Invest Like the Best with Patrick O'Shaughnessy
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: So at the time, again, we've got separation of investment banks and commercial banks. All of a sudden, European banks who weren't part of the same Glass-Steagall regulation, they started to unite with each other. So commercial banks and investment banks in Europe started to come together, which started to put the American commercial banks at a big disadvantage. And not only were they coming together, but they were also taking on more leverage than what was allowed with the guardrails of American commercial banks. So as a result of that, as you can imagine, all the commercial banks – and many market participants were saying, "Hey, we can't really compete against some of these European guys." In 1998, Deutsche Bank bought Bankers Trust, and that was definitely a moment. Citibank announced that it was merging with Travelers, which at the time when they announced the merger, it actually wasn't allowed under Glass-Steagall, under the current regulation. So that's what sort of led up to it. So I think it's a couple of things – globalization. Now, all of a sudden, you're competing against Europeans who have – think about it, they can provide services and balance sheet and capital. You're at a pretty big disadvantage. So the System 1 started to get less competitive as we moved into a globalized world. And that led to 1999 when Glass-Steagall was repealed. [00:00:00] S0: So what comes in its place? It's basically just deregulation.
· Alan Waxman
[00:00:00] S1: It's deregulation. And literally after that, you saw a wave of mergers of combining commercial banks and investment banks. So you saw JPMorgan Chase. There's many others, but with everything, there's knock-on effects. So that came together, created these powerhouses that could compete with what was going on in Europe. But now you had all these investment banks that weren't commercial banks. So think about my old firm, Goldman Sachs, and many others. Now they had to start competing. They didn't have access to cheap capital because they weren't a commercial bank. They had to compete with combined investment banks and commercial banks because a lot of the commercial banks, both in Europe and the US, they started to use their balance sheet to get investment banking business. So what did all the investment banks do? They started to leverage up. And that's one of the other stories leading into the system, the development of the fixed income market. So think about corporate bonds, mortgage-backed securities, asset-backed securities, sovereign debt. That went, literally from the 80s to the 90s, went from $7 trillion to $14 trillion. These are all financing mechanisms that could finance the investment banks to basically allow them to leverage up. And that's what started to happen. So literally from the time of Glass-Steagall being repealed, you had commercial banks uniting with investment banks, both in US and Europe. You had leverage going up. Leverage went up for commercial banks, in some cases 20, 30 times leverage. And all the investment banks were operating with leverage because they had to take on leverage to be able to compete with the combined commercial banks, investment banks. And then nine years later, what happened? You had the GFC. Now, just to be clear, there's a lot of polarizing debate of how much attribution the repeal of Glass-Steagall had on the GFC.
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: What do you think? [00:00:00] S1: Well, I think like everything, it's nuanced. There was definitely some attribution to it. I think that was clearly not the only reason. My view, it's some combination, but ultimately it had to do with the system and the set of incentives. In that case, after putting all this together, a lack of guardrails that existed in the first system we spoke about. [00:00:00] S0: And in System 2, is the lesson that it's the combination of liquidity or asset liability mismatches and leverage, that basically is the cocktail for every historical financial crisis. One of those two or both are involved. [00:00:00] S1: Leverage always plays a role, and they're all connected. But just the mismatching of assets and liabilities. You could be the best investor in the world making the best illiquid investments, but if someone comes and asks for your money in a quarter when you haven't had time to actually have that investment play out the way that you underwrote it to do, you're going to be a bad investor. You're going to get called out of your option, and you might have to sell it at a deep discount. So there's a few things. I think it's one, anytime you bring retail or individuals, so think about people depositing to a bank next to principal risk-taking activity. I think that's one thing. The second thing is just anytime you mismatch assets and liabilities. And then the third thing, again, going back to what we talked about earlier is what are the incentives? What are the guardrails? And what's the market structure?
