The Detour Around Banking Disaster: How We Lost the Roadmap

by: Mark Sunshine

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 (NYSE: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