Ignorance As Established Doctrine Is No Longer Tolerable

Ignorance As Established Doctrine Is No Longer Tolerable
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Today, the world of banking is made up of behemoths, giant multi-national firms that do many different things for many different people. Regional and small banks exist, but they are no longer proportionally significant, nor do they account much for the marginal direction and intensity of the aggregate system. There was brief furor over this state of affairs in the aftermath of 2008, where Too Big To Fail (TBTF) became a rallying cry for more than just banking. It was symbolic of the corruption in capitalism often called crony capitalism, as if the latter term could still be an apt description with the former attached to it.

Massive banks are a modern development, at least in this country.  The concept of a multi-state branching system wasn’t truly pioneered, even really allowed, until the 1940’s and 1950’s.  Transamerica was among the first, and really the first to go big with it.  Between 1934 and 1946, the company skirted branching rules using a holding company approach, acquiring 126 banks and establishing 74 more branches across five states.

They were not the only one to do it, though most often bank groups, as they were termed, were not so bold about crossing boundaries, at least those of geography. A 1937 confidential Federal Reserve memo on the subject of bank groups describes other tensions as the practice was practiced.  It estimated that in 1920 there were 4.5 branches for every bank office; 8.4 in 1925; 13.2 by 1930.  The ratio rose further to 17.5 by 1936, but that was a consequence of so many head offices being suspended or closed, or branch systems merged due to the Great Crash 1929-33.

One of those that survived was one relatively new to the idea. Marine Midland Bank had been in Buffalo, NY, for decades by then and had grown to considerable size through the loose affiliation of branch systems.  Banks in New York State at the time were restricted by statute to specific bank districts where the head office was located.  In many cases, the size of a single district was limited to a few sparsely populated upstate counties. By 1929, Marine Midland had put together 17 such bank groups of all types of registrations; national, state, reserve member, and non-reserve member.  By October 4, 1929, less than three weeks before the crash, it became a bank holding company tying them together.

The accumulation of banks in this format and others did not escape notice for its possible relationship with the causes of the Great Depression.  However, most of it tended to focus on the variability of business lines available to a bank group or holding company rather than the size or reach of it.  Transamerica had by the mid-1940’s become a true conglomerate, operating a real estate business, insurance sales and underwriting, the brokerage of seafood and fish, and even the manufacture of diesel engines.

In 1952, the Federal Reserve Board of Governors submitted a letter to the House Committee on Banking and Currency that was investigating the holding company proliferation.  In it, the Fed described what it had deemed as the principle problems with its regulatory mandate under the previous legal regime of the Banking Act of 1933:

“…the combination under single control of both banks and nonbanking enterprises, thus permitting departure from the principle that banking institutions should not engage in business wholly unrelated to banking because of the incompatibility between the business of banking which involves the lending of other people’s money and other types of business enterprises.”

That was the essential distinction that made banks such a special case in law as well as in practice.  They were charged with “the lending of other people’s money”, and therefore safeguards were paramount preferring people over institutional flexibility.  But what of a case where that could become a distinction without a difference? 

Eventually, Congress moved.  The Bank Holding Company Act of 1956 was one of the most significant pieces of bank legislation in modern history, though I wonder if it has been in the spirit under which it was designed.  The impetus for the legislation was to allow modernization without repeating 1929.  What became the rallying cry for it from the perspective of banking groups was that a bank holding company arrangement would actually be a significant defense against a repeat of the Great Crash and the waves of bank failures that doomed the global economy.  A single bank, it was argued, just could not withstand even local failures in its own region or even its specific banking district, as isolation was a serious deficiency no one would dispute. A holding company, by contrast, could act as its own clearinghouse or quasi-correspondent system, martialing resources from other parts of the bank to aid in liquidity crisis for any branches suffering under trouble.

There was, as usual, merit to the argument. In the testimony leading up to passage of the bill, however, one witness (whose name I could not track down) described a far different and darker possibility:

“The holding company is a diabolical instrument destructive of our old system of banking, directly and indirectly, and the father of a movement that, if unchecked, may unduly concentrate the credit machinery of the country.”

Banking in the United States up to that moment had largely been molded in the fashion of Thomas Jefferson, apart from short periods of deviation, where mistrust of them meant a legal framework for them very much mirrored of the US system of government – fractured and limited.  But there would always be a natural tension between that distrust and the relentless march of modernity and innovation, as efficiency could not be ignored. 

It is likely just a quirk of fate that the Bank Holding Company Act became law in the US at the very same moment the eurodollar was being born.  Being a wholesale format of money, the eurodollar had the potential of obliterating that distinction I mentioned earlier, where banks would no longer primarily rely upon “other people’s money”, and instead become increasingly reliant on “the market” for it.  It is an evolution that I struggle very hard to describe in terms of its implications, but still one that cannot be overstated no matter how poorly I or anyone else might do it.

