loan losses

I didn’t realize that when I first wrote about this issue I was plunging into so deep a pool. I knew that it was a hot topic, but the amount of time and space being devoted to it are, to say the least, extraordinary.

Today’s edition brings two major players into the game: Martin Wolf, my favorite writer at the Financial Times, and Ben Bernanke opining on the Fed’s view.

I disagree with both, so I owe an explanation as to why.

“There is nothing more dangerous in the economy than a greedy dunce. Unfortunately we are blessed with a number of very large ones. They could do less harm both to themselves, and to us, were they all a lot smaller.”

Let’s tackle Wolf first.

His opinion is presented in an op-ed piece in today’s FT. He starts by stating the obvious: big banks are a problem and that the problem is now much worse than before. It became worse because we didn’t do anything yet to fix it, while the big banks that survived the last crisis have now gobbled up weaker players and grown market shares. They are even bigger than before.

Wolf describes all of this, so I am fine up until the moment he backs off the inevitable and obvious solution. If some banks are too big, then we should make them smaller. Instead he offers up a rather lame defense of letting them stay large: we might find it difficult. Plus he muddles some rather easy facts around to create a better target to shoot at.

Allow me to straighten Martin out.

His straw man is the notion – one I agree with in principle – that we should re-instate the separation between regular, main street, banking, and what he calls ‘casino’ banking – I have used the word ‘gambling’ – which used to be the exclusive domain of the old investment banks. The reason for separation is clear, at least in theory: main street banking is boring stodgy and utility like. It includes dull stuff like managing checking accounts and making small business loans. There is very little sexiness in that business which is why all the real ‘high flyers’ flock towards investment banking. The ‘casino’ banks would include all the various activities we have come to know and hate: derivatives, securitized products trading, and the real bete-noir of the AIG collapse those infamous credit default swaps. In other words all the high stakes gambling stuff that any sensible main street bank would avoid like the plague.

Wolf argues that it would be very hard to separate the two activities. He uses a cheeky sleight of hand to support this contention: he says that “all the lending” would be left to the casino banks – including lending to households and small business. This is plainly false. The old commercial banks we had in the US – before the ill-fated abolition of Glass Steagall – were not just payment system operations the way Wolf suggests the new main street banks would be. They went much further: they were the primary providers of credit to small and medium sized businesses and to households. Why they wouldn’t continue in this role Wolf fails to explain. I think he is arguing that the new main street banks would have absolutely no credit risk at all. I don’t see why this should be. The system worked well for decades after the Depression era laws like the Glass-Steagall Act broke the banks up. Yes there were periodic bank losses, but they were never even remotely as catastrophic as last years implosion. All those periods of loss were associated with the economic cycle – banking lagged the cycle because profits dropped as customers suffered losses and defaulted on loans. Last year the banks were the cause of the problem: banking had become a leading factor instead of a lagging factor.

I give Wolf credit though, because he highlights a big issue that seems lost in the current discussion.

He suggests that the solution I just gave – re-creating the old commercial banks – implies that generating loans is good, but securitizing them is bad. He wonders why it is that we should think securitization is bad. Because it separates the bank from its customers. That’s why. He misses the point that the re-creation of the old commercial banks includes with it the reduction – if not the elimination – of securitization.

Why is this so important?

Securitization allows banks to package up and sell loans that they have made – those awful mortgage backed securities based upon packages of sub-prime mortgages are a classic case in point. This process frees up capital on the bank’s balance sheet, it generates fees, and it, in theory, reduces risk for the banks because the default of those loans is now someone else’s problem. All true so far. But: it also means that the lender has no enduring interest in the customer. This is great in good economic times, but when the seas get a little choppy it also means that customer’s have a much harder time getting forbearance or other types of help to allow them to weather the storm. The old fashioned customer-lender link is severed. The economic consequence of this is that there is no organization with an interest in acting as a brake on the deterioration of the asset: the new holders have no relationship to protect, so they are quick to ask for foreclosure on bad mortgages. The other damage that securitization brought us was also rooted in this customer-lender severance: the lender had no long term interest in the loan, but had a very high interest in the volume of loans – that’s where the fees are generated. It doesn’t take a rocket scientist – although the point eluded all the math wizards on Wall Street – to realize that this is a recipe for loose credit standards. If a bank doesn’t have to face the potential loss of a loan it makes it will be willing to lend to just about anyone. Sub-prime mortgages are a direct result of securitization for exactly this reason.

So Wolf gets it totally wrong: securitization is bad when applied en masse to bank loans. The type of commercial bank I advocate as the future would be forced to hold their loans, or at least the majority.

It is one thing, and a very normal thing, for a bank to lose money when the economy goes into recession. It is quite another for banks to lose money because they willfully overlook basic underwriting techniques. Securitization is not the only cause of bad lending – unrealistic profit targeting is another obvious one – but is a major one.

