Wednesday, 15 July 2009

The Big Lie

Yesterday's Goldman Sachs results have been illuminating. The investment bank that everyone loves to hate produced record returns for its shareholders (and management) with a quarterly profit of USD 3.4bn . Its prowess in financial markets trading is unparalleled in the finance world and they certainly deserve it...or do they?

An institution that was on the verge of bankruptcy just nine months ago and required public financial assistance is now producing record profits and paying oversized salaries to its top management. It seems that many financial institutions will follow suit in the coming quarters. Where are the returns on the public investment?

The “Big Lie” that we have been fed by a compliant press is that the stimulus packages which have been implemented in major economies were designed to support the real economy. In fact, these packages have been used primarily to prop up the banking system, a worthy aim in itself had not the main beneficiaries been shareholders, bondholders, and management. In plain English, taxpayers have had their pockets picked to support investors and top management in financial institutions.

I think that no reasonable economist can disagree with the need for the government to step in to save the money centre function of banks by safeguarding retail deposits and clearing relationships, but I can see no worthy use of taxpayer funds in supporting the financial rewards of institutional investors and management. The latter, after all, are trading risk for return. In 2008, after many years of return, risk reared its head and proceeded to destroy the value of financial instruments in a violent and unprecedented move. In my opinion, it is only fair that financial rewards for shareholders and management should have been wiped out. It is a basic premise that owners and management are responsible for the actions of the financial institutions they control.

Not content with direct assistance to the industry, monetary authorities have also stepped in to ensure that banks quickly start making money. How is this achieved, you may ask? It is as simple as enabling the carry trade...central banks have flooded markets with liquidity so that short term interest rates have collapsed. Banks can then borrow cheap short term money and lend longer term without taking on much risk. Call it a licence to print money.

Ostensibly, the policy of cheap money was designed to save the real economy but I don’t believe that a real investment project is sensitive to rates at levels below 5%. The only institutions that measure returns in basis points are financial institutions, given their high leverage and portfolio of financial assets. The fact is that rates have been reduced with massive liquidity injections because they assist in the repair of banks’ balance sheets by providing access to carry trade income. Again, governments have used public policy tools to protect well connected shareholders and top bank management.

Further evidence of mis-use of public funds is implicit in the conflict of interest of regulators. Ask these questions: How many of the financial sector regulators own or have friends/relatives that own substantial stakes in bank shares? Are they chummy with top management or do they get access to perks? I suspect that regulators are responding to hidden incentives in many instances....help your friends and they will help you; with a job in the future, or maybe access to holiday homes, yachting holidays and “business” opportunities.

In Spain, the lack of freedom of press has led to few and far between debates about the convenience of using tax-payer funds to save bank shareholders and stakeholders in Cajas. When referring to stakeholders, I include management and the political establishment which has benefited from the largesse provided by directing savings from depositors. Much in the same way that industrial companies used to own banks in order to provide cheap funding for their industrial activities, politicians have continued that ancient tradition to channel funds to pet projects. The lack of debate regarding the recent restructuring fund set up by the government has been egregious.

We live in a world in which society at large has been skimmed to pay for the returns of stakeholders in banks: so called sophisticated investors and management. Once more, prudent economic agents have had to bail out the aggressive imprudent agents, reinforcing the moral hazard which will inevitably encourage the next financial bubble under this “let’s socialise the losses and privatise the profits” policy.

1 comment:

Angel said...

Eddy is back. You've been missed