Barrier To Entry?
Each quarter I have the depressing task of writing a report on the regional economy and real estate market of Detroit, Michigan. While people elsewhere continue to debate whether or not we are in a new recession and how bad it will be, in Detroit one could argue that the old recession that began in late 2000 never ended. Detroit is paying the price for being a backward looking place where lots of people had lots of unearned advantages and sought to stop the future in order to lock them in. A center of innovation at the dawn of the automobile industry, the city and state’s key industry evolved into a Big Three oligopoly that paid big bucks to hordes of executives and provided rich pensions after short careers for unionized employees. All while producing inefficient motor vehicles that at one time, a time the Big Three have yet to live down, had lousy quality. Many of my relatives of my grandparents’ generation worked on the assembly line at the GM Fischer Body plant in Tarrytown NY, yet I may be the only member of my extended family that owns a GM automobile. All of this is a massive warning to New York City, because our financial sector, like Detroit’s automobile industry, has become increasingly concentrated in just a few companies, even as no new ones open here. Why?
No new automobile companies have opened in Detroit over the past 50 years either, even as existing companies merged and consolidated, despite that city’s motor vehicle heritage and expertise. Over in the smaller market of Japan, meanwhile, no less than eight companies – Toyota, Honda, Nissan, Mazda, Subaru, Mitsubishi, Suzuki, Isuzu – were forced by competition to innovate and produce quality cars. These companies increasingly dominate the U.S. market, from factories in states other than Michigan. During the past 50 years the Big Three have had enormous political power, and they have used that power to (among other things) prevent the government from mandating higher fuel efficiency. A lack of fuel efficiency is killing them now.
And in New York? Well, there is a bank called JP Morgan Chase. It should really be called JP Morgan Chase --Chemical--Manufacturer’s Hanover--Bear Sterns, among other things. Citigroup similarly includes what were once a large number of large New York financial companies, including Citibank, Salomon Brothers, Smith Barney, and Travelers Insurance. We are down to a handful of major money center banks, and a handful of major New York-based independent investment banks, down from a substantial number of each just 25 years ago. The latter are Merrill Lynch, Lehman Brothers, Goldman Sachs, and Morgan Stanley. In accounting, meanwhile, the Big Eight firms is now the Big Four. There are three financial rating agencies. And, while they are not in New York, we have but one Fannie Mae and one Freddie Mac.
There are fewer and fewer choices for the customers. So how well have those customers fared?
To the extent that New York’s financial firms have innovated, they have found more innovative ways to lose other people’s money, all while paying themselves on a scale that would have embarrassed Caligula. Wall Street has moved directly from the Enron-type scandals of the dot.com era the mortgage securitization disaster of the present, destroying the finances of company shareholders and company customers alike. Someone I know who knows a great deal about the financial industry put it this way: the reputation of investment banking firms was their entire franchise, and they wouldn’t have dared to put that at risk, lest no one be willing to accept the securities they underwrite, and they lose all their business to competing firms. But what if they ALL lose their reputation for fair and competent dealing?
Well then the more honest competition doesn’t exist, so I guess they have nothing to worry about. Or do they?
New York City was once the world’s financial center. It took that role from London, because Great Britain had gone from being a creditor country with a sound currency to a debtor country with a weak currency, while the United States had done the reverse and become the world’s largest creditor. If you needed to raise capital, you did it in the country with savings – the United States. If you had savings to invest, you did it in the currency that maintained its value, the dollar. The transaction was handled in New York. Now that the world economy has become much bigger, New York is one of several major financial centers, located around the world in different time zones, but this may only be a transitional phase. The United States is now the world’s biggest debtor. The dollar is sinking in value as the government tries to inflate its way out of otherwise unsustainable debts -- federal, state, local, corporate, personal, financial.
And now people and firms all over the world, taking losses on AAA-rated mortgage bonds, may come to believe that none of the existing financial institutions in New York City can be trusted. Could Dubai take New York City’s place? I’ll bet a lot of investors find the idea of putting money in a place where thieves get their hands cut off rather attractive right about now. Yes we own a GM car rather than a Honda or Toyota. But aside from demand deposits (checking) and cases where government rules require me to hand over my savings to intermediaries of someone else’s choosing or pay higher taxes (401K, 529), we have our savings with a company based in Pennsylvania.
