The Detour Around Banking Disaster: How We Lost the Roadmap

In 1998 the current banking crisis was both predictable and predicted by Congressional leaders and a future Comptroller of the Currency.

In April 1998, the House Committee on Banking & Financial Services held hearings where “lessons” from the 1980s bank and thrift crisis were discussed, and fears of industry consolidation were expressed. Hearings transcripts clearly demonstrate that the United States learned important lessons in the 1980s and 1990s… and then promptly forgot them.

The chilling 1998 transcript provides a roadmap for how to avoid blowing up banks and taking down the economy. But, instead of learning from the past, banking regulators and other politicians from both parties veered off course and drove the economy into the ditch.

The backdrop for the 1998 hearings was a wave of massive consolidation of the banking industry and concern that systemic risk was being created by institutions that were "too big to fail”.

During the 1998 hearing, John Hawke, then Under Secretary of the Treasury and soon to be Comptroller of the Currency until 2004, stated:

… I would say that we have a lot to learn from the experience of the 1980’s, but I think principal among the things we have to learn is that you can’t deal effectively with an industry like the savings and loan industry when it is already insolvent.

That was the problem that Congress faced. The industry was insolvent by 1980, and we were all pretending that it wasn’t. We tried to deal with remedies that were intended to gamble on an insolvent industry pulling itself out of insolvency.

I think the congressional response in later years, putting emphasis on the maintenance of high levels of capital, putting emphasis on prompt corrective action and on better disclosure, is a marked change from what happened during the experience of the 1980s.

When an industry or institution is insolvent, it is too late to try to bring remedies to bear, and regulation and supervision should be aimed at preventing insolvency and bringing market forces to bear, so that we are not dealing with institutions that have no net worth left. That was the problem of the 1980s.”

Congresswoman Carolyn Maloney knew what to do with insolvent banks, i.e., shift losses to:

…the person who is initiating the risk and make them realize they will have to pay for it…if you make a mistake, if you squander money, take all these outrageous risks, they…are going to have to pay for it, not the American taxpayer…

Representative Joseph Kennedy understood systemic risks of putting together larger and larger institutions. Of course, the banking establishment considered Kennedy a lightweight intellectual populist who opposed financial innovation (like sub-prime mortgages and predatory lending). But, as it turns out Kennedy may have been the smartest guy in the room. In 1998 he said

…Sometimes when I look at what has happened in the banking world in the last couple of months, I think that maybe the chairmen of these banks have just gotten a prescription for the Viagra pill. I think every time I turn around they are growing and growing, but I don’t know what is going to come of it.

Mega-merger mania is the new Beanie Baby of the American financial scene; everybody has got to have one, but at the end of the day they are not worth very much…

Kennedy understood that bigger isn’t better and size isn’t the same thing as value.

The Late Congressman Bruce Vento agreed with Kennedy when he said:

…I am concerned about mega-anything, especially mega-entities with deposit insurance backed by the taxpayer and an implicit moral hazard phenomenon that is assumed.

But Congressman Maurice Hinchey voiced the most unsettling and predictive words of the 1998 hearings. He worried about Citigroup (C) and its relative power and sheer size (at the time Citigroup had acquired Travelers Insurance and was trying to get Glass Steagall legislation revoked) when he stated:

…the Citigroup companies are essentially playing a very expensive game of chicken with Congress…

History repeats itself, and Citigroup and other mega-institutions are again playing chicken with Congress. Destruction of the U.S. economy is threatened if they are not bailed out.

Next week the United States will debate how to fix the banks. The nation will be given the false choice of either:

• economic ruin; or
• saving shareholders of failing banks through the formation of a “bad bank”.

The debate will employ politically charged words like “nationalize” and “socialize” to describe what happens to banks that are actually “insolvent” and “failing”.

Institutions resisting seizure will imply that their companies have value which the Government wants to unfairly expropriate. Communist regimes and tin pan dictators “nationalize” profitable companies. But the banks that are in trouble aren’t profitable and aren’t able to survive without government assistance. The companies at risk of seizure don’t have enough net worth to survive as going concerns.

Professor Nouriel Roubini and other non-establishment economists have been pushed aside as they plead with leaders to stop playing along with failing bank managements and face reality. But, as in 1980, regulators and political leaders don’t want to admit the obvious about insolvent institutions. Instead, just like in the 1980s they seem willing to bet that insolvent banks will somehow pull themselves out of trouble without going through the pain of resolution. It isn’t a bet that has worked in the past.

