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James Bond and the banks

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James Bond and the banks

Picture President Obama as James Bond. As such, 007’s new arch enemies are the large banks. This appears to be the new reality in Washington, as Obama admonished a number of bank CEOs, telling them that they took hundreds of billions in bail-out cash, and now they must give something back. They owe the American people.

Obviously, Obama is setting the stage to blame the banks, and their Republican supporters, in case the unemployment rate does not drop rapidly enough to prevent substantial losses for the Democrats in next year’s mid-term elections. Finding scapegoats is easier than telling the electorate, particularly one that has been conditioned by politicians to expect immediate gratification, to be patient. There is little that the government can or should do at this time to accelerate the pace of recovery. The U.S. economy has turned the corner, and the rate of growth will accelerate as we move through 2010.

We expected Obama to be a leader, a president who would be forthright and be prepared to tell it as it is; not a president quick to resort to blaming others. Unfortunately, we set our expectations  too high, for at the end of the day, he is a typical, although charismatic, politician.

The banks did fail in their role as financial intermediaries.

Finance 101 teaches students the Miller-Modigliani (MM) theorem which essentially states that there is no benefit to leverage. An investor’s return on equity should not increase if s/he increases the leverage of an investment. The more debt used, the much higher should be the cost of the debt, until in the extreme, the cost of debt matches the cost of equity. Tax considerations modify the basic conclusions. However, the principal lesson still holds – the cost of debt should rise sharply with the degree of leverage.

So how did the banks fail?

In the heady days of 2004 to 2007, leverage was not penalized with higher debt costs and more restrictive covenants. The cost of debt seemed to be almost independent of the degree of leverage, and covenants were non-existent. Private equity firms were able to buy almost any company because banks were willing to lend them up to 100 percent of the price. People could buy homes and finance more than 100 percent of the price of the home.

There are many reasons why the MM theorem failed, and creditors, especially the banks, did not do their jobs. Fees, securitization, short-term bonuses, credit insurance, lax regulations, comfort letters, free riding on the rating agencies, etc. all played a role. Perhaps, some time soon we will find out what went wrong.

Thus, the banks deserved to be scolded. And there is a need for a new regulatory structure. A return to Glass-Steagall would be a great start. But no new system will prevent the periodic blow-ups of banks and other financial institutions. Greed, short-sightedness, ego and stupidity make the problems endemic.

However, President Obama’s proposed reforms are too complex and will miss the mark. Further, he was wrong to claim that the bail-outs via TARP played any role in turning around the banks. TARP largely was irrelevant. It was the Federal Reserve, and the numerous innovative programs launched by Ben Bernanke, Time’s person of the year, that salvaged the financial system and the economy.

And demanding that banks make loans that might be very risky at a time when they are still fixing up their balance sheets does not make for good policy. The banks might make such loans, but they would be costly, as they should be; and hence would not satisfy the small and medium size companies that claim they cannot get loans. Providing loans at too low a rate of interest would just repeat the failure of the banks in the mortgage, commercial real estate and private equity markets.

The opinions expressed in this blog are personal and do not reflect the views of Global Brief or the Glendon School of Public and International Affairs.


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