It seems clear to me that if New York City is going to remain a major financial center, it’s going to have to develop new, untainted financial and related firms. And given the importance of finance to New York City’s economy, it is fair to say that this is an issue that dwarfs all others. So given all the financial talent here (a great deal of which is becoming, how should I put this, available) and all the money, why isn’t this happening? What is the barrier to entry that has prevented new banks and investment banks from getting started here? Are there simply too few people whose character is sufficiently trustworthy to form a Board of Directors anyone would take seriously? Or is there a political problem?
Like the Big Three domestic automakers, Wall Street has enormous political power. At the federal level, in fact, I believe it is fair to say that New York’s financial and health care sectors matter, and no one else in New York City matters at all. And currently occupying the seat of that power, and representing and defending the industry’s interests in Washington, is one man – the champion Democratic fundraiser, Senator Chuck Schumer. Yes he does the silly Sunday night press conferences on silly issues, but that isn’t what makes him important. In the 1990s there was a consensus (perhaps mistaken in light of recent events) that banks, investment banks and insurance companies should be allowed to be part of one organization in the United States, as they are in much of the world. Legislation kept being introduced, and former Senator D’Amato kept taking contributions from each of what was then three different industries, each of which wanted the merger to take place under rules favorable to themselves. Then somehow the legislation would get scuttled, and the contribution gravy train would keep going. Until Senator Schumer replaced D’Amato, and moved onto the banking and finance committees. The Gramm Leach Bliley act passed a few months later.
With the financial industry a creature of the federal government, clearly Senator Schumer is a key man in its future, and thus a key man in our future. And if anyone needs to be thinking about its well being, it’s him. So New Yorkers had better know what he, and Mayor Bloomberg, think about this issue. They co-sponsored a very detailed report on Sustaining New York’s and the US’ Global Financial Services Leadership. That report was released on January 22, 2007 and, let’s just say it has been overtaken by subsequent events.
The accompanying press release said “New York could lose its status as a global financial market without a major shift in public policy. Schumer and Bloomberg, together with New York Governor Eliot Spitzer, warned that New York financial markets, stifled by stringent regulations, and high litigation risks, are in danger of losing businesses and high-skilled workers to overseas competitors, relegating New York to regional market status and adversely impacting the U.S. economy…If New York goes from being the financial capital of the world to becoming only a regional market, as this report predicts will happen within the next ten years, every aspect of New York life will suffer, not just financial services.” Serious stuff. So what is the problem?
The report was based on consultant interviews with key existing financial industry players. NYC has its advantages, it said, but “the findings also identify three factors that clearly dominate financial services leaders’ views of New York – and by extension the United States – as a place to do business: skilled workers, the legal environment, and regulatory balance.” As for skilled labor, the report indicated a problem recruiting high-level foreign workers than had developed in the wake of 9/11. And as for litigation and regulation, it alleged an over-reaction in the wake of the Enron scandals, along with some technical problems in the organization of the U.S. regulatory apparatus and its international coordination.
“The increasing pace of innovation and new project development in financial services has meant that responsiveness and flexibility have become ever more important features of regulation. Yet against this need for speed comes regulators’ obligation to protect investors and customers…Not surprisingly, the vast majority of interviewees and survey respondents strongly believe that the pendulum of regulation in the United States has swung too far in recent years.” All this makes fun reading in light of subsequent events, eh? The problem is overzealous bank examiners bent on overprotecting consumers from financial innovation? Ha! “The more amenable and collaborative regulatory environment in London in particular makes businesses more comfortable about creating new derivative products and structures there than in the U.S.” Lucky them. No wonder they’ve started having bank runs over there.
As I said the report is absolutely quaint in light of subsequent events. The worst case scenarios today are, well, the worst. Both the financial regulatory system and the financial industry itself are going to be completely reorganized not as a result of a plan, but in response to a crisis. Senator Schumer has a lot of work to do.
Financial regulation is a subject about which I am a position to know just how little I know, so I won’t comment on it here. Let’s move on to what isn’t in the report, or what isn’t in it much. There is little concern expressed about industry concentration and the lack of new entrants. We are having to bail out Wall Street because the firms are too big to fail, but 18 months ago no one seemed to be too worried about them getting that big to begin with. But it seems to me there aren’t enough of them.
