Chris Whalen: The Fallacy of “Too Big To Fail”–Why the Big Banks Will Eventually Break Up
Why politicians let MF Global investors get taken
Show transcript of Chris Whalen: The Fallacy of “Too Big To Fail”–Why the Big Banks Will Eventually Break Up
JIM: Joining me as my special guest on the program is Chris Whalen. He’s senior managing director of Tangent Capital.
And Chris, as long as I’ve been reading your work, you've been a critic of the too-big-to-fail fallacy. In your opinion, you think the big guys are going to break up. Why do you believe that to be the case? [0:59]
CHRIS: Well, the big banks are under an enormous amount of pressure. First off, Fed interest rates; it’s destroying the economics of the business. If you think about your average broker-dealer, repo lending, all of these basic activities that were once normal before the crisis are gone. So the Morgan Stanleys, the Goldmans, they are all sitting there with inventory where they earn nothing on repo; they don’t even bother because the rate is zero. So that’s the first issue.
The second is Basel III. If you look at the new Basel accords that the US is supposed to be adopting, it’s entirely hostile to lending. So I think whether you’re talking about real estate, residential, commercial, we have some really big issues with this regulatory regime. For example, most banks are going to have to get out of the conduit business; that’s going to end up in the non-bank sector. Well, look at where profits came from the big banks over the last seven or eight years. It was mortgage banking; it originates itself. So if I’m even Wells Fargo, which is the last man standing in the US marketplace today, 30 percent market share, I’m eventually going to have to get out of that business; I won’t be able to own a conduit anymore. That’s pretty radical stuff.
So I think the basic assumptions in large bank business models are all being questioned. And so if you don’t react to that as an analyst or, you know, I’m a banker. I’m out trying to raise money for small banks, non-bank lenders, you know, we've started a hedge fund and focus on the financial sector. In each one of those cases, we're not even looking at the big banks because I don’t see them as bankable. [2:28]
JIM: Yeah. Because your new fund which is going to be invested is more in favor of banks that focus on the old-fashioned lending, avoid the risky businesses like the derivative trading, which so much dominates the big banks. [2:41]
CHRIS: Oh absolutely. Think about JP Morgan. Here you have a bank that’s a dominant lender, so they actually know when your company is going to go bankrupt. They may even be arranging DIP financing. They’re also trading credit default swaps on the other side. I mean isn’t this is an anti-trust problem? Isn’t this a conflict of interest? Of course it is. And yet nobody ever thinks of it this way because the large banks are seen as sacrosanct, all the payment flows go through them every day — mortgage payments, tax payments, everything else — and the Fed says, Oh, mio my, we can’t break them up. Yes we can.
If I was appointed trustee at Bank of America to restructure the litigation liabilities that are killing that bank, I would have no problem selling five, six institutions in IPOs and raising a lot of money and then we would have five more banks about the size of US Bancorp. I think that would be very good for the economy. So you can break these things up, but in an economic way that’s not going to scare the public; you have to communicate effectively obviously. But I think the economics of these big banks, it no longer works.
I’ll give you another example. Look at Citi. They sold Smith Barney. Morgan Stanley is supposed to be consolidating that whole business on their balance sheet. I think they’re going to have to sell it. The economics are just not there in retail brokerage. And there’s a whole list of other — so look at Wells Fargo with the old Wachovia brokerage business that they bought from Prudential. It doesn't work. They’re driving brokers out in droves. So I think over the next couple of years, these banks are going to have to change their business model to suit the realities. That’s what it comes down to. [4:14]
JIM: Now, you've often been critics, not only of the banking system, but maybe sometimes of policies by the Fed, and there are some individuals at the Fed who don’t appreciate sometimes your comments, even though at one time, Chris, I believe you worked at the Fed. [4:29]
CHRIS: I was at the Fed in New York. I was a management trainee and I worked in bank supervision and then the bond department. And you know, however they feel, they feel. But I think the Fed has mishandled bank supervision consistently. I think we should take it away from them and just have them focus on monetary policy, market surveillance; I think they could handle that.
I don’t really have much problem with their monetary policies. They’re doing what they had to do after a period of insanity; right? But when you look at the way that they allow large bank mergers and all of the other policies that the Fed follows, which essentially enforces the monopoly by the top banks and disadvantages community banks, why are we doing that? It makes no sense.
