I'm posting this transcript because I feel that it's not something you'll see in the press and feel it's informative.
Ex CEO of the NYSE and Merrill Lynch John Thain speaks to the students at Wharton along with a panel discussion with Professors Jeremy Siegel, Richard Herring and editor of Knowledge@Wharton Mukul Pandya.
If you're going to comment please refer to something in the discussion and open a dialog. This is more about discussing solutions, problems and thoughts so it's unacceptable to rant. Things like "Wall Street is the suck" or USA #1 wheter in the thread or tags will be dealt with. I have friends in the right places so behave yourselves.
OK fire away...
Part I: Thain's Remarks
Jeremy Siegel: Let me tell you a little bit about the format of our session this afternoon. I'll give a brief introduction to John. He will speak, and then professor Richard Herring from the finance department, Mukul Pandya, executive editor of Knowledge@Wharton, and I will ask some questions. I am Jeremy Siegel, also from the finance department. Then we will have questions from the audience. So this is a three-part session. [ John Thain's resume'.
Looking over John Thain's resume, it is truly incredible.... He was born in 1955 in Antioch, Illinois -- 60 miles from Chicago. My hometown is Chicago, too, so we're both Midwesterners. He was valedictorian of his class, captain of the wrestling team and lead debater. He went to MIT and got an engineering degree in 1973. After that he went to Harvard Business School and got his MBA in 1979. He then joined Goldman Sachs and rose up through the ranks to become president and chief operating officer during a very successful time for both him and Goldman Sachs.
In 2004 he joined the New York Stock Exchange. That was after there was a slight controversy about past president Dick Grasso, who took a $140 million bonus, which some thought was excessive for a non-profit quasi government organization. But Thain stilled that controversy and took the New York Stock Exchange even further as it was privatized. The process was started under Dick Grasso and he continued it. He then saw through the very successful merger with Euronext. Thain takes over Merrill Lynch
Spoiler:
In December 2007, he joined Merrill Lynch. And that began the interesting part of his life. Again, there was a little dissatisfaction with the prior CEO, Stan O'Neal, who was being blamed for subprime losses. O'Neal said don't worry about them; the losses will be held to about one half billion dollars. But that, of course, did not prove to be the case. So the situation was just beginning to get serious. John took over at a very, very difficult time both for the firm and for the financial system.
As the subprime crisis worsened, I think John did a very smart thing ... probably the best thing that could have happened to Merrill. He arranged a merger with Bank of America. What was so foresighted about this -- it was not like what Dick Fuld did for Lehman Brothers, which was waiting until the price got to zero and then it was too late to merge it into any company -- was that John negotiated at an early stage. I guess Bank of America had been taking an interest in Merrill for a long time and thought that it would be very good synergies. The merger was announced a year ago.
We had a session last year [at Wharton] to try to explain what was happening. It was the week when Lehman went under. That very day is when the announcement of the merger between Bank of America and Merrill took place. AIG was rescued. On the next day, we were debating that back and forth. Would it go or would it not? I said they would rescue it because there's such chaos in the market. The money fund -- the reserve primary money fund -- broke below a dollar. Panic was in the market. This is probably going to be enshrined as one of the most notable weeks in history for the financial markets. And that's when the merger was announced. The merger price was $29 a share.
Although that was only about half the price of Merrill when [Thain] took over the company, it was still a 70% premium over the market price that Merrill was trading at, at the time the deal was announced, which valued the brokerage house at just under $50 billion. So I don't know of anyone who could have done better for the shareholders of Merrill....
As I said, the interesting part of John's life probably started when he took over Merrill. I know that John is going to talk about it so I don't want to spend any more time on it.... Of course, losses mounted -- really not due to John's mistakes -- but mistakes that were made early on. Then there came a big controversy -- were these revealed to Bank of America shareholders on time? That's one. Then there was an issue of the bonuses. Big issue.... And then there is, well, the issue of the office. John is now enjoying retirement and is going to talk to us about the pleasures of playing golf and attending charity events. John, welcome.
Amazing times, bubbles and how this happened
Spoiler:
John Thain: Thank you very much, at least for most of that introduction. This is supposed to be a panel discussion, so I am going to talk only for a few minutes. I'll cover a few things. I really do want to talk a little bit about why, at least in my view, this all happened. What was the cause of this? I want to talk a little about some of the areas that I think need to be changed that aren't being focused on that much. I suppose, because I have to, that I will deal a little bit with the losses and the bonuses. And if I really have to -- my office. And then we'll open up for questions....
I will say that a year ago -- really a couple of days before a year ago -- I was in the Federal Reserve on Friday, Saturday, Sunday and this was truly history in the making. There will be lots of books written about this. This will be studied for years and years and years here and at least some of those other business schools that deal in really important things. It was a pretty amazing time....
So let's start out with, how did this happen? I think this was a pretty classic bubble. And because you're at Wharton, you have probably already read [Charles P.] Kindleberger's book [Manias, Panics, and Crashes: A History of Financial Crises]. But if you didn't, you should, because if what happened here is a pretty classic bubble, [we should be] trying to figure out whose fault this is and who should be punished and how we make sure this never happens again. Of course we won't make sure this never happens again because bubbles have been happening for hundreds of years. But it was a classic bubble. It just happened to be particularly big.
The beginnings of the bubble really stem from the U.S. Federal Reserve's monetary policy. There was too much money available for too long at too low of a cost. That fueled excessive amounts of leverage in the housing market. It fueled excessive leverage in financial institutions. And it fueled excessive leverage in the private equity firms; ultimately that fed into the stock market. There is plenty of blame to pass around -- including Wall Street. But let's just talk a second about the housing market.
Mortgage originators
Spoiler:
One of the problems in the housing market is that mortgage originators get paid for originating mortgages, and they don't really care what happens to them after they get made. So mortgage originators were originating mortgages with higher and higher loan devalues, with lower and lower credit checks on the borrower, until ultimately it got to the point where the mortgage originators were totally in the dark.
You had 100% loan devalue mortgages being made to people who had no jobs, no income, no assets. They started calling them NINJA loans -- no income, no job or assets. Those were mortgages that the mortgage originators really didn't care about because they really weren't regulated by much of anyone and they got paid just for volume. So that's one problem that needs to be looked at.
Lenders
Spoiler:
Second, the lenders themselves didn't really care because the lenders were able to push these mortgages -- all of them -- into the marketplace. So they didn't keep any of the pieces of them. One of the proposals that's being talked about now, which I think is a good one, is requiring lenders to keep at least some equity -- some piece of these mortgages -- so they have some responsibility and they do care what actually happens to them after they originate them.
Freddie and Fannie
Spoiler:
We, of course, had Fannie Mae and Freddie Mac -- you could spend an entire day talking about the problems of having a government-sponsored entity whose actual original purpose was a good one. The idea that Fannie and Freddie should use their government sponsored status to standardize mortgages and to guarantee them, making home ownership more affordable to people -- that's a good thing. But making them a for-profit, public company wasn't such a good thing because they then used their government status to grow a giant portfolio, which really didn't do anything to further the public purpose but did, in fact, allow them to make a lot more money since they could fund their portfolio at slightly over government rates. Their shareholders did better and their executives did better. And, by the way, that's still an issue that has to be dealt with -- what to do with Fannie Mae and Freddie Mac.
Wall Street and rating agencies
Spoiler:
We then get, of course, to Wall Street itself. Wall Street was securitizing all these mortgages and, as the credit quality deteriorated, Wall Street decided that we would make more and more complicated structures until we finally got to the point where no one understood them -- certainly not the rating agencies, certainly not most of the buyers of them. And I think, for the most part, not very many people on Wall Street understood them. The best evidence of this was that some of the Wall Street firms -- including Merrill Lynch, which created a lot of these things when it became more and more difficult to sell them -- thought it would be just perfectly okay to pile them up on their balance sheet. That turned out to be a very, very bad idea. But there's no question that, as the securities themselves became much more complicated, the rating agencies completely failed in their jobs [by] rating big chunks of these things triple-A. They had a tremendous amount of leverage built into the structures. The agencies never would have rated a corporation triple-A that had that much leverage.
The prospectuses that these were sold under didn't even explain what the real collateral was inside of them. The buyers didn't understand what they were buying, and Wall Street was packaging these things up and selling them to make money, and then of course also piling on their own balance sheet, which led to the ultimate destruction of several of the firms.
Regulators
Spoiler:
There's also blame to go around on the regulatory side. The regulators -- as the markets went up and as asset prices rose -- allowed financial institutions to get more and more leverage. So whether it's investment banks or commercial banks, the amount of leverage in those firms grew dramatically. That's a problem. Also, the policies on capital were very pro-cyclical. In a positive environment when banks are earning money, where asset prices are rising, they were allowed to have less capital as a percentage of their total assets.
And then, of course, as the market turned around and went the other way, they need to have more capital, which of course is exactly the wrong thing to do because then they are forced to raise capital at the worst time to try to liquidate assets. And that caused the downturn to be even bigger. We really haven't yet dealt with the regulatory structure that is needed to [handle] these very large financial institutions. I'll come back to that in a minute.
