Tectonic Shifts in Financial Markets by Henry Kaufman

A Wall Street veteran offers timely warnings on the fragility of institutions

by: Review by John Authers

Regulators and politicians have had a bad post-crisis. Financial markets recovered far quicker than expected after the disasters of 2008, and damage to the economy proved less than feared — outside the periphery of Europe — but the sense of injustice and anger has multiplied.

Far from taking advantage of the crisis to establish a sustainable financial order, politicians came up with complicated regulations, which Donald Trump appears likely to dismantle. No chief executive of a large financial institution had been prosecuted over events of 2008, until last week.

In Tectonic Shifts in Financial Markets, Henry Kaufman offers a scorching account of how Wall Street got into this mess, how it failed to get out, and what to do now. Coming from a pivotal figure in modern finance, now in his 90th year, it will command attention. Kaufman was at high school with Alan Greenspan; at the New York Federal Reserve with Paul Volcker; running research at Salomon Brothers as it created the US mortgage market and dominated bond trading; and on the board of Lehman Brothers in the years before disaster hit.
This book is not an autobiography. Neither is it a detailed manifesto for where we should go next. But the brevity of Kaufman’s proposals, and the force lent by his experience, should ensure that they are heeded.

His central point can be made with a scientific analogy. The laws of physics remain unchanged.

Credit build-ups will end with disaster, investment bubbles burst, and so on. But the geology of the ground, the tectonic plates, has shifted. This is because the nature of financial institutions has changed and, in Kaufman’s words, “we cannot go home again”.

Modern institutions are unfit to withstand potential dangers. So a different kind of regulation, involving greater intervention, more judgment, and far less trust for quantitative models, is needed to stop the behemoths from inflicting another financial crisis.

How did the plates shift? Compared with 1960, total US government debt has risen from $320bn to $17tn, while the 10 biggest financial conglomerates control 75 per cent of US assets — in 1990 it was 10 per cent. Financial derivatives, which barely existed in 1960, are now worth $630tn. The concentration of power, and increased disintermediation, mean that the person extending a loan or investing in a stock is no longer the person who loses if something goes wrong. These amount to tectonic shifts.

Some of the effects: when people talk about financial “liquidity,” they now mean that they have access to credit, not cash in hand; corporate debt has grown so much compared with equity that in any future crisis creditors stand to lose far more than in past crises; large investors cannot make shifts in their portfolio without disrupting markets; and only the central bank can now be trusted to provide liquidity, as all the biggest private-sector banks are so large and interconnected.

Kaufman is angry that the Fed, largely under Greenspan, failed to check the effects of the growth of institutions, and as a result found that its usual monetary remedies no longer worked.

He holds that the central bank will ironically have greater power — and become more political — as a result of past mis-steps. Rather than setting interest rates, which will need to be far higher to inhibit financial activity, he suggests the Fed will need to be far more intrusive in the few big institutions that wield the power, and which cannot be allowed to fail.

He is disgusted by what he sees as Barack Obama administration’s failure in 2009 to achieve reform. Banks had never been so unpopular, they were dependent on the government, and Mr Obama’s political capital would never be higher. Kaufman quotes Ron Suskind’s Confidence Men, which alleges that the Treasury department under Tim Geithner ignored an order from the president to prepare to nationalise Citigroup.

When Citigroup was created by the merger of Travelers Group and Citicorp in 1998, in a wildly popular deal, Kaufman was virtually the only voice to speak out, warning of dire consequences from excessively large financial conglomerates that have since come about. He was right then. It would be wise to listen to him now.

The writer is the FT’s senior investment commentator

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