Better Banking Law responds to PIMCO's misguided assertions

In a recent FT article, PIMCO responded to Neel Kashkari's statement that the largest banks may need to be broken up, by stating that they think it is a bad idea. They make the following five assertions:

1. REGULATIONS ARE ALREADY HELPING. Better Banking Law does not disagree; however PIMCO goes on to state that several large banks have shrunk their balance sheets in recent years. But they neglect to say that, while one or two banks may well have done so, the fact remains that the four largest banks, as reported recently in the Wall Street Journal, in 2015 held $8.01 Trillion in total assets, which comprised 51% of all bank assets. Whereas in 2006, those same four banks held $5.18 Trillion of total assets, representing a mere 44% of the total. Some shrinkage!

2. A BREAK UP COULD PROMPT ANOTHER CREDIT CRUNCH. This is surely an odd argument, since it was the large universal banks that contributed in a major way to the financial crisis in '08 through their foolish underwriting of bonds backed by toxic mortgage assets and derivative securities thereof.

3. SMALLER BANKS ARE NOT NECESSARILY LESS RISKY. Better Banking Law has never asserted that small banks are not without risk. But when small banks have failed, the FDIC has very effectively dealt with those failures. However, when gigantic banks fail, FDIC funds become woefully inadequate and require, as in 2008, the bailout of such universal banks, to protect the nations economy. Furthermore, the smaller banks seldom deal in derivatives or other exotic financial instruments, which can lead and have lead to disaster.

4. BOND HOLDERS WOULD BE WARY OF NEW ENTITIES. At present, holders of the bonds of large US bank holding companies are unsure, due to BHCs complexity, just what the source of payment for their bonds may be. However, since all BHC bond holders were bailed out in 2008, such holders likely assume that the bank debt owed them will ultimately be paid by Uncle Sam. This moral hazard must surely end. BHC bond holders get significantly more yield than they earn on US treasuries, so why should such holders be bailed out again by the government?

5. THERE COULD BE A POTENTIAL INCREASE IN COUNTERPARTY RISK. After a breakup, a counterparty would be much more assured that a specific entity, which can be far better analyzed than the entire BHC, is responsible for its payment of its obligation.

PIMCO's final statement is as follows: "While further measures to encourage simpler and smaller balance sheets and operations may be needed, policymakers need to keep a close eye on their unintended consequences, no matter how politically appealing the measures may seem." Had this sentence not included the word "politically", it would have been fine. Sadly, with that word, the statement becomes a cheap shot. This issue is not political: it has to do with protecting taxpayers from a situation where, if things work out for the banks, their bondholders, stockholders and executives get the benefit. Whereas, if they fail, taxpayers are on the hook - as happened in 2008. Furthermore, to the extent politics is involved, the lobbyists and lawyers for the banks have far more access to Congress through their and the banks' own gigantic campaign contributions. Thus, the taxpayers become the only party without political representation in Congress.

Neel Kaskari's full speech "Lessons from the Crisis: Ending Too Big to Fail" can be viewed here.

Oddly Inconsistent Views on the Financial Crisis

Paul Krugman’s October 16th New York Times article, “Waaaaah Street Attacks” is oddly inconsistent. First, Better Banking Law certainly agrees with him that “repealing Glass-Steagall was indeed a mistake.” However, he then takes a wild turn in his very next sentence: “But it’s not what caused the financial crisis, which arose instead from ‘shadow banks’ like Lehman Brothers.”

Had he said: “The repeal of Glass Steagall was only one of the causes that contributed to the crisis and that Lehman Brothers’ failure was also a contributor” he would have had no argument from Better Banking Law. But to flatly state that the repeal did not cause the financial crisis, he is essentially asserting that the ability of Federally Insured commercial banks to underwrite toxic mortgage-backed bonds did not cause or contribute to the crisis in a major way. This is nonsense and Mr. Krugman surely must agree since several paragraphs later he reverses course once again, stating accurately but too narrowly: “After all, runaway banks brought the economy to its knees, causing millions to lose their jobs, their homes, or both. What’s more, banks themselves were bailed out, at potentially large expense to taxpayers.” I say narrowly because there were several other culprits, besides the banks, which I will allude to later.

Lehman Brothers was an old line investment bank which underwrote and traded securities that, due first to bank regulators eviscerating Glass-Steagall and then Congress repealing a key part of it in 1999, now had to compete in the investment banking arena with Federally Insured commercial banks. A prime example is Citigroup which, in addition to having FDIC insurance, could, in an emergency, also borrow funds from the Federal Reserve.  Lehman had neither advantage and, unlike Citigroup, was not bailed out by the taxpayers and instead went bankrupt. Citigroup incidentally was the #1 underwriter of Collateralized Debt Obligation Bonds in 2007 with $41.7 Billion while Lehman only ranked 10th with $16.7 Billion. In fact, in addition to Citigroup as number 1, the 3rd, 4th, 5th, and 8th ranked underwriters of such bonds were also commercial banks.

