WE ARE THE TITANIC

Analysis

Jay B Gaskill

“In part, what would happen in the wake of a Greek default would depend on whether European leaders could create a firewall* to control the damage from spreading widely-”.

Greece Nears the Precipice, Raising Fear, New York Times 9-20-12

http://www.nytimes.com/2011/09/20/business/global/as-greece-struggles-the-world-imagines-a-default.html

*Hint- There is no firewall. Read on….

SINKING THE TITANIC … AGAIN

The Unintentional Conspiracy That Almost Destroyed American Banking And May Yet Do More Damage…

CARELESS CONSERVATIVES & CLUELESS LIBERALS

The essence of the traditional conservative project is the preservation of boundaries - social, political and economic; and the essence of the liberal project is to seek the elimination or amelioration of the same boundaries. Both seek the improvement of the human condition – but conservatives lean towards less tinkering and more evolution, while liberals favor more social and economic engineering; liberals usually, but not always have less concern for the boundaries between private and government action. History is full of examples in which each of these approaches has worked better than the other one…for a time.

Now let’s turn to the banking mess, where invisible boundaries are crossed all the time, often with damaging consequences. In the financial world there are several such boundaries: between borrowing and owning, for example, between consequential failure and subsidized failure, and between high risk and low risk banking operations.

THE TITANIC AND THE CONTAINMENT OF FAILURE

The design of the Titanic included below-deck watertight compartments; these were steel walls designed to contain flooding so that the entire ship could escape capsizing as long as any leak was confined, leaving enough undamaged compartments to provide net positive buoyancy. The concept was sound, though poorly executed using the technology of the day. The practice is now standard in the large vessel shipping industry using improvements in design and execution such that large vessels almost never capsize anymore.

THE FALSE FIREWALL OF EUROPE

Greece is only the first and most visible of the EU’s basket-case economies. The firewall reference in the opening quote from the New York Times betrays a fundamental misconception about the very concept. There was no firewall between the European economy and the Greek economy. What the author apparently means by the term is a bailout in the form of a capital infusion as an emergency substitute for the lack of a firewall. As in the Titanic, a firewall – or sealed watertight compartment – is to avoid having a bailout. As the Titanic taught us, bailouts sometimes cannot work. A robust Greek firewall would have either prevented the Greek government from misusing European borrowing power to run up an irredeemable level of indebtedness or insulated the other EU members from the damage to the common currency.

THE NO-FIREWALL BANKING EXPERIMENT

There once was a working failure-containment strategy that allowed commercial banking to weather the storms that periodically buffet the investment side. The strategy, partly cultural and partly regulatory, had two key elements: (1) keeping a sufficient number of separate banking institutions so that several failures among them would not bring down the entire system – or stress the FDIC guarantees past the breaking point; (2) maintaining a robust wall between high risk investment banking operations and the conservative banking services used by the day-today consumer and business depositors.

We are still suffering through the ripple effects of the 2008-9 US banking crisis (the scope and severity of which cannot be overstated). That crisis was a direct result of operational and organizational changes in the finance industry during the last 15 years. Over those years, propelled by the “dot com” bubble and other high profit lures, investment banking institutions began ramping up profits by taking greater risks, ultimately trading in bundled mortgage-secured debt instruments to create the illusion of financial soundness. These instruments were, in fact, faux assets that had been leveraged as much as 50-1 then used to pad the balance sheets of a number of major financial institutions, to support more risk-taking.

Then, in a breathtaking change of policy, American commercial banking systems simply abandoned protective compartments and firewalls altogether. Speculation in bundled mortgage debt packages, shot through with negative value assets, was allowed to contaminate traditional banking services. But during the banking crisis, Canadian banks and the more conservative commercial banks, like US Bank, were largely unaffected. Those few conservative, traditional banks were like a handful of immunized families during the black plague.

The failure of America’s mainline banking institutions to honor the boundaries that would contain bank speculation-engendered failures was a failed experiment with liberalism enthusiastically embraced by conservatives. Among the many, otherwise intelligent conservative voices, the scholars and analysts of the Heritage Foundation and the American Enterprise Institute joined with the liberal Brookings Institute in praising the change. Consumer bank fees were reduced, American banks became more “world competitive”. It was a win-win for conservatives and liberals alike. Or was it?

As a research fellow from the Heritage Foundation recently wrote, “Prohibiting banks from engaging in certain types of financial activities is an old and discredited concept that was once embodied in the Glass–Steagall Act of 1933. Before its repeal in 1999, Glass–Steagall limited banks’ ability to meet the needs of their best customers as new, cheaper financing products developed that were outside the scope of their allowed activities. Some banks were weakened through their inability to compete with other types of financial institutions, while eventually other banks found ways around those restrictions.

“…[attempts via] misguided legislation to reestablish the Glass–Steagall Act assume that a bank should be essentially a utility limited to taking in deposits and making certain types of safe loans. They reason that if banks are protected from risky activities, other types of financial services firms can be allowed to fail without causing problems to the overall financial system. However, these proposals completely miss the point that as far back as the 1998 failure of the hedge fund Long-Term Capital Management, systemic risk to the financial system is less likely to come from banks than from non-banks.

By David C. John, Senior Research Fellow in Retirement Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.

Heritage Foundation Web Memo No. 2810, February 22, 2010

That piece spoke for the conservative establishment.

Background: The Banking Act of 1933 that first established the FDIC and inaugurated depression era banking reforms, was also known as the Glass–Steagall Act. Among other things, it barred any bank holding company from owning other financial companies. These and other firewall protections of commercial banking were repealed in 1999 by the Gramm-Leach-Bliley Act. This one measure took down the wall between investment banks that issued securities and the commercial banks (classic deposits and loan). And it repealed conflict of interest restrictions on investment bankers who simultaneously served as commercial bank officers.

