A Tale Of Two Banks

It’s about 22 miles between midtown Manhattan and Paramus, N.J. Not a lot of distance and without traffic about a 40-minute drive. But what has happened in the past few days between the two cities explains much about how the mortgage meltdown came into being, where it is and where it’s likely to go.

In New York we now have the bailout of Citigroup, a vast financial colossus which is at the heart of the American banking system. In Paramus we have Hudson City Bancorp, a company which has just turned down as much as $600 million in federal bailout money.

The End of The Glass Steagall Act
It was during the worst days of the Depression that the Glass Steagall Act, also known as the Banking Act of 1933, divided the banking world in two. You could have a “retail” bank that collected deposits and made loans, you could have an “investment” bank that raised money by selling securities and related services, but you could not have one bank that did both.

Bank operations were separated under Glass Steagall because the massive banking failures of the Depression had shown that the potential for bank abuse and conflict was enormous. The Banking Act established the Federal Deposit Insurance Corporation (FDIC) and the government did not want deposit money used for stock market speculation — nor did it want federal money used to pay off bank claims when deposit money was lost in the stock market.

Glass-Steagall worked very nicely until it was repealed in 1999 with the passage of the Gramm-Leach-Bliley Financial Services Modernization Act. Now banks could become financial supermarkets offering everything from savings accounts to securities and insurance.

In fact, Gramm-Leach or something similar had to be passed for a very simple reason: A year earlier in 1998 Citicorp (a bank) and Travelers Group (an insurance company) had merged under a waiver to create the largest financial services company in the U.S. Gramm-Leach was merely an affirmation that after 65 years Glass Steagall was dead.

Under Gramm-Leach banks could effectively go into just about any business because the law provided they could set up and own financial holding companies and other types of financial subsidiaries. Such subsidiaries could engage in any businesses which were “in nature or incidental to financial activities.” This is a description so broad that it potentially defines any business where cash changes hands, including real estate brokerages, stock brokerages, vegetable stands, tree farms and car dealerships.
While banks effectively received a license to go into virtually any business, they were protected from competition: Gramm-Leach did nothing to up-stage the Bank Holding Company Act of 1956, legislation which prevents non-banks such as Wal-Mart, Target or 7-11 from entering the retail banking business.
Given that the marketplace had been fine-tuned to assure both bank profits and minimal FDIC claims the results were not surprising: In the decade between 1998 and 2008 multi-bank holding companies saw assets rise from $4.5 trillion to $8.9 trillion.

“The government during the past decade did everything possible to assure the success of the financial sector,” says Jim Saccacio, Chairman and CEO at RealtyTrac.com, the nation’s leading online marketplace for foreclosure properties. “While the general goal is understandable and in the national interest, the simultaneous failure to effectively regulate allowed lenders to develop and market so-called affordability mortgage products and to skip traditional underwriting standards. The result is the massive number of foreclosures we have today, foreclosures which are central to our national economic disruptions.”

Among the biggest multi-bank holding companies in the world, Citigroup had a net income of $24.6 billion in 2005 and $21.5 billion in 2006. In 2007, net income fell to $3.6 billion for the year.

The annual numbers do not tell the whole story, however. In the last four quarters the company lost more than $20 billion and the final quarter of 2008 will likely show a massive loss.

Such losses are remarkable given that the company’s asset base rose from $1.4 trillion in 2005 to $2.1 trillion just two years later.

What happened, essentially, is that quickly increasing assets did not generate additional income. By 2007, says The New York Times, Citi became the world’s largest holder of collateralized debt obligations (CDOs). Instead of selling such paper, Citi held on to it as values fell.

The Bailout
On Friday, Nov. 21, Citigroup shares closed at $3.77. Given 5.45 billion shares, the entire company was worth a little more than $20 billion. Between February 2007 and November 2008 Citi shareholders lost equity worth more than $270 billion, one of the largest corporate losses in financial history.

Over the next weekend the Treasury stepped in to prop up Citigroup with a generous offer:

  • The government will guarantee up $306 billion in Citigroup assets.


  • The government will absorb 90 percent of all Citigroup losses after the first $29 billion.
  • The government will pay $20 billion to acquire non-voting preferred stock paying 8 percent annually ($1.6 billion).


In other words for $20 billion the U.S. government, meaning taxpayers, could have bought the entire company. Instead, the government bought shares with no voting rights and made guarantees that could cost additional tens of billions of dollars.

While the government was bailing out Citigroup, just a few miles away Hudson City said no to federal aid.

Hudson City Bancorp would be eligible for between $200 to $600 million under the Capital Purchase Program (CPP) created by the government to bail out banks. However, the company already has $4.8 billion in capital

“The amount of capital we would have been eligible for in the CPP would not significantly enhance our ability to execute our business model,” says Ronald E. Hermance Jr., the bank’s chairman, president and CEO. “In addition, under the terms of the CPP, we would need the FDIC’s approval prior to raising our dividend or continuing our repurchase program. We raised our dividend for the fourth consecutive quarter in October 2008 and we currently have 54,973,550 shares that are available for repurchase under our existing stock repurchase program. We believe that it was in the best interest of our shareholders to not participate in the CPP since the equity interests we would have issued would be dilutive to our current shareholders. In addition, the yet-to-be determined and ever changing regulatory environment related to CPP participants could have unintended consequences for Hudson City.”
How come Hudson City could turn down government money?

“Hudson City’s business model has always been to provide first mortgage loans on residential properties to qualified borrowers who have equity in the property,” Hermance explains. “We have never offered subprime mortgages, negative amortization loans, payment option loans or other risky mortgage products. We do not sell any of our loan production to the secondary market. We keep all of our loans in portfolio. As a result, we have not been seriously affected by conditions in the marketplace. While we are not immune from economic conditions, our strong underwriting policies, as evidenced by our average loan-to-value (LTV) ratio of 61% at time of origination, have protected us from significant levels of loan losses.”
While other banks are closing the vault doors, Hudson City has increased lending.

Hermance says “our loan production is at record levels. We accepted more mortgage applications during the first nine months of 2008 than we did in all of 2007, which itself was a record year for us. For the first nine months of 2008, we originated $4.01 billion of mortgage loans as compared to $2.65 billion for the comparable period in 2007.”
Somewhere Mr. Glass and Mr. Steagall would no doubt approve.
Peter G. Miller is the author of the Common-Sense Mortgage and is syndicated in more than 100 newspapers.

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