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? Washington’s Blog.

Why isn’t the government breaking up the giant, insolvent banks?

We Need Them To Help the Economy Recover?

Do we need the Too Big to Fails to help the economy recover?

No.

The
following top economists and financial experts believe that the economy
cannot recover unless the big, insolvent banks are broken up in an
orderly fashion:

• Nobel prize-winning economist, Joseph Stiglitz

• Nobel prize-winning economist, Ed Prescott

• Dean
  and professor of finance and economics at Columbia Business School, and
  chairman of the Council of Economic Advisers under President George W.
  Bush, R. Glenn Hubbard

• MIT economics professor and former IMF chief economist, Simon Johnson (and see this)

• President of the Federal Reserve Bank of Kansas City, Thomas Hoenig (and see this)

• Deputy Treasury Secretary, Neal S. Wolin

• The President of the Independent Community Bankers of America, a Washington-based trade group with about 5,000 members, Camden R. Fine

• The Congressional panel overseeing the bailout

• The head of the FDIC, Sheila Bair

• The leading monetary economist and co-author with Milton Friedman of the leading treatise on the Great Depression, Anna Schwartz

• Economics professor and senior regulator during the S & L crisis, William K. Black

• Economics professor, Nouriel Roubini

• Economist, Marc Faber

• Professor of entrepreneurship and finance at the Chicago Booth School of Business, Luigi Zingales

• Economics professor, Thomas F. Cooley

• Former investment banker, Philip Augar

• Chairman of the Commons Treasury, John McFall

Others, like Nobel prize-winning economist Paul Krugman, think that the giant insolvent banks may need to be temporarily nationalized.

In addition, many top economists and financial experts, including Bank of Israel Governor Stanley Fischer – who was Ben Bernanke’s thesis adviser at MIT – say that – at the very least – the size of the financial giants should be limited.

Even the Bank of International Settlements – the “Central Banks’ Central Bank” – has slammed too big to fail. As summarized by the Financial Times:

The
report was particularly scathing in its assessment of governments’
attempts to clean up their banks. “The reluctance of officials to
quickly clean up the banks, many of which are now owned in large part
by governments, may well delay recovery,” it said, adding that
government interventions had ingrained the belief that some banks were
too big or too interconnected to fail.

 

This was dangerous because it reinforced the risks of moral hazard
which might lead to an even bigger financial crisis in future.

If We Break ‘Em Up, No One Will Lend?

Do we need to keep the TBTFs to make sure that loans are made?

Nope.

Fortune pointed out
in February that smaller banks are stepping in to fill the lending void
left by the giant banks’ current hesitancy to make loans. Indeed, the
article points out that the only reason that smaller banks haven’t been
able to expand and thrive is that the too-big-to-fails have decreased
competition:

Growth for the nation’s smaller banks
represents a reversal of trends from the last twenty years, when the
biggest banks got much bigger and many of the smallest players were
gobbled up or driven under…

 

As big banks struggle to find a way forward and rising loan losses
threaten to punish poorly run banks of all sizes, smaller but well
capitalized institutions have a long-awaited chance to expand.

BusinessWeek noted in January:

As big banks struggle, community banks are stepping in to offer loans and lines of credit to small business owners…

At a congressional hearing on small business and the economic
recovery earlier this month, economist Paul Merski, of the Independent
Community Bankers of America, a Washington (D.C.) trade group, told
lawmakers that community banks make 20% of all small-business loans,
even though they represent only about 12% of all bank assets.
Furthermore, he said that about 50% of all small-business loans under
$100,000 are made by community banks…

Indeed, for the past two years, small-business lending among community
banks has grown at a faster rate than from larger institutions,
according to Aite Group, a Boston banking consultancy. “Community banks
are quickly taking on more market share not only from the top five
banks but from some of the regional banks,” says Christine Barry,
Aite’s research director. “They are focusing more attention on small
businesses than before. They are seeing revenue opportunities and
deploying the right solutions in place to serve these customers.”

