IT’S A WONDERFUL LIFE
By Melvin J. Howard
Before I get into my entry for this week I thought I should make a disclaimer there has been a lot of an American bashing lately and some of it rightly so. But enough is enough its just like when you are getting a divorce. You can talk bad about you’re pending ex-spouse but you don’t want anybody else too. That’s how I feel when I am in a foreign country and people start bad mouthing the US. Although there is a lot of turmoil going on in the US financial, real-estate and capital markets. The US stands for free markets through out the world and I would not have it any other way. I am proud that in America you have choices and until you go to some other countries and have those choices denied or worst non-existent. Then it hits home for example can you imagine having one phone company to choose from one cable company, three or four banks, one gas company, two or three wireless phone carriers, not able to choose your doctor or to find one to take you on. Not getting the surgery or treatment you need in a timely manner. Not having access to top notch technology, one or two television networks that are so intertwined with their government that no real news gets out. The list can go on and on what I am saying is Capitalism is America’s trademark. Socialism and Communism are relics of the past. Where else but in America you could be dirt poor and rise to become a billionaire. Or a black man that was virtually unknown a year ago. Now is a serious presidential candidate the amount of money that he has raised also says something of the man himself. A lot of countries will advertise or promote diversity. But you do not see ethnic high ranking officials in judicial, governmental, corporate, police and finance etc. In America we put it to practice time and time again. Any writing that I do is not to bash but to point out something here is wrong and we need to correct the problem like the one now. As you will see as you read through this the tools are there to even fix this crisis.
Remember in it’s a wonderful life Jimmy Stewart’s character had to step in and restore the confidence of his depositors when everybody wanted their money at the same time. Not good for banks no matter what country they are in. Well in the biggest bank failure of the housing downturn to date, federal banking regulators closed IndyMac Bank. The bank's parent company, IndyMac Bancorp Inc., was one of the nation's largest independent mortgage lenders, and had been hard hit by delinquencies and foreclosures. IndyMac Bancorp Inc. announced Monday that it was no longer considered "well capitalized" by regulators and had stopped making most mortgage loans. This calls into questions how are other banks health tied to mortgage lenders doing? Convoluted and confusing financial statements of banks and large corporate institutions serve no good purpose for anybody. Warren Buffet says he only buys companies he understands and I am with him on that 100%. Have you taken a look at some of the financials of some of the conglomerates lately? You have to be versed in hieroglyphics how can you tell if the company or bank is about to blow up. You have to ask yourself do these accounts reflect reality like who deposited how much, when and subject to which conditions and who borrowed what, when and subject to what terms. These arrangements are so stealthy and convoluted that sometimes even the shareholders of the bank lose track of its activities and misapprehend its real situation. Unscrupulous management and staff sometimes take advantage of the situation. Embezzlement, abuse of authority, mysterious trades, misuse of funds are more widespread than acknowledged.
The thunderous disintegration of the Bank for Credit and Commerce International (BCCI) in London in 1991 revealed that, for the better part of a decade, the executives and employees of this penumbral institution were busy stealing and misappropriating $10 billion. The Bank of England's supervision department failed to spot the rot on time. Depositors were - partially - compensated by the main shareholder of the bank, an Arab sheikh. The story repeated itself with Nick Leeson and his unauthorized disastrous trades which brought down the venerable and veteran Barings Bank in 1995. The combination of black money, shoddy financial controls, shady bank accounts and shredded documents renders a true account of the cash flows and damages in such cases all but impossible. On to the stratospheric rise in Wall-Street in the last few years.
Potentially the most pernicious type of asset bubble is. When financial institutions lend to the unworthy but the politically well-connected, to cronies, and family members of influential politicians they often end up fostering a bubble. South Korean chaebols, Japanese keiretsu, as well as American conglomerates frequently used these cheap funds to prop up their stock or to invest in real estate, driving prices up in both markets artificially. Moreover, despite decades of bitter experiences from Mexico in 1982 to Asia in 1997 and Russia in 1998 - financial institutions still bow to fads and fashions. They act herd-like in conformity with "lending trends". They shift assets to garner the highest yields in the shortest possible period of time. In this respect, they are not very different from investors in pyramid investment schemes. Asset bubbles in the stock exchange, in the real estate or the commodity markets invariably burst and often lead to banking crises like now. One such calamity struck the USA in 1986-1989. It is instructive to study the decisive reaction of the administration and Congress alike. They tackled both the ensuing liquidity crunch and the structural flaws exposed by the crisis with tenacity and skill. Compare this to the lackluster and hesitant tentativeness of the current lot. True, this crisis is the result of a speculative bubble that concerns the banking ,real estate and the capital markets. But the similarities are there. The savings and loans association, or the thrift, was a strange banking hybrid, very much akin to the building society in Britain. It was allowed to take in deposits but was really merely a mortgage bank. The Depository Institutions Deregulation and Monetary Control Act of 1980 forced S&L's to achieve interest parity with commercial banks, thus eliminating the interest ceiling on deposits which they enjoyed hitherto.
