Too Big to Save

The GFC brought the realisation that some banks and other financiers were simply too big to be allowed to fail. But now the survivors have become too big to save. In this interview, US insolvency expert Jim Millstein outlines the weighty issues still confronting us, including a break-up of the banking behemoths.

During the first days of the global financial crisis, Jim Millstein happened to be in the right place at the right time. He answered a call in late 2008 from the Obama administration’s Treasury Transition Team asking him to join soon-to-be Secretary of the Treasury Tim Geithner’s economic unit as its Chief Restructuring Officer. He was charged with overseeing the US government’s attempts to save the global insurance giant, AIG, and other important bail-outs in the financial sector.

In the wake of the Lehman Brothers collapse in late 2008, no less than US$8 trillion was provided by the US government to prevent a run on banks and to shore-up public confidence in the financial sector. The feared collapse of the world’s largest single economy was stemmed, but people were shocked to find that such a massive and extensive rescue was required and that the system came so close to meltdown.

Quite simply, Treasury and Congress had to act because the major banks were too big to fail – a term that has entered the common lexicon and is now the title of a best-selling book and movie.

In Millstein’s view, the leading US banks - Citigroup, JP Morgan, Goldman Sachs, Morgan Stanley, Bank of America and Wells Fargo - are still too big to be allowed to fail. These top six have aggregate assets and liabilities that account for 85 per cent of US GDP, having grown so large in part as a result of industry consolidation sparked by the crisis. But, Millstein warns, another scary scenario is currently being played out, and not just in the US. “There are 18-20 huge financial institutions in the US and Europe that are now too big to save,” he says in an exclusive interview with The Review.

Q. Why did the financial crisis occur and how did it unfold?

A. The proximate cause was a toxic combination of leverage in financial institutions and leverage in the household sector, both in the US and in a number of European countries. The amount of debt in residential real estate in the US doubled in the eight years to 2007. The financial sector more than doubled its debt during the same period.

Banks were critical cogs in the money creation wheel, and much of their increased leverage was funded with short term credit ultimately backed by the residential real estate loans on their books. The banks and the households to whom they lent were in a symbiotic relationship. Each fed off the other.

When housing prices fell, the surge in credit creation collapsed and so did the short term funding that the banking system relied upon because the mortgage collateral on which it was based was no longer reliable. That caused a huge contraction in money supply as the banks tried to repay their short term obligations. GDP on an annualised basis fell by almost 10% during the fourth quarter of 2008. That caused all kinds of knock-on effects, both real and psychological. The banking sector went into a paroxysm of fear and the economy went into real decline. The government was forced to intervene.

Q. What lessons can be learned from that? Are financial institutions now too big to fail and what does this mean for the US and global economy?

A. The top six banks in the US have aggregate assets and liabilities amounting to 85% of US GDP. In Europe, it’s even worse. In Switzerland, the two largest banks are at about 350% of Swiss GDP. In France, the three largest banks are at almost 300% of GDP. In Germany, it’s 150%, while in Spain it’s three times and in Italy the same. There are 18-20 huge financial institutions that are too big for their home country governments to save.

The liquidity needs of any of these institutions in a crisis are beyond the financial might of their home country’s ability to handle. That is what is playing out right now in Europe. In the US, the problem was comparatively smaller so we were able to put together the US$350 billion TARP program to recapitalise them. But in Europe, where the institutions dwarf the size of their home country governments and their fiscal capabilities, a supra-national type of financial rescue is going to have to be fashioned. We saw recognition of that from the summit meeting of European Union heads of state. They are, in effect, putting together their own TARP fund to be able to recapitalise the Spanish banks. Then, no doubt, it will be used for Italy’s banks and potentially for those in France. They are all inextricably linked.

Bond markets in Europe are less developed than those in the US and so the primary source of funding for governments, corporate businesses and individuals is the European banking system. If the banks are facing tight funding conditions themselves or are under-capitalised, then credit to the public and private sectors in Europe is constrained and governments cannot borrow. So banks and governments are each critical to the funding and solvency of the other. The recapitalisation of the banks is critical to governments being able to fund their deficits but the needed recapitalisation of the banks increases those deficits.

