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business newsToo Big to Fail System: On Its Way Out?
By
Professor Pinch
Nov 07, 2011 9:50 am
The current mood of distrust could signal the end of complex global arrangements.
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For the past few months while the Occupy Wall Street protests have gone on, one thing has been a clear theme in the movement: Corporate greed needs to be held in check, and with that, the greed of people at the top needs to be stopped. Stories of MF Global (MF) CEO Jon Corzine's $12.5 million severance package only seemed to heighten this demand as the company lays in shambles, along with the many people who worked at the firm doing the grunt work of clearing and settling trades, dealing with the firm's customers, and, in general, doing the actual work of a broker-dealer.
And as the firm went into bankruptcy, the questions started surfacing: Who would be next? Is MF Global the proverbial “canary in the coal mine”? Important questions, for sure. Because in an interconnected, multinational financial system, one firm's problem can quickly set off a domino-like chain reaction of margin calls, forced liquidations, and a systemic draining of liquidity from markets.
And that liquidity drain happens more swiftly and acutely now than before. Why? Because when a system has significant concentrations of assets spread across a relatively small number of counterparties and is tightly interwoven, actions and reactions happen swiftly and very violently. This isn't your parents' or grandparents' banking system anymore. A recent excerpt from Michael Mayo's forthcoming book puts it succinctly:
Mergers, cost cuts, and then additional leverage to boost balance sheets, returns on equity, and executive compensation -- this is a paradigm that has been at least 20 years in the making. While the law Mayo references was passed in 1994, the push to allow for consolidation had been happening for a while before that. It was argued we needed consolidation in financial services because the Europeans were doing it, the Japanese were doing it, and if we were going to compete we needed to follow them down the Primrose Path. And so we did.
So where has that gotten us? Well, besides the fall of '08 where we sat and watched aghast as it looked like the entire system was collapsing on itself, there was also the consolidation of the system that followed. A pile of wreckage built upon a mountain of detritus composed of a mishmash of synthetic assets that all derive their returns from some correlation to a relatively small pool of cash-based products. Regardless, it has now left us with a system that has people protesting against it.
So what does this system look like, which has so many people raging against the machine? A recent article from the New Scientist highlights a research paper from Stefania Vitali, James B. Glattfelder, and Stefano Battiston that looked at the architecture of the ownership network in the global economy and shows us exactly who these entities are. It's quite an elaborate network, and the analysis done is very thorough.
As for the result, it's hardly surprising. Almost all of the top 50 entities are in financial services. No software, no telecom, no manufacturing, and no retailers (although Walton Enterprises LLC manages investments on behalf of the Walton family). Some of them are insurance companies, some are asset managers, and a number of them are in fact banks:
Wait, this can't be right. Why isn't Goldman Sachs (GS) at the top of the list?! Sorry, but empirical analysis' job isn't to confirm our suspicions and conspiracy theories; its job is to get us closer to the truth. But in looking at the list, I wasn't all that surprised. As the former NFL coach and one-time poet Denny Green would say, “They were who we thought they were!” But it's kind of a testament to the complexity in our economic ecosystem that we had to resort to discussions of network topology; loosely connected, tightly connected, and superconnected nodes; and bow-tie statistics to simply confirm what a lot of people already knew. This network topology graphic came out of the paper and illustrates the top 50 in red. Very pretty to look at. But still, how much can you trust a system that is this concentrated? This interwoven? This complex?
And not to be outdone, the Financial Stability Board came up with its list of the 29 “global systemically important financial institutions.” From the New York Times:
Again, they were who we thought they were. This is the “too big to fail” list, which means that until it becomes too onerous for these institutions to carry on at their present size or composition, these are the ones who will be bailed out. Because regardless of what rules are on the books, government officials and regulators won't leave things to chance when it comes to handling these behemoths. It's too risky.
