By Larry McDonald

The four year anniversary of Lehman Brothers bankruptcy is three weeks away, and frankly I am shocked by the ineptitude of the incumbent administration.
There is simply a total lack of critical changes needed to fix the regulatory spinal cord of the financial markets. This subject is being ignored at the highest levels, and at times I find myself waking with a cold sweat, unable to conceive what a dangerous course they tread!

We often hear about President Obama’s intellect, how well read he is, how well spoken, how utterly polished. But after all we’ve been through the last four years, as close to the brink as we came in 08, why he is NOT leading the charge to fix a massive web of confusion over responsibility and accountability in our financial regulatory infrastructure, is the 10 trillion dollar question? His performance thus far has been nothing short of unconscionable in this regard. In fact, his administration and Congress have exacerbated the problem, and today the system is far more convoluted than ever.

It’s either the height of foolish, blind ignorance of systemic risk or an agenda as dark as you could imagine, and nothing in between. Let me explain.
As many of you know, I wrote the global bestseller “A Colossal Failure of Common Sense, the inside story of the Collapse of Lehman Brothers.”   I was an advisor to the Financial Crisis Inquiry Commission, participant in the academy award winning documentary “Inside Job.” Likewise, I participated and advised award winning documentaries, “The Love of Money,” produced by the BBC and the CBC’s “The Fifth Estate.”   My book was strongly referenced in Andrew Ross Sorkin’s bestseller, “Too Big to Fail.”

But I don’t tell you this to impress you, merely to impress upon you how much time I’ve spent analyzing what went wrong in our financial system, and how I’ve developed a burning anger about the fact that nothing substantive is being done to fix our most dangerous problems. Some people on the left side of the political spectrum may have a problem with my ideas, analysis and research, but I make these points after an exhaustive amount of work, searching for solutions to bury the destructive forces that pave the road ahead.

Ticking Time Bomb
If you look back over the great financial panics in the last 50 years, we had the S&L Crisis in the late 80s, the Long Term Capital Management crisis in the late 1990’s, and the biggest bankruptcy in the history of the universe in 2008 with Lehman Brothers. They come at us every ten years, like clockwork. And yet each one is larger than the last, and quite disturbingly so, relative to GDP. Taking a look at global systemic risk, Long Term Capital Management was systemically 10 times bigger than the S&L crisis, but Lehman was 100 times the size of LTCM.

Exponential Growth of Systemic Risk

In the S&L Crisis, after banks repaid loans through various procedures, there was a net loss to taxpayers of approximately $124 billion dollars by the end of 1999, according to the book “The Cost of the Savings & Loan Crisis: Truth and Consequences.” Yet, because financial institutions in the 1980s were about 40% to 80% less leveraged than those in the 1990s and 2000s, there was dramatically less systemic risk. The birth of credit derivatives was still years away, and banking collapses were more isolated, with the dominos were miles apart.

According to the financial classic, “When Genius Failed: the Rise and Fall of Long-Term Capital Management,” at the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion, for a debt to equity ratio of over 25:1. But it wasn’t the size of LTCM, it was the fact that they had amassed off-balance sheet derivative positions with a notional value of approximately $1.25 trillion. Counterparty risk was born. This threatened many financial institutions globally in one way or another, a stage in history where the dominos were moving ever closer together.

In 1998, the year Lehman first teetered on the brink of collapsing, the firm had a balance sheet of about $38 billion. By 2007, it had grown to over $700 billion. But again, it wasn’t Lehman’s size and 40 times leverage that was the systemic problem. It was their $7 trillion of counter-party derivative risk, exposing banks across the world to incalculable destructive forces, this time the dominos moved only inches apart.

At the time Lehman failed in 2008, the size of the world stock market was estimated at about $36.6 trillion. Today, the world derivatives market has been estimated at about $791 trillion face or nominal value, 11 times the size of the entire world economy.

It’s simple math, if you look at the size of these explosive monsters as measured by systemic risk over the last 50 years, compared to GDP, we are on a collision course with a $10-$12 trillion dollar problem, enough to engulf the Federal Reserve.

Mr. President, What are You Doing?

