Amid the ruins of the financial crisis, Wall Street powerhouses J.P. Morgan Chase and Goldman Sachs last week reported big second-quarter profits, triggering hope among those who long for a return to normalcy in the financial sector — and criticism from those who fear the profits were at least partially the result of the kind of business-as-usual practices that helped to create the crisis in the first place.
In separate interviews, Wharton finance professors Franklin Allen and Jeremy J. Siegel offered contrasting reactions to the results. Allen said that while the firms’ quarterly results reflected overall gains on Wall Street, “by and large, you can’t make large sums of money without taking risks.” He worries that the government’s intervention in the financial sector last fall, which benefitted these firms and others, created an environment of moral hazard, in which Wall Street executives assume that taxpayers will rescue them from risky bets gone bad. Siegel was less concerned about this issue, noting that “both these firms now have a lot to lose after having recovered a lot.”
The transcript of Jeremy’s Siegel’s interview follows this transcript of the interview with Franklin Allen. (The recording of the Allen interview, conducted by phone while he was traveling overseas, could not be posted because of poor audio quality.)
Knowledge at Wharton: We saw some very positive results for Goldman Sachs and JP Morgan last week, and I wonder if you see any signals in that, regarding where we are in terms of the recovery of the financial sector, and the broader economy.
Franklin Allen: I’m keenly aware of the very good results for both, and I think it has to do with the recovery in the stock market and how well that sector did, and how enabled the banks are to do well. I think these high profits, though, raise a big issue — a big political issue — which is that the government has obviously put hundreds of billions of dollars into the financial sector. And Goldman Sachs, for example, wouldn’t be here without having had access to the government’s discount window and the ability to turn into a commercial bank. And now, they’ve repaid the TARP money back, which is great. But the question is: Did the government get enough of the support that they implicitly or explicitly gave to these banks? And I think that that is a real political issue going forward, as to how we deal with that. You know, these employees at these firms are going to get record bonuses. And yet, it’s only a year ago that we were putting these massive amounts of money in. So, I think there will be some big issues going forward.
Knowledge at Wharton: And the bonuses, of course, were a big issue last year, when the banks had first received their TARP funding. Do you suppose that it’s going to be back to business as usual with bonuses going forward?
Allen: Well, I think this is going to be the big question. Because Goldman is doing very well, and its people are making lots of money for the firm. And then the question is, how much will they get paid. I don’t think it’s going to quite be business as usual, because they’ve put in longer term compensation plans, so it’s not just year-by-year. They now have a longer horizon. But I think it does raise this whole issue of what the structure of the financial system is going to look like, when the banks know that if they get into trouble, they’re going to be bailed out. And I think it sort of underlines the paradox that we now have, and the problem of moral hazard. I think we really need to think very hard about whether the kind of support that the government gave is the best way to go. I think they did the right thing, in terms of preventing contagion, to step in and make sure the banks didn’t default on critical liabilities. But I think there is an issue — my own preference would be that any bank that potentially failed, they should temporarily nationalize it, but then … they should liquidate it. Too big to fail doesn’t mean too big to liquidate….
The other aspect of this that’s important is that the banks that do survive, because they are prudent, should get a reward for that. And I think they need to be able to expand, rather than having one who failed, effectively survive and continue to fight the risks and so on that they took.
Knowledge at Wharton: Is there a step that the government can take, to make it clear — if that is the case — that … there won’t be a rescue the next time?
Allen: I think they have to be very clear about what they’re going to do going forward. So, if they wanted to send that signal, one way to do that would be to start breaking up Citigroup and selling it off. Now, I think we’re some way from that. If Citigroup goes back for more money, then they will do that. But I think at some point, they’re going to have to change what they’re doing. Because the current policy of stepping in and providing these banks with what they need, and in many cases not even acquiring an equity stake, it’s just sowing the seeds of future problems. At some point, they’ve got to decide what they’re going to do about that. And as I say, I think that the best thing is to temporarily nationalize, and make sure there are no defaults.… But everybody should know that if they do fail, then they won’t have a job going forward.