Unfortunately, Mr. Schumer has emerged from a political culture that I identified in this post as American Feudalism. Under capitalism you get what you earn, at least in theory. Under socialism you get what you need, at least in theory. But here in feudal New York those with unearned privileges get to keep them, and get others, whether they need them or not, deserve them or not. While being open to new people and new types of people, as long as they are politically powerless and are made to kick in far more than they get out (to make up existing interests doing the reverse), New York’s political culture has not been welcoming to new businesses and new types of business. Look at the political reaction to national chain stores from elsewhere moving into New York City. Has anyone asked why, for the past 20 years, no one has been able to create and develop a new national retailer from New York City that would then expand elsewhere?
Schumer and Bloomberg didn’t have McKinsey Consultants interview the CEOs and business leaders of firms that didn’t exist yet. Nor do such non-existent firms provide existing jobs or tax revenues. You can’t be lobbied by the executives of such ephemeral firms, or meet with them in a social setting, and they don’t provide campaign contributions. The fact that barriers to entry are not mentioned as a problem in the report is troubling. It makes me think that Senator Schumer believes the interests of New York’s financial industry and the interests of its existing firms are one and the same, when in some cases they may in fact be opposed. As in the problem of not having enough major new firms.
Even now a bill in Congress is getting approved to bail out Fannie Mae and Freddie Mac with taxpayer dollars. Those firms play a vital role in the mortgage market. But the federal government created Fannie and Freddie, and rather than bailing them out, it could have simply decided to create replacements for them. But the replacement firms that do not yet exist haven’t been spending zillions lobbying and contributing to members of Congress. Fannie and Freddie have.
The only reference to the need for new firms in the report is contained in a section on creating a new public-private organization to promote NYC’s finance industry. The more important recommendations in that section are to maintain “an active dialog with the City and State’s top financial services employers about their expansion and relocation agenda.” In other words, let them not pay as much taxes as new companies have to pay, and subsidize them, when they threaten to move to New Jersey. “In addition, it should develop relationships with a short list of high-priority financial services institutions that might consider expanding what is a limited presence in New York today.” In other words, act like New Jersey and tell large existing financial companies from elsewhere that they won’t have to pay as much in taxes as new companies have to pay if they move here.
That section of the report also suggests creating a “special international financial services zone” in New York City to provide “development incentives, differential taxation, and differential regulation.” In that zone, the subsidy would be directed to new firms to “alleviate the risk of a regional or national fiscal race to the bottom” while attracting a cluster of “next-generation financial services firms and support industries” which, based on other sections of the report, means things like hedge funds. I believe, though it doesn’t say so, that the suggestion is that firms in the “enterprise zone” would pay lower federal taxes than financial firms elsewhere in the U.S., a suggestion that presumably would go over like a lead balloon in light of the ongoing Wall Street bailouts.
Next generation? Forget the whiz-bang. How about plain old banks, securities firms, accounting firms and rating agencies that aren’t tainted by having robbed people repeatedly over the past decade? How about some new ones of those? According to Sandy Weill’s biography, he and three partners started a brand new investment bank, Carter, Berlind, Weill and Levitt, Inc., in the mid-1960s. Also in the mid-1960s, Edmond Safra founded Republic National Bank of New York, which grew to substantial size and later merged with H.S.B.C. Weill and Safra got really rich. Is this no longer possible? If not, why not? (Come to think about it, back in the mid-1960s there used to be actual contested elections for state legislature and new political parties were formed in New York, too).
Whatever the reason is, that is the biggest threat to New York City’s financial industry other than the decline of our currency and the debt pauperization of our country. Because over time, as each cycle creates its own wipeouts, the existing players will inevitably disappear. If there are no new ones, New York’s financial industry will disappear with them. After all lots of New York's financial institutions, along with most of the Savings and Loan industry, disappeared in the wreckage of the last real estate bubble in the 1980s, which was residential in the Northeast and California but commercial through most of the United States.
Barriers to entry is what Senator Schumer should be worried about. That and the fact that our economy is drowning in debt, and the dollar is losing its status as the world’s reserve currency. Hey Chuck if you aren’t working to get rid of the barrier to entry, whatever it is, then perhaps the barrier to entry is you.
And as for Mayor Bloomberg, if he wants to help NYC’s financial industry, the when he leaves office he should sell Bloomberg Media, find a few other rich people who have some semblance of a reputation for integrity (is it possible to form a quorum of such people in the current era?), and use the capital to start a new money center bank. He should do a through investigation as to the feasibility of doing so whether he intends to or not, because if he finds it is infeasible, he has then identified the problem. And after al, the way things are going, and based on his personal fortune alone, by 2010 his bank could be the most highly capitalized institution chartered in the United States.
Post new comment