What’s Actually Behind the Banking Crisis? Why You Pay When They Play.

Yves here. This post is the first of today’s double header on the bank panic and the reflexive Fed bailout, here done specifically done so as to be able to keep increasing interest rate in order to increase unemployment. Interviewee Walker Todd is one of the comparatively few to have had a lot of experience inside the regulatory tent, at in senior roles the New York and Cleveland Feds, who is willing to describe how the sausage is made.

By Lynn Parramore, Senior Research Analyst at the Institute of New Economic Thinking. Originally published at the Institute for New Economic Thinking website

Over the last two weeks, you could hear rumblings under the global financial system as one large, ugly crack appeared after another. Soon everybody was bracing for an earthquake.

We have just witnessed the second and third biggest bank failures in American history, putting the health of the financial system on high alert. Events have sent global markets reeling with fears of fallout not seen since the 2008 financial crisis.

Walker Todd was assistant counsel of the New York Federal Reserve, assistant general counsel, and research officer at the Cleveland Fed, and has been actively involved in financial regulation for decades. When he looks at the U.S. banking sector, he sees several problems driving these recurrent crises, chief among them a profound transformation in capitalism known as the “financialization of everything” in which corporate executives chase short-term profits through risky activities. Businesses and their bankers securitize accounts receivable, thus separating ordinary consumer transactions from their primary funding sources. Then the bankers end up demanding bailouts when things go wrong and the consumers stop paying, all the while lobbying against regulation and oversight.

Todd, a former INET grantee, spoke to the Institute for New Economic Thinking about how serious this crisis looks to him and why it came to be that banks are allowed to play casino games that wreak such havoc.

There’s a motto on Wall Street: “I.B.G.-Y.B.G.” or “I’ll Be Gone, You’ll Be Gone.” The idea is that long as you’re making money right now, what happens tomorrow is not your problem. According to Todd, it is most definitely our problem. He explains why bailout capitalism is bad for everybody.

Lynn Parramore: Let’s start with a general assessment. How bad is this current situation in your view on a scale from 1 to 10?

Walker Todd: Two years ago, when it looked like the pandemic was coming under control with vaccinations and a lot of people thought 2021 might be a normal year, my fear of a financial crisis was a 3. Now I’d say we’re up to about a 6.

LP: Before we dive further into the current situation, can you give a little history on how banking has changed over the years in ways that helped get us here?

WT: In the 1980s, commercial banks decided they wanted to enter the investment banking business, partly because they were becoming bigger and bigger. Walter Wriston at Citibank wanted to be number one. He wanted to be to finance what General Electric was to manufacturing. Investment banking had been separated from commercial banking in 1933 during the Great Depression with the Glass-Steagall Act. Now pressure rose to repeal it. That repeal (1999) played a role in what later came to be called “the financialization of everything,” which we’ll talk about.

In the ‘80s, big commercial banks landed in serious trouble through some of their lending decisions. What had been a foreign lending problem became a domestic problem linked to oil prices. The high price of oil, about $25 per barrel then, led the banks in Texas, in particular, to keep investing in new commercial and sometimes residential real estate ventures, assuming the whole world would keep moving to Texas for the oil boom. They didn’t notice when the oil price stopped rising. Something like half or two-thirds of all the loans that later went bad in the Texas banking system were booked after oil prices had reached their peak. In ‘85 and ’86, Saudi Arabia pushed down the price of oil to squeeze other producers out of the marketplace. In West Texas, oil prices collapsed to $10 a barrel. Every loan in Texas looked bad.

That system-wide failure in Texas was really the first banking crisis in my career that looked similar to what we’re seeing today. There have been several more since then that we know about. In the late ‘80s to early ‘90s, there were real estate crises in coastal regions like New England, the Sunbelt Region, and the West Coast. Meanwhile, New York banks faced a non-stop series of major issues. In Texas, real estate and bank loans that collapsed in ’86 and ’87 didn’t really recover to their former value until around 1995. For Texas, it was pretty much a lost decade.