Knowledge at Wharton: And so, the government needs to lay out a very specific scenario for what would happen if these banks were to get into a similar condition again, as they were last year.
Allen: Yes. But I think that they need to move on from the kind of emergency steps that they took last year, and start laying the future policies that are going to prevent them just writing a blank check for these banks. And the problem is that — politically, it’s going get more and more difficult if, after having given hundreds of billions of dollars, these bankers start making enormous sums of money again.
Knowledge at Wharton: Especially if they’re making them on risky bets.
Allen: Right. Especially if these risky bets look as though they’re doing it because it’s a “heads we win, tails you lose” kind of bet.
Knowledge at Wharton: Do you think, though, that there may be some belief among some of these bankers and perhaps the broader public that there is this implicit guarantee that the government will step in if they fail? Do you think that there’s any greater sense of being cautious about risks, than there was previously?
Allen: I think that’s the problem with these big earnings; because by and large, you can’t make large sums of money without taking risks. And the more money you make, the indication is that you probably took a fair risk to do it. Otherwise, there’d be lots of people making these big returns. And I think that’s part of the problem.
Knowledge at Wharton: And so then the only way to really address that is to get the government to make this kind of statement about — about what they’d be doing going forward, in the event of another crisis.
Allen: Yes. I think that they need to start thinking very carefully about what their policies for intervention are, going forward. And start making it clear what they would do in various scenarios. I think the fact that they didn’t rescue CIT is a step forward. And the fact that the private sector was prepared to come up with the money was also a big positive.
Knowledge at Wharton: And it’s certainly a big positive, in terms of the way risk is being allocated. Do you think that it’s a big positive in terms of the fact that this private sector was even able to step forward and put that deal together?
Allen: Yes. I think it’s a big step forward, the fact that they had the confidence to do that. And it may work — it may not work out, still, of course. But the fact that they did come up with a solution is a big step.
Knowledge at Wharton: Thanks for being with us today, Franklin. We appreciate your time, and for arranging to be with us, even though you were out of town. And we hope to be talking with you again soon.
Jeremy J. Siegel
Knowledge at Wharton: We are here today with Wharton finance professor Jeremy Siegel to talk about the results this past quarter for J.P. Morgan and Goldman Sachs, and what they have to say about the state of the financial sector.
Jeremy, there are some who think that these results suggest Goldman and J.P. Morgan were taking some big risks, and that they are taking risks because they believe that if they fail the government will step in and help them. What do you think about that?
Jeremy Siegel: I don’t think that’s the major reason at all for their profits. I believe there are a couple reasons why they did so well. First of all, a lot of their competitors are gone. Bear Stearns and Lehman and others — although some of the people have been absorbed elsewhere. There’s less competition for those profits. So that’s one reason they are able to do well.
And, secondly, we’re in a [period] of … record risk spreads. Markets are still not liquid. They’re still volatile. These are the climates in which firms such as Goldman and J.P. Morgan do extremely well because they survive on the spread between the bid and the ask — the arbitrage between different types of instruments that are just slightly different. And those spreads have been very, very wide. With the lack of others competing against them [Goldman and J.P. Morgan] have been able to take even better advantage of that. So I think it was easy profit because of what’s going on in the financial markets. I don’t really think they were taking any appreciable risk.
Knowledge at Wharton: Do you think that these results will lead to bonuses of the sort that generated some concern last year on Wall Street?
