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December 4, 2011

"Taking stock" of Wall Street

The recently outing by Bloomberg of the breadth of the Fed’s support of the largest US banks during the financial crisis together with the likelihood of substantial option grants to bolster compensation in 2011 brought me right back to 2008. The hypocrisy and irony of these two stories is not lost on me. During the financial crisis I strenuously argued that bank balance sheets should be marked-to-market immediately, demonstrating the true capital and liquidity position of our largest financial institutions. Naysayers argued that this was tantamount to pushing these firms into bankruptcy and fomenting the seeds of crisis in an already jittery market environment. Transparency and disclosure are hallmarks of healthy, well-functioning markets. Many lined up on the opposite side of the aisle, willing to defer problems until the market could hopefully bail them out. This hasn’t happened: big mistake.

Back in 2008, settling accounts based upon current market prices would surely have caused every major financial institution to show negative net worth much less meeting minimum regulatory capital standards. This would have wiped out both equity holders and unsecured debt holders, and pushed the Fed to insure all deposits regardless of amount and forced the segregation of sound, cash-flowing assets from highly speculative and illiquid assets. In essence, an RTC-style Good Bank/Bad Bank restructuring. When the dust settled, we’d have a portfolio of healthy, well-performing assets backed by deposits and owned by the US taxpayer and a portfolio of busted, illiquid assets supported by Fed bridge financing and also owned by the US taxpayer. The latter would be aggressively worked out and sold to private equity firms, hedge funds and other alternative asset buyers with the ability to price and manage complex risk, and moved off the Fed’s books as soon as possible. The proceeds would be used to pay off the taxpayer subsidy via the Fed, with the resulting risks and rewards moved to private balance sheets. The Good Bank assets could either be separately capitalized and offered in the public markets, or sold to strategic buyers for attractive prices. The bottom line of both of these steps is that market prices would be observable for both performing and non-performing assets. The ability to price risk hastens the extension of credit, the one think lacking from almost every market participant at this time - except the Fed.

My belief is that Wall Street was bankrupt and should have been owned by the US taxpayer, not its legacy shareholders and certainly not firm management. Yet three years hence, those same managements are receiving large equity grants not unlike those received in the depths of the crisis in 2008, once again resulting in a transfer of wealth from the US taxpayer to private executives’ pockets. I am a hard-boiled free marketeer and a fervent proponent of paying handsomely for the assumption and taming of risk, but the question is who is getting paid for assuming whose risk? When private market executives get paid for exposing the public sector (read: the US taxpayer) to risk, something is askew. Yet this is exactly what we have today. Firms that are still afloat due to the Fed’s comfort with spending our money and paying yet more money to managers on the back of the US taxpayer: all is not right with the system. 

We still lack the firm resolve to force the marking to market of financial institutions balance sheets as well as the vision and guts to take over insolvent institutions and to work them out. “Full faith and credit” is a notion promulgated by the Fed but could be applied more broadly if investors really understood the nature of the risks they are buying. But opaque balance sheets coupled with mind-numbing and complex derivative asset pools make it difficult for credit to flow to places where it is desperately needed. Further, we are about to witness yet another round of stock grants in firms that owe their lives to the US taxpayer yet who simply keep on paying. This destructive cycle must stop and transparency must rule. Which “rogue” politician is willing to lie on the legislative third rail and go up against the financial services lobby and their cronies in Congress for the benefit of our country? My guess is nobody: it will be business as usual.  And our country will suffer.

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