A banking strategy that pleases no one

By Bethany McLean
February 24, 2012

Ever since the $25 billion settlement over foreclosure abuses between five of the nation’s biggest banks and the state attorneys-general was announced, there’s been a steady drumbeat of naysayers who’ve asserted the deal does more for the banks than it does for homeowners. And barring some happy accident in which the settlement somehow inspires banks to behave, they’re probably right: In comparison with the estimated $700 billion difference between what people owe on their mortgages and what those homes are actually worth, $25 billion is peanuts.

But the problem isn’t that the settlement is part of some grand plan by the government to help out the banks. Rather, the problem is that the government doesn’t seem to have a grand plan for the banks.

For all the current and well-deserved bank bashing, few question that a well-functioning economy is predicated on a well-functioning banking system. And few question that confidence is a critical ingredient. So then the issue becomes: What kind of banking system do you want to have, and how do you inspire confidence in it?

At two major junctures, our government (Congress went along with the Bernanke-Paulson-Geithner triumvirate) made the call that it wanted the banking system we had, not a radically reshaped one. First, the government bailed the big banks out in the fall of 2008. Perhaps more critically, the Obama administration made the call not to break them up or nationalize them in early 2009. In a sense, this new settlement is a continuation of that call. As Yves Smith at Naked Capitalism has pointed out, it’s a bailout for the banks: It will reduce the amount that people owe on their mortgages, thereby helping them afford their home equity lines of credit, roughly $400 billion of which are parked on the balance sheets of the big banks. And Scott Simon, the head of the mortgage business at bond giant Pimco, has argued that investors, not banks, will bear the brunt of the cost of any mortgage modifications.

But most important, the settlement lets the banks off the hook for repeatedly breaking the law in the foreclosure process. One analyst who has studied this tells me that their legal transgressions alone could have been used to rip apart the banking system, had the government desired to do so. Even if it’s true that the banks merely violated technical aspects of the law, and didn’t kick anyone out of a house who deserved to stay, that still flies in the face of everything we’re supposed to believe about the importance of the rule of law. Next time you get a ticket for running a red light, try arguing that you shouldn’t have to pay because you didn’t hit anyone.

But at the very same time, the government is doing a host of other things that look like they’re designed to undermine confidence in the banking system, if not the system itself. The news of the settlement broke at about the same time President Obama announced a new task force that would delve into the crimes of the bubble era. It’s not clear how this task force will differ from the one he announced in 2009, but the point — look out below, banks and bank investors! — is consistent with his anti-bank rhetoric. And the settlement is only a small piece of the litigation facing the banks. As Obama said: “This settlement also protects our ability to further investigate the practices that caused this mess … we’re going to keep at it until we hold those who broke the law fully accountable.” Indeed, multiple other investigations and lawsuits are ongoing; the Wall Street Journal also reported that the SEC might soon bring cases involving the packaging of mortgages.

The litigation isn’t all. Investors express a whole host of other worries, including Dodd-Frank’s so-called resolution authority — which dictates the way big banks in crisis are supposed to be unwound and, some say, basically means that politicians will pick the winners and losers in the next crisis. These concerns also include new capital requirements, President Obama’s proposed $61 billion bank tax, and the Volcker Rule. It’s death by a thousand cuts. All those things, plus a much tougher operating environment, help explain the continuing dismal performance of bank stocks. Yes, they’re up from the lows of last fall, thanks to the general market rally, but bank stocks are still depressed, thanks in part to the political risk they face. And the mere fact that political risk exists is a big problem in and of itself. (One smart investor uses the phrase “political finance” to describe the dangerous intertwining of two spheres that should be separate.)

You might say: So what? Surely the banks deserve to die for the agony they’ve inflicted on our economy! Which is probably true. But that’s a reaction, not a policy. Now, the prudent policy might well be to kill the big banks. Plenty of very smart people, like Simon Johnson, the former chief economist of the IMF, Mervyn King, governor of the Bank of England, Paul Volcker, and Thomas Hoenig, the next vice-chairman of the FDIC, have inveighed against the dangers posed by banks that are too big to fail. So then, let’s kill them outright! While we’ve missed our best chance, there would still seem to be some fairly simple ways to do that, like reinstating the Depression-era Glass-Steagall law separating commercial and investment banking or mandating sky-high capital requirements for any firm over a certain size. That would bring its own set of challenges — most notably a drift of activities to the shadow banking system — but I’m not sure anything could be more challenging than regulating today’s big banks, given not just their complexity but also their well-oiled political and regulatory influence machine.

There’s an argument that articulating a clear policy, let alone executing it, is simply beyond Washington’s capabilities. Which is scary, because right now, we have the worst of both worlds: A banking system that the population at large abhors, and one that investors can’t trust.

