By Bernie McLaughlin
In the 1973 movie “The Sting,” Henry Gondorf (Paul Newman) and Johnny Hooker (Robert Redford) set up an elaborate “sting” operation to avenge the death of their partner by a criminal banker (ironic, as you'll see below), Doyle Lonnegan (Robert Shaw). The operation is of course rigged to ensure that Lonnegan loses a very large sum of money in a “no lose” charade masterfully carried out by Gondolf and Hooker. Of course, the movie is fiction.
Now, imagine a real-life business operation where you could make a risk-free investment in a similarly “rigged” system that guarantees you a healthy return – a set-up that provides you a “no lose” wager, so to speak. Well, some say the current big bank mortgage/investment banking model available to large U.S. banks provides such an arrangement. But before we get into the “Sting” part, here’s how the mortgage banking system is normally supposed to work:
After a bank originates a mortgage loan from you, the consumer, it earns the mortgage closing fees that you pay for the mortgage loan transaction. The bank then creates an asset on its books (your mortgage) that yields interest income beyond what their “raw material” (deposits) costs – in banking terms, it's what’s called the spread. This traditional banking scenario (the income generated from what the bank pays for its deposits versus what the mortgage loan yields) is the classic mortgage bank/customer “value exchange,” which has been the bedrock for our mortgage banking system since mortgage lending was created. The risk remains on the bank’s balance sheet, while the rewards come back to the bank in the form of “generated earnings” that cover the loan risk and makes the bank a profit to continue to operate.
Now for “The Sting”
With repeal of the Glass-Steagall Act on Nov. 12, 1999, large banks were enabled to create an investment arm to take your loan (their asset) from the traditional mortgage loan process explained above, and transfer it to their investment banking side of the house (the side which is now allowed with the Glass-Steagall repeal in 1999). Their investment side of the house can now “bundle” your mortgage together into a saleable asset called a mortgage derivative with other mortgages they originate, and sell off these loans (along with their risk) to a third-party buyer, collecting more fees generated by the mortgage derivative sale.
To mitigate risk for the derivative buyer, the derivatives are packaged into tranches (groups of high to low risk mortgage Loans); the idea here is that the varied risk levels are spread out across a number of mortgage loans that are unlikely to go bad all at once. When your bank makes the derivative sale, it is then “off the hook” from the risk of your mortgage loan and all other loans in the derivative that its mortgage bank originated. And they get to collect all the fees from both transactions and eliminate all future risk.
So, in this post Glass-Steagall world, in addition to the original fees your bank collected from you at origination, it also gets to collect the fees for selling the packaged derivative to a third-party. These fees are collected and the risk is sold off–gone. In a perfect world, this practice should, be good for all parties. However, four conditions in the process tend to get in the way of that perfect world.
Conditions in the Process:
1. With a bank having the ability to both originate mortgages and then sell them on the investment banking side of the house, there is a concern of sound loan quality from their mortgage origination process. Why is this concern? Because when a bank originates mortgages that it never intends to hold onto by selling them as derivatives (aside from secondary mortgage loan sales which usually provide a "claw back" provision), the quality of the origination of those mortgage might not seem to matter much to them. And if it doesn’t matter, then a lot of poor-quality loans could be made without the risk of them going bad on the bank before they are sold off. Many say that this problem was a major contributor to the 2008 crisis, which has never been fixed - that ominous financial environment still exists.
2. Evidence to #1 above: during the 2008 crisis, a sea of fraudulent loans materialized by lenders who didn’t seem to care much about loan quality, or the integrity of the information provided by originators/borrowers because the income was fast and furious and they were going to sell the loans off and eliminate the carrying risk.
3. We also know that these large banks pay their own rating agencies to officially rate the overall quality of their mortgage derivatives and the quality of the loans in the tranches. How cozy is that? Are those agencies going to provide impartial ratings? Hmmmm...
4. And since the fees collected (twice) are very lucrative, and the risk is completely mitigated, the more loans you can originate, package and sell, the more risk-free money you stand to make.
Who Takes Advantage?
So, who is able to take advantage of this “no lose” sting? Large that who are backed by the U.S. taxpayer in a “too big to fail” system. They are able to do so because Congress allowed it. We’ve enabled our banks to get "too big to fail” thanks to the repeal of the Glass-Steagall Act, which was originally intended to separate banks and investment houses following the worst financial crash in U.S. history in 1929.
Let's be clear, though, that banks are able to do it because it’s perfectly legal, and nothing has seemed to change since 2008 to protect us all from this “no lose/no risk” threat. Check out the movie, The Big Short.
Banks are always complaining about the “unlevel playing field” with credit unions due to the CU tax exemption. I believe it is high time for our credit union industry (and our two major trade associations included) to take the major lead in calling for a change in the media narrative from credit union taxation to preventing another 2008 crisis by bringing back a modern-day version of the Glass-Steagall restrictions.
We should unmask the one-sided, dangerous game that the banks are playing; all at the expense of you and me, the U.S. taxpayers.
Helping to bring back a 21st Century Glass-Steagall type legislation would help. And it shouldn’t be that difficult, as we know it’s about the only thing that Elizabeth Warren and President Trump and their respective parties all agree upon.
Bernard McLaughlin is CEO of Point Breeze Credit Union in Hunt Valley, Md.