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Dopeheads: How the Feds Feed Wall Street's Debt Addiction

One of the main lessons of the financial crisis was that the banking industry has grown dangerously large relative to other parts of the U.S. economy. Has anything changed since the housing crash? Consider this telling stat from Friday's WSJ:

Top-line, or pretax, operating profits economywide hit a record high at the end of 2010. All of the gain was in the financial sector [emphasis mine]....
After rising like the Phoenix, the financial industry now accounts for about 30 percent of all operating profits. That's an amazing share given that the sector accounts for less than 10 percent of the value added in the economy.
These numbers suggest at least three things about the financial industry. The first two points are by now self-evident. I'll expand on the last point because it bears most directly on the risks that are again building up within the economy like pressure within a nuclear reactor:
  • The U.S. economy remains highly unbalanced and dependent on finance
  • Large financial firms get more from the economy -- a lot more -- than they contribute
  • Banks are still boosting profits with borrowed money
Wall Street: Still hooked on debt
JPMorgan Chase (JPM) analysts recently estimated that Wall Street banks use twice as much debt as the typical hedge fund to increase their investment returns from securities trading. In fact, bank trading leverage is "well above" its level before the financial crisis, according to the report.

Such leverage, in turn, helps explain how big banks recovered so quickly from the crash, while other parts of the economy continue to struggle. That's how leverage works. It allows small profits -- and losses -- to become big ones. And "too big to fail" banks are flourishing now in part because the U.S. government continues to subsidize that debt by allowing them to borrow money for next to nothing.

That amounts to a huge competitive advantage over non-financial companies, with little to show in return for the broader economy. The disparity between how much banks earn and how much real economic value they generate underscores just how much the financial industry's profits stem from the government's low-interest lending. As Stanford University economist Anat Admati, who has argued persuasively about the risk of feeding big banks' addiction to debt, told me by email:

When large banks have a funding advantage over other firms, they can borrow at rates that do not reflect the riskiness of their business (due to underpriced explicit guarantees and free implicit guarantees, and because of an extra kick from tax deductibility of interest). Meanwhile, other industries have costs of capital that reflect the actual risk of their business and is not impacted as much by subsidies, so it is no wonder that financial firms are doing well.
Washington: You're my pusher man
Admati makes another crucial point in explaining how the financial industry operates today: "Competition in banking has become competition for creative ways to take on leverage." By contrast, where banks are in alliance is in their lobbying effort to thwart financial reform. That includes trying to poke holes in new derivatives rules and holding the line on requirements that they hold more capital.

The danger is that leverage can swamp the financial system. Because the bigger and riskier banks get, as we've learned all too well, the harder and more expensive they become to save.

It's textbook co-dependency. The government won't break Wall Street of its dependence on debt for fear of slowing the economic recovery, while bankers continue to juice profits with the aid of balance sheet-altering debt.

Images from morgueFile

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