9
making the most of the banking system
BANKING IS THE business of finance. It has been ridiculed and almost nationalized, but it is not broken. The financial system ran aground in the first decade of the twenty-first century because it abandoned the direct borrower/lender relationship in favor of a complex geometric expansion of unsustainable credit through exotic financial instruments. Today’s major money-center banks are transaction oriented. They are conditioned to volume and processed by computers, and they do not take into account the human element. But, even in the wake of the recent financial crisis, smaller banks have not abandoned this approach, and they can be a great asset to the entrepreneur.
To run a business, you will need a bank. You will definitely be a depositor, and you will likely need to get credit either by borrowing money or by opening a revolving line of credit to draw on for various reasons, such as expanding your company or bridging a gap in your receivables. To obtain this credit in the smartest possible way, you need to know how the banking system works.
Let’s say you apply for credit and are turned down. That does not necessarily mean your business is not worthy of a loan or a line of credit. It may not be your fault; it may be the banker’s. The banker may be restricted by federal regulations from giving certain kinds of loans, and he may not tell you that. For example, the FDIC might have placed the banker under either what is called a Memorandum of Understanding (MOU) or the next step down, which is a Cease and Desist Order (C & D) or Consent Decree, in which case that bank cannot make you any loans. And if you already have a revolving credit line, you need to understand how and why it may be called and, more important, how to avoid this.
The four banks in which I have held an ownership stake—located in suburban Phoenix, the Century City section of Los Angeles, San Jose, and Crestview, Florida—have operated very profitably by staying away from subprime loans, credit default swaps, and derivatives. They are healthy because they are not in ancillary businesses. They operate on the old-fashioned banking principle rooted in the “know-your-customer” rule. They are community minded and more personal, and they are the type of bank that favors the small businessman.
I first became involved in the banking business in 1979 when Lew Wolff, his close friends Phil DiNapoli and Ted Biagini, and I started a bank in San Jose, California, called The Plaza Bank of Commerce. Lew, who had spearheaded the redevelopment of San Jose, determined there was a need for a bank in that area, and, with the backing of the DiNapoli family and a good management team, the bank became very successful.
Through this experience, I saw how a community bank that catered to the small business and individual loan market on a highly personalized basis could be exceptionally profitable. The value of the stock increased sevenfold over ten years, and the bank was eventually sold to Comerica, a large retail bank then based in Minneapolis and now headquartered in Dallas. I also learned how to make this critical resource work for me as a small business owner, an absolutely essential ingredient to any entrepreneur’s existence.
Any entrepreneur or person doing any sort of business must find a bank where he or she can establish a personal relationship with a banker. If a banker knows the customer, that is better than any financial statement because anybody can manipulate numbers on a piece of paper. The banker will look beyond the conventional and ask questions about the borrower’s personality and background and past personal experience and will not reduce everything to a computerized profile that says nothing about the borrower that differentiates him or her from any other cipher.
The truth is that the banking business should be relatively simple because it is so highly regulated; therefore, understanding how the system works is essential. The federal government, through the Federal Deposit Insurance Corporation (FDIC), has long guaranteed individual depositors up to $100,000 (raised to $250,000 in the fall of 2008); therefore, banks are deservedly subject to more intense rules and regulations than other businesses. Federal and state regulators go through a bank’s books to make sure the institution meets deposit and lending ratios. The banks are rated under a CAMEL rating system—capital, assets, management, earnings, and liquidity—and given a score from 1 to 5, with 1 being the gold standard and 5 meaning you’re ready to close the doors next week. All of this is reported to the FDIC, which then makes it public.
The entire financial underwear of every bank is on display. All you have to do is go to your computer, pull up the website www.fdic.gov, and type in the name of the bank. Whether you are applying for a loan or depositing your money in a bank, it is critical that you do some homework and find out the health of your bank. You do not want to be the one left holding an empty bag.
the right banker makes all the difference
One of the first things to realize is that bankers as a whole are not required to be imaginative people. The key word in that sentence is “required.” No matter the size of the institution, you will not find an exceptional level of discretionary management expertise in the banking business, principally because it is so highly regulated. On the other hand, when you get superior management, the results can be reflective.
