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ESSAY

THE PROBLEM

WITH BANKS?
BANKERS

Bad loans, not bad laws, created the current crisis
By L. J. Davis

L

ate this

past winter, those energies in Washington not summoned to join the Mother of Battles in the sands of Kuwait were directed to the nervous contemplation of a no less uncertain and mine-laden ground: the distinctly queasy landscape of the American banking business. A crisis had begun to roll through the vaults of the nation's 12,806 commercial banks-banks whose main function has traditionally consisted of making large, short-term loans to underwrite business and governmental activities, but whose role had now apparently expanded to include providing bad loans to anyone who could fill out an application. Bad loans to overextended farmers followed by the mid-Eighties collapse of the domestic oil business-which turned numerous wildcatters into deadbeats-had extinguished many smaller commercial banks in the country's heartland, but this was something else. For eleven large banks in the nation's traditional money centers of New York, Chicago, and San Francisco, return on assets in 1990 fell to about 0.3 percent, a grim return even by the banking industry's usual less-than-stimulating standards of profit. And a great many of the nation's commercial banks made no money at all: Last year, one in seven posted a loss.

A newly acquired understanding of the savings and loan scandal-an ongoing and still worsening mess that, as I wrote in these pages last fall, will end up costing American taxpayers an estimated $500 billion-no doubt sharpened the curiosity of official Washington with regard to the health of the nation's commercial banks. (See my report, “Chronicle of a Debacle Foretold: How Deregulation Begat the S&L Scandal," in the September 1990 issue of Harper's Magazine.) The creation of this abruptL. J. Davis, a Harper's Magazine contributing editor, wrote about the S&L scandal in the September 1990 issue. The article was nominated for a National Magazine Award.

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ONE OF THE ODDER

LESSONS OF THE DISTINCTLY

ODD REAGAN ERA APPEARS TO BE THAT A CERTAIN KIND OF ECONOMIC BOOM IS ABSOLUTELY TERRIBLE FOR THE BANKING BUSINESS

ly raised consciousness could also be traced to the grainy photographs that crowded the front pages of nearly every big-city newspaper during the first days of January, photographs showing bundled, sullen men and women lined up like Moscow shoppers to withdraw their hard-earned monies from the Bank of New England, the thirty-third largest bank in the country before its seizure on the sixth of that month by the Federal Deposit Insurance Corporation (FDIC).

One of the odder lessons of the distinctly odd Reagan era appears to be that a certain kind of economic boom is absolutely terrible for the bank. ing business. The banking crisis did not emerge with the nation's economic downturn that commenced last summer. It just got worse. In the forty-six years that divide 1933—the year federally backed deposit insurance was created, in the wake of the Great Depression's banking crisisfrom 1979-the year before an amiable marionette named Ronald Reagan began his march on Washington-558 insured banks failed, an average of slightly more than twelve a year. From 1980 to 1989, however, 1,085 insured banks either failed or were rescued (at no small cost) by the FDIC, an average of 108 a year, and the pace of failure was quickening; 630 of the failures occurred in the recklessly prosperous years 1986-1989. Something had gone very wrong.

The ominous signs emanating from the commercial banking system were, alas, among the numerous warnings of grave national peril that, from January 1981 through December 1988, utterly failed to murder the presidential sleep. It is not clear when Reagan's successor began to ponder the vexed matter of the banking system, but one may plausibly speculate that well before last year's belated emergence of the S&L debacle as a volatile political issue-an issue, perhaps not incidentally, with George Bush's son Neil rather close to its dark heart-the new chief executive suspected that things were not quite as they should be. Indeed, how could he not have known? A man of modest wealth, inherited position, and the finest education that private means can buy-and for years the perennial sidekick of the Republican establishment-Bush counted many friends among the men in subtle pinstripes who occupied spacious corner offices in the handful of large northeastern banks whose very names (Chase Manhattan Bank, Chemical Bank, Citibank, etc.) are the ones people think of when they think of banking at all. (Bush also has many well placed friends in Texas, his adopted home state, where 638 banks have failed since 1988.) Friends in trouble have a way of letting one another know, and the gentlemen in the pinstripes were in very big trouble. They had, it seemed, been making bad loans, frightfully bad ones, and they had been making a lot of them.

In September 1990, drowned out by news of looming war and budget deficits, came word that Chase Manhattan Bank, the nation's third largest, would eliminate 5,000 jobs, slash its dividend by 52 percent (to 30 cents a share), and place $650 million in its reserves to cover possible losses on bad loans-the latter move meaning that Chase could no longer use two thirds of a billion dollars in real money it could have used only the day before. By year's end, under intense pressure from government regulators to rebuild its capital, Chase had sold $9 billion of its assets, reducing its size by 8 percent. Citibank was also in trouble, and also shrinking; it nearly halved its dividend and eliminated 8,000 jobs. And there was more bad news to come. In January of this year, Citi revealed that perhaps $2.5 billion it had loaned to customers in commercial and residential real estate were "non-performing," which meant that the loans either were not being repaid or that there was a strong likelihood that they would not be repaid. It was recalled with a certain bleak irony that as recently as the spring of 1990, which now seemed an age ago, the bank's chairman, John Reed, had confidently predicted that annual earnings at Citi would soon reach a record $5 billion.

46 HARPER'S MAGAZINE / JUNE 1991

In the wake of all this troubling news, R. Dan Brumbaugh Jr., a former deputy chief economist of the Federal Home Loan Bank Board, believed he had detected unmistakable signs that a run had begun on the big money-center banks-a silent, not easily perceived run, because (a) the deposit bases of the banks were not actually shrinking all that much; and (b) no one, understandably, has much of an interest in talking about this distressing event, a bank run being the great nightmare of finance capitalism. According to Brumbaugh, and he was not alone, large institutional investors such as pension funds had begun this past winter to withdraw millions of dollars in largely uninsured deposits. Meanwhile, the resulting shortfall was being made up by the brokerage houses and investment banks that assemble so-called brokered deposits: funds invested as deposits for their clients-many of those very same institutional investors-usually packaged in bundles of $100,000 to qualify for federal deposit insurance in the event of a bank failure.

More banks could well fail, and fail dramatically, taxing the already sapped FDIC. This spring the corporation finds itself with little money, and it may very well have none at all in any practical sense of the word. The FDIC estimates its available funds, following the fiasco at the Bank of New England, at $8 billion, or about 42 cents for each $100 of insured deposits. (During banking's age of reason, which ended in, roughly, 1974. people talked of having on hand $1.50 per $100, and almost no one gave the insurance system a second thought.) But the $8 billion figure does not reckon with the corporation's contingent liabilities-real losses that the FDIC has actually recognized and artfully hidden. Finding its template in the desperate actions of the insolvent and now defunct Federal Savings and Loan Insurance Corporation, the FDIC handsomely reimburses a sound bank for assuming the creaky outstanding loans, many of them very bad indeed, of a failed bank. Because these dangerous loans, for which the FDIC is ultimately responsible, are carried off the corporation's books, the true magnitude of the

insurance fund's exposure to possible losses is concealed. In fact, the unaudited FDIC exposure to such contingent liabilities in 1990 was at least $6.5 billion.

The FDIC, fully aware of the losses it nevertheless keeps well hidden, has turned to other sectors of the government for help. It wants to borrow some $5 billion from the U.S. Treasury to clean up the mess caused by the Bank of New England's failure, and it entertains hopes of obtaining as much as $65 billion more-from the Federal Reserve, the Federal Financing Bank, and the banking industry, as well as the Treasurybefore the nationwide crisis is over. In this regard, one should recall that since the establishment of the insurance fund in the 1930s, the cost of dealing with failed banks and paying back insured depositors has been covered solely with monies the FDIC amassed through collecting premiums from banks it insured. (In each of its first fifty-four years, it operated at a pleasing and consistent profit and actually returned $20 billion to the banks as surplus premiums.) One should also regard with healthy skepticism the claim of FDIC chairman L. William Seidman that the banking industry itself (by charging itself increased insurance premiums) will pay off the many billions in loans, or, if that fails, that the necessary funds

THIS SPRING THE FDIC

FINDS ITSELF WITH LITTLE MONEY,

AND IT MAY VERY WELL HAVE NONE AT ALL IN ANY PRACTICAL SENSE OF THE WORD

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Illustrations by Keith Bendis

ESSAY

47

48

WHEREVER THE FDIC TURNS

FOR MONEY IN THE END, AND
THERE WILL LIKELY COME TO BE A
BUST OF AN END, THERE IS EVER

ONLY ONE SURE SOURCE
OF FUNDS: US

will be raised through the sale of the assets of closed banks in the (already glutted) marketplace. Wariness is further recommended when one studies the FDIC's canny appeal to sources other than the Treasury, making it seem as though tax dollars are not at issue, which they are: The Federal Reserve et al. have only the Treasury to turn to should the loans to the FDIC go sour. Wherever the FDIC turns for money in the end, and there will likely come a bust of an end, there is ever only one sure source of funds: us.

he Bush administration would have you think it has devised a plan to prevent such a parlous outcome. The President chose to have his Treasury secretary, Nicholas Brady, not only announce but calmly explain the administration's proposal to reform the banking industry-a proposal the President has called nothing less than his chief domestic legislative priority for 1991-early in February, when the smoke of Middle Eastern battle was at its thickest. The result, perhaps unintended, was that its specifics have been less firmly grasped than the plan's contemporarysounding goal: getting the banks and the banking laws up to speed by making them conform to "the reality of the marketplace." The marketplace emphasized by Brady is the international one, where only one U.S. bank Citibank-ranks among the world's top thirty, most of which are now Japanese. As recently as 1970, Brady reminded assembled reporters,

"We had nine banks" in the top thirty. And so, with a bold and single stroke, it was miraculously revealed by the administration that the problem with banks was not a matter involving billions of dollars in terrible loans made by too-easily-duped bankers. The problem was simply one of "modernizing" the banking system for the international marketplace, a problem to be solved-as might be expected from the Bush administration-through the magic of deregulation.