So you've got to remember; these are academic economists who have never met a large bank they don’t love and they’re also really concerned about maintaining the access of the Treasury to the debt markets. So that means you’ve got to try and protect primary dealers, right? But we didn’t do that during the crisis because we lost five primary dealers. They slammed Merrill Lynch and Bank of America; horrible transactions. [5:33]
JIM: Two issues which I think are related which you've written about recently, which is Greek credit default swaps and also MF Global. And I want to talk about derivatives because the idea — or the proponents for derivatives are saying this is a wonderful way that individuals or institutions can diversify risk. But as you point out recently, in a derivative transaction, there’s going to be one winner, there’s going to be one loser. So at the derivative table, when a contract is negotiated, it usually is the smarter firm with the deeper talent pool who exploits the lesser players who end up losing. [6:15]
CHRIS: That’s correct. I mean Marty Mayer said to me many years ago, credit default swaps are all about moving the risk to the dumbest guy in the room. And it is a zero-sum game; there is no additive value creation in derivatives. I think, going back to the point about conflicts, though, I would like to see all of these derivative products that can actually be put on an exchange moved out of the bank, so that the bank again becomes a lender and an agent for customers, but they don’t have that principal conflict that you see so much with this whole reporting about JP Morgan and this fellow doing the energy trades out of London.
What’s interesting is that all of his colleagues in New York have already been fired because of the Volcker rule. [6:57] So the principal trading activity here in New York is basically done because the lawyers told JP you have to get rid of all these people.
But again, going back to the conflicts, imagine if you own a company and you’re in distress and you come to JP Morgan and you say, Hey, I need DIP financing. We're going to file bankruptcy.
Doesn't that make you feel a little uncomfortable that the same institution can be shorting you in a credit default swap market while they’re arranging a loan for you for bankruptcy restructuring?
I have a big problem with that and I don’t think we fully understand how many conflicts and asymmetries there are in this marketplace. And to me, the very simple solution, Jim, is to push all these contracts onto an exchange. Get it away from the bank, get the collateral away from the bank, too, by the way, because that’s where these guys make a lot of their money in these bilateral relationships. And then I think we can start to restore transparency, equity and fairness to a market that does have some reason to exist.
You know, credit default swaps are basically ways to short a bond that you can’t borrow. If you think about a public company, right, in most cases you can’t borrow a corporate bond or even a bond issued by a bank because it’s sitting in somebody’s portfolio; they don’t want to lend it. So a CDS gives you a way to create a short position on a given credit. That’s fine, but when you have contracts that have no cash basis, I don’t think we should allow those. They are entirely speculative. [8:23]
JIM: Yeah, because it used to be, Chris, let’s say I own a bunch of GM bonds or let’s say in the case of Greek bonds and I’m a little unsure about the credit quality so I’m going to go out and buy a credit default swap. Now, if I go to collect, just like owning car insurance and I get in an accident, I turn in the damaged car or in this case the bond that’s in default. But you have a lot of people who are buying this stuff who don’t even own the bonds, so they don’t have to turn in a bond to collect on the CDSs. [8:53]
CHRIS: That’s right. Well, it’s because we allow cash settlements. If the buyer of protection was forced to deliver the underlying — whatever it was, it could be a loan, could be a bond, could be accounts receivable — whatever it is, you could create a spec on an exchange that would allow for that. It’s just the way you can deliver different Treasury bonds against a bond future based on the yield; right? Then you would have some discipline because all of those people have an insurable interest.
But because Wall Street has perverted the legislative process in Washington, we’ve pretended these insurance contracts are not insurance. They should be regulated by the state of New York and the other states that have major insurance operations. But the banks wanted to keep this derivative market for themselves because the basic operations of these banks are so unprofitable. Credit default swaps are the most profitable activity inside most big banks, followed by things like structured notes, which are essentially derivatives.
Those types of activities have very high risk, but they also help profitability inside big banks that really aren’t that profitable. If you look at the retail operation of JP Morgan, it’s probably a loss. If you look at cash securities in the age of deregulation, right, probably a dead loss in most firms. They don’t make money on it. So we've skewed the business model of these organizations with government intervention, regulatory efforts to try and address the problems caused by government intervention.
So today, the little community bank or non-bank lender is really the only business model out there that makes sense, whereas the big banks I think are just going to fly apart because the economics are not there any more. You don’t have to do anything, by the way, Jim, we could just watch. [10:38]
JIM: I want to talk about another conflict of interest and we saw this with the Greek default or the restructuring of Greek debt. You have this organization ISDA which is dominated by the big banks. It’s the supposed standards setting body for the marketplace and yet they ruled that, well, that really wasn’t a default so the banks didn’t have to pay up. Isn’t that another conflict of interest? [11:02]
CHRIS: Again, because the banks have taken the old model from the foreign exchange markets and the interest rate markets and they’ve migrated what used to be a swap — in other words, I would pay you a fixed rate, you would pay me a floating rate — and there’s nothing wrong with that contract. It’s fairly transparent; it’s pretty well standardized. But we then migrated that legal template to credit default swaps and so ISDA is now in a position where not only do they have to set standards for this over-the-counter, non-exchange market in interest rates and currencies, but they almost have to become an arbiter of default. And people feel somewhat uncomfortable about this because each case is essentially subject to special judgment on the part of this private entity that is the rule maker — the de facto rule maker — to this OTC market in credit default swaps.
