HOUSING, SUB-PRIME LOANS AND NEAR BANKS

James Cayne made his billions the hard way. Recently named one of the world’s richest individuals by Forbes magazine, Cayne, a college dropout, sold scrap iron before moving to New York to play bridge full-time. Hired by Bear Stearns in 1971 to sell stock, he rose quickly in the finance world, becoming CEO of Bear Stearns in 1993. In January 2008, Mr. Cayne left the company with a golden parachute containing in part almost 6,000,000 shares of Bear’s stock. Last month the volatile stock market shaved almost $500 million off of Cayne’s wealth when Bear’s stock price dropped from $80 to $2 in just one trading day. This downturn put a serious dent into his ability to pay for the New York City condominium that he purchased for almost $28 million just one month before the collapse. But as Mr. Cayne might, say, “I don’t have a credit problem, the people I owe money to have a credit problem.”

Not withstanding Mr. Cayne’s pain, the most important issue surrounding Bear’s near collapse is how the Federal Reserve Bank (Fed) dealt with it. One day after the pounding, the Fed provided $30 billion in loan guarantees for Bear. Thus, Mr. Cayne and other Bear stockholders were allowed to keep between $2 and $11 per share of their wealth. This represented
the first time since the Great Depression that the Fed granted loans to a non-bank, or what I will term a “near-bank.” Defenders of the Fed’s action contend that the loan prevented a ripple effect whereby other securities firms would have failed, with a chain reaction stretching from New York City to Oahu. Critics, on the other hand, contend that these near-banks have obtained many of the benefits of banks without the burdensome regulations borne by their financial cousins.

Traditional bankers argue that these near-banks have siphoned off banking profits and increased financial risks since they are in many instances judged “too big to fail.” Banking leaders, especially community bank CEOs, argue that institutions such as Bear Stearns and Goldman Sachs have stolen business from banks without having to abide by the same level of regulatory oversight. In fact, according to the Fed, between 1998 and 2003, the proportion of small businesses using non-depository institutions, or near-banks, for financial services advanced from 40 per-cent to 54 percent. Invasion of near-banks into the banking industry also resulted in the banking industry’s share of U.S. financial assets dropping from 20 percent in 1994 to 12 percent in 2005. Even more startling, the number of community banks plummeted from approximately 10,000 in 1994 to slightly more than 7,200 in 2005.

This decline has left many communities, especially those in rural areas, in what I call Rural Mainstreet, with increasing reliance on large city near-banks. Not surprisingly, CEOs of community banks complained loudly to the Washington office of the Independent Community Bankers of America when the Fed bailed out Bear Sterns. Leaders of community bank, banks with less than $1 billion in assets, argue that these near-banks should have been allowed to fail and that such a rescue only encourages greater risk taking and simply delays the ultimate calamity. But others counter that community banks,
especially those in farming country, are currently indulging in their own form of excessive risks.

«April 2008 Edition