Citigroup received a minimum of $45 Billion of Uncle Sam’s bailout funds while Lehman got none. Had Glass-Steagall still been in effect, how in the world could Citigroup have lost so much money had it not been permitted to underwrite and trade securities, whether CDOs, mortgage-backed bonds or other securities?

We at Better Banking Law have never said that the repeal of Glass-Stegall was the sole reason for the financial crisis of 2008. There were several other culprits including:

1. Toxic mortgages consisting of liar loans brought to market by unscrupulous mortgage brokers which were then securitized and repackaged by Wall Street banks and securities firms;
2. Individual borrowers that took on debts which they didn’t understand and couldn’t afford unless the housing bubble continued to expand;
3. Credit rating agencies which blessed many hundreds of questionable mortgage backed securities issues with their highest ratings of AAA;
4. Irresponsible lending by Fannie Mae and Freddie Mac, which lowered their own credit standards so as not to lose market share to Wall Street; and
5. Federal banking regulators that utterly failed to do their jobs.

Of course Lehman Brothers and the other investment banks were just as guilty as the Federally Insured commercial banks of causing the financial crisis along with the other culprits mentioned. However, the issue is whether, had Glass-Steagall still been in effect in 2008, thus preventing Federally Insured commercial banks from underwriting the hundreds of $Billions of toxic bonds they did, the crisis would have grown to anywhere near the size it did. Any fair-minded person would have said no, it could not have grown nearly as big and the bubble would have burst much sooner had Federally Insured commercial banks not first joined the party and later nearly dominated it.

Furthermore, it is hard to believe that Congress would ever have bailed out stand alone investment banks. After all, commercial banks, not investment banks, are at the heart of the nation’s payments system and that was why the Fed, the Bush Administration and Congress bailed out the Federally Insured commercial banks.  

It is important to remember that no investment banks were bailed out unless and until they were first either purchased by a commercial bank or became bank holding companies themselves. Think of it. Of the five largest independent securities firms in early 2008, Bear Stearns, about to fail, was absorbed by J.P. Morgan with strong encouragement by the US Treasury and the Federal Reserve and immense financial help from the Fed; Lehman Brothers went bankrupt; a shaky Merrill Lynch was bought by Bank of America; and shortly thereafter the two strongest, Goldman Sachs and Morgan Stanley, were firmly encouraged by the Fed and the Treasury to become, and quickly became, bank holding companies.

It is also helpful to recall that, prior to the crisis, hundreds of investment banks went bankrupt or were forced into mergers. Taxpayers hardly noticed. A generation ago, Drexel Burnham, the dominant underwriter of high yield bonds, went bankrupt and the financial markets shrugged. It is not the same when a Federally Insured “Too Big To Fail” commercial bank fails. First the FDIC, and ultimately the U.S. taxpayers, bail them out. If Glass-Steagall or something similar, such as the U.K.’s current “ringfencing” statute, were the law in the United States, those commercial banks would not need to be saved by taxpayers.

A Celebration of Yesterday, Today, and Tomorrow

Today is a small celebration for us at Better Banking Law, as it marks the first of many posts on the subject of bank reform. Your comments and questions are always welcome, with the hope that together, we can contribute meaningful dialogue to this important movement.

Yesterday, June 16th, we celebrated the 82nd Birthday of the Banking Act of 1933 aka Glass-Steagall. The Act served the nation extremely well for 66 years by: (1) creating Federal deposit insurance; and (2) separating commercial banking from investment banking. Unfortunately, the separation part of the Act was repealed in 1999, permitting Federally insured banks to engage in investment banking, i.e. securities underwriting and trading. That repeal contributed greatly to the nation’s financial Armageddon in 2008 which required U.S. taxpayers to bailout the banking industry. America is still recovering from that disaster.

Tomorrow, June 18th, is the 25th Anniversary of the publication in Investment Dealer’s Digest of an interview with Robert Downey, the Founder of Better Banking Law, who was then Chairman of the Securities Industry Association (SIA). In the interview, Mr. Downey described the SIA Plan which would have permitted subsidiaries of Bank Holding Companies (BHCs) to engage in securities underwriting and trading. However, those separately capitalized investment banking subsidiaries must succeed or fail on their own and would be completely separated (ring fenced) from the BHC’s Federally insured commercial banking subsidiaries. Commercial banks had been eager to enter the securities business and had constantly advocated for the repeal of Glass-Steagall. However, if commercial banks were to participate in the risky, cyclical securities business, there was a need for Congress to adopt a law in a way that would be safe and fair, while keeping federal deposit insurance (and Uncle Sam) separate. The SIA Plan accomplished those goals.

Aside from the re-enactment of the full Glass-Steagall Act, the SIA Plan (with some minor updating), if enacted into law, would be the best method to prevent future bailouts of the nation’s banking system and to end once and for all the concept of Too Big To Fail.

You can read the IDD interview and discover more detail about the SIA Plan within the Better Banking Law website.