AMERICAN BANKER: Gentlemen, thank you for coming. This is a periodic thing we do at American Banker called Analyst Roundtable. Our topic today is a big one and a broad one but I think it'll be a fun one. We basically want to talk to you about the economy, the outlook for it and what does that mean for banks. That's pretty much the underpinning of all the questions.

My first question is, ultimately, "Will the real economy please stand up?" You know I was just jotting down some headlines in the last couple of weeks. One day, I believe it was a Friday, there were some really poorly received jobs numbers, and the stock market went down. About a week later much rosier data came out, the market went up. Then last Friday there were some not very good jobs numbers and not very good GDP numbers and the market didn't care for that.

I even saw stories in the paper today, one: "Record corporate earnings expected in second half of the year." Another story: economic signals so poor, credit markets feeling to bonds. I mean it's in the same paper; they're almost right next to each other. So with all that as a background I wanted to ask each of you guys what kind of — what is the actual economic reality banks are operating in? Anton, why don't we start with you?

ANTON V. SCHUTZ: I think part of what you have to think about, too, is by product, by region in terms of the economy reality. It's not just the economy; the different states have very different demographics and things that are going on, particularly with housing. You have a lot of data skewed by what's going on. That's important.

What also is important is that we've had an economy dominated by global macro events. We've had all sorts of things, you know from the European debt crisis to melting Japanese nuclear reactors. Those have all had their own impacts in some degree. I mean I think we're coming out of the bottom pretty strongly. Last year the Euro fell off a cliff and confidence fell off a cliff. We kind of got ignited again in the fall when there was some talk about potentially extending the Bush era tax cuts, which really got businesses I think off the dime again and got consumer confidence going.

Lo and behold, once again now that we have this deficit and everybody's attacking it differently, you have one party that wants to reduce the deficit by bringing back, you know, increasing taxes just a few months after they said, no, it was OK; we're going to extend them. Then the other party is talking about cutting taxes even more and cutting spending. They've gone at it very differently. Again I think that's created confusion out there. Obviously the reactor and earthquake has created a real bottleneck in terms of parts and actually created some slowdown in the economy that's real. But I think confidence once again is sort of wavering.

AMERICAN BANKER: OK. Peter?

PETER J. KOVALSKI: I agree with what Anton said. In addition to that, I guess I would say we're going through a transitional period between the recessionary period and expansionary period. During this period you will get ebbs and flows where you may have some strong economic data followed by weaker economic data. I think this is probably not out of the norm during a typical economic cycle.

I think what's prolonged this transitional period is that the government and the Fed is being much more manipulative in the capital markets than they have in the past. I think that's actually been a detriment to getting the economy turned around, not a stimulus.

AMERICAN BANKER: Very good. Paul?

PAUL MILLER: I always — you know I tell people who would have thought that we had a tsunami, a major nuclear accident plus I think that Greece almost defaulted and the stock market's up 1,800 points since then, right? It even went down like a 1,000 and went up 1,800. I think the QE2 is working about as best as it possibly could and I think a lot of that is the government stimulus program that was passed two years ago, it's finally kicking in. I can't drive around D.C. without going into a road project. You know QE2, the amount of liquidity in the system is by far the most we've ever seen before.

But what I can't get over is the five to ten million homes that probably have to be foreclosed upon in some form and moved through the system. You know and I also — I also don't believe we're done deleveraging. I don't think that we're anywhere near an expansion in the U.S. economy. I think what we've done is we've contracted so much that now we're bouncing a little bit and that bouncing has gotten the confidence up much more so than what's really happening out in the world.

Home building right now is at 300,000 units a year. You know at the peak it was two million homes. There is always a lot of data out there that talks about that for every new home there are about 2.5 jobs. You can pretty much say from 2.1 to 300,000, that difference, multiply it by 2.5 was the eight million jobs that we lost during the recession so quickly.

What I wonder is, you know we went from a military industrial complex to a housing complex in the early '90s and that drove the expansion for almost 20 years. What's the new industry that's going to take over that's going to drive the expansion? That's what I struggle with. Because it can't be housing. We have two million homes empty. We have probably a million and a half people not paying their mortgages, which is a stimulus in its own right. You're not going to get home building up above 300,000 for the next five years, until we move through all this. This deleveraging has to continue to take place in the banking system.

So I think what we're going to have is a very sluggish economy. I think it's not going to — you know we saw — we looked down into the pits in 2007 and 2008. We didn't fall in. I think that was because the government did take the correct actions. But now we have to live through those actions, which are going to take a long time. I think we're going to have this type of "what type of economy are we in?" for at least three to five years. Are we in an expansion? Are we in a contraction? I can't figure it out.

AMERICAN BANKER: And that's what you mean by bouncing?

PAUL MILLER: We're just going to be bouncing around. I call it — you know a lot of people call it bouncing on the bottom. You're going to have good quarters and you're going to have bad quarters. I think that's where we are. You have to work through those REO on those banks' balance sheets. You have to work through them. There's no easy solution. When you start to move through them too quick, the politicians stop you and it increases the cost of that.

I mean we've politicalized the foreclosure process to the point now there's even a group of people arguing that maybe we shouldn't foreclose on homes at all, the attorneys general. You know? Therefore you've interrupted what the banks do really well, is take that collateral and sell it back out. Right? It's a nasty business but because it's nasty, you know we decided to stop it or increase the cost to the point where it's very difficult to foreclose on homes. So the more the politicians play with that, the longer we're going to slug through this economy.

ANTON V. SCHUTZ: Some of the points you've brought up are just really critical. If you think about what the politicians have done, I mean they took away the tax credit without any phase-in period. Boom. Gone. You know, it pulled demand forward so there's no surprise that housing is going to drop in value and activity is going to slow down right after that happens. Quite frankly the market always gets upset when there are no new homes getting built or the numbers are bad. I mean I'd almost advocate doing what we used to do to the farmers, which is pay them not to grow something. Pay the builders not to build houses. I mean we've got this inventory to work through; why does new supply even need to come onto the marketplace? I think that's an important point.

But even when they look at the QRM and some of the crazy ideas, they're talking about the 20% down, you know you can talk about that in a bull market and that's how you can cool a market down. But when you've got a market that's trying to come off the bottom and people barely qualify, when you say mortgage insurance doesn't count and you need to come up with 20% cash, it's very hard. You know a large percentage of the population can't actually pull that off. There is absolutely no way to fix housing if you do that.

Then you want to take away the deductibility of a mortgage. I mean again, what are they doing here? There is no relief for jumbo. It would have been very simple to say, you know let's stop playing around with metro areas and valuations. You know Fannie and Freddie can fund everybody because all the activity has been in the Fannie and Freddie eligible activity; very little activity has gone on in the jumbo. If you want to let a wealthy person refinance and they get monthly savings on their mortgage payments, where is that money going? It's either going into the market, which allows for capital formation and growth or it's going into spending. We'd like to encourage both of those things. And you know what? Tax rolls go up then as well. So I mean I think there's stupidity, it just seems like some of the people running around Washington have no economic background at all.