It was a bipartisan orgy - liberals and conservatives banding together in the heady days of the dot com boom to erase some pesky, antiquated, profit-impairing boundaries. The House passed the first version the act 343-86 when republicans rolled a few nay-saying conservatives and most democrats. But the democrats jumped on board when the House voted 241-132 (most republicans opposing, most democrats supporting) to instruct negotiators to insert provisions against redlining. You may recall that redlining is what liberals called the practice of mortgage lenders who used strict borrower-criteria in poor (read minority) neighborhoods, based on the quaint notion that anyone would ever have to actually pay back a mortgage loan!

The final bill incorporated strong anti-redlining provisions. It passed the Senate 90-8, and by the House 362-57, and was signed into law by President Clinton in late 1999.

As it turned out, this would be a key ingredient in a toxic stew. The anti-redlining provisions led to political pressure on mortgage lenders, Fanny May and Freddy Mack (The Federal National Mortgage Association and the Federal Home Mortgage Corporation) to make more and more questionable loans. This led to a cultural watershed: The practice of making loans that depended on the expectation of appreciation instead of the borrower’s actual ability to repay the borrowed money became the norm. Thus the seedbed for the real estate lending bubble that would dominate the 90’s and the first eight years of the 21st century was planted, watered and fertilized.

We had been warned. Three years earlier, in 1996, Federal Reserve Chair Alan Greenspan had given a famous speech before the American Enterprise Institute (recall this was during the height of the dot com bubble) in which he asked “How do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions?” The final answer would come in with a shock in late 2008.

The recession that immediately followed the dot com bubble became dramatically worse in the immediate aftermath of the attacks of 9-11-01. But the real estate speculation bubble was able to fill the void, replacing the dot com froth with toxic asset fizz. American investment banks jumped into the risk pond and frolicked for seven years in a state of uncritical, irrational exuberance. When the inevitable banking collapse finally took place in 2008, the damage could not be confined to a few, compartmentalized risk-takers. The “toxic asset” problem (really faux assets, un-payable loans on overvalued properties – leveraged by a factor or 50-1 in some instances) had infected Wells Fargo, Citibank, Chase, Bank of America and hundreds of other major banks, including their day-to-day main street commercial operations.

But not all banks were among the hundreds receiving bailout money in 2008 and 2009.

Worldwide Financial Crisis Largely Bypasses Canada

“Canadian banks have not gone shaky like their American counterparts, economists and other experts said. There is no subprime mortgage or home foreclosure mess. And while the United States fears a prolonged recession, Canadians have remained relatively sanguine…”

“Strict rules also govern mortgage lending. By Canadian law, any mortgage that will finance more than 80 percent of the price of a home must be insured. Two-thirds of all Canadian mortgages are insured by the quasi-governmental Canadian Mortgage and Housing Corp. As a result of the tough standards for insurance, ‘people tend not to get mortgages they cannot afford,’ Gregory said.

“’Defaulting on a loan is also more difficult in Canada than the United States, Gregory said. ‘You can't just drop off the keys and walk away.’

“For Canada’s seven biggest banks, the percentage of mortgages at least three months in arrears was 0.27 percent in July, close to historic lows, according to the banking association. Also, few Canadian banks got caught holding large numbers of toxic American mortgages.

“Amid this relative health, there have been reports that American companies, needing cash and credit, have been turning to their Canadian subsidiaries for short-term loans.”

http://www.washingtonpost.com/wp-dyn/content/article/2008/10/15/AR2008101503321.html .

CNN Money published the initial bailout list of US Banks – there were hundreds - http://money.cnn.com/news/specials/storysupplement/bankbailout/ .

LESSONS

Old fashioned conservatism and sane liberalism tend to respect the essential boundaries on which day-to-day commerce depends. Those are simple boundaries, such as those between assets and liabilities, between secure loans and speculation - the boundaries that ensure reasonable safety and dependability, and they include the institutional boundaries that enable the compartmentalization of risk.

Who would tether a fully loaded 707 passenger jet to somebody’s experimental rocket plane? Common sense and ordinary folk wisdom are not rocket science. But to the politicians and mavens with the hubris to think that a country’s economy can be “managed” by experts using techniques and algorithms that even financial advisors can’t penetrate, common sense might as well be the type I, types IIA and IIB, and heterotic SO(32) and E₈XE₈ superstring theories of cosmological physics.

Without the profit incentive and the discipline of failure, government’s well-meaning ventures are usually expensive failures, frequently they are one-off gestures, and rarely are they free of malign unintended consequences. This is because government failures never punish those who engineered them. [Read my popular article, Legislative Malpractice, and weep - http://jaygaskill.com/CongressionMalpractice.htm .]

Government, especially at its well-meaning best, breeds bureaucrats as fast as a warm pile of manure breeds flies. And mindless bureaucracy (the phrase is a redundancy), whether it infects banks, or regulatory agencies, or real estate sales agencies, or congress or the executive branch, or investment firms, is the enemy of creativity, individual judgment, and personal accountability. The fatal attraction of pyramid schemes (and that was the housing market from 1988-2008) seduced both liberals and conservatives alike. But only the naïve liberals and complicit unthinking conservatives were reckless enough to entice poor people into that game. Of course, we need government, but we need insurance against its good intentions.

Spare me the elites who can’t seem to understand why the ordinary people of this country are angry at therm.

JBG

For further reading, see The American Creative Surge, also by the author, linked at http://www.jaygaskill.com/ACS2011.htm.

Forwards and links are welcome, with attribution. For all other permissions, your comments and suggestions, contact the author via E-mail at law@jaygaskill.com.