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Size Really Does Matter!

To really understand what is happening in the banking industry nowadays, we must first go back to the Reagan era and the deregulation of the Savings and Loan (S&L) industry.

Back in the 80's, you remember, we had double-digit inflation and double-digit unemployment and double-digit mortgage rates. The housing market was in total disarray. Today's housing market is bad, too, of course, but the cause this time is excessive debt and poor lending practices, whereas back in the 80's, other culprits were responsible.

In those days, we had Savings and Loans institutions making mortgage loans as well as banks. In fact, the S&L's were in direct competition with the banks. The S&L's were designed to bring banking to small communities and to facilitate mortgage lending in rural America. As rural areas became suburbanized the competition between banks and S&L's became even more pronounced.

Banks and S&L's had different charters and a different set of rules to play by. For example, the S&L's were capped as to what they could pay depositors, so banks could offer higher rates on certificates of deposit. This was just one of many differences between the two, but it was a very important one, because deposits were naturally fleeing to the banks and leaving the S&L's. Since the original purpose of the S&L's was to lend in small rural communities, this flight of money away from the S&L's left a void in the housing industry, which was already suffering due to those high mortgage rates and runaway inflation.

Under Ronald Reagan, this seemed like a good opportunity to deregulate the S&L's. It seemed perfectly logical to allow S&L's to compete with banks on a level playing field. But somehow the process of deregulation went far beyond a simple leveling of the field. Congress also changed the ownership requirements for S&L's, a new twist that opened up Pandora's Box --- soon real estate developers could own S&L's, a development that gave birth to a rash of strip malls. Remember those?

Now the fox was guarding the hen house. For all practical purposes, the President of the S&L (with an alias --- many times --- of "Real Estate Developer") had all the financing needed to fund a real estate project. This practically gave unlimited financing for the developers at the expense of the taxpayer, and with deposits guaranteed by good Ole Uncle Sam. Before long, WHOOPS, down came the S&L's. This time they pretty much stayed down.

Yes, I've oversimplified matters in some respects, but stay with me as we continue to follow the principal thread in this story.

About this time, the RESOLUTION TRUST appeared on the scene, doing essentially for the S&L's what the FDIC does for the banking industry. To protect the taxpayers, the Resolution Trust took over failed S&L's all over the country. Meanwhile, back in Washington, Congress was plotting away to deregulate the banks. Seeing what a great success they had produced with S&L's, they decided to do it again with banks. And so they did.

The first step was to repeal the interstate banking regulations. Bank charters could now cross state lines. This Congressional step created an immediate buyer for all of those bankrupt S&L's. Do you remember First Union of North Carolina and NCNB (North Carolina National Bank)? NCNB is now Bank of America. I can remember Ed Crutchfield saying "I'll buy 'em from the sheriff." He was then the CEO of First Union. Hugh McColl had the same mindset at Bank of America. They both went on a buying spree. Under the new regulations, both companies were able to expand quickly with tremendous economies of scale.

This actually made good business sense. Allowing banks to cross state lines spreads their risk over many different economic environments. A good example might be Detroit, Michigan, which was and still is a depressed area. Buying a local bank or S&L from Detroit, Michigan, and then spreading that risk with, say, banks throughout Florida would significantly reduce the overall risk for the parent bank.

No doubt you remember when, just about every time you drove by your bank, it had a new name. Now you know why. And the combination of these two events I have just described pretty much cleaned up the S&L industry. The US Treasury actually made money on this bailout.

And what happened next? Well, along with the change in the interstate banking rules, Congress in its infinite wisdom allowed banks to get into all phases of the financial industry. Over the next ten years banks expanded into areas many people believed they should stay away from. CitiGroup essentially became BANK, INVESTMENT BANK, BROKERAGE FIRM, INSURANCE COMPANY, MORTGAGE BROKER, MUTUAL FUND MANAGER, HAIR DRESSER AND SUSHI BAR.

This created the fastest consolidation of financial companies ever seen in history. It also gave significant credence to the claim that some banks were simply "TOO BIG TO FAIL." This in essence caused the biggest financial bailout in history. We could not let these banks fail without throwing us into a depression that could make 1929 look like a mere contraction. Bank of America, for instance, felt they were buying Merrill Lynch at a bargain, only to discover later that, had they not bought Merrill, it would have crumbled like Lehman Brothers.

One of the areas of consolidation was truly a major problem, the mortgage industry. It was nothing new for banks to underwrite mortgage loans --- they have always done that --- but to package and securitize mortgages was quite new. This role was traditionally left to the investment bankers, who created these securities and sold them off to investors. Selling these mortgages was an important part of differing (diversifying?) risk for the banks. This consolidation allowed banks to control the entire process to include distribution of these mortgage backed securities. Yes . . . they made money on every single transaction.

Meanwhile, back in Washington, Congressman Barney Franks and others had this great idea that every last American should own a home. They decided to loosen lending requirements for anyone wanting the American dream of owning their own home. These included 95-100% financing, second mortgages up to 110% of home value, special programs for minority lending, and last but not least, extremely low credit scores, all as a part of this initiative. I had a mortgage broker here in Fayetteville, NC, tell me that Congress (?) even had a program for credit scores lower than 600. All of this, of course, would be backed by Fannie Mae and Freddie Mac, the two government agencies that were under the watch of Barney Franks and his committee. This amounted to Government Guarantees for all the mortgages that were underwritten by these programs.

Once these mortgages were packaged up and sold as securities to banks, pension funds, mutual funds, foreign countries and their banks, and of course, to individual investors, they were anointed by S&P and Moody's coveted AAA ratings, because they were "Government Backed Securities." HELLO . . . IS ANYONE LISTENING OUT THERE?

To make matters worse, with the AAA rating assigned to them and the government-implied guarantees, the banks could now leverage these securities many times over. Talk about a house of cards! Let me get this right . . . we have a batch of mortgages lent at 95-110% of fair value of the real estate, and we are making these loans to people with sub-600 credit scores, because they have a history of making timely payments, and they have "never had a problem." All this apparently made sense to certain career politicians and their constituencies.

The house of cards eventually collapsed, of course, and the Government had no choice but to bail out the banking industry, thereby bringing us, more or less, to where we are today.

Today banks won't look at mortgage applicants without 750 plus credit ratings, and they are not real excited about lending money for any purpose, it seems. We have Fannie Mae and Freddie Mac holding tons of foreclosed properties. Of course, they are trying to sell these off in a flooded market. The housing market will be back, but it's just going to take some time. Unemployment rates will eventually fall, too, but they won't make huge strides until the housing industry is repaired and inventories are worked off. Bottom line: We will survive the current crisis, but first we need to understand what happened. In my own way I have tried to show you just that.

The Glass Stegall Act grew out of the Great Depression. It was put in place back in 1933 to protect the integrity of our banking system. It was repealed in 1999, creating these mega-financial institutions/sushi bars. It seems to me the interstate banking legislation of the early 90's was a good thing. What happened after 1991, however, was a total disaster.

It seems to me our Government often goes too far in reacting to economic issues. Of course the issues need addressing, but not by "solutions" that just create more problems farther down the road.

You've heard it said that "The road to hell is paved with good intentions." That saying certainly applies in our current circumstances. Another saying applies equally well --- "Sometimes size really does matter."

Don't be surprised to see much of Glass Stegall re-instated.

Thanks for listening!

Mike Chandler

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.