Private Equity
Spoiler:
We also had too much leverage in the private equity world. Private equity firms were able to borrow more and more money. That also helped to drive stock prices up. So what basically happened was a fundamental bubble that was driven by, first, monetary policy, but then ultimately all these other factors. And that bubble burst.
New Regulatory Framework
Spoiler:
We're now in the mode of trying to deal with the damage of the bubble bursting and what to do to at least try to make sure that -- I don't think you can prevent bubbles from happening -- they don't do as much damage as this particular one has done.
So let me talk about a couple of things that I think we need to focus on. One is the regulatory framework in the United States. I think it's unfortunate because one of the great things about crises -- if there is anything good about them -- is you can use them to make change. At least at the moment, it doesn't seem to me we're going to make what are the fundamental changes in the regulatory structure in the U.S. financial system. Why do we have the SEC and the CFTC [Commodity Futures Trading Commission]? Why do we have the FDIC [Federal Deposit Insurance Corporation], the Fed, and the OCC [Office of the Comptroller of the Currency]? There is no real attempt to consolidate and to eliminate the duplication in that regulatory structure.
We certainly don't have a mechanism to capture the gaps in those structures. When you have multiple regulators that are duplicative, you also create gaps. That's one of the reasons AIG financial products was able to do what it did, which was basically write massive insurance contracts without any regulatory requirements whatsoever. I think it's unfortunate but I'm not very optimistic that we're really going to do something to create a more logical, less duplicative, less expensive, but also better regulatory structure for financial institutions. But I think that's an area that needs focus on it.
Bonus structures on Wall Street
Spoiler:
The second area I think we need to focus on is the whole bonus structure on Wall Street. I'll talk specifically just for a minute about Merrill, but I think it's more the concept. I don't think there's anything inherently evil about bonuses. Having compensation that's variable is better than having compensation that's fixed. So if you just pay people X millions of dollars no matter what they do -- whether they perform well or not and whether or not the company has performed well or not -- that's not a good alternative.
But I do think bonuses have to be tied much better to longer-term performance. They have to be tied better to the shareholders. And they also have to be tied to real results.... If I'm trading foreign exchange, and at the end of every day my positions are completely liquid and you can see what they're really worth, that's one thing to pay me based upon that. But if I'm creating triple A ABS [asset-backed securities] and CDOs [collaterized debt obligations], and I'm marking them to market but I'm building up a huge pile of them on my balance sheet, which ultimately leads to losses in the future, that's a totally different and much less high quality of earnings. You want to pay people much differently for that kind of thing.
So you first have to take into account what exactly is generating earnings. And second of all I think you have to make compensation -- and bonuses, in particular -- longer-term and more equity-based and then require that the stock be held for a long period of time.
I think you'll see some of this happen. You will see some of the firms use much more stock or stock-like things, make people hold them for very long periods of time. But that's not the only answer and I think there's too much focus on the bonuses, because actually Lehman, as well as Bear Stearns, had components of equity in their compensation structure and made their employees hold them for long periods of time. And that didn't do them the slightest bit of good. So I also think there has to be much better focus on risk management. Because even if you have a compensation structure, if you don't have good risk controls -- if you don't understand the risks that you're taking, if you allow traders or businesses to wipe out the earnings of all the other employees of the firm -- that undermines the entire compensation structure no matter what you have. That was one of the problems at Merrill Lynch.
The losses that were generating Merrill Lynch's P&L -- almost all of them were mortgage and mortgage-related. All of the people who created those losses either got fired before I got there or I fired them. So I then have 60,000 people who are working in wealth management, working in investment banking, working in equity trading -- basically all of whom are doing a good job. They come to work every day. They're actually earning money in their businesses. And all of their efforts get wiped out by these legacy assets that were put on this balance sheet through a complete breakdown of the risk controls. None of the people are even there. So you have to tie compensation as well to good risk management because otherwise you still have the problem of one group or one business blowing up the entire firm, which is what risk management is supposed to prevent.
Too big to fail
Spoiler:
The other topic we're going to cover is "too big to fail." We have a problem in this country right now, which is that the concept of moral hazard has been thrown away. We have the very large financial institutions right now that are too big to fail -- Lehman has proven that they are, in fact, too big to fail. And so they have an implicit government guarantee. But we haven't done anything to change how they do business. We haven't done anything to change their regulatory requirements. We certainly don't have any intention of breaking them up so that they're smaller. And there isn't any formula right now to actually make them pay for that implicit government protection. The FDIC charges for deposit insurance. Right now we have implicit government insurance of these big financial institutions that they don't pay for, and at least so far, they haven't changed their behavior. I think that is a potential problem in the future.
Merrill's bonuses and "the lie"
Spoiler:
I will cover a couple of Merrill things since you brought them up at the beginning. It will save you all from asking. Easiest one is the bonuses. When we negotiated the deal in September, there was no TARP money. There was no government injection of capital into any of the financial institutions. We negotiated really four main things. We negotiated the price. We negotiated the bonuses. The third thing we negotiated was the materially adverse change clause. The fourth one doesn't really matter.
So as part of the deal on that September weekend, Bank of America agreed then that we could pay -- they agreed to pay up to $5.8 billion of bonuses. They did that for what they now say is the obvious reason -- that if you have 60,000 people, if you don't pay them anything, they have alternatives and they'll leave. Since the company basically is a people business, you can't just not pay 60,000 people anything, or they will go find alternative places to work where they will pay them.
So they agreed in September that we could pay up to $5.8 billion of bonuses. They were totally involved in the process to do that. I'll give you some of the details just for fun. When we agreed in September, it was supposed to be 60% cash, 40% stock. They asked us to change it to 70% cash, 30% stock, which we did. We ultimately changed $5.8 billion to $3.6 billion because we were trying to at least reflect somewhat what was happening both in the market as well as at Merrill. They asked us to use their stock instead of Merrill stock. So it's a little interesting in January when they claim they didn't know anything about these bonuses since we used their stock to pay them. And basically when I got fired in January -- when they said John Thain secretly accelerated these bonuses -- they were lying.
That has now trapped them into a lot of trouble because there's a piece of paper -- there's a document -- that says yes, they in fact agreed to this in September. So one take away for all of you is it's really always better just to tell the truth.
Merrill's Last Stand
Spoiler:
When I thought Lehman was going to go bankrupt, I believed at the time that this was going to be catastrophic in the marketplace, which unfortunately turned out to be true. But I also thought it would be catastrophic to Merrill Lynch because of the amount of bad assets we had on our balance sheet. So the idea that we were going to lose money in the fourth quarter after Lehman went bankrupt is why we sold the company. If we were going to make money, we wouldn't have sold the company.
So I don't think there was any question that -- given the complete shutdown in the credit markets and given the amount of bad assets that were on our balance -- we were going to lose money. Did we lose more than maybe Bank of America thought we were going to lose? Well, probably. But the market was really, really bad. And a lot of those losses actually were just mark-to-market losses and actually a lot of them have come back. Merrill Lynch contributed the vast majority of Bank of America's earnings in the first quarter. Part of that was these losses being reversed.
So I don't think there is anything particularly surprising other than perhaps the overall size. But the idea that we were going to lose money in the fourth quarter was pretty obvious, I think.
His office and what a commode is
Spoiler:
And the last thing, since you brought it up, I'll talk about my office. So you all learn lessons from people who make mistakes. I joined Merrill Lynch in December 2007. That was before Bear Stearns, before the world imploded, before there was any government money, and I used my office to receive clients, to receive guests. I used it as a meeting space. The way the office was set up, it had a big desk right in the middle. So it didn't have seating space. You couldn't really receive clients. And also one of the conference rooms had been converted into a private gym. If I want to work out, I don't need to work out at the office. I can work out at my home or in a real gym. So we tore out the private gym. We reconfigured the office so that it was like a normal office where you could have guests and have meetings. And we decorated it in kind of the style that Merrill Lynch offices, which were very, very nice.
Now, in hindsight that was a mistake. All right? I admit that was a mistake. I didn't know the world was going to explode, but it did. And that was a mistake and I'm sorry that I did that. If I had that to do over again, I'd furnish it in IKEA.
But I also did as much as I could do to correct that mistake. There was no government money that went to pay for any of that stuff ever -- no matter what certain politicians say. Given what happened and given that it clearly was a mistake, I reimbursed the company for the full cost of all those renovations. So I believe in doing the right thing. That renovation was a mistake and so I corrected it to the extent that I could and so that it didn't cost the shareholders any money either. And, by the way, just for all of you who watch TV or whatever -- a commode is not a toilet. A commode is a chest of drawers.
So I still recommend -- if you're going to go to a financial institution in difficulties -- just go to IKEA or keep the furniture that's there. So that's it. I'm happy to answer whatever questions you have. Thank you.
Siegel: I have a few questions. First let me say that I had the honor of having Professor Kindleberger in my graduate work at MIT. In Manias, Panics and Crises, he talked about the cycles. There's also something called the Hyman Minsky Cycle, which is similar where a period of stability gives rise to excess leverage and then a bump causes a tremendous reaction. So it's in the spirit there. Professor Kindleberger lived all the way into his 90s. He just passed away a few years ago.
