……came out yesterday. Klein gives the crux of the findings:
The Financial Crisis Inquiry Commission has released its final report, which looks to “determine what happened and how it happened so that we could understand why it happened.” The full document — including the dissents from four of the Republicans on the panel — can be downloaded here. The transcripts of the hearings the committee conducted can be found here. If the thousands of pages in those two links seem like a bit much to you, the FCIC’s conclusions are here (pdf). This, I think, is the key takeaway:
We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essential to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us.
Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs. The tragedy was that they were ignored or discounted. There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregulated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner.
The prime example is the Federal Reserve’s pivotal failure to stem the low of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: Financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines?
We have the full doc up on Scribd. Unfortunately, Tumblr is jacked up right now, we can’t do direct coding and put it on the post as we usually do. Once it’s back to normal, we’ll add. It’s a beast. 700+ pgs. But they 19 days of hearings, thousands of pages of subpoena’d docs. Remarkable effort. Worth your time to at least glance over.
#GREATMOMENTSINBANKINGHISTORY #theyarewhowethoughttheywere #50hotones #godswork
This being Christmas (at least for those who didn’t get coal in their stockings), it seemed like a fine time to revisit the leverage debate. We here at The Scrambler thought this was just the moment to return to our occasional series/tongue in cheek hashtag, GREAT MOMENTS IN BANKING HISTORY.
The Baseline Scenario had a great piece a little while back by Anat Admati (she teaches Finance I, among other things at the Stanford GSB). She responds to a long NYTMag article on Jamie Dimon and his assertion that JPMorgan should continue to grow. She also dismantles the larger issue of the cost of capital for the street. It’s riveting. Basically, her argument is that debt financing has made it too cheap for the banks to operate (ie, they don’t fully internalize their costs to society and risk to investors alike due to their heavy reliance on leverage/debt financing). If they moved more towards equity, we’d all be better off (or at least, less likely to suffer another cataclysmic meltdown). Excerpt from the piece below. Click the link here for the full Baseline Scenario. Her article is based on a longer working paper put out last October (the full paper is Scribd below). Print this one out and enjoy with your lunch. If you took a low blow (or some long-dated shares) last week, you could use it to wipe away your tears. But it’s really fascinating. Read it before turning it into Kleenex…
What Jamie Dimon Won’t Tell You: His Big Bank Would Be Dangerously Leveraged
By Anat Admati, Professor of Finance and Economics at Stanford Graduate School of Business. To see her explain these issues in person, watch this Bloomberg interview. This is a long post, about 3,500 words.
The debate is raging about banks and their size, financial regulation, and the international capital standards known as “Basel”. Jamie Dimon of JP Morgan Chase, in his New York Times magazine profile, expresses admiration for the Basel committee and says,
“… they are asking the questions that, in theory, bankers ask of themselves: how much capital do banks need to withstand the inevitable downturn, and what is an acceptable level of risk?”
There is one problem, however. Basel may have asked the right question, but it did not come up with the right answers, mainly because it allows banks to remain dangerously leveraged, setting equity requirements way too low. This fact is not understood because the debate on capital regulation has been mired with a cloud of confusion, and filled with un-substantiated assertions by bankers and others. As a result, the issues appear much more mysterious and complicated than they actually are.
After a massive and incredibly costly financial crisis, we seem to have financial system that is a more consolidated, more powerful, more profitable and, yes, as fragile and dangerous as we had before the crisis. How did this happen and what can we do?
Here are some questions on which the confusion is staggering.
(i) Is “too big” the same as “too big to fail?”
(ii) Do capital requirements force banks to “set capital aside for a rainy day” and not use it to help the economy grow?
(iii) Are banks different than non-banks in that high leverage is essential to banks’ ability to function?
(iv) Would terrible things happen if capital requirements were to increase dramatically?
The first order of business is to clear the fog and focus on the right things. I will try to explain. With the basics in place, answers will begin to emerge, or at least the right questions to ask.
By the way, I answer an emphatic NO to each of the above questions.
I’ve been wanting to get this up all day.
First, here’s to all of God’s workers. You know who you are. Your just reward awaits.
Contrary to appearances, I’m not obsessed with Goldman Sachs, and this will be my last post on the subject for a while. But the Wall Street firm issued its latest profit report today, and I thought it would be interesting to compare its results to those of Apple, another iconic American business, which yesterday published its own profit figures.
Many people are put off by financial accounts, but they provide an invaluable window into what is really going on in a given corporation, and to how much it is contributing to society. I may be weird, but sometimes I actually like poking around in 10-Qs, 8-Ks, and other disclosure forms that public companies have to file with the Securities and Exchange Commission. One word of warning, though. What follows should be considered a process of me thinking out loud, and pointing out some things that strike me, rather than reaching any definitive conclusions.
