You Can Bank On It

This is a long and somewhat convoluted post, but the payoff comes at the end. Make sure you have a full cup of coffee (or other beverage of choice) and slog through it. I think (hope) when the pieces come together you'll be glad you did.

In a previous life I worked for about 20 years in the financial industry - banks, and savings & loans (if you remember S&Ls then you're a greybeard just like me). I've lived through all the changes to our banking system, and suffered through the resulting carnage.

Back in the old days, a fundamental concept of our financial system was separation of functions. Savings and loans took deposits and made mortgage loans (the old-fashioned kind where people had to have a down payment and a job, and the S&L held the mortgage and didn't sell it off to some Wall Street institution). That was about all they did. No checking accounts, no commercial loans, just a simple, straightforward, low risk business model.

Commercial banks, on the other hand, could offer checking accounts and make commercial (i.e., business) loans. That was a riskier business model, since companies went out of business more often than people defaulted on their mortgages, but the banks made up for it by charging higher interest rates. The key for both S&Ls and banks was that, for the most part, they lived with the loans they made, so there was a significant degree of self-interest involved in making good loans that had a high likelihood of being repaid.

But that wasn't enough for them. Back in the 1980's the distinction between S&Ls and commercial banks was erased. Both types of institutions could make both types of loans. Predictably, S&Ls got in over their heads when making commercial loans (lack of knowledge and experience) and banks started making mortgage loans. But mortgage loans are long-term (usually 30 years) while most business loans are for much shorter terms. The banks quickly found out that they didn't like waiting for the principal to be paid back, and pressured the government for the ability to package and resell their mortgage loans. This eventually led to repeal of the Glass-Steagall Act of 1933, which separated commercial banking and investment banking (investment banks, which underwrite the issuance of securities, arrange financing for mergers and acquisitions, IPOs, and the like, aren't really banks in the traditional sense, but rather brokers for large institutional customers and complex transactions).

It's that last sentence above that's key - repeal of the Glass-Steagall Act. The end result is that the large Wall Street banks are now gambling with depositors' money, not their own. If Bank of America underwrites enough investments and ventures that ultimately fail, the federal government (i.e., the taxpayers) has to bail out the bank in order to protect the depositors - you and me.

Another end result was consolidation among banks, so that today we have 10 or 12 huge banks that dominate the market, leading to the notion of 'too big to fail.' If a bank knows that there are no negatives consequences to its actions -- that the feds will bail it out because it's too big to fail -- then there is no downside to making risky investments. And that's where we are today.

The most recent example is the billions of dollars in losses by JPMorgan Chase on financial derivatives. The derivatives (high-risk, highly leveraged speculative transactions) are on the books of FDIC-insured megabanks, which means that you and I are on the hook if anything goes wrong.

All of the above is a long-winded way of saying that Joe Biden actually had a valid point when he spoke about banks and chains (actually, the lack thereof) that bind Wall Street banks. Of course, he bungled the message, but that's another story.

I'm for the most part a free market guy, but this is an instance where a little reasonable regulation would go a long way. Re-institute Glass-Steagall. Let the Wall Street boys play with their own money, not that of their depositors. That will make them evaluate the investment risks more thoroughly, and shrink the number and size of the megabanks so that 'too big to fail' doesn't come into play anymore.

On a personal note, back in the 1980s I worked at Lamar Savings Association, an Austin-based S&L that failed. Its chairman and several officers were eventually convicted on a number of bank fraud charges and served time in prison.

After that I went to work for First City, a Houston-based bank holding company (a bank holding company is a shell corporation that own a number of banks - in our case we owned over 60 banks). As fate would have it, First City failed not once but twice, a record that will hopefully never be broken. And continuing my personal streak of choosing wisely, several of First City's top officials were convicted on bank fraud charges.

Taking that one step further, the chairman, vice chairman, and several of their their cronies were from Chicago, and did business the Chicago way. For example, they arranged for the bank to loan money to Calumet Farms, a Kentucky thoroughbred racehorse operation. Triple Crown contender Alydar was part of the collateral. When the loan went bad, they paid a security guard to break Alydar's leg so that the horse had to be put down. The life insurance policies on the horse were more than enough to cover the loan. Thankfully, they were also convicted and sent to prison.

Now we have the president of the United States coming from Chicago. As the French would say, "Plus ca change, plus c'est la meme chose."

The more things change, the more they stay the same...