Bottom line: in the history of the planet earth, there’s NEVER been a more important time for our regulators to focus precisely on systemic risk. The question is, how many of them have ever actually taken risk, been in the game?

As most know by now, fifteen years ago, the combined assets of the six biggest banks totaled 17% of GDP. By 2006, that number was 55% and by 2009, it was 63%. The government created these mega-giants. Thanks in part to acquisitions of Countrywide Financial Corp. and Merrill Lynch, the assets of Bank of America have jumped 36% from before the financial crisis to $2.34 trillion. JPMorgan bought Bear Stearns Cos. and Washington Mutual Inc. and has assets of $2.14 trillion, up 37%. The top four banks now have 40% of the nation’s deposits, according to the FDIC, Cleveland Fed & NCUA and Simon Johnson, professor, MIT’s Sloan School of Management.

Even more disturbing, the European banking system is still over $46 trillion in size, nearly three times total EU GDP. Imagine the Swiss nationalizing just UBS and Credit Suisse, whose assets constitute 500% of the Swiss GDP.

A Meteor is Heading at Us as We Do Nothing

The banking industry has become ever more concentrated since the 1980s. Today’s 6,291 commercial banks are less than half the number that existed in 1984, according to the Federal Deposit Insurance Corp.

One would logically conclude with a problem this big and this deadly that modern financial reform would be laser focused on getting to the root of the problem, and protecting our capitalist system from catastrophe. With so much on the line, with all the cries from the Occupy Wall St. crowd, it is almost gross negligence that President Obama, Elizabeth Warren and many other left wing politicians are using the financial crisis to shot gun financial reform into areas of the financial system that had nothing to do with the crisis. The stakes are just too high in 2012 not to attack this problem with precision solutions.

Giant bureaucratic silos that don’t share critical information with one another, that aren’t run by proven risk takers, are the number one threat in the world to our capitalist system.

Too Big To Fail Lives On

The 5 biggest banks in the US today are about twice as large as they were a decade ago relative to the economy, per Federal Reserve data.

“If a large financial institution should ever fail, this reform gives us the ability to wind it down without endangering the broader economy,” Obama said before signing the Dodd Frank act on July 21, 2010. This simply is not true.

There’s a world of difference between winding down and a Savings and Loan in Atlanta and to Too Big to Fail Institution in Manhattan. I’ve spent dozens of hours analyzing the FDIC’s plans for a resolution authority and living wills, I’m here to tell you the truth, it’s all academically contrived, fantasy land hot air. If put to the test of a true Lehman like event, they simply don’t have the people with intellectual horse power to pull it off. You just don’t snap your fingers and assemble a team of people with the proper skill sets to unwind a TBTF institution, let’s get real, that would take 6 – 9 months even in a best case scenario.

I agree with banking veteran Harvey Rosenblum, the head of the Dallas Fed’s Research Department, when he recently said, ” “TBTF institutions were at the center of the financial crisis and the sluggish recovery that followed. If allowed to remain unchecked, these entities will continue posing a clear and present danger to the U.S. economy.”

What is the Problem and Why hasn’t it Been Fixed?

Our regulatory system has not kept pace with the speed and sophistication at which 21st century financial products have grown – not even close. Why is so much time spent on insider trading cases? They pose zero systemic risk to society. If insider trading is so important to prosecute, why did it take until 2009 for the SEC to try its first case involving credit default swaps? Don’t even get me started looking at the number of insider trading cases involving stocks vs. CDS. Modernization of finance technology has moved at the speed of sound, and the regulatory ecosystem is stuck in the breakdown lane.

The classic strengths and weaknesses of the public and private sectors are moving capitalism full circle, to its possible breaking point. I am just at a total loss as to why the Obama administration has done nothing about this threat in four years.

It’s not just the obvious failures of Dodd Frank, the most serious problem of all could be addressed outside of the short comings of this legislation, but the President has not made it a priority. We still have a chance but we must do something now or all will be lost.

I’ll never forget Alan Greenspan’s TARP testimony in front of Congress in 2008, almost three years after stepping down as chairman of the Federal Reserve. A humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets, and had failed to anticipate the self-destructive power of care free mortgage lending.