But going back to the paper by Vitali, Glattfelder, and Battiston, there was one observation I heard and I don't think it's a trivial one. Number 44 on the list is the Deposit Insurance Corporation of Japan. That's the Japanese equivalent of our FDIC; a government body is on this list. How hard-wired and incestuous is the relationship between big business and big government when you see this? Think about that for a moment. This is why they protest. This is why people are frustrated. This is what must end.
And yet, when we look at Greece and the European debt crisis, we see more of the same. Debt stacked upon debt, wrapped in a breading that is a blend of a complexity rye and largesse pumpernickel. Austerity for the citizens in order to save the bondholders. But the fact is, the program hasn't worked because Greece has missed GDP targets, deficits have continued to rise, and social unrest has become the order of the day. And there's only so much more of this International Monetary Fund-endorsed sandwich the Greek populace is willing to choke down. I have a very colorful name for such a sandwich, but I'll let you dear readers figure out what that name is.
The fact is, ever since markets realized there was a debt issue in Greece, we have heard myriad plans, schemes, and concoctions, but none of them seem to be workable solutions as far as the markets are concerned. A default seems inevitable now because I don't think the Greeks, the Italians, or the Irish will take another year of more of the same. Because conditions will just keep deteriorating from here if they do. And there's nobody around to help leverage the European Financial Stability Facility.
A default is definitely simpler than all of that. All of these complicated plans aren't addressing the real issues; they're just trying to buy time. And with each new agreement, each new commitment, the amount of time being bought keeps getting smaller. And soon, there won't be any time to buy.
The bull market on large complicated systems and entities is over. We don't trust them; we don't think they work. And a new bull market in simplicity is on the horizon.
Follow the markets all day every day with a FREE 14 day trial to Buzz & Banter. Over 30 professional traders share their ideas in real-time. Learn more.
And as the firm went into bankruptcy, the questions started surfacing: Who would be next? Is MF Global the proverbial “canary in the coal mine”? Important questions, for sure. Because in an interconnected, multinational financial system, one firm's problem can quickly set off a domino-like chain reaction of margin calls, forced liquidations, and a systemic draining of liquidity from markets.
And that liquidity drain happens more swiftly and acutely now than before. Why? Because when a system has significant concentrations of assets spread across a relatively small number of counterparties and is tightly interwoven, actions and reactions happen swiftly and very violently. This isn't your parents' or grandparents' banking system anymore. A recent excerpt from Michael Mayo's forthcoming book puts it succinctly:
Five years after the interstate banking law of 1994, which allowed banks to operate across state lines, the easy gains from consolidation were over. When banks couldn't maintain their growth momentum through mergers and cost cuts, they took the next logical step -- they made more consumer loans. Logic dictated that this meant the quality of those loans would probably decrease, and, in turn, create a greater risk that some of them would result in losses. At the same time, executive pay was soaring, aided by stock options, which can encourage executives to take on greater risk.
Mergers, cost cuts, and then additional leverage to boost balance sheets, returns on equity, and executive compensation -- this is a paradigm that has been at least 20 years in the making. While the law Mayo references was passed in 1994, the push to allow for consolidation had been happening for a while before that. It was argued we needed consolidation in financial services because the Europeans were doing it, the Japanese were doing it, and if we were going to compete we needed to follow them down the Primrose Path. And so we did.
So where has that gotten us? Well, besides the fall of '08 where we sat and watched aghast as it looked like the entire system was collapsing on itself, there was also the consolidation of the system that followed. A pile of wreckage built upon a mountain of detritus composed of a mishmash of synthetic assets that all derive their returns from some correlation to a relatively small pool of cash-based products. Regardless, it has now left us with a system that has people protesting against it.
So what does this system look like, which has so many people raging against the machine? A recent article from the New Scientist highlights a research paper from Stefania Vitali, James B. Glattfelder, and Stefano Battiston that looked at the architecture of the ownership network in the global economy and shows us exactly who these entities are. It's quite an elaborate network, and the analysis done is very thorough.