The regulatory requirements are clearly spelled out. A bank is taking in money at one price and lending it out at a higher price. The difference is called the spread. The bank deducts its operating costs from the spread, and the rest is profit. The price of this money is controlled to a great extent by the government’s central bank, the Federal Reserve, through its open-market operations and what it sets as an interbank lending rate.
A bank is not a building; it is a people business. You do not do business with a building. You do not bank with a particular institution because it has a giant edifice at the corner of 50th and Fifth Avenue in New York City. You do business there because you know somebody at the bank who knows you. That is the way the banking business began. Amadeo Giannini started the Bank of Italy (which became Bank of America) in 1904 in San Francisco by lending to Italian immigrants because nobody else would. But he knew the people, and this knowledge allowed him to make successful loans.
Such loans are called character loans, and, regardless of anything else, character is the most critical element and tells you why you need a personal relationship. There was a time in the banking business when the local banker knew everybody in the town and everyone knew him. Loans were based on a person’s character. Bankers who were not raised in the electronic era will tell you even today that a character loan is the best kind of loan. You can throw the financial statement out the window; it’s just there to decorate the file. If the banker knows the borrower and the borrower’s family, business, and collateral, that is better than any financial statement because anyone who is desperate enough can write down exaggerated numbers on a piece of paper. However, today’s major money-center banks are transaction oriented. They are conditioned to volume and processed by computers, so they do not take into account the human element.
This point is underscored by a story my uncle told me once about a man in a small town in Alabama who walked into a bank and addressed the teller.
“I want to borrow a thousand bucks,” the man said.
“Do you have any collateral?” the teller asked.
“Yes,” he replied. “I am holding four aces in a poker game above the barber shop across the street.”
“Sorry, sir,” the teller laughed. “The bank will not lend on that.”
The president of the bank was passing by and knew the man. “Hey, Joe, how’s it going?”
“Great,” he said. “I’m holding four aces in the poker game across the street, but I’m short.”
“How much do you need?” the bank president asked.
“A thousand dollars,” Joe said.
“You got the hand with you?”
The man reached into his vest pocket and spread the hand for the banker to see.
The bank president turned to his teller and said, “Give him the money.”
Why? First, because he had known Joe a long time and knew him to be a man of his word. Second, he saw the collateral. Third, he understood the risk.
I have lived through many variations of that story. I once had a banker to whom I went for a loan that my financial statement would not support. I said, “I’m going to run this by you, but I don’t think it’s going to fly.”
The banker asked me what the loan was for, and I explained that it was to invest in a promising real estate deal. After I gave him an overview on the project, he said that he’d grant the loan. When I cautioned him that he was going to have trouble with the loan committee, he told me he would handle them. Curious, I asked what he would tell them.
“I’ll tell them that it is for a solid investment, and I’ll tell them about you,” the banker explained. “In the five years you’ve banked with me, you have never been late on a payment. You have always lived up to your word. If you said you would be here at two o’clock on the first of the month to pay off a loan, you were here at two o’clock with the money. Your word was your bond. That is what I’m going to tell them.”
That is the kind of banker you want. It may take time to develop such a relationship, but it will be worth it in the long run, particularly if you want to start a new venture.
Wallace Malone, a friend of mine who was chairman and CEO of SouthTrust, a multimillion-dollar, six-hundred-branch bank that later merged with Wachovia, ran the bank that way. If he knew a borrower was having trouble and the borrower came to him and explained his problems—not ducking his responsibilities but doing his best to solve them—Wallace would work with the borrower. He would come up with an accommodation, say interest-only for the next three months, until the problems were worked out.
Wallace’s philosophy was that no bank wants a bad loan on its books. The bank wants its borrower to succeed. It is like the Mob. They don’t want the guy who owes them money dead; dead people don’t repay their loans. That’s why they don’t kill him and put him out of business; they make an “accommodation.”
why the big banks failed
From late 2008 until well into 2010, big banks stopped lending money to many businesses, curtailed their lines of credit, and called their loans. Every day, the news was filled with stories of shop owners closing their doors because they could not access the credit they needed to survive. The way the system is set up, this will likely happen again, and it may be even worse the next time around. Understanding what happened and why may help you avoid losing your business during the next crisis.