And Fed Governor Daniel K. Tarullo said in June:

The
importance of traditional financial intermediation services, and hence
of the smaller banks that typically specialize in providing those
services, tends to increase during times of financial stress. Indeed,
the crisis has highlighted the important continuing role of community
banks…

For example, while the number of credit unions has declined by 42
percent since 1989, credit union deposits have more than quadrupled,
and credit unions have increased their share of national deposits from
4.7 percent to 8.5 percent. In addition, some credit unions have
shifted from the traditional membership based on a common interest to
membership that encompasses anyone who lives or works within one or
more local banking markets. In the last few years, some credit unions
have also moved beyond their traditional focus on consumer services to
provide services to small businesses, increasing the extent to which
they compete with community banks.

Indeed, some very smart people say that the big banks aren’t really focusing as much on the lending business as smaller banks.

Specifically
since Glass-Steagall was repealed in 1999, the giant banks have made
much of their money in trading assets, securities, derivatives and
other speculative bets, the banks’ own paper and securities, and in
other money-making activities which have nothing to do with traditional
depository functions.

Now that the economy has crashed, the big banks are making very few loans to consumers or small businesses because they still
have trillions in bad derivatives gambling debts to pay off, and so
they are only loaning to the biggest players and those who don’t really
need credit in the first place. See this and this.

So we don’t really need these giant gamblers. We don’t really need JP Morgan, Citi, Bank of America, Goldman Sachs or Morgan Stanley. What we need are dedicated lenders.

The Fortune article discussed above points out that the banking giants are not necessarily more efficient than smaller banks:

The
largest banks often don’t show the greatest efficiency. This now seems
unsurprising given the deep problems that the biggest institutions have
faced over the past year.

 

“They actually experience diseconomies of scale,” Narter wrote of
the biggest banks. “There are so many large autonomous divisions of the
bank that the complexity of connecting them overwhelms the advantage of
size.”

And Governor Tarullo points out some of the benefits of small community banks over the giant banks:

Many
community banks have thrived, in large part because their local
presence and personal interactions give them an advantage in meeting
the financial needs of many households, small businesses, and
agricultural firms. Their business model is based on an important
economic explanation of the role of financial intermediaries–to
develop and apply expertise that allows a lender to make better
judgments about the creditworthiness of potential borrowers than could
be made by a potential lender with less information about the
borrowers.

A small, but growing, body of research suggests that the financial
services provided by large banks are less-than-perfect substitutes for
those provided by community banks.

It is simply not true
that we need the mega-banks. In fact, as many top economists and
financial analysts have said, the “too big to fails” are actually
stifling competition from smaller lenders and credit unions, and
dragging the entire economy down into a black hole.

The Giant Banks Have Recovered, And Are No Longer Insolvent?

Have the TBTFs recovered, so that they are no longer insolvent?

Negatory.

The giant banks have still not put the toxic assets hidden in their SIVs back on their books.

The tsunamis of commercial real estate, Alt-A, option arm and other loan defaults have not yet hit.

The
overhang of derivatives is still looming out there, and still dwarfs
the size of the rest of the global economy. Credit default swaps have arguably still not been tamed (see this).

Indeed, Nobel prize winning economist Joseph Stiglitz said recently:

The
U.S. has failed to fix the underlying problems of its banking system
after the credit crunch and the collapse of Lehman Brothers Holdings
Inc.

 

“In the U.S. and many other countries, the too-big-to-fail banks
have become even bigger,” Stiglitz said in an interview today in Paris.
“The problems are worse than they were in 2007 before the crisis.”

 

Stiglitz’s views echo those of former Federal Reserve Chairman
Paul Volcker, who has advised President Barack Obama’s administration
to curtail the size of banks, and Bank of Israel Governor Stanley
Fischer, who suggested last month that governments may want to
discourage financial institutions from growing “excessively.”

While the big boys have certainly reported some impressive profits in the last couple of months, some or all of those profits may have been due to “creative accounting”, such as Goldman “skipping” December 2008, suspension of mark-to-market (which may or may not be a good thing), and assistance from the government.

Some
very smart people say that the big banks – even after many billions in
bailouts and other government help – have still not repaired their
balance sheets. Tyler Durden, Reggie Middleton, Mish and others have looked at the balance sheets of the big boys much more recently than I have, and have more details than I do.

But the bottom line is this: If the banks are no longer insolvent, they should prove it. If they can’t prove they are solvent, they should be broken up.

The Government Lacks the Power to Break Them Up?

Does the government lack the power to break up the TBTFs?

