Posted by on June 12, 2016

There is a lively blame game relating to the great financial crisis (GFC).  The Left likes to blame it on deregulation (especially the partial repeal of Glass-Steagall) and greed.  The more accurate view is that it was largely made in Washington.

As I have pointed out before, the first claim of the Left is total nonsense.   There was no relevant deregulation and the Left’s desperate attempts to hang it on Glass Steagall are just that: desperate.  Even the Washington Post, not exactly a right-wing mouthpiece, has admitted this multiple times (recently here).

Peter Wallison, who was the lone dissenting member of the Financial Crisis Inquiry Commission, the body set up by Congress to review the GFC and whitewash any role the government played in it, has made it his life’s work to dispel this myth, including here on a podcast.  Wallison also has the best explanation for the Left’s obsession with Glass-Steagall.  Since there was no other deregulation, and since deregulation must be the cause of the GFC (if we are to justify more regulation), then the partial repeal of Glass-Steagall must be responsible.  For the Left, this constitutes quod erat demonstrandum.

As for the role of greed, blaming the GFC on this factor is a lot like blaming an airplane crash on gravity.  Greed is always there, usually balanced by fear.  Mess with this equation and bad things happen.

People like Wallison, conversely, blame the government, under both Democrats and Republicans.  I won’t go through all the argument (which is described at length in Wallison’s book Hidden in Plain Sight and summarized in this article), but he puts the blame on things like the Community Reinvestment Act, FHA policy on downpayments, the government-sponsored apotheosis of the rating agencies (with things like banking capital regulations) and the repeated congressional mandates given to Freddie Mac and Fannie Mae to increase their lending to low-income families (eg., sub-prime borrowers).

Much of this is true, but I think that Wallison misses out on the biggest factor in the sub-prime boom and bust.  This is the role played by the Federal Reserve which, through its low-interest policies following the bubble, was the great enabler of greed over fear.  Wall Street was manufacturing the snake oil – nothing new here – but the scramble for yield is what created a ready market for it.

But there is another way in which government incompetence contributed massively to the most visible and hated aspect of the GFC: the bailouts.  And this is the failure to come up with efficient bankruptcy laws.

The free market cannot function properly without an appropriate legal framework.  An underappreciated part of this is bankruptcy law.  This section of the law is extremely important because not only does it determine the allocation of value in the case of bankruptcy, which touches upon the rule of law and enforcement of contracts, but it also tremendously affects the incentives of borrowers and lenders prior to bankruptcy.[1]  Yet, it is a legislative and legal backwater.

I was reminded of this by some articles that have appeared recently.  The first ones relate to the failure of banking regulators to agree “living wills” with large banks, as mandated by the Dodd-Frank Act from 2010.  The idea of a living will is to provide regulators with a road map on how a large and complicated bank in financial distress can be wound down without recourse to public funds.  This is the role of an efficient bankruptcy procedure, which is long overdue.

As I have commented before, there was no need for the bailouts if an efficient regime to “bail-in” had existed.  The problem with the banks during the GFC was that they had made a lot of bad loans and investments, particularly related to real estate.  Since the banks had become massively leveraged due to other governmental failures (as I pointed out in Jamie and the Whale), often with equity equal to only 2-3% of their total assets, it did not take much in the way of losses before the value of their assets was less than the value of their liabilities.  This is the definition of bankruptcy.

There were two ways to address this problem of excess liabilities: either someone had to provide fresh money to the banks, to be used to pay down liabilities, or the liabilities had to be written off.[2][3] The first is called a “bailout,” particularly when the government provides the money, which always required when the bank remains fundamentally over-indebted.  The bail-in, conversely, can be a completely private sector affair.

Let’s take the case of Lehman Brothers, for example.  For those who have read Too Big To Fail by Andrew Ross Sorkin, you will remember the attempts by the rest of Wall Street to save Lehman Brothers over the weekend prior to its bankruptcy filing.  The basic strategy was to create a “good bank” and a “bad bank,” the former to carry on the operations of Lehman and the latter to house the bad assets in a liquidating structure.  The problem was that there were excess liabilities of $30 billion and there was(were) no private sector actor(s) willing to throw money into this black hole.  Had the government done its job and created an effective system of bankruptcy, however, the source would have been obvious: the $30 billion would have come from a write-off of some of the liabilities.

(Some will object that this write-off would have simply spread the problem through financial “contagion.”  We can never know the truth of this matter since history cannot be rerun.  However, I note that at the time of its bankruptcy, Lehman had over $600 billion of debt; $30 billion represented only 5% of this total, which should have been absorbable when spread over multiple creditors.  It is also true that ultimately no counterparty went under as a result of the Lehman bankruptcy, which certainly suggests that the actual contagion risk was small. It is true that the hit to confidence may have exceeded this ultimate loss, but I would argue that much of the reason why the financial sector is prone to these crises of confidence is once again bad policy.)

