WANT TO KNOW WHY BANKS AREN'T LENDING?

This Money Morning article is by far the best piece I have read about the "brokered deposits" and "hot money" pheonomenon that's challenging our banking and economic system. Simply put, the need to find higher yields with FDIC guaranteed deposits (which bank brokers do), coupled with the need of our biggest bank's to pad their books, helps to explain why bank loans to Main Street have collapsed (in spite of trillions in taxpayer dollars being thrown at the banks).

Students who have been in my American Politics class (and paid attention), and those who have followed this blog, will understand immediately the importance of our current brokered deposits situation. Brokered deposits help to explain why I believe we're gearing up for Round Two of our Economic Meltdown.

If you don't read anything else today read this article. And if you're inspired, you should read this piece from Zero Hedge, which explains how Bank of America is covering their losses with U.S. government guarantees.

- Mark

A PRIMER ON CEO PAY

If you want a primer on what's wrong with our nation's executive compensation system, this open letter from Yves Smith at nakedcapitalism.com is a good place to start. It focuses on the perverse incentives that encourage the Chief Executive Officers (CEOs) of America's largest financial firms to embark on reckless "heads I win, tails you lose" business strategies. 

These reckless business models compel industry CEOs to focus on extracting rather than creating wealth. All of this is detrimental to both sound business decisions and the principles that surround market capitalism. Here's Yves' letter to Sheila Bair, Chairperson of the Federal Deposit Insurance Corporation. My synopsis and final comments are below.

Dear Chairman Bair,

America can no longer afford to have a banking system that serves the ends of its executives rather than those of taxpayers and communities who have been saddled with cost of reckless profit-seeking. The FDIC proposal to tie deposit insurance premiums to the incentives in executive compensation programs would be an important step forward towards making sure that bank managers operate in a way that reflects the value of the extensive government support and safety nets they enjoy. Bank officers should not be encouraged, as they are now, to take “heads I win, tails you lose” bets with deposits.

There is no question that the annual accounting/bonus cycle is badly out of line with the time horizon of many of the wagers that financial institutions take. Unfortunately, the belief that using stock options or restricted shares as an important part of compensation would lead to responsible behavior has proven wildly false. Both Bear Stearns and Lehman had substantial equity ownership at both the executive level and among the rank and file. By contrast, when Wall Street was dominated by private partnerships, so the management group was jointly and severally liable for losses, the sort of profligate risk-taking that took place in the run-up to the global financial crisis was virtually unheard of.

Unfortunately, all compensation arrangements at public companies are inherently, “heads I win, tails you lose.” No matter how badly a corporate team performs, its pay is immune from clawback, except in the case of fraudulent conveyance in bankruptcy, and even then, the “lookback” period is usually shortly before the failure of the firm. By contrast, it often takes years to reap the bitter harvest of bonus-flattering decisions.

It may be that the only way to cope with the agency problems inherent to risk-taking in a public firms is to make pay arrangements more symmetrical, as in to find ways to recover compensation from executives and senior business unit managers who managed and led programs and products that were ultimately destructive to their companies. The better the arrangements of the old private partnerships can be approximated (admittedly a tall order) the better.

In addition, I would encourage you to think hard about the perverse incentives posed by acquisitions. One of the striking developments in the US banking industry over the last 20 years is an increase in concentration, particularly among the largest players, which has played directly into our current “too big to fail” policy problem. The usual rationale given in greater efficiency, that is, that bigger banking is cheaper. Yet every academic study I am aware of has found the reverse: that once a minimum threshold is reached (there is some disagreement as to where that lies), banks in the US exhibit a slightly negative cost curve, which means the bigger the bank (measured in assets) the higher its cost ratios. Thus the dramatic expense cutting that occurs in the wake of acquisitions could have been done by each of the merged institutions, separately.

Another reason to be skeptical of bank acquisitions is the poor track record of mergers generally. Virtually every academic study ever done has found most mergers “fail” as in they deliver negative outcomes to stockholders.

So why do deals continue? First, there is a large constituency that promotes them because they are particularly lucrative, in particular, investments bankers (who collect M&A and financing fees) and management consultants. A host of other “helpers” such as lawyers and accountants also reaps fat fees from deals.

But the biggest incentive is again flawed executive compensation. Bank CEO pay is highly correlated with the size of the institution, measured by total assets. And the senior team of the acquired bank is effectively bought off via golden parachutes.

