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The Real Reason That the Bailouts May Not Work

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A recent WSJ article on banks in trouble focused on the fact that many of these banks were TARP recipients: QED, TARP was bad and the bailouts didn't work. While state bashing is nothing new in the pages of the WSJ, it's worth remembering what the bailouts were actually designed to do: stop the global payments system freezing up. It was not designed to bailout some community lender in the West who got in over their heads in commercial real estate. It is also worth putting these prospective failures in perspective. The median size of these banks was $439 million. Compare that to the balance sheet of Bank of America and the combined $4.2 billion tied up in these banks is a drop in the bucket. Moreover, while 98 failing banks seem a lot, we should remember that between 1985 and 1992 2109 banks failed, so let's not get too excited about this most recent spate of casualties.

So why the focused attention on these relatively normal events? Perhaps the answer lies in the continuing campaign played so deftly by the banks and their allies to turn the largest ever private sector failure into a public sector failure, thereby getting themselves off the hook for the mess that they made. To take just two examples, the minority report of the Financial Crisis Commission blamed Fannie and Freddie for the crisis, despite the fact that the crisis hit over 20 countries and yet only one of them has Fannie and Freddie. Similarly, the global banking crisis has been turned into a crisis of profligate sovereigns, sidestepping the fact that the debt bloating states' balance sheets are bailout costs and lost revenues, not runaway social programs. Mere facts, it seems, can't compete with a good ideology. However, the WSJ may be more right than they know. The bailouts may not ultimately work, but for an entirely different set of reasons.

To see why it's worth having a look at two pieces, one by John Cassidy in the New Yorker Magazine and one by Andy Haldane at the Bank of England. Taken together, they suggest that all may not be well going forward, despite the billions of dollars thrown at the banks: on a fundamental level, their business model may have run out of juice.

Cassidy's November New Yorker piece asks, "What Good is Wall Street?" If it significantly adds to capital formation, then the argument for compensation orders of magnitude beyond other sectors is somewhat justified. The problem lies in showing this, since doing so rests upon a series of counterfactuals that are hard to prove. For example, the existence of a $400 billion swaps market doesn't mean that its absence would result in lower GDP growth. It does however mean lots of fees for those who arrange the swaps.

Looking at the link between what banks do and capital formation, Cassidy notes that the part of Morgan Stanley that does link borrowers to savers and raise capital, traditional investment banking, delivered a mere 15 percent of 2009 revenues. For Citibank "about eighty cents of every dollar in revenues came from buying and selling securities, while just 14 cents on every dollar came from raising capital for companies." As such, the claim that these institutions are doing "God's work," AKA capital formation, seems to skate on rather thin ice.

Andy Haldane, executive director of Financial Stability at the Bank of England, similarly set out to measure the contribution of the financial sector to growth. Is it a productivity miracle or a statistical mirage? Haldane concludes that it's a mirage, but what is of most interest is how he dissects the underlying business model of investment banking, which enables us to see Cassidy's numbers in a different light.

First of all, you give up on customers and develop counterparties. That is, you fatten your trading book, and to do that you need lots of different products to trade, hence the growth of complex and opaque securities. Second, you use said securities and the firm's balance sheet to develop massive amounts of leverage so that even if the margins on each trade are thin, with enough volume you can earn a lot of cash. Finally, you 'cover' all this by writing deep out of the money options that give you a near risk free income stream: until it doesn't.

This is how banks actually make their money, until 2007, when it all went wrong. This raises two problems going forward. First of all, the revenues generated by this model are contingent upon some raw material going into the system as an input that one can profit from as the asset increases in value. Over the past twenty years those raw materials were equities and then real estate and then (briefly) commodities. The latter markets were too small and fragmented to pump this system, hence the 2006-7 boom and bust, and the former two and now either held up by massive amounts of free liquidity (equities) or are underwater (real estate). As such, it's not clear that these engines of profitability can be effectively restarted.

This is a worry since the bailouts were based upon two complimentary definitions of what this was a crisis of. For the Americans this was a crisis of liquidity. That is, the engine was sound; it's just run out of oil (credit crunch) and with enough liquidity it will spontaneously restart (limited stimulus etc.) For the British, the engine blew a cylinder and it had to be rebuilt (12.5 percent of GDP as bank recapitalization), and with enough oil (liquidity) it will restart.

But what if the raw material to feed these engines is no longer available? Then the business model as a whole may be in much more trouble than we think. Add to this the impending foreclosure mess really coming home in 2011-12 and the revenues may simply not be there anymore.

TARP and associated programs worked. They saved the global payments system. That is what they were supposed to do. They were not supposed to save small-cap banks from their own investment decisions. They were also not designed to save a business model that may have run its evolutionary course.