The second story of governmental failure in this sector relates to the latest efforts of Italy to revive the country’s banking sector, as described in The Economist.  The Italian economy is still 9% below its pre-GFC peak.  This fact, combined with the gross incompetence and corruption of much of the heavily regulated and cossetted Italian banking sector, has left Italian banks with about EUR 360 billion of non-performing loans (NPLs), equal to about 18% of GDP (although in reality the figure is probably higher).

The Italian government believes that the NPLS have hamstrung the banking sector, contributing to the economic malaise of the country.  The  government wants the banks to sell their NPLs and get back to the business of creating new ones – that is, to lend again.  The problem is that if the banks sell the loans at less than 40% of their face value, they will incur massive losses, eroding or wiping out their capital bases.  But investors are only willing to pay about 20 cents on the dollar for these duff loans.

Why so little?  As someone who has bought plenty of Italian NPLs in my career[4], the answer is simple: like almost every other part of the Italian legal system, bankruptcy law is a disaster.  In a normally functioning legal system, which already includes many inefficiencies, bankruptcy takes about two years.  In Italy, according to The Economist, it averages about eight.  What the article doesn’t mention is that this average consists of roughly six years in the relatively functional north of Italy, combined with basically infinity once you get south of Rome.

Who are the winners from all of this value destruction?  It is the borrowers and the bankruptcy administrators.  The former get to hang onto their assets, notably real estate, and milk them for much longer; Italian borrowers are past masters at this process.  The bankruptcy administrators are even more predatory.  So long as the bankruptcy continues, they can charge fees which take priority over the claims of creditors, frequently leaving them with an empty shell.

The Italian government is trying to address this problem by strong-arming the banks into creating a centralized fund to buy out NPLs and re-capitalize banks.[5]  The government is also promising reforms of the bankruptcy and foreclosure laws, but potential loan buyers have heard that one before.  The key lesson is that, once again, government failure is providing an excuse for more government.   It must be great to be in an industry where you can create demand through your own incompetence.

One of the most pernicious consequences of this failure to provide effective bankruptcy law is that it provides further incentives for debt.  As I have discussed before in Jamie and the Whale, the tax codes of most countries, and especially the US, perversely incentivize leverage.   Lax bankruptcy laws, which spare corporate borrowers the full and rapid consequences of their bad decisions, create a further perverse incentive.  There is a tremendous amount of economic literature on how financial downturns, like the GFC, are made much worse by large amounts of debt.  Yet, governments have done nothing to address the legal, tax and monetary biases that promote borrowing.  Except, of course, to come up with new ways to blame the private sector for these problems.

A final comment: Elizabeth Warren, the comprehensively misguided Senator from Massachusetts, taught bankruptcy law at Harvard Law School before she decided to inflict herself on the nation.  She could actually do a lot of good by raising the profile of this massive government failure, but this will never happen.[6]  She would rather spend her time with the much more exciting (and re-election-enhancing) work of giving out free stuff and finding villains to blame

Very Good News

The profitability of banking has plummeted.  This is very good news for the economy.

Michael Lewis tells a story of his early days as a bond salesman at Salomon Brothers.  Mervyn King, an academic who had taught Lewis at the London School of Economics and who subsequently headed up the Bank of England, was visiting the bank and wanted to see some trading floor action.  He sat next to Lewis and eavesdropped on his sales calls.  After an hour or so of listening to Lewis’ spiel, he asked him how much the bank was paying him.  Upon hearing the answer, King said “[t]his really should be against the law.”

Increasingly, it is.  Or, to put it more precisely, the law is finally reversing many of the policies and subsidies that made it possible.  The consequence is that banking is becoming a lot less profitable.  For example, Goldman Sachs, previously referred to as a “vampire squid,” has now become, according to Gillian Tett at the Financial Times, a “flattened slug.”   Goldman’s return on equity, a key measure of profitability, hit 39.8% in 2006.  In the first quarter of 2016, it was 6.4% and stock analysts are hoping for a rebound to 10% for the rest of the year.  Hoping.

The consequence is that compensation in banking is falling.  This year at Goldman, it is running 40% lower than last year.  Total employment is falling, too.  Looking at the entirety of finance, it was 8.4 million in 2007; in April of this year, the figure was 8.25 million.  If you exclude insurance and real estate, to focus just on banking, the contraction is more dramatic: employment peaked at about 3.85 million in 2007, but has now fallen to about 3.5 million.

This decline in financial services has released a huge amount of highly valuable human resources to other sectors of the economy.  When I was working for banks, it seemed that Wall Street was sucking in about half the graduating classes of leading universities, including very large percentages of students with STEM degrees.   This is not surprising since compensation in banking hit a peak of 1.6 times other professions in 2006, neatly equaling the ratio last reached in 1928 – just before the stock market crashed.  I don’t know what the current figure is, but I bet it is a lot lower.