You mentioned a critical subject -- too big to fail. I don't know if you've had time to look over the Treasury's proposals. They recommend that they look at the financial institutions and those that reach a certain size -- called Tier 1 financial holding companies -- would have to have more regulation, much more risk capital, maybe even subordinated debt.
Do you think this is a realistic way to pursue regulation? Admit that there are going to be firms that are too big to fail, and if they are, we just have to have them with enough equity so that they don't take excess risk and throw the cost on to the taxpayer?
After all we've done that with banks. The same argument used to be held against the banking system -- don't let the banks get too big or that will happen. And we've had a few occasions where it has happened. But on the whole -- Dick might want to comment on that -- I think it's working very well. But the question is, do you think that is the new reality out there, that we will identify such firms and have them under more regulation? The good part is the government may step in and guarantee your senior bonds. The bad part is you're going to have to have more regulation being that big and the firm will have to worry about the trade-off between those two.
They are too big to fail and what might be some options to that
Thain:
Spoiler:
First of all, I think we have to accept the fact that these institutions -- at least as they exist today -- are, in fact, too big to fail. Of all the things that happened over the last year, the single biggest mistake was allowing Lehman Brothers to fail. For what would have been at the time somewhere between $20 billion and $30 billion, if the government had done a program that was similar to what they did with Bear Stearns -- where they took a chunk of their commercial real estate assets and pulled them out and protected them and put them on the Fed's balance sheet -- for $20 billion or $30 billion of exposure, either Bank of America or Barclays would have bought Lehman and, at least in my view, the trillions of dollars of destruction that followed Lehman's bankruptcy is much less likely to have happened.
Yes, there may have been another one down the road. And AIG certainly would have been a problem, but there's no question in my mind that allowing Lehman to actually go bankrupt was a huge mistake. So with too-big-to-fail institutions, you can deal with them a number of different ways. You could, in fact, say you can't be that big -- you can break them up. I don't think that's very likely to happen. And it's not necessarily good for U.S. competitiveness because remember, these financial institutions compete around the world.
You could have a regulatory capital regime that really does force them to have enough capital to deal with the risks that they take. I think that's possible. I'm pretty skeptical the government will be very good at that. I'm also skeptical that [the government] will actually have the ability to make them have enough capital to take into account the risks that they're really taking. But that certainly seems to be the direction that we're going.
And the third thing you could do -- and maybe you do this in combination with the capital requirements -- you could actually charge them for being that big. So just like the FDIC charges insurance for deposits, you could charge them. And the bigger they get and the riskier they get, you could charge them more. So they could have both more capital and pay for at least some of that implicit guarantee.
You could, on the other hand, go down a different path that says that if a financial institution is going to go under, I'll wipe out the shareholders, I'll wipe out the stock holders, I'll wipe out the preferred holders -- maybe I have to wipe out the subordinated debt holders -- and maybe if the loss is big enough, I get all the way and I haircut the senior debt. But it doesn't mean you simply default on all the contracts. And so even in the case of Lehman Brothers, it would have been much better if they said, 'Okay, we'll wipe out the common, we'll wipe out the preferred, we'll wipe out the sub debt, but then keep the contractual arrangements in place' so that you didn't have the complete shut down of the capital markets. The other alternative is to take that approach.
Richard Herring: Could I follow-up on your notion that we've done a good job with banks? I think one could have argued that if you have only a bank and not a bank holding company, the sorts of things that John just described do actually happen. The FDIC can step in. They'll do it always on a weekend very carefully. They'll open the next Monday. They'll apply haircuts to the stockholders, the preferred shareholders and usually the subordinated debt holders and maybe even the uninsured depositors. But it would only be credit risk; it wouldn't be liquidity risk. They actually make an attempt to give them the expected value right up front so you don't add liquidity to a credit-risk problem.
The reason it hasn't worked -- and you've seen very little of it in the last two years -- is that our largest banks have chosen to hold 20% to 40% of their assets in their holding companies. And their holding companies are subject to bankruptcy laws. It would be just like Lehman Brothers all over again. So the Fed at this point -- in fact the whole government, as we saw after Bear Stearns -- simply doesn't have the tools to deal with this sort of problem.
I'm wondering about another kind of issue, because it is true the Obama plan tends to dwell on size as the feature of systemic risk. But there are other aspects as well -- interconnectedness is something that came up with Bear. In fact, Bear didn't even make the list of the large complex financial institutions, although of course Merrill did. Part of that stems from their corporate structure. Part of it indeed stems from the international structure that you spoke about. A bank like Citibank has something like 2,400 majority owned subsidiaries -- more than half in foreign countries. Every single one of those foreign countries has a different resolution process.
If you even thought that the countries had the goodwill to try to work together, the coordination costs of doing it are almost unimaginable. So one tack that could be taken is to do what the British have done and suggest that each of these firms figure out a plausible winding down scheme that would make it possible for them to gracefully leave the scene without causing horrendous side affects for the rest of the market.
In fact, investment banks used to be like that because investment banks used to have this wonderfully liquid balance sheet that allowed them to expand and contract like an accordion, depending on the funding base. It was really only within the last seven or eight years that the asset side of their balance sheet got to be so illiquid -- in terms of having bridge loans and complicated instruments that were not very easy to sell -- that they began to look like banks, but without the safety net.
Now that they've got the safety net ... do you see investment banks coming back? Do you think it's really stable to put them together with large bureaucratic banks? Or do you see them spinning off at some future time?
Consoliation in banking and a shift to smaller boutiques
Thain:
Spoiler:
I think what will happen is actually a reversal of what has been happening over the last 30 years. Over the last 30 years, there has been a continual consolidation in both banks and investment banks where the number of firms shrinks and the ones that remain are bigger and bigger. I think we're probably at the point now where you're going to start to see a whole lot of new, smaller, private -- to some extent -- boutique types of firms start. I think that will probably mean there will be a greater number of smaller firms. Some of them will grow and be successful.
And you have to remember -- I made this comment earlier today -- 30 years ago, Goldman Sachs was not one of the top tier firms. Thirty years ago, the top three firms were Morgan Stanley, White Weld and Dillon Reed. Goldman Sachs was actually in the second tier with Kidder Peabody and a bunch of others. Salomon Brothers was actually there, too.
Herring: And probably no one of them was too big to fail.
Interconnected around the world but under many different rules
Thain:
Spoiler:
I agree with that. I totally agree that probably none of them were too big to fail. So what's happened is there's been this consolidation. Now you've got these huge, huge firms that are completely interconnected around the world and do, in fact, have operations all over the world. They operate through, as you said, thousands of subsidiaries and under all different regulatory regimes, all different tax regimes and all different bankruptcy regimes, which makes dealing with them in bankruptcy really, really difficult.
I'm pretty skeptical about the idea that you're going to be able to have this living will and make it really work. So just think about that. Okay, if you told Citi to create a living will, more likely they'd be dead before they come up with it. There's just no mechanism to resolve having subsidiaries -- thousands of subsidiaries -- because you have to have regulatory regimes. You have to comply with the local regulatory regimes. You have to comply with the local tax regimes. And if you have problems, you have to deal with the bankruptcy laws in all of the different countries. I think it would be quite optimistic and naïve to think that the world is going to come up with some global regime that will actually be practical.
Herring: But that actually takes us back to one of your earlier themes, which is this has been a regulatory failure. Indeed, to give institutions incentives to have such complicated structures has also been a regulatory failure. The main reason that Citicorp has most of those subsidiaries is to evade regulations of various sorts and to comply with the tax code, which gives them benefits to structure certain products in certain ways in certain offshore centers.
So there's a sense in which the regulators have the tools -- if they have the will -- to set up an entirely different incentive system. What do you see as the main benefits for being a very, very large financial institution? Because the academic literature really doesn't find much evidence that there's benefit to society or to shareholders.
How big is big?
Thain:
Spoiler:
There's a question of, how big is big? There's certainly a point at which financial institutions get too big. They get too big to manage. Whatever efficiencies are created by consolidating in size and getting bigger at some point become inefficiencies.
I don't know the answer about where -- that's probably a good academic study. There is probably some efficient frontier about what's the real optimum size of a financial institution.
Herring: The academic studies say it's somewhere in the range of $100 billion of assets, which is way, way short of where we are now.
Thain: I don't know the answer to that.
Siegel: In other countries, the tendency is bigger and bigger. What is the average size?
Herring: The tendency is bigger and bigger. There are lots of reasons [for this]. People get paid a lot more at big institutions.
Siegel: Firms like Lehman, Bear Stearns and many others formulated either in the 19th century or in the early part of the 20th century survived the shock of the Great Depression, which is many, many times what we've experienced in this crisis. Why did they fail here? In particular, I would like you to address -- and I think you were at Goldman when it went from being a partnership into a stockholding company -- whether when they went public there was a different sense of risk. Was there maybe an abdication by CEOs or others about taking into account the big picture of what the risk was? Do you think that this was better controlled under a partnership system, or that this was not a factor in what had happened?
