The Financial Crisis (3)

Up until sometime in the 1980s, Wall Street actually provided useful services to society:

• It gathered capital and provided it, in the form of debt (bonds) and equity, to new and growing businesses.
• It allowed those who had invested in the early stages of business to reap their just rewards by underwriting Initial Public Offerings.
• It gathered capital to lend to governments at all levels
• It provided advice and valuations when companies decided to engage in mergers and acquisitions.
• It facilitated the purchase of what is effectively 'price insurance' using uncomplicated and relatively easy to understand derivatives such as futures and options.
• It allowed investors to trade their holdings.

The financial sector's role was to act as an intermediary by facilitating transactions that had real economic value. For this service, they took a modest scrape - at least by modern standards - and relatively little risk. The financial sector acted as the grease that lubricated the real economy.

In the early 1980s things changed. Salomon Brothers was only the first of the major investment banks to change from being organized as a General Partnership, where the partners were liable for all of the company's obligations - without any limit, to becoming a corporation where shareholders could lose their entire investment - but no more than that. Managers, instead of owning the entire company and being liable for all its losses, now owned only a tiny part. In addition, since they could keep much of their wealth outside of the corporation, there was a safety net. The incentive to take enormous risks was irresistible because the worst that could happen was that they lost their jobs and their unexercised stock options.

Investment banks, instead of being middlemen, saw that the big money was to be made through proprietary trading - taking a position on which way the markets would move. Then they amplified the rewards (and the losses) with vast amounts of borrowed money.

The repeal of the Glass Steagall Act of 1933, which had separated deposit taking institutions (commercial banks) from investment banks, brought another major change. Investment banks, once solely conduits for capital flows, now performed that service only as a sideline while focusing on speculation for their own accounts. Commercial banks as well as Savings and Loans, neither group known for the quality of their management, joined the mob of speculators with the advantage of an explicit government guarantee in the form of deposit insurance provided by FDIC and FSLIC.

The relationship between management, shareholders and the taxpayer, became 'heads I (management) win, tails you (shareholders and taxpayers) lose'. The inevitable result was risky and dysfunctional behavior.

In an ideal world, big banks would be allowed to fail. Since, in 2008, the expected effects of major bank failures on the real economy of goods and services were so dire, the government - not unreasonably - felt that it had to intervene. The Wall Street bail out pleased few but arguably saved us from a catastrophic economic meltdown.

While your correspondent is reluctant to see another expansion of government power, a very good argument can be made that President Obama should act in the same sort of manner that President Theodore Roosevelt - a former Republican President of whom he thinks highly - did with respect to the industrial trusts. Break up the financial institutions that are too big to fail because too big to fail simply means too big.

Period.

Then provide suitable penalties for those that remain organized as corporations and certain benefits for those that are organized as General Partnerships. Couple that with a very modest limit on total compensation ($250,000 say) for those who are not Partners so free rides (heads I win, tails you lose) are no longer part of the game.

Let the senior executives put all of their net worth - and more - on the line and see whether they continue to take outrageous risks. If they do that, then there are no limits to how much they can make but, perhaps, the financial sector will return to its roots as a net contributor to society and our economy.