For the US, the immediate crisis has passed but we’re by no means out of the woods completely. The burden of high capital requirements on financial institutions will make many of their businesses less profitable and as a result, it’s going to be very hard to pay the kind of salaries and bonuses that have traditionally been paid to the employees who run them. The drive towards international banking will likely reverse itself as senior managers realise that their risk management systems are not up to the task of handling the credit, liquidity, market and funding risks of their multifarious international operations. JP Morgan’s recent announcement of multi-billion dollar losses from an alleged “hedging” operation in the UK is clear evidence of this problem. So, my guess is that a lot of the non-core businesses of banks like JP Morgan and Citi will need to be shed, in the same manner that they were accumulated during the past 20 years to take advantage of Government-subsidised financing. The Government is not going to provide implicit guarantees any longer. Banking will become a lot less complicated and likely a lot less profitable.

Q. Where is the Euro crisis heading now and how far will it go?

A. They have a long way to go. For a variety of reasons, regulators in the US calculated that they couldn’t save Lehman. That set off a panic, and forced the regulators immediately into crisis mode and the development of innovative programs to fund capital and liquidity needs of the system as a whole. The US Government committed almost US$7 trillion to refinancing the financial system as well as US$200 billion into banks and insurance company recapitalisations. So far, the crisis in Europe has not had such a Lehman moment to force the member nations to confront the crisis on a systemic basis, rather lurching from country to country, summit to summit, inching their way to a more systemic approach. So far, most of the response in the banking sector has been run through the ECB, providing liquidity through long term repo operations, but there is still no systemic recapitalisation program like TARP in place. That is what is making news now. They appear to be on the way to turning the European Stability Mechanism into a TARP program. That’s good because the banks need both capital and liquidity.

Eventually, they’re going to need a federal government of Europe and new sources of revenue to handle the crisis before them. In all events, we will see a narrowing and shrinking of the finance sector in Europe, which is long overdue.

Q. Spain has taken some of the spotlight off Greece in recent times. How do you see that playing out?

A. In some fundamental way, Greece is a failed state. The fundamental power of a state is to tax its citizens so that it can defend itself and fund its budgetary priorities. Greece has proven itself unable to tax its citizens to pay for its own government programs so, in that sense, it is a failed state. Moreover, I don’t think that they can support the debts that remain, even after having written off half their private debts under the EU rescue program, because they don’t have the will or the administrative capacity to enforce their tax laws. Also, they are part of a common market where other countries’ labor and business licensing markets are much less rigid and so they have significant structural impediments to becoming “competitive” in the common market they have joined.

Governments that can’t deliver on their promises don’t last long. Greece is on its third government in three years. They have over-promised and are continuously failing to deliver. My fear is that there is going to be a revolution in Greece. And while that might scare the rest of Europe into getting its act together, my sense is that Greece is going to go through a very difficult period and that everyone would be better off (the Greeks and the Europeans) if Greece left the Eurozone.

Q. What was it like being in the thick of the action during the global financial crisis?

A. From a professional and personal point of view, it was amazing. I worked for 27 years as a restructuring professional, as a lawyer and banker, and then the Secretary of the Treasury asked me to come and apply my trade during the greatest economic crisis of my lifetime.

I had to learn a lot of things that I did not know a lot about. That included bank and insurance company regulation, the structure of the money system and how it works and the structure of the emergency powers of the Federal Government. Banking and insurance is very much a joint venture with the State, so it was very different to what I was used to in the corporate sector.

It was also the most stressful job I have ever had, and the most interesting. There was a lot on the line. And I think we got a couple of things right so that is professionally satisfying.

Q. Have the financial problems in the US been solved? What impact will there be at the end of this year when the Bush tax cuts expire?

