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Untangling The Complexities Of The Banking Crisis

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The Associated Press

Published: February 22, 2009

These days, you access an ATM at the grocery, the pharmacy, the gas station, the hardware store, the office, even the ballpark. You can check your Bank of America balance on your iPhone. You can text Chase, and Chase will text you back.

That's banking today: It has grown from an almost quaint relationship between teller and customer into a massive, dizzyingly interconnected network.

And right now, the federal government is hoping to keep U.S. banks from collapsing.

Not just to get the banks lending again. To keep them alive.

"The banks are at a terrible junction," says Robert Reich, a labor secretary under President Bill Clinton. "The bottom is falling out. Almost every area of the credit markets, we're finding people unable to repay their loans. That means many banks are basically insolvent."

"If one big bank implodes," he says, "the reverberations could be endless."

So how did we get into this mess?

And how do we get out?

The First Bust

In the 1980s, falling interest rates and loose lending standards opened banking to the masses. The government began pushing home ownership.

Banks and savings and loan associations spread across the country offering cheap, 30-year mortgages. By 1980, banks had $1.5 trillion in outstanding mortgage loans, more than double the amount from 1976.

Then came the bust. Unable to pay their mortgages, homeowners and businesses began defaulting in droves. Delinquencies soared, triggering the savings and loan crisis, battering the stock market and prompting a huge, taxpayer-financed bailout.

The Second Bust

Some ingredients of the S&L mess, such as cheap credit, loose lending standards and weak oversight, also are part of the current debacle. But two new trends - the rise of the global banking behemoth and the packaging of debt into securities that investors could buy and sell - make this meltdown unique.

In the span of a decade, Citigroup, Bank of America and JPMorgan Chase, once bread-and-butter providers of free checking accounts, grew into international banking conglomerates that buy and sell stocks and manage assets.

The 'Universal Bank' Model

The "universal bank" model, which took hold in the late 1990s, changed the face of global finance. And it linked Main Street with Wall Street in a way never seen before.

Banks lured first-time homeowners, many of whom thought housing prices would go up forever, with attractive lending rates and lax requirements. And instead of holding on to the loans, the banks bundled them into securities and sold them to investors across the globe.

When Banks Fail

In January, the government took over six failed banks. Last year, it took over 25.

What would happen if one of the nation's big banks, the kind that manage hundreds of billions in assets, went down?

"That would probably cause a complete meltdown of the American financial system," says Andreas Hauskrecht, an associate professor of money, banking and finance at Indiana University.

The government safeguard of depositors' money, the Federal Deposit Insurance Corp., could have its deposit limit eliminated if a huge bank, such as Citigroup or Bank of America, were to fail, says Jim Wilcox, a professor of financial institutions at the University of California at Berkeley.

No one has ever lost money in an account insured by the FDIC. But news of a giant bank's downfall would probably touch off a panic in which even depositors with money in safe banks rush to get it out.

The bigger problem: Other lenders would stop lending, and businesses would fail.

What Can We Do Now?

What keeps financial experts up at night is a scenario similar to that of Japan, which bungled its own bank bailout in the 1990s and limped along during a "lost decade" of anemic economic growth and high unemployment.

To prevent that, President Barack Obama's administration must choose the best of difficult options. The medicine prescribed by the last administration - flooding the financial system with billions of dollars - hasn't worked.

In theory, the government-run bad bank would buy soured debt that is gumming up the banks' books and clogging the flow of credit. That could shore up banks' base of capital, soothe investors and get banks lending again.

But it's far from simple.

No one knows how much these assets are worth. The complex nature of mortgage-backed securities, credit default swaps and other products has made investors too afraid to touch them.

Pricing them is tricky.

If it pays too little, the government risks forcing banks to record huge losses, potentially putting them out of business and wiping out shareholders. If it pays too much, it risks shortchanging taxpayers.

Nationalizing Banks

Bill Seidman, a former chairman of the FDIC who ran the government bailout during the savings and loan crisis, and others are calling for an alternative rescue plan that they say would avoid the pitfalls of past efforts: a short-term nationalization of the banks.

To many, the thought is an affront to the free-market system. But that's exactly what the U.S. government did in the 1980s.

After cleaning up the S&Ls, the government-run Resolution Trust Corp. sold them back into the private sector.

In the S&L days, the government recouped some money by selling the physical assets of the banks, such as real estate, not the hard-to-value paper assets held by banks today.

That wrinkle makes it much harder for the government to follow the Resolution Trust Corp. strategy, says Jonathan Macey, deputy dean at Yale Law School and the author of a book about a government bailout of Sweden.

Treasury Department's Plan

Emerging details of the Obama administration's revamping of the government's financial-system rescue reveal the Treasury Department intends to operate two programs to infuse capital into the nation's banks.

One program would seek to ensure the survival of the biggest banks so that they might return to something like business as usual. These fewer than 20 institutions will undergo a mandatory "stress test" to see whether they can withstand an economic crisis lasting two more years.

If the exam indicates one of these big banks is in bad shape, it will have to take on new capital from private investors if available or, if not, from the government.

The second program will include about 8,300 smaller banks, few of which had anything to do with exotic mortgages or toxic securities backed by them.

These banks likely will get a less extensive review, Treasury officials say, and will receive capital if they are strong enough that they probably do not need the investment.

The government is looking at this group of banks, each with assets of less than $100 billion, as being more likely to increase lending.

Smaller banks probably would be screened in a process similar to that used in the first phase of the Troubled Asset Relief Plan. Under TARP, the Treasury began investing $700 billion in banks in October.

Information from the Los Angeles Times was used in this report, which was compiled by editor Jackie Kunzmann.

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