I think that’s what makes people a little antsy. If you had a mutual exchange where all the clearing members are transparent, where you have a credit committee and you have published rules for each contract, then there’s no issue. The default is defined, everybody understands what default is. That’s it. So I think the subjectivity and the lack of transparency in the ISDA process is a big problem for people. And remember, who controls ISDA? The big banks. JP Morgan. [12:22]
JIM: Let’s move on to MF Global because if there is a lesson here, it seems the lawyers and the lobbyists for the large banks have rigged the game in favor —
CHRIS: Oh, very much.
JIM: — of the OTC market and large dealers. So what happened here? What’s going to happen to that $1.6 billion? Will the customers ever get that money? And if I’m a fiduciary and I’m holding customer accounts, I’ve got to be leery in terms of who I’m clearing with. [12:50]
CHRIS: Well, the 2005 bankruptcy reform legislation, which is one of the most hideous laws ever passed by the Congress, strengthened the safe harbor in bankruptcy for secured lenders. Why did they do this? To protect the OTC derivatives market.
Unfortunately, one of the side effects has been that if you’re a customer of a broker-dealer and the broker-dealer fails, in almost every case you’re not going to see a receiver appointed, you’re simply going to have a bankruptcy trustee. Now, why is that important? Well, in Madoff and MF Global, what you’ve seen in each case is that the very long standing view of the court and in the law that says that the trustee is tainted by the estate and can only act on behalf of the estate; it essentially prevents the trustee from going after third parties on behalf of the victims. So in this case the estate is MF Global, the failed broker-dealer, but the trustee can’t act for the customers. The customers have to organize themselves, hire counsel and go into the bankruptcy litigation. Even then, their chances of recovering funds, in this case by clawing them back from JP Morgan and the other secured parties is small because of the changes in the bankruptcy law.
Unfortunately, in the US, since the 30s we’ve seen a decline in the use of receivership. You saw a receiver in the case of the Stanford Group. In that case there was no bankruptcy. The creditors just went to a federal district judge and said, there’s fraud, there’s disarray, et cetera. We need a receiver.
The receiver works for the court and the only standard a receiver is following is equity. It’s very different from a trustee.
So I think what MF Global and Madoff illustrate is how the large banks have perverted our legal system and have made it difficult for bankruptcy judges to even do the right thing. You know, essentially what we've done is endorse fraud and we’ve said well, if management of a broker-dealer steals customer funds and uses it to pay a margin call by a lender, then the victims of the fraud can’t get their money back. That’s essentially what you have with MF Global. So we need to repeal the 2005 bankruptcy reform in total and I think also tell the courts that it’s okay to appoint a receiver where you have fraud.
And I think, you know, financial people and investors — anybody who works in these markets — has to know that as soon as you take a loss, you file a claim in the bankruptcy and then you go to the judge immediately and you ask for a receiver. You can’t wait six months. You have to understand what your rights are. And even if you go to the federal district judge who supervises the bankruptcy court, that’s okay. Put the issue before the court. Argue the merits and I think you can win. [15:38]
JIM: What was amazing to me, Chris, is in the ’91 S&L crisis, there were a lot of white-collar crimes; a lot of individuals went to jail over that scandal. We recently talked to William Black and he said as a result of the 2007-2008 crisis, nobody has gone to jail. In the case of MF Global, there have been no allegations — or at least nobody is being held under criminal charges. Has that surprised you that $1.6 billion disappears and everybody pleads ignorance in terms of where it went? [16:17]
CHRIS: Well, no. This is Barack Obama. Look, Barack Obama is bought and sold by the big banks. He could have bought a variety of claims against people who use deception in a securities transaction. It’s illegal; it’s a violation of most state laws and it’s a violation of the uniform securities act. But nobody has bought the claim. He’s waited long enough now that the statute of limitations has run on most of these claims. So this is really Barack Obama. I mean if Mitt Romney has his act together, he should crucify Obama over letting the bankers get away.
See, what judges don’t understand, especially at the federal and appellate level is that the fraud in the US today is just as bad as it was in the 20s. And when Louis Brandeis came down with his great decision in 1925 in Benedict v. Ratner, he basically slammed the door shut for Wall Street. We couldn't do structured securities deals for 25 years until they had the revision to the Uniform Commercial Code in the late 50s after World War II.
