Spero Consulting

Posts Tagged ‘bigger not better’

Note: We’ll likely expand and edit this post in the morn­ing, but wanted to cir­cu­late the idea before bedtime.

We’re rather dili­gent – but not obsessed– about keep­ing up with finan­cial new.¹ We’ve heard many finan­cial firms announce lay-​offs and have read how at a few, like Gold­man, senior man­agers have decided to forgo bonuses.

As we recall, most banks have announced with­drawals from sub­prime mort­gage orig­i­na­tion and loans, which seems like a wise move, but given the mag­ni­tude of their errors and mis­takes, we’re very sur­prised that we haven’t read more about banks tak­ing dra­matic and dras­tic actions to limit risks and exposures.

We don’t mean hoard­ing cash and the knee-​jerk reac­tions not to lend. We’re think­ing more about their invest­ing, trad­ing, and struc­tur­ing operations.

Maybe the banks are elim­i­nat­ing desks and floors, but they just aren’t talk­ing about it, or maybe they have men­tioned it, but we’ve missed it.

We’d cer­tainly encour­age finan­cial firms to change their ways. In fact, while we’re close to Lib­er­tar­ian on many eco­nomic issues, we wrote on Octo­ber 11, to Elim­i­nate Pro­pri­etary Trad­ing at Insured Insti­tu­tions as a way to mit­i­gate moral haz­ard and pro­tect tax-​payer interests. (Once they’re insured, it is no longer a free mar­ket, and there should be quid pro quo, not just subsidization.)

On Sep­tem­ber 24, in our post Could a “Bailout” Pro­long the Finan­cial Cri­sis?, we wrote:

So, if the government’s pur­chase of these thin­gies is approved, we would expect to see a con­tin­u­a­tion of the pan­icky behav­ior until the secu­ri­ties are actu­ally trans­ferred to the gov­ern­ment because it is unlikely that any­one will know who has the worse ones so (means that) all remain sus­pect. (Also note that the most pan­icky firms might be ones who are pro­ject­ing their port­fo­lios onto oth­ers, and so might be the ones that other firms would like to avoid.)

Now that the TA is out of TARP, it seems that this week’s equity mar­ket per­for­mance, par­tic­u­larly among finan­cial firms, sup­ports our Sep­tem­ber 24^th pre­dic­tion above, i.e., the con­tin­u­a­tion of pan­icky behav­ior until actual trans­fers occur. We dis­cussed related issues on Octo­ber 7, in Even A Per­fect Bailout Will Fail.

Or maybe they’re just tak­ing a wait-​and-​see approach. That’s what we pre­dicted in early Octo­ber when we described the very high prob­a­bil­ity of fail­ure of TARP.

Today’s Wall Street Jour­nal reports that Citi Weighs Its Options, Includ­ing Firm’s Sale, and we won­der if it will sur­vive the weekend.

As we argued in Big­ger Is Not Nec­es­sar­ily Bet­ter way back in Sep­tem­ber, we see no rea­son to encour­age mega-​mergers and we based that argu­ment on both moral haz­ard and sys­tem­ati­za­tion of idio­syn­cratic risk considerations.

So, as we argued in around Octo­ber 10, we believe that It’s Time! to nation­al­ize the worst offend­ers leav­ing no share­hold­ers, except non-​executive employ­ees, with any own­er­ship inter­ests. We reit­er­ated much of the same argu­ment in a very long post from Wednes­day: OMG, Mr. Paul­son Agreed with Us Twice in One Week! (Yeah, we have a teenager.)

It seems that given its size of around $2,000,000,000,000, we tax­pay­ers will be on the hook for Citi, any­ways, so why not elim­i­nate the mid­dle­man and pro­vide any upside ben­e­fit to the true resid­ual claimants?

In two recent posts, The Fail­ure of Boards to Direct and When the Going Gets Tough…Quit, we’ve crit­i­cized the com­po­si­tion of Citigroup’s board because of their gen­eral lack of finan­cial indus­try expe­ri­ence. (We’re sorry, but that seems uncon­scionable to us.)

We won’t repeat all of our argu­ments for nation­al­iza­tion, but the expro­pri­a­tion of Cit­i­group would cer­tainly moti­vate other banks to act quickly and largely to mit­i­gate risks and sta­bi­lize cash flows. (It would likely stop insur­ance com­pa­nies and oth­ers from buy­ing small banks or S&Ls in their beg­garly attempts to become bank hold­ing companies.)

By the way, for new read­ers, we’re not just for the nation­al­iza­tion of a few banks, we actu­ally have a pri­vate solu­tion for the mort­gage cri­sis that involves pro­vid­ing the right tax incen­tives – like invest­ment tax cred­its – to indi­vid­u­als, firms, and fund man­agers. (Read about it here: A Bet­ter Solu­tion (than a gov­ern­ment takeover).)