In addition to freeing up human resources for more productive, non-subsidized activities, there is a more subtle benefit to this fall in profitability and compensation.  As anyone who has worked on Wall Street knows, there is a large disparity in the average quality of personnel on the “sell side” (the banks) and the “buy side” (the investors).  The prevailing fiction is that institutional investors are sophisticated enough to hold their own against the sharpies on the sell side.  Although there are many very sophisticated institutional investors, this is far from universally true, particularly if the buy side is a public or quasi-public institution (such as many pension funds and banks).  The fall in the profitability of banks will help the buy side compete for talent.  This levels the playing field dramatically and greatly reduces Wall Street’s ability to sell toxins.

Roger Barris

Weybridge, United Kingdom


[1] As anyone who has studied finance knows, there is a huge amount of literature dedicated to “financial distress,” much of it related to the perverse incentives it fosters.

[2] Of course, there can also be combinations of the two, but I will ignore this for simplicity here.

[3] I have said “written off,” but in reality, the liabilities are usually exchanged for deeply subordinated claims (a so-called “hope note”) or equity.  Again, I will ignore this for simplicity’s sake.

[4] For example, my group once bought 50% of a portfolio of EUR 15.4 billion of Italian NPLs, the largest transaction that had been completed to that date.

[5] The government is forcing the private banks to do this, instead of doing it itself, in order to avoid European Union rules on subsidies.

[6] In any case, her stupefying economic ignorance would probably only make matters worse.

Posted in: Finance, Policy


  1. Anonymous
    June 12, 2016

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    …Lehman had over $600 million of debt; $30 billion represented only 5% of this total, which should have been absorbable when spread over multiple creditors.

  2. Tom
    June 12, 2016

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    Wallison was not the “lone dissenting member” of the FCIC. All of the minority appointees voted against the report and issued dissenting statements. Keith Hennessey, Douglas Holtz-Eakin and Bill Thomas issued one, and Peter Wallison issued another. The FCIC limited the length of the dissenting statements that would be printed in the official report, so Wallison supplemented his on line.

    The majority FCIC report was an exercise in political justification of subsequent regulation and was a great example of “the victor writes the history.” The dissenters were much more accurate in their assessment of the causes of the crisis, but even they gave too little credit to the threads connecting US housing policy to centralization (in the rating agencies) of mortgage credit (and regulatory capital) determinations. The ratings agencies’ views fueled the growth of redistributive US housing policy in part because of the green light afforded to those policies by the high “stand alone” ratings (based largely on mortgage criteria) awarded by the ratings agencies to the federal housing entities. The ratings agencies adopted overly optimistic criteria (that aided US policy) in part to protect their oligopoly from government action. Remember Moody’s retreat from unsolicited ratings in response to a DOJ anti-trust investigation. The US ratings agencies “expert view” on mortgage credit (that was corrupted in part by US housing goals) was exported to the rest of the developed world. Interestingly, the mortgage market was one securities area where the banks could participate, even under Glass-Steagall (again, in furtherance of US housing policy). As you say, the easing of Glass Steagall restrictions had little if anything to do with the crisis.

    • Roger
      June 12, 2016

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      Thanks, Tom. Very thorough, as always.


  3. Dave Anderson
    June 12, 2016

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    It would be interesting to see a reform under which the lawyers, and maybe even the judges, only got paid at the end of the bankruptcy, and either without interest or even with negative interest. That might speed things up considerably.

    • Roger
      June 13, 2016

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      Hi David:

      I think that it might be easier than that. I don’t know this area tremendously well, but I think that it might be another area where the English — as in many areas of the law — are much better than we are. First, I don’t think that they encourage metaphysical discussions about when a company is in financial distress, like we have in the US bankruptcy code. It is simple: if a company cannot pay its bills when due, then it’s game over and the company falls under the control of the creditors; none of this “insolvent” versus “bankrupt” nonsense, the trigger point is clear and objective. (This, among other things, would be a big disincentive for people financing their businesses with too much short-term debt.) Next, I think that when this happens, the company is immediately turned over to an administrator, who takes over management on behalf of the creditors and is mandated, at the order of the creditors, to sell the company as a going concern or liquidate it, depending on what delivers the greatest value for the creditors. The management and the shareholders are out of the picture the minute insolvency hits, as is right given that they failed. The proceeds of the sale or liquidation are then distributed in strict order of priority. I think that the creditors can agree any payment scheme and incentives with the administrator that they like.

      I am sure that I have missed things in this description and oversimplified it, but this general structure strikes me as being far more likely to be fast and efficient, and to provide the right incentives, than the overly complex system that we have in America. But, like I say, I am no expert.

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