A. Back in 2009, we looked a lot like Spain does today in terms of government debt to GDP and the leverage in our banking sector. But the US economy is larger and more diversified and less regulated. We have more capital and a greater tradition of entrepreneurship. Despite the excesses of the banking system, the impact of its failure on the real economy, the lack of fiscal leadership in Washington and the growing burden of the resulting deficits the US economy remains very dynamic -  ideas, capital and technology flow in and out. People want to be here. There is lots of capital and liquidity and people want to invest here. Moreover, we are very well endowed from a natural resources perspective.

A lot of people talk the US down, and that’s largely as a result of the dysfunctionality of our politics. But the truth is that, even in the worst economic crisis in the past 80 years, the economy remains relatively strong. We have fiscal challenges ahead for sure. The Democrats and Republicans are currently locked into opposing positions. The Republicans want more tax cuts and to unwind the so called Great Society programs of the past 50 years. The Democrats view those Great Society programs as inviolate. This political impasse cannot go on forever because the resulting deficits will kill us. It has to end, and the end is nigh.

The Bush tax cuts all expire in December. The reduction in defence and discretionary spending agreed to last fall go into effect in January. If Congress does nothing to extend the tax cuts and allows the spending cuts to go into effect, we will reduce our current budget deficit next year by 40 per cent and put the budget on a better trajectory. If I were a betting man, I would say that this is the most likely scenario: that is, that Congress does nothing. And then, depending on who wins the election, the winner will probably give some of those tax increases and spending cuts back, but the die will have been cast and the present imbalance between revenues and spending will have been reversed, at least in part.

Q. How will events in the US and Europe impact on Asia, in particular China and Japan?

A. China is probably the most remarkable economic and political development in my lifetime. In the 1970s, I was one of five students in a college of 4000 undergraduates to study Chinese. At that time, Nixon had yet to re-open diplomatic relations with the Communist mainland and the Cultural Revolution had not yet occurred. There was very little interest in studying Chinese in America. Now, it’s full on. Thirty of my kids’ friends are now studying Chinese language in high school. China has become our largest trading partner and is deeply integrated into our businesses’ strategies. Apple would not be able to sell so many iPads in the US without the ability to deliver them at $600 a shot by manufacturing them in China.

Our economic fates are now inter-linked. The industrial and communications revolution is happening in China in just one generation, whereas it took 200 years in the West. Whether they can keep up with the changes those revolutions produce in community and family structure, in mores and social and political attitudes is the big question of this century. Whether they can have a smooth transition from an agricultural society to a literate, market-based commercial society in such a short period of time is the big question. There are a lot of economic problems based around the fact that they have an investment-led growth model rather than a domestic spending growth model. That has challenges, because the rest of the world cannot afford to keep consuming more of their production. So, one way or the other, there will be a massive transition, from investment-led to consumer-led growth in China. But still, we have to marvel at all they have achieved as a nation in such a short period of time.

Q. What problems remain in the US for consumer banking, particularly in the housing sector?

A. The US Government has largely failed to adjust its policies to the globalisation of its leading businesses. Globalisation is real and its impact on lowering manufacturing and service job wage rates is real and inevitable. While the Apples of this world may design products in California, they produce them in Guangzhou. The policy response to declining real incomes in the West was to make credit more available, allowing people to substitute with credit what they have lost in income. As a result, we have given far too much credit to people who cannot afford it. There has to be a day of reckoning and I think this is the real take-away from the recent financial crisis – we need a set of new job policies rather than merely a set of new banking regulations to deal with globalisation. We cannot all be investment managers.

All that said, because of our accumulated capital, and our abundant natural resources, and our generally stable political culture, the US will remain an attractive place to do business, and an attractive place to live. The economy will still be vibrant and there will be jobs.

Q. How well has the Chapter 11 bankruptcy regime worked and should such a model be used in other parts of the world?

A. The insolvency market has been slow here but that is because most US corporations have built up large cash balances in reaction to the financial crisis. When the economy slowed, corporations looked at the banking sector and realised that they had to look after themselves because they could not rely on the banks. American corporations have done a very good job of that. The weakest corporations are those that underwent LBOs in 2005, 2006 and 2007 when financing was cheap. But the economy has been weak ever since and those LBOs are going to have trouble re-financing when the LBO debt matures between 2013 and 2016.

