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Lesson from S&L Bailouts: Say No to Bank Nationalization

Submitted by chemjeff on Sat, 02/21/2009 - 05:30

So the trendy thing nowadays appears to be to advocate for bank nationalization as the way to solve our current banking crisis.  But, a careful reflection of the S&L crisis of the late 80's/early 90's, where a similar type of nationalization/bailout took place, suggests that's the wrong course of action to take now.  Here is why.

In the beginning, there were heavily-regulated Savings and Loans.  Government regulations required them to be regional banks only.  They were required to invest the majority of their assets in 30-year fixed mortgages on real estate within a 50-mile radius of the bank.  They were restricted in the types of products they could offer customers - no fancy schmancy high-risk products.  So the products that they could offer to depositors constituted traditional banking instruments like passbook savings.

Then, in the late 1970's, interest rates spiked.  This was really, really bad for the S&L's, because the majority of their assets were tied up in long-term fixed-rate mortgages, but they had to pay higher short-term interest rates on demand to their traditional banking customers.  This is a recipe for disaster.  S&L's would have gone totally insolvent had they not been deregulated in the early 1980's.

This deregulation took the form of permitting S&L's to invest their assets not so heavily in local fixed-rate mortgages.  This would allow S&L's to invest in things that were more risky, but offered higher rates of return, which would then give them the money to pay the higher interest owed to their depositors.  Sounds good, right?  Except that the S&L deposits were still guaranteed by deposit insurance (FSLIC, the S&L equivalent of FDIC at the time).  So no matter how risky the S&L's investments became, the depositors would never lose a dime because, in the worst case scenario, the government would bail out the depositors.  And if you are an S&L owner in a competitive marketplace, you have to seek out ever riskier investments for your portfolio, because you have to try to stay one step ahead of your competitors.  In essence, S&L's had little to lose and much to gain by abandoning all their risk management standards.

So the entirely predictable happened: when times were good in the booming economy of the 1980's, S&L's were able to offer great rates of return financed by risky investments that were nonetheless performing well since times were good.  But when the party ended and the economy went into recession, the S&L's began to fail.  But there wasn't enough money in FSLIC to cover all the losses, as nobody anticipated mass S&L bank failures all at once, so Congress had to step in to make good on its promise to make depositors whole.  That legislation was FIRREA.

What did FIRREA do?  It created a new regulatory agency for S&L's, the Office of Thrift Supervision (OTS).  It established the Resolution Trust Corporation to take over the failed S&L's and dispense with the assets however it could.  This of course led to a loss to the taxpayers of about $100 billion.  But not all S&L's failed, some were just very weak by the poor state of the economy.  So FIRREA also allowed bank holding companies to purchase S&L's outright, the idea being that acquisition of a struggling S&L by a healthy bank is preferable to letting the S&L fail later on down the line.  But guess what this did: a bank that purchased an S&L was now subject to different regulations, those of an ordinary bank (e.g., regulations made by the Federal Reserve) and those on an S&L (e.g., regulations made by OTS).  So a bank holding company that owned an S&L could play both sides of the regulatory fence.  If a bank holding company wanted to duck onerous Federal Reserve regulations, that company could just assign those duties to the S&L that it now owned.  The net result was a contravention of the regulations' intentions.  It is no surprise then that once the immediate S&L bailout aftermath had died down, banks stopped buying failing S&L's and instead created subsidiaries within their organization deliberately as new S&L's.  You can even make a good argument that since S&L's were so heavily involved in real estate in the first place - that was their whole reason for existence - that the banks' current problems with mortgages stem directly from their acquisition/creation of S&L's in the mid to late 90's, which was permitted out of necessity by FIRREA in 89, which was a response to the only partial deregulation of S&L's in the 80's, which was only necessary because S&L's were so tightly regulated beforehand.

So I share the original poster's skepticism in nationalization of the banks.  I don't entirely believe that upon nationalization the government will never release them ever again, although that's a minor fear.  I do believe that, like with the S&L example above, it will set off a chain of events, each with their own unintended consequences, that will create an even larger disaster in the future.  In other words I have absolutely zero faith that bank nationalization, even if temporary, will actually solve the banking crisis.  Furthermore, the stakes are MUCH higher this time around - the S&L bailouts cost "only" $100 billion, and nowadays that's chump change.  We are all already in debt way over our eyeballs (thank you Porkulus!) and we cannot handle a trillion-dollar S&L-style disaster.

And this doesn't even get into the more ideological parts of FIRREA - it was written by Democrats you know.  So there's a part of FIRREA which explicitly demanded that the number of minority-owned S&L's didn't decrease as a result of all the bank failures.  How the government is supposed to guarantee this in the presence of widespread bank failures is anybody's guess.  Oh and it also broadened the scope of the CRA.  We can only expect more of the same nonsense this time around.  When government sells off the nationalized banks back into the market, what Democrat-friendly investment requirements will it place on the new owners?  God only knows.

