James Grant Gets on the Investment Bank Train

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Includes: AIG, FMCC, FNMA
by: Cam Hui, CFA

I see that James Grant came around to my point of view to bring back the partnership investment bank that I wrote about back in early 2009:

Happily, there's a ready-made and time-tested solution. Let the senior financiers keep their salaries and bonuses, and let them do with their banks what they will. If, however, their bank fails, let the bankers themselves fail. Let the value of their houses, cars, yachts, paintings, etc. be assigned to the firm's creditors.

Such a proposal would have prevented many of the recent excesses that we saw on Wall Street. If the bankers want to pursue short-term profits at the price of big long-term risks, let them! To paraphrase the old adage: The prospect of being bankrupt has a way of focusing the mind.

A reader pointed out to me that the implementation of this proposal would not have prevented the AIG debacle. I agree. I would therefore amend my proposal for financial reform as follows:

  • Bring back the partnership investment bank
  • Require all derivative contracts to be listed on a centralized exchange

The latter requirement would bring much needed transparency for market particpants to better assess the level of risks any firm is taking. That way, market discipline would not have allowed AIG, Fannie (FNM) and Freddie (FRE) to take the outsized bets that they did.

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