The Largest U.S. Banks Have Repeatedly Gone Bankrupt Due to Wild Speculation, and the Fed Blessed the Speculation and then Helped Cover Up Their Bankruptcies

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As I have previously pointed out, the New York Times wrote in February:

In the 1980s, during the height of the Latin American debt crisis, the total risk to the nine money-center banks in New York was estimated at more than three times the capital of those banks. The regulators, analysts say, did not force the banks to value those loans at the fire-sale prices of the moment, helping to avert a disaster in the banking system.

In other words, the nine biggest banks were all insolvent in the 1980s.

Richard C. Koo - former economist at the Federal Reserve Bank of New York and doctoral fellow with the Fed's Board of Governors, and now chief economist for Nomura - confirmed last year in a speech to the Center for Strategic & International Studies that most of the giant money center banks were insolvent in the 1980s.

Specifically, Koo said:

• After the Latin American crisis hit in 1982, the New York Fed concluded that 7 out of 8 money center banks were actually "underwater"

• All the foreign banks (especially the Japanese banks) had to keep their lending facilities open to American banks so the American banking system didn't collapse overtly and out in the open

• The Fed knew that virtually all of the American banks were "bankrupt", but could not publicly discuss how bad the situation was. If went out and said the "American banks are bankrupt", the next day they will go overtly go bankrupt. So the Fed had to come up with a lot of stories like "its good debt on their books"

• Then-chairman Volcker instructed the banks to keep lending to the Mexican dictator so that the Mexican economy didn't totally collapse, because - if Mexico collapsed - it would become obvious that all of the U.S. banks were underwater, and they would immediately collapse

• It took 13 years to manage the crisis (at another point in the talk, Koo says 15 years).
  The way that Volcker approached the problem was that he allowed U.S. banks to keep their lending rates relatively high, while the central bank brought short-term rates down. The spread between the two (the "fat spread") became revenue for the banks, and the banks used the high fat spread to gradually write off problem loans and to repair their balance sheets.

• Volcker's covert rescue of the American banks using secrecy and a high fat spread didn't cost U.S. taxpayers a cent

• Koo points out that you can't use the fat spread approach where there are no borrowers

Lessons for Today

So what is the take-home message from all of this? What are the lessons for today?

Well, initially, it shows that it wasn't just some S&Ls, or a Long Term Capital Management or two.

Virtually all of the largest U.S. banks gamble and speculate and then all go bankrupt. The money center banks gambled in Latin America and lost. They went bankrupt.

Have they changed their behavior?

No. They have - with the Fed's blessing - simply changed casinos, and for the last decade or so, have put all of their chips into CDOs, CDS, and other leveraged and securitized bets built like a house of cards on top of subprimes and option arms and alt-as and whatnot. Now they've lost and gone bankrupt again.

And the Fed playbook obviously includes pretending banks are solvent when they are not Indeed, as ABC news notes today: 

The Treasury Department and the Federal Reserve lied to the American public last fall when they said that the first nine banks to receive government bailout funds were healthy, a government watchdog states in a new report released today.

The Fed (as well as Treasury and other agencies), have cost the American taxpayer quite a few cents this time around - trillions of dollars. So the Fed's approach to the current and the Latin American crisess are completely different.

The fat spread approach can't work now, because there has been a secular shift in borrowing habits by Americans. the reduction in American consumer spending is a long-term trend. For example, Alix Partners finds:

While American industry is struggling to get through what could become the worst recession since the Great Depression, Americans say that even after the recession ends, their spending will return to just 86% of pre-recession levels, which would take a trillion dollars per year out of the U.S. economy for years to come. According to this in-depth survey of more than 5,000 people, Americans plan to save (and therefore not spend) an astounding 14% of their total earnings post-recession, with the replenishment of their 401(k) and other retirement savings leading the way among their biggest long-term concern.

And Huffington Post notes:

"There will be a fundamental shift in the kind of cars we buy, a fundamental shift in the homes we buy, and a fundamental shift in consumption generally," says Matt Murray, an economist at the University of Tennessee. "And that is not something that took place in the 1980s."

People are hunkering down, like they did for decades after the Great Depression, and no approach which relies on Americans increasing their debt load will work. See this.

Moreover, as I have repeatedly argued, Summers, Geithner and Bernanke's entire plan seems to be to restart the great leverage machines, but that this plan is doomed to failure.

Specifically, I have argued for months that the boys believe that if they can just re-start the shadow banking system and lever the economy back up, that all boats will be lifted, asset prices will rise (and the "toxic assets will regain their "true" higher value), and the whole economy will be afloat once again, so that we can go merrily sailing onto paradise.

But if Americans don't want to borrow more, and if trust in the entire economic system has collapsed, then how can the boys restart the shadow banking system and re-lever up the economy?

Isn't that like trying to re-start a car after the engine has been removed?

And if those who claim that we are in Minsky moment of crushing debt overhang are right (and everyone - from Federal Reserve governors to Nobel prize winning economists - are dusting off their history books and studying Minsky right now), re-levering simply won't work.

Finally, the big banks are much bigger than they were in 1982.  See this and this. What may have worked for 1982-sized banks won't necessary work for the current behemoths.

The above-referenced statements by Koo start at about 30 minutes into the talk. If you have trouble playing the audio, download it and then play it from your computer.