Gordon Gekko Reborn: 1987-2010
The Following is a contribution by Nouriel Roubini to the book “Wall Street: The Collector’s Edition” that was published by Newmarket Press following the debut of the Oliver Stone movie “Wall Street: Money Never Sleeps”
In 1987 Gordon Gekko declared that “greed is good”, the creed of a decade of corporate and financial sector excesses – the rise of junk bonds and the real estate bubble – that ended up in a bust by 1988-89 with the collapse of the junk bond market and the S&L crisis following the real estate bust of the late 1980s and triggered a banking crisis and a painful recession in 1990.
Two decades later starting in 2007, as Gordon Gekko exited jail and returned to the financial world, another asset bubble in housing – a subprime mortgage bubble and a much broader credit bubble that included a wider range of assets and securities – went bust and caused a much bigger financial crisis and recession, the worst one we have had since the Great Depression.
The history of financial crises – presented in my recent book Crisis Economics – shows that such crises have many common elements and causes; they are “white swans” that are predictable and preventable rather than random and unpredictable “black swan” events – like an unpredictable earthquake – popularized by Nassim Taleb in his famous book. Crises are the outcome of a build-up of macroeconomic, financial and policy vulnerabilities and risks:
- Easy monetary policy
- Lax supervision and regulation of the financial system by regulators and supervisors that are asleep at the wheel
- Greed and arrogance taking the form of excessive risk taking and leverage by bankers and traders in the financial system
- Excessive borrowing and debt accumulation by private and public agents
- Delusional belief that asset bubbles can last forever
In this sense, while each crisis has its own peculiarity they all have common factors. The last three U.S. recessions and periods of financial distress were all caused by three asset bubbles that went bust: the real estate and credit bubble of the 1980s that led to the banking crisis and recession of the early 1990s; the tech bubble of the 1990s that led to the recession and corporate distress of the 2000-2001 period; the subprime and credit bubble of the 2000s that lead to the financial crisis and recession of 2007-2009. The similarities of these episodes are greater than the differences.
The interesting question is not why, in each boom and bust cycle, some individuals – like myself and a few other students of crises in the recent cycle – are able to predict the storm well in advance. It is rather why most agents live in the delusion of a bubble – as rapidly and forever rising home prices or tech stocks – that cannot last forever. The reason is that when there is a bubble everyone lives and believes in the bubble as their own self interest depends on the bubble going on forever: households could, for a while, live beyond their means by using their homes as ATM machines; politicians were happy as high and unsustainable growth of the economy led them to be reelected; Wall Street and the City were making gazillions of profits by underwriting and slicing and dicing utter junky and toxic securities; rating agencies were massively conflicted being paid by those who they were supposed to be rating; regulators and supervisors were subject to regulatory capture (a polite word for bribing) by the financial industry and started to believe in the non-sense laissez faire ideology of self-regulation, market discipline and internal risk management models. When there is a bubble everyone lives in a bubble and starts to believe that the bubble is the real world rather than a fantasy that will eventually pop and crash.
The “greed is good” mentality of the traders and bankers is a regular feature of these episodes. In each bubble and bust there are some greedy and arrogant villains that epitomize that era. Ivan Boesky and Michael Milken might have been the tragic heroes and villains of the 1980s that inspired the character of Gordon Gekko. In the remake of Wall Street the villains are more diffuse and may take real life inspiration from characters such as Richard Fuld, Jim Cayne, and perhaps Lloyd Blankfein. Every era also has also its own Ponzi involved in Ponzi schemes and scams, like Bernie Madoff in the latest saga.
But were the traders and bankers of the subprime saga more greedy, arrogant and immoral than the Gordon Gekkos of the 1980s? Not really, as greed and a lack of moral norms are common throughout the ages in financial markets. Human beings react to financial incentives, and greed has caused and driven asset and credit bubbles for centuries. What can prevent such excesses is not teaching morality and values in business schools, but changing incentives that reward short-term profits and bonuses that lead bankers and traders to take too much risk and leverage. The bankers and traders of the latest financial crisis were not more greedy or immoral than the Gordon Gekkos of the 1980s, rather they rationally reacted to a compensation and bonus scheme that allowed them to take a lot of risk and a lot of leverage that provided high short-term profits and bonuses and was guaranteed to bankrupt a large number of financial institutions with probability one.
To avoid the excesses of Wall Street and of the City it is not enough to rely on better regulation and supervision of the financial system for three reasons:
- Smart and greedy bankers and traders will always find ways to bypass such regulations (regulatory arbitrage)
- CEOs and boards of directors of financial firms – let alone regulators and supervisors – cannot effectively monitor the risks and behaviors of thousands of separate P&L (profit and loss) centers in the firm as each trader and banker is a separate P&L with its own capital at risk
- CEOs and boards are themselves subject to major conflicts of interest as they don’t represent the true interest of the firms’ ultimate shareholders
As a result, any reform of the system of regulation and supervision of the financial system will thus fail to control bubbles and excesses unless several other fundamental aspects of the financial system are changed.