Let’s back up for a moment and see how we arrived at this point. Our system of banking rules was forged out of the crash of 1929 and the recommendations laid down in the subsequent Pecora hearings in 1933, and it worked well until Congress began to unravel it in the late 1980s. (The Pecora Commission, named after chief counsel Ferdinand Pecora, was convened by the Senate Banking Committee to investigate the causes of the crash.)
The hearings uncovered a wide range of abuses by banks, such as the fact that they were underwriting bad securities to pay off debt. The biggest violator was National City Bank, the precursor to Citibank. (How about this for irony: Citibank was bailed out by the American taxpayer in 2008 after underwriting bad securities.) These hearings resulted in sweeping securities reform and the creation of the Securities and Exchange Commission (SEC) to regulate the industry.
They also led to the passage of the Glass-Steagall Act, which prohibited banks from owning other financial companies, and created the Federal Deposit Insurance Corporation (FDIC) to insure consumers’ bank deposits. Contrary to popular belief, the FDIC insurance fund does not come from taxpayer money. It comes from assessments on the banks themselves, a distinction that the public does not realize.
In the late 1980s, the large banks began lobbying Congress to overturn Glass-Steagall, thereby allowing them to enter the securities and insurance businesses. They claimed that permitting them to do so would enhance competition and benefit the consumer by lowering prices for financial services.
I was asked to testify on this matter before the Subcom -mittee on Financial Institutions of the House Committee on Banking, Finance, and Urban Affairs in February 1988. I tried to convince the subcommittee that abandoning Glass-Steagall would be a major mistake because it would lead to a breach of the foundation on which the banking system was built: confidence and trust. Another witness that day was the Nobel laureate Lawrence Klein of the Wharton School, whose testimony was identical to mine.
I started by asking how many committee members had read the transcripts of the Pecora hearings. I might as well have been talking to a wall, because no one said a word. Mind you, these weren’t tellers at your local bank; these were members of Congress charged with regulating the U.S. banking system. I then pointed out that all the evidence they needed to deny banks the right to enter the securities industry could be found in the Continental Illinois debacle.
What was that? In 1984, Continental, the seventh largest bank in the United States at the time, had become insolvent due to bad oil and gas loans that it had purchased from Penn Square Bank in Oklahoma City. In the largest bank rescue to that date, the FDIC bailed out Continental because it feared the bank’s failure would spread panic and create a domino effect in the financial system. Sound familiar? But then, in early 1987, the FDIC allowed Continental to wander into the securities business by purchasing First Options, a move that resulted in a $500 million loss for the bank. Continental was subject to perhaps the highest level of federal bank regulatory scrutiny of any financial institution in the country at the time—and still it was allowed to branch out into uncharted waters at the expense of the taxpayer. This is a prime example of why regulation, as opposed to legislation, does not work.
Finally, I testified that overturning Glass-Steagall would lead to the creation of large financial institutions that would one day become “too big to fail” and predicted that, as lender of last resort, the federal government would have to bail them out. I predicted that the abuses that contributed to the 1929 crash would once again prevail. Again, in the words of Santayana, “Those who cannot remember the past are condemned to repeat it.”
Nevertheless, in the early 1990s, the large American banks complained to Congress that they could not compete in the world market because the Japanese banks were moving into the United States and stealing their business; therefore, they needed to become bigger. The bankers dispatched their lobbyists to Capitol Hill—paying them more than $300 million in fees—to claim that the market was being destroyed. The solution, the banks said, was to allow them to own other financial service businesses, including investment banking arms and insurance companies. In April 1991, I returned to the same House subcommittee to repeat my plea that Congress not overturn Glass-Steagall.
