Wall Street Isn't Fixed: TBTF Is Alive And More Dangerous Than Ever

Tyler Durden's picture

Submitted by David Stockman via Contra Corner blog,

Practically since the day Lehman went down in September 2008 Washington has been conducting a monumental farce. It has been pretending to up-root the causes of the thundering financial crisis which struck that month and to enact measures insuring that it would never happen again. In fact, however, official policy has done just the opposite.

The Fed’s massive money printing campaign has perpetuated and drastically enlarged the Wall Street casino, making the pre-crisis gamblers in CDOs, CDS and other derivatives appear like pikers compared to the present momentum chasing madness.  In a nutshell, the Fed’s prolonged regime of ZIRP and wealth effects based “puts” under risk assets has destroyed two-way markets. The market’s natural mechanism of risk containment and stabilization—-short sellers—has been driven from the casino. Accordingly, carry-trade speculators engorged with free money funding have taken the market to lunatic heights, while leaving it vulnerable to a violent collapse upon an unexpected drop because the market’s natural braking mechanism—short sellers taking profits—- has been eviscerated.

At the same time, the giant regulatory diversion known as Dodd-Frank has actually permitted the TBTF banks to get even bigger and more dangerous. Indeed, JPM and BAC were taken to their present unmanageable size by regulators—ostensibly fighting the last outbreak of TBTF—who imposed or acquiesced to the shotgun mergers of late 2008.

So now these same regulators, who have spent four years stumbling around in the Dodd-Frank puzzle palace confecting thousands of pages of indecipherable regulations, slam their wards for not having sufficiently robust “living wills”. C’mon! This is just another Washington double-shuffle.

The very idea that $2 trillion global banking behemoths like JPMorgan or Bank of America could be entrusted to write-up standby plans for their own orderly and antiseptic bankruptcy is not only just plain stupid; it also drips with political cynicism and cowardice. If they are too big to fail, they are too big to exist. Period.

Indeed, it is utterly amazing that adult legislators and regulators could even take the idea of a “living will” seriously—-let alone believe that they could possibly thwart the recurrence of another outbreak of so-called “financial contagion”. Yet so thick is the beltway cynicism and so complete is the K-Street domination of policy-making that a trite bureaucratic gimmick like the “living will” has become a major component of so-called macro-prudential policy.

So there is nothing to do except go back to the fundamentals. First and foremost, the September 2008 meltdown was not a main street banking problem; it was a crisis confined to the canyons of Wall Street, owing to the fact that the gambling houses domiciled there had massively bloated their balance sheets with toxic assets and risky derivatives trades, and then funded these balance sheets leveraged at 30:1 with huge amounts of “hot money” in the form of repo and unsecured wholesale loans.

As I demonstrated in the Great Deformation, the “bank run” was almost entirely in the Wall Street wholesale market. By contrast, there was never any danger of retail runs at the corner branch bank offices, and the overwhelming majority of the 7,000 main street banks did not own the kind of toxic securitized assets that were roiling Wall Street.

In fact, the wholesale market runs in the canyons of Wall Street were actually a positive, economically therapeutic event. They had already taken out three of the reckless gambling houses—- Bear Stearns, Lehman and Merrill Lynch—-and were fixing to finish off the remainder, that is, Goldman and Morgan Stanley.

Had the market been allowed to finish off the work of the economic gods in late September 2008, the TBTF problem would have been substantially alleviated. Today there might have existed a half dozen “sons of Goldman” in the form of M&A, trading, investment banking and asset management boutiques—run by chastened veterans who lost their lunch during the 2008 Wall Street cleansing.

The excuse for Washington’s massive intervention against the free market in the form of TARP and the Fed’s monumental flood of liquidity, of course, is that the US economy was about to be annihilated by something called financial “contagion”.  But that is a specious urban legend invented by the crony capitalists who controlled the Treasury and the money-printers who had fueled the housing and credit bubble at the Fed.

As I have also shown, for example, AIG’s dozens of insurance subsidiaries were money good and would have been protected in bankruptcy by insurance regulators and capital maintenance rules, while settlement of the holding company’s fraudulent CDS insurance would have been parceled out pennies on the dollar by a Chapter 11 judge to the dozen giant global banks who had stupidly attempted to turn toxic CDOs into AAA credits. Likewise, FDIC could have liquidated Citigroup’s regulated bank, while allowing the gamblers who bought the stock, bonds and other obligations of the holding company to face their just deserts.

In short, TBTF became a “problem” to be ostensibly remedied with bureaucratic malarkey like living wills primarily because Washington made it a problem—- by means of its panicked bailouts of Wall Street in the fall of 2008. Indeed, the true solution to TBTF is always and everywhere to allow the free market to cleanse its own excesses and imbalances and to impose financial discipline and demise upon outbreaks of reckless gambling and leverage when they occur.

Unfortunately, even if Washington were to refrain from ad hoc bailouts, the free market cure would be perennially compromised by the giant moral hazard posed by deposit insurance and the Fed’s cheap money discount window. Owing to these policy institutions, which systematically encourage excessive gambling by their beneficiaries, US banks are inherent wards of the state—including the easily abused privilege of fractional reserve banking conferred by regulatory charters.  The right thing to do would be to abolish these sources of moral hazard and tell the K-Street financial lobbies to fold up their plush tents because their employers are now all expected to sink or swim on the free market.

Needless to say, the chances that Washington would permit the Wall Street gambling houses to be returned to the unfettered free market that they profess to defend—are somewhere between slim and none. Accordingly, a second best solution is warranted, and it could readily be done.  And it would be far more effective than the lunacy of living wills and all the other bureaucratic mumbo-jumbo that has come out of Dodd-Frank.

First, Washington should re-enact a strict version of Glass- Steagall. Only “narrow banks” which take deposits and make consumer and business loans would have access to the Fed’s discount window. By contrast, propriety trading, underwriting, merchant banking, asset management and all the rest of the financial services sectors would be banned at regulated banks and sent back to the free market where they belong.

Secondly, a ceiling on regulated bank size would be established—perhaps measured at 1% of GDP or $200 billion in terms of asset scale. There are no demonstrated economies of scale in deposit and loan banking above that size, anyway.

Stated differently, banks wishing to indulge in the moral hazard of deposit insurance and accessing the Fed’s discount window would not have to prove they were not “too big to fail” or that they had a viable “living will”. Instead, a TBTF law would do it for them in the form of a statutory cap on the size of regulated banks.

To be sure, Wall Street would scream that such a regime would interfere with the ability of small business and American consumers to get cheap loans. But in a national economy that has gone through a rolling 30-year LBO resulting in $60 trillion of credit market debt outstanding and which sports leverage ratios against income in all sectors that are off the historical charts—that complaint has no merit. Making debt more expensive and permitting it to be economically priced on the free market is, in fact, just what is needed to eventually cure the nation’s debt-ridden economic malaise.