First, the system of compensation of bankers and traders needs to be radically changed. Clawbacks of bonuses based on ex-post medium term results of risky trades and investments are necessary to supplant short-term based bonuses that lead to excessive risk and leverage. Regulation of compensation is essential as banks will not do it themselves for fear of losing human capital talent to the competition.
Second, the repeal of the Glass-Steagall Act that separated commercial and investment banking was a mistake as it was also associated with the move of broker dealers from a model of private partnerships – where partners had an incentive to look after each other to avoid reckless investments – to one of public companies aggressively competing with each other and with commercial banks to achieve ever-rising profitability and returns on equity targets that were achievable only with ever-rising levels of reckless leverage. Similarly, the move from a model of “originate and hold” of loans and banking to one of “originate and distribute” based on securitization led to a massive risk transfer where every player but the last – the final investors – in the securitization chain was not holding the ultimate credit risk but rather making high fees and commissions as part of that securitization chain (mortgage brokers, mortgage appraisers, bankers underwriting the mortgages and repackaging them into RMBS, investment bankers slicing and dicing those RMBS into tranches of CDOs, CDOs of CDOs, synthetic CDOs, CPDOs and the entire alphabet soup of structured finance, monoline bond insurers, rating agencies).
Third, financial markets and financial firms have become a nexus of conflicts of interest where thin Chinese walls are a fig leaf that doesn’t prevent these conflicts of interest from being effectively controlled. Asset managers of every sort – traditional and alternative – often pursue schmalpha (partying investors and savers from a large fraction of the returns on their savings via outrageous fees and commissions like the proverbial 2/20 of hedge funds and private equity) rather than alpha (superior returns). Firms that are involved in commercial banking, investment banking, prop trading, market making and dealing, insurance, asset management, private equity, hedge fund activities, and a whole slew of other financial services have massive conflicts of interest as they are on every side of every deal (with the recent case of Goldman Sachs with the CDO just being the tip of an iceberg of a systemic set of conflicts of interest among most financial firms). Greed, arrogance, and a lack of institutional memory are endemic to the financial system. There are also massive agency problems in the financial system where principals (such as shareholders) cannot properly monitor the actions of agents (CEOs, managers, traders, bankers) that pursue their own interest. But in financial markets the agency problems are not just in the form of long-term horizon shareholders being shafted by greedy short-term oriented agents. Even the shareholders have agency problems for two reasons. First, if the financial institutions do not have enough capital and the shareholders thus don’t have enough of their own skin – or flesh – in the game they will themselves push CEOs and bankers to leverage too much and to take excessive risks as their own net worth is not as much at stake. Second, there is a double agency problem as the ultimate shareholders – individual shareholders – don’t directly control boards and CEOs. These ultimate shareholders are represented by institutional investors (pension funds, etc.) who have their own interests, agendas and cozy relationships that are often more aligned with the firms’ CEOs and managers interests rather than the interests of the ultimate shareholders of the firms. So, the repeated financial crises are also the results of a failed system of corporate governance where a massive set of conflicts of interests goes in the governance chain from ultimate shareholders to institutional investors to CEOs, managers and boards and all the way to the traders and bankers.
Fourth, greed cannot be controlled by an appeal to morality and values. Greed has to be controlled by fear of loss and a compensation regime that prevents excessive risk taking and leverage. Fear of loss is derived from knowledge that individual institutions and agents will not be bailed out if they engage in reckless risky activities. But the systematic bailout of financial institutions in the latest crisis – however necessary to avoid a global financial meltdown – has worsened this moral hazard problem deriving from bailouts. Not only too big to fail (TBTF) financial institutions have been systematically bailed out. But, the TBTF distortion has become worse as these institutions have become – via financial sector consolidation – even-bigger-to-fail: JPMorgan took over Bear Stearns and Washington Mutual; Bank of America took over Countrywide and Merrill Lynch; Wells Fargo took over insolvent Wachovia; and even Citigroup went after Wachovia not because such an insolvent bank was sound, but rather because it was trying to become even-bigger-to-fail and get further bailout funds. To resolve the TBTF distortion – that is also a too big and too complex to manage distortion as no imperial genial CEO or board has the brains or capacity to properly manage and supervise extremely complex global financial supermarkets – more radical action needs to be taken: if it is too-big-to-fail it is too big, period, and it should be broken up.
Unless we make these more radical reforms of the financial system new Gordon Gekkos and Ponzis will soon emerge in the financial system – as has been the case in any previous cycle of boom and bubble followed by bust and crash – that will cause even more severe and damaging financial crises and severe economic recessions. For each chastised and born-again-moral Gordon Gekko – as the reformed one in the new Wall Street 2 film – hundreds of other meaner and greedier Gekko’s will be born in every age and time that need to be tamed.
Nouriel Roubini is professor of Economics at the Stern School of Business, NYU, Chairman of Roubini Global Economics (www.roubini.com) and co-author of the book Crisis Economics.
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One Response to “Gordon Gekko Reborn: 1987-2010”
A highly valued contribution, Dr. Realist.