It’s so clear to me why the self correcting power of capitalism failed in 2008. Capitalism does not work without transparency of risk, and ultimately, our regulators simply did not have the financial acumen to fully grasp our MOST IMPORTANT problems.

9-11 and Lehman

We sadly learned after 9-11 that thousands of civil servant employed by the State Department,
FBI, CIA, DOJ and ATAF were dangerously and horrifically uncoordinated in 2001. Simply put, they were not sharing the critical information needed to stop terrorists from striking the heart of the USA.

My Friend Tom Ridge

I remember the time I met the former, Pennsylvania Governor and Home Land Security Chief Tom Ridge. We delivered the keynote speeches at Duquesne University’s fourth annual Beard Symposium on Sustainability.

At lunch Tom and I had a long talk about 9-11. I asked him, how was he able get all of those government agencies to finally communicate, share critical information, work together, the vital components to protecting our country from another attack.   He gave me and long hard stare eye to eye, put his hand on my shoulder and said, “that was the key, the missing link, breaking those bureaucratic silos into submission.” I said “but Tom, how did you, as a new comer into Washington over power all of those power bases.” He said, “Larry, President Bush had my back every step of the way.”

Does President Obama have the back of the right person in the right spot today? Simple answer, no. The isolated silos within the regulatory machine in Washington are as disconnected as ever, our capitalists system, our way of life, hangs in the balance.

60 Minutes

Last week, 60-Minutes re-aired a shocking revelation that the SEC was actually inside Lehman Brothers for most of 2008. What did they learn? Did the critical information die on the vine?   Many people feel the reason there have been no criminal charges filed against Lehman executives is because the SEC is actually culpable, since they were inside the bank!

In 2008, there were 3,798 people working at the SEC. Only 24 people were assigned to regulate the ten largest investment and commercial banks.

The Most Important Senate Race in the US

I’m supporting Senator Scott Brown in his race against Elizabeth Warren, his giant character and integrity advantage comes first in my mind, but then it’s the fact that Ms. Warren represents everything that’s wrong with financial reform. An academic who’s never taken risk, layering more bloated, confusing regulatory units on top of what we already have is not the answer. If we’ve learned anything from 2008, this idea is more dangerous than ever. Employing an army of Ms. Warren’s friends with juicy jobs shouldn’t be the ultimate goal. We need new ideas, our regulatory and financial system are at great risk.

Democratic National Convention

Just how out of touch is the President with our most serious threat? He’s chosen none other than Elizabeth Warren to speaking in prime time, just before President Clinton at September 5th’s Democratic convention.

Let’s all get real, please. In 2008, we had protecting us, the Federal Reserve, the New York Fed, US Treasury, SEC, CFTC, FDIC, FINRA, Office Of Thrift Supervision, Comptroller of the Currency, State Insurance Commissioners, Department of Justice, OFHEO and the FBI. Some 60,000 people work for all these government agencies, but how many of them have actually taken risk???

Do columnists for the NY Post take the field at Yankee Stadium? In a strange way, they do on
Wall St. at the highest levels of our regulatory system.

How to Fix the Problem by the Smartest Guy I’ve Ever Met

Warren Buffett’s lifelong business partner Charlie Munger was nice enough to invite me to Omaha for the Berkshire Hathaway annual meeting and offered me a private one-on-one meeting. He’d read my book and wanted to discuss what went wrong in our financial system and how to fix it.

I’ll never forget his words of wisdom, “it’s all about the incentives, Larry. Always follow the incentives as far as you can, and there you’d find solutions and truth.” Point being, in 2008 there were all the financial incentives in the world for talented people to join the ranks of Paulson and Co, Goldman Sachs and JP Morgan. Yet, how many incentives were there for those same talents to sign up with the SEC, CFTC and the FDIC?

An Insightful and Unexpected Meeting

This spring I was at New York’s JFK International Airport, on the way to deliver a speech at Calamos investments, just outside Chicago. As the plane backed away from the gate, I noticed a gang of maintenance personnel approaching the aircraft, as the pilot announced we were returning to the gate.

