Two Guys Not To Invite To The Staff Morale Meeting

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"Bank of America and other institutions have built their business model on taking advantage of people, and that's not good long-term for the economy." 

— James KwakSometimes you don't need a Dan Brown or Oliver Stone to produce a good piece of conspiracy theory fiction to be frightened. Sometimes you just have to look around you, and in the case of credit unions, close around you—and there's no closing the book or turning off the movie.

If you're just trying to survive the assessments, scrape together some change-in-the-ashtray net income, and hang on until the economy and markets bounce back, you probably shouldn't pick up a copy of "13 Bankers" by James Kwak and Simon Johnson. This is a book, after all, whose title goes on to add, "The Wall Street Takeover and the Next Financial Meltdown."

Next financial meltdown?! Kwak and Johnson believe so, arguing that deregulation, the emergence of six too-big-to-fail banks that have Congress on their payrolls, and Wall Street institutions that have all but set up shop inside the Treasury Department have led to enormous, embedded, systemic risks to the financial system, and that recent legislation will do little to head off another burst bubble.

The book is a blistering indictment of nearly every financial policy, from housing to capital requirements to the repeal of Glass-Steagall. Its authors—Kwak has operated several businesses, been a consultant with McKinsey & Co., has a Ph. D from the University of California and is currently in Yale Law School, while Johnson is a professor of entrepreneurship at MIT's Sloan School of Management—tell the story of 13 bankers, beginning with Jefferson and Hamilton through modern days, showing the same chapters of boom and bust repeating themselves in large part due to a reluctance by Congress to keep bankers and financiers in check. The next meltdown, suggest Kwak and Johnson, who also are coauthors of the popular blog The Baseline Scenario, may be even worse.

"The Dodd-Frank Financial Reform bill is the sweeping regulatory bill to affect the financial system since the 1930s and, I think at best, this is a first step in what needs to be done," Kwak told a audience at a Washington league meeting recently. "I think we still have the same loaded, predatory financial system we had before the crisis, and Dodd-Frank doesn't do much to change that. Private financial sector assets have doubled in last 60 years, but have not doubled in banks and credit unions. CDOs and mortgage-backed securities are major factors in that growth. The big question for the reform movement is whether Dodd Frank will help reverse this trend, and that is an open question."

When Kwak polled his audience of credit union execs on what led to the 2008-09 collapse of the financial sector in the U.S., responses included the housing bubble (and resulting collapse in credit market), bad loans, low interest rates, Chinese over-savings, Americans' over-consumption, and bad management at Fannie and Freddie. Kwak added to the list psychology ("people like bubbles"), and income inequality, too. But that's not the big cause, Kwak believes.

"I think that if you look at all these phenomenon of the past 30 years you will see policies, pushed primarily by the major banks, and the common theme of these policies is either the deregulation or the non-regulation of the financial sector," Kwak said. "The last 30 years have dismantled many if not most of the regulations. In 1980, we had the deregulation of S&Ls, which led directly to S&L crisis. Then we had deregulation of interest rate caps, which made possible the subprime lending boom. Deregulation of interstate banking made possible all of the mega-banks. In 2000, Gramm-Leach-Bliley, which eliminated Glass-Steagall, made possible the Citibanks and all the major banks. Later it made it impossible to regulate over-the-counter derivatives."

In short, it has all occurred due to the business of dollars, both by those who manufacture them (banks and financial services firms) and those who depend on them (Congress), according to Kawk. "The constant deregulation of the financial system happened because the banks were able to built increasing amounts of political power," Kwak said. "Since the 1970s money has become much more important in politics. The financial sector, by far, is the largest contributor to political campaigns. Lobbying has also become much more important, and really began to rise in the 1970s. Before that lobbyists really worked to get (government) contracts. There have been a lot of big-bank victories in regulatory agencies, such as 1984 SEC ruling to reduce the level of capital that had to be held. The intervention by the OCC and OTS in 2002 to pre-empt predatory lending laws; banks lobbied to preempt state laws with fed regulations. Banks have plenty of people in high places—Henry Paulson and Robert Rubin—both are former chairs of Goldman Sachs, and that is only the tip of the iceberg when it comes to Wall Street executives in Washington."

By 2000, said Kwak, "the banks had effective control over all the levers of regulation and government that affected their business, which meant they could do more or less what they wanted." The result has been not just bubbles, he said, but the creation of new business lines and profit centers that have little to do with the "real economy."

For instance, Kwak said that OTC derivatives, which were essentially created in 190, have grown from a $100 billion to $3 trillion in market value.

"Derivatives a very profitable industry for the financial sector, very complicated transactions that customers are not able to price accurately, so you can charge whatever you want," he said. "Since 1980 financial sector profits up by a factor of 9. This happened remarkably despite the fact the banks were paying their employees more and more during this period, sharply outpacing domestic private sector compensation."

But the big bust that every credit union is currently dealing with, summed up Kwak, stems from a "system that encouraged people to take excessive risk and it underestimated those risks."

Some in credit unions would no doubt say that extended to certain of the corporate CUs, as well.

