Bad News for Investment Banks; Good News for the Rest of Us

by: Tom Evslin

Matthew Dalton in The Wall Street Journal writes the following:

Support is building among senior European finance officials for a plan to press Greece's private-sector creditors into accepting a debt exchange that would result in delayed repayment to them, people familiar with the matter say.

But that aggressive course of action — which would probably trigger the euro zone's first-ever debt default — faces opposition from the European Central Bank, which would have to be a key player in the plan, and it will face tough battles at a series of meetings of politicians this month.

Just as governments and central banks tried to hold big banks harmless when they aggressively wrote and resold bad mortgages against inadequate collateral, the protectors of investment banks have tried to make sure that their campaign-contributing wards don't have to suffer from the bad loans they made to countries that pursued reckless fiscal policies.

So far, the European bailouts of Greece and Ireland and the proposed aid to Portugal have assured that "private-sector creditors" take no losses. This has been great for the private-sector creditors who charge extremely high interest rates because the loans are "risky" but then are spared from taking any losses on the risky loans by loan guarantees and cash infusions by the International Monetary Fund and the European Central Bank. The reasoning is sadly familiar from TARP: We wouldn't want to have a "banking crisis." Note in the quote above that the European Central Bank is every bit as protective of European banks as the Federal Reserve is of its US clients.

Ireland literally tanked its economy to save its banks. Aided by a roaring real economy, Ireland's government was not in bad fiscal shape. But its banks were over-extended; the government promised that it would use its credit to assure that no banks failed. But the potential liabilities were so great that lenders then doubted whether the government's finances were adequate for these guarantees. Ireland itself "had" to be bailed out; the government responsible lost the next election.

Profligate governments – just like profligate people – are reined in when they can't get credit. But, when the banks are guaranteed repayment, they'll loan to anyone. The profligate borrowers shouldn't be bailed out, but neither should their lenders. Essentially the big banks made sub-prime country loans just like they wrote sub-prime mortgages; they got paid high interest rates but counted on being able to palm the risk of default off on someone else – us.

What is changing is politics in the best sense. We the people, both here in the US and in Europe, don't want to bail out any more banks. We want them to be subject to the same laws of economics as the rest of us; those include the chance of failure. We won't devalue our euros or dollars indefinitely to make sure that bankers' lifestyles don't suffer. We've also observed that bailed-out banks don't an economic recovery make. In other words, no more crying wolf.

Here in the US the tide is also turning. Both The New York Times and WSJ have headline stories today on the low and still-declining stock prices of the big banks. Nelson Schwartz in the Times writes:

Bank stocks took another tumble late last week after Moody's, the credit rating firm, warned it might downgrade the debt of giants like Bank of America (NYSE:BAC), Citigroup (NYSE:C) and Wells Fargo (NYSE:WFC) as the government eases back on support for the sector. Even as the market absorbed that news, reports that Goldman Sachs (NYSE:GS) had been subpoenaed in an investigation by the Manhattan district attorney further unnerved investors, and sent that giant investment's bank's shares sinking.

Two pieces of good news in one. The too-big-to-fail banks had an enormous advantage over their ordinary (and generally more responsible) smaller brethren – Uncle Sam was standing behind them. That support meant they could borrow money more cheaply than their competitors and become ever that much more too big to fail. As the US backs away from those guarantees and looks ready to require these banks to raise more capital, the monster banks have to pay more to borrow; their earning shrink; their competitive advantage disappears. And, as Congress responds to political pressure by investigating the big banks, it looks like prosecutors may finally end their strange reluctance to investigate who did what to whom during the banking crisis.

The biggest threat that capitalism currently faces is the consequences of saving investment banks – and some other companies –from the consequences of their own actions. If governments are going to guarantee banks, then governments have to run the banks. If governments allocate credit, we don't have capitalism or the many benefits it brings. Money will be politically allocated; credit will be used to buy votes; innovation will mean innovation in lobbying and public corruption. Bad news for the investment banks is good news for the rest of us – especially us capitalists.

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