Back to the partnership structure and risk management
Thain:
Spoiler:
I absolutely agree with you that a partnership structure, where you're betting your own money, is a much better one at focusing you on risk management. I think one of the reasons why Goldman has always been better at risk management and one of the reasons why Goldman, even in this environment, continues to do better on the risk control side is because, as a partnership, it really mattered to have good risk management because it was your money you were risking. So having your own money at risk is a very, very powerful motivator to make sure that the risk and reward tradeoff is being made correctly. That develops a culture in a company where the risk managers have equal power to the risk takers.
That doesn't exist in very many other companies. So even though Goldman changed into a publicly traded company, still that culture of "it's your money" stayed there to a fair extent. Of course Goldman's employees collectively continue to own a significant portion of the stock. But you still have to [acknowledge that] well, Lehman's employees and Bear Stearns' employees also owned a significant portion of their stock.
Herring: In fact, even greater.
Dick Fuld, corporate culture and risk taking
Thain:
Spoiler:
Nobody lost more money than Dick Fuld. No individual, anyway, has lost more money than Dick Fuld in the collapse of Lehman. So why was that economic incentive still not enough to make them be more careful? I think it has to do with the cultures of the firms and the focus on making sure there's a much better balance between risk takers and risk managers.
Herring: Could I suggest another hypothesis that I think fits something you said earlier? We have a real problem with pro-cyclical capital requirements and pro-cyclical supervision. Part of it is very easy to understand. In fact, you were, I guess, one of the first firms to adopt the new Basel II rules because of the agreement with the Europeans, which is really rigorously pro-cyclical in a way that the former regime wasn't. But the problem, of course, is in the way we count profits. Because what does a $100,000 a year supervisor really have to say to a Wall Street manager who is making hundreds of millions when [that manager] is doing very well? The same thing, I think, happens internally within firms.
Risk managers don't get a lot of attention when things are going very well. People don't want to hear bad news in general. But they get a lot of attention when things go badly. So there's this pro-cyclical affect in risk management, too, that I think is equally damaging.
Value of a Trader versus a Risk Manager
Thain:
Spoiler:
I agree with what you said, but I think that this is highlighting one of the problems. A trader who makes $100 million versus a risk manager who saves the company from losing the $100 million -- why is one worth millions in compensation and the other is worth $100,000 in compensation? As a matter of fact, I would argue that the risk managers should be paid much more comparable to the traders. The other thing that, for instance, Goldman did and still does is it takes people who are traders and puts them on the risk management side. I think that any company that takes the attitude that risk management is a low-level function and that the traders are kings are setting themselves up for a problem.
Herring: But isn't it very difficult to compensate a risk manager for essentially the dog that didn't bark? Because when they're good, you scarcely ever know it because things go well. But when there's a lapse, then you know you've had a real problem. It may be because you didn't listen to them or it may be because ...
Leadership
Thain:
Spoiler:
If you have good leadership at the top of your firms, you will recognize the value of good risk management and you will compensate them appropriately. So I would argue it's just good management, good leadership. It's not that it's structurally difficult to do.
Siegel:I just want to follow-up on something John said. You talked about Dick Fuld losing a lot of money. I want your judgment on it, that a lot of these CEOs had taken a lot of money out. They may still have a lot of stock, but one of the things about a corporation versus a partnership is that you get to diversify out. You get to cash out. And so, yes, he may have lost a billion there, but he may have had a billion somewhere else. It's not like the CEOs, when it was a partnership, [putting] all of their wealth there. Warren Buffett always says, "I put everything in Berkshire Hathaway. 100%. I'm not taking part of it out. That's where I'm going to keep it. That's my wealth. I'm going to act as if the risk for my shareholders is the same as the risk to me." I'm just wondering whether the cash out business means yes, I still have a lot of stock, but I'm independently wealthy if something goes down.
Risk Management in Partnership versus Corporate structures
Thain:
Spoiler:
I don't know their personal circumstances, but I think your basic point that a partnership -- because it focuses the mind when you have got all your wealth at risk every day -- is a better structure for risk management. You can't return all these firms to partnerships, but any form of compensation that has that affect [would be positive]. So for instance, paying the senior executives only in stock, that they have to hold for 10 years and can't sell until after they retire, which is not that dissimilar from a partnership because basically under the old Goldman partnership, you couldn't take your money out until you actually retired, and even then you had to take it out over time. You could set up that structure. You could basically say okay, CEOs of big financial institutions take 100% of their compensation in stock. The stock vests over 10 years. And you can't sell any of it until after you retire. And then you sell it out over five years after you retire. A structure like that actually mirrors to a fair extent the partnership structure.
Siegel: Okay. One more question and then we're going to give Mukul a chance also to ask questions before turning it over to the audience.
The whole question of who is responsible -- you could, as you say, spread the blame. But do you believe ultimately that it's the CEO? The buck stops here. The person at the top had to take the big view and failed to take the big view -- abdicated a responsibility to say hey, listen, I know [what] my technicians say, but I'm putting this firm and its thousands of workers at risk. They failed to make some very critical judgments that could have saved their firms.
Protecting the franchise and CEO failure
Thain:
Spoiler:
Yes. I absolutely agree with that. My dilemma on that weekend a year ago was if Lehman's going to go bankrupt, the risk to Merrill Lynch is going to be enormous. I'd been the CEO for nine months. The last thing in the world I want to do is sell Merrill Lynch. Merrill Lynch was a great company. I liked being the CEO. No matter what happens, I'm not going to be the CEO going forward if I sell the company. So my job is to protect the Merrill Lynch shareholders. My job is to protect the Merrill Lynch employees. That's what I'm going to do. And, you know, if I lose my job over it, that's what -- although I didn't get paid -- that's what I should have gotten paid for. And that was my job. It is the CEO's job to do the right thing for its shareholders and to protect the shareholders. Where the CEOs didn't do that -- whatever the reason -- they failed in their jobs.
Mukul Pandya: During the past year, I wonder how your view of Wall Street has changed. How is Wall Street different today than it used be? Is investment banking, for example, still going to be a viable career option for our friends here from Wharton and other business schools?
Yes and politicians are never at fault (sarcasm), humble upbringing and That's the American dream. That's a good thing. And the fact that this has been kind of demonized now, I think, is very unfortunate.
Thain:
Spoiler:
The easy answer is yes, there will still be a viable career option. As a matter of fact, you're already seeing Wall Street coming back. I think the one very unfortunate thing that has happened -- and this is, again if you read Kindleberger's book, it's not unusual -- after there's a bubble that bursts, basically it has to be somebody's fault. Politicians have to blame someone. It certainly isn't the politicians' fault because it's never their fault. So to some extent, Wall Street has been blamed for this. That is unfortunate because I think Wall Street continues to be a great place for people to come and work and be successful and have great careers.
I don't want to personalize this, but I grew up in a small town in the Midwest. I had never been to the East coast. My friends in high school pump gas, sell insurance or are in jail. I went to school. I went to a good undergraduate school ...went to an okay business school. I went to Wall Street. I knew nobody. I had no contacts. I knew not one person. I had no money. Purely based on the fact that Wall Street is a pretty good meritocracy -- you have to have the right skill set -- basically you can start from zero there. You can become the president of Goldman Sachs. You can become the CEO of the New York Stock Exchange. You can become the CEO of Merrill Lynch. You can make a lot of money.
That's the American dream. That's a good thing. And the fact that this has been kind of demonized now, I think, is very unfortunate. But it will change. It will come back. I think Wall Street still is a great place for people to be successful. It's just not true that it has no socially redeeming value. It funds business and companies and economies, and you can see what happens when it doesn't work. It causes huge problems with the economy. That doesn't mean that it's not a great thing to be a doctor or -- I don't know -- lawyers are in a different category. But it doesn't mean it's not a great thing to be a doctor or a scientist or go work for an NGO. By the way, it's also a great thing on Wall Street, and it's a particular tradition coming out of Goldman, to do a lot of other not-for-profit or other community service things. That's also a great thing.
So I believe Wall Street and financial institutions will still be an attractive place for young people to go to be successful. I do think that they should do other things than just make money. Actually it is a great place to do a lot of really good things beyond just your day job. So I still think it will be a great place to go.
Siegel: I want to say that when you look at the crisis, it isn't because the demand for financial services collapsed -- wealth management service, everything else, financing new companies. Yes, subprime mortgages will not be popular for a while. But that is a small part. The demand for finance is there. The problem is the firms got over leveraged in that position, tanked themselves, but it's not like horse and buggies are going out because the automobile is coming. We're training people for jobs that don't have any demand any more.
The demand for those jobs -- especially with internationalization and the globalization of finances -- I think is going to be as big as ever. I'd like to go to the audience unless you have one more question.