PHOTO: A man walks past a Wells Fargo Bank branch on a rainy morning in Washington January 17, 2012. REUTERS/Gary Cameron

19 comments

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/

“Reinstating the Depression-era Glass-Steagall law”. This is by far the best move we could immediately make, and a far better choice then the much argued Volcker rule. Simply split off the portions of the banks that can make speculative investments. Loss of Glass-Steagall in 1999 set up the environment that led to our later collapse.

Posted by Araes | Report as abusive

The primary argument for a strong banking system is that banks keep capital moving toward new projects. So…. that’s what banks should do. Lend money and get it back. And charge interest for that service. Basically, just do what we were all taught that banks did.

No credit default swaps. No relationships with ratings firms. No ‘debt sales.’ No insurance business on the side. No hedge funds disguised as banks. No shorting positions. No fingers in the stock market at all.

Just lend money to businesses and individuals, and collect interest on those loans. Banks should be banks. Nothing more, nothing less.

Posted by AlkalineState | Report as abusive

Legislation to reinstate Glass-Steagall was introduced in the last session of Congress by Senators McCain and Boxer.

http://freerisk.org/wiki/index.php/Glass _Steagall#S_2886_Banking_Integrity_Act_o f_2009

Posted by Cate_Long | Report as abusive

I like to see a banking system that encourages long term investment and deter sort term gamble. Current financial crises was brought on by the short term profiteering which is detrimental to our society.
Some form of “Glass-Steagall law” plus a punitive tax on capital gain held less than 3 years would be good for the nation.
Let Investor invest and Gambler gamble. our current system are letting Investor gamble and Gambler invest. We all see what mess they made.

Posted by Bilancia | Report as abusive

The Banks have become a source of income and political capital for the politicians. If we want to move forward, the Banks need to be set free from all the bashing by government agencies.
They should pick on the gas companies, gas refiners and commodities speculators. Gas price has more adverse impact on the economy than Banks.

Posted by MYap | Report as abusive

The banks have been operating as if there were no laws. It’s long past time for them to be reined in. I’m caught up in a situation that makes no sense. I’ve been trying to sell a house for a year and a half but can’t because the bank can’t find the paperwork to prove it owns the mortgage so there’s no clear title for me to hand over. It seems another bank may actually own the note – at least it’s the one on record in my county, and today I was informed a third bank is involved. On top of that several notorious Robosigners were used to move the mortgage into MERS by a bank that can’t prove it had the right to do so. I’m disgusted. I’ve had no choice but to sue. God knows what good that’s going to do me.

Posted by SunnyCollins | Report as abusive

Its a behavioural issue, symbiotic between the legislators and bankers. Without all the off balance sheet lending to hedge funds as starters, then the ability to damage by speculative bets are clipped.
How can you have a system, where capital held in aggregate by a few major funds overwhelmed that of the total aggregate of the GNPs of a collection of nations on this planet earth?
Supposedly, these funds, be they private equity, hedge, funds of funds are better allocators of $$ resources than the traditional bank can do in lending to businesses, then, there should be no disguise, in the banks’ lending practice – i.e risk assessment, to which, because of the sweet deals amongst and between themselves as a cartel, the bankers crafted a permeable wall of convenience with the removal of Glas-Steagal, churn $$ movements without fiduciary diligence.
There is no money to be made from traditional lending other than from boring interest rate spreads; for all the innovative engineered financial products designed, the bankers cream off a minimum of 15% off from the face value, before all the add ons. This invariably puts the cost of capital higher, to businesses without that ability to issue own bonds. What is being produced by the bankers? Documentation and a plethora of fees generating income and upper most importance- bonuses ans self enrichment, before businesses can even produce anything real!Why do you think recent Social Media IPOS are valued at stratospheric $B by investment bankers? These valuations are “cartelised” motivated by the fee/bonus culture-behaviour, disguised in esoteric languages in 1000 pages IPO documentations that no one can understand. Its a Casino and regulators and legislators are equally inept, even condone, the deck of hands dealt to the ordinary tax payers.

Posted by rissey | Report as abusive

A modern version of Glass Steagall would be great, but it’s not enough if the laws are not enforced. Even without Glass Steagall, there were plenty of federal and state laws broken before the crisis.

The SEC should not be the primary enforcement for those laws. They are too close to the problem and too friendly with the lawbreakers.

A new generation Glass Steagall should be fashioned to dovetail nicely with RICO and the federal courts should be obligated to enthusiastically prosecute those who break those laws.

RICO allows for a lot of prison time and the confiscation of all ill-gotten assets.

Posted by breezinthru | Report as abusive

Glass-Steagall. That would be a great start.

And a 5% Federal fee on mortgage originations covered by any type of Federal tax money guarantee / “insurance” or any other equivalent term. No fee, no insurance — ever! We have built more than two times the houses we can afford.