PAUL MILLER: I mean being in Washington and trying to get as much of a policy angle as possible and talking to as many regulators as possible, you know you really get a feel. Case in point: QRM, one — the FDIC is talking about QRM. You have Fannie and Freddie talking about dropping services and fees to five basis points and I think you had the Treasury dealing with another issue. None of these guys were talking to each other. And they were all going down their separate train track, right, without really confiding in one another what does all this impact mean to one another.

There's no housing czar. There's no central housing agency. HUD tries to be that; they just don't have the talent to do it. That's not a criticism of HUD; it's just a criticism of the resources that they have.

So I think you have a lot of regulatory people that have the right thought but they don't work together. In some cases the government is not supposed to work together but in this case you would wish they would kind of work together because there is no constant housing policy and therefore politicians are getting inconsistent messages I think from politicians in their own right. Then the Dodd-Frank bill, which is just — you know let's just throw everything in there and see what sticks, right? Regulators are overwhelmed by all these regulations, which they don't understand anyway. I think that's one of the bigger problems.

The other issue is the fact that — you know everything is geared toward home ownership. We have this home ownership. Everybody needs to own a home. That's what makes a good citizen. That's what got us into this mess starting in the '30s. But the other issue is we are not helping out a big slug of money, that's the investor in this process, who has the money to come in and fix a lot of these problems.

ANTON V. SCHUTZ: Which kind of investor are you talking about?

PAUL MILLER: Somebody who is going to come in and buy the house, refurbish it and rent it. Right? The issue is all the policies that have been created, it was all about owner-occupied. You had to show that you lived in the house. There are still even policies at Fannie and Freddie, which are sitting on some of the biggest chunks of REO, not to sell to any one person more than ten homes. There are companies out there that can buy slugs of homes, two, three, four hundred and then property manage them and rent them out. They're being kept on the sidelines because of all these other policies about, "Well if we're going to do something it's going to be for the owner-occupied."

That's what the other issue is. You need to — in the '80s there were a lot of investor-related programs, which have been pushed to the side because we want people to own their own home, which is what got us in this trouble to begin with.

ANTON V. SCHUTZ: Well you know, I mean you get to the point it's anti-capitalist in terms of things we're trying to do. You go to that policy and then you go to private equity and then say private equity can't help rescue the banks. We'd rather write off hundreds of millions or billions of dollars. I think like United Western might be a good example, where private equity had agreed to fund the bank and they seized it anyway. I think those are the kinds of situations where it's very much against capitalism. The question is you've got regulators all over the place who are acting not necessarily in the best interests of an economy.

PAUL MILLER: You know you go back, I remember when I got in this business and I was a bank regulator at the Fed. The articles that came out in the early '90s about how all these guys made all this money off the RTC. It's almost like they're going to make sure that nobody really makes a lot of money through this crisis.

ANTON V. SCHUTZ: Which is bad for everybody.

PAUL MILLER: Which is bad because if you don't make — I think that's what Bill Seidman understood is that he allowed people up front to make a lot of economics because he knew that would bring a lot of money off the sidelines. Now the FDIC transactions that in the front did that, you know, i.e., Kanas, Bank United. Bank United was able to profit off that but it was cut off very quickly.

But I'd go back to if you had policies to help the investor to come in, i.e., private equity, to buy up these REO and to rent them back out because it has to be rented back out; homeowners can't own it anymore.

AMERICAN BANKER: Do you need incentives for those investors to get into the market or do you just need to stop hassling them in the process of doing so?

PAUL MILLER: I think the first process is stop hassling. Make it an easier process. Invite them to the table. Fannie and Freddie should be actively inviting these guys to the table, the property managers. Right? Because the numbers are so mind-boggling about the amount of defaults out there that it's almost like I'm just not going to think about it anymore. Because there is no way. I think Laurie Goodman predicts almost ten million foreclosures in the next five years. I believe you might want to check those numbers but she also will tell you that it's just not going to happen. It can't happen. The government will do something in between. Now what I worry about, what exactly they do in between.

PETER J. KOVALSKI: You are seeing some investors come back in certain property types. I was down in Florida at the end of last year and heard incidents of limited partnerships coming in and buying see-through condo buildings in Miami and Ft. Lauderdale. The investment strategy was to buy up all the units in an auction at cents on the dollar. The units would be rented until the market stabilizes and then sold off unit by unit as opposed to a bulk sale of them. So you do have some entrepreneurial limited partnerships that are coming in but it tends to be more on a larger scale where you can buy a whole high-rise condo facility and control a number of units.

To what was just said about the U.S. government, Puerto Rico seems to have it right. They initiated a program to give incentives not only for owner-occupied but also investors to come in and purchase their excess inventory. If this program is successful, maybe the U.S. government can implement something similar in the U.S.

AMERICAN BANKER: This is all very fascinating. Now two follow-up questions there. One, in terms of incentives, you've all discussed that. Is this something that the banking industry should be lobbying for and does the industry have any political capital to be lobbying for anything at this point?

ANTON V. SCHUTZ: I think the banking industry has a little more political capital now, given some of the changes in the House. You know in fact, Dodd-Frank is getting a look through and maybe some changes going on. I think it's a good time. And I think it's relatively easy economically to prove what letting a free market come in and provide capital will do.

Quite frankly, if you look at QE2, it's created the ideal environment to rescue, whether it's housing or tracts or anything else. You know financing is out there. Money is sloshing around. Real rates of return are very, very low. You have people who are willing to invest and take risks, whether it's hedge funds or private equity or other institutions. It should be made pretty easy for that money to come rushing in and that money will rush in. The return potential is there. With rates being where they are and liquidity being where it is, it's obvious it should work. It's just there is too much red tape in the way.

AMERICAN BANKER: Paul? Peter? Do you think this is something banks should be lobbying for?

PAUL MILLER: We're seeing this with the Durbin bill. The banks aren't done. The banks have a lot more political capital than you think they have. And there are two sides to it. You have the big banks and you have little banks. Remember there are still 7,000, 8,000 banks out there and they all give politically to their congressmen. That's why a lot of the Dodd-Frank bill excluded small banks, right, to get rid of their —

ANTON V. SCHUTZ: — Yeah, well that's what they say.

PAUL MILLER: But you know, I think the banks, they're not — I mean the banks are caught completely flat-footed with all this REO. They really don't know. I don't think they really have a game plan with it. I always say the workout services have never — I mean they were always like a side function for the banks. They never had this much difficulty. They were put together not to have any interaction whatsoever with the customer. Then you wake up one day and you have all these millions of properties of REO and I don't think they really know what to do with it. I have not heard of them or talked to them about actively trying to get investors involved. I think they're just so overwhelmed they're just trying to make it to the next day. I think that's more than anything else.

I think that they do have the political clout. I think one of the problems is that there is no policy from the banks on what to do with REO besides just foreclose on it.

AMERICAN BANKER: This is from a business standpoint?

PAUL MILLER: Yes, I have not seen one.

ANTON V. SCHUTZ: There is a real divergence between what the big banks want and what the small banks want. The small banks will tell you that Dodd-Frank does impact them and does create more regulatory hurdles and hiring that they have to do. It takes revenue away, particularly Durbin. But they definitely have different goals and different exposures in what they're trying to achieve.

The large banks raised the capital and got healthy. The small banks don't have that same ability to get healthy and raise the capital. I think that's very different.

PAUL MILLER: There was also a capital hit with the Collins bill, which wiped out their only access to capital.

