Taking Stock / What We Need to Learn From the Wall Street Mess

Israel's financial market crisis of 2008 isn't like any other in its history. For the first time, it originates entirely from abroad.

Here they come. They've bided their time. They've prepared their texts in advance and waited. And last week, how predictable - they came bursting out, roaring their umbrage: Look at the global financial crisis, it proves that the reform of Israel's capital market three years ago was a hideous mistake.

Well, one can understand them. The so-called Bachar reforms deprived Israel's bankers of much of their clout. It created new, powerful financial bodies, decentralized decision making and weakened "Poaleumi" - that dynamic duopoly of Hapoalim and Leumi.

And what are the bankers saying? Look, they say, stocks are tanking, Wall Street is collapsing, Washington has to inject a trillion dollars into America's financial institutions. It proves once and for all that the Bachar reforms are a disaster.

What are Israeli investors to understand? Should they conclude that if Israel's provident and mutual funds were to have remained in the banks' hands, Wall Street would be fine? That Americans wouldn't have become addicted to that heady cocktail of cheap credit, buying property they couldn't afford, complex financial instruments and inflated leverage?

Goodness. Has anybody told Hank Paulson, secretary of the U.S. Treasury, that the root of the American disease lies on Rothschild Boulevard in Tel Aviv? That the original sin behind the financial tsunami washing over world markets is that meanies took control and ownership over provident funds from Eitan, Danny and Galia?

Or are our bankers telling us that if they had kept ahold of the provident and mutual funds, Israel's savers wouldn't feel so much as a pinprick of the worldwide pain? Because, presumably, the Poaleumi brains - unlike the rest of the investment managers from Jakarta to London to New York - know how to profit, be the market in bull or bear mode?

Well, we could go on asking stupid questions for a while yet, but you get the idea. Let's recap the facts.

Not local at all

First of all, Israel's financial market crisis of 2008 isn't like any other in its history. For the first time, it originates entirely from abroad. Local factors play no part.

In the early 1980s, Poaleumi and Discount Bank crushed the capital market and shattered the faith of the Israeli people for 20 years or so, by manipulating their share prices in ways even more aggressive than the ones Wall Street's bankers came up with.

In 1993, the bankers inflated share prices again - they pushed loans onto people to invest in the mutual funds the bankers ran. The mutual funds used the money to buy stocks and junk bonds that the banks and their creditors were issuing. In 1994 the mutual funds lost up to 50% or even more. People lost their savings, their apartments and their faith, thanks to Poaleumi's policies.

And don't forget the Cosa Nostra of the 1990s, when half the managers of the banks' provident and mutual funds were stealing client money by personally buying securities, manipulating their value to the skies and then selling their personal holdings at sky-high prices to client portfolios.

The combination of the banks pushing loans with the corruption discovered among bank employees, and the extraordinary dominance of Poaleumi led to an unprecedented crisis in 1995. No buyers could be found for the bonds when the redemptions from provident funds began. The banks were forced to beg the Finance Ministry and Bank of Israel to rescue them - to buy the bonds on the market to spread a safety net. Sound familiar? Is it something like the safety net that Paulson is spreading below the American banks?

And let's not forget the crisis of 2002, when the Bank of Israel warned that a major Israeli bank could fail because of the billions upon billions that the banks had lent to major borrowers and cronies of the banks' leaders.

Our bankers know perfectly well that most of the Israeli public still remembers their shenanigans. So they're trying another gambit: to claim that the American model that the Bachar reforms adopted has collapsed.

Sounds great. It's just completely inaccurate. The Bachar reforms didn't adopt an American model.

We have to explain, again, that the American investment banks collapsed precisely because this time they hadn't bet money belonging to their investors. They invested their own money.

In recent years America's investment banks grew greedy. They were tired of low profits on managing investment portfolios, and started to invest on their own behalf. Some of them basically turned into hedge funds, investing their own money.

Israel's investment banks do invest on their own behalf, in "nostro", or proprietary, portfolios, but the amounts are small. Most of them aren't leveraged, but in America the investment banks leveraged their own portfolios times 20 or even 30.

And which is the only body in Israel that grew all excited about the U.S. subprime market and wiped out 20% of its own equity? Was it Psagot or Migdal? Menorah or Prisma, perhaps? Or was it Bank Hapoalim?

Lower fees?

Now that the myth of similarity between the crisis in America and the Bachar reforms has been debunked, our bankers are trying another argument - that the private brokerages charge higher service fees.

Interesting, but dubious. If competition in the market has increased and there are more players, can the managers charge higher management fees over time? We think the answer to that is clear.

Or let's put it otherwise. Did the banks charge lower management fees because unlike the brokers, they weren't thinking about their bonuses, but of the customer's greater good? (Who do you think was financing salaries of NIS 10 million to NIS 30 million a year for the banks' CEOs?)

Or, let's ask, can the banks with their tens of thousands of employees and powerful unions, and thousands of freeloading employees, charge lower fees than lean young companies?

You know the answer. There's no free lunch, at least not over time. It paid for the banks to charge relatively low management fees because they had many more ways of sucking money from their customers, such as shifting clients' money from one investment avenue to another.

Dollar's red-hot? Let's push dollar funds onto the customers and collect transaction fees. Dollar's cooling? Let's put the client into stocks. Stocks are dropping? Let's put the client's money into short-term deposits making 3% interest while we lend to other clients at 13%.

Today Israel's investment banks do collect bloated management fees. Their management skills aren't worth the money. But the public will learn this when they study their returns and realize that companies collecting fewer management fees will bring them higher returns.

However, the capital markets supervisor should do the work, not wait for the market to lower fees. He should:

  • Investigate the relations between insurance companies, provident and mutual funds with underwriters and brokers.

  • Demand that the insurance companies as well as provident and mutual funds disclose all their management fees (including on transactions) and how the fees are shared with marketers pushing shoddy stuff onto clients.

  • Aggressively investigate the conduct of institutional investors' managers. It has been 15 years since the latest round of arrests and the Israeli market is rife with corruption.

    These are supplementary steps to the Bachar reforms. They are overdue, but have nothing to do with the mess on Wall Street.

    If the Wall Street crisis taught us anything, it's that we need aggressive regulation of the financial markets; that capitalism cannot be left in the hands of capitalists because they will abuse it.

    The Bachar reforms began to dismantle Poaleumi and create a more competitive marketplace. The regulators should pursue the reforms more aggressively and use stronger means of enforcement. The most dangerous outcome of the crisis would be for the Finance Ministry and Bank of Israel to freeze in fear and instead of pursuing the reforms, seek easy ways for the big players to increase their profits.

    As for media reports about similarities between the Wall Street mess and us, we don't need the Health Ministry to issue warnings "Reading this is bad for your health." This is one area where market forces can be left to work.