Don't Let Banks Sell Their Loans
© 2012 Elliott R. Morss
Almost all the world's economic ills in the last decade are attributable to unwarranted risks taken by banks. And all the remedies start by bailing out the banks, leaving the millions who lost their jobs resulting from the banks' reckless acts to fend on for themselves. In what follows, I document these assertions. I also argue that tighter banks regulations will not work and why the only solution is to require banks to hold the loans they make until they mature.
Banks Caused the Global Recession and the European Crises
- The Global Recession
By late 2007, there was a speculative US real estate bubble. What caused it? US banks and Federal agencies buying up mortgages, creating new derivative instruments, and selling them off. That worked for them until the real estate bubble burst. Suddenly, there was no market for the various forms of real estate "paper", causing the near complete collapse of US banks. As I have documented, the panic resulting from the perception that the US banking system was about to collapse - led to global stock market losses of $36 trillion and real estate losses of another $14 trillion. People suddenly felt poorer, much poorer. And the "wealth effects" of those losses caused a sharp cutback in consumer and business expenditures worldwide and the resulting global recession.
- The European Crises
Like the US, some European nations (the UK, Ireland, and Spain) had real estate bubbles. The Irish government is in the trouble it is in today because it bought up bad bank real estate paper. In other countries (including the US), banks foolishly "enabled" the governments of Greece, Ireland, Italy, Portugal, and Spain to continue down unsustainable deficit paths. Consider Greece: in 2007, it was clear that buying Greek government debt made no sense. 2007 was a boom year, but the Greek government was running a deficit of almost 7% of GDP and its debt already exceeded 100% of its GDP. Today, what was quite apparent would happen back then has happened. It is still running a large government deficit; and even after defaulting on 70% of its debt, the remainder has grown to an unsustainable 150%+ of GDP.
The Commonality of Bank Actions
Certainly, there were many contributors to the real estate and sovereign debt bubbles. But there was one common thread - with little or no regard to growing risk, the banks kept buying. All banks have staffers who are well aware that there are real estate cycles. The same is true for sovereign debt: all banks buying European sovereign debt have personnel who understand how to obtain, read, and understand the fiscal accounts of governments. And all banks have "risk management" experts.
So What Happened?
Over the last 30-40 years, the incentive structures driving bank actions have fundamentally changed. 40 years back, banks made loans they held to maturity. Those loans were their primary source of income. If those loans failed, they were in trouble. So they made loans with great care and stayed in close touch with the borrowers. They sometimes helped the borrowers out with problems they encountered. Their primary objective, their very existence, depended on getting the loans paid back with interest.
Today, despite their cadres of risk managers and other knowledgeable professionals, banks have little interest in the riskiness of their loans. Why? Because as soon as they make them, they prepare to sell them off for commissions. They also buy loans and derivative paper from other institutions, package them up in different ways, and again sell them off for commissions.
In short, commissions have replaced the interest generated on their own loans as the incentive driving bank actions. The solution? The Volcker Rule is part of it: banks should not be allowed to trade for themselves. But I add a second critical restriction: banks should not be allowed to sell off any loans they make.
Typically, I hear two objections to my solution: 1. It not needed - we just need better regulations and 2. not allowing banks to sell off their loans will sharply reduce the liquidity of the global financial system.
The claim that more regulations will solve the problem is lunacy. History has proven regulators cannot anticipate and block disastrous bank actions. The Bank for International Settlements was formed in 1930. For more than 82 years, bankers and regulators have been meeting in Basel to come up with better regulations. We have had Basel I, Basel II, and Basel III. What good have they done? Banks continue to take unwarranted risk and cause great hardship worldwide. Two recent examples of what I am saying:
- Sovereign debt: bank regulators allowed European banks to treat sovereign debt as safe as cash in calculating their reserve requirements.
- In the recent JP Morgan (NYSE:JPM) fiasco, regulators did not spot what was happening. The New York Times reported that neither the US nor British regulators were even aware of the JPM unit that made the trades until they were tipped off by the media.
The Liquidity Argument
The knee-jerk action to my proposal is often that it would sharply curtail the liquidity of the global financial system. Let's look carefully at this. For financial product sold, there has to be a buyer. There is no change in liquidity: the buyer loses the same amount of liquidity that the seller gains. And this holds whether it is a mortgage or some crazy derivative product that a bank has created - no change in system liquidity.
The key point here: allowing banks to sell off their debt products for a commission gives them the funding/liquidity and the incentive to create additional debt products. Allowing banks to sell off their loans only gives them the money to make new loans. This is a big mistake. I want banks to be required to hold on to the loans they make. That way, their incentives are what they should be: they work to insure they loans they make are sound. Let the hedge funds, private equity, et al take the risks. Let them go belly up. Banks should be safe institutions devoted to protecting depositors.
Why Banks Are Fighting Against Any Limits on What They Can Do
Senior bank officials want to make a lot of money, and they can't justify their pay-checks if they can't take big risks. Taking risks are a win-win proposition for bank executives. If they guess right, they make a lot of money and justify their salaries. If they guess wrong, governments bail them out. Have any of the big bank presidents lost their jobs as a result of the banking collapse in 2008? No.
Senator Merkley suggested to JP Morgan President Dimon: "If you want to be the head of a hedge fund, be a hedge fund…. Terminate your access to the Fed's discount window, terminate your access to deposits, and then we have no quarrel." Fine with me.
Implementing My Recommendations
Simple: Limit government deposit insurance to banks that do not trade on their own account and hold the loans they make to maturity.
Remember the collapse of the American banks in 2008? Think it is over? Think again. Of the 700+ banks who took out TARP money, there are still 367 who have not paid it back. They are paying 9% for that money. The banks with the largest debts to TARP? Synovus (NYSE:SNV), Popular (NASDAQ:BPOP), and Zions (NASDAQ:ZION).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.