Credit Default Swaps Threaten the System
We will get into banks being too big to fail in a minute, but the first problem to be dealt with is credit default swaps. What happened in the last credit crisis was that interlocking credit default swaps among so many banks made the ENTIRE system too big to fail. AIG basically sold naked options in the form of credit default swaps to all and sundry (in a unit basically created after Elliott Spitzer forced Hank Greenberg out, which allowed the unit to get out of control, yet another reason to not like Spitzer).
And nothing has changed. We again have credit default swaps (CDS) growing, and no one knows who could be overextended. Once again, everyone could be dependent on everybody else, and we have no idea if there is a Bear, Lehman, or AIG in these woods.
As I have been pounding the table about for years, we need to put CDS on an exchange. ASAP. I am not against CDS, per se. CDS are good things, just like futures. But they must go to a transparent exchange. There need to be position limits, just as there in futures and commodities. There needs to be very transparent pricing and commissions. And someone needs to monitor who owns them and what risks they are taking.
Why hasn't this been done? In a word, money. Banks make huge commissions selling CDS, as much as 2-3%, I am told. If they were on an exchange the commissions would be $10 a round turn. An enormous profit center would get blown up. So, the banks hire lobbyists to persuade Congress not to regulate CDS. Dodd's bill basically says we will deal with them later.
The good news is that there is some effort to regulate these derivatives in Congress. It should have been done a year ago, but the sooner the better. This shouldn't be all that partisan. It is common sense.
Too Big To Fail Must Go
We have large banks that take massive risks, which allow them to pay huge bonuses to management and traders; and then if they have problems the taxpayer has to take the losses. I can see why the banks like it. I don't get this business model from a taxpayer's point of view.
First, let me say that I thought, along with most of the world, that repealing Glass-Steagall was a good thing. OK, we tried that experiment and it didn't work out so well. Where is the movement to separate commercial banks from investment banks? And I must admit, Glass-Steagall is not really the problem. It is just a part of the problem. The problem is that parts of these large banks are essentially hedge funds, working with cheap commercial deposit money and putting the entire bank at risk.
I make a lot of my income helping investors find hedge funds and alternative investments. I like trading and traders, and we have a lot of client money with them. There is good money to be made there, if you are riding the right horse. But we don't put money with big investment banks, just private funds, and there is the difference. If our funds go bad, taxpayers don't bail us out.
When I put on my taxpayer hat, I don't want to be taking the risk so some big bank can have a trading desk and make large profits that only benefit their shareholders and management, and I have to pick up the pieces with my tax dollars when they fail. Separate traditional banking and investment banks. I want my commercial banks to be boring. You know, traditional lending to customers, services, that type of thing.
And This Thing About Leverage
The problem of too big to fail is ultimately one of leverage. If a small bank fails, no one really notices. If a giant bank fails and puts the system at risk, it costs us a lot. I have a simple proposal to mitigate the problem.
Why not reduce the allowable leverage the larger a bank gets? This would clearly reduce their risk and encourage them to only make prudent bets (otherwise known as loans), as their risk capital would be limited. If they wanted to make more loans, then they could raise more capital or retain more earnings. Would that hurt earnings and shareholders and limit share prices? Yes. And I don't care. If I'm not getting the dividends, then I don't want to be made to pick up the tab if there is a crisis. The world of privatizing the gains and socializing the risks must become a thing of the past.
What Happens If We Do Nothing?
What happens when we have the next credit crisis, when a major sovereign government defaults, as I think will happen? It will be a body blow to many banks, especially in Europe. Once again, we could have banks worried about lending to each other or taking letters of credit, which would be a disaster for world trade and the recovery we are now in.
That we (and Europe and Britain) have taken so long to enact real reform has the potential to really put the world at risk. In the next crisis, we will not have the tools available to stem the tide that we did the last time. Rates are already low. Do you think we could pass another TARP? The Fed's balance sheet is already bloated. It could get much worse unless we get financial reforms that have some bite.
All this debating about a consumer protection agency and where it should be and all the other trivia is wasting time. Fix the big things. Credit default swaps. Too big to fail. Leverage. Then worry about the details.