I was thinking, there’s a flight just about every hour leaving JFK for Chicago so why not limit my potential downside and catch the next flight vs. wait on the plane for possible hours of delay? The only question in my mind was, could I get off the plane first. I thought, there might only be just a few seats available on the next flight, I’d better grab one of them. I gathered my things and headed out the passenger door and up the ramp. I noticed there was only one person in front of me, a tall man, bald, with broad shoulders in a trench coat.

As we got to the Delta Airlines customer service area, I was relieved that there were seats available on the next flight. I looked behind me and there were maybe 50 passengers from my previous flight coming to make the same switch. A woman behind the counter asked me my name and flight ticket for the transfer.

As I identified myself, the man took a long slow turn of his head in my direction. I instantly recognized him. It was Henry Merritt Paulson, the former Secretary of the US Treasury who made the fateful decision to put Lehman to sleep and save just about every other bank, money market fund and insurance company in the western world. Fortunately, our seats were very
close to each other and we had the opportunity to talk about what happened in 2008 and how we might fight the current, potentially fatal flaws in our financial and regulatory systems.

Now, as much as I didn’t like Paulson’s selective God playing role during the financial crisis, I must admit, we were lucky to have him in his seat during this incredibly important moment in American history. Of all civil servants in Washington, looking over our financial system, he was one of a handful who’s actually played the game, taken risk at the highest level. He could play center field in the Big Leagues of finance with the best of them.

This thought stayed with me for much of the flight. A review of all the accounts, books and blogs covering the those fateful, ever so important days of the financial crisis, it’s very clear to me there was one man calling most of the shots, Hank Paulson.

In the end, with everything on the line, the only person in Washington with real world risk taking experience was making most of the big decisions. And when the New York Times reviewed his phone log, most of his time was spent brainstorming with Goldman’s Lloyd Blankfein and JP Morgan’s Jamie Dimon, not bureaucrats who’ve never played the game. What a power statement of truth pointed towards what’s needed in the future.

Follow the Incentives

Why did Hank Paulson make that fateful move to Washington in 2006? There’s no question, Time Magazine’s runner up 2008 Person of the Year was one of President Bush’s best decisions in his 8 year term. But why did he leave Goldman Sachs in 2006 to join the US Treasury? Sure there was a flash of patriotic flare, give something back, but ultimately as Charlie Munger told me, it’s all about the incentives.

The $183,000 annual salary for the Treasury Secretary position did not mean much to Paulson, who was used to earning closer to $40 million a year.

As many people know, thanks to a provision in the tax code, the former Goldman Sachs CEO got a colossal financial break for moving to D.C. Over the years at Goldman, Paulson amassed quite a fortune, a roughly $700 million equity stake. In the end he was able to diversify a good chunk of those holdings without paying a dime to the Internal Revenue Service.

By accepting the Treasury post, Paulson took advantage of a tax loophole that allows government officials from the EXECUTIVE BRANCH to defer capital gains taxes on assets they have to sell to avoid a conflict of interest, as long as the proceeds are reinvested in government securities or a broad array of mutual funds approved by the government within 60 days.

Why is this Productive Incentive Confined to the Executive Branch?

Former Gov. Jon Corzine of New Jersey, who later became US Senator, wasn’t so lucky. While serving on the Senate banking committee, he was pressured to sell off his $300 million stake in his Goldman stock. But alas, the tax perk is only available to members of the executive branch.

It’s Common Sense, Get Me 50 Hank Paulsons?

I’m writing these words to propose as loud as I can scream in this digital world. We must expand the Paulson Tax Treat to regulatory offices outside of the executive branch. Think of it as a military style draft, taking some of Wall St’s best and brightest into new roles at the SEC, FDIC, CFTC, DOJ, FBI, New York Fed.

Bringing real world players and risk takers into our regulatory system will go a long way to protecting capitalism from its ever growing threat.

Is it really wise and necessary to have academics and bureaucrats running our regulatory nerve centers while the best risk takers in the world are on Wall St running hedge funds and working on sell side trading floors. Isn’t this an idea of the past?

