On supporting Wall Street

In an excellent post on the problems the Fed is facing right now, Tim Duy writes

Fed officials see this a bit differently – they see supporting Wall Street as their mechanism for supporting Main Street

Does anybody else find something odd about this statement?  Supporting the commercial banking system as a means of supporting Main Street makes sense, but Wall Street?  How is it possible for Wall Street financiers to be such bad risk managers that they need support?  They don’t take bank deposits and carry illiquid loans.  How on earth did Wall Street get itself into a liquidity crisis — their standard business model should not involve carrying large quantities of high risk assets on their balance sheets.

If upstart companies want to make money making markets in junk bonds and other products of highly variable value that’s fine.  Let them enjoy their boom and bust cycle — making money in the good times and going bankrupt in the bad.  But why would companies that want to be around for the long-term ever get into these markets in a big way?

Yves Smith has the answer:  After Wall Street firms went public, they stopped being managed in a way that would allow them to be around for the long-term.  Prior to the 70s Wall Street firms were partnerships and every partners’ personal wealth was at risk in the event of failure.  Effectively financiers had professional liability exposure just like doctors — and the market was the arbiter of misconduct. For this reason, Wall Street firms didn’t fail.  They also didn’t make markets in junk bonds or other high risk assets.  They established the stock and commodities exchanges to reduce their exposure to loss from market making activities. In short, they understood the risks involved in market making and they were careful to minimize them.

Over the last quarter of the 20th century changes in the financial system allowed huge new markets in illiquid assets to develop.  As extraordinary levels of debt grew, this debt facilitated growth in the same way that increasing the money supply stimulates growth.  Unfortunately the foundations on which this debt was issued — and thus the foundations of this growth — were not sound.  Thus we find ourselves at the start of the 21st century trying to sort out how to maintain a functioning economy when the system of capital allocation (i.e. Wall Street) is completely broken.  The transition is sure to be difficult.  But if we recognize that the view that government has a duty to support investment banks has little or no historical support and that Wall Street functioned well in the past by treating the personal wealth of the financiers as the obvious source of funds for creditors of a bankrupt investment bank, then we can start to solve the problem.

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