The Great Deformation (74 page)

The former Hudson City Bancorp, for example, had the lowest operating cost-to-revenue ratio of any publicly traded bank in the United States, but had only $45 billion of assets and 135 branches. In fact, its operating cost ratio was less than half that of its mega-bank competitors such as Chase Bank and Citibank, with which it went head-to-head on its New Jersey turf.

Not surprisingly, Hudson City Bancorp had no trading operations or prop desk, and was strictly in the residential mortgage and community banking business. Unlike the banking behemoths, it did not suffer from “dis-economies of scale” and thereby maintained a pristine loan book. It never wrote a single subprime loan or any other risky “innovative” mortgage, and boasted a mortgage portfolio where the loan-to-value ratio averaged a rock-bottom 60 percent; that is, virtually none of its borrowers were “underwater.”

Accordingly, Hudson City Bancorp was the poster boy for prudent and proficient underwriting: it had only 500 bad loans out of 80,000 in its mortgage book. It also put the lie to the entire “size matters” propaganda that arose from the merger mania. Hudson City Bancorp not only suffered no scale disadvantages but also avoided the underwriting chaos of its Too Big to Manage competitors.

In truth, there are no significant economies of scale in retail banking above $50 billion in assets, period. Consequently, the massive “roll-ups” of retail banking should never have been tolerated by bank supervisors.

Nor was the case any more compelling with respect to corporate lending and securities underwriting. The relevant marketplace for these operations is global, yet that's exactly why almost every corporate financing of size is widely syndicated. The latter process—often involving dozens of financial institutions presenting widely differing geographies, customer bases, and scales of operations—represents the opposite of the mega-bank principle; the very purpose of syndication is to disaggregate scale, not concentrate it.

The constant claim by the likes of JPMorgan that it got huge because its global customers “demanded” it is mocked by the facts. JPMorgan is actually
the top corporate loan syndicator on the planet. In that capacity it does not throw its multitrillion balance sheet at customers but, instead, “arranges” new loans by spreading the credit exposure far and wide.

The remaining operations of the mega-banks basically consist of massive internal hedge funds and related trading and prime brokerage operations. Whether there are economies of scale in these internal hedge funds or not is irrelevant. As the great Carter Glass might have declaimed, those activities should not have been allowed within a country mile of deposit banking in the first place.

None of these considerations bestirred the Fed, the one agency that could have shut down the empire builders cold. In fact, the Fed actually encouraged the traditional money center and leading regional commercial banks to merge. Furthermore, by embracing the Glass-Steagall repeal it gave the green light for these commercial bank “roll-ups” to then branch out into all the trading markets, thereby transforming themselves into the very Wall Street behemoths that came crashing down on the Fed's own doorstep just a few years later.

Needless to say, the monetary central planners were so blindly focused on levitating the nation's economy through higher stock prices that they failed to read the warning signs in their own domain. The rip-roaring share prices of the mega-banks were evidence not of national prosperity but of massive speculation on Wall Street and in the credit markets. The disaster of “Too Big to Fail” was being erected right under its nose, and yet the Fed did not stop a single M&A deal of significance.

Indeed, the combined market cap of the five mega-banks grew from a few billion dollars posted by their predecessors in 1987 to $800 billion by 2008, but these munificent gains were serial gifts from the Fed. What caused the valuations of these insensible agglomerations to soar was swollen PE multiples, cheap wholesale funding, and a regulatory blind eye to the insanity of the banking merger mania.

It goes without saying that with all boats being lifted by a rising tide of stock prices—even transparently unseaworthy vessels like Citigroup—the free market could not do its job of capital allocation and assessment of the earnings quality being reported. So the market caps of these burgeoning financial mishaps kept rising, as mutual fund managers and newly emboldened Main Street punters alike piled into another momentum chase.

In the fullness of time, of course, it became evident that these behemoths were “too big to comprehend,” “too big to manage,” and “too big to be profitable” on a sustainable basis. Still, soaring stock prices gave CEOs, boards, and M&A bankers all the reason needed for ever larger mergers and consolidations.

