Smith Faculty Opinion Article	April 17, 2008
By Dr. Peter Morici, Professor of International Business                                                                       E-MAIL       WEB SITE

The G7, the Banks and GE

This week, it’s tough to pick the most significant news.

The G7 Finance Ministers Meeting was significant for what it didn’t do—something truly constructive about the credit crisis.

Tired carpenters, the ministers and central bank chiefs hammered the same old nails. Their Financial Stabilities Forum report served up the same tired nostrums—extended capital requirements, transparency, closer international cooperation and the like.

The report acknowledged that overly complex and excessive trading in loan-backed securities issued by major banks and securities companies were significantly responsible for the credit crisis and recession. They noted that bank executives had run off with huge amounts of loot. However, they offered little to clean up the sordid business practices and profiteering at Citigroup, Merrill Lynch and the other monasteries of the Wall Street Church of Divine Entitlement.

Merrill Lynch took another hit on its subprime loans and reported another quarterly loss but the P&L statements at major banks and securities indicate most big financial houses will emerge from the storm intact. The sheer breath of their activities cushion them from the worst consequences of the subprime mess, and that is a big part of the problem besetting the economy—the banks can go pirating elsewhere if they can’t earn outsized profits and bonuses by making bogus loans to irresponsible suburbanites and questionable businesses then sell those loans as bonds to unwitting pension funds, insurance companies and municipal cash managers. Hence, they simply won’t provide credit to responsible homebuyers and businesses.

It is simply impossible to borrow at 5 percent and lend at 7—the essence of traditional banking—and skim off the kinds of profits and executive bonuses bankers now expect and still provide for loan servicing, insurance and the other costs involved in lending and securitization. Only by slicing, dicing and pureeing loans into incomprehensible securities, whose value is exaggerated and risk disguised, to fool investors can bankers generate the kinds of incomes they now expect.

Now, the hoax uncovered, the bond market is closed to the big banks, they cannot turn loans into securities, and the nation faces a credit shortage, because over the last two decades, banking has moved from a “deposits into loans model” to a “loans into bonds model.” The latter shift is a good thing, because it eliminates the kind of risks banks bear when they borrow short and lend long, which mightily contributed to the Savings and Loan Crisis. But properly done, either model will only reward bank executives like their counterparts in other large corporations, not like Middle East oil royalty.

The banks are now part of financial conglomerates, and bankers can look elsewhere to pay 35-year old MBAs $10 million a year. Hence, if they can’t earn that kind of money writing mortgages and making business loans, they will hunt for fools elsewhere, and worthy homebuyers and reputable business go without adequate access credit and the public be damned.

The biggest news, though, may have been GE’s earnings hiccup and the ensuing fallout. Coming in less than expected, GE’s earnings set off the usual ruminations that the company’s businesses are too diverse to be effectively managed. These naggings remind me sadly of the 1950s cries to “break up the Yankees.”

GE and its problems are broadly representative of the U.S. economy. It is difficult to imagine GE would not have some difficulties as the U.S. economy goes through not only a recession but also wrenching changes in business patterns wrought by significant, permanent deleveraging. Just as Ben Bernanke, Henry Paulson and most economists have been repeatedly caught off guard by the scope of the problems and contractions gripping the economy, so were GE's financial analysts. After all, they did the numbers Jeffrey Immelt used prior to the disappointing earnings report.

The very fact that critics are at sixes and sevens about which businesses GE should divest to correct their fears may indicate the GE portfolio is no more out of line than at other times. It needs pairing in places but not radical restructuring. That is normal for what is the corporate model for the private equity paradigm of buy, revamp and then profit or sell.

Jack Welch’s hectoring only contributed to the distraction that will beset GE if it must constantly defend its business model to the world and Jeffery to Jack, when GE’s problems result mostly from the national economic hangover created by Wall Street’s buccaneers.

Jack Welch’s behavior does, once again, demonstrate Morici’s iron rule of management. Organizations should be run by strong CEOs, accountable to engaged boards, and retired CEOs ought not to meddle.

Jack, if you are listening: Shush!

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.                                                          ►More Faculty Opinion Articles