All the large banks who were bailed out have now repaid the TARP funds. Great news, right? Wait just a minute. When they still owed us, the taxpayers, money, at least we could receive interest on it which could go toward paying down the national debt. At least, when they still owed TARP funds, there were restrictions on big bank activities such as paying executive bonuses and dealing in those toxic assets like derivative securities. Now what? The big banks can now do what they want - again.
What Banks Are Charged to Do
To date, there has been no financial regulatory reform passed in Congress. The banks are under no more regulation than they were when they got into the mess that required the financial bailout in the first place. Do we now trust them to operate in a socially responsible manner? Why should we? In a capitalist society, the function of business is to maximize shareholder wealth. That translates to maximizing stock price. We all know that banks did not maximize the wealth of their owners when they almost failed during the Fall of 2008 and the beginning of the Great Recession.
Instead, their stock prices dropped like a rock. All their shareholders felt it. Look at the values of 401k's after that debacle. Another tenet of capitalism is social responsibility which goes hand in hand with maximization of shareholder wealth. In order to maximize stock price, in the long run, a business has to be socially responsible. In investing in derivatives and sub-prime mortgages, the large banks in the U.S. were anything but socially responsible. They failed every major test of capitalism except one - making money. And they only made money in the short-run. Why? They didn't maximize shareholder wealth and they weren't socially responsible.
Have Banks Learned a Lesson?
Have the big banks learned a lesson from the foray into the world of high-risk gambling in the form of derivatives or credit default swaps? Apparently not. The banks are still taking on significant risk by investing in derivatives. At the end of the 2009 third quarter, the Office of the Comptroller of the Currency issued a report stating that Goldman Sachs has almost three times the credit exposure as JP Morgan and if the deals collapse on either side, the banks could, once again, be in trouble.
Citibank is third in line with regard to credit risk exposure. Bank of America has actually increased its credit exposure since the credit crisis, though it appears to have a position below the other three. In other words, we could go through this whole credit crunch crisis all over again except this time it could be worse, because we haven't recovered from the last one yet.
What Are Credit Default Swaps?
A credit default swap is a complex financial instrument that can be used either for hedging, which is lowering financial risk, or speculation, which is raising financial risk to try to make a profit. It is a credit derivative contract between two parties.
Here's how it works. An investor buys a credit default swap from a bank against a company that is close to default. If the company defaults and the investor actually owns the debt of the company, then the credit default swap is thought of as hedging, which is usually acceptable.
However, there is another scenario. An investor can also buy a credit default swap against a company close to default without actually owning its debt. That investor is betting against the solvency of the corporation. Banks can make or lose money by speculating on the spreads of credit default swaps. They might think the spreads are too high or too low or speculate on the company's credit quality. You can see how this is truly gambling. Speculation is what our large banks did that helped cause the credit crisis. And they are doing it again.
The Prudent Man Rule
It used to be that banks operated under "the prudent man rule." The prudent man rule is based on an 1830 Massachusetts court decision. It simply says that trustees, like bankers, should invest depositors' money like they would invest their own. Before deregulation, banks operated under this rule. Obviously, they don't now that bank regulations have been so relaxed.
To Add Insult to Injury
Before the credit crisis and since, banks seem to be preferring to play around with their investment portfolios rather than do what they are supposed to do - loan money. This is the reasons the Glass-Steagall Act should not have been repealed in 1999 as investment banks could not do commercial banking business while it was in effect. Not only are banks not loaning money to small businesses and consumers, they are raising the interest rates on credit cards to essentially default limits and lowering credit limits. The reason for this is so they can make money through increased interest and late payment fees to make up some of their losses.
Banks aren't allowing small businesses and consumers to borrow in any reasonable way - not through loans or credit cards. This begs a question. Why are we depositing our money with these banks? What important services are we really getting? Shouldn't we move our money to local, community banks, help them build up their capital, and borrow locally? The big banks are doing nothing for us. Why not fight back and do nothing for them. Instead, do something for our local banks to shore up our local communities.
When the Banks Met With the President
Recently, President Obama met with a group of CEO's from both the large banks and the community banks. The large banks were not very receptive to the idea of picking up their lending to small businesses. Now we know why. The community banks were more receptive but discussed the difficulties they had with bad loan portfolios and low capital. We, as a group, can help them shore up their capital by turning our backs on the large banks that have turned their backs on us.