Our banks are criminal and are led by criminals who do not even know what a financial crime is. Our courts seem unable to find one either, other than falling behind on your mortgage payments.

Individual citizens should be free to sue criminals directly if they provide reasonable proof at filing. We cannot let political appointees make criminal decisions when it comes to finance. They obviously cannot be trusted. Let the suits begin!

Posted by txgadfly | Report as abusive

What is a “well functioning banking system” might just as easily begin with what it is not..

but in keeping with Ms. McLEan’s positive statement – and what we want:
- one which is fair to seniors and savers, and to students and doesn’t penalize taxpayers;
- one which is transparent, with risks to all parties fully disclosed;
- one which holds bank officers and owners at personal risk for folly or malfeasance (just like the rest of us).

In terms of accountability, Glass-Steagal was itself a fix for the transgressions and dishonesty of the day – which gave way to the Great Depression. Go back a few years earlier and bank officers were held personally liable were they to “lose” depositor’s savings.

If anyone wants some good background reading, try -

“Fiat Money Inflation in France – How It Came, What It Brought, and How It Ended” by Andrew Dickson White. http://www.gutenberg.org/ebooks/6949

- a short / easy read, and as relevant today as it was for France (or Post WWI Germany).

Posted by JonParks | Report as abusive

I fully agree with ‘breezinthru’. Re-introduce Glass-Steagall, then enforce the laws on the books. The SEC is suppose to regulate and investigate. Where there is evidence of malfeasance, the legal systems, both state and federal, should prosecute vigorously. Too often, white collar/financial crimes are somehow seen to be ‘not that bad’, so the government negotiates instead of indicts. It should also be noted that long sentences are no deterrent to the greed that drives the financial system. Bernie Madoff and the fate of similar people does not seem to have put the others off any more than the sentences for burglary deter would-be burglars. But if the majority of wrong-doers go to jail, we get them off the streets and out of our pockets.

Posted by steve778936 | Report as abusive

All great suggestions here, but you all missed one thing.
The banks have bought out our government. Business as usual. There is no hope unless we overhaul our political system, including the Supreme Court.
And while we are wasting all these resources on our banksters, China is leaving us behind.
Good luck, and God help us.

Posted by GMavros | Report as abusive

Great article. Always enjoy your work Ms. McLean.

Posted by lhathaway | Report as abusive

Great article. Always enjoy your work Ms. McLean.

Posted by lhathaway | Report as abusive

I agree implementing an updated version of Glass-Steagall would be a good start, but as the post by GMavros points out, the problem is the banks have bought our government, so no amount of legislation will do any good without a complete overhaul of our political system — one thing I want to point out that GMavros includes in his post, is that the Supreme Court is a MAJOR contributor to all of our problem, and has been since its ruling in Marbury v. Madison in 1803 in which it seized power for itself beyond its Constitutional limits.

The federal government unlawfully seized power for itself at the beginning of the Civil War.

The underlying problem is both the federal government and the supreme court have effectively overthrown the US Constitution, which was based on States’ Rights, thus enabling the disaster we see today.

Resolving this would take another constitutional convention. Simply continuing to “tweak” the original constitution amendments in this situation is pointless.

Posted by Gordon2352 | Report as abusive

Ms McClean: What we need is a banking system that is HONEST… and THAT we do NOT have…

Investors can be and will always be ‘investors’, sometimes known as gamblers…. but Bankers should only be bankers. Keep our money safe, and provide capital for small businesses….

Gordon2352: What you want is a return to slavery, no voting rights for women, indentured servitude, and a return to an agrarian economy, which is what we had under ‘States Rights’….. Easy to tell where you live…

Posted by edgyinchina | Report as abusive

This is the banking system I want:-
I want a state owned depository/transaction bank to be created. It will be the only bank in the nation authorised to recieve “at demand” deposits, it will be “not for profit”, it will not pay interest on deposits, it will not make or hold any investments, and will charge a monthly fee for actioning my transactions and holding my cash. All other banks will raise their capital from the bond or equity markets, and will be classified as investment banks, free to trade on their own account, leverage themselves as they see fit, thge government will never guarantee any investment bank and will be prohibited by constitioanal amendment from bailing out or making any investment in an investment bank,like wise the central bank will be prohibited from coming to the assistance of an investment bank, and when an investment bank becomes insolvent it will declare bankruptcy just like any other institution. If I want to buy bonds or shares in an investment bank, I will pay for it from my account with the State Transaction Bank, at my risk.

Posted by mbcullen | Report as abusive

edgyinchina,

What we need is an honest government to enforce the laws, not one that is run by the bankers. The ONLY way to ensure that is to have a legitimate government in power, which we do not have at present.

If you notice, I called for another constitutional convention to set things right. We cannot undue 200 years of bad laws and illegal government.