One of the arguments Congress put forth to defend its position was that out of the sixteen largest banks in the world, only one was a U.S. bank. My challenge to that assertion was, “When you say big, do you mean in deposits or in profits?” Because the fact of the matter was that, when measured by profits, five of the top sixteen banks in the world were U.S. banks—and none were Japanese. My position was that Japanese banks were “buying” their way into the U.S. market. This meant that if I went to an American bank, it would cost me 5 percent for a loan, whereas the Japanese banks were willing to lend at 4 percent.
I explained to Congress how the Japanese banks were going to go broke undercutting our banks. If money is priced at a certain level, that is the level the market has dictated. The cost of deposits is just like the cost of anything else: It is determined by competition in the free market. If some company wants to come in and steal the market by pricing under it, that company is essentially going to lose money—and it will ultimately fail. Guess what? Many of the Japanese banks did fail, and the country’s banking system collapsed with them, causing a major retraction of the Japanese economy that lasted ten years.
But, instead of letting the free market shake out the Japanese banks, Congress replaced Glass-Steagall with the Gramm-Leach-Bliley Act, spearheaded by Senator Phil Gramm of Texas. (What did Gramm do after leaving the Senate? He became a vice chairman of the investment bank UBS!) The new law passed in November 1999 on a party-line vote in the Senate—fifty-three Republicans and one Democrat in favor, forty-four Democrats opposed—and on an uncontested voice vote in the House. The course was set: Banks were not subject to the antitrust laws, so the big banks got bigger by expanding into new areas of finance.
Citigroup is the poster child for this expansion. The creation of Citigroup began with the acquisition of Commercial Credit in 1986 by interests controlled by Sandy Weill, who then promptly took the company public. Within two years, the company acquired Primerica, which had started as American Can and had gone through numerous configurations, ultimately acquiring several insurance companies and the investment firm Smith Barney. American Can’s transformation from a manufacturer of tin cans to a powerhouse in the business of finance was the work of Gerald Tsai, a legendary figure in the mutual fund business who had become head of the Associated Madison Companies, which itself had been acquired in 1987 by American Can and had changed its name to Primerica. Weill, who was even more adept at conglomerating financial businesses than Tsai, used Primerica as his vehicle to acquire Travelers Group, Shearson Lehman’s retail brokerage, Aetna’s property and casualty business, Security Pacific Financial Services, and Salomon Brothers. In 1998, Travelers was merged with the banking powerhouse Citicorp to create Citigroup.
At the time the two conglomerates merged, Glass-Steagall was still in place, so the combined corporation was given two to five years to divest certain entities. However, with the passage of Gramm-Leach-Bliley, Citigroup was allowed to stay intact and could offer commercial banking, brokerage services, investment banking, and insurance underwriting. Sandy Weill may have been critical to the success of this venture, and that possibility underlined a major problem. As they say in the movie business, headlining a star does not always guarantee a successful box office. It was not long before every other large U.S. bank followed Citigroup into these other businesses, setting the table for the biggest financial crisis since the Great Depression. Citigroup, which had to undo itself in late 2008 to survive, became a case study of everything that is wrong with the path enabled by Congress and pursued by money-center banks. This is a classic example of why bigger is not better.
After years of commercial banks buying investment banks to get into the securities business, the banking system ended up with companies that were “too big to fail,” just as I had predicted in my congressional testimony. Limited competition led to abuses, and a cancer of cheap debt and exotic banking instruments that few old-school bankers and probably no one in Congress understood spread through the system. The apocalypse came in 2008, and the big banks went running to Congress. At the insistence of then-Treasury Secretary Henry “Hank” Paulson, a former chairman of Goldman Sachs, Congress gave the banks $700 billion of taxpayer money to bail them out of the problems that Congress had allowed them to create.
Remember the inept Congress we talked about in Chapter 1? Well, here it was, sucking all the money out of the financial system, punishing small banks (which were not given the handouts), and creating a nightmare for the small businessman.
Instead of lending the bailout money to businesses and individuals, the banks used it for acquisitions, dividends, and bonuses for the very executives who had run them aground and to make payments on questionable deals such as stadium sponsorships. That spelled doom for any small businessman who was relying on big banks for lines of credit and loans.