Siegel: Well, Goldman paid back [the money it borrowed from the government]. J.P. Morgan did, too. And [the repayment was] with a profit by the way, which means the taxpayer did really well. So the question I think comes down to: Why would we want to mess with their internal compensation? There isn’t any government subsidy involved here. With that being said, it is true that the bail out of AIG did mean that some of the contracts that both Goldman and J.P. Morgan entered into were made whole. But in terms of the outright TARP money or Fed subsidy, it’s gone and we’ve all been repaid. And the truth of the matter is Goldman didn’t want it to begin with. Remember, Paulson forced it on the banks — J.P. Morgan and Goldman. Goldman was actually in very, very good shape. And he just said everyone is taking it. [Paulson said he did not] want the people who take it to get a bad name … so everybody was forced to take it. So I think it’s really unfair to penalize them for being forced to take it and having paid it back with a profit to the U.S. government. I think we should let them set their own compensation structure.
Knowledge at Wharton: And you believe that the taxpayers got a reasonable return based on the results?
Siegel: Absolutely. A very good return based on, first of all, the dividends that were on the preferred — full-interest on the loans, and the warrants that were issued were paid off at a profit. So we the taxpayer did very well off of Goldman. There was no subsidy involved from that angle whatsoever.
Knowledge at Wharton: Do you share any concerns about the moral hazard in the marketplace right now; that some of these firms might be taking risks they probably shouldn’t be because they’ll have this implicit sense that they’re going to be made whole by the government if they fail?
Siegel: Don’t forget when we talk about “bailed out” — what we’re saying is that we’re going to bail out the bondholders. The stockholders go to zero. There’s a huge amount of equity there in Goldman that is not bailed out…. Even AIG, their stock is virtually zero now and I think it will go absolutely to zero. When we talk about the moral hazard…, it does apply somewhat to the bondholders and the counterparties. But when you have substantial equity as you do in Goldman, particularly, and an increasing equity now in J.P. Morgan, it’s not a freebie. If you’re bailed out by the government now, the stockholders are going to lose everything…. So I don’t think [moral hazard] is a major play in the game. [Moral hazard occurs] when … you have nothing to lose — “heads I win, tails I was going down anyway let the government take it.” Both these firms now have a lot to lose after having recovered a lot — particularly Goldman in its stock price.
Knowledge at Wharton: Now what do those results say about the broader financial sector? Is it evidence that it’s coming back?
Siegel: I think right now the … financial sector opportunities are the greatest they have been. I would love to be a new bank without any legacy loans. All the loans made during the boom are pulling them [existing firms] down. The spreads between borrowing and lending are record highs. They’re paying almost nothing for deposits. They’re paying almost nothing on Fed funds because the Fed is keeping it so low. So … the profits are great. The problem is that they lost hundreds of billions in bad loans and the question that stockholders have to ask is — these profits are not going to last forever. As the situation gets normal, spreads will move to normal. There’ll be more competition on all angles. But for a period of time, on the new lending, on the new arbitrage, on the new trading, I think those players in Wall Street are going to do extremely well. Some of them will recoup the losses that they had through their bad loans. Others probably won’t. AIG and many of the others I don’t think will. It’s a question of whether Citi can. Citi is the big question mark. They lost probably $250 billion to $300 billion in bad loans. Is there enough profit left over the next year, two years, three years for them to recoup? I tend to think certainly not all of it. It’s not going to go back to the $40 to $50 dollars that it used to be. It’s a $3 stock now. Hopefully it may become a $10 to $12 [stock], but that’s about all. The others though might have enough opportunities to build back the profits to cover the loss. Bank of America would the next one to consider, to see whether it can do it. And I’m not sure. A strong bank such as Wells Fargo and J.P. Morgan will make profits that will overtake their losses and will do well. And firms like Goldman, that didn’t have many losses at all are going to do fantastically because they are in a financial environment that is very conducive to their type of operations.
Knowledge at Wharton: Given the reduced level of competition and these very favorable spreads, do you see new players moving into that area?
Siegel: Certainly. It’s a trouble getting capitalized, but I think hedge funds are beginning to move into that area. They will get the competition to be sure. This is a window of opportunity that will close over time and I think they’re trying to make the most of it right now. Also, internationally they don’t have the competition [either] also because … a lot of the international players were also certainly damaged. So for those players still active, this is certainly a special window for them.
