If you haven’t yet seen the film "The Big Short," then I highly recommend you do so.
The movie gives a great portrayal of the events leading up to the financial crisis as seen by four traders who were able to predict the credit and housing bubble collapse — and how they made money in the process.
One of those four traders is Steve Eisman, played brilliantly in the film by actor Steve Carrell.
In an op-ed in Sunday’s New York Times, Eisman argued for something that might surprise some.
The article, "Don’t Break Up the Banks. They’re Not Our Real Problem," includes an interesting explanation of how too much leverage on the part of banks led to the bursting of the housing bubble.
Eisman also explained that the current regulatory rules on banks are actually working, and that banks now are in much-better shape than they were eight years ago.
So, what’s the real problem facing the economy right now? Eisman says it’s "income inequality."
Eisman’s explanation of what led to the financial crisis reminds us of why corporate culture — and basically not knowing anything different — can be big problems if left unchecked.
According to Eisman, the reason the crisis occurred was as follows:
If I could sum up the catastrophe in one word, it would be "leverage." Using borrowed money, the financial system made huge bets just when losses were about to explode because of subprime mortgage loans.
Eisman explains that the balance sheets at big banks such as Citigroup (C) and Goldman Sachs (GS) surged from 2001 to 2007. He also explained that was due to leverage.
For example, Citi was leveraged 21-to-1 in the first quarter of 2001. By mid-2007, leverage had climbed to 33-to-1. The situation was similar for Goldman, and the rest of the big financial institutions on Wall Street.
As Eisman explains:
The explosion in leverage occurred for several reasons, but one underappreciated factor has to do with psychology and corporate culture. An entire generation of Wall Street executives came of age in the 1990s and 2000s.
Their incomes started to rise after the recession of the early 1990s, going up in virtually a straight line until the financial crisis. Each year they made more, and each year the balance sheets of their respective firms grew. The system fed on itself.
Unfortunately, Wall Street mistook leverage for genius. Then came the irresistible force known as subprime loans.
Now, I am pretty sure you are aware of the subprime loan fiasco and the death spiral it represented for housing, the banks and the entire economy.
The fact is that it nearly took the whole system down.
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In the wake of the destruction, Congress passed new regulatory reform such as the Dodd-Frank financial reform act of 2010.
Eisman explains that the division of labor among regulators was key, with the Federal Reserve regulating safety and soundness of the system while the Consumer Financial Protection Bureau is designed to look after consumers dealing with financial institutions.
As Eisman writes:
Under the new regulatory regime, the leverage of the large banks has been reduced. While Citigroup’s leverage peaked at 33-to-1, today it stands at less than 10-to-1. The Federal Reserve has forced similar reductions in leverage across the board.
Risky proprietary trading desks have been eliminated at banks by the Volcker Rule, part of Dodd-Frank. And while the consumer protection board has been around for only a few years, it seems to have made progress in safeguarding consumers from the more egregious practices of the financial-services industry.
I basically agree with this, although Eisman fails to mention that the costs associated with Dodd-Frank have been a big obstacle to banks being able to lend money freely, and to therefore get the economy back on track.
I also agree with another of Eisman’s assessments, and that is that the U.S. financial system is much less risky than it was before the 2008 debacle.
What I find a bit of a misnomer of sorts is Eisman’s basic conclusion. He writes that the real heart of the country’s economic problems is "income inequality."
Here’s how Eisman finishes the NYT article (emphasis mine):
The central economic problem of our time is income inequality, especially the lack of personal income growth for most Americans, which was one of the underlying causes of the financial crisis.
In lieu of rising incomes, credit was allowed to be democratized. Living standards were maintained only because increased credit supplemented deteriorating incomes.
That helps explain, post-crisis, why United States growth is slow: Without easy credit, consumers cannot increase spending, because their incomes have fallen since 2007.
If we want a stronger economy, improving the distribution and growth of personal income should be our focus. Breaking up the big banks will not help, and might even hurt.
I basically agree that the lack of personal income growth for most Americans is a real problem, and that it is at the heart of our economic sluggishness.
Yet calling it "income inequality" implies a kind of "limited pie thesis" — that there isn’t enough wealth to go around as-is.
This argument (which Eisman does not imply or infer in his article) is that income inequality is a problem that can be solved by the redistribution of wealth. This is at the heart of the candidacy of Sen. Bernie Sanders, and it’s a thesis many Americans accept as accurate.
Now, I also agree that if we want a stronger economy, we need to improve personal incomes and growth — and that breaking up banks won’t be a solution.
The way to do that, in my view, is to allow Americans to keep more of their hard-earned money via lower taxes, lower capital gains and dividends taxes and more free-market reforms that put more money in our pockets.
I think the best way to cure "income inequality" is to allow more people to get rich. It’s not to make wealthier people poorer via the taxman.
I hope that Eisman agrees.
Do you think banks are still the big problem they were before the crisis? Do you think income inequality is our biggest economic problem? What about my thoughts on growing the pie via less government?
Stocks finished flat after a volatile session, as traders position themselves in front of Fed Chair Yellen’s Humphrey-Hawkins testimony tomorrow before Congress.
• It’s primary day in New Hampshire. Fox News mistakenly reported early in the day that Donald Trump won. We’ll get the results tonight after polls close at 7 p.m. Eastern.
• The Empire Strikes Gold. "Star Wars" delivered for Walt Disney Co. (DIS) in Q4. Earnings per share came in at $1.63, blowing past expectations of $1.45. But ESPN remains a concern because of cable "cord-cutting." However, China’s Tencent has just agreed to a multiyear licensing deal to deliver ESPN’s sports content online.
• President Obama wants more money for regulatory oversight. In his fiscal 2017 budget, he asked Congress to boost the Securities and Exchange Commission’s budget by 11%, and the Commodity Futures Trading Commission’s by 32%.
• It was another down day for oil. West Texas Intermediate finished the day below $28 per barrel, a 5.9% loss.
Good Luck and Happy Investing,
Uncommon Wisdom Daily