David Einhorn: Break Up Too Big to Fail Institutions

David Einhorn delivered a speech at the 2009 Value Investing Conference that is creating a lot of buzz in the blogosphere. He said a lot of interesting things about the investing and political climate. A surprising amount of it comes out of the playbook here at Credit Writedowns.

Below are the quotes I want to highlight for you. At the bottom is an embedded copy of his speech.

Enjoy.

On short-termism in politics and government

Winston Churchill said that, “Democracy is the worst form of government except for all the others that have been tried from time to time.”

As I see it, there are two basic problems in how we have designed our government. The first is that officials favor policies with short-term impact over those in our long-term interest because they need to be popular while they are in office and they want to be reelected. In recent times, opinion tracking polls, the immediate reactions of focus groups, the 24/7 news cycle, the constant campaign, and the moment-to-moment obsession with the Dow Jones Industrial Average have magnified the political pressures to favor short-term solutions. Earlier this year, the political topic du jour was to debate whether the stimulus was working, before it had even been spent.

On crony capitalism and regulatory capture

The second weakness in our government is “concentrated benefit versus diffuse harm” also known as the problem of special interests. Decision makers help small groups who care about narrow issues and whose “special interests” invest substantial resources to be better heard through lobbying, public relations and campaign support. The special interests benefit while the associated costs and consequences are spread broadly through the rest of the population. With individuals bearing a comparatively small extra burden, they are less motivated or able to fight in Washington.

In the context of the recent economic crisis, a highly motivated and organized banking lobby has demonstrated enormous influence. Bankers advance ideas like, “without banks, we would have no economy.” Of course, there was a public interest in protecting the guts of the system, but the ATMs could have continued working, even with forced debt-to-equity conversions that would not have required any public funds. Instead, our leaders responded by handing over hundreds of billions of taxpayer dollars to protect the speculative investments of bank shareholders and creditors. This has been particularly remarkable, considering that most agree that these same banks had an enormous role in creating this mess which has thrown millions out of their homes and jobs.

Like teenagers with their parents away, financial institutions threw a wild party that eventually tore-up the neighborhood. With their charge arrested and put in jail to detoxify, the supervisors were faced with a decision: Do we let the party goers learn a tough lesson or do we bail them out? Different parents with different philosophies might come to different decisions on this point. As you know our regulators went the bail-out route.

On misdirected anger on main street

And the neighbors are angry, because at some level, Americans understand that the Washington-Wall Street relationship has rewarded the least deserving people and institutions at the expense of the prudent. They don’t know the particulars or how to argue against the “without banks, we have no economy” demagogues. So, they fight healthcare reform, where they have enough personal experience to equip them to argue with Congressmen at town hall meetings. As I see it, the revolt over healthcare isn’t really about healthcare, but represents a broader upset at Washington. The lack of trust over the inability to deal seriously with the party goers feeds the lack of trust over healthcare.

On breaking up too-big-to fail institutions

The proper way to deal with too-big-to-fail, or too inter-connected to fail, is to make sure that no institution is too big or inter-connected to fail. The test ought to be that no institution should ever be of individual importance such that if we were faced with its demise the government would be forced to intervene. The real solution is to break up anything that fails that test.

The lesson of Lehman (LEHMQ.PK) should not be that the government should have prevented its failure. The lesson of Lehman should be that Lehman should not have existed at a scale that allowed it to jeopardize the financial system. And the same logic applies to AIG, Fannie (FNM), Freddie (FRE), Bear Stearns, Citigroup (C) and a couple dozen others.

There is MUCH MUCH more below.

Einhorn Vic Speech 2009

Comments

[fishluvrain:]

Looking at Market Caps and Market Share perhaps there should be a limit imposed. When your market cap of a company exceeds that of some countries or your market share stifles competition I think you are too big. Should mistake or miscalculation occur more is at stake then the company or even the sector. This past year an example. Leverage may be your friend in many cases but it can also be a devastating foe, and to more than those making use of it. What macro economist wants to step up with a formula and what regulating body wants to demand what is divested, and how.

Oct 21 04:40 AM

[Moon Kil Woong:]

I agree. However, the biggest too big to fail institution is the Federal Reserve and Geithner wants to have them manage too big to fail institutions and systemic risk. Noted that just a year ago everyone quickly identified Greenspan as the biggest root of the systemic risk we presently face.

Furthermore, the Treasury and Federal Reserve have made sure the too big to fail institution including the Federal Reserve got even bigger during this downturn. They not only control more deposits and have bigger balance sheets (the fed made theirs out of thin air) they also own more of America than ever before (that's why you own less). So how exactly can we trust them to manage to big to fail or systemic risk when they are the problem and they have such a terrible history making too big to fail institutions even bigger? Is this ironic, pitiful, corrupt, or all the above?

The first big bank to be broken up should be the Federal Reserve. US Treasury auctions should go up through a bidding process. It's not like the Federal Reserve does that great of jon holding Treasury auctions anyway since nowadays it has to buy a lot of them themselves. In any other auction this would be illegal bid rigging. But so would writing guarantees in the trillions of dollars when you don't have the capital to back them up like AIG did (Federal Reserve backstops). Or blowing up your balance sheet 40 to 1 without taking into account market values or setting aside any reserves for losses much like Bear Stearns (The Federal Reserve balance sheet). Or thwarting all audits like Bernie Madoff (The Federal Reserve). Or refusing to disclose your shareholder structure (the Federal Reserve).

Ok it's too easy to slam on the Federal Reserve. But really, the biggest cause of most of our woes stem from the Federal Reserve's blatant mismanagement of interest rates and money supply. They are too big to fail and are the biggest ststemic risk in the system bar none.

