PoliFiLogic.com

I was once an Assistant Manager of a branch bank. The manager was a highly respected man by the name of Enos Price. We were in his office one day when he called my attention to the crowded lobby. He said, (paraphrasing) “Look at those people. They’re depositing money they need to feed their families and pay bills. They trust us to keep it safe. Whatever you do, don’t forget that.” I remember to this day, and always tried to make that my guiding principle as my banking career progressed. Unfortunately, most bankers today never had the honor of meeting Enos Price.

Taking risk is essential to capitalism. People who take risk start new companies, invent new products or further the development of existing ones. Willingness to assume risk is what made this country great. We should do nothing to discourage risk-taking. What we need to do, however, is make certain risk-takers don’t use other people’s money without their full knowledge, understanding and permission. This is the crux of the problem that resulted in the crisis we’re dealing with today.

There were approximately 12 million homes built in the United States between 2004 and 2007 and only seven million new family units created. Government encouragement of home ownership is unnecessary. It’s time to get government out of the real estate business. It was a mistake to allow investors to believe that the obligations of Fannie Mae and Freddie Mac carried the full faith and credit of the US. When the push came to shove, it became necessary to make that a reality. Let’s not make that mistake again. Bond buyers should risk their own money, not that of unwitting taxpayers.

It’s a fact that real estate has been at the heart of most of the largest bank failures in recent history, and was the culprit in this crisis, as well. The solution seems clear – separate real estate lending from consumer and commercial lending. It would not be difficult to create another class of banks that deal only in real estate. These banks would lend to developers and make other real estate loans, including commercial and residential mortgages. They’d develop greater expertise through specialization. Financing can be raised from the sale of mortgage backed securities and many other sources, but not from consumer deposits. Accepting deposits should be prohibited. Appropriately, FDIC insurance would not be available. This would effectively isolate real estate lending and prevent further crises such as we are now experiencing.

In 1999 when the Glass Steagal Act was overturned I remarked to my wife that a huge mistake had been made. I thought giving commercial banks the ability to underwrite and sell securities would result in a flood of sub-par stock offerings. I feared that banks, when confronted with over-extended borrowers, would be tempted to underwrite and sell stock in those companies as a way of getting questionable loans repaid. I had most of it right, except the type of sub-par securities. Instead of bad stock we got bad sub-prime mortgage bonds. Even then, there would have been no crisis if banks were not allowed to underwrite their own trash.

Commercial banking and investment banking must be separated. The risks associated with the two are dramatically different, as is the expertise needed to compete. Commercial banks should not be permitted to underwrite securities of any type, including those they generate as asset-backed bonds. Commercial banking, minus real estate, should look a lot like it did twenty five years ago before the mistakes were made that caused the S&L crisis and the current crisis. To the best of my knowledge traditional banking has never been the cause of a crisis in this country.

We’ve heard a lot about derivatives during this crisis. As Warren Buffet said in Berkshire Hathaway’s 2002 annual report, “I view derivatives as time bombs, both for the parties that deal in them and the economic system”. There are many risks involved with derivatives, the most serious of which is the fact that the paying party is not known until a claim is filed. This is because they are traded privately. The Federal Reserve is trying to form a market for them much like the options market, but has been unable to so far. Commercial banks should not be permitted to use derivatives unless they are traded on an organized exchange. In this way a financially responsible counterparty is assured, and risk is manageable.

Investment banks should be prohibited from accepting consumer deposits. Never again should they be allowed to obtain bank charters, as Goldman Sachs and Morgan Stanley did in 2008. This allowed them to repay loans with consumer deposits that were fully guaranteed by the FDIC. They were given the opportunity in order to calm the markets after the failure of Lehman Brothers, and it was probably necessary at the time. However, if Lehman Brothers and other investment banks weren’t deeply involved in commercal banking, Lehman’s failure would have been nothing more than a dip in the markets.

Another essential change is the separation of brokerage from investment banking. There’s an SEC rule that calls for a “chinese wall” to separate unerwriting from stock and bond brokerage. It’s a good concept, but doesn’t exist in practice. There were plenty of examples of this following the market crash of 2001. Those violations may have stopped, but others emerged. This practice presents too great a temptation, and should be prohibited. Similarly, commercial banks should not be allowed to own brokerage operations. Lending and investing are two very different business, and mixing the two can lead to questionable practices.

The changes above are sweeping, to say the least. It is my belief that excessive government is undesirable. Instead, government should create the necessary environment for the safe exercise of business. I believe the suggestions above fit that description.

Reshaping the financial services industry should be a much higher priority than completely revamping the nation’s healthcare. Unfortunately, President Obama has squandered far too much political capital on this and, in my opinion, has too little left to meaningfully change the financial services industry into a safe form for the long term. He’ll get no help from Chris Dodd or Barney Frank, either.