Wrong.

One of the world’s leading economic historians – Niall Ferguson – argues in a current article in Newsweek:

[Geithner is proposing that] there should be a new “resolution
authority” for the swift closing down of big banks that fail. But such
an authority already exists and was used when Continental Illinois failed in 1984.

Indeed, even the FDIC mentions Continental Illinois in the same breadth as “too big to fail” banks.

And William K. Black (remember, he was the senior regulator during the S&L crisis, and is a Professor of both Economics and
Law) – says that the Prompt Corrective
Action Law (PCA), 12 U.S.C. § 1831o, not only authorizes the government
to seize insolvent banks, it mandates it, and that the Bush and Obama administrations broke the law by refusing to close insolvent banks.

Whether or not the banks’ holding companies can be broken up using the PCA, the banks themselves could be. See this

And no one can doubt that the government could find a way to break up even the holdign companies if it wanted.

FDR seized gold during the Great Depression under the Trading With The Enemies Act.

Geithner
and Bernanke have been using one loophole and “creative” legal
interpretation after another to rationalize their various
multi-trillion dollar programs in the face of opposition from the
public and Congress (see this, for example).

And the government could use 100-year old antitrust laws to break them up.

So
don’t give me any of this “our hands are tied” malarkey. The Obama
administration could break the “too bigs” up in a heartbeat if it
wanted to, and then justify it after the fact using PCA or another
legal argument.

Is Temporarily Nationalizing the Giant Banks Socialism?

Many argue that it would be wrong for the government to break up the banks, because we would have to take over the banks in order to break them up.

That
may be true. But government regulators in the U.S., Sweden and other
countries which have broken up insolvent banks say that the government
only has to take over banks for around 6 months before breaking them up.

In
contrast, the Bush and Obama administrations’ actions mean that the
government is becoming the majority shareholder in the financial giants
more or less permanently. That is – truly – socialism.

Breaking
them up and selling off the parts to the highest bidder efficiently and
in an orderly fashion would get us back to a semblance of free market
capitalism much quicker.

The Real Reason the Giant Banks Aren’t Being Broken Up

So what is the real reason that the TBTFs aren’t being broken up?

Certainly, there is regulatory capture, cowardice and corruption:

• Joseph Stiglitz
  (the Nobel prize winning economist) said recently that the U.S. government is wary of challenging the
  financial industry because it is politically difficult, and that he
  hopes the Group of 20 leaders will cajole the U.S. into tougher action

• Economic historian Niall Ferguson asks:
  

  Guess
  which institutions are among the biggest lobbyists and campaign-finance
  contributors? Surprise! None other than the TBTFs [too big to fails].

• Manhattan Institute senior fellow Nicole Gelinas agrees:
  

  The
  too-big-to-fail financial industry has been good to elected officials
  and former elected officials of both parties over its 25-year life span

• Investment analyst and financial writer Yves Smith says:
  

  Major financial players [have gained] control over the all-important over-the-counter debt markets…It is pretty hard to regulate someone who has a knife at your throat.

• William K. Black says:
  

  There has been no honest examination of the crisis because it would embarrass C.E.O.s and politicians . . .

  Instead, the Treasury and the Fed are urging us not to
  examine the crisis and to believe that all will soon be well. There
  have been no prosecutions of the chief executives of the large nonprime
  lenders that would expose the “epidemic” of fraudulent mortgage lending
  that drove the crisis. There has been no accountability…

  The Obama administration and Fed Chairman Ben Bernanke have
  refused to investigate the nature and causes of the crisis. And the
  administration selected Timothy Geithner, who with then Treasury
  Secretary Paulson bungled the bailout of A.I.G. and other favored “too
  big to fail” institutions, to head up Treasury.

  Now Lawrence Summers, head of the White House National Economic
  Council, and Mr. Geithner argue that no fundamental change in finance
  is needed. They want to recreate a secondary market in the subprime
  mortgages that caused trillions of dollars of losses.

  Traditional
  neo-classical economic theory, particularly “modern finance theory,”
  has been proven false but economists have failed to replace it. No
  fundamental reform can be passed when the proponents are pretending
  that there really is no crisis or need for change.

