James Saft

The battle between the banks and nation states is shaping up as something that lies between a phony war and a rout.

The bald facts are that three years after the crisis in which banking almost brought down the global economy, the biggest banks are bigger, more global and more entrenched in their positions courtesy of a now all-but-explicit government guarantee.

All three factors make large banks harder for individual nations to control, even the U.S., and even if the U.S. manifested the desire to pull out of its heads-you-win-tails-we-lose bargain.

“Too big to fail (banks) really creates a capture problem … They are now larger than single nations,” Andrew Sheng, chief adviser to the China Banking Regulatory Commission said on Saturday at a conference at Bretton Woods sponsored by the Institute for New Economic Thinking.

“The top 25 banks comprise 73 of global GDP and 45 percent of total assets of the banking system … They are so powerful they are essentially Godzillas.”

Sheng argues, rightly, that the creation of momentum upwards in asset prices by financial engineering combines dangerously with lax and co-opted regulation and an incentive scheme at banks that encourages risk taking.

The result: repeated and ever-larger crises that begin in the banking system but the costs of which are borne by taxpayers.

The global nature of banking makes single-nation regulation largely impotent. The Dodd-Frank legislation recently enacted has a resolution program that, though intended to combat the risks of a large bank failing, can do very little due to the global nature of such institutions’ assets, liabilities and networks.

Even if this starts as a regulatory problem, it almost inevitably ends as a political one, as a glance at Iceland shows. Voters in Iceland rejected by a 59-41 percent vote an accord that would have allowed for the repayment of $5 billion to Britain and the Netherlands, the second time voters have refused to pay to make good the debts of their formerly out-sized banking system.

Iceland, you will remember, was the host nation to a group of global banks which borrowed and lent unwisely and when they collapsed left the nation of 320,000 with a staggering liability.

The most recent “No” may be foolish, as it will shut Iceland out of international capital markets and may be reversed by international courts anyway, but it is a good example of how people react to debts which may be legal but are certainly not just.

The mechanics and merits of Iceland’s situation are not fundamentally different from those of the U.S. or Britain; the chief difference is scale.

CAN GOLDMAN FAIL?
As the scale of losses rises, it is possible that the politics of TBTF banks change in the world outside of Iceland, but it looks as if that will wait until a further crisis breaks.

For now banks have bested the nation states. Compared to 2007 there exists the same incentives to take risks, largely, while the funding and trading positions of the largest banks are, relative to their smaller peers, now better because the world has had an object lesson in their special government guaranteed status.

Simon Johnson, the MIT professor and former chief economist at the IMF, conducted a thought experiment with the audience at the Bretton Woods conference, asking who believed that Goldman Sachs would be allowed to fail if, for whatever reason, it found itself on the brink.

No one, it appeared, in the audience thought Goldman would be allowed to follow Lehman Brothers into history, and Johnson reports that having tried that question on several audiences he has thus far only found one person who does, an evidently somewhat overenthusiastic Goldman short seller in New York.

Of course Goldman cannot be allowed to fail, at least in their current form and in the current state of play.

Of the ideas for righting this few have much chance of working, and those have little chance of coming to reality. Higher capital, especially on a sliding scale linked to size, might work, but at levels perhaps well above those currently being debated.

Resolution authorities would have to be international, making an agreement out of reach for the foreseeable future. The same can probably be said of a financial transactions tax, which again would only truly be effective if global.

That is even before we consider the fact that both regulators and elites in much of the world have largely been captured by finance. Where do you think people go to work when their days as public servants are through?

So, it is on to the next banking crisis. Whenever it sees fit to come it will be larger and may finally make the rest of the world a bit more like Iceland.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. Email: jamessaft@jamessaft.com)

One of the best things about Davos is the conversations you overhear. It's like no place else.

Sitting minding my own business, typing away I became aware of a central banker from a medium sized emerging market sitting nearby. He was joined by a gentleman from a bank in his home country. After a few muffled preliminaries the central banks said:

"So, how much trouble are you in?"

The banker responded in what sounded like soothing tones but I couldn't make out exactly what he was saying. The only other line that came through clearly was that after a long speech the banker said to the central banker, with an air of exasperation.:

"The prices are very low, but there are no buyers!"

That's it, in a nutshell.

Was letting Lehman go down the biggest mistake of the crisis? Many, including George Soros in the Financial Times, have argued that letting Lehman go down sowed panic to markets, consumers and businesses.

Not so fast, says Harvard historian Niall Ferguson, in an interview in Davos:

"My position is this is a typical error of historical understanding in which a single event is blamed for much more than it can possibly have caused. You can say ‘Hank Paulson is to blame for my troubles' and if you can change one thing in the story it would have a happy ending.

It's like saying if only Princip had not shot the Archduke Franz Ferdinand in 1914 there wouldn't have been a First World War.

If you go through the events of September of last year you will find it incredibly hard to produce a counterfactual scenario in which it could have been possible to save both Merrill Lynch and Lehman. There is one bank which could be bought by Bank of America but there couldn't have been two.

