How Senator Crapo’s Dodd-Frank Rollback Will Let Banks Bet More Of Your Money
In March of this year, the Senate passed the Economic Growth, Regulatory Relief, and Consumer Protection Act, introduced by the Senate Banking Committee Chairman Mike Crapo (R-ID). Among other changes, it reduced the amount of regulatory capital for small banks and permits them to speculate in the derivative market on credit — putting bank assets at risk. In other words, they can bet in the market with your money. This is another stage in dismantling some of Dodd-Frank. Here’s why it is a concern:
As a result of the 2008 Crisis, the Federal Deposit Insurance Corporation (FDIC) closed 465 failed banks from 2008 until 2012. In contrast, it had closed only ten banks in the preceding five years. The bank failures were attributed in large measure to inadequate capital reserves to meet a stressful situation and bad investments in derivatives. Thus, Dodd-Frank increased the regulatory capital requirements to protect all banks. Its Volcker Rule restricted banks using bank credit to speculate in the market for profit. While the Crapo bill proposes amendments to several provisions, I will deal with only the capital adequacy and Volcker Rule.
Seven years since the passage of major reforms, along with significant monetary policy easing and fiscal stimulus, credit is flowing, and the economy has significantly recovered. Corporate and industrial loans, as well as overall loans in the banking sector, have grown significantly since pre-crisis levels, 35% and 31% respectively. The financial system is back to pre-crisis levels of activity, representing over 7% of gross domestic product, consistent with some other developed nations. Bank profits were at record levels in 2016 and, in the third quarter of 2017, banking industry’s average return on assets was at a 10-year high.
It appears that the banking system ain’t broke, why are they fixing it?
Those backing the Crapo bill say its main purpose is to relieve community banks and credit unions from some of Dodd-Frank’s requirements that may be onerous for smaller institutions.
There could be another reason: S&P Global Market Intelligence estimates a cool $53 billion will be available. Would the released capital likely trickle down to help tellers? Studies show a full one-third of tellers receive some form of public assistance— a $900 million a year taxpayer supplement to the banking industry.
S&P has the better prediction: It will be available for dividends and share buybacks. And who are these investors that will receive this bonanza? Are they the mom and pop 401(k) investors, or are they the sophisticated members of the 1% of the 1%, including bank executives themselves?
So why should you care about changes to the Volcker Rule and the capital reserve requirement?
First, let’s look at how we got here and what meaningful capital regulation looks like.
Leading Up To 2008
Central bankers from the U.S. and other leading countries, had established a 60-member Bank for International Settlements (BIS) at Basel, Switzerland, which can be considered the Central Bank of central banks. The BIS describes itself as a meeting place for central banks that sets guidelines only. However, its guidelines have very sharp teeth. If a country, member or not, does not meet the guidelines, few foreign investors will buy its government bonds or invest in it.
In 1988, the BIS formed the Basel Committee on Banking Supervision to establish some global uniform standards on capital adequacy to make the dangerous business of banking safer.
BTW: You better pronounce it Bay-sell, not like basil the herb, or you’ll sound like a rookie.
One of the guidelines required banks to have adequate capital relative to the risks that loans would not be paid back (credit risk). The relevant capital adequacy standard before the 2008 Crisis, called Basel I, mandated a range an 8% capital buffer. (Basel II came in 2006, too late to influence the 2008 Crisis.)
Gaming Basel I
This section gets a bit geeky.
The Basel I guidelines divided bank capital into two categories: Tier 1 capital consists of rock-solid capital, shareholders’ equity, and retained earnings. It must be sufficient to fund the bank through the normal ups and downs of business. Generally, that means to have a buffer to tide it over if loans are not repaid on time. Tier 2 capital is all the other capital but is considered less reliable.
Banks needed to have a 4% of Tier 1 and Tier 2 capital (total 8%).
Banks make various types of loans. Thus, the financial stability of the bank will vary with the likelihood of the different class of loan getting paid back. Basel I gave each category a different risk factor. Residential mortgage loans, for example, were given a risk weighting of 50%.
If a bank gave out a residential mortgage loan of $100,000, it’s risk was calculated at 50% or $50,000. It had to have a total capital reserve of 8% against the loan or $4,000 to back that loan.
Recall that Fannie Mae and Freddie Mac mortgages were sold in packages (residential mortgage-backed securities — RMBS) similar to ones that later became known as mortgage-backed CDOs. Since their origination, Fannie in 1938, and Freddie later, their RMBSs had proved AAA safe. These were the low down payment (5%) mortgages given to lower-income people. Note, a prime mortgage is one where the likelihood of getting paid back is high. These were time-proven prime mortgages, and wealthy investors wanted them. Their track record over seventy years showed without doubt that they were as safe as government bonds and paid a higher interest rate.
In recognition of their safety, the US government determined that Fannie and Freddie mortgage packages be risk-weighted at 20%. For the same $100,000 mortgage the capital requirement would be 50,000 x .2= 10,000 x .08= a mere $800 — a big difference.