BANK MERGER MANIA:

EXECUTIONER OF GLASS–STEAGALL

The lamentable thing about the eventual crack up of the mega-banks is they were erected one step at a time in full view of Washington officialdom. By the end of 1998, the five great mega-banks had accumulated combined balance sheets of $2.5 trillion: a thirty-five-fold gain from the modest girth of their 1987 predecessors. Yet, rather than giving pause, these elephantine numbers seemed to only accelerate the chase.

By that point, for example, Chemical Bank had already merged with Manufacturers Hanover which, in turn, combined with Chase Manhattan. While each had thrived nicely as an independent money center bank since the 1930s, the threesome proved to be not up to the task of bubble finance. Accordingly, the huge firm then known as Chase Bank next merged with JP Morgan, thereby rewriting in one fell swoop the map of post-depression-era finance.

In short order, of course, the rewriting resumed when BankOne was brought into the Morgan fold in 2004. That merger brought along with it First Chicago and a whole landscape of midwestern community banks that the combo's namesake had accumulated over several decades. Accordingly, JPMorgan had now crossed the $1 trillion mark in total assets and was rapidly on the way to $2 trillion four years later.

The final flurry of bank merger mania also brought the ill-starred 1999 union of one of the nation's premier money center banks, Citicorp, with a discombobulated collection of financial services companies that Sandy Weill had assembled under the Travelers Group. The pieces and parts of the latter were a veritable history of Weill's 1990s M&A adventures including Salomon Brothers, Smith Barney, Travelers, parts of Aetna, the retail brokerage of Shearson, the insurance and consumer credit operations of Primerica, and countless more.

The result was a $2 trillion monster that the M&A king himself couldn't manage and that the world-class banker who came with the deal, John Reed, was never allowed to run. At length, the whole train wreck was seconded to what amounted to a trustee lawyer, Chuck Prince. The latter had no clue about what to do, but famously assured the gamblers who day-traded his stock that he would “keep dancing until the music stops.” In the event, he did, and it did.

The incongruous manner in which Citigroup spent the last few years of its pre-bailout life drifting toward the iceberg speaks volumes about the financial deformations that had settled on Wall Street. It goes without saying that no one saw any danger at its creation. It was literally voted through by
officialdom, since Chairman Greenspan, Treasury Secretary Rubin, his deputy Larry Summers, and the banking committees of both houses had all supported the Glass-Steagall repeal which enabled the Citibank-Travelers merger.

Then when troubles were already mounting down below, regulators allowed Citigroup to consume $100 billion in cash through stock buybacks and dividend payouts during 2004 through September 2008. This was turning a blind eye with a vengeance, but also perhaps explains why Ben Bernanke, Hank Paulson, and the rest of the bailout crew had no explanation for the thundering financial crisis of September 2008.

By their lights, it was all due to a mysterious “contagion” which had arrived unexpectedly, perhaps on a comet from deep space. The possibility that totally misguided public policies—including interest rate repression, the Greenspan Put, and the green light for bank merger mania—had brought down Citigroup and the other mega-banks did not cross their minds.

The other mega-banks arose and fell along the same timeline. The serial acquisition machine called Nations Bank combined with Bank of America in 1998, and the combo then scoured the land, absorbing regional banking chains like so many dominoes. The identical playbook was used by Wachovia Bank, which merged with First Union Bank in 2001.

Each of these latter two banks had previously “rolled-up” numerous regional banking chains and, once combined, actually accelerated their feeding frenzy, culminating in the disastrous acquisition of Golden West Financial in 2006. That bank was a giant financial turkey so stuffed with liar's loans and “negative amortization” mortgages that Charles Ponzi would have doubtless invented it, if he'd only had sufficient imagination.

