A BANKER'S VIEW OF THE BANKING CRISIS
 
 
Robert Porter
 
Bank supervisor and UConn graduate Robert Porter consults for the International Monetary Fund after his early Federal Reserve career, and has worked in the banking field for over 40 years--both overseas and domestically.  He also co-wrote a book with WILI's Wayne Norman called "Hoop Tales: UConn Huskies Men's Basketball."   Porter gives his views on the current banking crisis:
 
SIX SIMPLE REASONS FOR OUR BANKING FIASCO
 
In recent months, I have been asked countless times – from Hawaii to Africa to Russia to explain the banking portion of our current financial and economic crisis.  Most who ask are not from the banking sector, and so I am listing, from now a 40 year career, six basic reasons for what happened.  In no particular order:

1) Closed-end credit to open-end credit.  I have taught this simple concept for over 20 years and in about that many countries.  In 1967 while doing my college summer bank job as a teller, one day a factory worker came to me with his installment loan payment book.  As I took his payment and stamped the payment coupon, he said, “Only one more payment to go and then I can come back and get another loan.”  I never forgot the words of this honest man.  In those days, you did not get new credit until you fully paid off the old one and virtually ALL credit was extended on a closed-end basis, meaning payments (usually monthly) consisting of both principal and interest paid down to zero.  Also, a mortgage to buy a home required a 20% down payment on the purchase price and you could not buy a house if it cost more than two and a half times your annual income Compare that to the recent sub-prime story of the man who made $20,000 a year and was loaned 100% of the price to buy a $700,000 home!
 
In the 1980s or so, the shift was to open-end credit, meaning to the bank all that mattered was to get the interest - as the banks never wanted the principal to be repaid.  I first learned this in London in the late 1970s when British banks explained the perpetual (and authorized) overdraft was their preference not our American installment loans.  Their view was “so long as we get the interest, we want to keep the borrower in debt.”  We Americans soon went the same way but instead with credit cards, home equity loans, and eventually sub-prime mortgages.  The idea was keep the borrower in debt forever but keep collecting his or her interest.  This shift led to massive consumer debt over decades, as people found credit so very easy to obtain (unlike the 1967 factory worker) and never were required to pay it down to zero.  Consumer debt (see below) is now many, many times, by ratios as well as total, above what it was 30 or 40 or so years ago.  It is one of the five deadly debt areas (also explained below) that have led us to where we are.

2)  The “3 – 6 – 3 rule” of banking that used to be.  This is another teaching topic that gets a laugh in any country I teach in.  I say that from end of World War II to the late 70s, banking was: “pay your depositors 3%, lend to them at 6%, and you could play golf by 3 PM.”  But banks lost track of their core business (it is true external changes imposed part of this). Instead they moved to exotic (often so complex no one understood them) methods of making profits, which created the unfathomable derivative market mainly started in the 1980s.  A small amount of foreign exchange experience around 1980 made my head spin with calculating “foreign exchange options” which was kindergarten compared to today’s CDOs, credit default swaps, etc.  These recent instruments have nominal (face) values in the trillions.  Bankers used to need common sense and wisdom of the market cycle (the “business cycle” as my Dad taught me) of ups and downs.  Now, or until very recently, the best banking skill was a PhD in math (see 3rd reason).
 
But this complexity has led to another problem that has become the crux of recent events.  In the old days, it was easy to value virtually all bank assets.  I spent the 1970s doing the traditional approach to determining the value of loans and other assets, with the bad ones needing a certain “provisioning” percentage against probable loss.  But the complexity of these new derivative based assets and commitments has made them virtually impossible to value, thus no one has been certain as to the extent of losses of these so-called “toxic assets.” This, the speculation of insolvent large banks is presently (end of February) running rampant – again because no one knows for sure the extent of losses, both now and under future scenarios.   This uncertainty as to value of assets and thus the solvency, or likely insolvency, of huge, essential banks is the main cause of why credit markets have virtually frozen between banks and, more painfully, from banks to borrowers.  Again all this used to be so easy when the “3 - 6 - 3 rule” prevailed.

3) The 30 year old wizards and their clueless 60 year old bosses.  This started with the infamous trader Nick Leasson around 1990 who was smart enough in Singapore to bring down a 300 year old British bank (Baring Brothers) because the old guy directors in London had not a clue as to how he was trading (dealing) and the risks he took that no one was paying attention to – or understood.  The recent old guy version is former financial guru Robert Rubin (a Clinton Treasury Secretary) making an eight figure annual sum from Citibank and finally recently admitting, “I myself did not understand all the details and risk of our more complex derivative transactions.”  Thank goodness he is now gone from our most important bank!  The young ones are so very smart as to math and very computer savvy but they never had experienced down markets in housing or stocks.  The old ones, like me, had seen plenty of recessions, etc, but we could not understand the incredible complexity of new financial instruments and how to manage them.  Again I thought foreign exchange options in 1980 were complex - well those were 1st grade arithmetic compared to recent years.  There is probably very little fraud in the current mess, but the above was rampant.