Once Wolf dismisses breaking the banks up he is left to answer the ‘too-big-to-fail’ question in other ways. He resorts to the same arguments that Bernanke also uses. He suggests we impose huge capital requirements on riskier activities; that we introduce laws to make bankruptcy easier and more painless for financial institutions; that we abolish off balance sheet activities – yes banks have vast amounts of assets not recorded on their balance sheets and thus not protected by capital; that we require fancy and more rigorous loan loss provisioning – a loan loss provision is a ‘rainy day fund’ that banks create to offset loan losses, the idea being to set the fund up when the bank is profitable and then to draw it down in hard times; and that force banks to have better capital – more plain equity and more ‘contingent’ equity which is an exotic form of capital that is only converted into plain equity in emergencies.

At this point Wolf and Bernanke are making the same suggestions so I should conflate them for my response.

First: all of these novel ideas have been floating around for years. Why were they not adopted? because the banks lobby really well and managed to prevent them being put into force. Wold and Bernanke will have to be much more convincing to persuade me that the banks, who are now more powerful, will not be able to stop them again.

Second: imputing higher capital ratios is a great idea. I am all for it. The problem is that we have capital ratio requirements already. Banks have proven to be very adept in avoiding them. Regulators have been very lax in enforcing them too. There is no evidence I know that suggests that either the banks or the regulators will change. Indeed as soon as this crisis abates enough I would wager that laxity will pervade and a new crisis will form.

Third: those plans for easy bankruptcy are not that easy. These mega banks are arcane warrens of subsidiaries and murky tax-dodge off-shore vehicles. Unless the bankruptcy procedures include a regulation that clears away all that mess up front – forcing the banks to eliminate their tax dodges would help finance more adequately staffed regulatory bodies, which is an exquisite use of bank profits – the courts will inevitably foul up anything remotely hasty. The unwinding of Lehman still rumbles on with international squabbles over jurisdiction delaying the process. Somehow I doubt whether we could feasibly wind Citicorp up over a weekend even with the best bankruptcy laws in place. Besides the problem is not simply winding up a bankrupt bank, it extends deeply into allowing the markets to digest and value the bits of the bank being wound up. And a mega bank has, by definition, a huge share of the market, which begs the question: who would buy all that stuff? Would we have to resort, as we just did, to forcing a Merrill sized chunk down the throat of an unwilling Bank of America? If so, what have we gained?

There is nothing easy about a mega bank bankruptcy. No matter what the law; no matter what detail its ‘living will ‘ has; and no matter how well oiled the regulatory framework for the bankruptcy may be: at the end of the day we will have to have buyers for the assets. The most eligible buyers would be … the other mega banks. Who would then become super-mega banks and we would immediately compound our original problem. The other alternative would be for the government to own some of the assets itself, but we shied away from nationalization before and are unlikely to go that way in the future.A third course of action would be to break up the failed bank and sell it off as stand alone entities to private investors. But … ummm … both Bernanke and Wolf don’t think breaking up the banks is a good idea.

Unless, apparently, when the bank in question is bankrupt. In which case: I can think of a couple of large banks that fit that category last year. And what did we do? Nothing.

Which brings me back to breaking up the banks.

I am all for all of Wolf’s suggestions. I think they’re dandy. We need to impose them on the newly broken up smaller banks. That way these new banks will have strong incentives not to get too big. That would be great wouldn’t it? A whole bunch of smaller, highly capitalized, safer, and competitive banks. More choice for consumers and businesses. More safety and soundness. A capitalist dream. Who doesn’t want that?

Well Bernanke.

The key insight into his position is when he argues that one reason we don’t want to break up the banks is so that we can preserve value for the financial sector. Wow. Our regulatory regime has to be cognizant of the shareholder value of the banks? It has to preserve that value? I think Bernanke has his proverbial knickers in a twist here. Tightly too. Silly me. I thought the object of the regulators was to preserve safety and soundness – the public part of the banking system. In technical economic parlance the safety and soundness of banking is a ‘public good’. That means it belongs to all of us since we benefit from it. That public good provides us with a motivation to preserve it. It has value to us. Hence our willingness to bail banks out and to regulate them. The ‘private good’ in banking – the profits that go to the shareholders – is of no consequence to us. That’s the private investor’s problem. That’s why they have Boards of Directors. The Board oversees the protection of the private goods. The regulators oversee the protection of only the public goods.

Duh.

Economics 101.

Obviously not at Princeton.

Actually Bernanke’s startling comment gives us an insight into why the Fed – and the Treasury – has been so soft so far in imposing an new regulatory regime – they think like Wall Street. They act tough: Paulson’s hard ball tactics late last year being an instance. But now that things have calmed down they are back to being obsequious. I find it astonishing, and dismaying, that Bernanke has anything but a tangental interest in bank values: capital yes, market value no.

When all is said and done I just don’t see a viable alternative to break up. Everything else can be worked around. Besides, as I mentioned above, all those other methods for controlling the banks are great additions to the break up process.

Let’s have both.

The banks proved to the world that they were a combustible mix of incompetence and venality. There is nothing more dangerous in the economy than a greedy dunce. Unfortunately we are blessed with a number of very large ones. They could do less harm both to themselves, and to us, were they all a lot smaller.

Break them up.