Gaming the Bank Bargain

As promised, the HSIB book review editor is now in possession of Calomiris and Haber's Fragile By Design: The Political Origins of Banking Crises & Scarce Credit, and is not disappointed by the first chapter.

A few stray facts from which; Only 6 of 117 countries studied have a banking system that is both adequate for credit provision (approximately 83% of GDP) and stable (no banking crisis since 1970). The USA is one of only 3 high-income countries prone to banking crises. Between 1990 and 2010 private bank lending to households and business firms was 95% of GDP in Canada, but only 19% in Mexico (our other NAFTA partner). Being 'under-banked' (having less than 83% of GDP in private credit provision) is correlated with low economic growth. Or, alternatively, finance leads growth. And that's all contained in the first seven pages.

Pressing on, the attentive reader will see that though banking is heavily regulated, entry restricted, licenses required, rules promulgated to be adhered to, exams conducted by regulators...banking systems all over the world still manage to continually get into trouble. Why, you ask? Well, you should.  It's because the logic of banking is not economics, but politics. There are no truly private banks, anywhere. All are effectively government-banking partnerships, and all serve the needs for credit of governments. Though, 'variations in political institutions [throughout the world] drive variation in the nature of government-banker partnerships.'

That brings us to the truly peculiar history of the U.S.'s banking system history. Throughout the 19th century, well into the second half of the 20th, thanks to populism and federalism, small bankers in coalitions with farmers were able to fight and win their battles in state legislatures (rather than in open debates at the national level, which they would have lost to the interests of large national banks). That left America with a very inefficient, frequently panicked 'unit-banking' financial system that was unable to diversify away from regional risk, and to enjoy economies of scale in administration.

Just when it looked like the system was collapsing, due to real estate loans defaulting in the early 1930s, the coalition was rescued by Senator Carter Glass and Congressman Henry Siegel Steagall's by the creation of federal deposit insurance. But, the solution--popularly known as Glass-Steagall, but properly; The Banking Reform Act of 1933--contained the seeds of its own destruction.

When the ink and paper world gave way to electronics, and money could be transferred from one institution to another in a matter of seconds, unit-banking was doomed. Now interstate banking could not be denied to the American citizen any longer. That, ceteribus paribus, would have made the system both more efficient and more stable. Where Sonny Bono's Law--there are people who will game any system--enters the Game of Bank Bargains.

In the early 1990s a new coalition arose of political activists calling themselves 'community organizers', and large money center banks who wished to get even larger. It was a costly bargain. For $850 billion in credit extended to the various activist groups (like ACORN), and a further commitment of $3-1/2 trillion in loans with weakened underwriting standards (in the name of 'affordable housing'), those activist groups supported the mergers of their new best friends into the mega-banks that were Too Big Too Fail. I.e. that were too important to be allowed to suffer the consequences of their reckless lending practices, and thus were backstopped by, not their own shareholders, but by the American taxpayers.

By 2006, 46% of first-time home buyers were making a down payment of ZERO dollars. The median down payment of all home loans was down to only 2%. It took many little steps to get there, but the most crucial was the inveigling of Fannie Mae and Freddie Mac into the scheme of loosening lending standards. It was all downhill from there. Literally. Say the authors;

We cannot stress this point strongly enough: the politics of regulatory approval for bank mergers set in motion a process whose ultimate outcome was that large swaths of the American middle class were able to take advantage of mortgage-underwriting rules that, compared to those of any other country in the world and of earlier periods of America's own history, were inconveivably lax. The result was the rapid growth of mortgages with high probabilities of default for all classes of Americans.

If you're a Housing Cause Denialist--and you haven't already guessed--you will hate this book.