Einhorn: Break up too big to fail financial institutions
David Einhorn delivered a speech at the 2009 Value Investing Conference that is creating a lot of buzz in the blogosphere. He said a lot of interesting things about the investing and political climate. A surprising amount of it comes out of the playbook here at Credit Writedowns.
Below are the quotes I want to highlight for you. At the bottom is an embedded copy of his speech.
On short-termism in politics and government
Winston Churchill said that, “Democracy is the worst form of government except for
all the others that have been tried from time to time.”
As I see it, there are two basic problems in how we have designed our government.
The first is that officials favor policies with short-term impact over those in our long-term
interest because they need to be popular while they are in office and they want to be reelected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions. Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.
On crony capitalism and regulatory capture
The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.
In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, “without banks, we would have no economy.” Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.
Like teenagers with their parents away, financial institutions threw a wild party that eventually tore-up the neighborhood. With their charge arrested and put in jail to detoxify, the supervisors were faced with a decision: Do we let the party goers learn a tough lesson or do we bail them out? Different parents with different philosophies might come to different decisions on this point. As you know our regulators went the bail-out route.
On misdirected anger on main street
And the neighbors are angry, because at some level, Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don’t know the particulars or how to argue against the “without banks, we have no economy” demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings. As I see it, the revolt over healthcare isn’t really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.
On breaking up too-big-to fail institutions
The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.
The lesson of Lehman should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie, Freddie, Bear Stearns, Citigroup and a couple dozen others.
There is MUCH MUCH more below.
The idea that banks-are-too-big-to-fail is yet another myth.
All you need to know is what’s happening to house prices (if they go up faster than wages, that’s a warning sign) and to look at how fast each individual bank is expanding (anything faster than 4% or 5% is a warning sign) as well as total mortgage indebtedness.
That tells you when banks are “too big”.
But seeing as the government subsidises banks by guaranteeing deposits (using taxpayer as ultimate guarantor), it’s only fair for the government on behalf of the taxpayer to expect banks who benefit from the subsidy to toe the line.
And to nail this down, there should be no bail-outs.
Sure, bail out the people with less than £50,000 on deposit (or whatever is politically necessary) but if banks lose money then they should be made to do debt-for-equity swaps – each bank just has to rank all its bonds in order of who gets swapped first and who gets swapped last (i.e. all these fancy phrases like “junior” and “senior” debt or “subordinated bonds” or “mezzanine finance” or “permanent interest bearing shares” “SIVs” “Structured investments” “Residential mortgage-backed securities” etc just get given a numerical ranking).
There is no need for new legislation or anything, we have bankruptcy laws that apply here (and the threat of bankruptcy alone is enough to focus banks’ attention).
It is then mathematically almost impossible for savers to lose a penny, it’s all about risk and reward, and “the markets” will sort out the balance by paying higher interest rates on bonds that are more likely to be swapped.
I agree. Risky lenders should fail. That is central to allowing markets to work. Bailouts are the worst possible option.
What Einhorn says about Grandma getting frisked and taking away shampoo in response to 9/11 is what is going to happen again here with Obama and the banks. They want to be seen doing something, but nothing of substance.
By the way, your point about not needing new laws is right on the money. Regulators need to do their jobs.
Ed, my view is that banks wouldn’t “fail” anyway, bonds would get swapped for shares and the new shareholders would hopefully run things a bit better, and if not, another layer of bonds get swapped for shares and so on.
The government would only have to make good the deposit guarantees if a banks’ assets fell to less than the amount of customer deposits, which, even in the case of the worst run UK banks like NR or B&B simply did not happen, we were nowhere close to that. It’s the “money markets” who’d have to take the loss on the chin.
That’s why we need a special resolution process where lawmakers “mandate guidelines on haircuts equity and subordinated debtholders must take before any taxpayer money is used.”
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