The result of the government’s bailout of the very institutions it helped create is that the taxpayer is going to be paying the bill forever because of the cerebral vacuity of the members of Congress who refuse to understand what caused the problems. The simple reality is that when people undertake an obligation they cannot afford—be it a Wall Street bailout package or a car loan—sooner or later they are going to have to pay up or lose the asset. In 2008, American consumers were shouldering $900 billion of personal credit card debt and had little more than flat-screen TVs to show for it. The most unfortunate consequence of the bank bailout—and all the other bailouts, for that matter—is that the average person will never get anything out of it.
Congress claimed that the banking system was going to collapse. The fact of the matter is that we had more than 10,000 banks in the United States at that time. Almost all of those that were not major banks were relatively healthy. We had just 25 bank failures in 2008, and we had 140 failures in 2009. Here’s my point. Four banks hold over 50 percent of the banking assets in the United States, and if one of these were to fail, the system would be in serious trouble. But if 140 of the smaller banks out of the more than 10,000 that exist were to fail, the percentage of failures would be too low to affect the entire system.
Every single action Congress and Paulson took proved that the Treasury secretary really had only a vague idea what he was doing, and soon the Fed was printing money in a desperate and ill-conceived effort to keep the system moving. Essentially, the government worked in reverse, complicating the problem it helped create by sanctioning shotgun marriages of large financial institutions and plowing billions into failing banks. The government ended up making the big banks bigger.
beware: know your banker
Why do you need to know all of this about the banking system? So you can protect yourself. So you will not allow your loans to be sold off in pieces, carved up in tranches and syndicated to people you have never heard of, and “derivativized” beyond your ability to control how the loans are ultimately satisfied. If the rule for the banker is “know your customer,” then the rule for you, the borrower, is “know your banker.”
Bank of America is a case study in this sheer lunacy. It was pushed to acquire an ailing Merrill Lynch by Paulson and by Fed Chairman Ben Bernanke, but when Merrill’s balance sheet was not as advertised and the once-profitable company took a $17 billion quarterly loss, the government dumped another $20 billion of taxpayer money into B of A (on top of $25 billion it had already put in), and the Federal Reserve was forced to guarantee $90 billion or so in bad investments. B of A had become way too big to fail. This strategy, also executed when Wells Fargo was put together with Wachovia, leads to centralization and overregulation that are detrimental to competition and, ultimately, to the economy itself. So the basic plan to fix this overconcentration in the banking industry was to make the big banks bigger and hope they did not fail by trying once again to regulate them.
This entire process pushed aside free-market competition, which benefits the entrepreneur, in favor of saving big business. We now have two banking systems in the United States. Again, one system consists of four banks that hold more than 50 percent of all banking assets; the other system consists of ten thousand–plus banks that hold the rest. Those four behemoths—JP Morgan Chase, Bank of America, Wells Fargo, and Citibank—are not just too big to fail, they are too big to exist. And yet, rather than fixing the problem by breaking up these institutions, the president of the United States and Congress simply kicked the can down the road by giving us a new financial reform act of 2010 that does nothing to correct the problem. In this act, they effectively declare that no bank that is “too big to fail” will be protected. So what exactly will the government do if any of those money-center banks runs aground?
Many of the books written and the commentary offered on the subject of how to right the economy have also missed the point entirely, because they rely on expertise acquired exclusively through study, rather than hands-on experience. Nobel Prize winners Paul Krugman, author of The Return of Depression Economics, Alan Blinder, writing in the New York Times, and Joe Stiglitz, writing in Vanity Fair, detailed the causes and consequences of the financial crises. These Nobel-come-latelies mentioned en passant the repeal of Glass-Steagall, but they did not talk about the fact that the banking crisis was caused by “too big to fail,” and that the cure was the breakup of major money-center banks and the return to local banking. They made an undocumented assumption that these banks were doomed to fail and thus justified the bailout of the money-center banks; then, they unilaterally declared the cure to be more regulation, instead of competition.
