David Brodwin is a cofounder and board member of American Sustainable Business Council. Follow him on Twitter at @davidbrodwin.
This week, Bank of America was charged with large scale and wide-spread fraud in its mortgage business. Federal prosecutors say that the bank knowingly dismantled safeguards in loan review process and doctored applications so they could write mortgage loans that could never be repaid. Then the bank fraudulently sold these bad loans to Fannie Mae and Freddie Mac, so the bank could take profits and continue the process. The long-overdue charges raise important questions about what it means to have a sustainable banking sector.
The suit says Bank of America committed fraud in many ways. According to the suit, they doctored loan paperwork; they falsified appraisals to show inflated values; they dismantled procedural safeguards to speed up flow of mortgage approvals They removed highly experienced and qualified staff from the review process and replaced them with unqualified junior staff. They failed to notify regulators of skyrocketing default rates. The charges are well-supported with whistle-blower testimony and other evidence.
The federal charges are welcome, but they're a day late, a dollar short, and arguably timed to involve election-year politics. As the statute of limitations looms, federal prosecutors have sued several major players in the mortgage industry: Countrywide (which Bank of America snapped up in 2008), Bear Stearns (bought by J.P. Morgan Chase at the government's urging and with government guarantees), and Wells Fargo. All these suits focus on alleged misdeeds around 2007-2009 at the height of the mortgage boom and the beginning of the Great Recession caused by the boom.
A Sustainable Banking system
The charges against Bank of America, Wells Fargo, and J.P. Morgan Chase raises important questions about what it means to have a sustainable banking system. Most people, when they hear the term "sustainable", think of environmental concerns such as clean energy, or a sustainably-managed fishery or forest. But sustainability matters in all aspects of the economy. Sustainability, in a broad sense, means managing our economy so that the current generation can meet its needs without destroying the ability of future generations to get their needs met.
A sustainable banking system has four key characteristics:
- It provides a safe and secure place for investors to deposit surplus cash and earn interest.
- It provides a place where businesses can borrow to get started or to grow, and consumers can borrow for sound investments such as buying a house or car.
- It does all this efficiently, meaning that the portion of money that is siphoned off between the borrower and lender is as small as it can reasonably be to get the job done. (A truly competitive market would lead to this result.)
- It does all this reliably, meaning it doesn't depend on bailouts and doesn't disrupt the rest of the economy.
Our banking system does not pass the test of sustainability.
Does our banking system provide a safe and secure place for investors to deposit cash and earn interest? Only partly. Individual retail depositors have been largely kept safe through the expansion of Federal Deposit Insurance Corporation guarantees. But many depositors who are too big to enjoy guarantees but too small to merit federal protection have suffered tremendous losses. Depositors don't earn interest any more for all practical purposes, thanks to Bernanke's quantitative easing program that shores up the balance sheets of troubled banks at the expense of individual depositors.
Does our banking system provide a place where qualified borrowers can raise money for legitimate investments that build businesses and create jobs? Again, only partly. Small business has suffered a multi-year credit drought as lending capital dried up and banks tightened standards excessively. Big banks resisted writing down bad mortgages and other nonperforming assets. They made the bet that by lending less and keeping more capital on hand they would be able to weather the storm. As a result, the funds that taxpayers funneled into banks to keep them alive were not pumped back into the economy in the form of loans to businesses and consumers.
Does our banking system operate efficiently? No. Over past decades the banking system has needed to consume more and more of the nation's wealth to perform the simple function of providing liquidity and providing a bridge between those who need cash and those who have cash to invest. For example, in the boom economy of the 1960s, the banking and finance industry accounted for about 4 percent of GDP. Now it's twice that. Back as recently as 1990, the financial sector made up 7.5 percent of the S&P 500 index. Now, financial services accounts for about 20 percent. The financial services sector is now the "giant sucking sound" towards which value flows, sucked out of technology, manufacturing, agriculture, and other sectors that produce real goods and services that real people need and want.
This chart shows the growth in the financial sector vs. the rest of the economy. Note how the Great Depression and the Great Recession were both preceded by a rapid run-up in the size of the financial sector. This itself is an asset bubble of enormous and dangerous proportions.
Does our banking system operate reliably? Clearly not. Our banking system requires repeated large scale bailouts to stay afloat. These bailouts impose both a direct cost and an indirect cost. The direct cost is the money paid directly to banks to keep them alive and to those holding federally-insured deposits when banks do fail. For example the Trouble Asset Relief Program was authorized to spend $700 billion, though its ultimate cost will be less. Earlier crises have been more costly to resolve. The Savings and Loan Crisis of the late 1980s cost more than 3 percent of total GDP to resolve.
The indirect cost of an unreliable banking system is far higher. The near-collapse of the banking industry in the wake of the mortgage crisis was a direct cause of the Great Recession which so far has absorbed more than a trillion dollars in stimulus money. (Some may argue that the Great Recession was not the result of the mortgage crisis, it would have happened earlier but was simply held at bay for a few years due to the bubble in home values that was produced by liberalizing mortgage securitization rules.)
Recent Federal Actions Against Banks Are Not Enough
The federal charges against Bank of America are welcome, though long overdue. But they are not enough to address the fundamental instability of the banking sector First, the amount involved is too small. The acquisition of Countrywide, where the fraud took place, is said to have cost Bank of America about $40 billion in total losses. What difference will another billion make? Second, the action is civil, not criminal. Bank of America can settle the charges without a guilty plea. Third, no individual executives have been accused of wrong-doing and no one will go to jail as a result. So banking execs have little reason to operate differently next time.
To build a sustainable financial services sector, we need much more. We need more aggressive enforcement of existing laws, including criminal charges. We need a full and vigorous implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act, including adequate funds for investigators to root out fraud. We need compensation clawback rules to remove the financial incentive to abuse the system. We need a reinstatement of Glass-Steagall regulations to prevent banks from speculating with federally insured deposits, leaving taxpayers holding the bag. We need an end to the doctrine of "too big to fail" and an end to the programs that implement it. Only when we take these steps will we have a sustainable financial system that provides liquidity to those who need it at a price the nation can afford.
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