ANTON V. SCHUTZ: Correct.

AMERICAN BANKER: You're talking about the small banks?

PAUL MILLER: Yes.

ANTON V. SCHUTZ: So Dodd-Frank is much more unfriendly to the small banks than the politicians say or even know. Any small bank CEO will tell you they're pretty upset about it.

PAUL MILLER: But you know during the process, the small banks stayed on the sidelines. I mean when you sit there and you talk to them about QRM, about stuff in the Dodd-Frank bill, they go, "That doesn't really impact us." Right? But what impacts the small banks is the OCC, the FDIC. My banks are telling me that the level of regulatory scrutiny that's coming in these banks through these regulators is very large, very material and the cost of compliance has gone up materially without Dodd-Frank. Right?

I just had a conversation with a banker who got — I have to be careful walking down this path but is probably going to get some type of enforcement action down the road because the regulators said, "I've got to be picky." They were very picky. The stuff that you're looking at where they're going to get picked at, you're going like you've got to be kidding me, right. They go, "No, but the regulator came in and says, 'I'm going to be picky. You're going to hate me, but I have orders from Washington to be picky.'"

They're going through and just dinging them on anything. I don't know if they're being told to go out and find something but it sure looks like they've been told to go out and find something wrong. The worst thing that can happen is a regulator at the door. When I hear a banker say, "I have a regulator, OCC, FDIC next week," I'm staying away from that bank.

ANTON V. SCHUTZ: I'm going to encourage Peter to say something in a second. [LAUGHTER]

AMERICAN BANKER: You guys share, OK?

ANTON V. SCHUTZ: You know what the problem is, once again here we are. We have one part of the Administration go, "You banks. You should be lending. You're bad guys." Then the regulators come in and smack them over the head with a baseball bat and go, "You can't lend like that." A lot of the things, the demands they're making are completely irrational and unreasonable. Some of the banks that have enforcement actions or MOUs or C&Ds on them, it's not coming from the primary regulator; it's coming from Washington, D.C. They don't even know the institution or the situations. There are numerous examples of that in the industry right now.

PAUL MILLER: It's a giant black hole from what the bankers tell me. It's like OK, we fixed all the issues. We go to our local region. They go, "It's all in the hands of D.C." Well can you tell me if I'm going to get a hearing or a finding? "No. We'll tell you. We'll call you. Thanks."

AMERICAN BANKER: Peter, any thoughts on any of that?

PETER J. KOVALSKI: Well a comment about the politicians. They tailor their comments to the audience that they're speaking to. So in any given day a politician at one meeting will be saying, "The banks are not lending." Then at the very next meeting they'll be saying that the banks were too aggressive in their lending which caused the housing crisis. It's a no win situation for the banks.

Whenever politicians decide to target a particular industry, they have the soapbox. They're on TV every night and they can say whatever they please and it can disrupt whatever industry they're attacking for their own political means. Politicians have two objectives. One, stay in power and two, obtain additional power. So whatever they say, whatever they do, is based on those two premises, not on what's best for the economy, the constituents or the industries that they're trying to save.

AMERICAN BANKER: Where are you seeing areas in which, if I suppose the regulators were a little bit more open-minded, there would be significant growth right now? I mean are we talking consumer, are we talking — so where I guess would a bank, a reasonable bank with good judgment that wasn't going to do anything stupid, where would they be rapidly growing their loan book at the moment, if anywhere?

PETER J. KOVALSKI: I don't like when politicians talk about banks not lending. The banks that I speak with want to lend. That's their business. The only way they can generate a decent enough return for their investors is to lend. They can't make a reasonable interest spread just investing in securities. So it really depends on which market that they're serving, both geographically and product type, that determines what loan demand will be.

You get down to the smaller banks and they focus on particular niches within their market. You may have a bank that just focuses on small business lending. In that case, the level of loan demand is tied to the economic growth of the bank's service area.

Every banker that I talk to right now is aggressively trying to find quality loans. Only banks that are under-capitalized and the regulators are reducing their growth or asking them to reduce the size of their balance sheet are restricting lending. The other banks are very aggressively going out, knocking on doors, trying to find good business accounts.

The problem is the good quality credits don't need the loans now. They have enough excess capital sitting in the banks earning five basis points or 0%. They will draw down their deposit account before, and they draw down on their line of credit.

AMERICAN BANKER: Am I right in thinking that, given what's been happening to loan spreads and the sort of tightening competition in a lot of different markets for anything resembling a decent customer, that perhaps — well are you saying that there is sort of a level beneath where banks are currently lending with perhaps not as pristine a credit in either consumer or others that they could safely go to and they're not currently at all, which is forcing them to sort of concentrate on the above? Or is it — I mean I guess I'm thinking sort of more nationwide, because absolutely there are — I can think of a few examples of niche banks and niche lenders that really have certain areas going on. Are you saying that regulators have kept banks out of a certain segment of the market, from going as deep as they should have?

PETER J. KOVALSKI: It affects the smaller banks more because the regulators scrutinize the loan books closer than a large Citigroup or Chase of the world. So when they come in and do an aggressive safeness and soundness review of the loan portfolio and they criticize all these different aspects of the loan-underwriting policies, they in turn are causing the credit standards of that particular bank to rise. A bank is not going to go make a loan and then the next exam the regulators come in and say we told you that you need these particular covenants, you need this particular collateral and why are you still doing these type of loans.

The larger banks have a more extensive loan portfolio. Small loans underwritten in one region of their franchise most likely fall under the radar of a bank examiner. Last week I was in Southern California visiting a number of community banks. As my discussions turned to loan competition, the No. 1 name that came up time and again as the most aggressive lender in business loans was Chase Bank. Not only are they aggressive on their pricing but from what I understand very aggressive and loose on their terms, almost back to the go-go days. But because those are relatively small business loans, the regulators are not going to look that far down into their loan book and scrutinize what they're doing. They're focusing more on the large loans and loan concentrations that can cause risk to the balance sheet.

But for the community banks that are trying to compete against Chase in that market, these loans are their bread and butter. When the regulators go in and take a sample of their loan portfolio, these loans are going to come up. They're going to say, "Why did you underwrite these terms?"

ANTON V. SCHUTZ: I want to echo on those things that Peter said. Peter talked about also institutions that are undercapitalized. Given the regulatory scrutiny they're under, to what extent is the undercapitalization a function of the loans that they've made being overly criticized, performing — nonperformers. There are huge buckets out there. You can argue all day long whether or not something is really going to go into default or just look like it's a nonperformer. I think that's put a lot of pressure on it.

Let's face it, most small banks, community banks, the collateral is real estate. If they want to lend to business, it's real estate. If they get criticized and beaten up for lending to real estate or because of the fact that the appraisers are running scared as well and all commercial real estate is devalued because of the appraisers. I mean one can argue about that in residential as well.

You've created a scenario where people can't get financing at all because the banks aren't allowed to finance it. There are concentration issues with what percentage of capital they're allowed to allocate towards commercial real estate. Well in a little community that may be the only way to create some collateral and create some velocity. JPMorgan may not be in that little community making those loans. I think there are some real issues here. Some of it is definitely driven by regulatory overzealousness.

AMERICA BANKER: Paul?