That solu­tion to the mort­gage cri­sis stills leaves the larger liq­uid­ity or con­fi­dence cri­sis for banks. That has arisen because the mort­gage cri­sis has informed us (and oth­ers) that despite their pseudo-​sophistication and the veneer of objec­tiv­ity and sci­ence (almost), there is a very good chance that they don’t under­stand their envi­ron­ment or have reli­able ways to value many of their prod­ucts – despite their mas­sive invest­ments and activ­i­ties for those pur­poses. In terms of an adverse selec­tion prob­lem, they’ve reveal them­selves to be low types. (See last week’s Global Warm­ing and the Mort­gage Cri­sis for a dis­cus­sion on that topic.)

So, as a nation, we should want (and attempt to moti­vate) the banks to act quickly and deci­sively (and with their pri­vate infor­ma­tion) to get their accounts in order.

The ben­e­fits of TARP don’t seem to have pro­vided the cor­rect moti­va­tion to the bank­ing firms to act to main­tain their own liq­uid­ity and cap­i­tal posi­tions. We’d argue that this is an incen­tive prob­lem and that if the ben­e­fit of the TARP “car­rots” have been insuf­fi­cient moti­vate socially-​optimal behavior. So, per­haps a “stick,” like the threat of expro­pri­a­tion, induce clean-​up. More­over, it is seems that Citi will be ours any­way, so, why not give it a try on tax­pay­ers’ terms rather than tax­pay­ers’ backs?

It is already Thurs­day, and we’re just get­ting around to writ­ing about a few arti­cles in Wednesday’s (Octo­ber 1) edi­tion of The Wall Street Jour­nal. They are worth men­tion­ing because they are closely related to our post on Tues­day, Big­ger Is Not Nec­es­sar­ily Bet­ter, which warns about addi­tional con­cen­tra­tion risk as the largest banks con­tinue to grow larger.

One is a very small arti­cle in Deal Jour­nal, enti­tled Big-​Bank View: Get­ting Big­ger! that we can’t find online and other is At Lehman, How a Real-​Estate Star’s Rever­sal of For­tune Con­tributed to Col­lapse.¹

We’ve com­mented a few times that big­ger banks are not nec­es­sar­ily bet­ter for soci­ety or the econ­omy because mam­moth size exac­er­bates moral haz­ard prob­lems, i.e., the too-​big-​to-​fail men­tal­ity – noth­ing new there – and because it con­sol­i­dated assets and decision-​making under fewer, idio­syn­cratic (and rationally-​bounded) per­son­al­i­ties (and cul­tures). That first par­en­thet­i­cal com­ment does read bet­ter and sound nicer than the more par­si­mo­nious, “irra­tional,” but the point remains the same.

The big-​bank-​getter-​bigger phe­nom­e­non is actu­ally being encour­aged and expe­dited by expe­di­ent fed­eral reg­u­la­tors, who seem to have absolutely no long-​term plan. Those reg­u­la­tors’ recent actions and state­ments remind us of a com­ment we once over­heard in the exec­u­tive suite of a large firm: “Sorry, but we don’t have time to develop a strat­egy, we have to act.” We’re really not talk­ing about pulling some­one from a burn­ing car or house, but even in those dire, dan­ger­ous, and instan­ta­neous cir­cum­stances, one should have an aware­ness of the envi­ron­ment and a plan if one is to have a chance of success.

The other arti­cle, about Lehman’s real-​estate débâ­cle, puts most of the blame for com­mer­i­cal real-​estate losses on one man, Mark Walsh. Of course, the ulti­mate blame lays with Lehman’s lax board and senior man­age­ment, which pre­sum­ably did not have the knowl­edge or courage to prop­erly under­stand the busi­ness and man­age risk. Addi­tional blame can be placed on senior man­age­ment for improp­erly design­ing incen­tives scheme that induced exces­sive risk-​taking, which we would guess would have been exhib­ited by a “get it done how­ever you can” mentality.

We don’t know Mr. Walsh, and sus­pect that he was doing exactly what was expected of him, but that’s our point. The folks at Lehman in res­i­den­tial real-​estate were likely doing exactly what was expected of them, too, and the com­bi­na­tion was deadly for the firm.

Because of someone’s tastes, pref­er­ences, favor­able past expe­ri­ences, igno­rance, inse­cu­rity, or neglect­ful­ness, the firm suf­fered from excessively-​concentrated risks.

Now, who would think that the val­ues of com­mer­cial real estate and res­i­den­tial real estate within a city or region might be related? Actu­ally, we would guess most adults who didn’t make it past the sixth grade could fig­ure it out, and the same goes for cur­rent mid­dle school and high school students.

In fact, our own small-​sample sur­vey reveals that a high school fresh­man will likely respond with a “Duh!” when asked, “Do you think house prices and office or store prices would go up together and down together in, say, your home­town or do you think they would be unre­lated?” We didn’t ask, but we sus­pect that they would likely note that on a day-​to-​day basis they might not be related, but over longer term they will be. Oh well. What is it about col­lege that destroys that com­mon sense?