In 1998, Long Term Capital Management, an investment bank and private equity fund in suburban Connecticut, blew up. They had attracted money and talent because some of the principals were former Federal Reserve people and Nobel Prize winners. But their mathematical formulas didn’t account for the possibility that Russia might default on its debt. The Fed had to come to the rescue. That was a forerunner for what we’re dealing with now with Credit Suisse.

Fast forward to the period of low inflation and low growth after 2001. The real estate boom set in, and that’s when you really had the financialization of everything. Up to then, the practice had normally been that banks would make mortgage loans and either keep them on their own books or, even if they sold them, they would sell the whole mortgage to Freddie Mac, Fannie Mae, or to the private sector. Then someone came up with the idea that if you carve the loans into tranches and sell the tranches separately, you might receive more money than if you sold the whole thing.

It worked out for a while that way and that’s why everyone did it. That opened the door to the financialization of everything.

LP: What does this concept, the “financialization of everything,” entail?

WT: That’s when you start treating everything like it could be a bank liability — auto loans, credit card loans, and the like. You treat them the same way as the new mortgage credit – carving them up into tranches with different levels of credit risk and interest rates attached and selling them off as chunks instead of altogether as one block.

A New York securities lawyer friend and I used to speculate that we could even securitize and sell air rights in New York. That way you would be selling the blue sky itself! Obviously an absurd concept, but I assure you that people likely gave serious thought to it.

LP: How is the current banking crisis an outcome of the process of financialization?

WT: In several ways. Going back to the ‘70s and ‘80s, Walter Wriston at Citibank introduced the concept of “brokered deposits,” certificates of deposit that could be negotiated in the secondary market and resold. Nobody ever thought of doing that before. Traditionally, you took out a deposit in the bank, a CD account, and you kept it. That was that. You could borrow against it at the bank, but you didn’t go try to sell that to somebody else.

Thanks to that process of creating brokered deposits, the liability side of the bank’s balance sheet became financialized. The FDIC eventually put limits on the percentage of deposits that one bank could have that were brokered deposits because they were viewed as non-core deposits, quick-to-flee money, money that won’t be there in time of need, etc. That’s very much like what we’re seeing today.

On the asset side, banks like Silicon Valley and Signature were loaded up with things like mortgage-backed securities and also long-term Treasuries. They were doing that just to have the appearance of liquidity, the appearance of risk-free assets while ignoring so-called duration risks, that is, exposure to interest rate problems the longer the term of the bond or other obligation that you’re holding. By ignoring these issues, banks like Silicon Valley, First Republic, and Signature painted themselves into a corner. They have brokered deposits chasing the highest yield funding assets that have embedded risk that is not recognized in the kind of accounting they wanted to see.

LP: Regulators evidently knew these banks were in risky territory back in 2018, after President Trump signed a bill rolling back the Dodd–Frank Wall Street Reform and Consumer Protection Act. The Financial Stability Oversight Council listed mid-sized banks that could pose a risk because of their uninsured deposits, which couldn’t be covered if they failed. The list showed that Silicon Valley Bank had over 90% of deposits uninsured and First Republic Bank had 67% uninsured. So they knew, yet nothing was done. That seems like a pretty big regulatory screw-up. What’s your take?

WT: It was a regulatory screw-up, but it appeared to be one mandated by Congress under political pressure at the time. Randal Quarles of Utah was then Vice Chairman of the Fed in charge of supervision, and he was willing to listen to the banks’ arguments that these changes should be put in place to make them more competitive. But even if he had said no to the banks, I think they would have just gone to Congress and spread enough money around to put on pressure to get the changes they wanted.

LP: So the money and politics aspect of this story is quite significant.

WT: Totally. In fact, I’d say that at almost every stage of the game. From a traditional bank examiner’s viewpoint, one of the problems with brokered deposits held in out-of-state banking institutions is that you don’t know anything about the banks and you don’t know anyone who does. Well, what about all these mortgage-backed securities? Typically, they’re covering out-of-state mortgaged property. You don’t know anything about those properties or the nature of the local market.