The “bad bank” that the Obama Administration is considering is a bad idea that perpetuates the fiction of solvency.

A good idea (and one that worked in the past) would be to form a “bad bank” that acquires bad assets from insolvent institutions following their seizure by the FDIC.

What is at stake is who benefits from the cleaning up of the banking sector, current shareholders or taxpayers?

It’s pretty clear that the members of the 1998 House Financial Services Committee would have voted that taxpayers should get the benefit from the bad bank clean-up, since the taxpayers accepted the risk and paid the cost.

It is a shame that each generation of banking regulators and political leadership gets the opportunity to relearn the lessons of the past at the expense of the citizens of the United States. It would be better, and cheaper, if each generation simply studied the past and stopped rediscovering the obvious truth “that you can’t deal with an industry when it is already insolvent”.

- By Mark Sunshine and Ira Artman

Comments

[Big Al45:]

And that is precisely the problem. What would make anyone think that TARP II (or III or IV) can be correctly implemented "to allow bank investments to play out over their natural timeframes."

Particularly, since some of those so called "investments", like CDOs squared, are probably already worthless


On Feb 02 05:30 PM mathgeek wrote:

>>
> The objective of government invention should be neither to protect
> nor to punish bank shareholders and executives... rather, the role
> should be to allow bank investments to play out over their natural
> time frames and prevent panic liquidations. The TARP program, implemented
> correctly, could acheive these objectives.

Feb 02 05:42 PM

[nova:]

Do not expect much from Obama and his people
- Look at his people. They are the same people who are responsible for the present financial & economic catastrophe in a first place. People who even refused to pay their taxes. Yes, they have made mistakes, i.e., were caught.
- As for Obama himself, he came from one of the most corrupt places in the nation. He is very long on demagoguery and very short on integrity and constructive experience.

Feb 02 06:20 PM

[nova:]

I like to thank Mark Sunshine for a very good review.

Feb 02 06:22 PM

[and:]

afj

Feb 02 06:29 PM

[klarsolo:]

I know that people love thinking that huge disasters could have easily been preventable, if only certain factors would have been taken into account or certain people would have been listened to, etc. Especially after the horse left the barn it is often easy to identify what went wrong.

Tons of people said three years ago that the housing bubble was to end badly, just like the stock bubble. But who of them would have in their wildest dreams forecast that the housing problems in four US states would drag the entire global economy down? Not even Shiller.

Feb 02 06:37 PM

[klarsolo:]

But even if you do get the extent of the crisis right, how do you convince others to change things long before the music stops? It is virtually impossible to stop the party while it's still going. No matter what the lessons are this time, we'll do very similar mistakes again in the future.

Feb 02 06:41 PM

[James H. Wang:]

Great points all, I think. We're playing around too much with zombie banks when we should simply have a "bank holiday" close them all down, clean up their books, and figure out what we have left.

Putting off the pain for a long time will not actually cause it to just go away. Especially not when a lot of these institutions are this deep in the hole.

It'll hurt, but we do have to come with grips with what we've got at some point or another.

Feb 02 07:04 PM

[Chuch:]

There is a still a lot to happen before banks get back on track, see here crashmarketstocks.com

Feb 02 08:34 PM

[EEB:]

Thanks to Mr. Sunshine and Mr. Artman for an insighful article. I liked the part about how "nationalize" is a politically charged word. The sophists and con-artists who ran the nation into the ditch are still trying to suck as much money out of the economy as they can before it totally collapses. They are using rhetorical devices to distract us for just at bit longer. At least if we take over some of the insolvent financial institutions we can prevent further looting by the financiers. As for the economy, I think that it might be too late. This recession is going to be long, deep, and nasty.

Feb 02 08:40 PM

[Dirk McCoy:]

What's fair for the goose is good for the gander- as long as banks are able to cover their depositor's withdrawals while they rebuild their capital, they should be left to their own devices.

If they can't cover withdrawals, are found fraudulent, or are destroying capital, then put them in workout.

