Banking on Geniuses 3 - Falling Dominoes

The first article in this series drew on a laudatory New York Times article about Mr. Jamie Dimon, the C.E.O. of JP Morgan Chase, to explain Mr. Dimon's vision of a very large bank being free to offer as many different kinds of financial products as it found convenient.  The second article in the series explained why we at Scragged disagree with Mr. Dimon.

Much as we dislike government regulation in general, we believe that for the safety of everyone who uses money, there must be limits on the kinds of financial products any one business is allowed to offer.  We also stressed the importance of confidence - if everybody believes a bank is OK, they'll leave their money in it, but if they're worried, they'll all ask for their money at once and the bank goes down.

This article explains how problems in one part of a bank's market can take down the whole bank.  The risk of cross-contamination within a bank is a major reason we don't like the idea of banks operating in too many different markets.

Contamination

The importance of confidence explains another reason for not letting banks offer just any products they desire.  To go back to Mr. Dimon's analogy with Wal-Mart selling lettuce, food, toys, clothing, and anything management desires, it's important to understand that Wal-Mart's lettuce business has nothing to do with the toy business.

If something happens in the lettuce market and lettuce prices go through the roof or drop to zero, does this threaten Wal-Mart?  Not at all.  They may lose some money, but nothing that happens in the lettuce business threatens their toy business or their clothing business.  No matter what happens to the value of lettuce, the toys and clothing on their shelves have intrinsic value.

Banks are entirely different because money is interchangeable and has no inherent value of its own.  Suppose Mr. Dimon's bank offers 100 or so different products, credit cards, home loans, auto loans, business financing, derivatives, futures, and other products too complex for us to understand.  Any whisper of bad news in any part of the business immediately puts the rest of the business at risk because depositors might panic.

The government-backed Federal Deposit Insurance Corporation guarantees that bank deposits will be honored up to some maximum.  Even if the bank goes completely under, the depositors will be made whole.

That helps, but it's no panacea.  The NY Times reported, "As depositors fled from weaker banks, J. P. Morgan took in an additional $180 billion."  Depositors were worried enough about their own banks to move $180 billion to JPMC, which was perceived as a stronger bank.  Moving their money hurt their original banks in spite of government deposit insurance.  Financial contamination spreads at the speed of rumor.

Mr. Dimon understands the problem of contamination extremely well:

Since the financial crisis, Dimon has asserted that it’s the interconnectedness of markets — the tendency of investors to flee from one vulnerable asset class and then another — rather than the size of banks that presents the greatest systemic threat.

The more different markets a bank enters, the more connected that bank is.  The more ways its exposed, the greater the risk that something will go wrong in some obscure market area which will reduce confidence in the overall business.  That's why it's inherently risky for banks to be able to offer too many different financial products.  Indeed, the history of the past few years strongly argues that Jamie Dimon is wrong and that different types of financial services really should be restricted to separate companies and these companies shouldn't become too dependent on each other.

Jamie the Genius

The Times article included a number of statements which suggest that Mr. Dimon is far, far smarter than the average banker:

• When markets melted down and the economy plunged into recession, J. P. Morgan remained not only solvent but profitable every quarter.
• Instead of reviewing brief summaries of the bank’s operations, as his predecessor had, Dimon demanded to see the raw data — hundreds of pages detailing J. P. Morgan’s businesses every month.
• Instead of simply trusting his traders, Dimon put himself through a tutorial, so that he would understand the complex trades the bank was exposed to.
• Rather than run its mortgage machine at full throttle for as long as possible, Dimon reined in lending earlier than did others and warned his shareholders of looming trouble.
• “You go in his office, there is almost nothing on his desk,” says Steve Black, a longtime colleague. “He reads it and remembers."
• He nixed the most aggressive type of mortgages, known as option ARMs, on which borrowers were hooked on an initial low teaser rate.

Mr. Dimon wasn't without mistakes, as it turns out.  JPMC ended up making a number of "stated income" loans where home buyers were not required to prove their stated income, a costly and time-consuming process.