Now, the argu­men­ta­tive reader may retort that Lehman is not a good exam­ple because it was an invest­ment bank and so wasn’t scru­ti­nized by the reg­u­la­tors as much as large com­mer­cial banks are (or will be); so, such risk won’t be an issue because bank reg­u­la­tors are on the case. Though the agen­cies and per­mit­ted lever­age ratios were dif­fer­ent, we doubt that the degree of reg­u­la­tory over­sight was much dif­fer­ent across those two indus­tries, espe­cially for the larger firms. More impor­tantly, does the con­trary reader really want to make that argu­ment? (Hint: con­sider Wachovia, Wash­ing­ton Mutual, etc.) As we men­tioned on Thurs­day, reg­u­la­tors have their own incen­tive problems.

While big­ger may per­mit con­sol­i­dated oper­a­tions and cost sav­ings. Are those sav­ings large enough to jus­tify the assump­tion of addi­tional, sys­tem­atic risk or, more pre­cisely, the loss of a diver­si­fi­ca­tion ben­e­fit, caused by the cen­tral­iza­tion of allo­ca­tion deci­sions? The past year has made us very doubt­ful that the ben­e­fits exceed the increased sys­temic risks of a few busi­ness seg­ments bottoming-​out together.

Today’s (Sep­tem­ber 30) Wall Street Jour­nal con­tains a front-​page arti­cle, Indus­try Is Remade in a Wave of Merg­ers, which reports that the three largest banks now con­trol over 30% of the nation’s deposits.

We’re writ­ing because we take issue with the paper edition’s blurb: “For the econ­omy and gov­ern­ment offi­cials, the very size of these banks means they should be bet­ter insu­lated from big shocks…” In our mind, there seems to be an implicit, but unjus­ti­fied, diversification-​benefit argu­ment behind such statements.

We see no evi­dence that mas­sive size has insu­lated any finan­cial firm in this cur­rent cri­sis or any pre­vi­ous cri­sis in this coun­try or any other coun­try. In fact, we argue that the oppo­site is quite pos­si­bly true.

As we’ve writ­ten in the past, e.g., two weeks ago Forced Merg­ers? Big­ger Is Not Nec­es­sar­ily Bet­ter! and reit­er­ated Sun­day in What Will Wachovia’s Pre­sumed Demise Mean for B of A?, per­mit­ting cen­tral­iza­tion (of asset allo­ca­tion) into the hands of fewer and fewer indi­vid­u­als cre­ates its own sys­tem­atic risk. Each senior decision-maker’s idio­syn­cratic (and pos­si­bly irra­tional) beliefs and judg­ments affect a larger and larger share of the economy’s resource deci­sions, and that can’t be a good thing. Thus, there is a trade-​off of the cost sav­ings (of con­sol­i­da­tion) ver­sus the addi­tional risk of such cen­tral­ized decisions.

Such idio­syn­crasies go beyond any sin­gle indi­vid­ual and include orga­ni­za­tional fac­tors, as well. For exam­ple they include the behav­iors both con­sciously and uncon­sciously induced by con­trol schemes, includ­ing per­for­mance mea­sures and reward schemes; cul­ture and ethics; his­tory; and even mod­el­ing tech­niques and assump­tions. All of these together cre­ate a firm-​specific, idio­syn­cratic com­po­nent to the prob­a­bil­ity of income and losses being real­ized, which could amplify vari­abil­ity and the prob­a­bil­ity or mag­ni­tude of bad outcomes.

When we have the time, we’ll try to graph an exam­ple of an effi­cient fron­tier as the num­ber of firms shrink. It is not sim­ply the con­sol­i­da­tion of past (or prospec­tive) uncor­re­lated posi­tions, which on aver­age would pro­duce real­ized diver­si­fi­ca­tion ben­e­fits, e.g., higher low out­comes. Instead, unlike much of tra­di­tional finan­cial the­ory, which assumes cer­tain dis­tri­b­u­tions and com­pletely ratio­nal decision-​makers, it is easy to imag­ine someone’s past suc­cesses unduly influ­enc­ing their decision-​making and cre­at­ing a con­cen­tra­tion of risk within a par­tic­u­lar indus­try, region, or asset class. Per­haps Wachovia and mort­gages is a good exam­ple of this behavior?

The sec­ond part of the blurb, which we did not repro­duce, con­tains a “too big to fail” state­ment, and the writ­ers cor­rectly note that this men­tal­ity inten­si­fies moral haz­ard prob­lems by pro­vid­ing a per­ceived lim­ited lia­bil­ity on the loss side, thus mak­ing such insti­tu­tions more likely to take risks and get into trou­ble. That’s not our argu­ment, but it does exac­er­bate the issue that we’ve identified.