Tim McCarthy and the Business of Good

Newsletter: Will We Learn?

Mar 15, 2010 6:46:00 AM / by Tim McCarthy

Risk and reward is the basis of all successful financial systems so the US government must not intervene in such a way as to put that system out of balance.  [more]

I’ve been reading Barry Ritholtz’ book Bailout Nation and I can now say – for the first time – that I think I understand what happened to cause the breakdown of the world economy.

I was so confused by the Republicans saying it was the Democrats fault and the liberals saying it was a failure of conservative philosophy. Ritholtz’ book rests on the premise that this crisis has many parents. In fact, late in the book he lists the culprits - they number 23! And they are not just individuals and certainly they do not favor one party or one philosophy.

The problem, he believes, is systemic and still remains, a fact that really scares me since we are two years into it and I am aware of no significant change in the policies that guide us.

Ritholtz believes that we have morphed America’s unique brand of capitalist democracy into what he calls “socialism for the rich; capitalism for the rest.”

And rather than sensationalize his views (though he does have a real flair for storytelling) he uses many facts and a historical perspective to support his theory. That is, that the USA has now gerrymandered the capitalist system so badly that corporations can gain great short term rewards while taking relatively little risk and responsibility. Further, that the individuals who take these risks will be paid huge money regardless of whether they succeed or fail.

Bailout Nation not only explained to me the current crisis in terms I could understand, it also gives clues to my deepest social concern: that we have become a financially polarized society.

You see, to me it is less likely that terrorists will bring down our nation as it is that we will destroy ourselves by continuing to widen the gap between the very rich and the very poor. I believe that this, more than anything other single matter, is our most pressing social issue.

Yes, I know that poverty is not new. The bible says “we will always have the poor” and metaphorically the rich have been driving BMWs through the ghettos for centuries. But it seems to me the breadth of the problem is what’s relatively new – we have both more BMWs and more ghettos.

In 1980, the average CEO earned 40 times what the average worker in the USA earned.

In 1997, only 17 years later, the imbalance had grown to 100 times.

Only eight years later, in 2005, the average CEO made $11 million and the average American worker made $42,000 – a difference of 262 times.

So how did we get to such protection for the rich while getting less for the poor?

Richoltz believes it started with the government’s first bailout – Lockheed in 1971 for $250 million. Since then, says he, the size and velocity of bailouts has increased until from 2007 to 2009, depending on how you count them, there were roughly 30 bailouts at a price tag of $14 trillion.

And so the problem Richoltz worries about is: if you know that risk will be mitigated by government, particularly if you are “too big to fail”, then you are incentivized to be reckless.

Read the book for details. You will know some of the more talked about recession causes such as sub-prime lending and the 1999 repeal of the Glass-Steagall Act. But here is one of many causes that are less talked about that Richoltz thinks rocked our financial foundation.

In 2004, at the urging of the five largest investment firms, the SEC suspended a 1975 rule stated that investment banks could borrow no more than $12 for every $1 they had in capital. Interestingly this 29 year old rule was suspended ONLY for firms with more than $5 billion in market capitalization. Those firms were the “Big Five” of brokerage houses: Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns and Morgan Stanley. By 2006 (less than two years later), all five firms had gone from under 12 times leverage to having borrowed more than 30 times their capital, one betting over 40 times its worth.

By 2008, when the real estate and financial markets collapsed, one of these “Big Five” disappeared and two others were bought on fire sale by other big organizations (with government help and money). The two that remain in business have received billions from the US Treasury.

Of much more concern to me is that there have been no significant changes in investment bank governance since the debacle.

So, as Richoltz asks in the book, published a year ago, “What is to keep this from happening again?”

Will we learn from the mess? Will we require leaders of “too big to fail” institutions to moderate their risk?

Or will we drive our BMWs through the ghetto until we all crash.

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Tim McCarthy

Written by Tim McCarthy