The constant claim by the likes of JPMorgan that it got huge because its global customers “demanded” it is mocked by the facts. JPMorgan is actually the top corporate loan syndicator on the planet. In that capacity it does not throw its multitrillion balance sheet at customers but, instead, “arranges” new loans by spreading the credit exposure far and wide.
The remaining operations of the mega-banks basically consist of massive internal hedge funds and related trading and prime brokerage operations. Whether there are economies of scale in these internal hedge funds or not is irrelevant. As the great Carter Glass might have declaimed, those activities should not have been allowed within a country mile of deposit banking in the first place.
None of these considerations bestirred the Fed, the one agency that could have shut down the empire builders cold. In fact, the Fed actually encouraged the traditional money center and leading regional commercial banks to merge. Furthermore, by embracing the Glass-Steagall repeal it gave the green light for these commercial bank “roll-ups” to then branch out into all the trading markets, thereby transforming themselves into the very Wall Street behemoths that came crashing down on the Fed’s own doorstep just a few years later.
Needless to say, the monetary central planners were so blindly focused on levitating the nation’s economy through higher stock prices that they failed to read the warning signs in their own domain. The rip-roaring share prices of the mega-banks were evidence not of national prosperity but of massive speculation on Wall Street and in the credit markets. The disaster of “Too Big to Fail” was being erected right under its nose, and yet the Fed did not stop a single M&A deal of significance.
Indeed, the combined market cap of the five mega-banks grew from a few billion dollars posted by their predecessors in 1987 to $800 billion by 2008, but these munificent gains were serial gifts from the Fed. What caused the valuations of these insensible agglomerations to soar was swollen PE multiples, cheap wholesale funding, and a regulatory blind eye to the insanity of the banking merger mania.
It goes without saying that with all boats being lifted by a rising tide of stock prices—even transparently unseaworthy vessels like Citigroup—the free market could not do its job of capital allocation and assessment of the earnings quality being reported. So the market caps of these burgeoning financial mishaps kept rising, as mutual fund managers and newly emboldened Main Street punters alike piled into another momentum chase.
In the fullness of time, of course, it became evident that these behemoths were “too big to comprehend,” “too big to manage,” and “too big to be profitable” on a sustainable basis. Still, soaring stock prices gave CEOs, boards, and M&A bankers all the reason needed for ever larger mergers and consolidations.
BANK MERGER MANIA:
EXECUTIONER OF GLASS–STEAGALL
The lamentable thing about the eventual crack up of the mega-banks is they were erected one step at a time in full view of Washington officialdom. By the end of 1998, the five great mega-banks had accumulated combined balance sheets of $2.5 trillion: a thirty-five-fold gain from the modest girth of their 1987 predecessors. Yet, rather than giving pause, these elephantine numbers seemed to only accelerate the chase.
By that point, for example, Chemical Bank had already merged with Manufacturers Hanover which, in turn, combined with Chase Manhattan. While each had thrived nicely as an independent money center bank since the 1930s, the threesome proved to be not up to the task of bubble finance. Accordingly, the huge firm then known as Chase Bank next merged with JP Morgan, thereby rewriting in one fell swoop the map of post-depression-era finance.
In short order, of course, the rewriting resumed when BankOne was brought into the Morgan fold in 2004. That merger brought along with it First Chicago and a whole landscape of midwestern community banks that the combo’s namesake had accumulated over several decades. Accordingly, JPMorgan had now crossed the $1 trillion mark in total assets and was rapidly on the way to $2 trillion four years later.
The final flurry of bank merger mania also brought the ill-starred 1999 union of one of the nation’s premier money center banks, Citicorp, with a discombobulated collection of financial services companies that Sandy Weill had assembled under the Travelers Group. The pieces and parts of the latter were a veritable history of Weill’s 1990s M&A adventures including Salomon Brothers, Smith Barney, Travelers, parts of Aetna, the retail brokerage of Shearson, the insurance and consumer credit operations of Primerica, and countless more.