Unfortunately, the fraud today is at least as bad if not worse and because the politicians are, as I say, bought and sold by the big banks; that’s where they raise all their money. You know, Obama was just up here in New York raising money from the banks. He’s let them go. And I think it’s only when the public gets angry enough to start voting these people out of office and you start maybe seeing some attorneys general at the state level — like Eric Schneiderman, who may want to run for higher office — do the right thing and bring fraud claims maybe under New York state law (well, It would be better under New York law, in fact, it would be easier to prove), then you may start to see some justice. But you know, Barack Obama dropped the ball. It’s very simple. [18:00]
JIM: A final question. You've been a critic of the Volcker rule, even though Paul Volcker was a friend of your father’s and family. You don’t think it does what it’s supposed to do. [18:13]
CHRIS: No, the Volcker rule is bizarre, Jim. I mean think about it. What happened in the subprime crisis? We had bad securities, we had bad loan underwriting that went into those securities, right? Did prop trading cause any failures? No. And the Volcker rule is primarily focused on shutting down own-account trading by banks.
But what are the side effects is that you know, in my market for example, big banks own the securities issued by little banks. The chief investment officer at JP Morgan is one of the biggest investors in small bank securities. He’s not allowed to trade around his position anymore; they’ve had to fire all those people. You've probably been reading about the whale trade in London. That guy works for the same group, he’s probably going to be let go because of the Volcker rule. So what’s happened is you've had a decline of maybe a third of the securities, of the liquidity for small banks and regional banks because of the Volcker rule.
Is this what Chairman Volcker intended? I doubt it, but I don’t think anybody thought it through.
You know, you've got to always remember in a democracy we always do the wrong thing, and so, you know, we had a problem with securities fraud, we had a problem with lending and bad underwriting, so we come back with consumer protection, right, foreclosure abuse, neither one of which are significant compared to the fraud, and we have the Volcker rule, which is almost a Calvinist punishment for big banks: You can’t trade your own account.
But what did that have to do with the crisis? Nothing. But this is what we do in a democracy; we always do the wrong thing first. And my hope is that after the election, we’re going to come back and look at this again, hopefully revise some of these laws which were pushed by the Democrats by and large.
And you know what, they’re crushing real estate lending, they’re crushing other aspects of credit creation in this economy. And when we don’t have any job growth this year and the year after, maybe we’ll think about this again. We’ll come back and we’ll fix it because the current Dodd-Frank act and Basel III and all the rest of it is going to kill us. You’re going to see home prices going down more next year and there maybe people who get angry.
Unfortunately, that’s the way our system is set up. We have to wait until the pain level gets so intense that you start to see change in Washington. We're still not there yet believe it or not, after five years of this. [20:29]
JIM: Chris, I mean the very issues you and I have been discussing here, for the average investor out there who probably doesn't understand the implications of what’s going on here the way that you have explained them, is it going to take somebody a little bit more sophisticated — an attorney general who wants to make a name for himself — who goes after this and starts cleaning this up. [20:49]
CHRIS: Well, I think so. You know, unfortunately, we've got the third string on the field today. If you look at the people that have guided the country through the Great Depression and you know, Jesse Jones and some of those great figures who literally restructured the US economy, we don’t have people of that caliber on the case right now. Look at Tim Geithner; he has no banking skills whatsoever. He has got two festering situations, Allied Financial probably the most significant. You could see a bankruptcy for Allied before the election. So what do you think that’s going to do?
The other fascinating thing is the credit union industry. The administration, the Fed are all hiding the problems in the credit union sector; they don’t want anybody to know about it. They’ve been actually stuffing the paper in the Fed in New York. So you know, these things are going to fester and they are going to blow up.
And the ability of the third string to hide these problems, you know, remember AIG, nobody thought that was going to blow up. So I suspect we're going to see another systemic event soon. And the definition of a systemic crisis is something that surprises the market. So to the extent the market thinks we’re done with all the bad stuff in the banks and the financial markets, when we surprise them and tell them, no, we're not done, and we have to restructure a couple of good-sized bank holding companies, then I think people are going to start to question why we have the current leadership. And you know, to your question, maybe we need different leadership. [22:13]
JIM: All right. Well, listen, Chris, I know you have a busy schedule. I want to thank you for joining us on the Financial Sense Newshour. And for our listeners, I highly recommend you read Chris’s book called Inflated: How Money And Debt Built the American Dream.
We've been speaking with Chris Whalen senior managing director at Tangent Capital.
Chris, thanks for joining us on the program.
CHRIS: Thanks a lot, Jim. [22:34]
In a riveting interview on the banking industry, Christopher Whalen of Tangent Capital Partners in New York joins Jim on Financial Sense Newshour to discuss the fallacy of "too big to fail," conflicts of interest in the derivatives markets, problems with the 2005 bankruptcy laws, and why politicians let MF Global investors get taken.