So you’re essentially gambling deposit money on properties that you know nothing about. It’s a particular problem with private-issued mortgage-backed securities. Even the government agency mortgage-backed securities only guarantee timely payment of principal and interest. It’s not the same thing as buying a 30-year Treasury because the credit standing of the Treasury is unquestioned, backed by the Full Faith and Credit (the taxing power) of the United States. With a mortgage-backed security, even with a government guarantee of payment of principal and interest, you’re dependent on Congress appropriating or authorizing annual money equal to the amount required — and they may do it or they may not do it.

LP: What current assumptions about banking need to be rethought?

WT: I think the 1999 repeal of Glass Steagall (the Gramm-Leach-Bliley Act) was the major mistake for the long haul. It set in motion trends that culminate, ultimately, in each successive crisis being more difficult to resolve than the one that preceded it. That’s where we are today. It’s not on the scale of 2008, but if we keep mishandling the problem, we can get there.

LP: When crises occur, the risky activity subsides for a while, but eventually financial executives crank up the casino once again to get the profits flowing so that their incomes can expand. What could be done to stabilize things in the long run?

WT: Ronnie Phillips’ “100% Reserve Plan,” also known as the “Chicago Plan,” persuaded me that it’s the next best thing to the gold standard because it requires the parts of banks linked to the payment system to maintain, at all times, assets at market value equal to the amount on deposit. The investments would be Treasury bills, Treasury notes, and Treasury bonds. They could hold those things and you could do away with deposit insurance because if the only assets are Full Faith and Credit government paper, then there’s no point in having it.

And what about the lending side of banking? Like investment banks before the ‘90s, they would have to raise their own funds in the wholesale funding market, knowing that their own notes, bonds, and stock issues raise operating funds. They would use the funds to make loans or they could buy investments or even government securities. The point is to take away the Fed’s argument that we have to rescue these poor babies because otherwise, they will crash the payment system. If they’re cut off from the payment system, what is the risk if they go down?

Drexel Burnham Lambert, a fairly large investment bank, was allowed to fail in 1990 with no consequences for the payment system. We know that some senior Fed officials wanted to make bailout loans to Drexel to save the world, to save the payment system. But senior staff worked hard to persuade the higher-ups that there was no risk to the payment system then, before the repeal of Glass-Steagall. Drexel could not have access to the payment system so there was no reason to intervene. When Drexel failed, it turned out that the accounts had been properly maintained and most people came out okay. The only people really hurt were the shareholders.

That’s the way things are supposed to work out. It’s a political matter that we refuse to go back to this model of handling failures of large banks that look like investment banks or mutual funds.

LP: What is the cost of banking crises to the ordinary person?

WT: The federal rescue costs are spread around so thinly that you don’t notice that $200 of your annual income is going, for example, to a $30 billion rescue package. And even if you didn’t, the government does not fund the rescue through tax but rather a special assessment on the banks. The banking system has to figure out how to swallow the $30 billion and spread it around among depositors and shareholders through fees and the like.

LP: So it’s not accurate when a politician claims that the taxpayer won’t pay for the bailout?

WT: The taxpayer will definitely pay. It may be spread over 150 million tax returns, but the taxpayer will pay.

LP: With financialization driving this ongoing instability, do you see any possibility of curbing the trend through regulation? Can it be done now that the horse is fully out of the barn?

WT: Good question. If you go back in history, you can see that new regulation actually was done through the Securities Act of 1933, the Securities and Exchange Act of 1934, the Investment Company Act of 1940, and other statutes like that. So it was done. But politically it might be impossible today because you’d have to persuade members of Congress vulnerable to political donations to allow the Fed, the FDIC, and others to suspend the financialization of both sides of the bank ledger.

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  1. Samuel Conner

    In a less stupid timeline, the saying would be “I’ll be gaoled, you’ll be gaoled.”

  2. Regis II

    I would like to know if the person being interviewed agrees with the “loans create deposits” idea. He doesn’t seem to understand that. In the endorsement of the “Chicago Plan”, he doesn’t explain where the deposits that will be used to purchase the 100% safe assets will come from.

    Also, I don’t understand this part:

    WT: That’s when you start treating everything like it could be a bank liability — auto loans, credit card loans, and the like.

    I thought loans were bank assets, not liabilities.