Four years is a long time, 1460 days, Dodd Frank is a lazy man’s spray gun approach at financial reform, we desperately need precise fixes applied to our most important challenges.

With the Spanish government extremely reluctant to apply for official assistance, other options will be explored exhaustively. These include ESM/EFSF Primary Market Bond, the granting of precautionary credit lines by the EFSF and ESM to Member States, ESM/EFSF Secondary Market Bond Purchasing, or an ESM/EFSF partial guarantee – all of which are subject to strict conditions.

Ultimately, however, it seems likely that a sovereign bailout is coming down the tracks. With an ailing property market and levels of foreign direct investment down 50% from 2007, the economic fundamentals suggest the prospect of Spain being able to grow its way out of this crisis is increasingly unlikely.

The success of such a program shall be determined by the level of austerity imposed by Germany and the ECB, and how the Spanish central government politically manage its implementation in the autonomous regions of Spain without fostering social upheaval.

The Spanish economy is in a perilous state. On 24th July 2012 the government signed off on as much as €100 billion of aid to the banking sector from European rescue funds. The Prime Minister is weighing a second bailout as he struggles to implement a fourth round of spending cuts and tax increases since taking office eight months ago.

The regions, which account for more than 50% of public spending, are delaying the implementation of necessary spending cuts with some threatening the State with legal action and others refusing to cooperate. Economists are predicting overspending may remain close to 8.9% of GDP for a second year.

The government itself has proven reluctant to make the necessary cuts and has ruled out cutting pensions – which account for 32% of government spending and have been highlighted by the European Commission and IMF as a target for cuts – and extended benefits for the unemployed.

Indeed, many of the government’s current troubles can be attributed to political pandering and, in particular, the decision to delay the 2012 budget until after the Andalucia regional election in March 2012. In doing so, the government conditioned the pace of fiscal adjustment to party interests, signalling to the markets that it was unwilling or unable to come to terms with the scale of the economic challenges it was facing.

The grace period for meaningful reform, often granted to a new government, is now over.

With budget deficit targets looking increasingly unachievable and a bleak political and economic landscape the June bailout is likely to be followed by a second bail-out of the sovereign, possibly in the form of large-scale purchases of Spanish debt securities by the ECB and the EFSF or its successor the ESM.

Whatever form it takes, the second bailout is likely to involve the surrender of even more political and economic sovereignty resulting in cuts and reforms even deeper than those being fiercely resisted within Spain at the moment.

Indeed, the ECB has already signalled which further policies it expects from those countries under financial assistance programmes, including Spain: additional cuts to public-sector wages, further liberalisation of the labour market, the elimination of restrictive practices in protected sectors and “courageous policy action on structural reforms.” According to the ECB, this will require “boldness in the face of lobbying by privileged groups and vested interests”.[41]

Recognising the massive changes in the political landscape, Spain’s two main trade unions, the General Union of Workers (UGT) and the Trade Union Confederation (CCOO), are considering merging in order to maximise their leverage in opposition to a second bail-out and the cuts in spending which would accompany it. Given these conditions, confrontation is a certainty and the consequences could be severe for the political and economic climate.

The ECB, and indeed Germany recognise, that in order for the Spanish Prime Minister to have sufficient political capacity to implement the necessary structural and economic reforms in Spain, a legally binding Memorandum of Understanding with quarterly inspections and all the trappings that come with such a manoeuvre is the only way in which Spain will be able to ultimately achieve growth alongside austerity.

However, Germany and the ECB are equally cognisant that dissimilar to Ireland, imposing EU/IMF conditionality on Spain will be fraught with political and social stability risks and therefore minimising the economic adjustments, as a result of transferring banking losses on shared basis through direct ESM lending, and also potentially imposing losses on senior creditors, increases the likelihood of a successful program in Spain.

The likely success of a program in Spain shall be determined by the level of austerity imposed by Germany and the ECB, and how the Spanish central government politically manage its implementation in the autonomous regions of Spain without fostering social upheaval.

The relationship and tensions between the Central government in Spain and its autonomous regions is likely to be the key focal point of the Spanish crisis over next 2 to 3 years