The Toxic CDO
All analysts of the 2008 Crisis agree that the toxic CDO was at the heart of the meltdown.
The colorful Lewie Ranieri enters our story at this point. Back in 1989, he saw a tremendous profit in adapting the CDO model for investment banks. Investors had come to trust the mortgage-backed security through experience with Fannie and Freddie. As Fannie and Freddie did, the Investment banks would buy prime mortgages from commercial banks and private label mortgage companies (like the notorious Countrywide Financial), package and sell them to investors. These were called collateralized debt obligations (CDO). The collateral was the house pledged as security for the loan, the debt obligation was the loan.
There were huge upfront profits to be made because the investors would pay for the investment on day one and wait for their profit in the principal and interest payments over time. Lots of immediate cash for bonuses for bankers and anyone who could help the bankers get the fillings for the CDOs.
Originally, investment banks had faced a big problem. Pesky regulations prohibited them from doing that very thing because it was considered too dangerous. Lucky for Lewie, he was at the beginning of the surge of the markets-can-regulate-themselves movement and its prime promoter, Ronald Regan, was in the White House.
Ranieri had the privilege of standing beside Reagan at a great deregulation moment when he signed a law entitled the Secondary Mortgage Market Enhancement Act (SMMEA) that removed the prohibition from investment banks creating the CDO. Interfering Big Government was stepping out and leaving the solution to the market’s ability to police itself. The police would be the highly skilled Rating Agencies.
I want to be clear that I am in no way suggesting Ranieri had anything to do with including subprime mortgages by passing them off as prime mortgages. His original packages included only true prime mortgages. The deregulation seemed advisable. However, there was a fatal flaw in the underlying assumption that investors could catch later bankers who would try to game the system.
This landmark financial innovation required yet another deregulation. These new investment bank-originated CDOs would still carry a 50% risk-weighting. In 2001, the regulators came to the rescue. They changed the categorization so these new, untested CDOs would carry the same low-risk weighting as the time-tested Fannie and Freddie RMBSs but now for commercial banks. This obscure law was called, for short, the Recourse Rule. This kind treatment was later extended to investment banks.
Thus, as another example of the law of unintended consequences of deregulation, the government incentivized the banks to hold CDOs as part of their regulatory capital. Let’s review how they became toxic.
The Supply Dries Up
As investor demand grew for the mortgage-backed CDOs, sources dried up. There weren’t enough homeowners who qualified and wanted new mortgages. Remember that Fannie and Freddie required good credit ratings. So although their borrowers were in a lower income bracket, and they had only a 5% down payment, they were not part of the subprime market. To the contrary, these were prime mortgages.
So the commercial banks and the private label lenders (called mortgage originators, because that is where the mortgages started), began the process of signing up any warm body that could legibly sign its name. These became famous as the NINJAS (No Income, No Jobs, No Assets). Their applications were fraudulently altered.
In All the Devils Are Here: The Hidden History of the Financial Crisis (ebook loc 2698), the authors repeat a posting by ex-AmeriQuest loan officer, Christopher Warren, who had posted a webpage telling how he taught fraud to new hires. A welcome package, he said, included a pair of scissors, tape, and white out.
Investment banks knew full well that these mortgages were below subprime yet they certified that their quality control departments had vetted them and checked that they were prime mortgages. One brave whistleblower, Alayne Fleischman, then an employee at J.P. Morgan in quality control, left a memo as evidence that the bankers knew the mortgages were crap.
As a result of that single memo, which became known in banker circles as the “Howler” after the Harry Potter messages, the DOJ began civil suits against 18 of the major banks alleging the fraudulent certification of subprime mortgages as prime mortgages. All the banks negotiated settlements with fines. JP Morgan paid $9 billion. However, this was long after the 2008 crisis news cycle had passed. The admission of how widespread this bank fraud was made no impression on the public consciousness.
It will be no surprise that Fleischmann no longer works on Wall Street. She is employed in a government department in western Canada. Although relatively unknown in America, this year she was given an international award in for courage in Sweden. More on her story here.
Was it possible that the right hand of the banks, the guys who approved lending and investments, didn’t know what the guys who fabricated the toxic CDOs were doing? Or, did they really believe that they could get away with it because it was the ideal setting for a Ponzi-like scheme as the housing market would always rise?
StephenMatteoMiller of the FinRegRag answered this question in part for me. On Page 260–262, the Financial Crisis Inquiry Commission Report (FCICR) tells the story of what happened in Citibank. The securitization desk noticed in 2005 that there were indications of serious problems as some of the borrowers could not make even the first few months payments. However, that desk did not share that data with the CDO desk that increased its buying believing it was a temporary weak market.
That was the innocent explanation passed off to the FCIC. Because of Fleischmann and the resulting lawsuits, we now know that the securitization desks at all the banks knew, from day one, that the mortgages they were packaging contained many of the worst of the subprimes.
