The Banking Crisis - Scathing Critique and Real Solutions

By Michael Collins

The most concise and useful history, analysis, and set of remedies regarding the financial crisis  is found right here in Numerian's latest post, What to do About the Banks.   He's the internet poster who has been warning about the calamity facing the economy since 2005 on The Agonist.   Read this post, which deserves to go viral, and listen to William K. Black's testimony before the House Financial Services committee, and you've got all the information you need to realize that we've been subject to an organized scam for nearly a decade, one that was enabled by that frightening menace, the "bipartisan coalition."

Numerian begins by distinguishing banking from the other financial services:

"The privileges accorded to the banking sector, especially the right to borrow money directly from the government and the right to take the public’s money in the form of deposits, are unique, and banking has always been thought of as a special sector of the economy that requires special government oversight to protect the interest of the taxpayers and the public as depositors.

"It is difficult to do banking properly, to gauge the credit-worthiness of potential borrowers, and to manage the bank’s liquidity so that it can meet cash demands under almost all circumstances. Because of this, banks do fail, and in such an event, the goal of the regulator is to minimize the losses to the government by liquidating bank assets at the best price possible, and to minimize losses to the public by guaranteeing most of the bank’s depositors. The goal of the regulators is not to prevent the bank from failing. If bank management senses it will be rescued under all circumstances, the due care and discipline necessary to manage bank risks properly disappears quickly."

Banking is more than just another business, it's a public utility.

The Great Depression produced reforms that worked well until 2000:

"Unarguably, this system worked well for nearly half a century until it began to break down in the 1970s. Investment banks began encroaching on commercial bank territory by taking on consumer deposits without any FDIC insurance. Large commercial banks began underwriting bond and stock issues for their customers. Both industries devised ways to move much of this activity off the balance sheet and out of the eyes of their regulators, their shareholders, or the general public. A new class of instruments arose called derivatives, which proved relatively useful and safe when confined to easily priced and liquid instruments like foreign exchange and short term loans, but which turned cancerous when applied to the securitization of long term mortgage loans. By 2000, among the big commercial and investment banks the concept of credit risk, as understood by the precept “know thy customer” had become old-fashioned. These institutions did not know their customer. They felt they didn’t need to in large transactions because the risk was immediately being securitized away to someone else (even though it was very clear these investors had far less of a chance of understanding the credit risk they were being sold). When it came to the millions of home equity, credit card, and auto loan customers, credit risk was done in the aggregate through models and credit scores. The only place traditional credit risk was being done in the U.S. was at the smaller community banks."

The new era was officially ushered in by the repeal of the Glass-Steagall Act and the enactment of the the Commodities Futures Modernization Act in 1999 and 2000 respectively. The eruption of an era of greed provided the high octane fuel to start the final storm and collapse.

"We cannot talk about this period, and we cannot intelligently talk about reform of the banking industry, without discussing two critical financial sectors which arose in the 1970s and were dominant players by 1990: the hedge fund industry, and the private equity, or leveraged buyout industry. Hedge funds are private pools of capital that to this day are completely unregulated, and that promise investors better returns than might be available from traditional mutual funds. Supposedly, they do this by both buying the market and sometimes being short the market (mutual funds are only long the market), but the truth is they can only generate large returns by taking on large risk through leverage. They may borrow two to three times the amount of assets they have in order to juice up their returns, and they are therefore intricately involved with the banking industry and its push for larger and larger amounts of credit being devoted to this industry. This in turn led to the banks placing this additional credit off balance sheet.

"The theory behind the leveraged buyout industry is that by taking poorly managed companies private, the industry can clean up these companies, install new management if necessary, reduce expenses, and bring them back to the public markets in a healthier form. The truth behind this industry is that it long ago ran out of truly badly run companies in need of their services, so the industry seeks out any company with assets that can liquidated, connives with management to buy the company from its shareholders, loads the company up with debt, takes out hundreds of millions of dollars of “fees” for itself, fires 25% or more of the staff, transfers production to China or other cheap manufacturing sites, and then makes millions of dollars more by bringing the company back to the public markets and selling shares to naïve investors. Few of these companies ever perform well in the long term once they go through this process, and many have not survived this recession. The private equity business is a predatory business that destroys manufacturing capital and enriches only the pockets of private equity companies. This too is an unregulated and secretive industry with heavy reliance on the banks for the loans to undertake their buyouts."

Numerian identifies the general changes needed followed by specific recommendations for banking regulation. In general, we can't afford "too big to fail" banks. We can't have this crisis repeated in another few decades. And we must "move away from debt as a product, to debt as a discipline." Then he delivers cultural critique that should be read as the opening prayer every day Congress meets:

"Our political and economic elites failed this country grievously. Our elites were consumed by greed and easy money, and while they encouraged the middle class consumer to live beyond their means through debt, the elite 2% of the population took home the lion’s share of the nation’s income. So pervasive has greed been, that we accept as natural the $500 million bonus of a private equity king, the perversion of Christianity that is taught as the “prosperity gospel” by evangelical ministers, the easy use of free jet travel from corporations that is lavished on Congressmen, the journalists who get rich becoming celebrities while abandoning their journalistic independence and responsibilities, the $50 million payouts given to CEOs who have failed at their jobs, the mega-million pay packages given to hucksters like Glenn Beck and Rush Limbaugh or mediocre baseball athletes, the fluidity with which the sons and daughters of the wealthy move into coveted slots at universities and cushy jobs in their father’s industry despite their manifest disqualifications for the work, the revolving door open to Congressmen and their staffers and various admirals and generals into consulting and board gigs that pay hundreds of thousands of dollars on top of the generous pensions these “public servants” receive, the speaking fees and book contracts that turn celebrity politicians like Bill Clinton and Sarah Palin into multi-millionaires, and so on and so on. Those who should be leading this country, and contributing to its development, have spent the past 25 years joining the parade of looters and predators who have found ways to extract wealth from the middle class and the poor in this country."

