I hope employees of Goldman Sachs and Morgan Stanley are enjoying the huge taxpayer-subsidized bonuses they're receiving this year. It could be their last such bonanzas, if the Obama administration is serious about implementing proposals unveiled Thursday morning.
The new plan has two major goals. It wants to put in place safeguards that would ensure that banks don't get too big—that they don't take on too large a share of the nation's deposits or other types of liabilities. If they're not too big, we won't feel compelled to come to their rescue if they fail. More controversially, Obama is proposing a measure that would "ensure that no bank or financial institution that contains a bank will own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit." In English: No federally backed bank will be allowed to use other people's money to take big risks, reap most of the rewards, and suffer minimal consequences if the investments fail.
In the olden days, hedge funds and investment banks generally raised money from partners, employees, institutions, and shareholders, and borrowed money from the capital markets. They couldn't borrow from the Federal Reserve or take deposits that would be insured by the FDIC. After the erosion of the Glass-Steagall Act, a few banks—notably Citigroup, JPMorgan Chase, and Bank of America—united investment and commercial banking operations under one roof. Other large investment banks—Bear Stearns, Goldman Sachs, Merrill Lynch, Lehman Bros., and Morgan Stanley—stayed outside the system. These investment banks all engaged in proprietary trading and ran hedge fund and private equity operations.
The crisis that began in 2008, with the near-failure of Bear Stearns, triggered a host of policies to shore up the investment banks. First, investment banks like Bear and Goldman were allowed to borrow directly from the Federal Reserve's discount window—a privilege heretofore afforded only to commercial bank holding companies. After the failure of Lehman Bros., Goldman and Morgan Stanley hastily transformed themselves into bank holding companies, which allowed them to take full advantage of all the Fed's and FDIC's new programs. First, the FDIC boosted the amount of deposits it would insure, and then it offered to guarantee debt issued by financial institutions. Goldman was one of the biggest users of this new subsidy.
Throughout 2009, the surviving investment banks used these very cheap, subsidized forms of capital to lend but also to trade and invest and take positions for their own accounts. Some did that rather well. Goldman Sachs earned $13.4 billion last year.
Obama isn't proposing to reconstitute Glass-Steagall, the Depression-era law that separated commercial and investment banks. Under this plan, banks can still have a retail branch network and perform many of the most profitable components of investment banking: advising companies on mergers and acquisitions, underwriting securities, managing investments, executing trades for clients. But, should this plan pass, they won't be able to take the FDIC-insured deposits we give them and use them to do funky algorithmic trading. "This prohibition says you can choose to engage in proprietary trading, or you can choose to own a bank," said a senior Obama administration official on a call with reporters on Thursday. "You have to make the basic choice."
This part of the proposal may as well be called the Lloyd Blankfein Act of 2009, for it is clearly targeted at Goldman Sachs and its largely unrepentant CEO. As a senior administration official put it: "As we saw the ones that got special protections turn around and make significant profits on proprietary trading, it persuaded the president and the economic team that it is worth looking at it in some detail." And while the stocks of all the big investment banks are down today, it will affect most directly the firms that derive maximum benefits from the cheap funding and have small presences in the lower-margin bricks-and-mortar banking businesses: Goldman and Morgan Stanley. This isn't as big a deal for JPMorgan Chase (see its earnings here), which in the most recent quarter derived less than one-fifth of its revenues from investment banking, or for Bank of America (see its recent earnings here).
The devil, of course, is in the details. I'm not particularly optimistic about passage of these measures anytime soon, given the financial industry's lobbying prowess and the Obama administration's less-than-hard-core attitude toward pushing legislation through Congress (see: health care). Banks will argue—correctly—that in order to serve clients and facilitate trading they have to take their own positions. The Obama administration says that'll be OK and permissible—as long as they are not playing with federal-backed dollars. What will no longer be OK and permissible is taking insured deposits and having in-house hedge funds blow them up.
Should the proposal go through, it will force some banks to close down or sell off certain units. The more likely—and most desired—response would be for Goldman and Morgan to give up their bank holding company status and go back to obtaining their funding from the market. The higher cost of capital and challenge of raising funds will make it harder for them to be so big. That's the point.
Expect to hear a lot about Washington's war on Wall Street. (I'm eager, however, to see the reflexive Obama-phobes explain why it's a good idea to let banks run hedge funds with publicly insured deposits. Malcolm X famously said of African-Americans: "We didn't land on Plymouth Rock. Plymouth Rock landed on us." Just so, we're not landing on Wall Street. Thanks to its own mismanagement and lack of foresight, Wall Street landed on us.
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