· Alan Waxman, Patrick O'Shaughnessy
[00:00:00] S1: Leverage always plays a role, and they're all connected. But just the mismatching of assets and liabilities. You could be the best investor in the world making the best illiquid investments, but if someone comes and asks for your money in a quarter when you haven't had time to actually have that investment play out the way that you underwrote it to do, you're going to be a bad investor. You're going to get called out of your option, and you might have to sell it at a deep discount. So there's a few things. I think it's one, anytime you bring retail or individuals, so think about people depositing to a bank next to principal risk-taking activity. I think that's one thing. The second thing is just anytime you mismatch assets and liabilities. And then the third thing, again, going back to what we talked about earlier is what are the incentives? What are the guardrails? And what's the market structure? [00:00:00] S0: Okay, so then what happens? Obviously, we know the global financial crisis is terrifying, and the reaction is many things. But what is installed post-GFC that sets the seed for, I guess we'll call the current system, System 3?
· Patrick O'Shaughnessy, Alan Waxman
[00:00:00] S0: Okay, so then what happens? Obviously, we know the global financial crisis is terrifying, and the reaction is many things. But what is installed post-GFC that sets the seed for, I guess we'll call the current system, System 3? [00:00:00] S1: So in 2010, two things happened. First is, Basel III was passed by G20 nations, and I'll explain what that is. And the second thing is Dodd-Frank. When you think about Basel III, so this applies across all commercial banks. And by the way, a number of investment banks that were not commercial banks were forced to become commercial banks as a result of this. Those commercial banks – and this is really a Basel III thing – had restrictions on capital, which for your audience, think about that as leverage. So the amount that they could be levered up, so they didn't get levered up 30-to-1 or 40-to-1 like they did pre-GFC. And the second thing is restrictions on liquidity. And liquidity is basically, through a bunch of shock scenarios, a bunch of things going wrong., do you have enough liquidity to meet all your obligations? That was a key part of it. Dodd-Frank was more aimed at, in the Volcker Rule – that didn't really last long – was really aimed at the principal investing activity. I would say it's more for the commercial banks. It was more Basel III, but Dodd-Frank played a big role certainly in the short term. [00:00:00] S0: How would you explain just System 3 and its guardrails and incentives to people out there?
· Alan Waxman
[00:00:00] S1: System 3, in my opinion – it took like 125 years to get here – has the potential to be the best system American finance has ever had. Because when you think about commercial banks or deposit-taking institutions, by the way, that are basically backstopped by the government, insured by the government through the FDIC. So think about GFC. There was a bailout, the taxpayer bailout. That's not good for society. That's not good for the middle class. That was not a good outcome for America. For those institutions, having restrictions on capital or leverage and liquidity, where they're doing lower risk-taking activity to finance a system, that's a good pillar of any financial system. Conversely on the other side, and this is where the current moment starts to come in, is now you've got private capital coming in. So when you think about private capital, think about pension funds, sovereign wealth funds, endowments, insurance companies, providing capital. In the beginning of this period, so-called System 3, Post-Basel III, Post-GFC, that's what resulted in the growth of the private capital industry because it was filling in the gap. So think about principal risk-taking activities. Private capital is filling in the gap. And with the exception of hedge funds and really REITs, those were matched assets and liabilities. So you think about private equity, private real estate, private infrastructure, private credit. They never had someone that could literally ask for their money back, or they didn't have depositors saying they need to get their money back, they can't get it back because of illiquid assets. So just to put it in context, private capital from pre-GFC to post-GFC. It was about $2 trillion pre-GFC. It's grown to around $14-15 trillion. Private credit, which is in the news today, grew from $500 billion to about $2 trillion, where it is today. So massive growth. And this filled the gap for that principal risk-taking capital to provide risk capital to all parts of the American economy, which is a good thing. And I would say up until 2018, the system was working great. You had commercial banks, deposit-taking institutions, effectively back-stopped by the government, doing safer things. And then you had matched assets and liabilities where an investor, a set of assets, couldn't get called out of an option, providing the risk capital.