Oligarchy: A form of government in which power is vested in a small but dominant class or clique distinguished by financial and/or political domination.
US observers often comment disparagingly on the nature of the incestuous relationships between political power and the most powerful businessmen in Russia, known collectively as the Oligarchs. Most owe their wealth to their manipulation and indeed corruption of the bureaucracy and political class, which has allowed them to capture and shift tens of billions in resource revenues offshore. Ironically, the relationship between the State and the Oligarchs has moved decisively in favour of the Russian government in the current crisis, which is now seeking growing strategic control over key assets lost in the Yeltsin years, while in the US the financial elite remain unbowed. Eisenhower warned in 1961 that: 'In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.'Perhaps if he was on the scene today, Ike would have had the courage and insight so lacking in recent Presidents to identify the financial complex as a similar threat. In fact, this capture of central government and regulators by a private sector elite is common in developing nations across Asia and Latin America, and the wealthiest entrepreneurs in those countries invariably profit from politically granted exclusive rights over key consumer imports or telecoms and energy access.
While explicit political corruption is very rare in the US, a combination of an overwhelming and self-serving intellectual consensus that laissez-faire policy was appropriate (a consensus fed by generous campaign contributions) and the revolving door of key Treasury personnel between Washington and Wall Street has made a strictly objective response to the current crisis impossible. John Snow, the Bush Treasury Secretary from 2003-6, was one of the few powerful figures to proclaim the risks of growing leverage to economic stability and propose measures to choke off its frantic growth. Instead, he was replaced by Hank Paulsen of Goldman Sachs whose personal lobbying had led to even greater relaxation of the few remaining constraints, notably on broker-dealer leverage ratios and fuelled a historic bubble in risk pricing. Not only were individual banks allowed to grow to a size that made them 'too big to fail' in recent decades but the same applied to the finance sector within the broader economy (which hit over 40% of corporate profits at the recent peak). The Fed 'Put' that investors implicitly assumed underwrote downside market risks was for the finance sector elite a Treasury 'Put'; balance sheet losses would be socialized if the worst happened and the status quo could be maintained. In other words, compared to other economic sectors where mismanagement led to bankruptcy and wholesale restructuring, risk was allowed to become wildly asymmetric, and economic behaviour was and still is distorted accordingly.
Until this situation is addressed radically, any recovery will be a feeble affair and the credit system will remain deeply compromised. The political opportunity to make much needed reforms is passing fast.Regarding recent bank Q1 earnings report, I'd observe firstly that during the equity bubble, it became fashionable for equity analysts to concentrate on operating earnings as opposed to as reported earnings, which factor in write-offs and restructuring charges. That difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. Credit analysts have been purist in maintaining analytical standards and equity and credit market analysis of recent bank results has diverged sharply as reflected in bond spreads and CDS pricing hugely lagging the sharp rally in sector share prices.
Banks are currently benefitting from a sharply upward sloping yield curve that allows them to generate significant earnings from borrowing short and lending long and an effectively zero cost of money, as well as lower competition in many market segments. Thanks to comprehensive taxpayer support via the various Fed liquidity schemes and the TARP/TALF, in recent weeks US banks beat undemanding expectations. US publicly quoted banks, having lost $52 billion in Q408, saw losses in Q109 down to a 'mere' $34 billion. And that's with very dubious accounting practices. Core businesses declined by 20-30%. Trading revenues (notably fixed income) rose sharply at most big banks reflecting high volumes of bond issuance, especially investment grade corporate issues and government guaranteed bank debt. Corporate issuance was the result of the continued tightening in credit availability as banks reduced balance sheet. The issuance of government guaranteed bank debt provided underwriters with a “double subsidy” ie the government guaranteed the debt but then allowed the banks to earn generous fees from underwriting government guaranteed debt.
Additionally, historic increases in spreads (by up to 2-3x in many credit products) boosted profits but at the expense of inv estors. Despite the closure of many prop trading desks, trading revenues also reflected principal position taking and trading, exactly the risky strategy that saw Lehman and Bear blow up. A huge question remains about the windfall from payments by AIG to major banks including Goldman Sachs ($12.9 billion), Merrill Lynch ($6.8 billion), Bank of America ($5.2 billion), Citigroup ($2.3 billion) and Wachovia ($1.5 billion). While these were collateral amounts due to the counter-party or settlement of positions that were terminated, they were also direct transfers from the Treasury which now controls AIG. In Q1,US banks benefited from a one-off increase in trading volume and spiking bid-offer spreads on these closeouts reflecting the distressed condition of AIG.
The banks also benefited from revaluing their own debt where credit spread widened. (The principle is that the banks could currently purchase the debt at a value lower than face values and retire them to recognize the gain. Unfortunately, banks are not in position to realize this “paper” gain and ultimately if the debt is repaid at maturity then the “gain” disappears.) Operating profitability is not the real issue, but rather the credibility of balance sheet marks in a still deteriorating credit market across many sectors. Banks don't look remotely adequately provisioned for further write-downs across commercial real-estate, credit cards, student loans etc. Increasing bad debt will flow directly into bank earnings as credit losses increase as the real economy slows. T he worst-case macro-economic environment assumed in the current Treasury stress tests looks dangerously optimistic if we see a Japan style outcome of prolonged anaemic growth. The global economic system is forcibly de-leveraging and levels of debt must be reduced over several years. In this environment, banks are likely to continue to suffer losses on assets (bad debts and further write offs) and underlying earnings will remain sluggish (lower loan demand and lower levels of financial transactions). Japanese bank shares staged several significant recoveries before falling sharply again as theye were recapitalized and consolidated the banking system through the late 1990's.
Even after around $900 billion in new capital, the global banking system remains short of capital by probably twice that again ; on IMF estimates total loan book write-downs will reach $4trn ultimately. The US financial system will be in intensive care under Dr. Bernanke for some time to come. Prof. Elizabeth Warren, Chairperson of the TARP Oversight Panel Report noted recently that: “One key assumption that underlies Treasury’s [PPIP] approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from non-functioning markets for troubled assets. On the other hand, it is possible that Treasury’s approach fails to acknowledge the depth of the current downturn and the degree to which the low valuation of troubled assets accurately reflects their worth.” Needless to say, she has been criticized by the banking industry attack dogs for bias and a suspect political agenda, but her point is valid. The real issue for the banking sector is not some temporary market failure but the reversal of unsustainable economic trends in US consumption and leverage that have left many institutions effectively insolvent on realistic asset marks and generated huge structural excess capacity in the banking industry. That is a reality that the industry will only accept when it finally loses its dangerously excessive status and influence in Washington.