The fact of the matter is that many of the pundits framed the debate with a quagmire of fifty-cent Wall Street words like “derivatives,” “securitization,” “credit default swaps,” “markto-market” accounting rules, and “toxic assets.” Most people, including the members of Congress charged with regulating them, have no idea what these financial instruments really are and how they work. But don’t you think you should know what the bank or brokerage house playing with your money is doing with it?
During the financial crisis in the fall of 2008, a successful businessman at a party in Los Angeles asked me to explain the description of a derivative. It was probably a question most people were asking who did not intimately follow banking as a hobby. We were standing next to a cocktail table, so I pointed to a tray of food.
“Imagine that all the cheese, sausage, and olives are all individual loans,” I started. “Now, let’s spread a little bit of each on twenty-five crackers. We’ll then ‘securitize’ every cracker. What does that mean? We are going to make each cracker group an entity in and of itself. And then we’re going to cut the topped crackers into little pieces and sell an interest in each resulting piece to several people and collect a fee. These individual cracker pieces are now derivatives, and the problem starts when the cheese goes bad because there is no way to go back and separate it from the sausage and the olives.”
It was not the greatest metaphor, but it does illustrate how difficult the situation is to explain to a lay businessperson. The bottom line was that the process separated the borrower and lender, and it was a bastardization of sound banking principles. In lending, the most important element is the underwriting credit analysis. The key person in any bank is the one responsible for checking the borrower’s credit, because if this person recommends that the loan committee of the bank approve a loan for people who cannot repay it, the bank is going to be in trouble. When the people recommending the loans pushed through dicey loans because the bank was simply acting as an agent to bundle them and sell them out the back door the next day, the system began to break down.
Out of this elaborate process came a need for something else: insurance. Because some of those pools of loans had a subprime rating, the banks would go to a company like AIG and have it write an insurance policy in case the loans turned questionable. The insurance company made a fee and then moved on to insure the next batch of loans. Once a pool was insured, its rating would go up to a higher level, which enabled the banks to market almost anything. The pool buyer was looking only at the rating and not at the underlying assets and so did not care what was in the pool. If the rating on a pool of loans was raised from B to double or triple A, then even conservative state pension plans would buy it. The “swap” was the buying and selling of that instrument—the credit default—that was insured.
The last line of defense—the regulator—was completely overwhelmed by the volume. Large institutions like Countrywide and Washington Mutual were doing thousands of loans a day, and no one could have kept up. The rating agency did not really know what the assets were worth. Files were papered with appraisals that merely repeated market statistics because lenders were interested only in justifying a preordained result.
The meltdown came when all of this became overleveraged. For example, suppose I buy a pool of these loans and spend all my money. I then go to another bank and say, “I want to sell this portfolio in which I have $100 million invested. What will you lend me on this?” “Well,” the other bank says, “We will lend you $75 million.” Then that bank goes out and buys another $75 million pool of loans. Once this begins to unwind and the asset that I bought for $75 million is only worth $25 million, it backs up the system, like the sewer reversing itself, neighborhood by neighborhood across America.
I have actually heard businessmen say, “Well, that doesn’t really affect me.” Oh yeah? Do you want to get a call from your banker, who says, “We’re cutting your credit line” or, even worse, “We’re calling your loan. You have until the thirtieth.” If you’re a successful businessman and a depositor, you need to know how your bank is investing your money. When you look at the bank’s balance sheet and see “securities,” you should know what those securities are and who the responsible counterparty is. Deposits are insured up to $250,000, but if the bank fails, it could take several months for you to receive your money from the regulators. Businesses that have more than $250,000 on deposit have that much more at risk if their banks go under.
So, if you are running a business, it is critical to know what your financial institution is doing. This goes back to doing your homework. In this case, because banks are so heavily regulated and the information is so easily available at www.fdic.gov, there is no excuse for not knowing. If you do not understand the system, you cannot make it work for you.
Thanks to the taxpayers’ money, several of the major banks were deemed “healthy” within a year of taking the bailout money. However, many of these banks just beefed up their balance sheets and made acquisitions with the money, rather than lending it to businesses. Their main incentive for paying back the government’s money as fast as they did seemed to be upper management’s wish to return to paying itself six- and seven-figure bonuses.
