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Too Small To Compete, Too Big To Fail

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As I write this, we have a new president who is promising initiatives to cure the current economic crisis. We wish him well and hope his efforts work.

The financial meltdown that we have experienced will no doubt be the subject of extensive analysis in the years to come. There will be plenty of finger-pointing and attempts to fix the blame, much of it politically motivated. The big question will be: Did we learn anything that will help avoid future meltdowns? History, I believe, indicates that economic memory is short and the most likely answer to that question is no.

I say that because even now a realization is starting to set in that the cause of the bank meltdown started some years ago when a cardinal rule was violated. The rule in point: “Never tear down a fence until you know why it was put there in the first place.”

In 1933, following the “bank holiday,” Congress passed the Glass-Steagall Act, which essentially placed a wall between commercial banks and commerce. It prohibited them from collaborating with full service brokerage firms or participating in investment banking activities. The purpose was to protect the depositors from the additional risks of security transactions.

As time passed and memory dimmed, major banks lobbied hard to tear the fence down so they could expand into the world of commerce. In an act of supreme arrogance, Citicorp merged with Travelers using a loophole in Glass-Steagall that permitted temporary associations, and then they went to Congress, after the fact, to make it legal on a permanent basis. To make it legal the fence provided by Glass-Steagall had to go. Led by then Senator Phil Gramm and cheered on by then Treasury Secretary Rubin, the Gramm-Leach-Bliley Act was passed in 1999 and the fence came tumbling down. Among other things, mortgages were bundled as securities and the result of that appears in the daily news.

But the banks have had help, and warnings that also go back to 1999. In an article which appeared in the September 30, 1999 issue of the New York Times, Steven A. Holmes had this to say, “In a move that could help increase home ownership rates among minorities and low-income consumers, the Fannie Mae Corporation is easing the credit requirements on loans that it will purchase from banks and other lenders.

“The action, which will begin as a pilot program involving 24 banks in 15 markets–including the New York metropolitan region–will encourage those banks to extend home mortgages to individuals whose credit is not good enough to qualify for conventional loans. Fannie Mae officials say they hope to make it a nationwide program by next spring.

“Fannie Mae, the nation’s biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits.

“In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called sub-prime borrowers.

“Fannie Mae has expanded home ownership for millions of families in the 1990′s by reducing payment requirements,” said Franklin D. Raines, Fannie Mae’s chairman and chief executive officer, “but there remain too many borrowers whose credit is just a notch below what our underwriting has required who have been relegated to paying significantly higher mortgage rates in the so-called subprime market.

“In moving, even tentatively, into this new area of lending, Fannie Mae is taking on significantly more risk, which may not pose any difficulties during flush economic times. But the government subsidized corporation may run into trouble in an economic downturn, prompting a government rescue similar to that of the savings and loan industry in the 1980′s.”

More recently, borrowers have also contributed to the crisis. Many of the subprime loans would likely have succeeded if borrowers had not used their home equity as an ATM. As home values increased, pressure to use the increased equity to finance consumption and investment came from many sources: banks pushing home equity loans, mortgage brokers “selling” refinancing, and some financial advisors selling “capital transfer,” that is, moving home equity into investments.

Before Congress, meanwhile, the mantra of bank lobbyists continued to be that banks had to grow in order to compete in the global market. Congress obliged and, according to news reports, prominent members of Congress–both in the House and Senate–played significant roles in this road to ruin. And now, sadly, their growth has made them too big to be allowed to fail.

A lesson in how not to compete in the global market can be gleaned from studying the financial collapse in Iceland. All three major banks have failed and Iceland’s currency is in the tank–all because of overzealous banking activity in the global market. Unfortunately, the government of Iceland does not have the resources to bail out the banks, so there will be worldwide repercussions.

It is time to return banks to their primary function of financing commerce rather than being a part of commerce. The fence needs to be rebuilt, but so far a champion for that cause has not appeared. If the new administration is really interested in change, this may be the opportunity.


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