Oct 21 04:43 AM

[Michael Clark:]

Part of the problem, Moon, is that Greenspan-Bernanke are actually in power to protect the banks. That is their unwritten program and charter. And, you are right, they are the biggest systemic risk because of this.

I'm not sure if I want to see the Fed abolished. Ideally, the Fed might work as a nonpolitical institution that, if not attached to ideology and old international banking money, attempts to manage monetary policy detached from election politics. But how do we guarantee independent Fed chairs who aren't taking orders from the banks on Wall Street or Main Street, who are acting truly in America's interest? I don't know.

Audit the Fed? Yes. The Fed should be doing nothing that is illegal or immoral.

Demolish the fed? Maybe. I'm open to ideas about that.

The Inflationists have been in power too long. Inflationism is a political ideology, something from which the Fed needs to be free.

I actually like my utterly rational plan. Raise interest rates during the Night-Cycle (2001-2019); lower rates through the Day Cycle (1983-2001; 2019-2038...) This is a scientific response to a series of human failings. To agree to do this, everyone would need to see clearly the 18 year cycles at work...which, I realize, is, at this time, nearly impossible.

Oct 21 04:54 AM

[Dave Wrixon:]

They are only two big to fail if the Federal Government has the resources to save them. It is not yet clear that point has been proven.

Oct 21 04:55 AM

[Michael Clark:]

I agree. We can come up with a yardstick; but then we'll have to watch the corporations and their lawyers as they try to run tricks to make it look like they are always under the yardstick.


On Oct 21 04:40 AM fishluvrain wrote:

> Looking at Market Caps and Market Share perhaps there should be a
> limit imposed. When your market cap of a company exceeds that of
> some countries or your market share stifles competition I think you
> are too big. Should mistake or miscalculation occur more is at stake
> then the company or even the sector. This past year an example.
> Leverage may be your friend in many cases but it can also be a devastating
> foe, and to more than those making use of it. What macro economist
> wants to step up with a formula and what regulating body wants to
> demand what is divested, and how.

Oct 21 05:24 AM

[WMBANZAI7:]

Excellent posting my friend!

Oct 21 08:11 AM

[waf76:]

The real danger in our political system is that the special interests have already hijacked this country without the majority even knowing it. As an American, I want my politicians to put America first, no country in the world can possibly have the identical interests as we do. I want lobbyist groups like AIPAC, who control our foreign policy to register as foreign agents. I want the Fed abolished. We need something other than a two party system. I can't decide who i hate more, the republicans or the democrats. All the write things are spoken in the run up to elections but once they are elected, certain actions that people voted for are now deemed 'politcally untenable'. Our system is a joke.

Oct 21 09:19 AM

[BRUCE E. W.:]

As I noted to your similar position in a recent blog:
" I question as to whether FRE/FNM are in the same category as Lehman/ Citi / Goldman / JP Morgan etc. since they are not intermediaries of the e-financials that have essentially printed their own electonic currencies in fanciful paper that ultimately diluted the economy and eluded legitimate accountability. The mortgages that are threatened and the government backed support of their security are not the same as the securities invented and then further insured as gambling stakes by AIG. I may be wrong, but the mortgage industry involves the only bottom/up restructuring that is actually based on real lives and peoples fundamental investments in necessities of life (housing) and surviving a crisis that was made from the top down."
Throwing the housing market to the wolves seems to be in vogue. I see it as the equivilent to selling it all short and creating a graveyard for many people who are trying to salvage their homes; a landfill garbage dump for scavengers in private equity; a waste treatment center for financials and a triage center for government agency. Meanwhile it is the most visable profile of existing misery which the financial sector would like to see go away (continually reminding us of the failures they conjured up with their derivitives markets...still being propagated and progressively extended to cover the same debt recovery process by way of more of the same).
Private equity interests have been trying to not just exploit but to destroy both FNM & FRE for decades, and there is some reason to believe subprime mortgage & its predator lending was partly fueled by this aggressive hostility to their specialized & underserved markets. It is an attack on the basic realizations of the American promise of fundamental "ownership" and another example of blind market raging and ranting while it takes everything down with it.
Meanwhile, just yesterday Reuters reported that FRE sold $3.5 billion in new two-year reference notes priced to yield 26 basis points over comparable U.S. Treasuries.
The joint lead managers on the sale were Goldman Sachs, Citigroup and Morgan Stanley.
More of the same: only the brand names GAIN. It seems that there is an entire segment of the financial community that is dogging this into a corner and seeking to collapse all hope of recovery. Apparently their own homes are not on the butcher block of arbitraged indifference. But It is the height of folly to believe that America will allow its homes to be invaded by some bankers waving banners of free market ideology.

The best scenario for America would be if the American shareholders could be allowed to invest securely into these institutions and the capital foundation could expand normally the way the stock market was envisioned to work. A great deal of the taxpayers' burden would be eliminated if the capital could be raised on the market; again, the way it is supposed to work. Instead, we get nothing but the professional predator and parasites eating away at potentially healthy investments and a negative media coverage which tilts the game plan in that direction. The more exagerated the claims the more downward pressure upon the trading and with it any chance of a market based recovery. At this time these stocks should be trading for healing purposes, not to create more victims. Stocks are certainly rock bottom and affordable to the average American. Why not let it work instead of eviscerating the market

Oct 21 09:53 AM

[Tony Petroski:]

From the article:

"As I see it, there are two basic problems in how we have designed our government."

Forgive me, but when did that pipsqueak design anything?

Oct 21 02:12 PM