The result was a $2 trillion monster that the M&A king himself couldn’t manage and that the world-class banker who came with the deal, John Reed, was never allowed to run. At length, the whole train wreck was seconded to what amounted to a trustee lawyer, Chuck Prince. The latter had no clue about what to do, but famously assured the gamblers who day-traded his stock that he would “keep dancing until the music stops.” In the event, he did, and it did.
The incongruous manner in which Citigroup spent the last few years of its pre-bailout life drifting toward the iceberg speaks volumes about the financial deformations that had settled on Wall Street. It goes without saying that no one saw any danger at its creation. It was literally voted through by officialdom, since Chairman Greenspan, Treasury Secretary Rubin, his deputy Larry Summers, and the banking committees of both houses had all supported the Glass-Steagall repeal which enabled the Citibank-Travelers merger.
Then when troubles were already mounting down below, regulators allowed Citigroup to consume $100 billion in cash through stock buybacks and dividend payouts during 2004 through September 2008. This was turning a blind eye with a vengeance, but also perhaps explains why Ben Bernanke, Hank Paulson, and the rest of the bailout crew had no explanation for the thundering financial crisis of September 2008.
By their lights, it was all due to a mysterious “contagion” which had arrived unexpectedly, perhaps on a comet from deep space. The possibility that totally misguided public policies—including interest rate repression, the Greenspan Put, and the green light for bank merger mania—had brought down Citigroup and the other mega-banks did not cross their minds.
The other mega-banks arose and fell along the same timeline. The serial acquisition machine called Nations Bank combined with Bank of America in 1998, and the combo then scoured the land, absorbing regional banking chains like so many dominoes. The identical playbook was used by Wachovia Bank, which merged with First Union Bank in 2001.
Each of these latter two banks had previously “rolled-up” numerous regional banking chains and, once combined, actually accelerated their feeding frenzy, culminating in the disastrous acquisition of Golden West Financial in 2006. That bank was a giant financial turkey so stuffed with liar’s loans and “negative amortization” mortgages that Charles Ponzi would have doubtless invented it, if he’d only had sufficient imagination.
Accordingly, during the five years after the LTCM bailout, the balance sheet footings of these five mega-banks had grown to $3.8 trillion, or by 50 percent. Moreover, after 2003 growth actually accelerated as these newly consolidated depositories tapped heavily into the same wholesale funding market which had fueled the explosive growth of the investment banking houses. The footings of the five mega-banks thus nearly doubled again to nearly $7 trillion by 2007.
The 1999 repeal of Glass-Steagall had been a mere formality: the real point was that the whole prudential banking régime that had been established by Glass-Steagall was gone, too. What had actually swept it away was a decade of merger mania that the Fed had blessed every step along the way, and which the maestro had actually heralded as another triumph of capitalist innovation and energy.
DEPOSIT BANKS ARE WARDS OF THE STATE AND NEED STRICT SUPERVISION
Yet there was more, and it was worse. As wards of the state, chartered deposit banks needed to be strictly regulated in order to prevent abuse of their fractional reserve banking privileges, to say nothing of the moral hazard implicit in taxpayer-supported deposit insurance and in their r
ight to access the Fed’s discount window for emergency loans.
Once again, however, the same misguided application of free market theory, which had led to a feckless posture of “hands off” with respect to bank mergers, came into play. Accordingly, these new behemoths were permitted to wander into every type of gambling activity known to Wall Street.
Thus, all five mega-banks were soon knee-deep in equity trading and underwriting, prime brokering, options and futures trading, commodities, swaps and derivatives, private equity, internal hedge funds, and much more. They had, in substance, become European-style “universal banks” and had a massive presence in all the traditional Wall Street dealer and investment banking markets.
Not surprisingly, therefore, by 2008 the five mega-banks, which had emerged from a decade and a half of merger mania, banking deregulation, and relentless penetration into nondepository markets, had reached colossal size by every historic standard. In fact, their balance sheet footings were now a hundred times larger than that of their predecessors in August 1987 when Greenspan arrived at the Fed.