Pandya: Just one last follow-up to what you just said. I read all those articles about the office and the commode and all that. I think that hearing you speak today you come across as a really honest and a really decent man. And a courageous man because you addressed those issues head on even though Jeremy Siegel let a pregnant pause stand after his comment about the office. So I just want to ask you this question from my heart. And the question is very simple. If you heard President Obama's speech on Monday, he said that apart from the sort of individual personal mistakes that people like you corrected, this country has lost $5 trillion in wealth. And I wonder in the privacy of your own thoughts if you have ever felt responsibility, regret or remorse at anything?
As a representative of Wall St. he takes blame, incorrect assumptions on housing and whether Wall St. executives should kill themselves
Thain:
Spoiler:
It is -- besides being a difficult question -- it's a very good question. Yes, there have been trillions of dollars of wealth destroyed. And that is a very bad thing. Millions of people have lost their jobs. Millions of people have lost their houses. Millions of people's lives have been disrupted by all this.
So do I -- does Wall Street -- collectively bear some responsibility for that? Yes, absolutely. Is it just Wall Street's fault? No, it's not. Has there been a failure here that we should try to make sure doesn't happen again? Yes, there has been a failure here. There was way too much risk. There was way too much leverage. People didn't think about the consequences of just assuming house prices were going to go up forever.
By the way, I was going to say this at the end, but I'll say this now. One thing that you really always have to think about: Relying on the world continuing to look like it used to look is a really bad idea. There's something called HPA -- Home Price Appreciation. All these mortgages -- all these securities -- all this was always based on the premise -- the belief -- that housing prices would only go up. Well, now that looks like a pretty stupid assumption. But if you said three years ago that you thought housing prices in the United States were going to fall 25% over the next couple of years, people would have thought you were crazy. So not relying on these assumptions that everybody takes for granted is a really important thing in terms of thinking out of the box.
But going back to your point. Yes, I think that we collectively -- I as a representative of Wall Street -- bear a cost and a responsibility for the financial destruction that has been caused. I don't think -- like some senator or Congressman suggested -- that we should kill ourselves over that. I think what we should do is say, how do we fix it? What can we do to get the economy started again so people have jobs? What can we do to minimize the damage of the housing price declines and people getting kicked out of their houses? How can we make it better? And what can we do to at least reduce the chances that it happens again to such an extent? Because okay, yes, it's very bad. But piling up investment bankers and burning them is not going to do any good.
Siegel: Thank you. We're going to have questions from the audience now. Speaker: My question is simple. Over the next 12 months, or in the near term, what do you see as the biggest risk to a recovery in the financial system? Commercial Real Esate problem
Thain:
Spoiler:
I think the biggest risk right now is in the commercial real estate market.... Asset prices there have fallen even if a lot of the equity holders don't want to recognize it. As debt comes due, it's going to be very hard to refinance it. So as I look out into the next 12 months, I think the commercial real estate market and the people who lent into that market -- that's probably going to be the biggest source of problems.
I still am pretty pessimistic about the U.S. economy. I know that the stock market has rallied and Bernanke has claimed that the recession is over, but there are still a lot of people who don't have jobs. And there are still a lot of people who are getting kicked out of their houses. The people who don't have jobs and houses don't buy things. So I think that the U.S. economy is going to be pretty weak, but the single biggest kind of concentration of risk that hasn't yet been recognized is in commercial real estate.
Speaker: Do you think the Fed should have a financial stability mandate? And, if so, how do they manage attention between that and their other two mandates? Bursting bubbles in advance?
Thain:
Spoiler:
I think the Fed already has a financial stability mandate and they just need to structure it and embed it into a regulatory and legal structure. But they already do that, and they were doing that. Thain: [In response to the next question]: It's a very interesting question about whether the Fed should use monetary policy to try to burst or reduce bubbles. Greenspan argued very strongly that the Fed shouldn't do that. But what they should do is they should use the regulatory structure and in particular, the regulatory capital requirements.... They could use that to mitigate the impact of bubbles. Actually, that's one of the things I think they probably will do.
Siegel: You talked about spreading some of the blame. I do think there was a major failure of the Federal Reserve.
Greenspan and Bernanke -- but particularly Greenspan -- didn't see the build up of these leveraged risky assets in key financial institutions. He never really talked about the housing bubble. He talked about a stock market bubble -- 1996. He made a lot of noise about that but did not really mention anything about housing. I think the Fed definitely has to take a big part of the blame here. Speaker: I just wanted to ask your opinion on executive compensation because that's a very emotional issue. It seems to me that when executive compensation is calculated and the contracts are signed -- even if the company doesn't do well -- a lot of people have golden parachutes and they just leave. You mentioned about linking it to long-term performance. Could you elaborate on that? No executive contracts or Golden Parachutes
Thain:
Spoiler:
I have actually never believed in either executive contracts or golden parachutes. I don't think people should have golden parachutes. I don't think CEOs should have contracts. My attitude about that might have changed a little bit after last year, since I didn't have a contract either. But, honestly, I think, CEOs should not have contracts that guarantee them compensation. They should get paid based upon the performance of the company. Obviously, you have to take into account how the company did in the environment that they're in. But I don't think CEOs should have contracts or golden parachutes. By the way, I think golden parachutes are pretty much done with. I don't think any board is going to award golden parachutes in the future.
But I don't think they should have contracts either. And, by the way, I also don't believe in multi-year contracts, even to employees. Investment banks should not be giving out multi-year guarantees to people to get them to change jobs, which is still happening to some extent. That is a very bad practice. People should get paid based upon how they do, how their firm does and, to some extent, how the industry does.
Siegel: John, it sounds like you would be against tenure, too. That's okay. Thain: Unfortunately, the answer is yes. I would be against it. Speaker: Professor Schiller of Yale University has suggested a system of channeling risk away from people and towards international well-diversified investors who would hold onto mortgage risk. Do you see such a development taking place in the near future? Thain: I don't know enough about how that would work to answer that and I haven't seen what he wrote. [To comment on] whether or not that's practical, I would have to understand it better. Siegel : Do you think that there could have been new risk sharing instruments that might have alleviated the crisis? Thain: I think we did a pretty good job sharing risk. We blew up Iceland. We blew up towns. Herring: One has to remember that 60% of the subprime debt was sold to Europeans. We did a lot of that. Thain: There was risk shared pretty much around the world -- at least among financial institutions. But I don't know the answer about the specifics of that proposal. Siegel: Related to that, I think you really hit on this when you said there was a lot of money creating these bundled securities and commissions in selling them. I think the problem was they were also being held. Maybe for two reasons -- maybe they couldn't sell them at the end, and maybe they just thought they were good investments. It was very different than the tech bubble where the brokerage firms basically ... got them all out into the system and didn't hold them. The actual loss of stock market wealth in that bear market was really very much similar to this, but it didn't have the impact on the financial firms because the financial firms didn't hold these Internet stocks that tanked the way this did. Should they have just gotten rid of them instead of having them concentrated in their own portfolios? Thain: Well, whoever owned them still is going to lose money. Siegel: But it wouldn't have tanked the firms. I think the tanking of the firms is really a major source of the recession. 3 hours on one of the fastest computers in the world to analyze one CDO
Thain:
Spoiler:
I agree with that. But these instruments were still bad. These instruments were so complicated. One of these -- I'm talking now about ABS CDOs, and actually the CDOs-squared are even worse. Merrill created one. I picked one particular one. To actually model out the things that are inside an ABS CDO [is difficult] because derivatives are already inside the CDOs. They're already derivatives created out of derivatives. So you have to go way underneath to get to the actual pools of mortgages. To model correctly one traunch of one CDO took about three hours on one of the fastest computers in the United States. There is no chance that pretty much anybody understood what they were doing with these securities.
Creating things that you don't understand -- that the buyer doesn't understand, that the rating agency doesn't understand, that the regulator doesn't understand -- is really not a good idea no matter who owns it. I think that the degree of complexity that was created in the securities, and the lack of anybody's ability to really understand how they were going to perform, was simply an error and a bad thing. The fact that the firms that created them were stupid enough to own them doesn't make me feel any better.
Siegel: Just the plain vanilla 80% mortgage when you've had prices go down 50% in areas like Phoenix, Miami, California, sometimes more -- those are going to be under water with no complexity at all. A lot of them blew up that were just the regular mortgages. We never had a decline in home prices of more than 3% or 4% before this crisis. So people thought that if I take the top 80%, it is going to be safe because we've never had a national decline. Herring: Just look around the world. They happen every 20 years. We have thousands of them. Siegel: They didn't happen in the United States. Of course, we didn't have the bubble. We never had increases of 25% year after year after year. You mentioned Bob Schiller, my good friend at Yale, who wrote about the bubble in real estate. There were people who were saying this is just unsustainable and it's going to cause trouble in the future. And indeed it did. Speaker: You alluded earlier to the incentive structures being completely misaligned. I agree. Have we done really enough? For example, the mortgage originators are paid on how many loans they close every day. Rating agencies are incentivized by the same investment banks that are asking them to rate the securities that they have to rate. So have we done enough to take these incentive schemes out of there and fix them? Because I think unless we do, there's no long-term solution to this. Continued problems with mortgage origination and rating agencies
Thain:
Spoiler:
The answer is no, we have not. The two places you mentioned: We have not fixed the mortgage origination process. We haven't fixed the rating agencies yet. I highlighted them because I think they need to be fixed. But, at least as of now, there hasn't really been a change as to how rating agencies get paid. And I don't know of any proposals to change how mortgage originators get paid. So I think those are both areas that need to be focused on.