Into the breach created by the rapid expansion of the eurodollar market and the Bank Holding Company Act, the decade of the 1960’s saw the creation and proliferation of “one-bank” holding companies. These were at the time not subject to federal regulation, and allowed the creation of leveraged bank holding companies and entities that no longer would need to be reliant at all upon customer deposits.  They were the first financial entities to enter the commercial paper market in size.

A firm of the one-bank design could freely operate and acquire any number of subsidiaries, which is why so many of the larger bank holding companies in the 1960’s began to convert to this format.  In 1966, it was estimated that 550 one-bank holding companies had by then come into existence, enough to force more legislative considerations including possible amendments to the Bank Holding Company Act of 1956 just a decade after its passage.  In the spring of ’66, testimony was given by Federal Reserve officials in favor of one such amendment that would bar these types of financial firms from entering non-bank areas on the grounds that it would be possible for the depository part of the structure to funnel resources by several means to riskier other parts engaged in questionable practices; exactly the sort of thing many believed sparked the calamity of the 1930’s.  

In that testimony, however, Fed officials were forced to concede that they had no evidence this had occurred, and was at that time the conjecture over mere possibility. Congress did not find it necessary to initiate a further delineation of permitted activities because the scale argument won, as did the market theory of banking as described in an article published in the University of Chicago Law Review in favor of the one-bank design:

“Another factor that should not be ignored in assessing the probability that one-bank holding companies will foster abusive banking practices is that of public confidence in a particular bank as opposed to banks in general. To survive, a bank must be able to attract and maintain deposits, thereby permitting it to engage in profitable credit transactions. Because of the competitive environment in which banks exist, any given bank which deviates too far from what the public considers to be acceptable banking standards is likely to find itself without depositors or with a very substantial decline in the level of its deposits. Thus, the same profit motive which might tempt a bank to engage in questionable conduct also serves to countervail this temptation. This countervailing force should exist regardless of whether the bank holding company is dominated by bankers or by the managers of a nonbank conglomerate.”

It was often said that banks were made honest by the fact that bankers themselves worked in glass offices, meaning that their books were always open to inspection and continual investigation by often several agencies. That argument is plausible when even one-bank holding companies were of the size they were in the late 1960’s, but does it necessarily extend to those after the waves of mergers in the 1980’s?  In these pre-wholesale times, bank books could literally be put into a book. 

One bank that participated in those 1980’s expansions was Marine Midland, both as an acquirer and one that was acquired.  In 1980, a controlling 51% stake was taken by HSBC, becoming full ownership by 1987.  Throughout the 1980’s and 1990’s, HSBC added to Marine Midland, especially its mortgage profile, combining in 1994 Spectrum Home Mortgage which had operated across 8 states. 

HSBC is no longer much of a presence in Buffalo these days.  In October 2013, it exited its long-time lease as the majority tenant of what was called the HSBC Center where it had occupied two-thirds of the 38-story structure.  It shuffled personnel to other locations in and around the city, but had already transferred its mortgage processing and servicing operations to PHH the year before.  It also sold all of its Upstate branches to First Niagara in July 2011. That May, management announced major changes for the US businesses, as reported by The Telegraph at the time:

“The US business will see major cuts and the bank said its US finance operation would cease writing new business, except for in its credit cards business.”

That would not be the end of the restructuring, as HSBC underwent another in June 2015.  The reductions in Buffalo and elsewhere were a part of the bank’s desire to cut its mortgage and retail bank businesses after suffering through the housing bust, where in the aftermath of the crisis management had decided instead to focus primarily upon Asian markets.  Given what happened in 2014 and early 2015, the decision to restructure also made perfect sense, as CNBC appropriately described:

“Just a few years ago, HSBC's status as a banking behemoth seemed unshakable. It appeared to have navigated the global banking crisis with relative aplomb. Despite taking a serious hit from its U.S. mortgage business, this was balanced by growth in its emerging markets business. Its aim to be the ‘world's local bank’ seemed to have paid off.”

Except it didn’t.  It was emblematic of the global behemoths after 2008, where there was no longer any place left to go that would resemble the same opportunities as from before the crisis.  Many banks thought similarly, as if the developed world would be mired in a “new normal” of concerning low growth after the Great “Recession”, at least there would be EM’s to capture volume; for it was always, always about volume.  That was something no depository system would ever be able to deliver. Unfortunately, the wholesale system by the time of the “rising dollar” showed it was no longer capable, either.  This is the whole difference between what looked like global prosperity prior to 2008 and global depression after it, though you wouldn’t be able to find that out via conventional sources. 

It has been overshadowed by other pieces, but HSBC must not be forgotten for its primary role in the crisis. On February 7, 2007, exactly ten years ago this week, it was actually HSBC who kicked things off.  Along with a now-forgotten new “bank” type firm, New Century Financial, the banks announced troubling expectations for early 2007.  They both would have to increase their loss expectations significantly, which meant for New Century a big change in underwriting standards and therefore considerably less volume, while for HSBC it confirmed what were at that time only fears.  Subprime wasn’t going to be a minor bump in the road, for if it could impact HSBC in serious fashion everyone had to truly start to consider that there might be quite a bit underneath all this. 

