A Background Note

The note below, authored by John Cassidy, was published earlier this week by the Financial Times.
Cassidy, is a staff writer at The New Yorker and a contributor to The New York Review of Books. He also is the author of Dot.con: How America Lost Its Mind and Money in the Internet Era which examines the dot-com bubble, and How Markets Fail: The Logic of Economic Calamities, which combines a skeptical history of economics with an analysis of the housing bubble and credit bust. This pedigree and experience positions him superbly to write about the lessons learned from the collapse of Bear Stearns over the past two years.

Lessons From The Collapse Of Bear Stearns

Two years ago on Sunday, Treasury Secretary Hank Paulson called up Alan Schwartz, the chief executive of Bear Stearns, and told him the jig was up. “Alan, you’re in the government’s hands now,” he said. “Bankruptcy is the only other option.” Thus began the epic stage of the credit crunch and 24 months on, many costly lessons have been learned.

1. Leverage kills.

In March 2008, Bear had tangible equity capital of about $11bn supporting total assets of $395bn – a leverage ratio of 36. For several years, this reckless financing enabled the company to achieve a profit margin of about a third and a return on equity of 20 per cent; when the market turned, it left Bear bereft of capital and willing creditors.

During the ensuing months, the same story was to be played out at scores of other banks and non-banks. Last year, the group of 20 leading economies agreed to impose higher capital ratios. So far, no figures have been published. Officially, the gnomes of Basel – the Basel Committee on Banking Supervision – are at work. Unofficially, Tim Geithner, the US Treasury secretary, has a maximum leverage ratio in mind. What that figure turns out to be will indicate how serious the authorities are about preventing future blow-ups.

2. It if quacks, it is a duck. If it borrows short and lends (or invests) long, it is a bank.

Officially, Bear Stearns and Lehman Brothers were investment companies; Washington Mutual was a savings & loan; AIG was an insurance company, GMAC and GE Capital were subsidiaries of industrial corporations; the Reserve Fund was a money market mutual fund. In reality, all of them were handing out money, or near money, and accumulating illiquid assets. Any such institution is vulnerable to a run by creditors and regulators should treat them alike – as banks. Failure to adhere to this principle will result in regulatory arbitrage and more blow-ups.

3. Markets are not always efficient.

Does this lesson need restating? I fear it does. Over the years, free market ideology has displayed an uncanny ability to resurrect itself. And there will always be powerful interests eager to cloak their selfish ends in the invigorating language of Adam Smith and Friedrich Hayek.

4. Big banks are like nuclear power stations.

They provide valuable services, such as channeling capital from savers to entrepreneurs. Occasionally, they blow up, causing damage to the rest of the economy and necessitating spending vast sums of taxpayers’ money on clean-up operations. In retrospect, the solutions to this problem are obvious: stricter supervision to reduce the probability of blow-ups and institution-specific “pollution taxes” to cover their cost.

President Barack Obama recently proposed such a tax, and Gordon Brown has taken it upon himself to transform this proposal into a global initiative. For once, a good idea appears to be making progress. Somewhere in the heavens, Arthur Cecil Pigou, the economist who invented the concept of negative externalities, must be smiling.

5. Statistical models are like bikinis: what they reveal is suggestive, but what they conceal is vital.

So said Aaron Levenstein, a late (and politically incorrect) professor at New York’s Baruch College. On Wall Street and in the City, the bikinis came in the form of “Value-at-Risk” models that assumed investors (and mortgage holders) were like so many molecules bouncing around randomly in a heated jar. These mathematical contraptions had the charming feature that when they were not needed they worked perfectly, and when they were needed they did not work at all.

6. Bagehot and Keynes were both right.

During a financial crisis, the role of the central bank is to lend money where nobody else will. During an economic slump, the government has to boost demand. In applying these truths, authorities from Washington to Frankfurt to Beijing prevented the Great Recession from turning into another Great Depression.

7. Rent-seeking is not wealth creation.

Some of the money that financial companies make consists of economic rents diverted from other groups, such as investors in actively managed funds, workers in companies taken over by private equity groups, and taxpayers who eventually bear the costs of excessive risk-taking. The losses that UK banks suffered in 2008-2009 wiped out roughly half of the economic valued added – wages, salaries, and gross profits – that the banking sector generated between 2001 and 2007.

8. Profits should not automatically accrue.

A century ago, progressive English thinkers such as J.A. Hobson and L.T. Hobhouse argued that much wealth is, in part, socially created, providing a justification for the state redistributing some of it to old age pensions and health programmes.

As far as modern finance goes, the New Liberals had it doubly right. Not only are some of the “profits” that bankers generate contingent on implicit state guarantees: much of the capital they put at risk belongs to others.

Given its lobbying power, the financial industry may yet head off some of the restrictions on its activities. But never again will bankers be able to argue that what is good for Citigroup is good for America, or what is good for Royal Bank of Scotland is good for the UK. Not with a straight face anyway.