PAUL MILLER: I mean I agree with what Peter and Anton are saying. The issue is if you're a small community bank and they come in there — the OCC shows up and says, "We don't want you to do home construction lending," there's nothing for you to do. You might as well just put a "for sale" sign on the front door and walk out the door because there — and that's exactly what's going on out there.

Third Federal, TFSL, is a big thrift out of Cleveland, Ohio. They have a HELOC portfolio. It's performing quite well. Regulators showed up one day and said, "Why are all these lines open?" and shut them all down. [CROSS TALK]

PAUL MILLER: Also by the way, de-lever, because "We think it's too big relative to your capital base." This company has tons of capital. Now I don't know exactly if there was something in there that they didn't like relative to managing this portfolio and what-not but there are not a lot of chargeoffs flowing through. There's not a big increase in NPAs. It's just they were uncomfortable with the loan product. Right? Therefore not only did they shut it down, they are forcing this company to unwind it. And this is a consumer loan, right, and one of the few consumer loans that a small bank can do. The regulators came in and shut it all down.

But yet again, like you said, nobody looks at the $120 billion JPMorgan HELOC portfolio that's sitting out there. Now they're not giving much loans either on the HELOC portfolio; they're trying to wind it down. But this is another loan product that has some equity in homes out there. There are some good home equity loans out there but yet again you can't deal with them anymore. You cannot do a construction loan anymore, a residential construction loan. Small home builders in the middle of Iowa cannot get funded period. They don't have access to national markets.

ANTON V. SCHUTZ: I own Third Federal and, let me tell you, I'd love to meet that regulator in Washington and have a conversation because I'd question their IQ. I'd love you to publish that because that I'm willing to take them on. Quite frankly, what they've done is they've forced this bank to contract its lines of credit, all of its home equity customers, in order for them to meet their goal. They were told to reduce their home equity book, they just said, "Reduce it aggressively."

Anybody who thought they had an ability to borrow money and spend it or put it in the economy now got cut off regardless of how good their own credit performance was. Third party appraisals came in and risk on the portfolio came in, still no change. I asked Third Federal management, "Have you heard from Washington?" "No." "When will you hear from Washington?" "We don't know." Are you kidding me? This is something that ought to be really easy. How much you want to reduce it by? Here's the number. You get there, apply again. You know?

PAUL MILLER: And the thing about Third Federal, which is odd, is they have plenty of capital. This is not an undercapitalized institution.

ANTON V. SCHUTZ: Right.

PAUL MILLER: More, it's an overcapitalized institution, right, that has decided to invest in the community rather than just buy back stock and pay a dividend and they were shut down. And what does that say to anybody else out there? It's like don't do anything different, new. What can you do as a bank? Okay I can't do HELOCs now. They don't like that. They don't want me to do real estate construction. Can't do that. CRE is a dangerous world. Can't do that. Let's do credit cards. Well JPMorgan and B of A own that market. Let's do home mortgages. Oh by the way, the way Fannie and Freddie drove the market, which is a government entity, you can't make any money as a small bank doing that anymore. What do you do with the bank?

You're right; the small, individual consumer, the small businessperson is getting cut off from credit because the credit decisions are being made by four giant banks sitting in New York City who don't care [about] the economic value of some small town in Iowa.

AMERICAN BANKER: That's a question I actually wanted to ask all of you guys about, which is so you go back 10, 15 years, small loans used to get made by small banks. Mid-2000s, small loans got made by big banks and by Fair Isaac Corporation's algorithms. At this point, what happens to that market? Do the large banks have the capacity to reasonably evaluate, with the necessary due diligence, consumer and small business to the point of almost being consumer type loans?

PETER J. KOVALSKI: I think this gets back to the lack of loan demand out there. I believe the reason why these larger banks are dipping down lower and lower into the size of their commercial credits is the fact that there's no loan demand in their typical bread and butter customers. I think this is a phase. I don't know if this is a long-term proposition. I remember back about, oh, maybe 15 years ago, that Citibank or one of the large banks was basically underwriting small business lines of credit using something similar to a FICO score.

MALE SPEAKER: It was Wells Fargo.

PETER J. KOVALSKI: They were in that for awhile and I assume their returns were not as expected due to loss rates and ended that product. My view is that the large banks will move back up the size scale in business lending when the economy strengthens. My feel is that banks right now are looking for whatever earning assets they can put on their books that are yielding better than a government security.

ANTON V. SCHUTZ: I want to take this a step further. The big banks look at things from a mark-to-market perspective. I've got a real problem with marking the assets of particularly a community bank to market because what the community bank brings to the table that someone using a credit model and doesn't know the customer can't bring to the table is history and knowledge and going, "Yeah, this guy's been in this community for a long time. His family are solid citizens. He's a solid citizen. There's no way he's not going to pay his loan." The value of that loan and that knowledge is far, far greater in the eyes of that community bank than it could ever be in the money center and certainly not in any of the securitized products that are out there.

At the end of the day, you have to have those small community banks in those small communities in order to make the credit markets work appropriately. You cannot mark their assets to market because no model will understand the relationships that are inherent in a small community or even how to value property. I went through an appraisal process with one of the money centers a few years ago. They did a drive-by appraisal. I mean they used some computer map and said this is where you are and that's what it's worth.

PAUL MILLER: I'm shocked they did that much.

ANTON V. SCHUTZ: Yeah, well.

PAUL MILLER: That's a lot.

ANTON V. SCHUTZ: 50,000 feet, right? So the community bank's going to run circles around that model all day long if they're allowed to. I think the most important thing here is that the community banks and the entire banking system is really the grease of the economy. If you're removing the grease from the economy, the opening question about how is this economy going to function, it's fits and starts because there are constantly changes in regulation. The grease keeps getting removed from the system or discouraged from the system.

PAUL MILLER: But I think going back to our forefathers, they had it right from the get go. They did not want to be like Europe. They did not want giant money center institutions that dominate economic policy. Therefore you had the unit banking in some of the Midwestern states. You couldn't bank across state lines, which was a law until the early part of the '90s.

Again, you know — and then when you go back to the '30s, the big mutuals that were starting to be created in the '30s was an offset to these big commercial banks attracting all the capital and only lending to their buddies or whatever, not out to the small consumer, which really by lending out to the small consumers brought the housing market to where it is today. That was the beginning of it. But then you get Fannie and Freddie involved; then you get these big institutions, you nationalize it and then all of a sudden you have a national market rather than regional markets.

The problem with that model, when regions go under, the banks go under with it. The regulators that said well Texas had, what, 1,000 banks fail because of the energy crisis in the '80s; what we need is to make banks more national. What we did was make the problems more national. I don't think anybody in Washington in the early '90s that wanted to revoke the Glass-Steagall bill thought they'd wake up in 2010 and there would be four banks controlling 65% of the assets or 65% of the credit decisions in this country with the lobbying power to get what they want out of Washington, D.C.

That's what we ended up with. I always wonder, no matter where you start economically, in 200 years you end up with four giant banks. I mean Bill Stevens said if you break them up they're still going to gobble each other up. That's what they do. So maybe this is just the progression of moving them down the same path as Europe because the big banks don't care about the small business people. They talk about caring but they really don't. The small banks care about small business. I think one of the reasons why we have such a robust small business, I mean it's robust economic activity, because we have small businesses. A lot of that funding came from the small banks. That I'm afraid is going to be very difficult to get back to.