What really happened that day as well as the one following it in the big picture sense was that what had remained completely in the shadows was for the first time visible to all.  In fact, it was no longer optional to ignore all these big things that had been hidden for decades.  The fruits of the transformation of global banking had been apparent for a very long time, however, nobody really cared to examine that actual transformation itself.  And why would anyone?  Alan Greenspan was the “maestro.” It was going swimmingly for banks as well as everyday Americans.  Though they found it suddenly harder to get jobs and increase their incomes, they could at least supplement themselves with home equities as ATM’s.

Because of this, the mainstream never could understand what was truly happening because it never bothered to understand what had truly happened.  In that sense, the events of February 7, 2007, did not actually bring out what had been taking place in the shadows, it merely forced everyone to admit that there was something going on in these dark recesses that was considerably more than just the usual parlor tricks of accounting. As usual, the “best and brightest” were among the last to notice the illumination.  Then-Federal Reserve Chairman Ben Bernanke in March 2007 expressed his usual bland concern combined with bewilderment, his default setting, especially as the stock market at the end of February 2007 was jolted by all this subprime stuff.

“CHAIRMAN BERNANKE. I had been puzzled about the quantitative relationship between the subprime problems and the stock market. I think that the actual money at risk is on the order of $50 billion from defaults on subprimes, which is very small compared with the capitalization of the stock market. It looks as though a lot of the problem is coming from bad underwriting as opposed to some fundamentals in the economy. So I guess I’m a bit puzzled about whether it’s a signal about fundamentals or how it’s linked to the stock market.”

I don’t believe he ever truly grasped the significance of it all, in fact I’m sure of it, even by the end of his tenure which had been marked by one failure after another after another after another.  The shadows were not really about subprime at all, as those kinds of mortgages were merely, along with EM finance, the most extreme versions of what was going on in all those dark corners of global finance. Bernanke’s thought expressed above was the perfect illustration of the whole problem, as the orthodox mainstream thoughts was always pegged in these small terms. The colloquialism of shadow banking is thus misleading, as it presents an idea of a relatively small amount of assets, capacity, or even functions concealed from view. 

This is one reason why after each round of “stimulus” economists would always be left crying for one bigger.  No matter what they did, and this extended to fiscal policy as well as the monetary, it was never big enough.  And that was true in the sense that they never gathered enough energy and honesty, quite frankly, to go into the shadows and see for themselves why that truly was. 

It betrays a shocking lack of comprehension, as the whole world needed definition at that point. We know they were heavily engaged in subprime mortgages, but again that was just a symptom.  We know there were heavily engaged in similar efforts throughout the EM’s, as HSBC helpfully demonstrated of both if staggered by a few years.  That, too, was just a symptom.  The shadow banking system was never truly in the shadows, nor was it much about banking, except as, you get the point. 

If the modern bank holding company was the “father of a movement”, then the eurodollar was its mother.  That association was to over time obliterate traditional banking in all relevant distinctions.  If these created the shadows by which banks could operate in ways they had always dreamed, it was an eclipse for and of money itself.  Deposits no longer were so primary, and over time by the 2000’s you could argue, as I do constantly, that they mattered so very little as to be largely irrelevant (in monetary terms). They absolutely were in 2008.

And yet, “our” whole theory of regulation and even the conventional understanding of money remains grounded in the depository system – as it is to this very day, ten years after it was no longer optional to be this way.  When the eurodollar system was building, growing, and altering everything in its path you could stick your head in the sand and skip past it; that isn’t the case on the other side. 

The world knows now that there are gravely important things in those shadows even as they remain today still undefined “things”; that was all that was ever learned, that there was and is something there. What was obscured before February 2007 is still in February 2017. It is utterly incomprehensible how that could be. In any other discipline this would never be allowed to stand. 

Economics, however, is one place where this actually makes perfect sense, at least so far as the disturbing incuriosity of its high practitioners.  Positive Economics rules the game, and that means policymakers believe wholeheartedly they don’t need to know how things work, they just need to have faith that they do.  In terms of the takeover of the eurodollar, shadow system, that was Alan Greenspan imagining that he was controlling the whole economy and monetary/banking system with quarter-point adjustments in the federal funds rate and no one of standing bothering to check to see if that was really the case.

It wasn’t, as it was as absurd an idea as it still sounds. That fact should have been recognized on February 7, 2007, at the absolute latest.  The plight of HSBC is a window into what has been wrong, on both sides of 2008. The minimal acceptable response from that point forward should have been a full and comprehensive illumination of all of what was and still is in the shadows, and what all that meant, leaving nothing to chance or assumption any longer.  Ignorance as established doctrine is no longer tolerable and hasn’t really been for a full decade now.  So long as it is tolerated, this depression will continue, at least until that can no longer be tolerated.    

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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