7.13.2014

Fragile By Design, Haber and Calomoris - A*

                                               In the fall of last year, the authors previewed this book in a 'Foreign Affairs' article that piqued my interest. Indeed, I was astounded, and still am, by one simple statement. Since the late 1830's, the US has suffered through 12 major banking crisis - Canada, none! My historic desire to read books about the 'dismal science' has been pretty low, perhaps exceeded only by my total lack of interest in books about banking systems.  But, how could our unbelievably successful nation have faltered so many times and still have wound up number one? I felt this was a must read.
                                               Banking systems are a function of national political will and design. In essence, you get the banking system your nation's politicians summon up. Without credit, a nation cannot grow and it is critically  important  that a system provide stable credit. The US has had ample credit, but in an inherently unstable system.  In this book, the US system is contrasted to that of a number of countries, but particularly those of England and Canada in what the authors call "The Game of Bank Bargains."  The starting point is that those in charge of the government partner up with aspiring bankers and create a set of rules.  The government charters the banks and passes laws that establish the rights of depositors, borrowers, creditors, investors and insiders. As the arbiter, the government has to juggle inherent conflicts of interest.  For example, how do you establish the rules of debt enforcement, when the people against whom debt may be enforced are the same people who elect the government?  The list of conflicts in a sophisticated modern democratic society are endless.
                                               The first important national financial institution was the Bank of England, established in 1694 to finance Parliament's wars with France and the expansion of the Empire.  It was the only joint stock company ( limited liability) with a banking charter allowed in England until 1825. "The Bank of England deployed its resources to serve government needs throughout the eighteenth and early nineteenth centuries."  Interestingly, it did very little to help finance the Industrial Revolution.  The tide turned against the B of E in the 1820's when other joint stock companies were allowed to charter banks, and the B of E began to establish branches around the country.  A central premise of this book is that strong national institutions with multiple branches are the key to economic growth and financial stability, whereas small dispersed single branch banks are incapable of spreading risk. The reforms of the early nineteenth century led to a burgeoning economy and a bank system that was essentially crisis free until 2007.
                                                The authors are American - one teaches at Stanford and the other Columbia - and it is our system that is the primary focus of this book.  The  Constitution is silent on banking and it was only by citing 'implied powers' that Hamilton was able to charter a national bank. The agrarian populists were opposed and in 1832 were able to revoke the banks charter. "From this point until roughly 1980, the coalition of small bankers and agrarian populists would dominate the politics of bank chartering and bank regulation." Thus, the US was poorly served by thousands of small state-chartered unit (one branch) banks that were non-competitive supporters of the local gentry. This inherently unstable system would pay low interest on deposits, make risky loans to its supporters and not have the wherewithal to survive liquidity crises. " By 1914, there were 27,349 banks in the US, 95% of which had no branches!" This system had spawned bank crises in 1837, 1857, 1861, 1873, 1884, 1890, 1893, 1896 and most famously, 1907.  After the banking system was saved by J.P. Morgan, Congress authorized the Federal Reserve.  The Fed, however, did not change the underlying fundamental, it merely provided a national liquidity vehicle.  "As late as the early 1970's, only 12 states allowed unrestricted intrastate branching and no states allowed interstate branching." Disintermediation, money-market funds, the computer revolution, globalization, urbanization and the 1986 Tax Act all added up to the end of the 19th century agrarian system in the 1980's. Banks operating national branching networks accounted for only 10 percent of the US banking system in the early 1980's. By the mid-90's, they accounted for more than 70%.  As the US system finally achieved the ability to spread risk, politics intervened. Merging banks were scored by the regulators on many fronts, and one was compliance with the Community Reinvestment Act of 1977.  In order to assure support on the CRA issue, the banks dropped their credit requirements for poorer  urban borrowers. Banks committed  billions  in CRA lending to underserved  or low -income communities between 1992 and 2007. In turn, the government supported entities (GSE's) of Fannie and Freddie adjusted their rules to accept loans that had smaller down payments, riskier profiles, etc. If this new type of inherently aggressive loan was ok for the urban poor, it was clearly appropriate for the middle class. Three percent down payments became the norm and no-doc loans categorized as Alt-A and sub-prime became the rule not the exception. "The result was the rapid growth of mortgages with high probabilities of default for all classes of Americans." Both the Clinton and Bush administrations pushed the housing envelope because it not only brought the American dream to a much higher percentage of the population, but because real estate fueled the boom that was the '90's and '00's.  The merry-go-round brought in mortgage bankers who churned out loans, leveraged investment banks that packaged and sold the sub-prime stuff around the world and the rating agencies that approved it all.  Capital requirements were lightened by the regulators because it seemed like the boom would go on forever. "By June of 2008 there were approximately 28 million sub-prime and Alt-A loans outstanding with a total value of approximately $4.8 trillion.... roughly half of all mortgages outstanding were high risk."After it was over, a deposed bank CEO said that you had to keep dancing while the music played. The music stopped and the government was required to bail out the banks in order to avoid a repeat of the Great Depression.  The damage to the US will reverberate for decades.  The authors believe, and I believe they make their case, that a strong centralized system with branch banks is the key to financial stability and growth. They laud the Canadians. For almost two centuries, the Canadian branch banking system has spread the risk around the country. It has been so effective that they didn't even need a central bank until the Depression and brought on deposit insurance later than the US.  There were no liar loans, no no-down-payment loans and no negative amortization tables. Excess did not seep into their system and they suffered no Great Recession.
                                               Although it appears throughout this book that the authors discredit perceived truisms of American history (dismissing deposit insurance as inherently risky), and that at times, they carry some right wing libertarian message, I found this to be one of the most insightful books I have ever read. I feel as if blinders have been lifted from my eyes. Branch banking seems so terribly logical and efficient.  When I combine that fact with my personal conclusion that Congress is, and has been,  structurally incapable of governing in the best interests of the nation, I view this book as an economic epiphany.  It was reviewed for the Times by the man who wrote the Pulitzer-winning treatise on the Great Depression called 'Lords of Finance'. The article by Liquat Ahamed on April 11 this year is a superbly composed  must read. He does think that our recent travails are more complex than the authors concede while making their case here and focusing on the CRA. But, he does refer to the book as "brilliant" and that "it deserves to become a classic."




                                           

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