AMERICAN BANKER: So regulators' attention is largely on the small banks and they're ignoring the large institutions on sort of the ground level?

PAUL MILLER: Look at every Friday who fails. It's not the billion dollars dealer bank. You look at the ones that they don't care about. They don't care about the small banks. They're picking them off one by one and they have a whole list about when they're going to go down and get them. It's a lot less than it was a year ago but they haven't failed a giant bank since Colonial, right? You know, they're keeping these banks alive to get recapped as much as possible.

AMERICAN BANKER: Let me sum up for a second and then let me take you forward with a couple of questions that come to mind from all that. I think among the three of you, you're fairly much in agreement in terms of the current situation and that the economy looks to be dicey and bouncy for awhile with Paul even saying that could go on another three to five years. We have that. We've talked about the —

PAUL MILLER: Just to clarify. I just don't think we get out of this muck until we deal with all these foreclosure problems.

AMERICAN BANKER: Fair enough.

PAUL MILLER: So do we get through it in three years, five years, seven years?

AMERICAN BANKER: Fair enough. That's fair enough and you definitely — I was doing a little injustice by summarizing too simply. With that in mind, we talked about the regulatory constraints and we've talked about what you guys see as the inequities both in treatment of community banks versus large and some of the economic realities of each. With all those things in mind, my next question would be two-fold. Will the economy help banks or will banks help the economy? Which is it? Which is the chicken, which is the egg? We've said all the things that banks can't do right now or are having trouble with right now. What can they do? Where is the revenue going to come from? Where are the profits going to come from?

PAUL MILLER: One of the things that I'm trying to figure out is what the banking model is going forward. I mean there is the banking model before QE1 and QE2 and the banking model after QE1 and QE2. I don't know if it's the same. Right? Before QE1 and QE2, a bank added value by cheap deposits. Anybody could give a loan. The loans were all standardized. You had to have the branch presence, you had to have the lender presence. You went out and you hired a bunch of lenders and you hired them from one another just like you do stockbrokers and the loans came in the door. But it was who could supply the best funding. Those were the banks that were the best, most profitable banks.

Now you flip that. Everybody has got deposits. So has that comparative advantage switched away from deposit gathering to actually putting good loans on the books, which is a different model? Right? So therefore, I mean you've still got to have that cheap funding but everybody — and we keep going down this path, everybody will have the same funding base. It's what type of yield do you put on the other side of that. Therefore do you have a lending arm that can put good loans on the books and stay away from the bad loans? That's the value-add going forward, which is different than the value-add you had in the past.

Now with QE1 and QE2, I also wonder to myself if we have supplied so much liquidity to the system that we've nullified the banks, made them meaningless.

ANTON V. SCHUTZ: I want to talk about that on the large scale. Clearly the bond markets are back and I think that's why the large banks are going downstream because the large corporate customers can come back and issue corporate debt at incredible spreads and incredible fixed rates, which the banks really can't even compete with. The capital markets units are busy issuing that debt but they're not getting the growth in terms of their balances so they're going further downstream.But you know the question —

AMERICAN BANKER: In terms of the kind of customer they want?

ANTON V. SCHUTZ: The customer they want. But in terms of the question are banks driving the economy or the economy going to drive the banks, you know it's what came first, the chicken or the egg. It's the same — the answer is the same; you can't have one roll without the other. Like I said, they're the grease of the economy. You need them lending.

PAUL MILLER: But going back, Anton, has the government replaced the banks as the driver of the economy? Has the Fed become the giant bank? That's what I wonder. And it's therefore nullified everybody else. We can move forward but the banks will be left behind.

ANTON V. SCHUTZ: Clearly the Fed's stepped in as a massive intermediary and became in some ways the bank in a very broad fashion and actually tried to provide grease to the little banks. They've done their job. The big banks have gotten their grease; they've raised the capital. The small banks aren't quite getting enough grease and couldn't raise the capital so they're struggling and failing. It's not that the Fed has been necessarily wrong, although they are a regulator; it's really gone down to the FDIC and other regulators that have just stepped on the neck of the banks. And I think the Obama Administration at one point made that statement. They talk about the big banks but they talk about stepping on the neck of the banks that did this. I think maybe they're choosing the wrong victims here to step on the neck of.

PETER J. KOVALSKI: To have a healthy economy you need to have a strong and sound financial system. You can't have one without the other. I think the Fed and the government were right to step in to stabilize the banking industry. Although I believe part of the problem the industry got as bad as it did was due to the politicians' negative rhetoric about the industry turning society against it.

I think right now the industry has been recapitalized at least by the mid to large banks. The very small community banks are still struggling. The capital markets are not yet open for them. But the industry is strong enough now that the Federal Reserve needs to hand the reins back over to the banks. The Federal Reserve's mandate is not to run the Bank of the USA. I believe they will be stepping back. I think there will be political pressure against this manipulative stance they've been taking.

PAUL MILLER: Peter, can I just add a little bit, though? Because I agree the same. I agree that the Fed has to back out. But the problem is it's like you've got society hooked on a drug and when the Fed backs out do the politicians and society have enough patience to take that pain? Because what it means are higher rates across the board. We're so addicted now. You know we already have a housing market that's on the edge with as much support as possible. You know and I know mortgage rates need to go to 6%, 7% for a healthy mortgage market. We know that pain, that pain. I think the Fed's going to try to pull out of QE2. Then there's going to be some pain and they'll come diving back in again. I hope I'm wrong. But we have to go through that pain, which means probably a negative GDP growth one or two quarters to get things back into balance.

PETER J. KOVALSKI: I have a little bit different view. I think QE2 has actually prolonged the downturn. Whenever you manipulate a market there are beneficiaries and there are people that are hurt by it. Nobody ever talks about the people who are living on fixed incomes and living off interest earned on their investments. Everybody's talks about the people who leveraged over their eyebrows and are under water right now.

What has happened, and I believe this is the first time it's happened, is the massive deleveraging that's gone on. In the past, every time there's been a recessionary period, there's always been the ability for industry and individuals to leverage more. I think what happened in this recessionary period is that we were at such a high level of leverage in this economy that we've seen a massive deleveraging going on.

When you manipulate interest rates down, what you basically do is transfer wealth or income from the savers of the economy to the borrowers of the economy. Typically that would work and stimulate sales if the borrowers had the ability to or were releveraging. In this case they haven't. What has been happening is the savers of the economy have been giving money to the borrowers and those borrowers are just paying down their debt.

The people who really got hurt the most are the retirees. They're on fixed incomes and they live on their interest that they earn on their savings and investments. When you think about it, if you want to get to a multiplier effect, retirees tend to spend actually more than their income. They actually live off their investments. So what the Fed has actually done is reduce the level of spending by the one segment of the economy that could spend and hand the money over to the borrowers who have not spent but actually are trying to get back into financial shape.

I think that's what's hurt the economy and why we haven't seen a more robust growth in retail sales.

PAUL MILLER: I agree a lot with what Peter said because the people who are actually paying for this crisis are the savers, which are the older generations. They didn't get us in this mess but they've been asked to pay for it.

