Why Did We Bail Out the Banks?

Includes: C, GS
by: Harry Tuttle

Almost a year ago, in the aftermath of the Lehman debacle, Secretary Paulson asked the American Congress for $700 million to relieve "our banks" (the meaning of the term was and is highly dependent on the user) of their "toxic assets" (his words). As Congress first said no, Paulson (aided by Bernanke) pretty much told us that failure to give him the money would mean the end of life as we knew it (another highly context dependent definition).

The American Congress, after consulting their oracle (aka "The Dow Jones Industrial Average") acquiesced under proclamations of better regulations that would ensure that "this will never happen again." Even those who knew that the mess had been bipartisan (the Glass-Steagall Act was repealed during the Clinton administration) believed that some regulation would be coming. After all, that is what normally happens in politics after the horses have left the barn.

I retrospect the appointments of Tim Geithner, who was involved in all the bailouts and other interventions at the NY Fed, and Larry Summers who was the main architect of the "self-regulatory" environment that created the $60 trillion CDS market, should have been enough warning that something wasn't quite the way we had expected.

Last week, Elizabeth Warren, who was appointed by Congress to oversee the banking bailout, said on a TV program that the banks still hold most of their toxic assets. At the same time, we learned that the large banks are not lending much and that Goldman (NYSE:GS) has not reduced its leverage and is trading as aggressively as ever. In addition, the same compensation schemes that had encouraged the excessive risk taking by these "regulated" institutions are back in vogue and close to their highest levels. If anything, we hear complaints from banks who cannot keep up with the competition. Furthermore, as far as I know, banks are not only still allowed to hold large off-balance sheet items but they continue to be allowed to trade CDS' and other leveraged products. Their own risk profiles are down, however, since we now KNOW that they won't be allowed to fail.

The question I would pose is why did we save these banks? It is clear that they are NOT indispensable as we were told since companies who can get credit seem to find willing substitutes either directly in the market or through smaller and healthier banks. Why should I, as an American taxpayer, have any interest in the existence of a large multinational bank prone to large risky bets that from time to time risk bringing down the whole financial system? Why does our society need to support these large institutions with their internal hedge funds and other operations that seem setup for the sole benefit of their executives?

Banks, which are regulated entities, allegedly exist to facilitate commerce by bringing together savers and borrowers for profit. Why do they need to be regulated? Because our society decided, in the 1930s that it was better to minimize systemic risk. In other words, we allow banks to exist under certain conditions because we think efficient intermediation is essential to our economy. In this model, our society as a whole benefits from having efficient banks as the cost of bringing our aggregate savings to deserving entrepreneurs is minimized. This was the argument used beginning in the Reagan administration to deregulate the banks and thrifts, "let us do business and we will bring borrowing costs down." Nothing wrong in principle as too much regulation can often get in the way of efficiency.

Unfortunately the original idea of freeing up the banks to allow them to compete at the national and global scale was stretched beyond recognition during the Clinton-Bush years. The repeal of the Glass-Steagall Act that separated investment from commercial banking, the conversion of Fannie and Freddie into aggressive for-profit institutions, and the extreme friendliness of government officials who were often regulating their future employers were all celebrated by republican and democrats alike as triumphs of deregulation. As if to add insult to injury, our system was imitated by many around the world.

This is how we ended up with our largest banks filled with toxic assets, off-balance sheet commitments, and in-house hedge funds among other "investments." I mean, who wanted to make money by intermediating savers and borrowers when you could ride the bull market with the bank's money and get paid in stock options? Unfortunately for us, they had it right because we were underwriting the risk. It wasn't the Greenspan or the Bernanke put but the USA put.

The reason this sad story is relevant today, is that this is STILL the model under which Geithner and Summers want to revive the banks. Forget about whether you believe it is possible for the banks to earn their way out of trouble "Japanese style." This is the model for when they become healthy. Lots of complex risk for large personal payout under the friendly eye of someone who will join their club in the not to distant future. If you think I exaggerate, ask yourself what has changed since the pre-Lehman days for those still employed in Wall Street? Not to mention that interest rates are zero again and the stock market is rallying (again) and they are making boat loads of money, again. How long until they decide to take another shot at sub-prime? (this time they will promise to get it right).

I personally have no problem with hedge funds and other speculative clubs, so long as they are not risking taxpayer money, whether directly (like Fannie and Freddie) or indirectly by threatening to bring down the system. On the other hand, since banks are supported by taxpayer money, I think it is fair to have their risk tightly controlled by an external regulator who should never allow them stray into areas unrelated to their core business of intermediating financial products. It is as simple as that. If they want to make money by guessing which way the December oil contract is going they can set up a hedge fund outside the bank and without implicit or explicit government guarantees.

Financial markets are perversely didactical, they will set us up to revise the lesson as often as needed, but learn it we will.

Disclosure: No positions.