However, as one executive put it, they were going to dance as long as the music played. They knew there would be an end, but everyone on the bank side would profit—as they did: right from the mobile mortgage brokers who got about $10,000 a deal for sourcing applicants, the front-line staff at the originators who harvested huge commissions, and the executives at the investment bank who pocketed their well-known sky-high bonuses. They got to keep it all. There were no clawbacks; there were no personal fines, there were no jail terms. A clean getaway.
By 2008, banks held a large number of toxic CDOs because of the favorable asset weighting. These pieces of junk slipped in under a favorable 20% weight when they should have been slapped with a 100% risk of non-payment.
Post-2008, Basel III enhanced the capital adequacy requirement to 12.5%.
The Crapo bill exempts banks completely from the capital adequacy requirement if they have less than $250 billion of assets. That is why the concern.
Betting Your Money
Economist John Kay, in his Other People’s Money: The Real Business of Finance, (ebook loc 171), tells us that we have a false picture of what bankers do all day. Banks were given their special monopoly as a helpmate to business, and we think that’s mainly what they do. Perhaps, at one point that was true. Today’s bankers spend about 90% of their time using bank assets, including our deposit money, to invest for bank profits for bigger bonuses, says Kay.
If these investments benefited the country, it would not be so outrageous. However, these investments are in synthetic derivatives. These are man-made concoctions similar to pure Las Vegas betting. Remember Nick Leeson, the Rogue Trader who bet a billion of Barings Bank money that the Japanese stock market would go up one day when it went down—dragging the venerable old bank with it. That kind of bet does nothing for the economy.
The story of the London Whale gives us another example of how useless most bank investing is to anyone but the bankers. Bruno Iksil was a member of a risk management department at J.P. Morgan charged with reducing risk. Over time he bet and lost $6.2 billion of bank money on complicated credit default swaps and other high-risk synthetic derivative schemes. While Iksil’s team of six got $105 million in bonuses in the year before the whale beached, nothing he did was of benefit to anyone but himself and fellow bankers.
BTW: Iksil’s awed colleagues in other banks searched for a word to truly capture the length, width, and height of his bids. They found it in the casinos of Las Vegas, where the high roller of high rollers is dubbed a whale.
Safety of the system should trump administrative ease for individual banks.
Volcker designed his rule to stop commercial banks from doing what Leeson and Iksil did. The Crapo Bill exempts banks with assets under $10 billion from the Volcker Rule. Now, the smaller state banks can return to their casino-style business again.
What’s Next For Crapo Bill? House Approval
The Crapo bill now goes to the House so there is an opportunity for modification.
Former Senator Dodd, of Dodd-Frank fame, is now director of a state bank, the New York-based Signature Bank. In spite of his new interest in promoting state bank interests, Dodd was concerned enough about the size of the exemption to write an opinion for CNBC objecting to the $250 billion criteria as too large; $125 billion would be safer. The $250 billion limit creates a systemic risk. Two or three of these smaller banks failing together would bring on a Lehman Brothers size strain on the system according to Dodd.
Indeed, as we saw with the S&L and the 2008 crises, if there’s a problem with one bank, there is often a problem with many banks. Former Fed Chair Alan Greenspan claimed “contagious defaults” are the chief threat to the financial system and the broader economy. Banks bet so frequently with each other in these synthetic derivatives that their financial heath is intertwined. Greenspan felt Dodd-Frank had not done enough for this danger.
The House also has the opportunity to do something about taxpayer subsidizing bank teller salaries. It could determine what a livable’s salary for a bank teller must be. Then, make it a condition of being eligible for any of the benefits of this new legislation, that the freed up cash be used first to bring all bank employees’ salaries in line with that minimum standard. Then we will know if the real motive is to relieve the admin burden or to cash in for shareholders and executives.
The Senate’s Crapo bill addressed predatory lending and application fraud with a provision requiring the state banks to keep some of the mortgages that they originate on their own books, so they have skin in the game. Banks do not usually keep mortgages on their books, but operate under the business model of ‘originate and sell’ (more on that here.) They pass on these mortgages to a government agency such as Fannie or Freddie, or to investment banks that use them to create CDOs.
There is a far more direct way to ensure that the banks are not fudging the application forms to falsely qualify NINJA applicants. Every mortgage application form should have a consent so that the bank regulator can directly obtain a copy of the applicant’s income tax returns for the prior five years from the IRS. The regulators could take random samples of applications and check the income claims to ensure that what they see on the application form is what the investors get.
There is no doubt that Dodd-Frank was crisis response legislation and we have learned much since 2010 about the causes of the crisis. We became aware of the unbelievably widespread fraud from mobile mortgage brokers, loan officers and executives at the mortgage origination level and with the investment bankers who compiled the CDOs. They have gamed the system and won. The decisive question is how they are doing it now.
Stopping bankers from gaming the system again should be at the forefront of the mind of any politician who wants to rewrite Dodd-Frank.
You can follow Jan on Twitter @JanWeirLaw