AVOIDING ANOTHER ROUND OF “TOO BIG TO FAIL”

Here is a thought-provoking commentary by Rodney Johnson, President of Dent Research, an investment advisory firm.  Here is Rodney’s story:

“It’s no secret I can’t stand banks, particularly Bank of America.  The institution is doing its best to get rid of any customer service that ever existed (fewer tellers, pushing clients to online services, etc.) while airing sappy ads about how much they care.  Care about what?  Their bonuses?  Certainly not their customers.

“But even with my long-standing grudge against B of A, I’m not joining the chorus calling for increased regulation or busting them up along with the other big banks.

“I’ve got a better idea.  Hold them responsible for their actions.

“In 2008 the financial world was in a tailspin.  JPMorgan, Bank of America, Citigroup, and Wells Fargo were desperate for capital as short-term lending dried up and the value of their assets fell.  The Fed and U.S. Treasury came to their rescue, providing much-needed loans and seemingly unlimited support.  The thinking at the time was that such banks were “too big to fail,” meaning that if they went under, they could damage the entire financial system.  They had to be saved.

“This happened right after all the lending giants Fannie Mae and Freddie Mac were taken over—and bailed out—by the U.S. government.

“Both are instances of privatized profits and socialized losses.  The years of gains earned by these banks and the mortgage companies were paid out in dividends to shareholders as well as salaries and bonuses to staff.  When everything went south, shareholders took a hit in their share price and some staff were fired or saw their bonuses cut, but the pain was short-lived.  Bank share prices rebounded some, and banks again paid seven figures to some of the same people who oversaw the crisis.

“Over at Fannie and Freddie, the story is a little different, and provides a cautionary tale.

“These companies were placed in conservatorship by the U.S. Treasury and given $187 billion in loans.  In return, the Treasury demanded certain payment terms, which it eventually scrapped and said simply, ‘Give us all your profits.’  Since the crisis, Fannie and Freddie have paid the U.S. (top line of page 2 got cut off) Treasury $240 billion.

“Not one percent of it reduced their $187 billion loan, which they still owe.  Under the current arrangement, Fannie and Freddie can NEVER repay their loans, because all net income must be paid to the U.S. Treasury for the price of bailing them out.

“There is no doubt that U.S. taxpayers were burned by allowing these companies to book private profits in the years before the crisis, and then required to bail them out with public funds in the time of need.

“But now we’re getting burned again because the government is using the profits from these companies as a slush fund to pay for ongoing operations, saving itself from the hard work of balancing the U.S. budget.  Now we have socialized losses and socialized profits.

“Anyone who thinks the government can efficiently run for-profit businesses without succumbing to political pressures, raise your hand—and check your sanity.

“A case in point, Fannie Mae recently unveiled a new initiative to promote lending, a 3% down payment loan.  That sounds suspiciously like some of the mortgage offerings that created the last crisis.  I’ve no doubt this will end badly.

“As for the big banks, all of our teeth-gnashing and Congressional hearings brought about precious little change.  These institutions controlled 44% of deposits in 2006, and now 51%.  They grew from $5.18 trillion in assets to $8.01 trillion.  How’s that for taming the Leviathan?

“The problem is that, because of their Systemically Important Financial Institute (SIFI) status, which is Congressional-speak for too-big-to-fail, everyone believes that when the next crisis hits, these banks will be supported by taxpayer funds.

“And it could get worse.  Instead of pushing the banks farther away, the government could pull them closer, where they end up in the weird world of Fannie Mae and Freddie Mac.

“A better solution for all of these companies would be to draw clear lines of responsibility, outlining what will happen when capital requirements aren’t met.  If more capital couldn’t be raised, junior bondholders would be wiped out, then senior bondholders.  After that, depositors would start taking haircuts.

“If these steps were illustrated, depositors would quickly realize that there isn’t much of a bondhold cushion between them and a haircut.

“And it’s not individual depositors that would be alarmed.  While some people do hold more than the insured maximum of $250,000 in their account, it’s mostly companies that have uninsured funds.

“Hopefully the real possibility of a deposit haircut would motivate these large bank clients to demand better risk management from bankers.  They might even take their businesses to smaller banks with less complicated balance sheets.

“Unfortunately, as long as there is a perceived safety net from public sources for the largest banks then the largest customers will use them, perpetuating the system, and putting our tax dollars at risk.”

On the other hand, Rodney, wouldn’t it be simpler and easier to reinstate the Glass-Steagall Act.  Let me explain:

In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure, as well as the Great Depression, Congress passed what is known today as the Glass-Steagall Act (GSA).  This act separated investment and commercial banking activities.  At the time, “Improper banking activity,” or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash.  According to that reasoning, commercial banks took on too much risk with depositors’ money.  Additional and sometimes non-related explanations for the Great Depression evolved over the years, and many questioned whether the GSA hindered the establishment of financial services firms that can equally compete against each other.

Reasons for the Act – Commercial Speculation

Commercial banks were accused of being too speculative in the pre-Depression era, not only because they were investing their assets but also because they were buying new issues for resale to the public.  Thus, banks became greedy, taking on huge risks in the hope of even bigger rewards.  Banking itself became sloppy and objectives became blurred.  Unsound loans were issued to companies in which the bank had invested, and clients were encouraged to invest in those stocks.

Sounds pretty much like what we saw in the 2008 financial debacle and what appears to be heading in the same direction today.

As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled.  Banks were given a year to decide on whether they would specialize in commercial or in investment banking.  Only 10% of commercial banks total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds.  Financial giants at the time such as JP Morgan, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income.  By creating this barrier, the GSA was aiming to prevent the banks’ use of deposits in the case of a failed underwriting.

Sounds like a good idea to me and a far better way to avoid the “too big to fail” problem!

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