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Wall Street Heads for the Exits

The Exchange

By Alex J. Pollock

“As the titans of Wall Street banks gathered…one common worry emerged: who is going to take over when we leave?” says a recent Reuters report on the self-important Davos meetings. Such a worry is a remarkable example of the illusion of one’s own inexpendability. In fact, we are all expendable. “After you’ve gone,” as an old banking colleague used to say, “we will all miss you for at least two weeks.”

“Some of the most ambitious minds in finance are leaving the industry,” Reuters goes on. Well, one of the essential elements in the success of market economies is the movement of the factors of production, including labor and human capital, among competing uses and sectors. It has often been not unreasonably argued that the American economy made an overcommitment of resources to financial activities, as it obviously did to housing—the two being closely tied together in the great 21st century bubble.

The Best and the Brightest

During the bubble years, among these most ambitious minds, some of the “rocket scientists” of Wall Street, as it has been wittily said, “built a missile which landed on themselves.” Some reallocation of these resources is hardly surprising.

“The issues, executives say,” according to Reuters, is “how much scope there is to innovate.” Now innovation from applying increasing knowledge is the most powerful force in long-term economic growth. But all innovations are not created equal, especially in finance. That acerbic chronicler of the foibles of finance, James Grant, has argued that science is progressive, but finance is cyclical. Surveying the financial disasters of the 1980s from the 1990s, he wrote:

“In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American history.” (Money of the Mind, 1992)

Only 20 years after the 1980s financial crisis, they did it again. This time, surrounded by vastly more computer power, supplied with untold reams of data, informed by Nobel Prize-winning financial theories, with the government pumping up the bubble through Fannie Mae, Freddie Mac, and the Federal Reserve, the ambitious minds made even more egregious mistakes.

In every boom, we hear about “creative” and “innovative” new financial products and structures. For example, the Clinton administration’s home ownership strategy in the 1990s call for “creative mortgages”—they got them, unfortunately. An extreme case of this sort of “innovation” was the “Option ARM” mortgage, where the borrower did not even pay all the interest due, thus borrowing more each month, with the additional borrowing booked as income by the lender.

These are not real innovations. They are merely new names for ways to lower credit standards, run up leverage, and increase risk. Likewise, the previously fashionable “innovations” of “CDOs-squared” and “SIVs” were merely new names for lending long and borrowing short, as the “GSE” structures of Fannie Mae and Freddie Mac were for running at extreme leverage. All these ways of increasing old risks by new names in optimistic times bring the same old, inevitable sad end—including the departure of previously star personnel. They are all illusory financial innovations.

However, finance has real innovations, too. These are much less frequent, because it is hard to do something truly new, but they do occur. Over the past several decades they include, for example, interest rate swaps, Treasury inflation-indexed securities, senior-subordinated structures in securitizations, money market mutual funds, general purpose charge and debit cards, and the 30-year fixed rate mortgage.

Real innovations produce, in Schumpeter’s celebrated phrase, “creative destruction,” and they create uncertainty. Uncertainty is more challenging than risk. It takes more than clever models and mathematics, it requires judgment and prudence -- especially when leverage is high and capital is proportionately small, as is the case for banks. The problem is how ambitious minds which want to innovate can also be imbued with the essential judgment and prudence.

No Place for Entrepreneurs

The great theoretician of financial cycles, Hyman Minsky, once told me that a healthy economy has to have a tension, or dialectic, between the fundamental psychologies of entrepreneurs and bankers. Entrepreneurs are emotionally warm, optimistic, risk-taking, self-confident, ready to take action, undaunted by obstacles and doubt, driven to create something new, and may have a long and successful record of ignoring fearful advisors. Bankers, on the other hand, should be emotionally cool and detached, pessimistic, skeptical or cynical, risk-averse, focused on the pitfalls, and preferring wide margins for error to protect the smallness of their own capital ratios.

In their proper roles, entrepreneurial drive and bankerly prudence balance each other. “A lot of the best people are leaving” the banks, says Reuters. But what is the definition of “best people” for banking? Entrepreneurs or bankers? Perhaps this reallocation of human resources is much to be desired.

Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington, DC. He was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.