What Do Our Nation’s Biggest Banks Owe Us Now?

This week, ABC News World News with Diane Sawyer is airing a series about the struggling middle class. The show’s producers posed the following question to a few of the nation’s leading economic and financial analysts, including UMKC’s own William K. Black.

QUESTION: As the nation’s largest banks have regained their footing, what, if anything, can or should they do to help Americans still struggling as a result of the financial crisis and recession? Are there specific solutions or actions the banks should take or HAVE they already done enough? Do the banks have an “ethical obligation” to help those average American families still struggling?

ANSWER: First, banks have not recovered. It is essential to remember that the banks used their political clout last year to induce Congress to extort the Financial Accounting Standards Board (FASB) to change the accounting rules such that banks no longer have to recognize losses on their bad assets unless and until they sell them. Absent this massive accounting abuse, hiding over a trillion dollars in losses, banks would (overall) not be reporting these fictional “profits” and would not be permitted to award the exceptional executive bonuses that they have paid out.

Second, banks have, in reality (as opposed to their fictional accounting ala Lehman) been suffering large losses for at least five years. They only appeared to be profitable in 2005-2007 because they provided only trivial loss reserves (slightly over 1%) while making nonprime loans that, on average, suffer roughly 50% losses. Loss reserves fell for five straight years as bank risks exploded during those same five years. Had they reserved properly for their losses the industry would have reported large losses no later than 2005.

Third, banks have performed dismally when they were supposedly profitable. They funded the nonprime and the commercial real estate (CRE) bubbles that not only cause trillions of dollars of losses and the Great Recession, but also misallocated assets (physical and human) during those bubbles. Far too few societal resources went to productive investments that would increase productivity and employment. Our nation has critical shortages of workers with expertise in physics, engineering, and mathematics — precisely the categories that we misallocated to finance instead of science and production. In finance, they (net) destroyed wealth by creating “mark to myth” financial models that maximized executive bonuses by inflating asset values and understating risk.

Fourth, when finance seems to be working well in the modern era it is working badly. Finance is a “middleman.” Its sole function is to allocate capital to the most useful and productive purposes in the real economy. As with any middleman, the goal is to have the middleman be as small and take as little profit as possible. Finance has not functioned that way. It has gone from roughly 5% of total profits to roughly 40% of total profits. That means that finance has, increasingly, become wildly inefficient. It is a morbidly obese parasite (in economics terms) that drains capital from the productive sectors of the economy.

Fifth, the things that finance is good at are harmful to our nation. Finance is very good at exporting U.S. jobs to other nations. Finance is very good at fostering immense speculation. When banks “win” their speculative bets Americans suffer, e.g., when their speculation increases gas and food prices. When they lose their bets the American people bail them out. (The least they could do would be to support the proposed Volcker rules. In reality, of course, they will gut them.) For the overwhelmingly majority of Americans, increased speculation simply causes economic injury. In very poor countries, however, “successful” speculation by hedge funds that runs up the price of basic food kills people. Speculation has also become intensely political. The right wing Greek parties engaged in accounting fraud to allow Greece to issue the Euro. When a left wing Greek party defeated the right at the polls the banks and hedge funds decided to engage in a speculative frenzy designed to cripple the nation’s recovery from recession. Finance is also superb at increasing inequality.

Sixth, the rise of “systemically dangerous institutions” (SDIs) that the government will not allow to fail optimizes moral hazard (fraud and speculation) and means that future crises will be common and unusually severe.

Seventh, while lending by smaller banks is flat, funding by SDIs fell by over $1/2 trillion.

Eighth, banking theory is horribly flawed. Financial markets are normally not “efficient”, markets do not inevitably “clear,” and banks fund “accounting control frauds” rather than providing effective “private market discipline.”

To sum it up, whether I’m wearing my economics, law, regulatory, or white-collar criminologist hat the situation in banking demands prompt, fundamental reform so that banking will stop being so harmful. Then we have to keep working to make it helpful.

Banks cannot do many of the things that need to be done to fix our economy. In the interest of limiting space, I’ll talk about only five economic priorities. I think banks can be helpful in only a few of these priorities. The most important thing we can do with financial institutions is reduce the damage they cause.

1) It is nuts that we think it is OK for 8 million Americans to lose their jobs (and far more lose their ability to work full time) and that we think that it makes sense to pay people not to work but is “socialism” to pay them to work during a Great Recession. We need a government-funded jobs program.

2) It is a disgrace that well over 20% of American children grow up in poverty. It is a greater moral failing that ending this is not a national priority. The banks have done a terrible job in this sphere. They caused the greatest loss of working class wealth since the Great Depression and have made tens of thousands homeless. This is overwhelmingly the product of what the FBI began warning of in 2004 — and “epidemic” of mortgage fraud. The FBI states that 80% of the fraud is driven by finance industry insiders.

3) It is insanity to the nth to run our state and local governments into massive cutbacks during a Great Recession when that undercuts the need for stimulus. The obvious answer is a public policy with impeccable Republican origins — revenue sharing. It passes all understanding that the Republicans and blue dog Democrats targeted revenue sharing for attack and reduced it to a pittance (relative to the scale of the crisis). The best things the banks could do in this regard are to stop (a) all participation in “pay to play” corruption involving state & local bond issuances, and (b) stop all sales of unsuitable financial products to governments (and the public). The opposite is happening: Goldman fleeces its public sector clients, the SDIs sell toxic derivatives to small Scandinavian cities, the investment bankers are all over public pension funds desperate for higher yields (on their underfunded pension funds) selling them grotesquely unsuitable financial products (typically, the “dogs” they can’t unload on more sophisticated investors), and the inimitable Goldman Sachs helping Greek governments deceive the EU.

4) Related to points two and three above, the most productive investment we can make is educating superbly the coming generations. The best thing the banks can do is get out of student lending. The governmental lending program for college students was administered in a much cheaper fashion. The privatized lending program is an inefficient scandal that keeps on giving.

5) Banks could put the payday lenders out of business by outcompeting them. That would be a real public service.

And, on a level of fantasy, banks as a group could tell FASB to restore honesty in accounting. Individual banks could report their real losses and change their executive compensation systems to accord with the premises that purportedly underlie performance pay. They could start making criminal referrals against the mortgage frauds (a mere 25 banks and S&Ls make over 80% of the total criminal referrals for mortgage fraud) — most banks refuse to file and help us jail the crooks. They could stop adding to the glut in commercial real estate. They could support the Kaptur bill to authorize the FBI to hire an additional 1000 agents so that we can investigate and jail elite financial felons. They could support a prompt end to the existence of systemically dangerous institutions (SDIs) by supporting rules and regulatory policies to require them to shrink to the point that they no longer endanger the global economic system. Pinch me if any of these dreams come true. I’d like to be awake to experience and celebrate the miracle.

About William K. Black 25 Articles

Affiliation: University of Missouri, Kansas City

William K. Black, J.D., Ph.D. is Associate Professor of Law and Economics at the University of Missouri-Kansas City.

Professor Black was the Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board, General Counsel of the Federal Home Loan Bank of San Francisco, and Senior Deputy Chief Counsel of the Office of Thrift Supervision.

His expertise is in: banking law, fraud detection and prevention, and the regulation and supervision of financial institutions.

Professor Black earned a PhD at University of California at Irvine and a J.D. at University of Michigan Law School.

Visit: UMKC

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