LOF: I would not. The way I look at the world as an investor today is very different than the way I looked at it in 2007. With hindsight, I now know that I was taking much too much risk in 2007, and part of that risk was in financial companies. I have significantly reduced that risk to a very, very small fraction of my own investment portfolio.
I think that it’s a fool’s game to invest in those banks, because there is so much uncertainty out there, in terms of the new rules and regulations, and also there is far too much risk embedded in these companies.
DAVID: Are you referring to derivatives?
LOF: Derivatives are certainly part of it, but it comes down to the exposure these companies have to other financial institutions. The interrelationships are immense, and the credit of each of these institutions is uncertain and hard to evaluate.
Let’s put it this way, they’re not doing business with the Procter & Gambles of the world, businesses you can do a fairly straightforward evaluation on. I no longer understand the complex interrelationships of the institutions. If I ever did, I no longer do. And I don’t like to invest in things I don’t understand, certainly not in size, so I’m uncomfortable with these institutions as an investor. For that matter, I would be uncomfortable as a regulator, and I would be uncomfortable as a customer.
DAVID: To many people, the “fat cat” bankers on Wall Street are viewed as the very epitome of unchecked greed, avarice, even evil. As you were part of that world for a long time, how would you respond – is the poor image warranted? Do you think the culture in the big institutions has changed over the years since you retired?
LOF: Most of the people I worked with on Wall Street were good people – well meaning, ambitious, but with a very strong moral compass. I suspect that is still true today.
I do think that the culture has changed… in one important respect. For many, many years – including when I worked there – Wall Street was dominated by large partnerships. The partners had every nickel they had – both in the firm and outside the firm – at risk, even their homes and cars. I was stopped frequently by partners who worried incessantly about too much risk threatening their financial well-being.
We weren’t permitted to take much of our capital out of the firm, and withdrawals were tightly monitored. Why? To reinforce the feeling that all we had was at stake and to encourage modest risk taking as opposed to “betting the ranch.”
That all changed once firms went public and partners were able to have large stakes outside the firm and achieve “limited liability.” It became “other people’s money.” A huge difference, I think, and one that contributed to a much greater willingness to do things that wouldn’t have been done in an earlier era.
A second factor was the elimination of Glass-Steagall, which had previously kept activities within bounds. Once that was eliminated, banks and brokerages were able to greatly expand their risk taking –without the capital necessary for such risk taking. And, in many cases, beyond the managerial expertise of any firm as well as the expertise of the regulators, because their activities became too complicated for mere mortals to understand.
DAVID: The news broke recently that the government is preparing to launch a new wave of lawsuits against the big banks over their mortgage lending practices. Do you get a sense that the honeymoon is over between the government and the big banks?
The average guy on the street looks at the big banks and the rotating door between the banks and government and thinks, “Well, these guys are all in the same bed.” Is that an accurate assessment of the way things have been, and if so, do you think that cozy relationship is now changing?
LOF: Well, it’s been pretty stunning how, on a number of fronts, the banks have gotten away with as much as they’ve gotten away with. That does suggest that there is this unholy alliance between the people that write the rules and the people that benefit or suffer from those rules, aside from the average person on the street, that is.
You’re right, that’s the perception, and I think it’s accurate given that nobody has gone to jail. Considering what’s happened, it’s amazing that that’s the case and suggests that corruption in the political process played a role in what happened. But that may be changing.
The elections of 2010 and perhaps the election of 2012 are putting a lot of people in office that are not beholden to the big financial institutions in the same way as was the case in 2008. That said, that’s not necessarily good. I mean it’s good in a sense, but at the same time, when you have the attitude out there that it’s the government against the banks, that’s not healthy for the economy either. It’s too early to say how all that will play out, you know, on a bottom-line basis.
DAVID: Based on your observations, do you think the banks were deceitful in how they marketed overrated mortgage-backed securities, or were they just blindly opportunistic in going along with the flow?
LOF: Have they been deceitful? I don’t really have an opinion on that, but I will say that the big problem in 2008 and 2009 was in the excessive overleveraging of these institutions and the amount of risk that they took on. The fact that they weren’t as candid as you would like them to be in terms of what they said about what they created and what they sold – I think that’s pretty much always been out there, but most of the people on the other side of these trades were pretty sophisticated people.
So I guess you can say that it was a caveat emptor kind of situation. In my view, it was the scale of what they were doing, the immense leverage that was embedded in the system, that was more of a problem than whether they were deceitful or not.
DAVID: Has the leverage been markedly reduced at this point?
LOF: You know, I haven’t studied it, so I can’t tell you that I know. I believe it has been reduced, but by how much, I really couldn’t say. Whether it’s been reduced enough and whether there’s enough capital in the system to cover the risk, who can say?
One of the things that’s sort of interesting to me is that Warren Buffett invested five billion dollars in Goldman Sachs back in 2008, and that gave a lot of confidence to others that somebody like Buffett would put five billion dollars in even though the capital was pretty expensive. And then, within a couple of years, they pay it back, which makes me question why they would have taken Buffett’s money in the first place.
I mean, it’s nice capital, and yes, it costs a little bit more, and maybe the reputational aspect of having Buffett as one of your investors was important at the time, and so you take the capital and then pay it back, but that doesn’t make a lot of sense to me. Then, recently, Buffett goes to Bank of America and offers them five billion dollars and they take it, but at the same time they’re saying they don’t need the capital, so it’s confusing.
Do they or don’t they need the capital? I’m not sure they know. I’m not sure anybody knows what kind of capital needs they have. Again, it gets back to my point as to how much they really understand their own businesses anymore, and the risks that are there and the amount of capital that they need.
If the companies themselves don’t understand it, how do you expect those people that are overseeing them to understand it? Bottom line, I question whether there’s enough capital in the system for the risk that is being taken, even today.
DAVID: Which begs the question that if another big bank runs into serious trouble, and Bank of America seems like a good candidate, do you think there’s an appetite in Washington to arrange another bailout? Of course, the consequences of not bailing them out are pretty significant.
LOF: I don’t think there is an appetite for more bailouts. You can see that by looking at what’s happening in Europe.
The question of what to do with banks and what to do with the problems they could create for the economy if you let them go is being grappled with worldwide. I think the only hope the policy makers have is that these problems will be solved through growth, as that is the only rational solution.
Which means the real question is whether or not that growth will occur in a reasonable time period. Frankly, it is hard to see where that growth is going to come from. It is certainly hard to see that in Europe, and it is hard to see that here in the US as well.
DAVID: On the topic of growth and trying to get money in the system, you’re a financial guy, so maybe you can explain the tremendous amount of money sitting on deposit at the Fed earning almost no interest, but enough, apparently, to keep the banks from lending that money back into the economy.
Do you have any thoughts about why the Fed is paying interest rates on the deposits and why the banks are leaving that money on deposit? It’s unprecedented as far as I’m aware. Any thoughts on that?