• Harvard professor of government Jeffry A. Frieden says:
  

  Regulatory
  agencies are often sympathetic to the industries they regulate. This
  pattern is so well known among scholars that it has a name: “regulatory
  capture.” This effect can be due to the political influence of the
  industry on its regulators; or to the fact that the regulators spend so
  much time with their charges that they come to accept their world view;
  or to the prospect of lucrative private-sector jobs when regulators
  retire or resign.

• Economic consultant Edward Harrison agrees:Regulating Wall Street has become difficult in large part because of regulatory capture.

But there is an even more interesting reason . . .

The number one reason the TBTF’s aren’t being broken up is [drumroll] . . . the ‘ole 80′s playbook is being used.

As the New York Times wrote in February:

In
the 1980s, during the height of the Latin American debt crisis, the
total risk to the nine money-center banks in New York was estimated at
more than three times the capital of those banks. The regulators,
analysts say, did not force the banks to value those loans at the
fire-sale prices of the moment, helping to avert a disaster in the
banking system.

In other words, the nine biggest banks were all insolvent in the 1980s.

And the Times is not alone in stating this fact. For example, Felix Salmon wrote in January:

In
the early 1980s, when a slew of overindebted Latin governments
defaulted to their bank creditors, a lot of big global banks, Citicorp
foremost among them, became insolvent.

So the
government’s failure to break up the insolvent giants – even though
virtually all independent experts say that is the only way to save the
economy, and even though there is no good reason not to break them up – is nothing new.

William K. Black’s statement that the government’s entire strategy now – as in the S&L crisis – is to cover up how bad things are (“the entire strategy is to keep people from getting the facts”) makes a lot more sense.

Dick Durbin is once again flapping his gums instead of actually addressing problems:

The legislation, introduced today by Senator Jack Reed of Rhode Island, would require lenders to evaluate all borrowers for affordable loan modifications before initiating foreclosure. It would also require banks to offer and approve a loan modification if the restructured mortgage returns more money, the so-called net-present value, to investors than would foreclosure.

The proposal would establish new penalties and would let borrowers overturn foreclosures if lenders fail to comply. It would also place new limits on fees charged in foreclosure.

The reason we have this crap going on is quite simple, and fixing it is also quite simple:

Banks are holding homes back and foreclosing when they should be modifying as a direct consequence of the policies and actions of the government.

As just one example the “loss share” agreement made with the buyers of IndyMac has set up a perverse incentive system where the usual incentives to modify loans have been intentionally and wantonly destroyed.

If you remember this was the deal announced:

As part of the deal, the FDIC entered into a loss-sharing agreement with IMB HoldCo. IndyMac will assume the first 20 percent of losses on a portfolio of “qualifying loans,” after which the FDIC will assume 80 percent on the next 10 percent of losses, and 95 percent on losses thereafter.

Ok, so we have a maximum loss that the investors (which include George Soros and Michael Dell, by the way) can take which is:

20% + 2% (80% of 10%) + 3.5% or about 25% of the total is theirs – but note that “theirs” is all at the top – once you get into the “meat” of the losses only 5% of whatever is left is theirs.

Here’s the problem: As part of the deal they also get to write down the portfolio as of the date of the deal.  They took that, taking roughly a 25% mark against the assets at purchase (in other words, they bought $20.7 billion of assets at a discount of $4.7 billion)

Now here’s the issue – in a deteriorating market the incentive to modify a loan exists only when the loss on a foreclosure will be materially higher than the loss on a modification.

But if someone “else” (like THE TAXPAYER) will eat (almost all, in this case, essentially 95% of) the loss, then your incentives shift – in a big way.

See, if you modify, you stop earning “fees” on the delinquent note.  You can’t charge late fees any more, you can’t charge “special servicing costs” and similar types of things that you can (and do) get to add to a delinquent note that is “headed for foreclosure.”  These are all immediate cash – and they’re all yours, never mind that if just 1 in 10 of these notes “cures” (after you hound the living hell out of them to pay somehow by hook or crook) you win huge since you got to buy at a 25% discount up front!

These “incentives” to NOT modify are usually outweighed by the much higher loss you’d take if you foreclose.

BUT THESE FOLKS ARE PROTECTED BY THE “LOSS SHARE” AGAINST ANY MATERIAL AMOUNT OF LOSS (95% IS EATEN BY SOMEONE OTHER THAN THEM!)

