I can tell you the moment the banking “crisis” of the 1980’s started.  Todd Conover was Comptroller of the Currency (the head of National Bank Examiners, for one thing; part of the Treasury Dept).  Mr Conover caused the crisis by making a statement during a speech at the American Bankers Assn meeting in Dallas.  He was the cause; now a little background.

When banks go into business, they draw up papers to propose a new bank, gather together investors that will provide the initial capital for the bank, and submit these papers to the Office of the Comptroller of the Currency (OCC) hoping to get a bank charter.  That bank charter is the government’s permission to go into business as a bank, and it’s also a promise to insure deposits up to the FDIC limit.

After a bank gets its charter, it is then subject to regular examinations by OCC.  This usually means a team of lawyers and accountants come in to examine the business of the bank, review loans, and generally make sure that they bank is being run according to OCC rules (no redlining, for instance).  One of the things that bank examiners do is look at loans to see if the are “performing” — which means, is the borrower paying back the loan according to the terms of the loan.

If examiners determine that a loan is “non-performing”, it is then “classified”.  I’m over-simplifying here, but basically, if the examiners don’t think a loan will be paid back, they put it on the “classified” list, and, most importantly, the amount of that loan is deducted from the amount of capital that the bank has.  As you read in a previous post, if enough loans are classified, a bank’s capital can be wiped out, and the bank goes under.

During the heady real estate go-go days in Texas in the early 1980’s, banks would loan money to developers and speculators to buy up commercial land.  Everyone had an expectation that land prices would go up (sound familiar to home prices will always go up?).  So bankers would loan money “interest only”.  A borrower would make only interest payments on the land, expecting to sell it in 6 months or a year, and pay off the original loan, plus the interest, and keep the rest as profit.  Works great — as long as prices go up.  Developers could come up with the interest payments to keep the loans current.  As long as they only had to pay interest, then they could pay off the loans when they sold the property.  Mighty high leverage, that.

There was a lot of fraud going on back then.  I read about a banker who bribed real estate appraisers to increase the value of the land each time it changed hands.  Sometimes the land would change hands 4 times in a day.  (The banker and the appraisers went to jail.)

All good real estate bubbles must burst, and Conover was just the prick that was needed to pop this bubble.  He announced at the ABA meeting that, from that moment forward, his bank examiners would classify (mark as bad) any loan in which the borrower didn’t have the cash flow to pay back the loan.  He didn’t mean “pay the interest” — he meant pay off the loan.  Now, you had a lot of real estate developers who were paper-rich and cash-poor (they had a lot of assets, but not much cash).  As I said, they could scratch up the interest payment on a $1 million piece of raw land, but they didn’t have the money to pay a regular mortgage on it.  (Think of this as if you agreed to pay your mortgage interest-only.  6% on a $300,000 house is only $18,000 a year, or $1,500 a month, whereas a “normal” payment would be closer to $2,500 a month.)

Most bankers back then didn’t really care about the cash-flow of the borrower, because the value of the property (collateral) was always rising, and the bank figured they could sell it to pay off the loan if the speculator investor defaulted on the loan.

So when Conover said at lunch that his folks would start looking at the cash-flow of the borrowers, instead of just the value of the collateral, bankers looked around the room at each other, and there was a collective “Rut-roh” moment.  Bank VP’s flew out of that room to call their banks and try to figure out a way to shore up those “interest only” loans that were stinking up propping up the bank’s books.

All good things come to an end — and real estate bubbles burst.  From that moment forward banks went out of business left-and-right, and investors couldn’t pay off their interest payments, let alone sell the property for what they had borrowed.

Moral of the story — the bankers should have looked more closely at the borrowers, and examiners should have looked at the financial position of the borrowers.  I’m not advocating more regulation per se; but if you want FDIC insurance on your deposits, you have to abide by the rules.  Conover did no one any favors by changing the rules so radically and so fast.  It’s my opinion that if he had announced that it would be phased in over a year or so the banking crisis would not have been as severe…but that’s 20/20 hindsight and my opinion only.

This is a historical lesson about how bankers (indeed, the free market) will work within the rules and come up with a way to game the system.  The current crisis seems to be caused by regulators forcing bankers to loan money for homes to folks who couldn’t afford the house and/or were otherwise poor credit risks.  This one was caused by the regulators — not caught by them.  In the current debate, the regulators (Dodd, Frank etc) should be the ones who do the jail time.  After all, the bankers would have said “no” to the borrowers if they government hadn’t pressured them to make these dumb loans.

How do I know they were dumb?  That’s easy — if you have to set up a government program to buy loans from the bank, the loans shouldn’t have been made in the first place.  The market should determine who gets the money, not the politicians.

Here endeth the lesson.