It is also remarkable that only a modest share of the massive balance sheet expansion of these five institutions after 1998 was funded by depositors, notwithstanding their status as FDIC-insured banks. The preponderant share of funding growth was obtained from the wholesale money markets.
What happened was that new assets were being snagged and then piled on these mushrooming balance sheets in a hand-over-fist manner. These newly acquired assets were then hocked in the repo market as fast as they arrived. Like their investment banking cousins, therefore, the five mega-banks were also becoming financially unstable and vulnerable to a wholesale money market run.
As these aberrations gathered force the Fed took no notice whatsoever. It had no clue that the $7 trillion of combined balance sheets assembled by these five mega-banks in barely a decade were essentially helter-skelter agglomerations, not managed banking portfolios in any traditional sense. Nor did it recognize that in due course these far-flung financial institutions would inevitably lose track of what was in their own turbulent balance sheets, to say nothing of those of their far-flung counterparties.
WHEN THE MONETARY CENTRAL PLANNERS MISSED THE $11 TRILLION TRAIN WRECK
The FOMC minutes show the Fed’s leadership circle ignored these mega-bank threats because it falsely assumed the US economy was strong. The vulnerability of these jerry-built balance sheets to the adverse macroeconomic trends actually under way, such as the massive increase of household debt, declining real wages, and the giant trade deficit and resulting offshoring of the tradable goods economy, escaped notice entirely.
Even as severe financial strains broke out in the subprime market and on Wall Street dealer balance sheets in the second half of 2007, the Fed’s take on the nation’s economic pulse was feckless. It consisted mostly of spurious patter about the monthly economic weather patterns and short-term fluctuations in financial ratios and spreads. Indeed, the tone of the Fed minutes in the run-up to the crisis was ostrichlike.
With their heads in the sand, the monetary central planners in the Eccles Building thus kibitzed about the trivial blips in regional purchasing manager surveys, construction jobs, and retail sales. Meanwhile, they blithely ignored the inescapable fact that in less than two decades Wall Street had been radically transformed and was now comprised of ten teetering financial behemoths.
By the end of 2007, the five investment banking houses plus five mega-banks posted a combined balance sheet of $11.4 trillion. They were now 300 percent of the size they had been in 1998, notwithstanding that the real economy had grown by only 29 percent during the decade.
So once again bubble finance generated a vast deformation. During the course of just eight years, these monuments to runaway M&A and the wholesale-market money shuffle expanded their balance sheets by the staggering sum of $8 trillion. Needless to say, this kind of insensible growth could only occur in a wholly financialized economy driven by a central bank that had rigged interest rates at absurdly low levels.
On the free market, by contrast, the endless hypothecation and rehypothecation of collateral which underpinned the massive balance sheets of these giant banks would have been stopped dead in its tracks. The reason stems from nothing more mysterious than the law of supply and demand.
In a wholesale money market with a freely functioning pricing mechanism—that is, one not contaminated by central bank interest rate repression—the explosion of Wall Street demand for repo and other short-term funding would have caused interest rates to rocket skyward. The effect would have been similar to what occurred in the pre-1914 call money market when the supply and demand for excess savings got out of whack; namely, money market rates would have soared into double digits.
Double-digit money market rates, in turn, would have quashed the demand for wholesale funding because the carry trades, which are the fundamental source of repo demand, would have been deeply negative. Stated differently, carry trades don’t work when the interest cost on borrowings is higher than the yield on the pledged mortgages, corporates, governments, or even junk bonds.
Furthermore, the elimination or even shrinkage of repo credit, which was mostly manufactured out of thin air by lenders who sold the collateral short, would have forced the mega-banks to seek plain old deposit funding. Needless to say, a scramble for deposits on the free market would have been a further potent antidote to expansion of Wall Street balance sheets.
