Extracting 'Environmental Clean-Up Costs' From Wall Street

Includes: BTO, XLF
by: Joe Eqcome

"Hell has three gates: lust, anger and greed." Bhagavad-Gita

Speaking of Greed: The reason why Wall Street's bonuses are so outsized is that Wall Street is not paying its fair share of "environmental costs" for sustaining a healthy and viable industry. Wall Street's compensation has been subsidized by the tax-payers under a "too big to fail" federal bail-out policy that encourages bigness. Currently, the five major U.S. banks hold 52% of the financial assets.

If the most recent financial debacle was an "oil spill", like the one in the gulf, there would have been significant and painful economic penalties designed to encourage better future practices and to compensate its victims. Neither has occurred.

Insult to Injury: To add insult-to-injury, this system has further facilitated a post-crisis transfer of wealth from its mid-class to the already wealthy bankers. It has done this by keeping interest rates unrealistically low on Main Street's savings to provide banks the "spread" they'll need to again become profitable enough to dole out bonuses.

All Gain and No Pain: This "all gain and no pain" investment model has allowed financial institutions and individuals to "bet the farm" without holding the mortgage. This encouraged a culture of greed that has been facilitated by three important events.

1. The repeal of the ban by the NYSE in 1970 that prohibited investment banks from being public companies.

2. The repeal of the Glass-Steagall Act in November of 1999, through the enactment of the Gramm-Leach-Bliley Act, which prohibited commercial banks from owning investment banks.

3. A bankable "put" by the U.S. Federal Reserve for a simulative monetary policy supporting equity markets in times of need.

Economics of Risk-Management: Prior to 1970, investment banks were private partnerships. The partners were typically owners and managers employing their own capital and participating directly in both the revenue and losses of their activities-a balanced risk/reward model.

Conversion to Public Companies: When these private investment banking partnerships converted to publicly traded companies, owners were: 1) no longer managers; 2) managers' risks were no longer directly tied longer-term to the profits of the enterprise; and 3) excessive leverage could be employed in the pursuit of higher profits risking faceless shareholders' equity.

Poster Child: This transition, and its impact on financial firms, is no more evident than in Exhibit #1: Goldman Sachs. As a partnership, Goldman was revered for its culture under its partnership structure and best exemplified by the Sidney J. Weinberg and John C. Whitehead co-management era. While I'm sure that it wasn't Goldman's intention to end-up "wrong footed", it is instructive to consider the "slippery slope" and its implication for less-storied financial operations.

Re-thinking Financial Risk: Consider the following.

1. Maybe Smaller is Better: This may necessitate bringing back some form of Glass Steagall "light" to formally separate and possibly sever the various risk pools currently held by bank holding companies. I don't buy the argument that it would place U.S. banks at a disadvantage versus foreign competitors. Replicating bad practices promotes a "race to the bottom".

2. Risk Your Own Money: While going back to the private partnership investment banking model may be impractical, the current "watering down" of the Dodd-Frank imposition on proprietary trading operations should be resisted.

3. Environmental Clean-Up Costs: Imposition of heavier "premiums" on financial services companies for current and future financial pollution generated by these institutions. (This is no different than the costs imposed on manufacturing plants that pollute our rivers and streams.)

Managing Conflict through Economics Incentives: In business, the old saw goes, "there is either a conflict of interest, or there's no interest".

The question has always been how one appropriately manages that conflict. We need to go back to a risk-management structure that places that burden on the economics of the business and the people that run them and not the backs of ill-conceived, backward looking regulations-as the regulators will ultimately be steps behind the operators.

Change Unlikely: The likelihood that we'll forget about the financial crisis and go back to "business as usual" is already evident. Banks are lobbying for milder restriction on proprietary trading and new legislation proposes less supervision for small IPO offerings that are better vetted by venture capital firms.

For those who believe "same-old, same-old" they ought to be long Select Sector SPDR-Financial (XLF) or John Hancock Bank & Thrift Opportunity Fund (BTO) as they'll benefit long-term through inaction. It's a sad but bankable commentary.

Disclosure: I am long XLF, BTO.