Thursday, January 14, 2010

Obama's Financial Crisis Fee -- sounds SO good, but oh, SO wrong

President Obama announced plans today to levy a “Financial Crisis Responsibility Fee” on the nation’s largest banks — those with more than $50 billion in assets. Basically, it will be computed as .15% (i.e., 15/100ths of 1%) of the banks’ liabilities, excluding deposits covered by FDIC insurance (because a separate fee is assessed on them).

To a revenge-starved public, this may sound SO right and be SO overdue, but it is SO wrong. Once again, Obama has proposed a solution — as he did with health care reform — that is so lacking in nuance that it is clear that he doesn’t truly understand the problem. Either that, or it’s simply more evidence that he’s in Goldman Sachs’ hip pocket.

So, what’s wrong with this solution? Answer: it penalizes conservative, well run institutions, and once again, lets those who are the real troublemakers off the hook. The troublemakers that are left alive, that is. Keep in mind that most of the institutions that caused the crisis are now out of business or were merged into more responsible firms and are now under new management. By far, the biggest culprit still standing — and thriving, as no financial reforms have yet been implemented — is Goldman Sachs.

Although Obama and the media refer to “banks” as a homogeneous group, it is important to separate routine commercial and consumer lenders from super-large “money center banks” (e.g., Citibank, BofA, Wells Fargo, and JP Morgan Chase) and Wall Street “investment banks,” the latter of which (e.g., Goldman Sachs) were not actually banks at all until the financial bailout. Although they’re called investment banks, they never had bank charters, weren’t regulated as banks, and didn’t have FDIC-insured deposits until Treasury Secretary Hank Paulson allowed them to convert into chartered banks in order for them to qualify for TARP bailout funds. It was a slight of hand to do a solid for his friends on Wall Street, plain and simple. The investment banks are the firms that engage in the most risky trading and derivatives activities, and such activities constitute a huge percentage of their overall businesses. Money center banks also engage in risky investment banking activities — “thanks” (I say facetiously) to the Clinton administration’s successful efforts to repeal the Glass-Steagall Act — but because they are so large and diversified in their activities, such risky activities are a much smaller percentage of their overall businesses. Even among the money center banks, however, some were much less careful than others in managing their risks: Citibank was perhaps the worst, and JP Morgan Chase seems to have been the best. Indeed, despite having a diversified portfolio of low-risk businesses, Citibank was nonetheless almost brought down by its relatively few higher risk businesses. (You remember the old saying about one bad apple, right?) Long story short, banks are very different from one another, and they need to be penalized based on the risks they take, not how big they are.

To illustrate the problem, I downloaded the September 30, 2009 financial statements for Goldman Sachs and a pretty “plain vanilla” large bank, U.S. Bancorp, from the Federal Reserve’s website. The financial statements show how much of the banks’ revenues come from routine banking activities versus high-risk trading operations, which are the “casino” activities that got us into so much trouble. Goldman’s assets as of September 30 were about 3.3 times greater than U.S. Bancorp’s, so I'll need to make some adjustments in my math for that. For the first 9 months of 2009, Goldman generated $28.3 billion of trading revenues and interest on trading assets. Essentially, rolling the dice, albeit, in a casino that they seem to have pretty much rigged most of the time, except for when things go terribly wrong. In comparison, U.S. Bancorp generated a paltry $125 million from trading. This is a staggering differential. Adjusting for the difference in the sizes of the two firms, for every dollar of assets deployed in their businesses, Goldman was conducting about 68 TIMES more casino activity. This helps put the difference in the nature of these two banks into some perspective. Relatively speaking, one is like a plodding old electric utility, whereas the other is a powder keg waiting to explode if any of its risk assumptions prove to be faulty, which is exactly what happened in 2008.

Recall, however, that Obama’s proposed fee will be based on liabilities exclusive of FDIC deposits. Granted, that helps equalize things just a bit, in that such deposits make up a much larger percentage of U.S. Bancorp’s liabilities. In other words, it will get a much larger exclusion from the fee than Goldman precisely because it is a more conservative institution, which is exactly what we want. Even so, however, when looking at casino activities for every dollar of liabilities to be taxed, Goldman is still conducting 25 TIMES more casino activity than U.S. Bancorp. Yet, they will both pay exactly the same fee on each dollar of assessed liability. Not exactly fair, is it? Relative to what it makes on high-risk activities, the fee/tax Goldman will pay will be insignificant.

Granted, I’m a financial professional, but it took me all of about 15 minutes to do this work. Importantly, though, I took the time to validate what I suspected intuitively. As I said in my second paragraph, solutions can sometimes seem so obvious and so clear, and yet be entirely wrong. This is an obvious trap to anyone who has ever done any serious analytical work, so trained professionals are always on the lookout for the biggest booby trap of all: things you think you know, but really don’t. That’s why solutions should be based on real analysis, conducted by bona fide professionals who know how to maintain their objectivity. As I have stated in previous articles, important decisions should not be based on hearsay, anecdotal evidence, or preconceived notions. Popular, but erroneous, decisions may sound good, but they don’t solve anything, they’re often unfair, and they often encourage the exact opposite behaviors of those we really want.

I know I sound like a broken record, but we simply need to demand a higher quality of work from our government.