Financial Reform Is No Silver Bullet

These days I find it very hard to be on the same side of arguments with Paul Krugman. I must admit that today I am mostly in agreement with what Krugman has written in the New York Times. (“Georgia on My Mind”, http://www.nytimes.com/2010/04/12/opinion/12krugman.html?hp.)

To begin with, Krugman asks the question: “What’s the matter with Georgia?” He raises this question because that Georgia has recorded 37 bank failures since the beginning of 2008 against 206 for the nation as a whole.

Why is Georgia different?

Georgia, he contends, was not a part of the housing bubble that saw home prices soar to the point that upon the collapse of prices, many home owners found themselves in a position of negative equity. Unlike many other states, Georgia had lots of land and few limits on expansion into empty spaces. As a consequence, Georgia, and especially Atlanta, did not see much of a rise in housing prices.

Still Georgia managed to create its own housing problem. Krugman states that “the share of mortgages with delinquent payments is higher in Georgia than in California” and “the percentage of Georgia homeowners with negative equity is well above the national average.”

The problem? “Georgia suffered from a proliferation of small banks.” And, these small banks were anything but conservative. “Actually, the worst offenders in the lending spree tended to be relatively small start-ups…”

These banks did not develop local deposit bases but relied on “hot money” from out-of-area investors. Their lending practices? New mortgage loans, subprime loans, and home-equity loans. Anything they could put on the books to generate fees and cash flows.

The prices of houses did not rise by as much in Georgia as they did in other states, yet the equity that people had in homes fell, and fell, and fell.

Krugman contends that the reason for this was the absence of consumer-protection regulation so that people could use their homes as “piggybanks” and almost continuously extract cash by increasing the size of their mortgages. He contrasts this behavior with Texas that also had lots of land and few limits on the expansion into empty spaces. Texas avoided the mess that Georgia found itself in because, according to Krugman, Texas had consumer-protection regulation.

This is where I differ slightly from Krugman in interpretation. To me the problem is that “Georgia suffered from a proliferation of small banks.” Too many banks were chartered to serve too limited a geographic area. The competition for loans was too great for the area. Real estate construction was expanding because it could get financed. People could continue to borrow because banks needed to push out money. The government was happy because more Americans were owning their own homes.

This was all a part of the general credit inflation of the past twenty years as more and more debt was created to support the movement of into housing. It came from an unlikely place: commercial banks.

If you would go back in history and ask bankers from the 1960s whether or not commercial
banks should hold more than 60% of their loan portfolios in real estate loans, you would have gotten an overwhelming vote of “NO!”

If one looks back at the 1960s, one finds that, for example, all domestically chartered banks held only 25% of their loan portfolios in mortgages or other real estate loans. Looking at the same figures for 2009 we find that all domestically chartered banks held 61% of their portfolio of loans and leases in mortgages or other real estate loans.

Commercial banks used to lend primarily to businesses. That is why they were called “commercial” banks.

Now domestically chartered commercial banks hold three-quarters of their loan portfolios in real estate loans and consumer loans.

We get a split according to size as well. Small commercial banks now hold almost 70% of their loans and leases in mortgages and real estate loans. The largest 25 domestically chartered commercial banks in the United States hold roughly 55%.

The largest banks hold 17% of their loan portfolio in consumer loans whereas the loan portfolios of smaller banks only contain about 9%. Adding the two numbers together results in both the big banks and the smaller banks holding around 75% of their loans in these categories.

Commercial banking has changed!

Since the 1960s, the mortgage market has become the place where commercial banks play. This is even more so for the smaller banks! And, Georgia represents our extreme example of this.

How did we get to where we are? A picture of this transition from the 1960s to now is presented by Michael Lewis in his book “Liar’s Poker”. The first mortgage pass-through security was issued in 1970. By the middle of the 1980s the mortgage market was the largest component of the capital markets worldwide. Lewis describes this part of the capital markets in his book.

I do agree with Krugman that some consumer-protection regulation is important in this world. But, it is not a panacea. And, along with other regulation of financial institutions it is not a “silver bullet” that will keep the United States from another financial crisis in the future.

We are hearing almost daily the things that the larger commercial banks are doing to avoid future regulation. Plus, it is my contention that these banks have moved well beyond what Congress is now working on to resolve financial crises. Furthermore, we are constantly bombarded by headlines like the one that appeared in the Financial Times this morning, “Banks seek to exploit new rules,” http://www.ft.com/cms/s/0/b6e57828-4588-11df-9e46-00144feab49a.html.

And, as Krugman argues, “The case of Georgia shows that bad behavior by many small banks can do as much damage as misbehavior by a few financial giants.” Of the 8,000 small- to medium-sized banks in United States, about one in eight is seriously in trouble. This certainly is not the major part of the pie as these 8,000 or so banks make-up only about a third of the assets of domestically chartered commercial banks in the United States. The largest 25 banks control two-thirds of the banking assets in the country.

Conventional regulation is not going to do the job in this information age. (See my comments on this beginning with http://seekingalpha.com/article/184153-financial-regulation-in-the-information-age-part-a.) I have found a regulatory scheme I believe will work better than the ones currently being proposed. I will write on this scheme later this week.