As everybody knows, Goldman and Apple are both making tons of money (although Goldman’s latest results disappointed investors somewhat). In the final quarter of 2010, the bank generated net profits of $2.39 billion on revenues of $8.64 billion. Apple, which has a much bigger turnover, made profits of $6 billion on revenues of $26.4 billion.
On Wall Street and in the computer industry, quarterly profits tend to bounce around a bit, so it is perhaps more illuminating to look at the entirety of 2010. With Goldman, whose fiscal year follows the calendar, this is easy. In the past twelve months, Goldman recorded net profits of $8.35 billion on revenues of $39.16 billion. Apple’s financial year ends in September, but by combining the results from its first fiscal quarter of 2011, which has just ended, and the final three quarters of 2010, I came up with the following figures. Apple made $17.63 billion on revenues of $76.28 billion.
On the face of it, the two firms’ profit margins seem pretty similar. For every dollar of revenue it generates, Goldman makes a profit of about twenty-one cents; Apple makes about twenty-three cents. But that is where the comparisons end. From an economic perspective, the real measure of a business is the return it generates on the capital it employs, which could be used in alternative projects. By this metric, Apple leaves Goldman far behind.
One popular measure of capital is “shareholders’ equity,” which consists largely of money invested in the firm and retained earnings. Wall Street analysts tend to fixate on return on equity (ROE), but it can be a misleading, especially when applied blindly to financial institutions. In good times, banks can increase their ROE simply by taking on more leverage (borrowing). Until the fall of 2008, this was precisely the strategy that Goldman and its rivals pursued: in the boom years, Goldman often generated a return on ROE of more than twenty per cent, but this wasn’t sustainable. When the credit bubble burst, high levels of leverage destroyed some banks and forced others into the arms of the government. In effect if not intention, the banks had been creating fictitious profits, much of which ultimately ended up as losses.
During the past couple of years, the banks, Goldman included, have cut their leverage ratios sharply, partly by issuing more equity to shareholders, partly by selling assets and paying down debts. As a result, we now have a more realistic estimate of their earnings power. Despite its return to profitability in 2009 and 2010, Goldman’s ROE last year was just 11.5 per cent. Apple, by contrast, generated a ROE of about thirty-two per cent in 2010, almost three times the Goldman figure.
Another way to gauge a firm’s performance is to take everything it possesses—its buildings, its machinery and other equipment, its product designs, and its financial holdings—and look at how much profit it generates for each dollar of assets on its books. In my opinion, this measure, which is known as return on assets (ROA), is the best way to judge a business, because it excludes the amplifying effect of leverage. Now let’s apply it to Goldman and Apple.
According to its latest filing with the S.E.C., Goldman ended 2010 with assets of $911 billion, which means its ROA for the year was roughly .91 per cent. (Yes, that is less than one per cent.) Apple ended 2010 with total assets of $86.7 billion, which means it generated an ROA of about 20.3 per cent.
To summarize: Apple isn’t merely generating a higher return on the capital it employs than Goldman; it is more than twenty times as profitable! How can this be?
Part of the answer is an accounting foible. Unlike some corporations, Apple doesn’t record on its balance sheet much of the value of its patents and other intellectual property—the look and feel of the iPad, for example. If it did this, the figure for total assets recorded on its books would be considerably higher, and its ROA would be lower. But accounting is only a small part of the story. (As far as I know, Goldman doesn’t capitalize its intellectual capital, such as it is, either.)
The main reason why Apple is so much more profitable than Goldman is a reassuring one. It makes tangible things—iMacs, iPhones, iPads—that millions of people want to buy, and for which they are willing to pay a premium price. (I am writing this post on an iMac.) Despite operating in a highly competitive industry, Steve Jobs’s firm has successfully differentiated its product line to such an extent that it now has considerable monopoly power: it can charge considerably more for its gizmos that they cost to manufacture.
Goldman, for all its reputation and smarts, has no such franchise. It does some things that its clients value and are willing to pay for—making markets, raising capital, providing investment advice, hedging risky positions—but rival banks, such as JPMorgan Chase and Morgan Stanley, provide practically the same suite of services, and pricing power is limited. (Not limited enough in some areas, such as I.P.O.s.) The only way Goldman (or any other investment bank) can increase its profit margins in a big way is to leverage up its balance sheet and live by its wits in the financial markets. But when banks all try this together, the consequences are usually disastrous.
Another thing that differentiates Goldman from Apple is how much it pays its employees. In 2010, Goldman’s 35,700 employees took home an average of $430,700. Apple doesn’t publish much information about its labor costs. According to the jobs Web site Simply Hired, the average salary at Apple is $46,000. Another Web site, Salary List, quotes a substantially higher figure—$107,719—but that doesn’t appear to include people working at Apple’s more than three hundred retail stores. Whichever number is more accurate, the basic message is the same. Apple employees earn a lot less than their counterparts at Goldman despite the fact they generate a much higher return—private and social—on the capital they use.