In fairness, it should be pointed out that there are aspects of the administration's proposal that have little to do with the international marketplace and are eminently sensible. For example, it is a perfectly reasonable and long overdue idea to allow banks to open branches across state lines and buy banks in other states without the archaic legal tangles that now cost the industry billions of unnecessary dollars. Consolidation would no doubt result, with larger banks, but this would actually do much to solve a problem, not cremany small banks being folded into fewer, ate one. Compared with its foreign competitors, the United States is a seriously overbanked country, a source of much strain to examiners. Japan has 18,000 people per bank, France has 63,000, and Britain has 86,000; whereas the comparable figure for the United States is 7,300 citizens per bank. (Citibank, the largest bank in the land, attracts only 1 percent of the nation's depositors.)

The heart of the administration's proposal, however, has nothing to do with rationalizing the system. Between January 1986 and October. 1990, the banks charged off $75 billion in bad loans. Are bankers to be castigated for this? No way. By a simple exercise in semantics, the bankers have been transformed by the administration into hapless and innocent victims of historical forces beyond their control, of global economic changes, and of the failure of U.S. banking laws to confront the

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HARPER'S MAGAZINE/ JUNE 1991

altered environment. By this reasoning, gullible bankers have not been responsible for losing money held by the banks they run. Banks have been unable to make money because of the governmental constraints placed on the luckless bankers who run them, and the time has come to strike off the shackles and set them free.

et us pause for a moment and examine the banker. Who is he? He is a man to whom you entrust your money. He keeps it safe in his vault, pays you interest for the privilege, and returns it when you want it, with a smile or a frown, as the occasion demands. To protect your money, pay you interest, and turn a (modest) profit for himself and his stockholders, he is also supposed to invest the funds under his care in carefully chosen, disaster-proof locations, such as Treasury bonds, real-estate deals examined beforehand with microscope and skepticism, gilt-edged foreign loans, and the business ventures of executives as cautious as himself. A banker need not be smart (a persuasive argument can be made that a banker should not be smart), but he must be prudent; he must not, under any circumstances, lose the money entrusted to his care.

The money, however, is the problem. A banker is placed in the vicinity of quite a lot of the stuff, the temptations are obvious, and the history of banking, when it is impartially examined, is not encouraging. After the 1929 stock-market crash, the cynical and worldly men of the New Deal decided that enough was enough: Bankers should be given clear rules, instructed to follow them, and punished if they did not. The resulting financial system, after an initial time-out for the remainder of the Depression and a subsequent world war, flourished, and the nation was immeasurably enriched in the process, though the bankers themselves chafed under an enforced prudence that assumed that quantities of cash made them stupid, which it does.

Under the Bush administration's plan, bankers will be allowed to do pretty much what they were happily doing in October 1929. For example, they might sell insurance, if the states in which they are chartered permit it, and several already do. Another of the administration's proposals would allow banks to underwrite corporate securities as investment bankers do, or sell mutual funds like the brokers do. The administration also wants to permit industrial companies to own banks, reasoning that this is how it works in Japan, and Japanese banking is the world's most successful. Unfortunately for this line of reasoning, a number of U.S. industrial companies have already entered the banking business in everything but name, and their success has been mixed at best. (In February Westinghouse Electric wrote off $975 million lost by its financial-services arm in bad real-estate loans, junk bonds, and leveraged buyouts; Unisys, the computer company, plans to sell off much of its finance unit's two-thirds-of-a-billion-dollar investment-debt portfolio, because servicing it has put a strain on the company's cash flow.)

These Bush administration reforms amount to little less than a potentially catastrophic counterrevolution. In the teeth of immediate precedent-the deregulation of the S&Ls and the resulting losses and frauds the administration would happily undo the safeguards, already somewhat eroded, constructed during the Great Depression to place a wall between banks and commerce. Much of the deposited money lost by bankers during the 1929 crash and the long depression that ensued disappeared as the result of their involvement in high-risk, deceptive, and complex transactions of the kind carried out today by investment banks. To encourage depositors to return their money to the commercial banks and thereby create the capital, in the form of savings, that a market economy requires for growth-Congress passed the Glass-Stea

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