I’ve been a bit surprised by the amount of agonizing in the financial media (and among politicians) over the question of what caused the recent “financial meltdown,” as it’s being called. The reason I’m surprised is because the answer is very simple and obvious.
Let me run through the background briefly before stating the obvious:
We’ve been hearing that the current “crisis” is “the worst since the Great Depression.” I’m not so sure about that, but the Great Depression is a handy place to start. During that prolonged and severe economic downturn, hundreds of banks across the United States failed. In response, the administration of Franklin Roosevelt instituted numerous regulatory safeguards intended to prevent a repetition. Among those New Deal safeguards (most of them contained in what became known as the Glass-Steagall Act):
* Commercial banking – involving the taking of deposits and making of loans – and investment banking – involving the underwriting of investment securities – were separated.
* Commercial banks also were barred from acting as stockbrokers or insurers.
* Commercial banks were required to charter separate holding companies in every state where they operated, effectively preventing any bank from doing business nationwide.
* The Federal Deposit Insurance Corp. was created to guarantee that customers would not lose their deposits in the event that a bank did fail.
Similar safeguards also were set up to protect the savings and loan industry, which was confined to making residential loans, in contrast to commercial banks, which could also write mortgages on commercial property.
These safeguards worked pretty well for many years from the perspective of protecting depositors and keeping the banking system out of trouble. One side-effect, however, was that bank stocks came to be regarded as dull, unglamorous, slow-growth investments, something for risk-averse old fogies to hold.
As time passed and new generations of executives poured out of the business colleges and into the banking industry, the trauma of the 1930s faded, and some of those freshly minted MBAs started looking for ways to jazz up the sector and make bank stocks a more attractive option for aggressive investors.
The first big change came mainly during the 1980s, when the industry mounted a full-scale assault on interstate banking restrictions. As those restrictions were eased, big regional and “super-regional” banks emerged through mergers. One of the most significant of those was the merger of C&S-Sovran (itself formed by the merger of Georgia-based Citizens & Southern with Virginia-based Sovran) with NCNB (formerly North Carolina National Bank) to form Nationsbank. Not quite 20 years (and numerous further mergers) later, Nationsbank is now Bank of America.
Through the 1990s, the industry continued to chip away at the New Deal safeguards. In rapid succession, banks were allowed to open securities brokerages and to sell insurance. (And just as rapidly, problems arose; the aforementioned Bank of America, for example, settled a class-action lawsuit that had accused its brokerage salespeople of misleading customers into thinking their investment accounts were protected by the FDIC.) By 1999, industry lobbyists had been so successful in persuading lawmakers to remove the firewalls and other protective measures that the final repeal of Glass-Steagall that year was largely a formality.
That this removal of safeguards was inherently very risky seems not to have crossed anyone’s mind, despite the implosion of the savings and loan industry only a few years before. That “crisis” came about when the industry was allowed to start making loans on commercial real estate. Thrift executives with no experience in commercial property started throwing money around like inebriated conventioneers in Las Vegas, rushing to offer financing for a zillion speculative strip malls. When the economy went into recession in mid-1990 and those strip malls couldn’t find tenants, the S&Ls saw their loan losses skyrocket, and eventually the federal government had to step in.
Which of course is exactly what’s happening now, and for much the same reason: because industry executives with newfound freedom from regulatory safeguards and dollar signs in their eyes and a concomitant belief in perpetual economic expansion rushed headlong into investments they didn’t understand very well. What’s more, abetted by the real estate industry, they dragged a lot of financially unsophisticated customers along with them, putting people into far more house than they could afford by creating new kinds of highly “leveraged” mortgages that were guaranteed to go sour at the first hint of economic trouble.
So to the question that’s vexing so many – “Why is the banking system teetering on the verge of collapse?” – here’s one way of answering:
Suppose your city has burned to the ground, and you learn that the cause was some kids playing with matches. You quite reasonably forbid any kids to play with matches ever again, and you rebuild your city. And after a while, after you’ve gotten used to living in your rebuilt city, some more kids come to you and say, “Can we play with matches now?” What do you expect to happen if you say yes?
Tuesday, October 21, 2008
Playing with Fire
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2 comments:
This history of banking regs is interesting. With all the current talk about the banking bail-out being "socialism", I'd like to know what dereg has to do with government ownership and socialism.
That "socialism" talk is a throwback to primeval anti-New Deal rhetoric, in which every form of safety net for workers was attacked as "creeping socialism." You know, things like the 40-hour workweek, the minimum wage, Social Security.
To a degree, the current complaints are based on the idea that the Paulson-Bernanke plan for the U.S. government (i.e., taxpayers) to own stock in financial companies amounts to "nationalization" of those companies, sort of like what Hugo Chavez is doing with the oil industry in Venezuela. So it's an invidious comparison.
Also behind some of the complaining is the modern Libertarian dogma that says government really shouldn't do anything for anyone; instead, we all - and I guess that includes corporations - should pay out of our own pockets for everything we want or need. In my opinion, that approach amounts to a total abrogation of the Social Contract, which of course holds that people join together to form governments in the first place because there are some things we can do better collectively than individually, such as build roads, maintain law and order, and defend ourselves against violence domestically and internationally. I guess in the Libertarian view, we're all supposed to send our children to private schools and employ our own personal bodyguards.
As for deregulation, it's about rolling back not only the protections instituted by FDR, but also those set up by those wild-eyed Commies William McKinley and Theodore Roosevelt - things like the Pure Food and Drug Act, the Sherman Antitrust Act, etc., and the agencies that used to enforce them, such as the FDA and FTC. And the purpose of deregulation is to reduce costs/increase profit margins for business owners, because, as some Chinese dairy producers can attest, unsafe products are cheaper to make than safe ones, and risky strategies can provide a bigger, faster return.
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