In summary: Don't nationalize the banks.  If a bank fails, it fails.  The depositors are dutifully insured up to their limit.  The shareholders would be wiped out, but they'd be wiped out in a nationalization anyway.  So the only real upside to nationalization vs. bank failure is if you think nationalization would actually do something beneficial that bank failure wouldn't.  And I don't buy it.

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Comments

Lesson from Japan - do something

Submitted by NextRightNando on Sat, 02/21/2009 - 09:11.

Don't just let the banks stagger on like zombies - they may be technically insolvent, but they can management will keep them afloat so that they can continue receiving their paychecks. Unfortunately, the resources that are expended on this life support mean that the banks can't perform the proper function in the capitalist economy - lending money.

Unintended consequences of bank failure

Submitted by johnson springs on Sat, 02/21/2009 - 17:26.

In order to make a convincing argument about the unintended consequences of putting insolvent banks into receivership you also need to address the potential for unintended consequences of the failure to do so.

I do believe that, like with the S&L example above, it will set off a chain of events, each with their own unintended consequences, that will create an even larger disaster in the future.  In other words I have absolutely zero faith that bank nationalization, even if temporary, will actually solve the banking crisis.

There are two cases to look at.

First, the Lehman bankruptcy is the best exemplar we have for a bank actually failing. And the consensus is that it was an unmitigated disaster that directly led to the failure AIG due to the latter's exposure to Lehman via credit default swap guarantees on Lehman debt; an $85bn unintended consequence.

Second, we have the case of the zombie banks. In this case banks remain "alive" so long as they value assets far in excess of any market price. Zombie banks do not provide any banking services because they don't have any liquidity; they are in effect pretending to have a liquidity problem to avoid recognizing that they are insolvent. In this case, it is not a question of letting banks fail. It is a question of letting them continue to masquerade as banks without providing any banking. So the question becomes what will the unintended consequences be to the American economy of not having a working banking system for a prolonged period of time?

Your posts suggests the unintended consequences of putting insolvent banks into the well-known process of receivership ("nationalization") in order to work through their problems and restore the banking system will be worse than the unintended consequences of the two scenarios outlined above. I don't think that is even remotely the case.

Larry Kudlow had three guests

Submitted by In between on Sat, 02/21/2009 - 10:13.

Larry Kudlow had three guests on his show at the same time last night. One of the guests was Bill Seidman who was Chairman of the FDIC and worked on the S & L problem. All three agreed with a nationalization plan of three months or so. Larry Kudlow was skeptical of course.  

Great analysis of the S&L crisis, but I think this is different

Submitted by lagomorph on Sat, 02/21/2009 - 14:33.

When the RTC took over S&L bad assets, the government was not required to purchase them, as would be the case with Geithner's initial "bad bank" strategy.  This imagines that the derivates would somehow be able to be decomposed to the extent that their actual value would be known in the first place.  Since that seems unlikely, pricing would simply be guesswork, and the sellers would then want the guesswork pricing marked up so that they could hope to profit in some fashion from the sale.  Enticing private investors to repurchase debt from the bad bank would only mean that the taxpayers would lose money on the initial purchase, then lose money again when the assets are sold at a low enough price to attract buyers. 

Based on what is now coming to light about the events leading up to AIG's crisis, I have to agree with Johnson Springs that had Paulson known the extent of Lehman Brothers' tentacles into so many areas of the domestic and global economy, he would have been far less reluctant to intervene to save them, his career-long rivalry with Richard Fuld and distaste for moral hazard notwithstanding.  Of course we'll never know for sure. 

In a normal situation all fiscal conservatives should require risk-takers to accept the consequences of their risk and fail.  After the repeal of Glass-Steagall by the Gramm-Leach-Bliley Act, robustly exploited by former Clinton Administration Treasury Secretary and Citigroup board member Robert Rubin to the tune of $126,000,000 in compensation, banks are no longer prohibited from lending, insuring, trading and risking credit - all within the same corporation - which is one of the key contributors to how we find ourselves in this crisis now.  As a direct result of Rubin opposing the regulation of credit derivatives of mortgage-backed securities, we can no longer look at the financial institutions involved in the current economic crisis as "normal".  High-speed transaction technology coupled with these unusually complex and mysterious financial instruments means that today these financial institutions are "quite beyond extraordinary". 

