The Bear’s Lair: Reform the Fed before de-regulating banks!

President Trump has promised financial de-regulation, and has hired the former Chief Operating Officer of Goldman Sachs, Gary Cohn, to design it. Given Goldman’s sorry record over the last decade, that should worry us. It should worry us even more when we consider that there is no sign of a change in Fed policies, so that the “funny money” that caused the 2008 financial crash and subsequent malfeasances is till in full effect. Without reforming the Fed, de-regulating banks will be largely counterproductive.

Ultra-low interest rates have two economic effects on the banking system. First, they encourage investment of all kinds, in fixed assets and leveraged equity bets. At the same time, the returns on these bets steadily decline, as the investing market moves beyond bets that are economically sensible and productive and enters bets that are highly speculative or just offer very low returns.

You can see the effect of this in the drastic decline in the returns on hedge fund investments. As of the end of 2016, the Hedge Fund Research Institute Weighted Composite Index, representing the universe of hedge funds, had returned an average of only 2.4% per annum over the preceding three years, compared to a return of 6.6% per annum on the Standard and Poor’s 500 Index.

The major college endowments, investors in hedge funds, have thus drastically underperformed the markets, returning minus 1.5% in the year to June 2016. According to Marketwatch, a simple Bogle Model, consisting of 40% U.S. stocks, 40% bonds and 20% international stocks, would have handily outperformed the largest college endowments over the past year, with modest outperformance in the past three, five and ten years.

In light of this, it is not surprising that the Harvard endowment is firing half its staff. Indeed, one can only wonder why it is bothering to retain the other half. Leave the fund to be run by the janitor on a Bogle Model and it will finally outdistance Yale and Princeton in its investment performance, thus demonstrating once and for all the superior intellect of Harvard’s investment managers – or at least, of its janitor.

A banking system whose loan portfolio consists largely of gigantic leveraged financings of foolish bets is in bad trouble. What’s more, that trouble will not appear in the day-to-day running of the bank, because of the “mark-to-market” accounting employed by the banking system today. While markets are strong, the loans secured against bad assets will appear solid and will be valued at close to par. As soon as markets begin to weaken, the loans will appear in trouble, and their market price will decline, thus in today’s crazy accounting world causing a “death spiral” that will send banks into default. It happened in 2008, even though much of the dodgy housing paper then outstanding proved to have considerable value; it will happen again as soon as markets begin to falter.

The other effect of ultra-low interest rates is to encourage leverage. It is of little use for regulators to bring in all kinds of new fancy systems for assessing bank leverage, with “weightings” for every conceivable kind of asset. The banks will just game whatever system is introduced. With interest rates at today’s levels, leverage is exceptionally cheap, or indeed altogether free, so banks naturally load up on it, telling regulators what they need to hear.

For example, for ten years, it has been profitable to borrow in the overnight market (generally through repurchase agreements) and buy long-term Treasuries or mortgage bonds. This does absolutely nothing to help economic growth – it encourages the government to borrow or consumers to buy over-large houses – but it makes bank earnings look glossy, and so long as the Fed can be relied upon to keep short-term interest rates low, there is very little risk to it. Successful bankers have never been known for their high intelligence and discrimination, but with strategies like this available, they can be truly knuckle-draggingly stupid, their only talent an ability to survive in the office political jungle.

As outlined here a few weeks ago, there is an additional problem related to the $2 trillion of excess reserves that U.S. banks now have on their balance sheets in the form of deposits with the Fed. With the Federal Funds market more or less dead (because the banks all have excess reserves) the only effective way the Fed can now raise interest rates is to raise the amount they pay on these deposits. But for each 0.25% they raise rates in this way, the big banks make an extra $5 billion, without lifting a finger. As interest rates rise, the banks’ incentive to do anything useful with the money declines.

The problem with de-regulation thus becomes clear. In a completely free market, there would be no deposit insurance, and interest rates would be set at a market level of a couple of percent above the rate of inflation. In such an environment, the banks would have no incentive to leverage themselves up to the eyeballs, indeed they would have a disincentive to leverage, as depositors would cast a very beady eye over the more leveraged banks, and withdraw their funding, thus compelling the bank to enter the more expensive wholesale funding market or sell assets in a hurry.

In addition, with interest rates soundly above the rate of inflation, there would be no incentive to spurious asset acquisition, nor to the formation of hedge funds that played pointless leverage games. In such an environment, assets that were financed by banks would not be overpriced, and would have a high probability of earning returns sufficient to service the banks’ loans.

In such an environment, de-regulation would indeed be both feasible and desirable. Regulations forcing banks to keep extra capital in such an environment would be superfluous; the market itself would force extra capital to be held. In the 1920s, before deposit insurance, banks were leveraged with about $4 or $5 of deposits and debt to $1 of equity, compared to 30 to 1 recently. The banks would have neither a “pull” enticing them to take on additional leverage because it was so cheap, nor a “push” enticing them to take on additional leverage because of the mass of apparently attractive asset lending opportunities available.

However, that is not the world we live in. As the disaster of 2008 showed, banks today have the incentive to leverage themselves up to the hilt, and engage in lending to the most fatuous projects – because there are always hedge funds wishing to undertake such projects, or companies seeking to take on leverage to repurchase their share capital. We are not in a free market, so removing regulations will not necessarily improve the functioning of the financial system.

Naturally, there are some regulations that impose pointless costs on the system; it’s not as if the Obama administration’s regulators were actually competent at designing regulations. The “fiduciary” requirement for recommending investments is just a generator of unnecessary lawsuits for any investment manager who does his job properly. Enticed by a sleazy lawyer, any investor who loses money will always be able to sue the financial institution to claim it failed in its fiduciary duty.

As with much regulation, much of Dodd-Frank achieved nothing more than providing employment for the more unpleasant lawyers, many of them in the public sector as with the interminable prosecutions of the banks for incomprehensible failings in the LIBOR and foreign exchange markets. The Consumer Finance Protection Bureau, also, needs to be dragged out from the Fed into the Treasury Department, where it can be managed properly, and not serve as a harassment mechanism for banks and Republicans.

Nevertheless, the core of financial regulation, reducing the leverage of banks so that they do not collapse in every downturn, and limiting the every more arcane risks they take on, since they have proved incompetent at managing them, is both a necessary and a desirable function until the Fed has been reformed. As the Bush administration demonstrated in 2006-08, putting a Goldman Sachs alumnus in charge of either financial regulation or government finance is a recipe for disaster, requiring massive taxpayer bailouts in short order, for the benefit of the big banks, whose chiefs remain over-rewarded and under-jailed.

President Trump’s first job in the financial area should be to find a replacement for Janet Yellen; a replacement who can be relied upon to manage interest rates in the same provident way as did Paul Volcker. Such a paragon will be difficult to find; he will certainly not be an alumnus of Goldman Sachs.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)