Too Big to Fail

Banks are like construction cranes, poised high above a building site on a needle thin scaffolding.

There is a debate taking place in America, particularly within the Democratic primary, about banks and whether they make a systemic risk to the American financial system.   Republicans are busy with other issues, fighting over personalities and delegate acquisition and how much worse the economy has gotten in these seven years.

FDIC and Federal Reserve report in today's news

But Democrats are having a real debate over issues, and many voters feel disappointed that the Obama administration did not pursue criminal charges against various bankers for fraud or other crimes.  I saw the disaster in the financial system from within it, but not the front row.   I was a branch employee of Citibank, one of the greatest malefactors and victims of the crisis, an employee whose business was then transferred to Morgan Stanley, another malefactor and victim.   It was my job to explain what was going on to clients and to attempt to protect them against losses in the event the entire system collapsed, an event that seemed quite plausible during an approximate 12 month period of August, 2008-August., 2009.

Simply put, during a period of extraordinarily loose credit standards a real estate boom apparently justified creation of pools of mortgages that were considered risk free (AAA) because they were backed by the underlying real estate.   This allowed banks (and non-banks like Goldman Sachs, Morgan Stanley, Lehman Brothers) to package and sell--and then hold for their own accounts--mortgage pools that supposedly had a risk free yield of 4-7% bought with money borrowed at 1%, a very, very profitable arrangement.   It fell apart when it became obvious to everyone that the real estate was worth less than anticipated, that the mortgage pools were worth less than face value, and that the money the institutions had borrowed was way greater than the value of the mortgage pools.

What then happened is that liquidity dried up.   The mortgages were worth something, maybe even close to face value.  But because it was unclear what they were worth they could not be sold to anyone at any price.   It was a liquidity issue as well as a valuation issue.   But banks needed to show that the money they owed lenders for purchasing the mortgages was balanced by the value of the mortgage assets they held.  If so, then the banks were solvent.  If not, they were not.   But they could not show the mortgages had any value because there were no buyers of last resort.

Picture that construction crain.   It can pick up many tons of stuff at the end of the boom in front of it, but only so long as the weight is balanced by an equivalent weight on the back.  In the financial crisis of 2008-09 the weight in front (the money the banks owed) was very apparent and measurable but they asset they owned (the mortgages) had no apparent value because they could not be sold.   They couldn't be sold because no one had confidence that the bank they were doing business with wasn't one day away from collapse, the construction crain tipping forward off its perch.

The government stepped in to provide liquidity and assurance the banks were solvent.   At the time it was argued that banks were a public good, that everyone needs banks, that banks are necessary for a place for everyday people out in the regular economy to deposit checks, issue payments to others, etc.   A guest post author, Thad Guyer, currently living in Saigon, Vietnam informs me that the business of paying for things, something so simple and effortless in America that we give it almost no thought, requires him and his agent one full business day every month.  One needs to go to the landlord's office to pay, in currency, the month's rent.   Same with electricity, phone, and other regular bills.  

The result is that banks stayed open, paychecks got deposited, bills got paid, and the government extracted a big investment in the banks, but they stayed independent, though regulated more tightly--Dodd Frank.   Democrats generally think the punishment to the banks was not enough.  Republican presidential candidates condemn Dodd Frank: it is too much.

My own sense is not one voter in a thousand has any real comprehension of the merits or demerits of the case and the people who are expert enough to have an informed opinion disagree.   The cheering for breaking up the banks by Democrats is simply cheering for a position backed by an impression that banks like Citibank and Goldman Sachs are undoubtably corrupt and they got away with cheating Americans; Republican cheering to end Dodd Frank is equally uninformed, backed by an impression that the government is probably wrong when it regulates anyone, and Senator Dodd and Representative Frank are Democrats so it probably is a very bad law.

Democratic candidate clash

It is way more complicated than that.    Capitalism requires financial institutions.

It is enormously convenient for Americans to have checking accounts, automatic withdrawals, credit cards, etc.    I just bought $300 worth of supplies for my melon business from a vender in Ohio, and paid to have them sent here instantly and reliably.   I could never have purchased them had I needed to find a secure agent in Ohio to go to their factory, stand in line, and pay with currency.    It takes banks and institutions that act like banks (Credit Unions, money market funds, mortgage companies, mutual fund companies) to finance businesses, to handle mortgages, to allow the economy to function.  

From Bernie Sanders Campaign Website

Bernie Sanders has an appealing argument when he says that banks did bad things (sold mortgage pools they knew were riskier than they let on), do self-interested things (tighten the bankruptcy rules and lobby to keep student loans at an interest rate way above market rates) and that they are still too big to let fail (today's news.)  Bernie was revealed in his interview with the Daily News to have had a more shallow knowledge than would be expected of someone arguing clearly for banks to be broken up of the implications that breakup, and how to accomplish it.  

It is Hillary's curse as a candidate that her solutions are more nuanced and complicated and gradual than Bernie's, and therefore harder to sell and less emotionally satisfying to hear.  She speaks of the need to regulate banks and shadow banks (i.e. investment banks and money funds and insurance companies which provide bank-like services without actually being banks.)    They need to be regulated, too, she says, because they can cause a crisis as easily as can a bank.

What is the bottom line?   What does it mean for Bernie or Hillary?   The government can never and will never get out of the bank regulation and ultimate safety net for banks and shadow banks.  It was a central fight between Andrew Jackson and the money men of New York 190 years ago and it is still an issue.   It is the nature of banks that they make a promise of liquidity while holding less liquid assets as collateral, which makes them subject to a run on the bank if confidence in bank solvency and liquidity falters in some crisis.   Ultimately the Central Bank--in the USA, the Federal Reserve, the Fed--with control of the currency, must be the lender of last resort to banks.  Only they can create money in a crisis.  Things happen. 

Bernie's argument is clear and simple and understandable.   
Hillary's is more subtle and complex, with no applause lines.   

Bernie wins support of Democratic crowds.  
Hillary impresses and reassures the business community.

Bernie wins the short game in the primary election.
Hillary wins the longer game of seeming to be "responsible".

Bernie says Hillary with being "too close to Wall Street", which damages her in primary.
Hillary reassures the business community, which may help her win the general election.