive misconceptions and twisted principles that bled through the masses during bubbles’ inflations. And the sense of vindication that John Paulson, Nouriel Roubini, Peter Schiff, Robert Schiller, Marc Faber, and the like must have felt is undoubtedly tantalizing. But anyone and everyone wants a share of that “I-predicted-it pie”.

Including the blamegamers, the scapegoaters, and other various groups of people shamelessly engrossed in one straw man fallacy after another.

This of course includes the critics of the too-big-to-fail institutions, blaming them for everything from the credit crisis to civil wars abroad. The fact is, at worst, these financial institutions were merely agents of demise, not originators of them.

I am personally of the opinion that the entire United States needs sharp deleveraging on all levels and a return to sound economic and financial principles to lead to efficiently-allocated capital and organic growth. Surely, many banks (especially those who were benficiaries of TARP, TLGP, etc) characterize the reckless, overleveraged, risk-ignorant principles that pervade the current flawed financial system. But is it the moral and legal obligation of banks to ensure the soundness of the financial structure of the United States and the world?

The answer is a pure and simple no.

Banks have intrinsic obligations not the US taxpayer, but to their shareholders. Their decree is to maximize profits for their investors, for the owners of the firms. When circumstances arise in which in order to merely compete with rival firms in your industry, important principles of risk aversion and financial soundness must be abandoned, the firm’s obligations becomes an incentive crisis, which is the harbinger of moral hazard.

Anyone who follows markets knows the story of famed investor Julian Robertson. From 1980, his hedge fund Tiger Management Corp turned $5 million of seed capital into $22 billion in 1998. But his reluctance to buy into the tech bubble led to investment losses and, more significantly, investor redemptions. He correctly predicted the current financial crisis and has made over $1 billion on trading gains based on it. But the point to take home from his story is the problem of opportunity cost in competition when the underlying drivers of growth are unsustainable.

Goldman Sachs, JP Morgan Chase, Morgan Stanley, Wells Fargo, Citigroup, and the like did not sit out the housing bubble. Had they, they may not exist today, irrespective of taxpayer bailouts, purely because of loss in competition against rival firms. Citicorp’s 1998 merger with Travelers Group, for example, was not met with prescient criticism targeted at the forming moral hazard and systemic risk. Rather, it was largely lauded with acclaim at the time.

Capitalism works because instead of fighting human nature, it embraces it, and funnels it into sustainable and organic growth, by checking it with natural negative-feedback mechanisms. The fundamental basis of this principle is found in the law of supply and demand. As demand rises, price does as well. And as prices rise, demand marginally falls.

But when these situations don’t exist, when the circumstances don’t allow for self-checking processes, the result is an assortment of myriad positive-feedback, unsustainable, inherently implosive and entropy-generating loops.

The fundamental blame for this financial crisis and the moral hazard accompanying it should be directed toward the purveyors of the artificial situations in financial markets that eliminated the natural self-checks of capitalism. This of course is found with the Federal Reserve and Congress.

Everyone knows about the Fed’s lax monetary policy that injected the financial system with free money at low borrowing costs. Everyone knows about the ramifications of Gramm-Leach-Bliley. And there is a lot of justified blame directed at these causes of crisis, as well. But much of it is misdirected toward banks.

The fact is, if any one of us were in the positions of the banks’ management, we would operate the same way. The idea of self-interest is intrinsic to human nature. That is the point of capitalism: to funnel that biological imperative into sustainable growth for the individual and the collective, and have natural checks and balances to prevent it from exploitative and unsustainable excesses.

Banks that engaged in illegal forms of predatory lending clearly broke the law and were unethical. But corruption and fraud exists in every industry, not just financial services. I’ve heard upwards of 90% of alt-A paper was originated on the premise of falsified borrower stated income. Surely these lax lending standards (through probably exaggerated by that statistic) led to the excesses behind the bubble and subsequent crash. But what about the borrowers themselves? “Everyone was doing it” and they would be at a competitive disadvantage by not engaging in such fundamentally unsound acts. This analogy is clear and direct, but absolutely lost to the conspiracy theorists, especially pervasive in financial blogophere.

It is no secret that Washington is a ticking pendulum of hypocrisy. Go back two years and see the Republican treatment of anti-government protestors; now the tea-bagging brigade has become the impetus for their dramatic revival. So it is no surprise to see the government so vehemently persecute banks that, although very clearly benefited from government support, have repaid their TARP debts, yet continue to support a dying American auto industry.

The new Obama tax to recover the TARP fund deficit is very problematic because while the banks did indeed require significant assistance, they were not responsible for the failure of the American auto industry; yet, the banks, which have already repaid their TARP debts are being forced to compensate for the lack of success of a completely unrelated industry, ironically making the auto bailout a Wall Street bailout for Main Street.

Let us ask ourselves who is the true culprit of the Too Big To Fail hostage dilemma. When viewing history objectively, the answer is immediately apparent. The fact of the matter is we have been here before with the American auto industry and left with the exact same results. A mere Google search of the ’79 Chrysler bailout forces one to double take and check the dates on the printed articles because they describe the very situation we see today.