Feb 02 10:02 PM

[hoover:]

The lobbying system has ruined the country in my opinion. Just think of the clear decision making based on logic, knowledge, and common sense that COULD occur in Congress if they were free from lobbyist influence, corruption, and control. The lobbying has become so ingrained in the system that it has turned a democracy (or republic if you prefer) into a monarchy. There were 120 million or so voters in the last election. If the swarm of lobbyists (locusts) in Washington influence, say 50% of the decision making, they are in effect being given special voting power. If the lobbyist swarm is say 12,000 with 50% influence over congressional decisions, and there are 120 million voters with other 50% of influence, it means that each lobbyist has the equivalent power of 10,000 votes. So, each normal citizen then has one vote and the average lobbyist has 10,000 equivalent votes. Not exactly a democracy, but a sort of a monarchy or generally bastardized system. My point is not the accuracy of my 50% influence value (just a guess) or the size of the swarm of locusts (12,000 just a guess), but rather that influence peddling can be converted directly to voter equivalency. And the Constitution allows only one vote person -- no special 10,000 or so votes for bankers and other special cheaters.

Feb 02 10:07 PM

[klarsolo:]

McCoy, I agree. I have no idea on what grounds people think Bank of America should be nationalized. It is currently not insolvent and won't be for the foreseeable future. You can't just take the current firesale value of assets they don't intend to sell, subtract the original face value of liabilities (btw, shouldn't the liabilities be marked to market as well? If not, why not?) and say "Aha, negative net worth. Let's nationalize."

If you really think the above equation is enough to justify nationalization, why don't we force everybody with a currently negative net worth into bankruptcy as well? If not, how exactly is Bank of America's situation drastically different from any one person that has more debt than assets? Why don't we force young doctors with huge medical student loans into bankruptcy simply because their net worth is negative, completely disregarding their huge positive monthly cash flow?

Feb 02 10:14 PM

[jrs87sch:]

I agree with the others; please email this article to your Congressmen. Yes, you can email some of them now.

If we take away the toxic assets from the banks, what would we have to fear anymore. Maybe slow growth in the economy for a little while, but we are letting these assets rot inside the banks and it is tearing at our country.

I'd much rather be able to have a job than get $800 bucks in the mail one time this year. A stimulus will do absolutely nothing for us.

Feb 02 10:33 PM

[John Lounsbury:]

Mark and Ira - - -

Said simply and understated - Thank you.

Klarso - - -

You made a great point: "You can't just take the current firesale value of assets they don't intend to sell, subtract the original face value of liabilities (btw, shouldn't the liabilities be marked to market as well? If not, why not?)"

I have yet to see anyone explain how mark to market for assets and mark to market for liabilities doesn't yield a zero sum game. Is the difference all the fees taken out by the investment bankers? Is the difference a humungous bid/ask spread? Has someone else run off with the money?

Can some one give some clarification on this?

Feb 02 11:53 PM

[Lin:]

Re

Great article . NOTE The current global real estate crisis is directly a result of the US breaking the dollar link to gold in 1971 . NOVA + EEB , you are spot on !

Feb 03 12:44 AM

[Moon Kil Woong:]

It is so easy for politicians to talk about what we should do but so impossible for them to do it. When they get lobbyist $ from banks like Citibank to revoke Glass Stegal against our better interest, they do it. When they get pressure to let Fannie Mae and Freddie Mac eat the whole housing mortgage market with little to no assets besides a government guarantee they wont go under they do. When they found out derivatives and weird market contracts were being written in the late 90's they decided to not regulate them at all because the banks didn't want them to. When the Internet bubble popped and they realized Citibank and others were getting too big and had no capital they let them hide their losses off balance sheet with Base I accounting rather than break them up, raise capital, or stop growing. At every turn they do the absolutely wrong thing. And at every turn the bankers want to gamble with money that isn't theirs and use their can't fail credit to stick the taxpayer with the losses.

Thanks for the article. When people say they didn't see yet another banking crisis coming I find that hard to believe. After all it happens more regularly than about any other financial event. 1987, 1991, 2001, and now 2008. The odds of another one in the 2010-2019 period is pretty good going by past history. Of course, at this rate the 2008 crisis may be just a long 10+ year one like Japan had instead. That would be a not so nice break from the decade after decade string of financial calamities.

Feb 03 01:07 AM

[Jason Rines...:]

How insightful you are to get at the root cause. This Congress will have it's way for another four years. Let's pray they don't destroy things further but in four years the investment community can help create our own lobbyist of Patriots in the other direction. There is a whole nation full of honest people willing to serve that feel $150k a year plus perks is a great job. We fund them.