Genuine Main Street savers would have demanded far higher interest rates to forego additional amounts of their now beloved consumption. Indeed, to get consumers to throttle back on consumption would have required drastically higher inducements than those which prevailed under the Fed’s price-controlled money markets. The magic profits of balance sheet arbitrage would have thus been largely eliminated on the free market.
Absent the money market carry trades enabled by the Fed, therefore, the $8 trillion expansion of Wall Street balance sheets would never have happened. And this means, in turn, that Wall Street’s financial meth labs, which manufactured trillions of subprime mortgages, CDOs, and other toxic securities, could not have opened for business. Without repo and other wholesale money markets, there would have been no place to fund the garbage.
By the time the final Greenspan-Bernanke housing and stock market bubble reached its peak in late 2007, however, any institutional memory of free markets in money—that is, the pre-Fed call money market—had long since vanished. Wall Street and policy makers alike had come to embrace as the “new normal” a rigged money market that was pinned down by midget-sized, Fed-administered interest rates.
Not surprisingly, therefore, policy makers did not recognize these bloated balance sheets as the freakish financial aberrations they actually were. Nor did they apprehend that these balance sheets were loaded with impaired and illiquid assets that had been recklessly accumulated by bonus-driven trading desks. In short, the Fed did not see the train wreck that was thundering toward it at full speed.
WHEN $1 TRILLION OF MARKET CAP VANISHED IN THE CANYONS OF WALL STREET
At the end of the day, the vast financial deformation embodied in these ten Wall Street mega-banks had been fueled by the lunatic overvaluation of bank stocks engineered by the Fed. The incentive for empire builders to assemble train wrecks like Citibank and Bank of America, and for bankers to invent financial tommyrot like CDOs-squared, is evident in the parabolic rise of bank market caps after 1987. The vast riches it bestowed on bank managements through stock options and stock-based cash bonuses had never before been seen in the financial system.
Thus, the implicit market cap of the ancestors of these ten mega-banks had been perhaps $40 billion prior to Black Monday in October 1987. By the end of the first Greenspan stock market bubble in late 2000, their combined market cap had reached $500 billion. Then, after the Fed launched its 2001–2003 rate-cutting spree, the market cap of the ten Wall Street banks literally shot the moon, reaching $1.25 trillion by mid-2007
.
In short, ten sprawling financial behemoths which provided almost no value added to the Main Street economy had experienced a thirtyfold gain in market cap in less than two decades. Yet not long after bank executives garnered hundreds of billions in cash bonuses and stock option cash-outs based on these preposterous valuations, the full extent of the bank stock bubble became evident.
By March 2009, after the Wall Street meltdown had taken its toll, four of the ten mega-banks were gone and the market cap of the survivors had shrunk to $250 billion. And so it happened that $1 trillion of market cap disappeared from the canyons of Wall Street in a financial market minute.
The monetary central planners did not give a moment’s thought to the implications of this violent collapse of what was a trillion-dollar bubble. And it wasn’t just another bubble of the type that had become standard fare under the Greenspan Fed; that is, the home builder, telecom, dot-com, and high-tech stock bubbles which had gone before. In this instance, the very financial transmission system, the primary dealer network that the Fed relied on to implement its policies, had lost 80 percent of its market cap.
These ten institutions constituted the overwhelming bulk of the primary dealer market through which all of the Fed’s interest rate pegging, debt monetization, and risk asset pumping operations were conducted. In any reasonable world, the shocking revelation that this crucial policy transmission mechanism had been run by reckless gamblers, and that their balance sheets consisted of a heaving mass of financial assets rented by the day, would have been conclusive.
By the time of the September 2008 financial crisis, the ten mega-banks posed an existential threat to the entire prosperity management model on which the Fed operated. Not surprisingly, the nation’s panic-stricken monetary politburo chose to bail out the misbegotten behemoths rather than reconsider its own ill-conceived model.
The Great Deformation Page 55