Generally, the Fortune 500 companies are doing well because they have access to the bond markets to raise debt. But, dependent on banking sector, there is a lack of credit for mid-cap and small-cap companies because they generally do not have access to the bond markets to raise debt. There continues to be a parade of chapter 11s in this space and it will likely accelerate if the economy takes a double dip.

Chapter 11 is a place to implement a deal, not to design a deal because chapter 11 is an expensive place to operate a business. American Airlines entered chapter 11 without an agreed exit strategy. They had to beat their employees up, their creditors up. It will be profitable for their lawyers and bankers, but for their creditors and unions, it will prove very costly. Financial institutions remain unsuited for chapter 11 reorganisation because of their overwhelming need for current funding. Lehman was a liquidation.

Q. What are you doing now?

A. I have spent the last six months building a business called Millstein & Co. I have hired 25 people in DC and New York to do corporate restructuring and M&A, and to advise sovereigns, investors and financial institutions in “special situations.” I have built a top team and am excited to be able to get back in the game as a private adviser and investor.

Jim Millstein


Jim Millstein is one of the foremost corporate restructuring experts in the US, and is best known for his work at the Federal Department of the Treasury from May 2009 to March 2011 where he was embroiled in rescue operations for financial institutions that were on the brink of collapse in the immediate aftermath of the Global Financial Crisis.

He was the architect of American International Group’s (AIG) successful restructuring, described by The Wall Street Journal as the “Super Bowl of Corporate Turnarounds”. During his tenure as Chief Restructuring Officer at the Treasury, Mr Millstein was also responsible for oversight and management of the Department’s largest investments in the financial sector. These included US Government investments and loans made to AIG and Ally Financial.

During that period, Mr Millstein participated in the policy-making process which became the Dodd-Frank Wall St Reform and Consumer Protection Act, introducing major regulation of banks, insurance companies and investment funds.

Since then, he has formed a self-named advisory firm – Millstein & Co – to offer advice to large financial institutions that need to restructure in the wake of the European debt crisis, troubled companies, investors and governments involved in “special situations”.

Even before he made his name in the pressure cooker atmosphere of the Federal Treasury, Mr Millstein had a reputation for his insolvency expertise in the private sector where The New York Times said that he “worked on some of the biggest bankruptcies in history”.

From July 2000 to April 2009, Mr Millstein served as Managing Director and Global Co-Head of Corporate Restructuring at the investment bank, Lazard, managing a leading restructuring practice in Europe, the US and Asia.

Selected engagements during this period included representation of the United Auto Workers in connection with the restructuring of their contractual relationships with GM, Ford and Chrysler; cable TV operator Charter Communications in connection with its pre-packaged plan of reorganisation under Chapter 11; the Republic of Argentina in connection with the exchange offer for its international bond indebtedness; telecommunications major WorldCom in connection with its Chapter 11 reorganisation; TV and telephony group United Pan-European Communications in connection with its pre-arranged plan of arrangement in the Netherlands and Delaware; and Marconi in connection with its scheme of arrangement in the United Kingdom.

Before joining Lazard, from September 1982 to June 2000, Mr Millstein was Partner and Head of the Corporate Restructuring practice at the international law firm, Cleary Gottlieb Steen & Hamilton. Significant engagements included representation of Daewoo Corporation in connection with its financial restructuring in Korea; Disney Corporation in connection with the financial restructuring of EuroDisney in France; Pan-American Airlines in connection with its Chapter 11 reorganisation; and, the private Zell-Chilmark Fund in its acquisition of various troubled companies in and out of Chapter 11.

Mr Millstein has a JD from New York’s Columbia Law School, and holds an MA in Political Science from the University of California, Berkeley. He previously graduated with a BA in Politics from Princeton University.