    1. Samuel Conner

      In context, the term “liability” might be meant in the sense of “source of risk of loss.” The discussion relates to securitizing garden-variety assets (the loans) into composite asset tranches segregated by risk. If that is the intended meaning, I would agree that it’s a bit sloppy on the part of the speaker.

      It’s a bit of a shame that so much effort, that could have been and could still be deployed into solving concrete problems, has been and continues to be put into the manipulation of financial assets. For me, it has the “feel” of a world in which everyone spends a disproportionate amount of time interacting with synthetic/imaginary worlds. We seem to be tending toward that. (This is not meant to disrespect gaming enthusiasts among the readership, but it would also be good to plant gardens.)

  3. The Rev Kev

    I was going to say that you would probably need a Great Depression-style event to overhaul the banking system and bring back measures like the Glass-Steagall Act but I am not so sure. It is not so much inertia but there are far too many parties that have a vested interest in keeping the present system going, no matter the level of economic damage. And here I am talking about both government and business. You could for example have a million protestors converge on Wall Street but as the government also benefits from the present system, that they would do a mass crack-down using both the police and military. One of the factors that brought in FDR back in ’33 was the number of Hoovervilles springing up around the country. But as the same is happening right now with the number of homeless people and the government is ignoring it, even millions more homeless after a crash would also be ignored. Hate to say it but I think that this will end in mass violence as the only way to force change.

    1. vao

      Judging by all the “deaths of despair”, mass violence is already here, but directed inwards (i.e. suicidal behaviours) instead of outwards (i.e. combative protests).

    2. SufferinSuccotash

      Trouble is, “mass violence” under the current circumstances would be far more likely to result to result in some sort of Fascist regime than anything else.

  4. Bjarne

    The cost to the taxpayer isn’t just $200 per $30 billion, etc. for this banking system we have. Its manifold and pernicious: lost income, ruined financial futures due to financial crisis induced unemployment, misallocation of national economic resources such that every “app” Silicon Valley wants to produce gets funded but our infrastructure is falling to pieces, people can’t afford rent, school, medical care and now food too. And the financialization of everything has deep cultural and spiritual effects as well: the commodification of human life, the lack of accountability that is seeping into every pore in our society where people feel no obligation to each other, watching people die on the streets in mass numbers from opiate overdoses and neglect. The system is rotten morally, spiritually, physically. And when those on top of this pile of burning embers realize what a disaster this is the “smart” money will flee to Eurasia where they care to build real economies based on actual physical goods. Our system will collapse and god help us then.

  5. John

    you’d have to persuade members of Congress vulnerable to political donations to allow the Fed, the FDIC, and others to suspend the financialization of both sides of the bank ledger.

    Translation: The banks make political donations to Congress. Isn’t that a genteel protection racket?

      1. JEHR

        In Canada, we have Boss Telecom, Boss Banking, Boss Air Transport, Boss Mail Service; We share with the US: Boss Apple, Boss Smartphone, Boss Facebook, Boss Google, Boss Microsoft, Boss TikTok, etc.

  6. michael

    What I haven’t seen addressed is whether a lot of the fleeing $$ is heading off shore. You know where there is unlimited deposit insurance. /s Or is it just bouncing from point to point at light speed never landing?

    JP Morgan et al isn’t sucking it all into its clutches. Yet the $$ is going somewhere. WHERE?

  7. michael

    One more thing, the repo and r-repo markets. It was stated that their was a lack of good collateral available during recent periods of stress in that arena. What is good collateral today?

    What’s up Zoltan Pozsar?

    1. Samuel Conner

      The thought occurs that the recent “bailout” of allowing “held to maturity” Treasury notes to be used as collateral at face value when that exceeds market value could have the effect of reducing haircuts on long-dated Treasuries in repo transactions. Perhaps that was, sotto voce, part of the intent — a two-fer.

      1. michael

        Good point. I agree. One crisis at a time please.

        In my link above, which is a very clear discussion of what’s happening today and ends with what will be the paradigm going forward, two point are made re the Fed. One, we are at full employment so the fed need only focus on inflation and two, inflation must be reduced below the Fed rate to induce positive rates for long enough to assure its demise for this cycle. The visual of holding an inflated beachball below water was very apt.

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