Knowledge at Wharton: And, in terms of the markets coming back, it looks like they’ve been all over the place in the last few weeks.
Siegel: The credit markets are what have really come back. We’ve talked before about the Libor Fed-Fund spread and how that ballooned all the way out to almost 400 basis points right after the Lehman bankruptcy. It’s down to around 30 now — 25 to 30. Now this is still way above pre-crisis — before the first little rumbling — about 2006-2007. But it’s well below what was happening let’s say July, August and early September  before Lehman’s spread was around 70 to 90. So we’ve repaired dramatically on those risk spreads. It’s still not back to normal, but it has been repaired dramatically.
The stock market is looking things over. The threats were higher oil prices has come down a little bit and I think that things do look favorable for a continued rise in the stock market. I still believe that this year will be an up year. In fact, right now, year-to-date we are up on all major averages now in the United States. And, in fact, most of the stock markets around the world are now year-to-date positive.
Knowledge at Wharton: But aren’t the credit markets still limping, especially in terms of loans for smaller and medium-size businesses — as we’ve seen with CIT, for example. And that’s where most of the jobs come from.
Siegel: Right. I agree with the government’s decision not to bail out CIT. I think there appears to be a rescue package by bondholders. It’s tough. Obviously, when you’re in a recession as severe as this, lending is going to go down because we see much more risk. You can’t borrow on inflated values like it was so easy to do in 2005-2006. They’re asking for hard appraisals and companies are having a hard time getting appraisals on real estate and inventories and others that can match their loans. That’s what happens in recessions and particularly deep recessions. As confidence comes back, lending will come back. It is beginning to come back. As I said, the spreads have already narrowed dramatically. It’s a matter of time. I think there is healing here, but it’s really a reflection of the risk and the fall in the asset values that used to collateralize the loans of these lenders. And now really the banks and everyone are asking — let’s see the values. You get the appraisal. You’ll get it. But I have to see the realistic appraisal.
Knowledge at Wharton: New polls are showing that public support for the Obama economic plan is starting to shrink. You’ve had some concerns about the plan yourself. How are you feeling about it right now?
Siegel: Well, as the unemployment rate rises, people are impatient. We do have multi-trillion dollar deficits, which a lot of groups are making sure that people get all scared of. I think there are a couple things here. First of all, if we see the continued recovery in the stock market, that’s one factor that will bolster confidence. And, secondly, we’re beginning to see — although not as fast as we had hoped — payroll declines slowing down. And I’m predicting GDP growth in this third quarter to be 2.5%, which should really stop payroll losses beginning in August, in September, hopefully even some small gains. Unemployment — as people go into the labor force looking for jobs — might continue to rise for another 6 or even 12 months. I don’t know how high it will get. I still think it will peak below the 10.8% record that we had in ’82, but not withstanding, we know that’s a lagging indicator. So the labor market is what gets the headlines, what affects the opinion polls. That’s the most lagging of the indicators. If the stock market comes back and we begin to slow down, as I believe we will very soon, the job losses, I think confidence will stabilize.
Knowledge at Wharton: Now, I just want to go back to these job numbers for just a second. You were talking about people returning to the job market, trying to find jobs. So you’re talking about I think some of these people who were discouraged workers who haven’t been seeking jobs and so they weren’t reflected in the unemployment numbers.
Siegel: Correct. Once they hear that the situation is a little bit improved, they come and actively seek work. We’re seeing a big increase, interestingly, in female unemployment. Not so much because females have been laid off — but because the situation is tight in households where there was only the male worker — they are now coming into the labor force as a second worker trying to see what kind of jobs [they can find] to bolster their situation. So their unemployment rate goes up — again not because of layoffs but because they feel they need to find a job. And, again, as the situation begins to improve, that number actually rises at first as people say “now is the time for me to look for a job.” Unemployment will rise even as payrolls begin to gain numbers.