As for the result, it's hardly surprising. Almost all of the top 50 entities are in financial services. No software, no telecom, no manufacturing, and no retailers (although Walton Enterprises LLC manages investments on behalf of the Walton family). Some of them are insurance companies, some are asset managers, and a number of them are in fact banks:
Wait, this can't be right. Why isn't Goldman Sachs (GS) at the top of the list?! Sorry, but empirical analysis' job isn't to confirm our suspicions and conspiracy theories; its job is to get us closer to the truth. But in looking at the list, I wasn't all that surprised. As the former NFL coach and one-time poet Denny Green would say, “They were who we thought they were!” But it's kind of a testament to the complexity in our economic ecosystem that we had to resort to discussions of network topology; loosely connected, tightly connected, and superconnected nodes; and bow-tie statistics to simply confirm what a lot of people already knew. This network topology graphic came out of the paper and illustrates the top 50 in red. Very pretty to look at. But still, how much can you trust a system that is this concentrated? This interwoven? This complex?
And not to be outdone, the Financial Stability Board came up with its list of the 29 “global systemically important financial institutions.” From the New York Times:
Following are the 29 global systemically important financial institutions identified by the board: Bank of America, Bank of China, Bank of New York Mellon, Banque Populaire, Barclays, BNP Paribas, Citigroup, Commerzbank, Crédit Agricole, Credit Suisse, Deutsche Bank, Dexia, Goldman Sachs, HSBC, ING Bank, JPMorgan Chase, Lloyds Banking Group, Mitsubishi UFJ, Mizuho, Morgan Stanley, Nordea, Royal Bank of Scotland, Santander, Société Générale, State Street, Sumitomo Mitsui, UBS, Unicredit Group and Wells Fargo.
Again, they were who we thought they were. This is the “too big to fail” list, which means that until it becomes too onerous for these institutions to carry on at their present size or composition, these are the ones who will be bailed out. Because regardless of what rules are on the books, government officials and regulators won't leave things to chance when it comes to handling these behemoths. It's too risky.
But going back to the paper by Vitali, Glattfelder, and Battiston, there was one observation I heard and I don't think it's a trivial one. Number 44 on the list is the Deposit Insurance Corporation of Japan. That's the Japanese equivalent of our FDIC; a government body is on this list. How hard-wired and incestuous is the relationship between big business and big government when you see this? Think about that for a moment. This is why they protest. This is why people are frustrated. This is what must end.
And yet, when we look at Greece and the European debt crisis, we see more of the same. Debt stacked upon debt, wrapped in a breading that is a blend of a complexity rye and largesse pumpernickel. Austerity for the citizens in order to save the bondholders. But the fact is, the program hasn't worked because Greece has missed GDP targets, deficits have continued to rise, and social unrest has become the order of the day. And there's only so much more of this International Monetary Fund-endorsed sandwich the Greek populace is willing to choke down. I have a very colorful name for such a sandwich, but I'll let you dear readers figure out what that name is.
The fact is, ever since markets realized there was a debt issue in Greece, we have heard myriad plans, schemes, and concoctions, but none of them seem to be workable solutions as far as the markets are concerned. A default seems inevitable now because I don't think the Greeks, the Italians, or the Irish will take another year of more of the same. Because conditions will just keep deteriorating from here if they do. And there's nobody around to help leverage the European Financial Stability Facility.
A default is definitely simpler than all of that. All of these complicated plans aren't addressing the real issues; they're just trying to buy time. And with each new agreement, each new commitment, the amount of time being bought keeps getting smaller. And soon, there won't be any time to buy.
The bull market on large complicated systems and entities is over. We don't trust them; we don't think they work. And a new bull market in simplicity is on the horizon.
Follow the markets all day every day with a FREE 14 day trial to Buzz & Banter. Over 30 professional traders share their ideas in real-time. Learn more.
No positions in stocks mentioned.
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