This is a crisis of too much bank leverage which began in August of 2007 and indeed had it roots far before. A bank leveraged 25-1 only needs a 4 percent decline in their assets to have their equity wiped out. And the notion that saving one investment bank could somehow have prevented or mitigated the crisis is a fantasy. The problem would have happened at some point somewhere else. There is a fundamental problem of bank solvency."

Ferguson argues that without another buyer for one of the two, one would have needed to have been taken into a kind of Treasury conservatorship, as Fannie Mae and Freddie Mac were. But those were already quasi-government and such a move would have required Congressional approval, which given that Congress turned down the first version of the TARP, was not likely.

"Historical arguments need to be based on a credible counterfactual, " Ferguson said. "Nobody has been able to tell me a credible story about how both Lehman and Merrill could have been saved. It wasn't possible."

My view is that the "Oh no, they killed Lehman" meme is just part of the denial phase of grieving. Few in financial circles wanted, or indeed want, to believe that things have changed fundamentally and that the good days won't be coming back any time soon. Blaming mom and dad is the last first refuge of the adolescent.

Jim Saft is a Reuters columnist. Any views expressed are his own.

Stephen Roach of Morgan Stanley, who pretty much called it at last year’s Davos, when consensus was for no recession in the “real” economy and decoupling of emerging markets, is gloomy again. Speaking with him this morning after he did an interview with Reuters on Davos Today, Roach said that there was a real threat of protectionism as politicians come under pressure from rising unemployment. The U.S. and China relationship will be key, he said.

On U.S. real estate – a continuing issue for banks and the economy:

“The interplay between the property and financial sectors has been ground zero of this crisis.

The problem was the banks played the property bubble just like consumers did and so we are all in this together.”

Not a big fan of equities, it seems:-

“Equities have pretty much discounted a dire outlook for 2009. The problem with equities as an asset class is that they are pretty much based on optimistic earning expectations for 2010 and 2011. We will challenge those expectations this year. I’d be pretty cautious before committing new funds to the equity market in this climate.

So what is Blackstone Group chairman Stephen Schwarzman’s prescription for solving the banking crisis?

More leverage and less transparency, apparently.

Schwarzman told a panel at Davos that you can’t mandate higher levels of bank capital at the same time losses are mounting and that mark-to-market accounting needed to be changed.

“You need lower capital. Do something with fair value accounting which is exacerbating things . . . We have to add more leverage to the system.” He further took issue with what he described as a “fixation on transparency” and said “We have to use regulators to schedule out losses.” By that I presume he means keep the bank on life support until they can make enough to absorb their losses. It did work in the 1990s with some prominent U.S. banks, but…

Laura Tyson, an economic advisor to the Obama administration, didn’t seem to be buying in to the more leverage less disclosure meme.

“Nobody trusts the private system, why should they trust them?” she said. She also mentioned the Swedish solution, which you may remember imposed some pretty tough conditions on bank shareholders. She said that voters would be watching who made money out of bailouts and would be concerned by “compensation and dividends.”

James Saft is a Reuters columnist. The opinions expressed are his own.

So, back we go next week to Davos for the World Economic Forum 2009, titled this year “Shaping the post-crisis world.”

Except the crisis ain’t over yet and shaping the world while it is happening is proving to be about as easy as tying your shoes while riding a bicycle.

Let’s dial back briefly to those more innocent days in 2008 and remember what was being discussed at Davos then.

Q – Will Sovereign Wealth Funds save the world financial system through equity investments? Are they a menace?

A – No, and even if they are it doesn’t much matter.

Q – Isn’t this just about a bunch of red-neck American sub-prime borrowers and the banks that were dumb enough to lend to them?

A – No and no. It is all of us, every one, and if the heart isn’t pumping sooner or later the limbs stop moving.

In fact this year’s SWFs, the people everyone wants meetings with, are just plain old governments, which are more or less the lenders of only resort and increasingly the owners of the global banking system. Think of them not as Sovereign Wealth Funds but Sovereign Debt Funds. One unofficial theme of Davos this year will be the positioning that is now madly going on by businesses which feel a new shall we say, urgency, to get close to government. Davos used to be a way for politicians to seem cool, cutting edge and productive by being seen with business people. That now would be just about reversed, but the point is no longer to seem cool but to be viable.

From that perspective Davos is arguably more relevant now, but oh lord has the balance of power changed.

Another theme, in my opinion at least, is how people are trying to position themselves for what promises to be an absolute blizzard of new regulation, on everything from how much banks can borrow to what they can pay, and to whom and how they can lend.

One person probably not coming back this year is John Thain, the now former CEO of Merrill Lynch, who left the company amid a flap over a reported $1.2 million office redecoration and the payment of billions of dollars of bonuses just before the firm was sold to Bank of America. Ironically, he was among the most downbeat about the prospects for banks last year.

Remember too that the villain last year was SocGen rogue trader Jerome Kervial, whose antics, just coming to light as Davos met, seem quaint in comparison with his 2009 counterpart Bernie Madoff. Come back Jerome, all is forgiven.

Here is the Davos pre-presser, which gives a more traditional read on the agenda.

James Saft is a Reuters columnist. The opinions expressed are his own.