On Feb 02 10:07 PM hoover wrote:

> The lobbying system has ruined the country in my opinion. Just think
> of the clear decision making based on logic, knowledge, and common
> sense that COULD occur in Congress if they were free from lobbyist
> influence, corruption, and control. The lobbying has become so ingrained
> in the system that it has turned a democracy (or republic if you
> prefer) into a monarchy. There were 120 million or so voters in the
> last election. If the swarm of lobbyists (locusts) in Washington
> influence, say 50% of the decision making, they are in effect being
> given special voting power. If the lobbyist swarm is say 12,000 with
> 50% influence over congressional decisions, and there are 120 million
> voters with other 50% of influence, it means that each lobbyist has
> the equivalent power of 10,000 votes. So, each normal citizen then
> has one vote and the average lobbyist has 10,000 equivalent votes.
> Not exactly a democracy, but a sort of a monarchy or generally bastardized
> system. My point is not the accuracy of my 50% influence value (just
> a guess) or the size of the swarm of locusts (12,000 just a guess),
> but rather that influence peddling can be converted directly to voter
> equivalency. And the Constitution allows only one vote person --
> no special 10,000 or so votes for bankers and other special cheaters.

Feb 03 01:12 AM

[Jason Rines...:]

That is a good argument against nationalization and suggest you check out Mr. Lounsbury's debate here at SA. I'll also be hosting a debate at my site in a couple of weeks.


On Feb 02 10:14 PM klarsolo wrote:

> McCoy, I agree. I have no idea on what grounds people think Bank
> of America should be nationalized. It is currently not insolvent
> and won't be for the foreseeable future. You can't just take the
> current firesale value of assets they don't intend to sell, subtract
> the original face value of liabilities (btw, shouldn't the liabilities
> be marked to market as well? If not, why not?) and say "Aha, negative
> net worth. Let's nationalize."
>
> If you really think the above equation is enough to justify nationalization,
> why don't we force everybody with a currently negative net worth
> into bankruptcy as well? If not, how exactly is Bank of America's
> situation drastically different from any one person that has more
> debt than assets? Why don't we force young doctors with huge medical
> student loans into bankruptcy simply because their net worth is negative,
> completely disregarding their huge positive monthly cash flow?

Feb 03 01:15 AM

[sleepless_o...:]

John Lounsbury,

I assume that your question is partly rhetorical? The reason that liabilities exceed assets is the default rate. When a loan is made, the lender has an asset, the promise to repay. He incurs a liability, the amount of money lent. The lender is on the hook for the liability whether the borrower repays or not. In writing the loan, the lender assumes some default rate is possible and that is included in the cost of all loans. When that default rate is larger, the net worth goes negative on the balance sheet for that loan. The bank is forced by accounting rules to keep the balance sheet positive or go into receivership.

Now we bring in mark to market. The market price of a loan asset is affected by the buyer's expectation of possible future default. If the expectation is high, the bid for an asset may be very low. This can be much less than the value of the current repayment discounted cash flows. The holder of the mortgage would like to value the debt as an asset to be the present value of the scheduled repayments. This could be considered the ask. Mark to market accounting rules dictate that as soon as a debt obligation (asset) trade occurs (assumably somewhere between the bid and the ask, similar obligations must be priced at the transaction price. Transaction prices have been very low (close to the bid, far below the ask) so asset values have tumbled. As a liability, the lender still has the same obligation to repay.

The present problem is avoided if mark to market rules for assets are suspended. Then assets are valued assuming the current repayment schedule is continued to maturity. If there are, in fact, future defaults, then the insolvency problem has merely been postponed.

Although a lot of feeder fish (suckers, leeches?) have taken fees and commissions along the way, they have presumably been factored into the performance over the life of the debt security. The real problem for the debt issuer/holder is that it has been beset by a humungous bid/ask spread and the transactions taking place have been too close to the very low bid, resetting the value of all similar assets while leaving the much larger liability intact.

Feb 03 09:42 AM

[klarsolo:]

sleepless_on_wall_stre...

but then why are the banks liabilities set in stone (even though they could buy back some of their debt at currently marked down prices), but their assets are greatly discounted, even though these assets are somebody else's liabilities and should be set in stone as well? I know what you're saying, and maybe banks with negative net worth should go into receivership. However, there is a big difference between receivership and nationalization. In the former current owners can realize sizable value if current marks turn out to be overly depressed. In the latter they will lose it all, even if all these securities currently trading at 60 cent on the dollar will ultimately mature close to par.

The problem is that people want to nationalize the banks to get lending going again. That is not necessary. The government can set up their own lending programs and offer them through other banks, if they are really concerned about that.

Feb 03 10:14 AM