But it still allowed them only very limited entry into commercial and consumer lending and trust services. Thus, these institutions were heavily exposed to the vicissitudes of the residential real estate markets in their respective regions. Every normal cyclical slump in property values or regional economic shock - e.g., a plunge in commodity prices - affected them disproportionately. Interest rate volatility created a mismatch between the assets of these associations and their liabilities. The negative spread between their cost of funds and the yield of their assets - eroded their operating margins. The 1982 Garn-St. Germain Depository Institutions Act encouraged thrifts to convert from mutual - i.e., depositor-owned - associations to stock companies, allowing them to tap the capital markets in order to enhance their faltering net worth. But this was too little and too late. The S&L's were rendered unable to further support the price of real estate by rolling over old credits, refinancing residential equity, and underwriting development projects. Endemic corruption and mismanagement exacerbated the ruin. The bubble burst. Hundreds of thousands of depositors scrambled to withdraw their funds and hundreds of savings and loans association (out of a total of more than 3,000) became insolvent instantly, unable to pay their depositors. They were besieged by angry at times, violent - clients who lost their life savings. The illiquidity spread like fire. As institutions closed their gates, one by one, they left in their wake major financial upheavals, wrecked businesses and homeowners, and devastated communities. At one point, the contagion threatened the stability of the entire banking system. The Federal Savings and Loans Insurance Corporation (FSLIC) - which insured the deposits in the savings and loans associations - was no longer able to meet the claims and, effectively, went bankrupt. Though the obligations of the FSLIC were never guaranteed by the Treasury, it was widely perceived to be an arm of the federal government. The public was shocked. The crisis acquired a political dimension. A hasty $300 billion bailout package was arranged to inject liquidity into the shriveling system through a special agency, the FHFB. The supervision of the banks was subtracted from the Federal Reserve. The role of the Federal Deposit Insurance Corporation (FDIC) was greatly expanded. Prior to 1989, savings and loans were insured by the now-defunct FSLIC. The FDIC insured only banks. Congress had to eliminate FSLIC and place the insurance of thrifts under FDIC. The FDIC kept the Bank Insurance Fund (BIF) separate from the Savings Associations Insurance Fund (SAIF), to confine the ripple effect of the meltdown. The FDIC is designed to be independent. Its money comes from premiums and earnings of the two insurance funds, not from Congressional appropriations. Its board of directors has full authority to run the agency. The board obeys the law, not political masters. The FDIC has a preemptive role. It regulates banks and savings and loans with the aim of avoiding insurance claims by depositors. When an institution becomes unsound, the FDIC can either shore it up with loans or take it over. If it does the latter, it can run it and then sell it as a going concern, or close it, pay off the depositors and try to collect the loans. At times, the FDIC ends up owning collateral and trying to sell it.
Another outcome of the scandal was the Resolution Trust Corporation (RTC). Many savings and loans were treated as "special risk" and placed under the jurisdiction of the RTC until August 1992. The RTC operated and sold these institutions - or paid off the depositors and closed them. A new government corporation (Resolution Fund Corporation, RefCorp) issued federally guaranteed bailout bonds whose proceeds were used to finance the RTC until 1996. The Office of Thrift Supervision (OTS) was also established in 1989 to replace the dismantled Federal Home Loan Board (FHLB) in supervising savings and loans. OTS is a unit within the Treasury Department, but law and custom make it practically an independent agency. The Federal Housing Finance Board (FHFB) regulates the savings establishments for liquidity. It provides lines of credit from twelve regional Federal Home Loan Banks (FHLB). Those banks and the thrifts make up the Federal Home Loan Bank System (FHLBS). FHFB gets its funds from the System and is independent of supervision by the executive branch. Thus a clear, streamlined, and powerful regulatory mechanism was put in place. Banks and savings and loans abused the confusing overlaps in authority and regulation among numerous government agencies. Not one regulator possessed a full and truthful picture. Following the reforms, it all became clearer: insurance was the FDIC's job, the OTS provided supervision, and liquidity was monitored and imparted by the FHLB. Healthy thrifts were coaxed and cajoled to purchase less sturdy ones. This weakened their balance sheets considerably and the government reneged on its promises to allow them to amortize the goodwill element of the purchase over 40 years. Still, there were 2,898 thrifts in 1989. Six years later, their number shrank to 1,612 and it stands now at less than 1,000. The consolidated institutions are bigger, stronger, and better capitalized. Later on, Congress demanded that thrifts obtain a bank charter by 1998. This was not too onerous for most of them. At the height of the crisis the ratio of their combined equity to their combined assets was less than 1%. But in 1994 it reached almost 10% and remained there ever since. This remarkable turnaround was the result of serendipity as much as careful planning. Interest rate spreads became highly positive. In a classic arbitrage, savings and loans paid low interest on deposits and invested the money in high yielding government and corporate bonds. The prolonged equity bull market allowed thrifts to float new stock at exorbitant prices.
As the juridical relics of the Great Depression chiefly amongst them, the Glass-Steagall Act were repealed, banks were liberated to enter new markets, offer new financial instruments, and spread throughout the USA. Product and geographical diversification led to enhanced financial health. But the very fact that S&L's were poised to exploit these opportunities is a tribute to politicians and regulators alike though except for setting the general tone of urgency and resolution, the relative absence of political intervention in the handling of the crisis is notable. It was managed by the autonomous, able, utterly professional, largely a-political Federal Reserve. The political class provided the professionals with the tools they needed to do the job. This mode of collaboration may well be the most important lesson of this crisis.