On the subject of high-speed financial transactions, it continues to amaze me that almost no news outlet has reported on the electronic runs on the money markets that precededed Paulson's plea to Congress on September 18, 2008, for the original TARP fund rescue plan.  Had Paulson and Bernanke not stepped up immediately to close down the money market account operations and institute the policy guaranteeing those accounts for $250K to stop the panic, the incredible run on the banks' money market funds to the potential tune of $5.5 Trillion on September 15, 2009 could have literally marked the end of Western Civilization as we know it. 

In a glaring omission of this significant event, Frontline's recent documentary on the economic crisis, Inside the Meltdown, which aired this week on PBS, completely skips any discussion of the utterly petrifying bank run on September 15, 2008.  Frontliine's economic meltdown timeline jumps from the weekend of September 14 over to "global panic" on September 16, with no mention of September 15 whatsoever.  For this reason I agree with Danny Schechter of Alternet that PBS Screws Up Report on Financial Crisis due to shoddy journalism, secondary sources and incomplete data. 

Because economic institutions have staggered so far from the path of normal, rational business practices, economists like Nouriel Roubini have persuaded me to widen my acceptance of extraordinary measures such as temporarily nationalizing "zombie banks" as the most market-friendly solution to recapitalize them without risking or wasting additional taxpayer money in unnecessary purchases, with the commitment that they are reprivatized once their health is restored. In an array of fiscally irresponsible solutions, nationalization may actually be the lesser of several evils to American taxpayers.

Prior to taking that step, we must insist that the Washington decision makers (which unfortunately includes incompetent legislators of both parties), perform their analysis with great diligence.  According to The Economist, the intervention of Paulson and the Bush Administration appears to be having a positive effect.  The gloom-and-doom-end-of-the-world-as-we-know-it psychological strategy of President Obama and the Democrats has led the destruction of investor confidence evidenced daily in the market.  I hope it doesn't lead to the premature nationalization of banks which might otherwise be edging their back from total disaster.

16 banks need to be nationalized,

Submitted by RisingTide on Mon, 02/23/2009 - 10:49.

or are really at risk of needing to be nationalized. The problem is manageable.

As for why media is engaging in active suppression of the true facts?

Born and Bred American Dopes. (that is to say, it's propaganda. what the fuck did you expect??)

Some quick comments

Submitted by chemjeff on Mon, 02/23/2009 - 03:59.

All, thanks for your great comments.  As you might guess I'm not an economist or a high-powered investment type, just a run-of-the-mill conservative kind of guy who is perhaps smarter than the average bear.  So I can't really argue against the minutiae of CDOs.  But what you write suggests an even scarier future ahead if the banks are nationalized.  From what you write, it seems as if our circumstances today are so exceptional that even conservatives ought to seriously contemplate bank nationalization.  But this just begs the question: Aren't circumstances always exceptional in one way or another?  Sure we have CDOs and MBSs and all sorts of other recent inventions that have now failed in a spectacular way, but once this current crisis has passed, won't we have some new exotic financial instrument that, since it is constructed by fallible human beings, will also fail in some way?  Isn't this the nature of the market generally?  IMO conservatives ought to take the long view, and I mean the really long view.  Wouldn't the correct solution be to let those who use new financial instruments bear the associated risk?  And that's why I see nationalization as scarier than just letting banks fail, because we are just perpetuating this endless cycle of success and inevitable failure subsidized by all of us.  It seems to me that the key problem is the FDIC insurance, because it does not require the banks to behave responsibly towards their depositors.  As long as depositors will get bailed out no matter what, the banks always have a perverse incentive to shoot for the riskiest investment that they can.

FDIC insurance puts a premium on risky investments

Submitted by RisingTide on Mon, 02/23/2009 - 10:53.

And there is a depositor limit of 200k. This saves small fry, but the big guys get sent out to hang.

The problem with CDOs and MBSs and all the fuck-diddly that the hedge funds play with, is that there is no TRANSPARENCY.

This is a problem easily solved with regulation. Just like the temporary regulations that required disclosure of all short positions.

The long view is to ensure that nobody invests in a non-transparent market like derivatives.

After what Dodd and Frank have done as mere regulators

Submitted by Ironman on Mon, 02/23/2009 - 07:08.

Would any sentient creature trust them to act as responsible owners? Look at the market's retching reaction to the concept even being broached 

I'm more worried about zombie politicians wreaking economic havoc than zombie banks.

Multiple Mississippi banks took bailout money, says Fed

Submitted by Harrison G on Sat, 01/08/2011 - 00:26.

The Associated Press reports that the Federal Reserve released a report in December that shed further light about the banks that accepted bailout money - and how much each took. According to the Mississippi-based newspaper The Dispatch, three banks in that state received large of amounts of money in Federal Reserve payday loans in order to sustain stability. Indeed bailouts are what many banks are turning into in an attempt to save it from bankruptcy.