PETER J. KOVALSKI: I would like to follow on to what Paul had said a little earlier. I think you were talking about all the savings and lack of loan growth. I believe that's due to where we are in the economic cycle. During recessionary periods, loan growth is very difficult to get. People park more money in the banks so low cost savings deposits are easier for banks to accumulate during a recessionary period. That tends to flip over when we go into an expansionary period.

Right now we have an awful lot of money that's sitting idle by investors and corporations in bank accounts waiting for investment opportunities to come around. I think once the economy picks up, they'll draw down on those deposits. So there is probably a lot of what we would perceive as core low cost deposits which is really just money waiting for the next investment opportunity.

Then what tends to happen and what drives a lot of the M&A activity during an economic expansion is the fact that banks don't have access to low cost funding so they have to acquire it from other banks. That's when the deposit premiums start to appreciate noticeably in M&A pricing.

PAUL MILLER: Can I answer, Peter here, for a minute? I go back to the housing problem again. You know other economists have put numbers on this much better than I have done it but CoreLogic has come out with numbers that there is $750 billion of negative equity in the housing market. Now some of that's in the private-label stuff and some of that's in the banks, right? I don't see how any of these bigger banks or any banks that have large residential portfolios, which a lot of them do, can grow loans. The commercial loan part of the book is going to offset the drag that these shrinking portfolios are going to continue to have.

Mortgage debt outstanding, which is the largest debt segment out there, peaked at $11.4 trillion I believe in the early part of 2008, maybe late 2007. It is now roughly about 10.7. It probably has to go sub-10, right? That's another $700 to $800 billion of loan shrinkage, almost 10% in the mortgage market alone. The mortgage market on the banks' balance sheets is roughly $11 trillion in size, $8 trillion in loans. $3 trillion of that is residential mortgages, either HELOCs or first liens. That has been shrinking about 1-2% a quarter. That's going to continue to shrink 1-2% a quarter over the next three to five years.

Commercial loans, which everybody is praying will save the day in the banks' balance sheets, only peaked at $1.8 trillion in 2007. It dropped to $1.3 trillion, $1.2 trillion today. Now everybody started to get excited because it tweaked up there a little bit, right? Everybody talked about utilization lines going from 45 to 27. Well 45 was utilization line on these commercial loans during the overleveraged peak of the market. It's when everything was humming. We're now at 27. It's been humming around 27, 28, depending on what bank you are, in that range.

I just don't think even if you added $300 to $500 billion of C&I loans today it's going to offset that drag resi pulls down. Therefore when you really break down those different loan segments, you've got to fix the resi markets. The resi markets tripled. I think in '97 there was like $3 trillion mortgage debt outstanding or $4 trillion. I don't know the exact number. By 2007, that was $11.7 trillion. That's the overleverage problem that has to come in and it has to continue to come in. Until that fixes itself, again, REO is part of that problem because that will wind down as REO moves off the balance sheets. That's how that shrinkage occurs.

ANTON V. SCHUTZ: I just want to talk about the growth of that market and what really stands out is that subprime mortgages during a lot of the resistance averaged about 8% of the mortgage market. In 2007, it was 34% of the mortgage market. It really tells you very quickly that 26% of those loans should have never been made, if not more. You just do that simple math. That just shows where the exuberance was and it was fed by Fannie and Freddie getting into that market. It was fed by the conduits securitizing all this paper. And it was certainly fed by all sorts of chains here, including appraisers that were part of this whole process of overheating the market.

PETER J. KOVALSKI: You brought up what I was going to mention, is that a lot of the subprime was not owned by the banks, it was owned by conduits and other investors. I don't know if, again, getting to your mention of the size of the mortgages, how much were actually held in conduits who will no longer be participating there.

PAUL MILLER: — Private label, yeah.

PETER J. KOVALSKI: And also the regulators will require banks to hold more of that paper on their balance sheet. But I agree, the size of the real estate mortgage pool is going to get smaller because there are a lot of people who shouldn't have bought a house that did buy a house. But the question is what percentage of that is going to be taken by the banks now versus the institutional investors or the conduits of the world. It may be that banks start holding more paper if it's a decent enough return for them versus selling it off.

PAUL MILLER: That was a huge argument. I mean that's always been the argument, the bull argument, right? It's definitely, you know the bear and the bulls come out here a little bit. That's always been the bull argument with banks, that the private markets have shut down. I saw models which I laughed at back in 2008 that had Bank of America growing 10% a year in 2009 because the private capital markets just shut down and the banks are going to own the world. The problem is those loans should have never been made. Right? The loans that went into that market should never have been made. So therefore, they're just disappearing and they're not being replaced.

But the other issue is part of that — you know when you look at mortgage debt outstanding growing the way it did from '97 to 2007, I'm not sure if it tripled but it almost tripled in size. A lot of that was driven by home price appreciation, not just more units coming on. We were building more units than we ever built in our lives but you were getting 20%, 25% annualized increases in property values in some areas, which goes right into the banks. On top of that, people were getting refi — cash out refis right behind it. A lot of that was Fannie and Freddie type stuff.

Now you have a situation where home prices are falling. In its own right, any loan segment where the prices are falling is going to have a negative impact on the overall growth no matter where it sits. Now a lot of people say well this is just a hiccup. It's going to go down a little bit and then it's going to pop back up but there are also a lot of economists that think that home prices will fall throughout this year and be down another 10%. That in its own self has a negative drag on these resi portfolios, coupled with the next derivative to that conversation, where my really bearish stance comes out. Everybody that got back into the market thinking it's safe, their home is down 10%. It's like what the heck happened?

AMERICAN BANKER: We've got about five minutes. Here's what I want to do. I think I'm going to hit each of you with one question and obviously you guys chime in with anything. How are banks going to make money going forward? That's what I want to know. So what — in light of everything that we've said, what is the solution for banks in the near term: cut more, find some good credits or some lending niche or is it something completely different? Feel free to point out an example.

ANTON V. SCHUTZ: I think it's a combination of a lot of factors here. I think that there are many pieces to this puzzle but the banks are going to be challenged certainly from a return on equity perspective. That's very clear because they all have to carry more capital so their return on equity numbers cannot be the same as they once were.

I think that what else is clear is that there are less loans to pursue. There probably will be less banks and should be less banks. If there is going to be more regulation and it makes it too expensive for the small banks to compete, they're going to give up and they're going to sell.

I think that something else that's very, very true and management teams I talk to all the time, they're tired. I mean they're tired. They're beaten. They've been beaten by regulators; they've been beaten by us investors. It's just not fun. It's not fun to be a banker. It hasn't been a lot of fun to be a bank investor either. So those management teams are very tired.

Board of directors, you know now they're getting sued at all these failing institutions. They've been beaten up by the regulators and they own a lot of these same stocks that have been driven into the ground. They're tired. So there's board of director fatigue, there's management fatigue and there are less returns that are obvious to be made.

I think we're on the brink, and the timing is the real question, of sort of a super M&A cycle and one that we're going to see the nation's banks go from the sort of 7,000 figure maybe down to 3,000 to 4,000. I think it's going to happen incredibly quickly over the next two, three, four years.