The cure of the so-called financial crisis of 2008 has set a precedent for something worse in the future. Congress thinks that the way to fix a financial crisis is to nationalize the banking industry and create giant institutions that are wards of the government. Because of their size—and this is the critical point—if any one of these banks fails, the only entity that can bail them out is the federal government, meaning you, the taxpayer! Rather than being curtailed, this philosophy has been perpetuated and can be stopped only by breaking up the behemoths and returning to a system where competition, not regulation, is the driving economic regulator.
If this is not done, the entire system could collapse.
Yes, collapse!
One Monday morning, the Treasury will go to market to sell T-bills to borrow more money to finance the ever-growing federal budget, only to find there are no buyers. Foreign governments, which currently hold one-quarter of our national obligations, may decide they have enough American debt. No one wants an interest-bearing piece of paper backed by the full faith and credit of a bankrupt government. Result: Goodbye, America. Hello, Greece!
What happens if the United States cannot meet its obligations? The government will continue to print money to prop up the system, and soon it will take a wheelbarrow-full to buy a loaf of bread. The consequences will be runaway inflation, social unrest, and some sort of revolution. Has this happened before? Yes, in the Weimar Republic, which ruled Germany after World War I. In an attempt to solve its financial crisis, the Weimar government printed money, which led to hyperinflation, massive unemployment, and lowered standards of living that ultimately collapsed Germany’s financial system, leading to a totalitarian regime. This possibility should shock any reader.
Does history provide a warning? Yes. Is this possible? Yes. Is this inevitable? I hope not. But you need to be prepared.
Your money and your business credit are at stake, so it’s important to ask what needs to be done to avoid another 1929 scenario. We need to take an approach different from the ones offered by politicians and academics and question why there is such arrogance in the resistance to look back in history for answers and such a belief that innovation is somehow superior to proven methods. The alternatives proposed thus far are doomed because they fail to deal with the size of the problem and talk only about regulating and bailing our way out.
The specter of the Great Depression is routinely raised as a scare tactic each time Congress considers bailing out these mismanaged, overleveraged companies. But I would like to see people start talking about the solutions that came from that historic event. In the wake of the Great Depression, Congress held three years of hearings—the Pecora hearings—to repair the economic system, and out of those hearings came solutions that righted the economy. The cleanest fix in the banking system is to return to the elements of the Glass-Steagall Act that would force major banks to get out of all these ancillary businesses. They should not be in the insurance business, and they should definitely not be in the securities business.
small banks are still in the banking business
Smaller banks are doing the job that large money-center banks should be doing, and they can continue doing it. One healthy community bank in North Carolina, Citizens South, took its bailout money and made loans to people to buy houses from developers that had borrowed money from Citizens. On a bigger scale, a borrower who says, “I need to go to Citibank because I need a big lender and as a practical matter I can’t go to twenty-five separate banks” could in fact simply find a lead bank or an investment bank to syndicate the loan. All of the large loans are syndicated by either a lead bank or an investment house. If a company goes to Goldman Sachs to borrow $5 billion, Goldman Sachs can earn its fee by going to other banks with the deal to get the loan done. These need not be money-center banks, because in our system the Federal Reserve functions as the major central bank.
Many of the struggling small banks can be combined in markets where there are too many banks or saved through private investment. Currently, a group of partners and I are working on recapitalizing some of the struggling community banks through a venture called Paradigm Capital. We are interested only in the troubled banks, which can be researched by looking at the FDIC’s website. These are banks that the FDIC is on the verge of closing. Because of the current financial crisis and the number of banks affected, the FDIC is understaffed and overloaded. This has created an opportunity for private capital and experienced management.
Most people do not know that all FDIC bailouts are financed by assessments on its member banks. They are no burden on the taxpayer! Only the big money-center banks—the too-big-to-fail banks—are funded by the taxpayers. Why? Because Congress did not have the political courage to reinstate the provisions of the Glass-Steagall Act, which served the system so well from 1933 to 1999. Currently, the FDIC is one of the few government agencies that has not been completely politicized. At least, not yet!