Speaker: That was actually my question related to the rating agencies. So to me, it seems like there was a big disconnect in actually identifying the risk and actually rating the securities properly. But to kind of piggyback on that question, do you have any specific recommendations or thoughts on what can be done to actually address that issue with the rating agencies? Rating agencies need more competition and pricing schemes
Thain:
Spoiler:
Well, there are a lot of different things that potentially can be done. For one thing, we should probably open up competition. Right now, the rating agencies basically have a duopoly because you can't get recognized as one of the statutorily approved rating agencies very easily. Second of all, I think we should change how they get paid. There are a lot of different schemes to do that. One would be to have the users pay for them rather than have the people who create the securities pay for them. There are different things. But right now there's clearly a problem with the compensation structure.
Speaker: If you're a sales person and your job is to sell securities, how would you differentiate the ethics of selling these securitized mortgages and selling, say, Merrill Lynch stock in Q4 of 2007 to Bank of America? Sophistication of the investor and selling investments
Thain:
Spoiler:
Whenever you sell anything to somebody, there are a few things that you have to do. One is you have to make sure that the person who is buying it has the financial capacity -- the sophistication -- to understand what they're buying. Second of all, I think you have some responsibility to make sure it's appropriate for them, which goes along with sophistication. So what you sell to PIMCO is different than what you sell to a grandmother in Iowa who doesn't know anything about financial securities. And then you have to make sure you fully explain to them what it is they're buying.
As they get more and more sophisticated and they become much more institutional, then they bear more of the responsibility for understanding what they're buying. But I think you have to make sure that they understand, and that it's appropriate and that you're open with them about what the risks of the securities are. Securities have risk. If you want to have a riskless security, buy a Treasury bill. Given our deficit, even that might not be riskless. I guess if it's short enough, it is. So securities all have risk. It's just a question of making sure the person can understand the risks -- that the risk is appropriate for them -- and that you explain it correctly. By the way, that's true whether you're selling CDOs or common stock. It's true whether you're individuals or institutions. You just have to make sure you're following those guidelines for the person you're selling to.
You shouldn't sell stuff to people that they either can't understand or don't understand. And, by the way, as a sales person, you should make sure you understand them as well.
Speaker: Jeremy mentioned that you've been playing a lot of golf and attending charity functions. But you're a relatively young man and you probably have two or three careers left ahead of you. I'm wondering if you've thought what you might do over the next few decades and what kind of imprint you'd like to leave on society? Doesn't play golf or go to charity events. His work in charitable arena and Bette Midler plants trees
Thain:
Spoiler:
Well, you can't believe everything people say. I haven't been playing golf because I don't play golf. And I haven't been going to charity events because I hate charity events. As a matter of fact, my normal line is I'll give you twice as much money if I don't have to go.
But I do a lot of charitable things. And, by the way, I did that before. These are not really new things. I'm on MIT's board. I am on the board of Columbia Presbyterian Hospital. I'm on the board of the New York Botanical Garden. I'm on the board of the French-American Foundation. One of the best things that I've done: Columbia Presbyterian was building a new hospital for children. I don't know if any of you have ever seen it. But they were building a new children's hospital. Columbia has always had a problem because where the babies are actually born is not where the children's hospital is. So if a baby is born with some problems, they then have to move [the baby] from where the babies are born to where the children's hospital is. So my wife and I actually gave them the money to build a new birthing unit on top of the children's hospital.
Every day, hundreds of babies are born in a brand new facility that is right on top of the children's hospital so that children, if they have a problem, can instantly go to the intensive care unit or the heart unit or whatever they need. The number of people who have their children there, who have had babies there, who say that was such a great thing to do -- that makes me feel very proud of the fact that at least I can give something back to society. And there's lots of ways you can do that, whether it's a little thing or a big thing.... Bette Midler plants trees in Manhattan. And, you know, every tree she plants makes Manhattan a little bit better. Whether it's planting trees or building babies units or giving time -- for a long time I always worked on a house for Habitat for Humanity. It doesn't matter what it is. All of you -- not just me -- you all should do those kind of things.
And you should view that as part of what you should do going forward, because in many ways work is work, but making the world a better place is something special. I would encourage you all to do stuff like that.
Speaker: Thanks for your talk Mr. Thain. What do you think of Ken Lewis? Thain: You know, it's tempting to answer that. But I'm not going to. Herring: Could I ask a more subtle version of it? What do you think of Judge Rakoff's decision to throw out the agreement between the SEC and Bank of America to keep it all sort of quiet for a fine? Thain: Anything that relates to the litigation I am not going to get into. Because this is too public a forum and I have kind of been out of it and have no reason to want to get into it. Speaker: First of all, I want to thank you for coming to speak with us. I know for many of us, we really appreciate the example of leadership you have shown and the way you have been able to balance taking care of shareholders, taking care of your employees and making personal decisions that the public views in a good light. So we want to thank you for coming here and being a good example. Thain: Thank you. Speaker: My question is regarding private equity firms buying failed banks. Do you think that doing that takes some pressure off the FDIC? Are there other regulatory issues that are challenging? And then, operationally, do you think they can actually run them better and unlock value? The should be able to buy banks.
Thain:
Spoiler:
First of all, I think that private equity firms should be able to buy banks. The FDIC, at least so far, has been making it sort of difficult for them to do that. But I think they should be able to do that. Many times the private equity firms run companies better. Not always, but many times they do. Where you have a banking system that is short of capital and needs capital, there's no reason why you wouldn't embrace what are generally very smart people coming into an industry and wanting to put capital in it. Because you're dealing with government guaranteed deposits, you have to make sure you're safe guarding those. You don't want those financial institutions to take excessive risks. But there's absolutely no reason why they can't do that in the normal regulatory structure. So I think they should be much more open than they are to allowing private equity firms to buy banks.
Speaker: How do you think your MBA degree has helped you to lead -- especially in challenging times? How his MBA helped him
Thain:
Spoiler:
It's a little bit specific to me because I went straight from undergrad to business school. At that time you could do that -- at least about 20% of Harvard's class did that. So one of the things that was very good for me -- but I think it's generally true -- is you really pick up a much broader way of looking at the world. Whenever you have a case, [it's a] different way of approaching [things], the different views, the diversity of thought about how you should deal with the particular problem that's in the case -- really respecting other people's views and listening to what other people have to say and thinking about how does what they say fit into what you think. I believe in leaders and CEOs. I believe in much more of a consensus driven style. So I believe that one of the jobs of a good CEO is to listen to those who work for you, to listen to your employees, to basically solicit input before you decide what you think the right thing to do is. I don't believe in the very authoritative -- "God has given me the view. I know the right path. And we're marching the way I said" approach, because nobody is that smart. One of the things that you pick up in business school is you realize that there are lots and lots of other very smart people who have different opinions and different ways of looking at things, and you need to pay attention to that.
Speaker: My question centers on the economy. You mentioned that there are no jobs and no housing and problems in real estate are looming. So what do you think it's going to take and how long are we going to go through this painful period? A long recovery time
Thain:
Spoiler:
Unfortunately, I think the thing that it's going to take is time. I just don't think that the economy is going to recover quickly. The U.S. historically is a consumer driven economy, and I don't think the consumer is going to spend like [he/she] did in the past. Longer-term, that's probably better because, as a country, we weren't saving anywhere near as much as we needed to save. So five or 10 years from now it'll probably be better if we have a more balanced economy and our savings rate is positive and we actually have built up a pool of savings.
But I think it's going to be painful the next couple of years. I just think the U.S. economy is going to grow slowly. That means that for all the people who have lost their jobs and lost their houses, it is going to be a difficult time. Things that we can do to try to mitigate that I think are good things include extending unemployment benefits. Trying to keep people from being kicked out of their houses by extending the mortgage terms is also a good thing. But I think it is going to be difficult for the next couple of years. Let's take one more question so that we don't end on that negative note.
Legacy
Thain: The question was, what do I want my legacy to be? How do I want to be remembered in light of my tenure at Merrill. My tenure at Merrill was only nine months. I've always taken pride in the fact that I've always tried to do the right thing. I've always tried to be honest and tried to think about the consequences of my actions. I also like to try to fix things. I went to the New York Stock Exchange because it was broken and it's an important part of the U.S. financial system and I was successful in fixing it. I think I could have fixed Merrill if I had had more time. You can't fix the problems that they had built up over five years in nine months. I think if Lehman hadn't gone bankrupt and if I had had two or three years, I could have fixed Merrill as well.
But I think the most important thing was to protect my shareholders and to protect my employees, and I did the right thing for what my job was. The fact that this came at the expense of my own job and then, even beyond that, to some extent my reputation was certainly damaged by the aftermath of that -- I still believe in being honest and telling the truth and doing the right thing. And I would like to be remembered for that. Thank you very much. [/spoiler]
When were fannie and freddie privatized, and what was the reasoning behind it?
