If you want to understand the current banking crisis, start with Philip Augar whose latest book about investment banking, Chasing Alpha, covers the crash and its causes.
Augar has a doctorate in history, although his recent books don’t mention it. As I recall from The Death of Gentlemanly Capitalism, he sort of stumbled into banking, and then thrived. He led NatWest’s global equity business and eventually became treasurer of Schroders. So he brings professional research and writing skills along with an insider’s view of the City and Wall Street to his books.
In Chasing Alpha, he depicts an England and America that had gone money mad. UK household debts soared, Americans piled into houses they couldn’t afford using subprime mortgages with cursory or no credit checks, and New York investment banks acted like giant Hoovers, sucking money out of unsupervised mortgage brokerage operations and bundling it into mortgage-backed securities that they stashed off their balance sheets in Special Investment Vehicles (SIVs) which they “insured” through credit default swaps, all approved by the credit ratings agencies. The net result was to make Bernie Madoff look like an underachiever.
The historical facts make up a critical take on banking, as he recalls city scandals such as Guinness, Blue Arrow, BCCI, Maxell and Polly Peck. Asset managers, meanwhile, seriously underperformed the FTSE. It is a highly unoriginal sin in investment banking to confuse good luck with talent, but the run of exceptionally benign market forces from 1997 to 2007, a good talent pool, and support from New Labour made the City a highly profitable place to work and led bankers to think they fully deserved their stratospheric pay.
In 1996, Gordon Brown pushed back against Tony Blair’s idea to promote a stakeholder economy, as promoted by The Guardian’s Will Hutton. Blair told an audience in Singapore: “It is surely time to assess how we shift the emphasis in corporate ethos from the company being a mere vehicle for the capital market to be traded, bought and sold as a commodity, towards a vision of the company as a community or partnership in which each employee has a stake.” Brown poured cold water on the notion and New Labour went with the shareholder view, the view which GE’s ex CEO Jack Welch recently derided in a statement to the FT: “On the face of it, shareholder value is the dumbest idea in the world,” he declared to a stunned world.”
Something of a missed opportunity there, perhaps one to revisit in determined next moves in governing the economy.
This wide-ranging account includes a reasoned discussion of private equity and concludes that it plays a relatively small, and relatively benign role in the economy. Here I think he is too kind. Businessweek did a piece on the way private equity firms strangled a regional US chain, Mervyns by stripping its assets, sucking out $400 million in cash, renting back the real estate at high rents, and putting 30,000 people out of work, many with no severance and unpaid vacation time. (Admittedly this is partly the result of horribly inadequate labour laws in the US)
He cites Gordon Brown’s Mansion House speech in June 2007, just before becoming Prime Minister, and its by now well known praise for The City. (London has enjoyed one it its most successful years ever, for which I congratulate all of you here on your leadership skills and entrepreneurship” was just part of it). The larger point he makes, one also made by BBC reporter Robert Peston in “Who Runs Britain”, is that New Labour bowed before The City – or at least it did once Brown persuaded Blair that the Stakeholder route would not work.
At the same Mansion House event, Bank of England Governor Mervyn King noted that excessive leverage is the common theme of past financial crises. “Are we really so much cleverer than the financiers of the past?” he asked.
Augar notes the leverage used by investment banks
Goldman Sachs 24:1
Morgan Stanley 25:1
Bear Stearns 33:1
This is the sort of leverage more commonly associated with hedge funds than banks.
Great while the market was going up, but when the market turned, it moved fast. In October 2007 Stan O’Neal left Merrill, Chuck Prince at Citi followed in November, and in January Jimmy Cayne was gone from Bear Stearns. Over the same period England was creating and expanding rescue packages for its banks.
The failure was system-wide, Augar concludes. Could the CEO of HBOS have announced that everyone else was wrong and he was scaling back? As at least one senior executive has told journalists, if he had cut back on the leverage he would have been replaced.
While Chasing Alpha has the value and shortcomings of a book produced as the crisis moved along (Augar notes that Sir Fred Goodwin left RBS with no leaving package; apparently his pension hadn’t hit the papers at the time of publication) my favorite of his books is The Greed Merchants, which came out in 2005.
Here he notes the incredible growth in profitability in the securities industry from 1973 to 2000, four times the growth of corporate profits.
It became accepted practice for employees to take half the revenues of firms which had gone public.
Augar is the only analyst I have read who offers an industry wide view on the reason – he says the securities business is a cartel with a few players who maintain oligopolistic pricing (IPOs fees in the US have stayed at 7 percent persistently) and the high payouts are a way to mask the huge profitability of the firms. (They are almost immune to business-changing lawsuits because all the firms with the depth to handle such a lawsuit work for the Wall Street firms).