The fact is that frequently neither Congress nor the Fed uphold their respective oaths. And in the cases where the government is not lacking in genuine intention, they often lack the understanding necessary for pragmatic implementation.

As Milton Friedman once said, “We all know a famous road that is paved with good intentions. The people who go around talking about their soft heart — I share their — I admire them for the softness of their heart, but unfortunately, it very often extends to their head as well.”

Take the idea that reducing the size of banks will reduce the systemic risk they present. Proponents of this idea somehow fool themselves into believing that one and two halves are not the same; in an industry that is fundamentally predicated upon mimicry, the likelihood of ten smaller firms engaging in risky behavior or one large firm engaging in such behavior is at best the same and at worst greater due to heightened competition.

Illegal acts during the bubble and in response to the crash are clearly not the subject of my attempted exoneration of the TBTFs. Many modern controversies, including the AIG CDS counterparty par-value payments and the accounting standards employed on marking asset books, are issues I follow closely and am very opinionated on. But these banks were employing the principle of self-interest and without logical, natural checks to it, the self-interest ends up damaging others.

The true blameworthy entities of the genesis of the financial crisis as well as the political and moral hazards associated with it are the Fed and Congress. By allowing excess money to float around at little to no cost of borrowing, the Fed allowed banks access to excessive money, all of which chased yield and all of which chased incrementally worse assets. This causes unsustainable valuations and also leads to paradigm shifts because of confirmation bias, which further feeds the inflating flame. Meanwhile, by allowing commercial and investment banking units to operate under the same corporate flag, Congress opened up depositor capital, which is inherently supposed to be liquid and accessible and only used to collect a spread by investing it into low-risk securities, to chase these illiquid, risky, overvalued assets that were bubbling up.

The basis of my argument is that, had it not been for the Fed’s and Congress’s lax monetary and regulatory policies in the late 1990s and early 2000s, the banks could have never engaged in forming a housing bubble and subsequently receiving taxpayer bailouts because of moral hazard and systemic risk. But had Goldman Sachs not joined the bubble bandwagon, the bubble wouldn’t go away: another bank would just take Goldman’s reins.

I have criticized bank actions in various articles, and I stick to them. Employing unsustainable leverage, having a toxic asset book, etc etc are all subjects of my critique. But the true blame falls on the supervisors allowing the artificial circumstances that permit these bank actions from being profitable in the first place.

Yes, I acknowledge the Wall Street lobby is one of the strongest and most influential on Wall Street. But all that means is the banks do the best job at getting their self-interests employed by regulators.

Blame the actual pervertors of American capitalism, the Federal Reserve and the Congress, for creating a situation in which the profitable way is an inherently destructive way in the long-run. Don’t fault the banks for simply going along for the ride.

Still don’t agree? Consider the following argument:

If A and B, then C.
If C and D, then E.

Then consider:

If A and F, then G.
If G and D, then H.

Now substitute:

A = Federal Reserve & Congress determine overreaching monetary and financial conditions
B = Federal Reserve & Congress allow free-market supply/demand valuations and self-checks to excessive risk
C = no asset bubbles exist and fundamentally sound risk assessment and valuations pervade
D = banks attempt maximizing profits and appeasing self-interest as much as possible, given monetary policy and regulatory laws
E = banks don’t engage in intrinsically destructive actions and no moral hazard or systemic risk exists
F = Federal Reserve & Congress allow free and cheap money and leveraging of depositor and other low-risk capital into high-risk and illiquid securities
G = asset bubbles exist and valuations and risk assessment are negatively skewed
H = banks become too-big-to-fail and the subject of populist rage.

There’s tons of wrongdoing by banks to be addressed and criminality to be punished. But the myopia in excessively blaming banks for everything under the sun is unwarranted and a by-product of the crash’s vindication of a select few, with the entire conspiracy theorist and contrarian bloc seeking a piece of that pie for their own agendas’ propagation.

In October 2004, the FBI’s assistant director of its Criminal Investigations Division made this statement before the Chairman of the Federal Reserve House Financial Services Committee on Housing and Community Opportunity:

“Based upon existing investigations and mortgage fraud reporting, 80% of all reported fraud losses involve collaboration or collusion by industry insiders. These schemes involve industry insiders to override lender controls.”

And what did the FOMC do from 2004 to 2007? Lower interest rates 17 times.

Blame Paulson the Secretary Treasury (hell, blame Bush for appointing Paulson). But don’t blame Paulson the CEO of GS.

But that’s just our view.

This entry was posted in Market Commentary. Bookmark the permalink.

One Response to In defense of the TBTFs, or the true originators of moral hazard

  1. Nauf Fan says:

    OBAMA and Bernanke are featured in a movie– about greedy hedge funds called “Stock Shock.” Even though the movie mostly focuses on Sirius XM stock being naked short sold nearly into bankruptcy (5 cents/share), I liked it because it exposes the dark side of Wall Street and revealed some of their secrets. DVD is everywhere but cheaper at

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s