We are targeting those banks that we think have a good franchise and strong core deposits (people who leave their money in the bank for a long time), as opposed to hot deposits (cash and short-term CDs that can be withdrawn at any time). The core deposits suggest that the banker knows his or her customer. Our interest is in the deposits in the troubled bank because that is the inventory for loans that ultimately allows the bank to make money. When we identify a troubled bank that fits our profile, we then go to the FDIC and put our name on the bid list.
The FDIC came into existence to protect depositors, not shareholders, so our interests are aligned with those of the agency. We have private capital that can rescue this bank. It will not cost the public anything! In return for our injection of private capital and our accepting responsibility for the deposits, we work out a sharing agreement on the toxic liabilities. The standard is 80/20, where the FDIC takes 80 percent of the bad loans and we take 20 percent. Maybe we will also assume all the administrative work for the bad loans to lessen the staff burden on the FDIC. Some of this is up for negotiation.
You are always going to be subject to the regulations, but if you don’t do your homework and know the rules, you can’t take advantage of them. Therefore, if you are in the business of banking or just want to understand the business of banking, you have to do your homework.
Looking at the bigger picture, you may wonder how the banking system can be fixed so that it works for everyone. We need to look backward to move forward. The “new” banking system that must be implemented would look a lot like the one that existed prior to the 1990s. Commercial banks would take deposits and make loans. Period. Then, as a totally separate business, investment banks would handle accounts of investors who trade stocks and bonds. Banks would have the privilege of having their deposits guaranteed by the FDIC; therefore, the minimum standards would be “adequately capitalized,” meaning that total risk-based capital ratios would be equal to or greater than 8 percent. Because these banks would be restricted as to what they could do, in times of extreme trouble they would be eligible to be bailed out by the FDIC. All banks pay a fee into the FDIC, and that money would be used for bailouts, not the funds of the American taxpayer.
One solution for preventing bad loans that clog the system is to force every bank that makes a loan to keep the top 10 percent of the loan on its books. That 10 percent would be a charge against its capital. In other words, the guy who approved the loan would be on the hook. The same applies to the next guy down the line. That way, each participant would have some responsibility for the debt.
Bad assets would be dealt with as they were in the past. We should simply say to these overcompensated, underperforming CEOs, “Fellas, you put them on your balance sheet, you get them off it.” And if they can’t and those bad assets drag down the bank, they would have to file for bankruptcy—that is the purpose of reorganization under the bankruptcy laws. The better-managed banks would work through the problem by auctioning off these bad assets, because there is always a price at which they will sell to a vulture investor willing to take a risk. The bank’s capital would then shrink accordingly. But those bad assets would remain on the balance sheet until the bank could dispose of them—not until the government wrote a check for them.
The investment banks spun off from the money-center banks would be free to return to the world of high leverage if they so chose, because their deposits would not be insured by the FDIC and they would not be bailed out by Congress. They could have capital ratios of 30:1 and run themselves like casinos. Investors seeking lottery-like rewards would know the risks. These investment banks could buy and sell all the derivatives they pleased, and if they became insolvent, they too would have to file for bankruptcy. That is why the bankruptcy laws and the courts exist.
We need to move away from all these short “fixes” that come out of the Federal Reserve, the Treasury, and Congress, because they will ultimately undermine the long-term health of the economy. They run counter to the free market, they deter competition, and they threaten to cripple the entrepreneur and the small business operator.
Commercial banks are privileged organizations by virtue of the fact that they have access to the Fed’s discount window and are insured by the FDIC. Because of this, they are highly regulated, so this is where the government can make sweeping changes in short order. The banks must be told that if they want to “grow” their business, they’re going to have to do it in a traditional fashion, not by going into ancillary businesses they don’t understand.
Above all, we need to restore our banking system to the old-fashioned principles where banks compete for and know their customers and people who borrow money can pay it back. That is when the entrepreneurs will once again have a fighting chance.