The financiers are among the leading political donors, and the political leaders on both sides of the Atlantic feared to annoy the bankers.
“Washington and Westminster had so much riding on Wall Street and the City that they could not and cannot afford to upset them.”
Investment banks concentrate power and knowledge through an integrated model of trading, sales, research and corporate banking. Augar says the largest banks know more about the world’s economy than any other organizations, because they are plugged into the markets for equities, bonds and commodities and talk constantly with leaders of the largest corporations – just 200 CEOs are regular users of investment banking services and the total number of clients globally, if you include occasional users, is no more than 1,000, he says.
Perhaps most damning is Augar’s conclusion that the US-UK investment banking model is actually bad for the economy. The banks enabled the waves of corporate corruption, such as Enron and Worldcom, in two decades they took more than $150 billion out of capital markets through abnormally high compensation, an amount that could certainly help plug the pension deficits in the two countries, and they have promoted mergers which made sense only in accounting rules while destroying value.
His conclusions? The integrated model has to be broken up – that’s the only way to alleviate the inherent conflict of interest between advising clients and making a proprietary profit on trading. Second, advising clients and then profiting from the mergers and acquisitions leads to conflicts for both banks and CEOs.
CEOs of companies are no match for fast-talking bankers, he says, and the bankers were able to dangle life-changing rewards in front of them in return for deals that actually destroyed value.
Advice should come from fee-charging advisory firms which do not handle deals. Deposit taking institutions should be separated from securities trading, and lending banks should keep the risk on their balance sheets, although he doesn’t specify whether this means keeping the entire loan. Investment banks would become providers of liquidity as pure trading houses.
This might lead to less liquidity and an increase in the cost of capital, although that isn’t certain, he adds, but such as system would be transparent and free of conflict of interest.
“Tinkering with the rules did not work in 2003 and it is doubtful it will make a lasting difference in 2009. Unfortunately, more tinkering is exactly what is being discussed at the time of writing.”
His first book on the City, “The End of Gentlemanly Capitalism,” showed the way clubby and somewhat outdated City firms were taken over by Americans, Swiss and German banks. The Americans in particular brought highly professional management, meritocracy in hiring and promoting, the ability to cross-subsidise London from New York, plus, of course, and the ungodly habit of working through lunch. (It too is an excellent book and easy to read).
All three books are valuable for understanding how we got to this point and where we can go from here. Augar has appeared more recently in the Financial Times where he had a recent article saying “It is time to put finance back in its box.”
“Unless governments in America and Britain really open themselves up to new ideas, emerging economies in Asia and mainland Europe, places where alternative economic and corporate governance models do exist, will seize the initiative and redefine the global agenda.”
He told Joe Nocera of the New York Times that
…he believes that the regulatory environment helped bring about the “Americanization” of the City of London, and that it was ultimately ruinous. All the big American investment banks raced to London — which they saw as a place to do business not just in Britain but all over the Continent. After the abolition of Glass-Steagall, the commercial banks came roaring in as well.
“Gordon Brown instituted a lot of pro-City policies,” Mr. Augar said. “He cut the capital gains tax. He combined about nine different regulators into the F.S.A.” — the Financial Services Authority — “which adopted something it called ‘proportional regulation.’ ” Mr. Brown himself had a more apt phrase: “light touch regulation,” he called it. In other words, he consciously aligned regulation in Britain with the free-market, deregulatory approach being promoted by Mr. Greenspan and Mr. Rubin.
Nocera, after a quick tour of London talking to finance experts, concludes that Britain faces a bigger problem than the US because financial services has been such a large part of the national economy.
“The country is drowning in debt. Mr. Brown’s Labor government is running large deficits in an effort to stimulate the economy.
“If that, too, sounds like the response of the Obama administration to the financial crisis, it is indeed quite similar. Here’s the big difference. New York is a big city in a big country, and our national banks, as big as they are, are much smaller as a percentage of gross domestic product. London is a big city in a small country, and during the bubble, its banks became truly immense, outsize really, given the size of the country they operated in.”
But Britain can’t regulate alone, he adds.
“…although no one will say this out loud, Britain can’t regulate unilaterally anymore — it is simply too dependent on American institutions. Its regulatory response will be to mimic whatever the Obama administration decides to do.
Nocera also caught up with Martin Wolf the Financial Times who told him “If regulation is transformed in London it is because of what the U.S. does,.The U.S. will say, ‘You are to follow us.’ We now have no regulatory autonomy.”
Are political leaders in the US, UK or Europe up to the challenge? I doubt it.