Joe Nocera, financial columnist for The New York Times, had an interesting conclusion to his recent article on Bank of America:

I admit it: I want to see the banks feel some pain. Most people do, I think. Banks did terrible things during the subprime bubble, and they still haven’t paid any real price. I find myself rooting for judges to rule against banks in foreclosure cases. I would love to see these big investors put the serious hurt on Bank of America, which will encourage other investors to pile on. I know this colors my thinking. I can’t help it.
Yet I also know the flip side. If the foreclosure lawyers start winning a lot of cases, if judges halt foreclosures on a widespread basis, if investors start to extract billions upon billions of dollars from the banks — and if banks become seriously weakened as a result — we’ll be right back where we were two years ago. The banks will need to be saved for the good of the economy. The taxpayers will have to come to the rescue. That’s an appalling prospect too.

Banks: We can’t live with them, and we can’t live without them. It stinks, doesn’t it?

This brief flourish of disgust for the banking industry received a lot of attention, almost all of it favorable. Millions of Americans want to see “serious hurt” put upon the banks, especially the big banks that are in the Too Big To Fail category. Why do we hate the banks so?

I suspect it is not the 8,000 community banks that are distrusted and loathed by the average American consumer. It’s the big banks, which are increasingly consolidated into the Big Four: Citigroup, Bank of America, JP Morgan Chase, and Wells Fargo. There are some wannabe big banks just below these four, like US Bancorp, PNC Financial Services, or SunTrust Bank, but even the biggest of these regional banks is but 1/6th the size of any of the Big Four. It’s the behemoths in the industry which have a nationwide presence and special coddling from the regulators and the federal government. These are the banks most of us deal with in some form or another, and the way they deal with us is very different from the approach taken by other banks. If you want to understand why Joe Nocera and so many others dislike these large banks, you have to understand what they think about you and what you mean to them.

The Science of Retail Banking

Even as recently as 20 years ago, retail banking was a very localized affair. You set up your account at your local bank, or the branch of a local bank, and your business stayed there until you moved somewhere else. If you were involved in the serious business of arranging a car loan or home mortgage for yourself, you had to talk to a senior banker, who asked a lot of questions that all ultimately focused on one critical question: How were you going to pay back this loan? The banker looked very carefully at your job, your income, your financial stability, and even your personal stability when the loan was for three years for a car purchase, or up to 30 years for a mortgage.
This old-fashioned way of doing things was very personal, and the banks usually called the department responsible for this line of business Personal Banking. You don’t hear this phrase used very much any more. Instead we are shepherded into Consumer Banking or Retail Banking departments, and this tells us pretty much everything you need to know about modern banking at the big banks. There is nothing personal about it.

As banks consolidated and industry giants rose to nationwide dominance, the winners in this competitive race found they could no longer manage individual banking on a personal basis. It was simply not cost effective to manage millions of customers one at a time. The banks could attempt to give you a personable greeting, but the way they managed your account was completely impersonal. Today at the very highest level of management, the head of the department is no longer a banker who grew up in this business, but a marketing or retail expert whom the bank hires from Pepsico or Procter & Gamble. These are men who know how to sell products, how to conduct marketing campaigns, how to film slick and convincing commercials, how to package material in attractive colors, even how to get all employees to wear the same color shirts and blouses (drop in at any Chase branch and you’ll see every employee wearing the same color blue).

The entire emphasis of the bank’s relationship with you is to get you to buy their products, and in the big banks employees are judged and rewarded on their success in “cross-selling” products. The Big Four want to get as much of your financial business as they can in their bank, because they know how difficult it is for an individual to close out accounts and transfer business elsewhere. This impersonal approach to the consumer now extends even to the most important aspect of the banking business – lending you money. Bankers no longer need to ask how you are going to repay that auto loan or mortgage; it’s all laid out for them in the numbers generated by computer models that produce such supposedly-predictive ratings as your FICO score.

Banking By the Numbers

To the banks, you are just an input into a computer algorithm. Your income, how many lines of credit you have, your repayment history, and even your area code are the sort of facts used to determine whether you qualify for a loan. The ubiquitous FICO score, originally intended to predict default risk for short term consumer loans, was extended to mortgage lending at the start of the housing boom, and this made it much easier for banks to hand down such an important decision to junior employees with no credit experience whatever. While the FICO score has been tarnished in this depression as a tool for predicting default risk on unsecured loans such as credit cards, it has been a disaster in predicting mortgage default risk, to the point where the banking industry’s use of such models for long term consumer lending can be viewed in retrospect as recklessly irresponsible.

Computer models find it impossible to predict whether a consumer will experience either of the two events that are most correlated to default risk: loss of a job, or a health catastrophe. While a human banker probably cannot predict these events either for a customer, a banker with a traditional personal relationship to the consumer ought to be able to judge whether the consumer justifies a loan extension or modification of terms in order to deal with the crisis. In modern banking, this is almost impossible to achieve because the hands of the banker – usually a junior level employee – are completely tied. The preferred way banks have of dealing with a customer at risk of default or late with their payments is to turn the account over to a collection agency.

This is one of the reasons banks have been so quick to foreclose on late mortgages, and why modifications to the loan terms are rarely granted, if the customer can even reach a banker to discuss the matter. The whole modus operandi of banks is to get you to buy their product – or at least it used to be before the credit crisis – and with existing mortgages the trick is to discuss with you only the lower monthly payments possible with a refinancing. The total amount of debt is never mentioned until the point when you sign the mortgage contracts. Everything is about marketing and retailing the product, which means that if ever you are at risk of default, you are no longer product-worthy and of any interest to the bank. That’s one big reason why the banks want such people off their books as quickly as possible, and why they do not allow for lowering of interest rates, short sales, or reduction of principal owed on mortgages. The Obama administration has learned this the hard way with its ill-fated HAMP program that has been a failure in getting banks to modify mortgage terms.

The TBTF banks earn billions of dollars each year on fees from product sales, of which loans are considered just one of many products such as checking and savings accounts or safe deposit boxes. The goal of these banks is to earn more from fees than they do from net interest income on loans, which has been their traditional source of income, because fee income is considered more reliable. Moreover, fee services don’t clutter up the balance sheet with assets which incur expensive capital charges, which is another big problem for loans (banks need to keep at least 8% capital for every loan they book). In order to convert loans into fee-generating products, it has been essential for banks to sell new loans to investors as quickly as possible so that they don’t eat up capital. This is the motivation behind the securitization process, where mortgages, auto loans, and credit card balances are packaged into bonds and sold to investors as fast as they come into the bank.

The interesting thing about securitization is that a 30 year mortgage might be on the books for no longer than 90 days on average, which means the bank only has to worry about default risk for three months, which is hardly any time at all. With securitization, banks have eliminated hundreds of trained loan officers who could make a reasonable human judgment whether a customer could repay the mortgage over three decades. Now just about anyone can make this decision, especially if a mathematical model is being used to assign a score that predicts short term default risk.

With these changes in place, banks removed themselves from the traditional business of assessing the consumer’s ability to repay loans, which means the debtor-creditor relationship was demolished and replaced with a buyer-retailer relationship. This is such a fundamental change in bank behavior that it begs some serious questions, such as whether the consumer can make an intelligent decision about the debt they take on, and whether banks deserve the special status they have always had as a privileged industry worthy of government support when they make mistakes.

The End of the Debtor-Creditor Relationship

In the current foreclosure crisis rolling through courts across the US, banks are arguing that whatever “technical” mistakes they may have made in perfecting their security interest in the homes in foreclosure, the borrowers are nevertheless in default. In less polite terms, these borrowers are “deadbeats” deserving of whatever pain comes their way.

What this leaves out is the heavily lopsided relationship that exists between a consumer seeking a loan and a bank acting as a retailer using misleading marketing techniques to drum up fee business. At the height of the housing boom, the airwaves and newspapers were filled with advertisements from banks, mortgage brokers and other financial intermediaries offering more and more attractive terms for mortgages. No income? No job? No assets? No problem! Need some quick spending money? Simply refinance your mortgage and take some “cash” out of your home while you are at it. The home equity line of credit became the easy-money tool for millions of Americans wanting a fancier kitchen, a new car, a vacation cruise – though often the money was used for real needs like medical emergencies rather than luxuries. One radio advertiser bragged about the client who refinanced five times, taking cash out of the home each time interest rates went lower. “The biggest no-brainer on earth”, the mortgage company would say, just to let you know how dumb you were to be sitting on all that equity in your home and not putting it to work for you.

And always in these advertisements, the emphasis was on the easy monthly payments that you could surely afford. There was no mention of the larger amounts of total debt you were taking on, or the balloon payments you incurred that increased your principal owed, or the guaranteed increase in interest rates two years hence. If you asked any questions about these risks, you were assured that two years from now you could always refinance because “of course” your home would increase in value by then. Behind the scenes, we have now learned that if you didn’t qualify even under the extremely liberal credit standards the banks were using, the banker would cheat a little by overstating your income or assets without you knowing.