At Bank One, Dimon had ceased buying mortgages from outside brokers because their performance was poor.  At Chase, he bought them. When I asked why, Dimon said underlings convinced him they were exercising proper caution, adding, “It was a huge business, packaging and selling [the loans] to Fannie Mae.” Turning silent, Dimon rotated his palms face up — as if nothing could excuse his error. “I bought that crap,” he concluded.

Many brokers seem to have been encouraging home buyers to lie.  These became the famous No Income, No Job or Assets (NINJA) loans.

Over the last two years, JPMorgan Chase suffered an astonishing $51 billion in faulty mortgages, unpaid credit cards and other bad loans.

Mr. Dimon kept the bank profitable despite these losses.  The JPMC stock price has remained flat, which doesn't make the stockholders happy, but other banks have lost half their stock market value if not more.  This suggests that Mr. Dimon is smart enough to operate a very large, complicated bank in a risky environment and that JPMC would make a lot of money if banks were given the freedom which Mr. Dimon desires.

Genius Isn't a Job Description

The problem is that you can't run an entire industry on the basis of needing a genius to make the big players work.

We saw the same problem at AIG.  When Spitzer, who was the Attorney General of New York State at the time, forced Mr. Greenburg out of the chairmanship, AIG took on a great deal of risk and the government thought it needed a bailout.  Mr. Greenburg had built AIG and seems to have been the only one who understood how it worked.

Mr. Greenburg had built AIG over a 50-year career and it seems to have been a one-man company - once he was gone, it got in trouble.

AIG is not unique in having to be run by a genius.  Harold Geneen built ITT into a hugely profitable conglomerate.  He had a unique management style which involved his personally remembering a great many details about the inner operations of all of his divisions just as Mr. Dimon knows more details of his bank's operations than the average bank CEO.

Given the difficulties he's faced, Mr. Dimon would probably appreciate Mr. Geneen's aphorism, "The only unforgivable sin in business is to run out of cash."  ITT foundered after Mr. Geneen retired - his management skills could not be replicated and ITT was not structured to be run in any other way.

We're not the only ones who worry about Mr. Dimon being unique:

“When you have a guy as skilled as Jamie, you have to be sure that the bank is not just Jamie — that you have a team,” a director told me.

The bottom line is that non-financial businesses can offer any products they want because different product lines don't affect each other.  By the nature of dealing in money, it's simply not possible for different financial products to be so distinct.  The fact that Mr. Dimon is able to do this doesn't mean that anyone else can, so prudence demands that banks be limited in what they're allowed to risk.

The Coming Crash

We've explained why we don't believe banks ought to be able to offer just any financial product they desire - their health is simply too important to the rest of us who aren't bankers.

There have been many crashes and panics in American history.  Each time, laws were passed to keep it from happening again but crashes keep happening.

The book The Great Depression: A Diary is a collection of notes made by Benjamin Roth, a lawyer who practiced in Youngstown, Ohio, during the depression.  He noted that lawmakers always try to keep crashes from happening:

Jan 9, 1937

Each time in a depression new theories and "New Deals" are tried out but rarely do they seem to change the basic structure of the economic cycle.

As John Kenneth Galbraith put it, "The foresight of financial experts was, as so often, a poor guide to the future."  The New Economics At High Noon, p. 269.  He also said, “The only function of economic forecasting is to make astrology look respectable.”

After each crash, the "financial experts" help write new laws to prevent the next crash.  Each time, the next crash comes anyway.

If we can reduce to an extent the degree to which financial institution are interconnected, we may make the crash smaller, but we can't prevent it without taking all the risk out of the financial system.  That would prevent crashes, but would also stop all economic growth.

We think that the pains of the occasional crash are an acceptable price to pay for a financial system which is open enough to allow investment and growth.  Trying to eliminate all crashes, like our current regulators wish, is stupid and counterproductive.  We just need to make sure that no one bank is big enough or interrelated enough to take down the entire system at one go - which is what we have now.

In the meantime, there will be another crash no matter what anyone does, the only question is when.  It wouldn't be a bad idea to stash a couple of bars of gold in a safe deposit box or under your mattress.