"We've been told over and over that these are really smart people," Kwak observed. "And the question is how could they make these mistakes. The first answer is they really aren't that smart. Bankers had incentives to make these mistakes, to set up bad risk-management systems, giving them deniability. This is the kind of financial system we had, at least with the mega-banks. It's generally the kind of thing that doesn't happen in credit unions. Some people compare Wall Street to a casino where the house is raking in the money. To some extent that's true."

Kwak, who illustrated his presentation in Seattle with a chart showing a decline in regulation compared to a simultaneous increase in compensation for big bank execs, said, " Crashes happen because some people benefit from them happening. They come at a price. The longer the crisis is put off, the more damaging it becomes."

The "End of Wall Street" was the prediction being made by some people in 2008, but "things have turned out differently," noted Kwak. While it's true more than 250 banks have failed over the past two years, none has been a member of the Too Big To Fail Club. Indeed, Kwak notes that the six mega-banks—BofA, JPMorgan Chase, Citgroup, Wells Fargo, Goldman Sachs and Morgan Stanley—together control nearly 60% of the U.S. gross domestic product. "At the top, things are still pretty good. The six big banks have just gotten bigger, in part due to consolidation and buying up the failed banks, absorbed by this oligarchy. More concentration means more pricing power, higher prices for consumers and for companies. Average funding costs has plunged. The cost of funding at large banks is one full percentage point below that of smaller FIs. People are now aware banks can fail, and will lend money to banks that implicitly can't fail."

Congress may not just be complicit, pointed out Kwak, but resigned to what's occurring. He cited a quote from Dick Durbin in which the senator said of the Senate, "The banks own the place."

As for the aforementioned Dodd-Frank bill, it leaves a lot of interpretation to regulatory agencies, noted Kwak, who believes its heft is belied by its lack of any teeth.

"The Dodd-Frank bill says the system is essentially fine, we just need to curb excesses when they occur," said Kwak. "The banks fought off the Brown-Kaufman amendment, which would have placed size limits on FIs; the Volcker Rule, the intent of which was to prohibit banks from engaging in a lot of activities that were a gamble using their government guaranteed deposits; the derivatives push out, which was a provision that would have required big banks to spin off their derivatives operations, and they seriously watered down the rest of the bill in conference committee.

"Essentially, what we have is business as usual," Kwak continued. "The bill says nothing about Fannie or Freddie, doesn't do much about the ratings agencies, it's weak on exec compensation, and most importantly, with regulatory incentives, it gives a lot more power to the same regulators who essentially failed calamitously, and regulators are still understaffed and underpaid and get most of their information from banks and lobbyists; the regulatory rule-writing will have regulators writing hundreds of rules, and that will take place in the shadows where the lobbyists and the banks' lawyers will be most effective."

Kwak said he would like to see higher capital requirements for large banks, and, ultimately, the break-up of those banks. He believes banks should be required to hold onto their securitizations.

What does all of this mean to credit unions?

"I think the mega-banks are bad for the economy and for the country," Kwak answered. "Unfortunately, they are not going to go away. The question for a lot of credit unions and community banks is, 'Should we become more like these big banks?' My own view is this would be extremely tough. Credit unions have strengths. Credit union charge-offs are much lower than big banks, as CUs make better decisions due to local information. Credit unions have specific, long-term member relationships, and credible relationships with small business. Internally, they have organizational flexibility. If you're a small business, when you go to BofA, you know with certainty that BofA does not care about you."

The challenge to credit unions, Kwak said, is in achieving differentiation. "I think it would be hard to beat BofA at the BofA business model—if the point is to lock me in with lots of crappy products, you will need to have lots of crappy products."

Among his other observations:

• Kwak is discouraged that big banks and Wall Street firms have sent a dangerous message to the country, and other leaders. "This has led to a belief that all business behavior is allowable, and that a person chooses to pay 200% interest, for instance." 

• "I hope the lesson taken away from the past few years is it's nonsense; free market will not always produce good outcomes, and it's not right because if you don't do it someone else will." 

• "I co-founded a software company nine years ago, and have had hundreds of employees. I have fired people, have negotiated with customers, have been sued and counter-sued. We held ourselves to high standards. We didn't lie. We didn't make promises we couldn't deliver. We tried to do what was right for the customer and the employees. We weren't perfect, but the most important thing for me is there is nothing I did that I won't be able to tell my four-year-old daughter about and that she can be proud of. I think that's true of the people in this room. I think the same thing applies when loaning money to someone. You don't take advantage of having information that the customer doesn't have; that is what the subprime lending mess was about." 

• "Economics 101 holds that all people are rational actors, all companies maximize profits all the time. That's not what people really believe."

• "Today there is widespread distrust of banks and people don't realize they have a choice. People have gotten used to being screwed by big companies." 

• "Derivatives? Why does this thing even exist? It can only exist if there are investors who don't see the trap. On the other side of this there is a counter-party. UBS gets a 'underwriting fee,' which is essentially a sales commission. On the other side someone is making a bet. It doesn't lead to any actual investments." 

Frank J. Diekmann can be reached at fdiekmann@cujournal.com.

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