Back-to-basics banking

"Simplify, simplify, simplify!"
Henry David Thoreau
ONCE WE have a functioning banking system again, banks need to go back to the basics - taking in deposits and making loans - so that investors and examiners can once again know that their assets have worth.

I recently debated an economist from the University of Chicago on the economic value of exotic derivative securities such as bonds backed by subprime loans. "They add liquidity," he insisted, repeating the standard wisdom. But recent events have shown that these unfathomable instruments indeed create oceans of liquidity - until suddenly they destroy it entirely.

The current crisis was supercharged by inventions of financial paper created at several removes from the real economy. For example, a "credit default swap" is an insurance contract against a bond defaulting. Many of the bonds that used this insurance were themselves derivatives, such as bonds backed by subprime mortgages.

Supposedly, these derivatives on top of derivatives "spread risk," but in truth they spread risk the way an epidemic spreads diphtheria. Mainly, they created financial pyramids that hid risk. This is otherwise known as a Ponzi scheme.

Bad bets on swaps by a tiny unit of A.I.G., the world's largest insurance conglomerate, took down the whole company. Though ordinary insurance is well regulated, with required reserves against insurance losses, regulation of this particular exotic insurance was nobody's responsibility. And with their bonds insured by insurers who were playing roulette, investors were spared the need to perform the most basic of capitalist duties - to understand what they were buying.

In a famous passage in Ernest Hemingway's "The Son Also Rises," one character asks, "How did you go bankrupt?" The other answers, "Two Ways. Gradually, and then suddenly."

People, banks, and entire financial systems go bankrupt "gradually, and then suddenly" because as their real situation worsens, they stave off the day of ruin by disguising their condition and borrowing. Bankruptcy comes with terrible suddenness when creditors stop lending. The more exotic and opaque the security, the higher the tower of possible debt and the more devastating the eventual crash.

So the next financial system, rebuilt by the government on the ruins of the old one, needs to be plain vanilla. The banking system should be restored to its basic role of supplying credit to the real economy, with as few complications as possible.

We need a system in which banks accept savings and make loans; where investment banks underwrite securities such as ordinary stocks and bonds; and where the complexity of bonds is strictly limited. This kind of system is transparent to regulators. Without complex derivatives that have no trading market and hence no valuation, it once again becomes possible for regulators to value assets and limit Ponzi schemes, and for investors to make informed decisions.

If complex financial engineering did all that its enthusiasts claim, we would have seen the results in improved gross domestic product. But economic growth was far higher in the era of plain vanilla finance - and there were no crashes.

The Chinese have grown at about 10 percent a year for two decades, with only the most rudimentary of financial systems. Banks take deposits and underwrite industrial expansion. Derivatives are prohibited. Much is unsavory about China's political system, but its financial system works, and may have to bail out ours.

Supposedly, financial engineers will always "innovate around regulators." But the regulatory problem is not technical, it's political. In 1994, Congress passed a law prohibiting subprime mortgage underwriting. But Alan Greenspan, then Fed chairman, refused to issue the necessary regulations. In 1995, Republicans took over Congress and no one held Greenspan's feet to the fire.

In 2000, then-Senator Phil Gramm, now an adviser to John McCain, got a law enacted for the benefit of Enron, prohibiting regulation of credit default swaps. Had these two forms of regulation not been politically aborted, the current financial collapse would have been avoided.

National governments, as they recapitalize banks, need to strip the financial system back down to its basics. The plainer and more vanilla, the better.

Robert Kuttner is co-editor of The American Prospect. His latest book is "Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency."