The Banks Will Crash Again: They Have Learned Nothing

Banks continue to be evil:

The Looming Bank Collapse

After months of living with the coronavirus pandemic, American citizens are well aware of the toll it has taken on the economy: broken supply chains, record unemployment, failing small businesses. All of these factors are serious and could mire the United States in a deep, prolonged recession. But there’s another threat to the economy, too. It lurks on the balance sheets of the big banks, and it could be cataclysmic. Imagine if, in addition to all the uncertainty surrounding the pandemic, you woke up one morning to find that the financial sector had collapsed.

You may think that such a crisis is unlikely, with memories of the 2008 crash still so fresh. But banks learned few lessons from that calamity, and new laws intended to keep them from taking on too much risk have failed to do so. As a result, we could be on the precipice of another crash, one different from 2008 less in kind than in degree. This one could be worse.

The financial crisis of 2008 was about home mortgages. Hundreds of billions of dollars in loans to home buyers were repackaged into securities called collateralized debt obligations, known as CDOs. In theory, CDOs were intended to shift risk away from banks, which lend money to home buyers. In practice, the same banks that issued home loans also bet heavily on CDOs, often using complex techniques hidden from investors and regulators. When the housing market took a hit, these banks were doubly affected. In late 2007, banks began disclosing tens of billions of dollars of subprime-CDO losses. The next year, Lehman Brothers went under, taking the economy with it.

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The reforms were well intentioned, but, as we’ll see, they haven’t kept the banks from falling back into old, bad habits. After the housing crisis, subprime CDOs naturally fell out of favor. Demand shifted to a similar—and similarly risky—instrument, one that even has a similar name: the CLO, or collateralized loan obligation. A CLO walks and talks like a CDO, but in place of loans made to home buyers are loans made to businesses—specifically, troubled businesses. CLOs bundle together so-called leveraged loans, the subprime mortgages of the corporate world. These are loans made to companies that have maxed out their borrowing and can no longer sell bonds directly to investors or qualify for a traditional bank loan. There are more than $1 trillion worth of leveraged loans currently outstanding. The majority are held in CLOs.

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It is a distasteful fact that the present situation is so dire in part because the banks fell right back into bad behavior after the last crash—taking too many risks, hiding debt in complex instruments and off-balance-sheet entities, and generally exploiting loopholes in laws intended to rein in their greed. Sparing them for a second time this century will be that much harder.

In summary: the 2008 crash was caused largely because of subprime CDO’s. Banks stopped doing CDO’s. Now, banks are doing CLO’s. Which are the same thing but business-loans instead of mortgages.

The reason why it could be worse according to the author? Because the banks might not get bailed out this time.

Which, is a reasonable worry. A complete collapse of the financial systems in the US would cause ripple effects throughout the economy. Our entire foundation rests on the shoulders of credit – no banks, no credit.

How would you get a house loan? You wouldn’t. How would you get a car loan? You wouldn’t. Or how would businesses get loans to stay in business, expand, or startup? Nada again.

It is not difficult to realize what this impact would do to things like house prices, at-risk industries, and employment levels.

At least, in theory.

While a collapse of the big banks (the ones holding and trading the CLO’s) would cause a massive credit shrinkage in the short term, they are not the only financial institutions.

Credit unions, small banks, and local co-ops still exist in plenty. They would not take as hard of a hit. A massive hit? Sure. But not insurmountable.

People still needs financial institutions. They need a place to store their money and conduct transactions. The location and brand of it may just need a change. From the big, national variants to the small, local versions.

I agree with the author of that article in his uncertainty regarding CLO’s. They certainly do appear to be exactly as problematic as CDO’s. Likewise, banks have clearly not learned any lessons from 08. This is obvious to anyone that understands basic risk-mitigation strategies.

If anything, the only lesson they learned is that they can do whatever they want and Congress will lovingly give them billions when it finally catches up to them.

Because of this lesson we’ve given them, they have no fear. And because of this bull attitude, a future bank collapse is inevitable.

Whether it is from CLO’s or some other product; their actions will lead to another round of 2008 at some point.

And when it does, the conclusion is obvious: bailouts don’t work. They merely incentivize the same kind of behavior in different products. They push actually addressing the problem further down the line.

With that said, continually letting them crash would not work either. It would be far too damaging for the average American to have to constantly endure a collapsing financial system. We also need credit, so we can’t ban them outright.

There are alternatives, however. I ascribe to the mindset of constitutional-esque limitations on financial industries.

The government is limited by a constitution. Maybe it’s time for a “bank constitution”.

In this, I mean a document that grants authorization only to a few disclosed and obvious items. The constitution of the United States states exactly what the government can do. Everything else is prohibited.

So the idea is a similar document for banks. A document that gives them a limited scope of practice: authorizing only a few things of what they can do. Everything else is prohibited. If they’re on good behavior, we can add one thing to this document every 10 years to test out and see if it is risk-tolerant.

Everything else? Banned.

In doing so, we can prescribe them a limited scope of practice. We let them do what banks should be doing in the first place: accepting deposits and providing loans. That’s it. That is their primary function and purpose.

Hiding other accounts to obscure their balance sheet while combining sub-prime loans into a pool to trade and invest on was never an important function of banking. Neither is half of what they do today.

This constitution should allow accepting deposits, putting out loans (maybe to a max percentage such as 90% loans to shares), setting maximum interest rates, implementing procedures for official loans, providing exact definitions of products that of which they can invest/trade/operate in, and related functions.

Once we do that, suddenly the issues would be resolved. All we would need is for the FDIC and related regulatory institutions to make sure they are in compliance.

Sure, banks wouldn’t be as profitable. But it’s not like the average American benefits from the banker’s profits anyway. Let them slide into non-existence. More stability for the average American is far more important to me than the banker’s moneybags.

They have demonstrated they are not trustworthy.

The law should not be designed to limit what they do after we find out it’s dangerous. It should be designed to authorize only what we want them to do in the first place.

In practice, we have the opposite. We have laws saying banks cannot do this. Which means anything that rests outside of those hardline no’s they can do. And it means whichever loophole they can find to re-categorize the “no’s” as a grey area is also fine.

The inverse of this approach is better. Let’s allow them to crash and then give them a list of things they “can” do. Everything else – no. Much less wiggle room, which means much less risk.

Right now, however, the risk is high. Very high.

One thing is certain: The banks will crash again. Just give it time.

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