Accordingly, during the five years after the LTCM bailout, the balance sheet footings of these five mega-banks had grown to $3.8 trillion, or by 50 percent. Moreover, after 2003 growth actually accelerated as these newly consolidated depositories tapped heavily into the same wholesale funding market which had fueled the explosive growth of the investment banking houses. The footings of the five mega-banks thus nearly doubled again to nearly $7 trillion by 2007.

The 1999 repeal of Glass-Steagall had been a mere formality: the real point was that the whole prudential banking régime that had been established by Glass-Steagall was gone, too. What had actually swept it away was a decade of merger mania that the Fed had blessed every step along the way, and which the maestro had actually heralded as another triumph of capitalist innovation and energy.

DEPOSIT BANKS ARE WARDS OF THE STATE AND NEED STRICT SUPERVISION

Yet there was more, and it was worse. As wards of the state, chartered deposit banks needed to be strictly regulated in order to prevent abuse of their fractional reserve banking privileges, to say nothing of the moral hazard implicit in taxpayer-supported deposit insurance and in their right to access the Fed's discount window for emergency loans.

Once again, however, the same misguided application of free market theory, which had led to a feckless posture of “hands off” with respect to bank mergers, came into play. Accordingly, these new behemoths were permitted to wander into every type of gambling activity known to Wall Street.

Thus, all five mega-banks were soon knee-deep in equity trading and underwriting, prime brokering, options and futures trading, commodities, swaps and derivatives, private equity, internal hedge funds, and much more. They had, in substance, become European-style “universal banks” and had a massive presence in all the traditional Wall Street dealer and investment banking markets.

Not surprisingly, therefore, by 2008 the five mega-banks, which had emerged from a decade and a half of merger mania, banking deregulation, and relentless penetration into nondepository markets, had reached colossal size by every historic standard. In fact, their balance sheet footings were now
a hundred times larger
than that of their predecessors in August 1987 when Greenspan arrived at the Fed.

It is also remarkable that only a modest share of the massive balance sheet expansion of these five institutions after 1998 was funded by depositors, notwithstanding their status as FDIC-insured banks. The preponderant share of funding growth was obtained from the wholesale money markets.

What happened was that new assets were being snagged and then piled on these mushrooming balance sheets in a hand-over-fist manner. These newly acquired assets were then hocked in the repo market as fast as they arrived. Like their investment banking cousins, therefore, the five mega-banks were also becoming financially unstable and vulnerable to a wholesale money market run.

As these aberrations gathered force the Fed took no notice whatsoever. It had no clue that the $7 trillion of combined balance sheets assembled by these five mega-banks in barely a decade were essentially helter-skelter agglomerations, not managed banking portfolios in any traditional sense. Nor did it recognize that in due course these far-flung financial institutions would inevitably lose track of what was in their own turbulent balance sheets, to say nothing of those of their far-flung counterparties.

WHEN THE MONETARY CENTRAL PLANNERS MISSED THE $11 TRILLION TRAIN WRECK

The FOMC minutes show the Fed's leadership circle ignored these mega-bank threats because it falsely assumed the US economy was strong. The vulnerability of these jerry-built balance sheets to the adverse macroeconomic trends actually under way, such as the massive increase of household debt, declining real wages, and the giant trade deficit and resulting offshoring of the tradable goods economy, escaped notice entirely.

Even as severe financial strains broke out in the subprime market and on Wall Street dealer balance sheets in the second half of 2007, the Fed's take on the nation's economic pulse was feckless. It consisted mostly of spurious patter about the monthly economic weather patterns and short-term fluctuations in financial ratios and spreads. Indeed, the tone of the Fed minutes in the run-up to the crisis was ostrichlike.

With their heads in the sand, the monetary central planners in the Eccles Building thus kibitzed about the trivial blips in regional purchasing manager surveys, construction jobs, and retail sales. Meanwhile, they blithely ignored the inescapable fact that in less than two decades Wall Street had been radically transformed and was now comprised of ten teetering financial behemoths.