Banking, risk, greed and a house of cards

When I took the  course on economics of money and banking,  banks were said to be financial intermediaries which means they act as the facilitator between savers and borrowers.

I thought about this a lot as I read House of Cards by William D. Cohan published by Doubleday in 2009.  It is an account of the history and collapse of Bear Stearns & Co. which was the fifth largest investment bank in the United States.

It appears the two big problems in this bank failure were risk and greed.

When a person borrows money there is some risk that he/she will not be able to repay the loan.  The longer the term of the loan the greater the risk. As interest is in part to allow for risk the longer the term the higher will be the interest rate charged.

The question: Who is going to take the risk? The depositor or the banker?  Whoever takes the risk should also get the interest compensation.

It is clear from this book that the bankers took upon themselves the risk although when the risk became reality  their depositors also lost.  The bankers may not have realized, may not have wanted to realize, the risk they were taking.,

What makes this risk attractive is that short-term interest rates are generally much lower than long-term interest rates.  Therefore a banker can make lots of money by taking short-term deposits with which to make long-term loans.  And this is what Bear Stearns was doing.  A large chunk of the mortgages they were holding in a couple of hedge funds were financed with overnight deposits.  Apparently this was/is a common practice on Wall Street.   There are two risks in doing this: short-term interest rates may move against you or your depositors may  withdraw.

So long as the economy was experiencing economic growth it worked and the bankers made obscene fortunes.  But when economic growth slowed down and it became known that these sub-prime mortgages were not as sound as they had been  promoted, the bankers found that their short-term  lenders refused to re lend the money. Disaster. And these guys had the nerve to whine when it became apparent they were going to lose some of their personal fortune.  They also had to be rescued because banks create money and are too important to let fail.  When Bear Stearns went down there was a lot of worry that the whole financial system would collapse.

One has to note this way of working probably under priced the risks of the sub-prime mortgages and that the investment bankers had a vested interest in doing so.  It made it much easier for them to sell their wares.  If the full risk of the sub-prime mortgages had been charged in interest rates most low-income borrowers would not have been able to afford them. (It is interesting that the U.S. government starting with Clinton encouraged this business by asking the banks to finance  housing for low-income people.)

It is probably safe to say most of these investment bankers were con artists.  However, I would suggest that to have a successful con you must have at least two greedy people.  It is hard to con somebody who is not greedy.

So how do we prevent bankers from taking upon themselves excessive risk?

The first answer is to changed the way in which our economy creates money so that banks are excluded from the process.  For more on this please see the essay LETS go to market: dealing with the economic crisis  on this weblog.

The second thing is to require banks to match the terms of their deposits and loans.  They should make their profits out of the spread between the interest rates they pay and charge. The risks and rewards should go to depositors according to the decisions they make.

The third thing us to require them to publish lots of information about their business.

As for greed, governments should probably not try to legislate. Greedy people should be expected to take the consequences. (Lets make a distinction between cons involving two greedy people and exploitation by a person who has superior strength)

Wall Street has rebounded from this  crisis.  One  has to wonder of any lessons have been learned or are investment bankers still financing long-term loans with short-term deposits.  If so there is potential for another crisis.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: