Appalled In Greenwich Connecticut

Clifford S. Asness, Ph.D.

AQR Capital Management, LLC

Preliminary version last updated: January 24th, 2009

Comments welcome: [email protected]
Related essays available at: www.StumblingOnTruth.com

The President, in these last few days following the second revolution against big
government started in Massachusetts, has come out swinging savagely against
“banks” in numerous ways in numerous speeches. Let’s be clear. There are
legitimate issues and reforms to be discussed. But my first question is why this
exact moment? The answer is simple. When a failing government with
totalitarian impulses needs help, it’s pretty standard strategy to call down a
pogrom against an unpopular class of citizens. The bankers are nothing if not
unpopular. Unfortunately for this President, he will, I hope, find the financial
community not cowering from his Cossacks on a shtetl in the Pale of Settlement
(Greenwich, CT), but meeting his accusations with logic and patriotism.

First let’s discuss the President’s recent rhetoric. Paraphrasing him, “we will get
back all the people’s money.” And the applause line, “every dime!” OK, fine.
But most of the banks, and in particular the ones in the headlines for paying large
bonuses, have paid back all their TARP loans.1 This logic causes him no pause.
Apparently, and we must read between the lines as this is the most transparent
administration ever, he means all the money lent out to everyone through TARP
not just to banks. So, loans to the car companies, and AIG, and FNMA/FHLMC,
all must be paid back, but by the banks, who already paid back their own loans.2
Makes sense. Has this administration seen a human activity they don’t
instinctively wish to socialize?

Apparently, unlike GM, Chrysler, and the GSEs, the banks didn’t get the memo
that said when you get a bailout the polite thing to do is to continue to fail.

An argument is often made that even if the banks paid their explicit debt back,
they simply would not have survived without the loans. Thus, they owe the
government much more than mere repayment. This is riddled with flaws:

• According to bailout alarmists nobody would have survived, neither man

nor beast, without TARP, so why is this argument unique to the banks,

1
Lest you find me too partisan, please note I am not ignoring nor forgetting that TARP and the bailouts
began under the Bush administration. Also, not all bailouts were through TARP, but I’m going to use that
as short-hand here.
2
Nobody has really added in the cost of the FNMA/FHLMC bailout yet. It’s the bailout the government
likes to talk about least. I wonder why?
 and again why are they paying back everyone’s debt just by virtue of their
success?

• Again, as in the Chrysler bankruptcy that drove me to a similar missive

last year, the government is seeking to write ex post facto rules. It’s
entirely possible that if during the dark days of the bailout the government
told banks, "we get half your profits for the next two years," the banks
would have signed the deal. No one asked. The deal was the deal.
There is no crying in baseball.

• What exactly do they expect the banks to do with the money they earned
in 2009? Well, there are really four choices. 1) Give it to the government
as a thank you tip. Their shareholders would sue their brains out and win
(and the government would probably just hand it to Louisiana and
Nebraska anyway). 2) Give it to their shareholders through dividends.
That is more reasonable, though the shareholders themselves should be
the ones to weigh in on this and they seem pretty happy paying large
bonuses for talent and reaping high stock prices. As a very similar
measure to dividends they could keep it as retained earnings. The banks
already have too much cash on hand and are being yelled at for not
lending it out (by they way, the lack of lending isn’t a problem of not
enough cash, it’s a problem of not enough projects they’re confident in,
and the fact that many of these “banks” never did commercial lending to
begin with). 3) Give it to charity. Goldman Sachs is already forcing their
employees to give 10% away, in a gesture of appeasement sure to
generate laughs from the Left at the insufficiency, confusion on the Right,
and only Neville Chamberlain’s ghost smiling in the middle. Goldman, you
run a great firm, but the reason it’s called C-H-A-R-I-T-Y is that it is
voluntary. Or, finally, of course, 4) Pay it to their employees.

• Another basic flaw is the words "bank" and "banker" are used in slippery
ways. "Bank" is sometimes used to mean regulated commercial bank,
bailout recipient, financial institution in general or any institution controlling
large amounts of capital. The "banks" guilty of causing the bubble need
not be the same as the "banks" that were rescued and neither group
coincides exactly with the "banks" to be taxed. This flexibility is one of the
great strengths of unfair scapegoating.

If you were running the banks you’d pay the normal proportion of revenue to your
employees, or perhaps a bit less in a gesture of appeasement as banks are
doing now. You know you would. Anyone would. Paying less means hurting
both employees and shareholders, in order to deflect criticism from people with
no interest in the matter save grandstanding.

With regards to the proposed bank tax and other banking restrictions, please
note this does not affect the bonus controversy. There’s nothing in the proposed

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bank tax or restrictions that obviously reduces market-clearing wages in the
financial industry. So the government, upset about banker bonuses, is penalizing
bank shareholders who will bear the brunt of this tax (not bankers) for these
same shareholders not getting paid enough of the 2009 profits, which the
shareholders were fine with. If that sentence is confusing, do not worry, you are
following as well as the government.

I was against the bailout at the end of 2008 (while admitting that the ridiculous
cumulative policy of too-big-to-fail left me scared at the consequences). But, for
those who were for it, this is the policy you put in place, and the deal you made.
Sorry.3

Now let’s talk about the narrative that’s been sold. We hear readily, from
politicians of the President’s party, and his media choir, statements like “the
bankers who brought us this crisis” as a lead-in to any discussion (sometimes
about the weather). As one tiny example consider the New York Times editorial
of January 13, 2010, with the Leftist dream title of, “Tax Them Both.” Early on
they throw in the simple line “Let’s be clear, the crisis spawned by banks’
recklessness has cost the country…” Not the crisis aided by banks’
recklessness, but the crisis spawned by banks’ recklessness, no hint of caveat o
nuance. The rest of us were just babes in the woods doing green jobs and
singing Disney songs while birds danced on our shoulders, but the bad
bank-witch made us eat her poisoned apples. This is one example but if you
dare/bet me to come up with 10,000 more, I will win.

Say something stupid and hurtful, but simple and with a compelling villain, long
enough and I guess it becomes our society’s version of truth (again, the
“narrative”). Bankers (and by this I mean Wall Street in general) are certainly
guilty of acting irresponsibly and aiding and abetting the bubble, but assigning
them sole blame is ridiculous. This is an Agatha Christie novel where everyone
is the murderer.

Government encouraged wild lending, virtually creating the sub-prime market,

and up until the end our representitives swore the GSE’s were all ok (the fact that
the President is flanked by Barney Frank while discussing how to ‘get’ the terrible
bankers should alone make you turn the dial and watch cartoons). Government
land use restrictions added more than a little oomph to real estate prices,
particularly in areas where the bubble grew largest. In addition, government kept
money easy (rates low) to grease the bubble’s wheels. Note, mixing metaphors
is allowed when appalled in Greenwich. In New Canaan it’s frowned upon.

Individuals and non-bank companies played their major parts as well, buying and
building too many houses, with too little equity contribution. People spent too
much on everything, not just houses, and companies cheerfully fed the demand
by extending unlimited credit, with the Federal Government the ultimate backstop
3
By-the-way, I’m not a banker. I’m an asset manager. So we are not talking about my money (yet).

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lender (and a very willing one at that). Every sector of the economy, every region
of the country, every demographic group except perhaps the Amish was
overleveraged (buggies have a very onerous haircut when on repo). No doubt
there are plenty of innocent individuals, but it's hard to point to any coherent
group of them.

Banks, and Wall Street in general, certainly failed to recognize the risks in time.
Or they recognized them but couldn’t see how to avoid them as bubbles that do
not burst for long periods put skeptics out of business – it is harder to do this real
time than many politicians and editorialists think. In rare cases some of the
lending may have been fraudulent, but the idea that most of the real estate
bubble was the result of predatory lending is a complete fiction. The "victims"
were happily getting rich without working, until the music stopped.

But the above, a world gone mad and all of us sharing blame, is not the
“narrative.” The narrative is Wall Street gravely injured us all, to their sole
shame, so now let’s get them! Why? Well, politicians certainly aren’t going to
blame themselves. They aren’t going to blame individuals who, what’s that thing
individuals do again, yeah, they vote. The press, certainly this press, with this
government, mainly repeats the party line, sometimes with their legs tingling. So,
who should they blame? Well, what better than casting sole blame on the evil
bankers? Who likes a banker? I’m not sure I do and many are my friends. I’m
not sure their wives or husbands like them. But that doesn’t make them guiltier
than others. Every financial crisis, for at least our country’s history and probably
way longer, has been blamed on bankers and speculators, and generally this has
been one-sided, exclusionary of the many real culprits, and often dead wrong.
The narrative once established is a powerful thing to fight, but fight it we must, as
it’s simply not true. Bankers deserve their share of castigation, but no more than
their share, and that inconvenient truth makes things a lot more complicated.

Another thing to note is that this is now called a financial or banking crisis. This
is true without being right (which is a difference with a distinction). Our current
economic pain, the high unemployment, the disappointing economic growth, has
deep and varied roots. For years, some things were unsustainably high and
growing: housing prices, the trade deficit, consumer debt and more recently
government debt; while other things were unsustainably low and falling: credit
spreads, inflation rates and savings. While people differ on which were the
causes and which were the effects, and who was to blame, few believed things
could have continued indefinitely (while again, calling the top a very dangerous
game to hold the bankers to getting precisely right). Some dramatic change was
inevitable, and it was equally inevitable that it would be painful. Perhaps wiser
and less greedy bankers would have given us an earlier and gentler wake-up
call, but the same is true of wiser and less greedy politicians, central-bankers,
non-financial companies and individuals, many of them with more latitude to step
off the gas than bankers with shareholders. The economy crashed, not just the

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banks. It was caused by the entire economy, not just the banks. It's the economy
that has to be fixed, not just the banks.

Although the stated reason for punishing banks is the false accusation that they
wrecked the economy all on their lonesome, much of the populist resonance of
this libel springs from the inconsistent argument that bankers are socially useless
parasites skimming money from real transactions. This doublethink is very old.
The belief is moneylenders and speculators are powerful enough to cause all our
economic problems, but not useful enough to deserve a share of our economic
successes. Where this power without usefulness derives from is never clear. In
fact, highly skilled bankers (in the broad sense, including lenders, traders, asset
managers and deal makers) are essential to an efficient modern economy and
some of them will therefore earn very large amounts of money. What they create
is as real as a shoemaker, as a modern economy would produce a lot less shoes
if instead of banking we relied on something closer to the barter system. If you
penalize these services, or legislate away the freedom to innovate and to get rich
by doing them better than anyone else, you destroy both a fundamental
economic freedom and a key component of economic growth.

With all that said, it's still important to fix the banks. Ignoring the obvious
pogrom-like timing of his ire, the President has a point. You can’t have a too-big-
to-fail policy and not have much tighter rules on the banks and similar institutions
(none of this explains the proposed bank tax which is purely grandstanding for
the mob). Nobody, including me, likes to see banks profiting on their gains and
socializing their losses. I dearly wish the government, if they had to do a bailout,
had struck a better deal (the difference is I won’t coercively force my preferences
after the fact). So, what do we do going forward? Add a ba-jillion (remember,
I’m a quant) new rules and restrictions, and have the bureaucrats run the country
like they run Congress? Or fix too-big-to-fail itself?

Well I think the answer is obvious. If you fix too-big-to-fail you fix almost
everything. You need light regulation as fraud is still illegal and banks bear their
own downsides. Risk is run much tighter by financial institutions who know that
nobody has their backs. All is well and we can keep on rockin-in-the-free-market
(can one legally paraphrase Neil Young while supporting Capitalism?).

So, how do you fix too-big-to-fail? Well, this is complicated, give me a moment. I
got it. You let them fail. There’s a famous episode of Happy Days (ok, by
"famous" I mean I remember it) where Ritchie needs help against a bully. The
Fonz (yeah, I went there) advises him to bluff, act like a maniac and the bully will
back off. Ritchie does this and turns to the Fonz, with his back to the bully, and
asks, “is it working?” The Fonz says no and Ritchie asks why? “Well”, the Fonz
explains, “it turns out that for this to work, some time in your life you have to have
actually hit someone.” Ritchie responds with those immortal words, “that’s a very
important detail to have left out, Fonz!” Well our government repeatedly blinking
and bailing out those who should have been allowed to fail (including the whole

5
economy which occasionally should’ve been allowed to suffer more without a
“Greenspan Put”) was a very important detail to have left out!4

I admit perhaps by fall/winter of 2008 this was a matter of brinksmanship, and

while I would’ve opted for no bailout (I think Capitalism is very robust), it was
scary. But it never should have come to that. From Continental Illinois to
Chrysler to LTCM (not technically a bailout but still a confirmation government
would ride to the rescue) to the “Greenspan Put” for 20 years, we built up the
doctrine of too-big-to-fail until it became a monster. But it can be tamed. How?
Well, you start planning for failure, how the piping and legal structure of the
system would work for major failures (some are calling these living wills for
companies), and you start letting people fail. Capitalism is a beautiful system
and free markets work. But failure, no matter how big, is as important as
success if not more.

Just a few more things. Let’s talk about hindsight bias. That’s where everyone
thinks they knew something was going to happen after the fact, when few really
knew it back then. Bias is the geeky way of saying “hindsight is 20-20.” Right
now we all find it incredibly obvious that circa 2006 or 2007 a giant real-estate
and credit bubble was about to kill us all. Certainly that was discussed by many
at the time. Certainly it turned out to be true. But to call it obvious, particularly
the timing and magnitude, which is much harder to get right than the existence, is
insane (even I say above that it was obvious something bad was coming – but
how big was not obvious even well into the crisis). If obvious why did the Fed,
possibly soon to be granted more oversight power, not see it and scream a
warning? If obvious why didn’t we all see it and act on it? If obvious why did
Barney Frank famously decide to “roll the dice” a little more with his GSEs (see, I
don’t even blame Barney). We should have known better, I don’t dispute that,
but it wasn’t as obvious as we all think now. Why is this important? Because the
less obvious it was, the less villainously incompetent all players involved were,
including Barney and the bankers (a good band name). But that just ruins the
“narrative” doesn’t it? You can’t get a good mob attack off the ground with that
kind of even-handed reasoning.

We commonly hear that this crisis was a failure of regulation, but we rarely hear
what exact regulation would have saved us, particularly from the real estate
bubble that was most of the problem (most real-estate rules that changed in the
last few decades were towards Left-leaning rules that exacerbated this bubble).
Anyway, I don’t argue all regulation is bad, or that we couldn’t improve it, but I do
argue that doing away with too-big-to-fail is way more important than tinkering
with regulation, and in fact renders much of the tinkering moot. Also I’d note that
the fixed income markets are far more regulated than the equity markets, which
did not fail us this time or in their own meltdown in 2000. Better regulation might

4
Barney Frank got this one right, paraphrasing him, “markets will never believe us until we let a big
company die.” Yes, in my example, Barney is the Fonz.

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be part of the solution, but bad regulation was not the main cause of the crisis
and good regulation cannot do much if we retain too-big-to-fail.

We hear a ton about bankers’ bonuses. In no way did the large bonuses, or
“asymmetric risk and reward” of bonuses, cause the real estate bubble, still the
major cause of our pain. And curing too-big-to-fail also cures this bonus problem
as if the banks pay out too much and don’t have enough left for safety, they are
gone along with all their equity. When failure is an option because the
government provides a safety net, discipline about bonuses as well as risk goes
out the window. Finally, the precedent of the government having any say in what
private companies, with shareholder approval, pay their people is chilling to
anyone with even the remotest understanding of limited government.5

Derivatives also didn’t cause the real estate bubble. They probably caused the
failures of some banks and insurance companies who made bad bets on the
bubble (particularly when used by companies like AIG not to shift their bets but
simply to make a much more massive leveraged bet on real estate). But these
banks and insurance companies should have known that they’d be allowed to fail
if they turned out to be wrong (if so presumably they would’ve made smaller
bets). Instead they knew the opposite. Again, a false culprit is exaggerated (the
math guys did it!), and again ending too-big-to-fail fixes the problem. Some
lessons from the crisis seem to be reasonable if not a cure-all, e.g., get more
derivatives on clearinghouses, but I doubt we need government fiat to move us in
that direction going forward.

OK, I’m done, but for a short recap. The bankers are far from without sin, and
there are things in the system that need fixing. But the bankers have largely paid
back what they borrowed and should not be penalized versus those who cannot
repay, simply because the bankers performed well post bailout (wasn’t that the
hope and intention?). Bankers didn’t cause this crisis any more than individuals
did, and probably less than government. But those last two are inconvenient
villains. In America we’re not supposed to choose our villains by convenience, or
how good a simple “narrative” is, but we’ll leave that for another day.

We should fix the system going forward but by making it more of a free market
not less. Punish failure. Don’t institutionalize too-big-to-fail by accepting it and
then try to regulate away large failures with telephone books of rules and
coercive government interference. Cheer outsized rewards when they are the
result of two-sided risk where skin was in the game, but castigate then eliminate
outsized rewards when they are the result of one-sided risk where the
government foolishly has the wrong end of the deal. Get the government out of
social engineering and dictating to private individuals how to live, work, invest,

5
As an aside, most bankers are not very highly paid. Following the confusion we documented above with
the term “banker”, we often say "banker" but we mean "trader", "asset manager", or "investment banker".
Those doing the banking, taking deposits, lending, etc., are, in general, not raking it in. They do however,
oddly, have a new target on their backs put there by the commander-in-chief.

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and conduct commerce. Most of all, do not look for simple answers and
scapegoats, particularly for political gain, it’s disgusting and beneath the dignity
we should expect from our leaders.

I would end this again, as in my last similar essay, with “I’m ready for my
personalized tax rate now” but given the plethora of suggestions in the offing
(bonus taxes, capital taxes, transactions taxes), I’m pretty sure that it’s in the
works anyway.

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