Large banks: OK. Cheap money: OK. Let banks do whatever they want: Disaster

To figure out what really caused the Great Recession, Paul Krugman compares America’s crisis-causing banks with Canada’s crisis-resistant banks. Krugman absolves two commonly cited villains: 1) The Fed’s loose monetary policy is off the hook because “Canadian interest rates have tracked U.S. rates quite closely”; and, 2) Krugman crosses off mega-bank consolidation as the culprit because “in Canada essentially all the banks are too big to fail: just five banking groups dominate.” What’s left?

Canada’s experience does seem to support the views of people like Elizabeth Warren, the head of the Congressional panel overseeing the bank bailout, who place much of the blame for the crisis on failure to protect consumers from deceptive lending. Canada has an independent Financial Consumer Agency, and it has sharply restricted subprime-type lending.

Above all, Canada’s experience seems to support those who say that the way to keep banking safe is to keep it boring — that is, to limit the extent to which banks can take on risk. The United States used to have a boring banking system, but Reagan-era deregulation made things dangerously interesting. Canada, by contrast, has maintained a happy tedium.

More specifically, Canada has been much stricter about limiting banks’ leverage, the extent to which they can rely on borrowed funds. It has also limited the process of securitization, in which banks package and resell claims on their loans outstanding — a process that was supposed to help banks reduce their risk by spreading it, but has turned out in practice to be a way for banks to make ever-bigger wagers with other people’s money.

It’s deregulation’s fault. You can have large banks. And you can have cheap money. You just can’t let banks do whatever the heck they want.

Banks aren’t ordinary companies. Banks hold and invest depositors' deposits. Bank deposits are federally insured. And politicians consider large banks too important — or, more accurately, too politically powerful — to fail, so large banks possess implicit bankruptcy protection.

Profit maximization leads banks to bamboozle — even defraud — customers. One trick is to overwhelm customers with piles of documents full of legal mumbo jumbo. (Does anyone really understand the mortgage documents they sign? Our attorney didn’t even give me time to read them when we bought our house in 2004. Just shoved a pile of paper in front of me and told me to sign them all quickly.)

But, in recent years, bank grifters' main marks weren’t mortgage borrowers but institutional investors (pension funds, cities and towns, university endowments, etc.). Banks — with help from complicit ratings agencies — tricked these “sophisticated investors” into buying their likely-to-fail CDOs (collections of likely-to-default mortgages gorgeously packaged up to hide all the crap inside).

Even worse, banks with little or no net worth have strong incentives to gamble with federally insured deposits. And even healthy banks took on trillions of dollars of risk to make highly leveraged “heads we win, tails taxpayers lose” gambles, (correctly) anticipating taxpayer bailouts if their bets became losers.

Posted by James on Monday, February 01, 2010