08 June 2013

How Banks Becoming Corporations Created the Great Recession of 2008

  • "We are always living far ahead of our thinking."
    - Marshall McLuhan

We still think about banks as if they were banks even though they're now corporations. Confusion about this simple fact is enough to make our legislation ineffectual at protecting us from big financial shocks.

One thesis in my book The Fourth Economy is that banks (or more broadly financial markets as represented by banks, bond markets, and stock markets) were the most powerful institutions from about 1700 to 1900. (The Bank of England was founded in 1694 and in an interview in 1914, Ford explained his policy of profit-sharing and explained that from the start they had decided to be their own bankers; the book reveals deeper reasons for rounding to 1700 and 1900 but these events seem illustrative of larger shifts). And after 1900, the modern corporation increasingly was the institution that defined the economy. There have been sweeping implications of that shift but one has to do with financial markets themselves. The corporate model was so irresistible that the bank became a modern corporation and that helped lay the foundation for the Great Recession of 2008.

Michael Lewis, in his fabulous book The Big Short: Inside the Doomsday Machine, closes with an account of eating lunch with John Gutfreund, who was head of Salomon Brothers during the 1980s (and Lewis's former boss - or more accurately, something like Lewis's boss's boss). As CEO, Gutfreund took Salomon public, changing it from a private partnership into a modern corporation. Eventually, all the Wall Street investment banks did this. And that changed incentives in a way that introduced far more risk.

Private partners could be characterized as greedy but greed is overrated on Wall Street. Everybody wants big returns. Even little old widows. If you lost 5% last year, you'd like to make 10% this year. If that makes a person greedy than everyone is and greed is a constant -which means it doesn't explain booms or busts. Private partners want big returns but they also know that they're liable for the losses. One of the few rules in markets is that risk and return travel together. If you want bigger returns, you have to accept their traveling companion of risk. If you want to avoid risk, you also shun its friend return. Your savings account is insured but it pays less than 1%. NASDAQ is up 15% so far this year but there is no guarantee that it won't drop 33% on Monday. Partners who run an investment bank are looking for a return but they have their eye on its companion risk; it's not a lack of greed that keeps them from doing stupid things with money but instead an appreciation for risk. Four years in a row of 20% returns will be erased by a drop of 50% in the fifth year. This aversion to risk changes when the bank is a corporation and the money made is in the form of salaries and bonuses, when even the CEO is just another employee and the shareholder is the one putting up capital. A partner is more cautious about losing equity because it is his own.

Between 2000 and 2008, the CEOs of the 14 largest financial corporations made an average of $133 million each and then walked away with another $76 million in stock holdings - a bump in personal wealth of $209 million in the decade leading up to the Great Recession. This in spite of assuming risks they showed little evidence of understanding. Risks that, eventually, the American taxpayer and their shareholders had to bear.

Michael Lewis writes of the consequences of Gutfreund's much-criticized decision to take Salomon Brothers public.
The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith. No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs [essentially bets on subprime mortgages with incredibly high probabilities of failing].
The US created legislation to regulate financial markets about a century ago. (First in 1913, about the time that Ford was changing the relationship between business and banking and then in the 1930s, in wake of the Great Depression.) That was a time when the modern corporation was becoming the new behemoth in the American economy and when banks were still banks. Banks are no longer banks. They are now corporations. They are no longer private partnerships managing their own capital but instead employees managing their shareholders' capital. We have not yet adapted our legislation to that new fact. Until we do, we're still susceptible to great crashes resulting from letting corporate employees - from bond traders to CEOs - split off risk to shareholders and taxpayers while keeping returns for themselves. Because it turns out that while you can't separate risk and return within markets, you can separate them within institutions.

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