A lot of people have mentioned the Fed's keeping of interest rates low for extended periods of time as a contributing factor. However the Fed doesn't actually provide the money so much as set the terms under which the money is provided. Where did all that money actually come from? With the Bush tax cuts we had vast amounts of money in search of a rate of return that did not require actual investment. Yet no one has mentioned the tax cuts as a contributor to the bubble. Why?
Back in the day when Greenspan kept complaining about "irrational exuberance" we had a bubble that he latter tried to deflate with monetary policy. That deflation strategy failed, because the real economy deflated instead of the bubble deflating. Was that a contributor to later inaction on the housing bubble?
How much did adjustable rate mortgages and balloon mortgages contribute to an unwillingness on the part of the Fed to raise rates in the face of the housing bubble? Since with ARMs and balloons any rate increase on the part of the Fed was certain to cause an increase in foreclosures.
Was the Fed, Greenspan and Bernanke, unwilling to call the bubble because the only tool they had to deal with it would have caused a collapse because of ARMs?
Now a couple of observations:
Politics (which Whomp does not want to deal with) is a real problem with reform. I forget where I read it, but the idea, for example, of combining the CFTC with SEC runs into the problem that the members of Congress that oversee these agencies do not want to lose their personal positions and power through consolidation. Now that's more or less human nature, and is exceptional that sometimes people do do the right thing in cases like that then when they don't. A further problem with reform is that there's a war going on. An article I read recently suggests that wars kill reform movements. There is simply too much else going on for the reform to be handled as it should be. (which may be the eventual cause of failure of health care reform as well) There is a lot of very well financed opposition to many of the reforms mentioned in this discussion and in other places. But little coordinated support.
Too big to fail: The only arguments I see for financial companies to be allowed to be too big to fail is that it would be too hard to dismantle them and the globalization means that they need to be big in order to be international players. But how valid are either of these arguments? Should a bank be a bank and nothing but a bank? What would really be the downside of saying that no company can own a bank and a bank can own no company? What really is the downside of saying that an investment firm must be a partnership, and not a publicly traded stock company?
Good questions Cutlass and I know the piece I posted is very long so hopefully this will stimulate a little discussion. Hopefully, people will like at parts and focus on them like you have.
On Fannie and Freddie they went public in 1970 and 1988. I think as John Thain said the reasoning behind making them public probably didn't make a lot of sense. You have two companies that could borrow at implicitly government rates but built huge portfolios of loans which really didn't provide any real benefit to the public. Their main purpose should be to standardize and guarantee them.
On taxes I'm not sure I see where it had a factor in this since housing stock amongst the wealthy is relatively small. Maybe when they changed the rule for housing from a one lifetime exclusion of $500,000 capital gain (which you could always roll the equity into a more expensive home but not roll down) to being able to sell as many times you want for a $250,000 exclusion on gains (with minimum of a 3 year holding period or 2 out of 3 or something like that). I don't know and can't remember when that was changed.
On Greenspan, it most definitely was a contributing factor. There's a big difference between owning internet stocks and holding mortgaged backed securities. Some individuals felt the impact on internet stocks but financial institutions/pensions etc were holding MBS. The other issue is there was no interest spread to take advantage of on any traditional or business loan either. You had to negotiate other parts of a loan deal like "covenant lite" features or non recourse since no one could differentiate value with rates so low.
ARMs were originally only for a sophisticated borrower and are still used by them. When they were brought to the masses is when it became a problem and easy money accelerated this problem. It goes back to non conforming lenders like mortgage brokers loosening lending standards that FHA, FNMA, FHLMC would not allow.
On regulatory reform, you make a good point. I think what's happened is what some would call regulatory arbitrage by not consolidating the regultatory bodies. People learn to game the system where there's a gap on who's authority they're under. Does it fall under the OCC, FDIC or SEC?
On too big to fail I think the question is valid whether a bank should only be in banking. The issue is the other entities like wealth, asset management, currency trading etc are quite synergistic with banking.
It's the complicated trading schemes, like CDO's, where it's hard to value assets are brought into the equation where a lot of problem lie. As John Thain said it took 3 hours on one of the fastest computers in the world to model one CDO held at Merrill Lynch. Their books should never be that complex nor that illiquid.
The downside of public versus private is availability of capital. At the same time, risk is handled better when it's your own money than someone else's money. I think Thain made a good point on "too big too fail". The bigger you get the more insurance you should buy from the FDIC. Seems fair and will make many consider size in their decision making.
I think you missed my point on the tax issue. It's not that the well off that got the tax breaks spent more on their own housing that I was commenting on. I think it is an accepted principle that the wealthy do not simply hoard wealth: That is it is always put to work in one form or another. Either through consumption, savings, or investment. Now what we saw through the Bush tax cuts was a very large increase in the wealth of the upper tier. Yet no one has ever shown evidence that there was an increase in investment. At at the same time the national savings rate remained low. There was a surge in conspicuous consumption, but that does not explain where all of the wealth went. So my question is, was the source of much of the money that flowed into MBS and derivatives related to mortgages money that was lying around looking for a bubble to fuel because the tax cuts put a so much money in idle hands?
What is the smallest a bank can be and be a true international player? banking is pretty well globalized at this point. But many developed nations hav only a dozen or less domestic banks. While the US still has 1000s. If the big banks were to be broken up, how far could that go before they were at a disadvantage globally?
I think you are probably correct that the Bush tax cuts could be a contributing factor since the cuts likely did not go towards helping the real economy but more likely trying to find a place to invest.
For instance, with rates plummeting with fed intervention spreads on junk bonds to treasuries went from their widest ever(2003) to narrowest ever(2007). It also helped fuel a boom in private equity and hedge fund businesses which were highly leveraged to capture greater returns. In turn, fueling more easy money for borrowers.
Having looked more closely at the rule change on housing which happened in 1997. The quote from Bill Clinton at the 1996 democratic convention was "Tonight, I propose a new tax cut for home ownership that says every middle income working family in this country, if you sell your home, you will not have to pay a capital gains tax on it ever-not ever"
So we went from a law that said you could avoid $250k of cap gain taxes one time after the age of 55 but were allowed to defer your gain when you rolled up into a more expensive home to anyone being able to sell a home and avoiding $500k of profit as long as you lived in the property 2 of 5 years. A fed study found that the number of homes sold was over 17% higher over the last decade thab it would have been without the law and 95% of these sales were for gains less than $500k. Add cash out refis and helocs and we get even more fuel. Confluence of events...
What capital gains? There weren't many to be had over the last decade other than housing. Even still moving capital gains rates from 20% to 15% probably didn't have as much impact as it would on qualified dividend income dropping to those rates. Where it's probably been a greater impact is on retirees who earned less than $69k AGI who paid 0% on capital gains (10 and 15% bracket payers).
By the way, I'm not sure if this will spark any interest but I just had Dr. Siegel in my office an hour ago. Some interesting discussion and I asked a lot of questions on a variety of topics (politics, Schumpeter, Keynes, China etc) including what came from the panel discussion. He said the only thing the press latched on from this panel discussion was the IKEA comment that John Thain made. Pretty sad...
What capital gains? There weren't many to be had over the last decade other than housing. Even still moving capital gains rates from 20% to 15% probably didn't have as much impact as it would on qualified dividend income dropping to those rates. Where it's probably been a greater impact is on retirees who earned less than $69k AGI who paid 0% on capital gains (10 and 15% bracket payers).
By the way, I'm not sure if this will spark any interest but I just had Dr. Siegel in my office an hour ago. Some interesting discussion and I asked a lot of questions on a variety of topics (politics, Schumpeter, Keynes, China etc) including what came from the panel discussion. He said the only thing the press latched on from this panel discussion was the IKEA comment that John Thain made. Pretty sad...
I was hoping more people would chime in on this. Guess not too many are up to this level of reading these days
So let me summarize and see if I got this all straight.
The government has been pushing/sponsoring/facilitating home ownership for decades. But over the last 1-2 decades that has become more aggressive and with looser controls.
Regulations that control the financial industry have been gutted both formally by Congressional actions and informally by executive and independent agency inaction on enforcement.
Mortgage originators and financiers first made riskier and riskier loans, because the risk did not fall on them. And then they made more and more fraudulent loans for the same reason.
The privatization of the government entities freddie and fannie made them more and more willing to take risks for their own profits at the public expense.
The Federal Reserve kept interest rates too low for too long. Possibly with the contributing factor that the fear of exploding the bubble of ARMS tied their hands.
The major financial institutions gamed the regulatory system even as that system was declining to aggressively do its job. Resulting in uncontrolled risk.
They also had, systemically, an internal failure to understand and control for their own risk. With a contributing factor of perverse incentives to leading actors and executives and the fact that the executives were no longer fully on the hook for personal losses.
The ratings agencies, which in theory exist to add transparency to the system, were instead captured by the mortgage banks and failed to do their jobs.
The complexity of the system came to exceed people's, even experts, ability to evaluate.