4) The Shadow Banking Sector.  The superb Nobel Prize winner and NY Times columnist Paul Krugman coined this phrase.  In my American banking supervision career (1971 to 1982) virtually all credit extending financial institutions (then almost all were banks) were more or less thoroughly supervised by the Federal Reserve, FDIC, or the U.S. Treasury (via the “Office of the Comptroller of the Currency”).  But by this decade, a huge percentage of credit extended, and virtually all sub-prime lending, was originated by financial entities outside this regulatory supervision umbrella, thus the “shadow banking sector.”  That tarnished former guru of finance Alan Greenspan (in the same league as the aforementioned Rubin) was warned six or so years ago (by people I knew) to pay attention and widen proper supervision to the shadow banking sector.  As expected, the former guru responded “No, no, the markets know best – we will not supervise them.”  Greenspan will go down as the Herbert Hoover of central banking.

5) The Competition for Regulatory Laxity.  In my first decade of work, I was fortunate to be sent by the Fed to London for a short assignment and wound up, in 1979 as part of an American group, in the hallowed halls of the world’s most revered financial entity--The Bank of England.  The dry old Brit, some 30 years older than I was then, said, “It does confuse us over here as to your multiplicity of jurisdictions of your banking sector.”  He meant the confusing roles of the Fed, FDIC, OCC and the fifty states, and that, in certain ways, banks could choose who regulated them - and many most certainly did.  But it became much worse when the hapless SEC took over their “so-called supervision” of the five giant investment banks on Wall Street early in this decade – none of which exist today in the form they did less than a year ago.  The SEC’s mess as to the big five investment banks and some horrid decisions made last September (Lehman Brothers being allowed to fail while Bank of America took over equally as bad Merrill Lynch - to perhaps bring down one of America’s two largest banks) were huge misjudgments by many, and thus have contributed greatly as to all that has happened since.  We need a virtual “start over” on how our financial system is regulated domestically (set in the 1930s and thus 70 years out-of-date) and far, far greater combined international powers (not the present vague guidelines) as to how the global financial giants are supervised.

6) The five deadly forms of debt – all at their all-time highs by any measurement.  The other superb financial writer (along with Krugman) is Kevin Phillips, who started in the Nixon White House. He has now has converted into a harsh critic of what have been the underlying causes of America’s economic decline this decade.  He shows that five forms of debt – mortgage, consumer, corporate, fiscal (Federal government deficit), and international are at historic highs, not just total but in ratios to the size of the economy.
 
The international levels of debt are worth a comment or two more.  I was fortunate enough, through a close friend, to hear in-person this past December Kenneth Rogoff, a former IMF Chief Economist (I regard the IMF as the only competent international organization in the world).  Rogoff, now a Harvard economist, said the current account indicated as far back as 2000, “not when but eventually” the current USA and global financial crisis.  The current account is largely the trade balance (exports minus imports) but includes invisible investments in a country as well. Like Rogoff, I read the current account as most important number in the world economy and look it is weekly in the ECONOMIST, and yes it has constantly shown the huge current account deficits of the USA, Britain, and even Spain, to indicate all three countries were living well beyond their means, as subsequent events have obviously proved.   
 
The USA and UK (unlike Japan and Germany and of course especially China), have allowed their financial sectors (which just churn money around and do not add real value) to, shockingly and significantly, exceed their manufacturing sector (the part that makes things people globally wish to buy).  As stated, both countries run large and persistent current account deficits. This of course led to a day of reckoning that has finally come.  Thus, the present crisis is deepest in the USA and Britain, both overly reliant on their financial sectors, with overblown housing sectors, shrinking manufacturing, and large government deficits (though Britain’s current account, at the moment, is much closer to balance than its large trade deficit).  The current account is an object lesson to us all.

So we Americans, and our British “cousins” have lived well beyond our means for at least two or three decades and alas, it will take years to get out of it.  In turn, somehow Canada always gets it right, whether it be in national health care, foreign policy, or banking, as a very recent World Economic Forum ranked Canada as the soundest banking system in the world – the USA came in 40th!!
 
The above six points are certainly not the only reasons for this mess, but they are all true, have all contributed, and perhaps most of all, they are all easily understandable.  Perhaps that is the saddest part of where we are.
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