The final section of the article contains a series of precise remedies to reboot the current banking system and start the return to a financial system that works for the people instead of the few at the top who so relentless rig the game in their favor.

It's time to demand that real financial reform take place rather than the piecemeal efforts of retiring Senators and the highly compromised Secretary of the Treasury. It's fitting that the very best analysis and solutions are coming from outsiders. When you destroy the financial basis for an entire nation, that's where the very best solutions arise.  Who would begin to trust the insiders?




Original article:  What to Do About the Banks by Numerian



I think at this point

I wish you would talk about specifics. The reason is we here on EP have been digging into the specifics on current proposals and legislation. For example, your friend doesn't mention the credit ratings agencies at all. This is becoming more and more obvious they are complicit and also obvious is they have enormous power. Paulson, Geithner, Bernanke were perpetually worried about downgrades, as in sovereign downgrades. You can see what happens to Greece with a downgrade and then we have ratings over and over on junk and this was going on long before these CDOs were being peddled.

Then, on too big to fail, what precisely should be the crtieria to break them up? A hard size cap, a percentage of overall GDP, by function, reinstate Glass-Steagall? Bernie Sanders amendment failed, but not by much. But there is nothing so far on the credit ratings agencies and supposedly this "resolution authority" is still present.

They are going to pass something and that's soon and odds are we will get a bait and switch even while the current bill is crappy.

Also, there is no audit the fed in the bill at all, which was in the House version.

Reply to Robert Oak

Numerian here.

You are certainly right about the ratings agencies. They are at the center of this financial crisis. The reason I hesitate to recommend what to do about the ratings agencies is because, of all the players involved, they have the least likelihood of surviving. We've already seen the muni insurers collapse, and with lawsuits inflicting potentially fatal damage on Moody's, S&P and Fitch, we need to get a better idea of their survivability. They have lost the one thing that matters most to their franchise: their credibility. The market doesn't even pay attention to them when they talk about downgrading the Aaa rating of the U.S.

One thing that needs to be done is remove the Basel II Accord reliance on public debt ratings in lieu of bank or BIS ratings and capital assessments. I don't know if the BIS is working on this formally but it has been discussed.

Should these agencies survive, their model of accepting fees from those they rate has to change. Assigning them a regulator makes sense but doesn't solve the real problem of developing independent and fearless credit analyses and ratings that are not strictly model driven.

Regarding the point on TBTF, it seems if a bank is so big the FDIC hasn't the reserves to shut it down, it is TBTF. That doesn't mean there shouldn't also be caps on asset or deposit size, and we definitely need leverage caps, but the best way to tell a bank it must reduce size is to show it would otherwise bust the FDIC. What I don't know is whether a bank can throw a $10 billion contribution at the FDIC and buy itself the right to be much bigger, but I suspect not. That just reduces their ROE and defeats the purpose anyway.

credit ratings agencies survival

I don't see anything to imply they would disappear and their power over sovereign debt, the ability to downgrade, which affects interest rates, so much interwoven in their ratings (I think something about government, i.e. U.S. legislation proposals, removing their ratings as criteria was around but I don't know about the latest bills?) It seems generally we hear proposals, such as the ones you note, but it all is rhetoric, goes nowhere.

They should be investment cops. So, does that imply they should be funded by governments? (oh, ye taxpayer will love this idea not!)...

Somehow they need to be separate from their clients. Honestly I'm not sure how to do that, to separate out their conflict of interest. Do you create a pool, make them into government agencies (huge expense to the U.S. taxpayer for ?? benefit of Wall Street?), pull it into the Fed as a service, i.e. who pays? That stuff ain't cheap to put together? But obviously having the clients with the actual products pay them is a little beyond stupid.

In terms of lawsuits, it seems everything is always settled, the funds a fraction, more like a "kick back fee" that are awarded, takes years to get anywhere in these suits and even the governments cave and do "slap on the wrist" in terms of fines, so I don't think they will be sued to oblivion.

On the TBTF, the FDIC sounds like one idea, although this almost goes into that Resolution Trust Authority ($50B fund in the Senate),...but I have a focus on contagion, systemic risk. So, Volcker, separating out the commercial from the investment banking sounds like a start, but there needs to be more "firewalls" between institutions instead of this huge pile of dominoes. I think a hard cap in relation to GDP just doesn't sound efficient frankly, maybe some sort of regulator with 'break up' power but I think if the focus was on these inter-dependencies, seems again Glass-Steagall and Volcker are the closest to that, it's the way to go. Also, contagion from other countries, not just US banks (i.e. Societe Generale allowed to "place bets" via U.S. AIG, the peddling of toxic derivatives to all sorts of nations and towns).

But if they also regulated, heavily derivatives, that would reduce these inter-dependencies as I understand it. CDSes should not be allowed to exist in their current form. They do not make sense mathematically, from the models and they are also not baked up with capital. It's ridiculous to have those be "many to one". If corporations want insurance they should only be allowed to buy insurance on the underlying assets they actually own.

Structured Financial "Products", derivatives, CDOs, I'm sorry but if one cannot easily validate something and that's from the mathematics or computational model, right there it should not be allowed to exist. I mean legitimate mathematical models go bad and there we are, cooking with mathematical and computational fiction? Hello?

Care to create an account on EP and cross post, write directly?