Knowledge at Wharton: Because the payrolls aren’t rising as fast as the number of people looking for work?
Siegel: That’s right.
Knowledge at Wharton: So today we have some indications about the Fed’s exit strategy for these troubled banks. What are your initial reactions?
Siegel: This was Bernanke’s semi-annual testimony — Humphrey-Hawkins testimony as it used to be called — before Congress. I think they’re right on. What he is saying is that he does not feel right now that we need to begin to think about raising interest rates. But the Fed is prepared to do so if it thinks that the economy and prices may overheat. So he gave us some confidence. The bond market reacted very favorably this morning with interest rates down 10-15 basis points.
He also talked about his exit strategy. What that means is how do you go away from this zero interest rate and still provide liquidity for the banks? And one of the first things that he did mention was that Congress has given him — just as a result of the crisis late last year — authority to pay interest on reserves. What that means is that he can begin raising interest rates on reserves and still supply a lot of reserves. Normally when you supply a lot of reserves, you drive interest rates down. But if you’re able to pay interest on those reserves, you can still supply a lot of reserves. In other words, keep the banking system very liquid, which is one of the goals that he has had, and at the same time begin to nudge up those interest rates to fight any inflation that might take place. So that was the first line of attack that he talked about.
And then he talked about the more normal traditional lines of what’s called open market sales and other transactions to reduce the amount of reserves in the system. And one thing he pointed out early on was that we’re already getting a reduction on reserves — not from the impetus of the Fed, but from the banks themselves saying, “I don’t have to keep all these reserves that have been given to me. I can now begin to find some opportunities.” So we’ve seen a shrinkage of the Fed’s balance sheet voluntarily as a result of banks paying back loaned reserves, which they felt they had to have at the end of last year. Now they don’t feel they need as many of. They’re paying those back. And that is just normally shrinking the balance sheet. So on many fronts … I think he’s right on the ball with it. I think they do have an exit strategy.
Knowledge at Wharton: When the process of the government helping the banks shore up balance sheets began, we heard some pretty large estimates of the amount of money the government might eventually have to provide…
Siegel: Over a trillion.
Knowledge at Wharton: It’s looking now then like we’re going to be spending a lot less.
Siegel: Much less. In fact … I think over a half a trillion in reserves has already been paid back voluntarily by the banks that just said they just don’t need it. They’re now giving, I think, an eighth of a percent of interest. It was so little. And some of them are saying I’d rather invest it elsewhere.
The loans will not come close in terms of costing the taxpayer the total amount that is there. As I’ve said, already those that have paid back have paid back with a profit. Now, as for Citi and others, we’ll have to wait and see. And, by the way, the AIG loans, the Freddie and Fannie loans — those are ones that I don’t think will ever be paid back, and we the taxpayer will be on the hook for those. But I think, again — and I’m throwing this number out — I think we’re going to see a total loss perhaps of the low hundreds of billions. That might sound still like a high number, but we were in the trillions. Given that almost $2 trillion was lent through the TARP plus the Fed loans, this is still maybe at most 20% net cost to the taxpayer. So it won’t be anywhere near the total amount lent, which is certainly good given the government is running such huge deficits on its own. The Fed is not going to contribute overwhelmingly to that.
Knowledge at Wharton: Would you say that this is about as positive an outcome as one could have expected at the beginning of this process?
Siegel: Yes. As I’ve mentioned, the Lehman bankruptcy and those weeks that followed were almost a knockout punch. The economy went into the ICU. I think it might be able to be moved to a regular hospital room now as at least we’ve survived. And, now, it’s a healing process. Healing takes time. It’s just not going to happen overnight no matter how big the stimulus plan is. But in my estimation it is taking place in due order. And I don’t think we should become discouraged at all.
Knowledge at Wharton: Well, Jeremy, thank you so much for stopping by today.
Siegel: Thanks for having me.