I strongly encourage the FDIC to remove the incentive for executives to bulk up their banks solely to pay themselves more. One way might be to require that executive bonuses be set in relationship to the pre-acquisition peer group for a substantial initial period (at least three years, better yet five) and be benchmarked against the new peer group of bigger banks only if the merged entity had met certain operational performance targets.

I also asked readers of my blog, Naked Capitalism, to offer their comments on the proposal that you, Vice Chairman Martin Gruenberg, and Thomas Curry are supporting. They are glad that the FDIC is serous about bank reform and are keen to see meaningful measures implemented to curb executive-serving, public-endangering compensation structures. I am attaching their remarks.

Sincerely,



Yves Smith

For those of you who aren't used to picking through the details, this is what Yves Smith is suggesting that Sheila Bair take a look at:

1. Excessive risk taking with short-term profit time horizons, and little to no liability for the CEO.

2. Paying CEOs with stock options that allow cash-outs with no loss price incentives, no matter how poorly the firm is doing.

3. No salary/bonus clawback provisions (like a retroactive tax) for executives who made short-term dumb decisions that collapsed firms after they left.

4. Unwarranted and inefficient mergers that benefit only a select few professionals at the top.

5. Volume-based compensation schemes which insure that the bigger the institution, the bigger the CEO pay schedule (which helps to drive mergers).

As one of the commentators added in the thread, it doesn't help that we have "zombie boards" made up of CEO friends and market sycophants, who also want the CEO to vote them big salaries on the boards they oversee. There's more to the story, but all of this is a good beginner's handbook for understanding what's wrong with Wall Street, and it's executive pay packages.

- Mark

A LOOK INTO AMERICA'S LOST DECADE

No matter how you slice it, the aughts - or the first decade of the 21st century - were an economic bust for Middle America. In fact, the Washington Post's Neil Irwin called it the "lost decade" (click on graph to enlarge).

How bad was it? Whatever jobs we thought had been created were wiped out by the market collapse that occurred between 2007 and 2009.

The primary reason for this development is that market analysts and media pundits drank the free market Kool-Aid that was being peddled at the time (incredibly, this same Kool-Aid talk is now making a comeback). In a few words the free market happy talk works like this: Trust market players, they will do the right thing.

Ooops.

What people missed was how all the free market happy talk was really the delusional babble of analysts and media pundits who ignored how a bubble economy had been built on growing consumer debt, favorable legislation, and deregulation. Worse, the bubble economy had been super-charged by market players who operated as if they were in a casino rather than as real investors in a capitalist economy.

Why did the market experts ignore this? Because they don't know how markets really work in today's casino economy. In a few words our casino economy works like this: You're on your own, market players can do what they can to take your money. They own the House.

A bit harsh? Perhaps. But I don't think so. Here's why.

In a wonderful (if somewhat overly technical) review of how some of America's biggest institutional players gamed the system, Yves Smith outlined how companies like Goldman Sachs and Morgan Stanley deceived market players into buying certain market products. The problem was that Goldman Sachs and Morgan Stanley were betting that these same products would fail.

The details of the deals are somewhat complex, but it would be akin to me selling you a car but then delivering you a lemon. Or, as I wrote about in October, it would be akin to me selling you a Classic '65 Mustang but sending you a piece of crap Pinto. Your argument would be "It's not the model I want." My argument (or Goldman Sachs' argument) would be "Hey, a Ford's a Ford." In the real world, unless you're seriously clueless - or just plain stupid - this wouldn't be tolerated. And if it were, the seller could still be charged with fraud.

But in today's Alice in Wonderland Economy companies like Goldman Sachs and Morgan Stanley think that they are not only entitled to sell you crap, but that if you lose money you should have known better because everyone can lose if they go through the wrong door.

As Yves Smith points out this kind of thinking is "irrelevant" when you consider many of the institutional investors who got taken for a ride (like union or state pension funds) were not equal partners in setting up the deals, nor were they given access to the same models that companies like Goldman and Morgan had for assessing deals. Worse, most of the deals were managed, "meaning they were effectively blind pools."

What does all of this mean in plain English? Goldman and Morgan were effectively selling crappy Pintos and getting Classic '65 Mustang prices. Their argument? Not that it was good business. Because it wasn't (collaborating with rating agencies is not good business). Instead, they're banking on the "it was legal" argument.

They knew they would get away with it because pension fund plans (for example) had neither the expertise, personnel, nor the models to assess the games firms like Goldman and Morgan were playing. Pension funds and the American taxpayer were effectively played as suckers.

As I point out in my book, what we have today is an economy based on wealth extraction, not it's creation. Worse, it's being extracted in a casino economy built on bubbles, industry lies (see esp. the rating agencies), favorable legislation, and debt.