The “deadbeat” accusation against defaulters says Americans should have known how much debt they were taking on and what the risks were for themselves if disaster should happen to them. The problem with this argument is that millions of Americans did know and did ask about these risks, but were given false assurances, or their concerns were brushed off by the banker. In some cases the banker outright fraudulently changed the consumer’s application when it came time to process the loan for approval. This was not a process where caveat emptor applied, because the buyer was from the start at a disadvantage to the bank. The buyer was induced and enticed to borrow because of sophisticated and often misleading advertising campaigns, and because critical facts regarding the loan were kept hidden from the buyer or made difficult to find. What was at stake for the banks were trillions of dollars in points and other fees that were extracted from the equity built up in the home, a fact also kept hidden from the borrower until the last moment.

Had there been a traditional and proper debtor-creditor relationship, had the bank had even a vague interest in how the borrower was going to repay the loan, and had the bank actually kept the loan on its books for the maturity involved, seductive and misleading advertising would not have existed. Instead, there would have been sober talk up front about the total amount of debt being assumed by the borrower, about the importance of meeting monthly payments, and about the risks of foreclosure. None of this happened because the bank had no relationship as a creditor to the borrower. In fact, no one did – least of all the investors who bought the mortgage in a security (and who it now turns out probably did not have a perfected security interest in the home because of bank malfeasance). The business of making loans, which provided an enormous social utility and was therefore heavily regulated, had been subverted into the business of earning fees for the banks, which had no social utility and was all about maximizing profits for the financial sector.

This breakdown in the debtor-creditor relationship has been entirely of the banks’ making and has been encouraged by powerful interests, including the Federal Reserve, the main regulator of the big banks.

Debt as an Instrument of Fed Policy

The Federal Reserve has always used debt as a tool to influence interest rates, by requiring banks to buy or sell debt instruments with the Fed. For most of the history of the Fed, this use of debt has been judicious, moving interest rates up or down in response to economic conditions, with the intention that banks in turn would expand or contract their lending activity given the change in the cost of money. It was also assumed that commercial and consumer borrowers would use debt cautiously, with great care regarding the consequences of default.

In this sequence of events – from the Fed to interest rates to banks and ultimately to borrowers – the Fed was relatively passive about how much debt was being taken on by the borrowers, as long as the economy overall responded as desired. In the 1990s, however, and especially in this last decade, the Fed has taken on a cheerleading role regarding the use of debt. Fed Chairman Alan Greenspan gave speeches lauding the new and innovative ways in which consumers could use debts – essentially endorsing the buyer-retailer relationship that banks had created with their customers. Greenspan went so far as to encourage consumers to take on floating rate mortgages, at a time when rates were exceptionally low and the risk of an increase in the cost of the mortgage was high.

Ben Bernanke, Greenspan’s successor, has continued this policy, and has acted with desperation to keep the debt machine going. The Fed has taken over the job of the private market as the sole buyer of mortgage-backed securities, and as seen in the foreclosure crisis, the Fed has abandoned its regulatory role as policeman of the banking industry, despite all the evidence of fraud in the origination and repackaging of mortgages as securities. The Fed arranged for Congress to approve a zero reserve policy, meaning banks no longer have to keep any reserves at the Fed, which short-circuits the traditional sequence of events in the monetary policy chain and allows the banks to make an unlimited number of loans as long as they can securitize them off their balance sheet.
The Fed has used every tool possible to revitalize the securitization market, even though it is obvious investors are wary of buying such paper from the banks again. The Fed has dropped interest rates close to zero to foster the creation of more debt, and now the Fed is contemplating a massive expansion of its Quantitative Easing program, wherein it buys up the debt of the Treasury Department, so interest rates on long term bonds can remain at record low levels, and so that the federal government can issue even more debt.

Debt, debt, debt – everywhere you turn authorities are urging American consumers and businesses to take on more debt, as if this were the only goal of both fiscal and monetary policy. Nowhere is there any mention of the need for prudence in managing debt, much less any recognition that at all levels of American society, there is already too much debt on the books. Nor is there any acknowledgment that the debtor-creditor relationship has disappeared, and that there is no one monitoring the debt that consumers take on.

It is true that the banks are imposing much harsher conditions on potential borrowers, but that is because the banks are scared of more bad debts, and because they might not have the capital to survive even the current level of bad debts on their books. This fear is not the same as reestablishing a proper debtor-creditor relationship, and there is no evidence the banks are willing to do this. To return to this traditional relationship, the banks would have to cease securitizing loans off their books, and manage the true risk of these loans by hiring thousands of loan officers to monitor these portfolios. The banks would have to scale back substantially their expectations on earning fees off their clients, and instead earn their income off interest rate spreads from their loan portfolio. The banks would also have to return to the early days of the home equity line of credit, when they allowed such loans only for the purpose of home improvements or a college education, not for frivolities like vacations or a new car.

The fact that the banks have abdicated their responsibility to serve as creditors to those to whom they lend money seems to have escaped the notice of the Federal Reserve. There are no learned studies being published on this topic, no speeches given at their annual central bank symposium at Jackson Hole, no criticisms of this irresponsibility when Fed regulators come to call on the banks. There was some talk a few years ago about the need to reform the securitization process so that someone monitors the credit risk of the millions of loans being put up for sale, but this died out, seemingly because of the impossibility of the task.

What makes any reform impossible to impose on banking is the fact that the TBTF banks would have to be dismantled and shrunk to local institutions again, the industry would have to drastically remodel itself by returning to its traditional role of credit watchdog and creditor to its borrowers, easy money products like credit cards and home equity lines would have to be severely limited in amount and purpose, and securitization would have to disappear. The implications of these reforms are equally momentous: no bank would be Too Big To Fail. No bank would be allowed to grow a national franchise, and no bank would have any claim on the federal government for help if it got into trouble. Systemic risk – the risk of one bank being so large it would pull down other banks if it got into trouble – would not exist to the extent it does today.

If the TBTF banks see this coming in Washington and have no lobbying way to prevent these changes, they might well argue: What about Canada? Canada only has five large banks, all with a nationwide presence, and all Too Big To Fail, yet the government there is not contemplating breaking them up. While it is true the Canadian regulators have been much more rigorous with their banks and did not allow the crazed lending that took place in the US during the 00’s, real estate bubbles have formed in major urban markets in Canada. These bubbles are only now peaking, partly because Canada has been a beneficiary of the commodity boom fueled by Bernanke’s desperate reflation policies, and this has masked any serious consequences of a real estate collapse.

In other words, Canada has not been tested yet to the degree financial markets have been tested in the US, UK, Ireland, Spain, Germany, Greece, and many other countries. This problem of the destruction of the debtor-credit relationship by the banks, and the abdication of their traditional role as prudent overseers of the credit risks assumed by their customers, is a global problem relating to modern banking practices in general. It is why systemic risk – previously unheard of outside of central bank circles – is now a very real problem around the world. In all major countries there are far, far fewer banks than existed 25 years ago, and those that remain are heavily interconnected and dependent on the health of major banks in other countries.

Banking as the Scourge of Capitalism

Since banks have given up their role as protectors of the financial markets from credit risk, and since credit risk in the past 10 to 15 years has exploded globally to the point where it now jeopardizes all economies, it is worth asking why banks deserve such a privileged position in relation to their governments. If banks are no longer performing their critical credit function, the taxpayer should be free to cut them loose from access to government loans and assistance, including special access to credit from their central bank. Of course, to do this the big global banks would have to be cut down to a manageable size, and be forced to get back into personal banking, away from credit model banking.

This, however, is at the moment a taboo or at least unmentioned topic. There are some brutally simple facts here: the TBTF banks in whichever country they exist refuse to even consider the fundamental reforms necessary to protect the world from the credit risks they create. The governments of the world, and especially the central banks, refuse to take on the necessary but difficult task of breaking up these banks, and returning to a model that existed a few decades ago and was known to work. In fact, the Federal Reserve is doing whatever it can – and some of this is against their charter – to revive the failed system of TBTF banks, securitization, and debt binges which will inevitably lead to another massive bubble, leaving the public on the hook for future bailouts. This is why Joe Nocera concludes that we can’t live with the banks, but we can’t live without them. No wonder millions of people hate the banks and distrust the regulators charged with controlling a global financial system that is clearly dysfunctional.

We might also ask whether free market capitalism can function or even survive with a banking system that cannot prudently control its risks; that sees its role not as a credit intermediary but as a fee-generating machine; that scours the land for opportunities to extract profits from the equity built up by its customers; that feels entitled to Midasian bonuses for its executives; that turns to the government and taxpayers for help in papering over its disastrous mistakes; that seductively markets debt like it were an addictive substance (which in a way it is) without alerting its customers to the dangers of the product; that sets up a mortgage securitization process which undermines two centuries of real estate law and practice; that fails to properly transfer title documents to the security pool, effectively rendering the investors uncollateralized; and that literally destroys the global economy through its predatory and avaricious practices.

This is actually a rhetorical question. Free market capitalism cannot survive a TBTF global banking system as currently constructed. There is much to lose in allowing this system to continue as it is, yet the governmental powers that be seem unwilling to recognize much less discuss this mortal danger to capitalism. It is a strange world indeed when the supposed stewards of our economy are willfully ignorant of the peril that exists in a financial system that is undermining the foundation of our prosperity.