PAUL MILLER: I agree with you. I don't know if it's going to be that much but definitely M&A is coming down the road. I mean you can't make money like you used to. You've got to make it the old-fashioned way, which means you don't need these huge cost bases that these guys have built up over the years. But yet again, when you talk to banks they're going like, "I like my cost structure right where it is." Then you talk to them about M&A and they're going, "Well I'd acquire XYZ and cut 50% of the cost out." Well why don't you just do it internally yourself, right?

It's like one of these guys who always says like, you know, you look in the mirror and you think to yourself you're fit but you're overweight. You know you're overweight but you really — but you know yet again, they won't look internally at themselves and do the cost cutting themselves. A lot of that cost cutting only comes through that process through M&A. The banking system built itself up on a lot of different revenue drivers, originations, Reg E, overdraft protection fees, all these different fees that they cannot collect anymore. The lending demand is not there anymore but yet again these guys don't want to downsize.

I think they've got to do massive downsizing. At some point they've got to get there. The problem is, as I always say, a CEO of a bank is always optimistic or he wouldn't become a CEO of the bank. An optimistic person never wants to downsize.

AMERICAN BANKER: And by downsize do you mean —

PAUL MILLER: Cut the heck out of their cost structure.

AMERICAN BANKER: People?

PAUL MILLER: Yes. There are too many people, too much cost, too many branches. You name it, there's too much of it.

AMERICAN BANKER: Peter, let me ask you this. One thing that banks have had go pretty well for them in recent times, you know the interest rate situation helped them. How much will interest rate risk play into how things are going to be for banks in the next couple of years, two years, three years?

PETER J. KOVALSKI: Why couldn't you ask me the M&A question? I agree wholeheartedly with Anton. I believe we are at the beginning of a massive consolidation cycle that could surpass in the number of deals the last cycle of the 1990's.

AMERICAN BANKER: And which banks win out and which ones lose from a rise in interest rates? How does that divide the industry?

PETER J. KOVALSKI: I know for regulators, that's been the hot button in their safeness and soundness exams. It's moved from credit now to interest rate management and analyzing the ALCO. They're demanding even small community banks that have more sophisticated software to help manage their process. It's hard to say right now because the fixed income markets are manipulated by the Fed. Who knows, when they eventually back away, where the curve is going to be. The curve is going to depend on where the economic environment is and where inflationary pressures are.

The smaller community banks tend to be very dependent on spread income. I don't see a fee product in the near term that can replace their spread income. So they are basic lenders and deposit gatherers. I don't see that model changing.

The investment banks or the money center banks are less dependent on spread income. They're always looking to create additional fee based products. They employ people with very creative minds that are incentivized to come up with exotic products to sell.

There's a question right now of what kind of return to equity can banks generate going forward. The regulators are demanding more in the way of capital and politicians are looking to take away the ability to charge fees to the consumers. My theory is banks will always come up with some new hot product. They always have. It wasn't that long ago that you didn't have that HELOC market and mortgage-backed security market. Now you can't think of society being without it. I believe there will be a product for the large money center banks but really when it comes down to the smaller community banks, they're going to have to manage interest rate risk better. A lot depends on how competitive it will be. It could be with fee income under attack by Washington that banks will now price the risk of their lending better and that maybe there will be some margin. We can only pray.

AMERICAN BANKER: Is that big banks or small banks?

PETER J. KOVALSKI: For the whole banking industry. Another unknown is once the capital markets come back and the institutional investors return, how rational will their pricing be. It was this segment which drove the mortgage market during the boom times. Rates were pushed down to crazy levels.

AMERICAN BANKER: So by pricing it better means higher?

PETER J. KOVALSKI: Yes, larger spread. I think banks need to get a little more rational. If their fees are being cut by the regulators, they need to make it up somewhere else, whether to institute new fees for services they've been providing free or by pricing their loans and deposits appropriately to get a decent enough spread. But the only thing with the spread is it's outside the industry's control. On the funding side, you have the money market funds that are going to compete with them and on the borrowing side you have the conduits out there that could move rates around. Bottom line, the banks are in a difficult position when it comes to spread income. But this isn't new to them. On the positive side, the regulators are pushing them in the direction of being much more sophisticated than they ever have in the past in managing interest rate risk.

AMERICAN BANKER: Anybody want to comment on that?

PAUL MILLER: Peter, do you think — because it's one of the things I think about — do you think maybe it's one thing that interest rate risk is getting too much attention? I mean when you really think about it, you know this, the thrifts didn't understand interest rate risk in 1980. That's when they got rid of Reg Q. That's when interest rate risk was a problem. But outside of that, like we ran tons and tons of models at our banks and NIM does not really move a lot with rates moving all over the place. I think it's one of these things that people are overly concerned about interest rate risk when the banks have been a very good managers of interest rate risk over the last 20, 25 years.

PETER J. KOVALSKI: Well I think the regulators have become more micro managing. If you look at the sophistication they've put into justifying the adequacy of a bank's loan loss reserve.

PAUL MILLER: It's ridiculous.

PETER J. KOVALSKI: The model even for small community banks is so complicated versus where it was just five years ago. I feel it's just the regulators saying if we can just put more metrics into the equation and have a better quantitative model, that we can somehow reduce the risk of the industry. You can't reduce the risk of industry.

This is maybe getting a little off the subject but the fact that the regulatory burden of having higher capital ratios is being put on the industry but not put on society is not going to solve anything. The leverage of the economy cannot be shouldered by just the banking industry; it has to also be shouldered by all individuals and corporations. So if you're going to still allow loan to values of 95% on a mortgage, you've got to expect defaults down the road. Now if you require a higher down payment, it's going to hurt the market initially because you're going to take some potential buyers out of it, but you will greatly lessen the chance of another boom/bust.

If you look at Canada, which tends to have a much more conservative underwriting, they did not have the speculative boom and bust event. I believe less leverage is part of the reason it didn't happen there. Just think if a minimum 20% down payment had been required to purchase a home how much less of a boom in home prices there would have been and how few homeowners would be underwater today. I believe the banking industry has been under so much pressure and they are being targeted by increased capital ratios to avoid any future calamity. The industry just doesn't have enough capital to support the whole economy. I think Washington needs to realize that.

AMERICAN BANKER: You're getting a lot of nods from Anton.

ANTON V. SCHUTZ: I've got to jump in on this because we haven't talked about this today. What all the rules and regulations have done is they've taken a certain segment of the economy and moved it entirely away from the banking system. Start with subprime; no one is doing that anymore. Now all of a sudden the regulators are going, "Hey, you're redlining again." Are you kidding me? That caused a lot of trouble to start with, okay, first of all.

Second of all, the credit card legislation, you mean I can't charge you a higher rate? So if you're bad credit, you're not getting credit. Goodbye.

Alright, let's move on to checking. Gee, you have $50 in your checking account. You overdraw it all the time and you do tons of transactions. But you can't get charged an overdraft fee and there are no fees on your account. Now the bank's going to charge you a fee. Probably 12 million Americans will no longer qualify to have a checking account.

I'm sorry; if you really think about what I just said, you would think that this was a Republican Administration that had done this to the lower class segment of the population. Lo and behold, we had a Democratic Senate, Congress and President where all this legislation got enacted and took those consumers completely out of the financial system.