In the next few months we're going to hear some good news on the economic front. Don't be misled by the Kool-Aid talk sure to follow. Think about it, $10-20 trillion in market bailouts and other guarantees should buy us some good news. But with consumer debt, favorable legislation, and deregulation continuing unabated what we're actually going to see is more smoke & mirrors.

Stay tuned.

- Mark

THE DEFENSE: "I'M JUST CRIMINALLY STUPID"

I was out this weekend but a colleague sent me a couple of articles that fit into what I've been posting or commenting on over the past year . . .

First up is this article ("The Failure of Our 401(k)s") from the LA Times, which outlines how the 401k program that we were sold back in the late 1970s became the financial smoke & mirrors that corporate America needed to start defunding corporate retirement plans. Their argument ran something like this: "Hey, you already have a 401(k), why do we need to fund you again?". The real stroke of genius lay in how the 401(k) plan allowed industry executives to shelter income (which reduced their tax load) while funneling money into the financial sector that otherwise would not have gone that way.

Moral of the Story: Wall Street got a free injection, which made them feel like masters of the universe; today we get less purchasing power, and a perilous private retirement system.

The next LA Times article ("Financial Scoundrels Have Little to Fear from the Law") makes it clear that, whatever the final outcome of the current economic mess, few of the perpatrators will actually be fingered and/or sent to jail. The reason is quite clear. Unless you were really reckless (like Enron's Ken Lay or Bernie Madoff) there really is no law against being greedy or criminally stupid.

Moral of the Story: White Collar crime pays, especially if it's tied to being criminally stupid.

- Mark

DEBUNKING THE “TAX-CUTS CREATE GROWTH & REVENUE” MYTH

Here’s an article from The Wall Street Journal that, once again, claims higher tax rates on the wealthy are not good for the country. Essentially the WSJ article makes this standard Republican-Conservative claim: Tax cuts for the rich will spur economic growth, enhance tax revenue, and lead to balanced budgets.

Nothing could be further from the truth. Here’s what’s NOT happening, and why we're in dire straits today ...

... THE REVENUE ARENA

BALANCED BUDGETS? When Supply-Side economics arrived on the political scene with Ronald Reagan in 1980, our country owed approximately $979 billion (with a “B”). Today, after almost 20 years of tax cuts for the rich, America now owes $9.4 trillion (with a “T”). This, my friends, helps to explain the dollar’s collapse, and why prices are climbing. As an aside, the only time we started balancing budgets was under President Clinton, who raised taxes on the rich.

ECONOMIC GROWTH? Do tax cuts on the rich increase economic growth? Check this out. With the exception of five years, federal tax receipts have increased every year since 1962. Did Bush’s tax cuts (or supply-side economics) have an influence on the economy starting in 1962 that we don’t know about?

INCREASED REVENUE/CORPORATE INCOME: A 2007 Congressional Budget Office report makes it clear that increased tax revenue after 2003 is due primarily to an “increase in corporate profits” and other policy measures that disallowed certain write-offs. Read the report. Tax policy plays a minimal role.

... IN THE AREA OF ECONOMIC GROWTH

THE BUBBLE ECONOMY: The vast majority of growth that occurred during the Bush administration was driven by low interest rates and the subsequent housing bubble. As the value of homes increased, homeowners took out equity lines and used their homes to purchase cars, boats, vacations, etc.

DEBT FINANCED PURCHASES, I: If more money was put into the pockets of ordinary Americans it’s not because of higher wages or the jobs created by new investments (effectively zero in both areas). It’s because the Bush administration borrowed money to send to American tax payers. A monkey could have borrowed money and sent out checks. Tax cuts were a political Trojan Horse designed appeal to unsophisticated voters. But they worked politically.

DEBT FINANCED PURCHASES, II: Americans went further into debt to finance consumption. This helped create the illusion of prosperity. Credit card and personal debt are at all time highs.

That's it. Debt, demographics, and bubbles. This explains the Republican-led spending and debt binge since 1980.

My friends, the argument that tax cuts for the rich creates growth is, at best, misleading. More probably, it’s a lie. At the end of the day we need to build bridges, roads, and schools. Someone has to pay for this. Contrary to the ideas pushed by Republicans, there are no Infrastructure Fairies out there. Oh, and did I mention that we now need to pay down trillions in debt caused by the Republican's tax cut jijad? No? Well, we do.

Borrow and Spend is not an economic policy we should continue to follow. That almost one-half of America can't see this says alot about the state of this nation.

- Mark