We need to start over.

Simply tacking amendments onto a Constitution that was never meant to handle a government like this is pointless.

What we are seeing is the inevitable result of special interests taking control of the government and using it to further their own ends, not that of the American people.

People calling for fundamental change in our government need to understand what that means at this point in time.

Who knows? Maybe this time we could get it right.

Posted by Gordon2352 | Report as abusive

I would like to clarify a point in my earlier comments.

I am NOT an advocate of States Rights’ as a solution.

I believe we need a strong federal government, but one that is answerable to the American people, which our present government is not.

One of the main problems with our Constitution is that our Founding Fathers were afraid the country would devolve into a democracy, as much of Europe was doing at the time.

As a result, they built in safeguards (e.g. the Electoral College) to ensure that the American people never had the power to vote. What we have for national elections is a sham. The popular vote doesn’t count at all.

This country is not a Democracy, but a Plutarchy (i.e. Plutocracy plus an Oligarchy), or basically rule by a small wealthy class. It has always been a Plutarchy, right from the beginning in 1776. The US Constitution was designed to be that way, and it still is today.

It was also designed to have a small federal government and limited powers for the supreme court.

As I said above, the deterioration began in 1803 in the case of Marbury v. Madison, where the US Supreme Court unlawfully extended its limited powers under the Constitution by means of giving itself the powers of “judicial review” over the intent and meaning of the written Constitution

—————————————————————————————–
Marbury v. Madison, 5 U.S. (1 Cranch) 137 (1803) is a landmark case in United States law and in the history of law worldwide.

It formed the basis for the exercise of judicial review in the United States under Article III of the Constitution.

It was also the first time in Western history a court invalidated a law by declaring it “unconstitutional”.[1][2]

The landmark decision helped define the boundary between the constitutionally separate executive and judicial branches of the American form of government.

Judicial review in the United States refers to the power of a court to review the constitutionality of a statute or treaty, or to review an administrative regulation for consistency with either a statute, a treaty, or the Constitution itself.

The United States Constitution does not explicitly establish the power of judicial review. Rather, the power of judicial review has been inferred from the structure, provisions, and history of the Constitution.[1]
—————————————————————————————

Notice the last two sentences in the above quote.

The power of judicial review of the US Constitution was “inferred” by the Supreme Court. The power of judicial review was discussed by our Founding Fathers, but never included in the Constitution itself, but the Supreme Court only 27 years later usurped the power on its own, thus establishing itself as an authority above the written US Constitution.

In effect, the Supreme Court instantly became more powerful than the US Constitution. What that also means is that every single law ruled on by the US Supreme Court since 1803 is invalid, since it has no actual power to interpret the US Constitution.

I doubt anyone at the time could see what would happen as a result of this action by the Supreme Court, but over time it permitted the unnatural growth in the size and scope of the Federal Government (especially as the nation expanded westward, and always at the expense of the individual states who continued to lose power in Supreme Court rulings).

As I said, the federal government, by declaring war on the southern states who wished to withdraw from the union in 1861, exceeded its legal authority under the US Constitution, since it has no such powers to do so, and has ruled unlawfully since.

A major reason why the federal government was able to grow as it did was due to the “constitutional” rulings of the Supreme Court, which gave it legal status it did not otherwise have under the Constitution, so the Supreme Court was the “great enabler” of the growth of the federal government, which helped to cause the Civil War over States Rights’ that were being constantly eroded.

(Yes, slavery was a major issue, but the real underlying reason for the Civil War was to enable expansion of power of the Federal Government.)

It is the combination of the federal government and supreme court working together that has been largely responsible for the massive growth in the size and power of the federal government throughout this country’s history.

The US Supreme Court — completely unanswerable to anyone in the government or the American people — far from being a check on the rising power of the federal government (i.e. the supposed “checks and balances” of our government) has acted mainly as the “power behind the throne”, being careful for the most part to maintain a low profile.

The truth is neither has the legal right — under the original intent of the US Constitution — to enact the laws they have enacted.

These are the facts of the situation as time and space permits.

Therefore, in order to address the problems we have in the federal government today, both the issue of the roles of the federal government and that of the supreme court MUST be addressed.

The present Constitution is not capable of addressing these issues.

This country is on the verge of disintegration once again, just as it was prior to the Civil War in 1861. Unless something is done we will have another terrible price to pay. I would prefer not to see that happen.

The American people NEED to understand the extent of the problem and how long it has persisted. This is very important to resolving the issues we face today. They must realize the only way to address it is to hold another constitutional convention — at which point we can create the government we want and need, one which will address the problems of the American people as they are now.

I don’t think that will happen, so by default we will again go through another period of crisis with little hope of surviving intact as a nation.

We have precious little time before it becomes too late again.

Posted by Gordon2352 | Report as abusive