The unrestrained merger mania on Wall St resulted in far too many financial institutions which were simply too big to manage, regulate, or control in any way. And they are so big that letting them fail causes far too much collateral damage to the system as a whole.
Globalization of private institutions make them harder to control and regulate.
Excessive tax cuts added fuel to the bubble.
A widely accepted, erroneous, view of market rationality and people protecting their own money led to a hands off policy which allowed an opportunity for the system to go to hell in a handbasket.
An extremely poorly designed regulatory structure combined with lax enforcement allowed financial institutions to get away with just about anything that they tried.
I think you nailed it and adding to that the perception by home owners and the institutions belief that real estate doesn't decline in value since it never had (at least in the US). I can't count how many times I've been told "buy land, they don't make any more of it".
The "too big to fail" thing could also be "too interconnected to fail". I think Thain even said that if Lehman was allowed to abide by their contracts but then sold in pieces with help from the government on the $30 billion or so of toxic assets it could've avoided trillions in losses when confidence and credit markets were annihilated.
I was hoping more people would chime in on this. Guess not too many are up to this level of reading these days
So let me summarize and see if I got this all straight.
The government has been pushing/sponsoring/facilitating home ownership for decades. But over the last 1-2 decades that has become more aggressive and with looser controls.
Regulations that control the financial industry have been gutted both formally by Congressional actions and informally by executive and independent agency inaction on enforcement.
Mortgage originators and financiers first made riskier and riskier loans, because the risk did not fall on them. And then they made more and more fraudulent loans for the same reason.
The privatization of the government entities freddie and fannie made them more and more willing to take risks for their own profits at the public expense.
The Federal Reserve kept interest rates too low for too long. Possibly with the contributing factor that the fear of exploding the bubble of ARMS tied their hands.
The major financial institutions gamed the regulatory system even as that system was declining to aggressively do its job. Resulting in uncontrolled risk.
They also had, systemically, an internal failure to understand and control for their own risk. With a contributing factor of perverse incentives to leading actors and executives and the fact that the executives were no longer fully on the hook for personal losses.
The ratings agencies, which in theory exist to add transparency to the system, were instead captured by the mortgage banks and failed to do their jobs.
The complexity of the system came to exceed people's, even experts, ability to evaluate.
The unrestrained merger mania on Wall St resulted in far too many financial institutions which were simply too big to manage, regulate, or control in any way. And they are so big that letting them fail causes far too much collateral damage to the system as a whole.
Globalization of private institutions make them harder to control and regulate.
Excessive tax cuts added fuel to the bubble.
A widely accepted, erroneous, view of market rationality and people protecting their own money led to a hands off policy which allowed an opportunity for the system to go to hell in a handbasket.
An extremely poorly designed regulatory structure combined with lax enforcement allowed financial institutions to get away with just about anything that they tried.
I was hoping more people would chime in on this. Guess not too many are up to this level of reading these days
So let me summarize and see if I got this all straight.
The government has been pushing/sponsoring/facilitating home ownership for decades. But over the last 1-2 decades that has become more aggressive and with looser controls.
Regulations that control the financial industry have been gutted both formally by Congressional actions and informally by executive and independent agency inaction on enforcement.
Mortgage originators and financiers first made riskier and riskier loans, because the risk did not fall on them. And then they made more and more fraudulent loans for the same reason.
The privatization of the government entities freddie and fannie made them more and more willing to take risks for their own profits at the public expense.
The Federal Reserve kept interest rates too low for too long. Possibly with the contributing factor that the fear of exploding the bubble of ARMS tied their hands.
The major financial institutions gamed the regulatory system even as that system was declining to aggressively do its job. Resulting in uncontrolled risk.
They also had, systemically, an internal failure to understand and control for their own risk. With a contributing factor of perverse incentives to leading actors and executives and the fact that the executives were no longer fully on the hook for personal losses.
The ratings agencies, which in theory exist to add transparency to the system, were instead captured by the mortgage banks and failed to do their jobs.
The complexity of the system came to exceed people's, even experts, ability to evaluate.
The unrestrained merger mania on Wall St resulted in far too many financial institutions which were simply too big to manage, regulate, or control in any way. And they are so big that letting them fail causes far too much collateral damage to the system as a whole.
Globalization of private institutions make them harder to control and regulate.
Excessive tax cuts added fuel to the bubble.
A widely accepted, erroneous, view of market rationality and people protecting their own money led to a hands off policy which allowed an opportunity for the system to go to hell in a handbasket.
An extremely poorly designed regulatory structure combined with lax enforcement allowed financial institutions to get away with just about anything that they tried.
I like this. We can debate the relative importance of each component, but there may be a valid causal chain among those events that lead to the housing crash in mid-2007.
I don't think it helps us understand the sudden crash in October 2008, but it can be useful for the first half of the recession.
Now to actually read the panel discussion. Thanks for the transcript/pointer, whomp!
By the way, I'm not sure if this will spark any interest but I just had Dr. Siegel in my office an hour ago. Some interesting discussion and I asked a lot of questions on a variety of topics (politics, Schumpeter, Keynes, China etc) including what came from the panel discussion. He said the only thing the press latched on from this panel discussion was the IKEA comment that John Thain made. Pretty sad...
Not at all.
He started by discussing his view which I was less interested in since it's so difficult to predict from the top down and I tend to think from the bottom up. His empirical data and behavioral comments were of more interest.
Anyhow, he anticipates...
4-5% GDP growth for the US in 2010.
He thinks the Fed will raise rates early next year.
No inflation short term but 3-4% long term.
The dollar will continue its gradual decline but felt it was a crowded trade with bears.
He expects equities will continue to rally since too many people expect it to correct. As well, from a historical standpoint there's more cash on the sidelines as a percentage of market capitialization ever. On top of that mutual fund investors have been redeeming equity funds going on 5 months straight. This kind of money tends to be a great contrary indicator.
His concern is oil prices and geopolitics. He would adjust his view if oil prices move above $80/barrel.
Most of the questions were asked by me. I think a lot of others in the room were afraid to ask (including one of our interns from Venezuela who's studying economics at Northwestern).
My questions were things like...
The panel discussion which I mentioned earlier. On the problem John Thain sees in commercial real estate he wasn't concerned about because the values dropped significantly in the 4th quarter when even prime real estate loans were trading at 70%. Since the US depends on credit markets working it was only natural we'd experience a severe downturn. But now that LIBOR is actually at spreads below pre-Lehman, credit markets have healed and getting financing on these properties shouldn't be a problem. However, it's not like we'll see any new strip malls being built.
I asked about China's export volume maintaining its 25% growth rate being unsustainable. He felt even if it moderates their growth will be exceptional and still creates enormous value in the US to those folks who shop at Wal Mart. He didn't see the tire issue turning into a trade war or at least hoped not.
Regarding the current administration he felt they were doing a good job. There are pundits out there that feel the debt created is unmanageable and he related that the economists view after WWII that the US would enter a depression again because of the huge deficits the country was holding (much larger than today) and they were proved wrong because of innovation and productivity.
Which led me to ask about Schumpeter versus Keynes. He said Keynesian economics works fine in the short run but really is not a model to build the economy long term. It's innovation that has the greatest impact. He mentioned that over the year the US may have lost 15 million manufacturing jobs we've created 45 million jobs in other areas and manufacturers have never been so productive in output. This is a product of innovation, productivity and technology.
I asked him about the students at Wharton. I noticed that there was an extremely high propensity of foreign students in the audience at the panel discussion. He said there's actually an even higher propensity of staff members that are from foreign countries. I followed up with are they staying? He said the students are mostly going back to their home country because of even greater opportunities in places like India but the faculty tends to stay because of operating in the best environment for higher education in the world along with compensation.
Regarding a conversation I had with his colleague at Wharton, Dr. Richard Martson, and his recommedation of allocating of 40% of equities to foreign markets and half of that to emerging markets he fully agreed. One thing he mentioned that I found profound is dividends paid by emerging market companies were 4% of total dividends a decade ago and are now 15% of total. Part of the reason is the more favorable treatment in other countries where they don't double tax dividends so they distribute more to shareholders rather than retain earnings.
I asked him what he's reading. He said "In Fed We Trust: Ben Bernanke's War on the Great Panic" by David Wessel and Justin Fox's book "Myth of the Rational Market". The second book goes along with his "noisy market hypothesis". Asked if he was planning to write a book on it he said possibly if he had enough time.
That's all I can remember which surprisingly is a lot...
There seem to have been quite a few books produced about the crisis so quickly. How many of them are any good?
I've been thinking a fair amount about the regulatory reform issue. It doesn't seem like there's a lot of progress on that front. I'm interested in getting a handle on what's optional versus what's likely. But I'm cynical that much is likely at all. There is just too much else going on.
Didn't Volker make a statement a few months ago that he thought derivatives served no purpose and we would be better off disallowing them as a whole? I have a feeling that Congress is still too much in corporate pockets for them to do the right thing on regulatory reform.
This site uses cookies to help personalise content, tailor your experience and to keep you logged in if you register.
By continuing to use this site, you are consenting to our use of cookies.
