Bank Bailout, Part II: The Root of the Problem

In the previous posting on this subject, we raised the possibility of an ESOP/CSOP combination as an alternative to letting the State throw more money at the problem of bankrupt banks and undertaking a program of nationalization of the country's financial institutions. An ESOP/CSOP for a bank, however, raises some special issues.

Ordinarily, a commercial bank is in the business of monetizing the productive capacity of an enterprise so that the enterprise can purchase what it needs to produce marketable goods and services. A commercial bank does this by creating money backed by the present value of whatever the enterprise is financing, and taking a lien on whatever is financed. As the project generates profits, the enterprise repays the loan, and the lien and the money are both cancelled. (In this, a commercial bank is different from a "bank of deposit," which cannot create money, but only lend out whatever people have deposited.)

The first issue is that today's financial institutions have managed to combine a number of incompatible functions, setting up automatic conflicts of interest. For example, from the early 1930s to the early 1980s under the "Glass-Steagall" Act, "commercial banking," "investment banking" insurance companies, brokerage companies, and bond rating agencies in the United States were carefully separated. Commercial banks are "banks of issue" (also called "banks of circulation"), meaning they can create money. Investment banks are banks of deposit, and can only serve as intermediaries to put people with money together with people who have "investment grade" securities to sell. The separation of independent companies involved in different stages of finance built "checks" into the system. For example, people with money demanded that the investment bank and other types of financial firms investigate all the securities they recommended very carefully, for millions, sometimes billions of dollars were at stake.

With the repeal of Glass-Steagall, however, the financial industry moved from independent competitors to vertical and horizontal monopolies. Commercial banks could buy an investment bank or set up their own investment bank departments, while an investment bank could purchase or set up a commercial bank. Similar things happened with respect to other specialized types of financial institutions, such as savings and loans, which (contrary to their established purpose of financing residential real estate) were allowed to lend for commercial real estate, a role traditionally filled by commercial banks.

This led to the great savings and loan meltdown of the 1980s, just as permitting commercial banks to invest in something other than loans to businesses and government securities set the stage for the home mortgage crisis. Giving investment banks direct access to the "money machine" of commercial banks meant that what are now known as "toxic assets" were not properly vetted or investigated, for the simple reason that it was extremely profitable to make and sell the loan, which overshadowed the possibility that the loan might not be serviceable. These bundled speculative assets were eagerly purchased by other financial institutions anxious to cash in on the rapidly appreciating value of the assets behind the loans.

Adding to the problem was the superabundance of loan money in the hands of predatory lenders and brokers. These were desperately seeking places to put the vast amount of "idle" cash from China and other countries that had piled up dollars resulting from the continuing U.S. trade deficits. The housing market, depending on individual consumers who in general lacked the necessary expertise to determine if the financing package they were offered made sense or was even feasible, was custom-made for making large "investments" in projects that were virtually guaranteed not to be scrutinized adequately or even understood by the people on whom the investment depended.

To this was added the fact that homes (except as rental property) do not generate their own repayment by producing a marketable good or service. That meant that the mortgage was only as good as the ability of the borrower to repay the loan out of other income. Unfortunately, because the ability of the borrower to repay was often the last thing the original lender looked at in order to clinch the sale, many of the loans went south the moment the housing bubble burst and real estate prices started to decline. Homeowners typically had no equity, either because they had borrowed against the appreciated value of the home, or because they had not managed to build up any.

Before we can attempt reorganizing individual financial institutions in trouble, then, even as ESOP/CSOP combinations, we need to undertake the task of reorganizing our financial system along more rational lines, building in natural checks and balances, and taking advantage of humanity's unique ability to specialize as individuals, while remaining generalists as a species. That will be the subject of the next posting on this subject.