PAUL MILLER: The problem is the bankers — the banking industry, call it from the mortgage brokers writing bad loans and the bankers saying, "It's not my fault that guy did it." They knew they were doing it. Right? You've got to put some on the shoulders of the banks. Overdraft protection fees hit poor people and college kids 80% of the time and they get nailed with a $400 bill before they knew what hit them because it's all in the fine print. The issue is they hid these fees behind the scenes, which is what the government really was upset about.

Yeah, are there marginal people in the checking account business that shouldn't be? Yeah. Are you pushing them out the door? That's the negative side to it. But the positive side is I've watched the banks do this for the last decade and I've been a supporter of the banks. But I also know when you go back and what they did, they did no due diligence at all on these subprime loans. They knew these people had no hope at all. "But you know what? We're not owning the loan; we're just writing the loan. You can't blame me for it." They put their hands up like that.

I'm not saying on one side that the overregulation isn't going to hurt the lower class. It is. What I am saying is the banks didn't police themselves and invited this scrutiny in the front door.

ANTON V. SCHUTZ: I agree with you. However, somewhere in between one could have put some sort of rational legislation in that would have limited or more disclosed the ways banks earn money. You don't push people out of the system. I'm not opposed to trying to improve the process; it was just such an extreme reaction to it all that it's removed a ton of people from the system.

PAUL MILLER: But Anton, that's only when politicians act. They don't act when things are good.

ANTON V. SCHUTZ: Of course not. They're always wrong!

PAUL MILLER: And they overreact when things go bad.

AMERICAN BANKER: Anybody else?

AMERICAN BANKER: So is subprime dead forever? I mean will we ever get back to that point?

ANTON V. SCHUTZ: History is always doomed to repeat itself. If you kind of look back, in the late '90s subprime blew up and wiped out a bunch of people and certainly a bunch of portfolio managers that owned those stocks. It just took a few years for it to light up again and get bigger than ever and once again come back and wipe out a bunch of people. So given history repeats itself and given that banks are getting beaten up for redlining again and encouraged to make loans that they probably won't get repaid on, the business will come back in a different form. They'll call it something else. Just like the CDOs, CLOs, all those three-letter acronyms, we'll have a new three-letter acronym attached to them.

I mean quite frankly, if you go back to the mid-'80s when you had junk bonds blow up a lot of the banking system in the markets. You know do the junk bonds still exist? Not in name. They're now called high yield. So yeah, subprime will be back.

PAUL MILLER: Subprime has been around I think for 50 years but who did them, owned them. Right? I think what — the model got out of hand when you didn't own the loan that you're originating. You were originating the loan knowing it wasn't going to get paid back but you didn't care. I think that's what the government is trying to do. I'm not going to support the government. They're going to sit there and say, "Listen, I've got no problem you giving a loan to a guy with a 500 FICO score but we want you to have so much economic interest in that loan that that loan is going to be collectible in some form or fashion." I think those are some of the good things. We have to get away from just originating to distribute.

But I also think bondholders who were part of the problem, too, are not going to go out and buy blindly a subprime tranche just because Fitch said it was AAA. Therefore nobody was doing due diligence. From top to bottom, the buyers, the guys putting them together, the originators, nobody did due diligence in the system. There is going to be no bond portfolio that's going to be buying subprime mortgages without doing due diligence or originating them themselves maybe. I think it does come back much smaller but you're going to own what you — you're going to own a big chunk of what you did. That's how it's going to be. It's not going to be capital market financed.

PETER J. KOVALSKI: Again, the economic cycle drives a lot of what happens in the financial sector. During an economic boom the risk premium gets shrunk because you have less probability of a default happening. You will also see that in the confidence index of the bond markets, that the spreads between risk-free and junk become very narrow.

I think if we get into an extended economic boom and memories start to lapse and fund managers are under pressure to get some yield pickup, I would expect that they would start demanding that product again. Nothing changes but the acronym of the product. What really drove this market in the last cycle was institutional investors. The Fed in had reduced rates so low that it prompted bond investors to reach for yield. In hindsight they were not properly pricing in risk premiums on the paper they were buying. As long as they got another extra five basis points or so, that knocked them up another quartile among their peers and they looked good to their investors.

Now they're coming back and saying, "Oh, we didn't know what we were buying." Well they were the ones who were actually demanding the product from the banker. I'm not saying the banker was not guilty as they had incentive to keep the production moving, but the investor was also demanding the product. That's what's going to determine whether subprime comes back again. It's going to be the end investor in that product. Do they need additional yield pickup and are they willing to take the additional risk. I think it'll happen during the top of an economic cycle.

AMERICAN BANKER: I think given the sort of grim realities that we've been talking about the last couple of hours — Suppose you have a child who's in college and they tell you, "When I graduate I want to be a banker." What do you say?

PETER J. KOVALSKI: I think unfortunately that the politicians basically killed the industry for one generation. I've heard from more than one banker with children in college that said the last thing their kids want to admit is that their father is a banker. And the last thing they or their friends want to be is a banker. It seems that Third World dictators have more friends.

They'll go to technology or some other hot field where they can still make an attractive income but not be perceived as evil greedy. But for one generation, banking is under a cloud. I think the pool of candidates is going to shrink for a period of time. Eventually the industry's reputation will improve. I feel it's a disgrace the way Washington has put this industry through the mud when the industry wasn't fully to blame for what happened.

In simple terms what happened was a boom and bust in one asset class. That's pretty common, during a long economic expansion that there'll be one asset class that becomes speculative. Everyone remembers the .com bust. There have also been busts in commercial real estate, oil and gas, farmland, Third World debt, LBO loans, etc. What was different in this case was that the asset class that blew up was the largest asset class and was owned by the most individuals in society. That's why it created a huge problem.

The banks got blamed because they helped facilitate the transaction, as is mandated to them by Congress. But they were not promoters of the asset. What's amazing to me is that the real estate brokers walked away unscathed by Washington and the media. These were the people pushing this product and telling their clients that "If you don't bid aggressively for this property and lose out you are going to pay more for the next property because home prices just keep going up." You don't hear of any lawyers going after them for improper sales tactics. Also surprisingly is that nobody goes after the homebuilders who were promoting their product. It appears that the focus was on banks because they have the deepest pockets.

ANTON V. SCHUTZ: I'll attack this from having a daughter who is a freshman at one of the schools that built all the exotic financial products or derivatives. She would never dream of going into finance. Astrophysics, yes. Building models for Wall Street, no. I think it's critical for the production of the economy, I think that level of intellect is a lot better off creating some product and getting some patents rather than building exotic derivatives that will come back in time. But that's a real live example.

AMERICAN BANKER: And she's at what stage?

ANTON V. SCHUTZ: She's a freshman at MIT.

PAUL MILLER: But you know I think it's a good thing because I think there are too many bankers to begin with. And during the boom time everybody wanted to run a hedge fund. That doesn't add any productivity. Like you said, we want people coming out of college building things, inventing new things, not, "I'm going to go out of college, build an exotic bond market thing and raise a billion dollars and make a lot of money doing that." I think it's a good thing because there were a lot of people on Wall Street that really weren't doing anything but trading bonds back and forth.

ANTON V. SCHUTZ: Slicing and dicing.

PAUL MILLER: What economic value was really being created?

AMERICAN BANKER: Gentlemen, we highly appreciate it. That was great.

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