So now the incentives are wildly tilted toward them telling borrowers to go stuff it up their backside, and they are.

These “loss share” deals are a big, big problem.

It gets worse.

Regulators are refusing to force a mark-to-market on this paper.  We continue to see banks fail where the FDIC reports 20, 30, 40, up to nearly 50% losses, with some sector-specific losses of 60%!  Colonial, again, had a 39% realized loss against their balance sheet claimed values when BB&T came in and purchased them.

The argument for permitting cost-basis (or other forms of “mark to mythology”) accounting is that the market price is in fact “not real.” 

That’s a nice fantasy put forward by the banking industry and lobby but we now have nearly 100 bank failures under our belt and in fact the market price seems to be about where these things wind up – putting the lie to any claim that market prices are “too pessimistic.”  Indeed I have yet to find one instance of a failed institution where balance sheet values ended up being too pessimistic once the regulators came in and started selling things off.

Such “extend and pretend” games, in addition to the ridiculously false view this presents of a financial institution’s balance sheet effectively precludes either modification or foreclosure and resale of the property, because either of those events “finalizes” any embedded and hidden loss and thus forces a mark to be taken.  That could be a wee problem if the bank or other institution doesn’t have sufficient capital to absorb these losses, never mind the hit to so-called “earnings” even if they do have the money.

The reason banks are not modifying loans in good faith and are playing these games is because the regulators AND LAWMAKERS are PERMITTING THEM TO LIE and HIDE losses.

Then, in compounding the error they are entering into “loss share” deals where there is NO INCENTIVE to modify because on a strict financial analysis IT IS MORE PROFITABLE TO “PURSUE FORECLOSURE” since the loss differential IS NOT THEIRS while the fees they can earn from NOT modifying ARE!

Finally, adding insult to injury you have the impact on local and state governments – these properties are not paying property taxes either, being in arrears in some cases by as much as two years.  Yes, this will eventually be recovered via tax certificate sales but the state and local governments deserve to get paid NOW – not five years down the road, when the cause of the delay and non-payment is intentional game-playing by regulators and banks.

Folks, this is really simple: If you want to see those modifications that make sense get done, including but not limited to principal forgiveness where it makes sense, and foreclosures to be prosecuted and properties resold at the market, thereby clearing it, you need to do the following:

• Force recognition of past-due loans on their current recovery value – all of them – as soon as they go past due.

• Force banks to foreclose on all loans more than 90 days past due in a diligent fashion.  To punish failure to do so provide that a foreclosure not diligently-prosecuted results in a clear deed being conveyed to the homeowner (that is, 100% loss to the bank!)  That will get their attention – FAST.

• Force banks to sell into the market at absolute auction all property held by them no later than 90 days after foreclosure.  They get 90 days to market privately for a higher price, after which it goes to the courthouse steps.

• Force ALL off-balance sheet exposures onto the balance sheet immediately, and prohibit as a matter of law the hiding of exposures off balance sheet (such as the infamous Wachoiva CDS)

In short if you want modifications that make sense to happen you have to stop making it profitable for banks to play games with the accounting so that they are forced to recognize losses as they are realized in the market rather than hiding them in the hope that they will magically “self-cure” (when the data says that is a statistical impossibility.)

You must also get rid of the perverse incentives that make it more profitable for the corporate raiders – who have been given a “no lose” proposition in their acquisition prices – to foreclose instead of making sustainable modifications.

As for the States, I have a solution there too – and perhaps that’s where we should focus our ire, since we can’t seem to get anyone’s attention in Washington DC given all the bribed, er, “lobbied” lawmakers

Change state tax certificate laws.  Sell off delinquent taxes in the fall following the delinquency (assuming a spring “due date”) thereby putting the certificate in someone’s hands six months after non-payment and shorten the allowed redemption (“cure”) period to 12 months – after which the certificate holder can pay the delinquent taxes in full and gain a clear title.  This will put an immediate stop to banks refusing to foreclose or dispose of delinquent properties, leaving them vacant (since they will wind up losing them to a tax sale) and it will stop the bleeding at the state revenue level.  As a beneficial side effect it will force a clearing of the market and re-establish occupancy, maintenance and upkeep of these homes.