http://www.financialsense.com/financial-sense-newshour/guest-expert/2012/04/20/chris-whalen/fallacy-of-too-big-to-fail-why-big-banks-will-eventually-break-up
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
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.
Transcript
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]
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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]
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