(Michael Chamberlain/Nevada Business Coalition) – Nevada Business Coalition (NBC) recently sat down with new Bank of Nevada President and COO John Guedry. Today we present Part I of that interview in which Guedry discusses what led to the inflation and bursting of the housing and mortgage bubbles and some of the challenges facing the banking industry.
NBC: It’s been a real tough time for a lot of industries, especially this banking. Why has it been so tough?
John Guedry: It’s such a highly-regulated industry and that adds to the challenge. And it’s just the general [economy]. Until things really show signs of recovery we’re going to be under a microscope and we’re going to have to do things much more conservatively than we’ve done historically. In some ways that’s not a bad thing. In other ways it’s hindering the recovery.
NBC: I’ve heard from other people who have some knowledge of the industry and some of what I’ve heard are on the one hand you have politicians and people in the government and other people outside the government saying banks need to lend more money. They need to get more involved. But what I hear more from people inside the industry is that while those people are saying that, on the other hand you have the regulators standing over your shoulder saying, “No, you can’t do that.” The rules are a lot more strict, probably for good reason, than they were a few years ago. Is that one of the issues you’re facing?
JG: I think that pretty much sums up what the industry is dealing with. I think it’s important that, when you mention the government, there are two distinct groups. There’s the political face of the government, in front of the camera. Then there’s the regulatory responsibility of the government.
Those two sides aren’t in sync and haven’t been in sync for some time. The regulatory role of the government has been, appropriately so, expecting the banking industry to really tighten down. That really shouldn’t come as a surprise to anybody.
When the economy is doing well and businesses are generating revenue and profits it’s appropriate for businesses to grow and borrow to meet those needs of capital to meet the growth needs. If a business is stagnant or shrinking, borrowing money is probably not the most healthy thing for that business to do.
So part of the reason lending has really slowed is the borrower recognizes they don’t need the capital. They’re not going to borrow something they don’t need.
A lender recognizes if a borrower is looking for capital, there’s got to be a way for that capital to be deployed and provide enough of a return to repay. So there are fewer businesses that meet that model – where they’re able to afford the capital and repay the loan. So there should be no surprise that lending has declined.
The demand for loans has declined and the ability to underwrite is tougher because of that. The regulatory environment of the federal government recognizes that.
Not so sure that the face of the government does. It sounds good and it’s a nice sound bite to stand in front of the camera and say the banking industry was just bailed out by the taxpayers and they need to be lending more money. Most reasonable people wouldn’t disagree with that.
Unfortunately there are a lot of variables that go into making loans, including, does the borrower want to borrow? That’s the reality. The reality is there’s less demand and there are fewer qualified borrowers. So until the economy does start to recover we won’t see any significant increase.
I will say in defense of the banking industry, and I think I can say that with a straight face not being in it for the last couple of years, banks would like nothing more than to be able to make qualified loans. We make the bulk of our income from lending money out that we’ve taken in as deposits. If we can’t lend the money out we typically can’t make profits, which is why most banks aren’t profitable these days.
So we would love to be able to make loans that can be repaid and do what loans are supposed to do – to be borrowed and be repaid. Implying that banks are sitting on money and they’re hoarding it is just a lack of understanding of how the industry works.
NBC: Wasn’t one of the problems in the past that certain institutions, whether encouraged or not by outside forces, were too eager to loan money to people who weren’t really qualified?
JG: It’s a pretty complex set of issues that, I think, created some of what caused us to get in the mess we’re in. Everybody has an opinion about it, so I’ll state this more as an opinion than a fact.
The opinion that I have, that I don’t think varies greatly from that of others that I’ve talked to, is there were a set of circumstances that created a market that didn’t really exist, specifically in the housing sector, which is where the initial bubble burst and it kind of rippled throughout the economy.
In the housing sector, for roughly thirty to forty years, we had a certain percentage of homeownership in this country that didn’t change dramatically. And I believe the number was, and I may be off by a couple of points here, but I believe the numbers were 66% of the market were homeowners and roughly 34% were renters. That was pretty much unchanged since, maybe, post-World War II.
In a period of about a five-year time span in the late 90’s to the early 2000’s there was a series of events that created a market that didn’t exist. Specifically, Congress wanted to see more low- to moderate-income homeowners and were either encouraging or mandating the two primary government-sponsored enterprises, Fannie Mae and Freddie Mac, to fund loans to low- to moderate-income families.
When there wasn’t enough of a demand, primarily because those borrowers could not qualify, the qualifications changed – less down payment to no down payment, higher debt coverage ratios to find a way to structure the deal with low-entry adjustable rates and raise them later when, in theory, they’d be making more money, or go longer term on the amortization so the payments are lower.
It was an encouragement to be very creative to find ways for potential buyers of homes to be qualified buyers. I don’t know where we peaked but I believe the number ended up somewhere around 70% of the country became homeowners. Four percent doesn’t sound like a lot but for a country our size that’s a lot of product – a lot of demand that for decades didn’t exist.
When there’s that much demand the market’s going to find a way to fill it. There were legitimate companies doing legitimate things to fill that niche – homebuilders building homes to fill it, mortgage companies making loans, appraisers valuing properties – and there were others, not so scrupulous, who found ways to make money in this hyperactive market. Unfortunately, there was just a series of a lot of different events combined that created this bubble that ultimately burst.
Basic Economics 101, when any market sees an increase in demand the price tends to go up for the product. That, in part, is what kept this market heated and going. The nonqualified buyer goes in, buys a home, the home goes up in value, they refinance and take cash out, use that to buy cars either through a second-mortgage or some other mechanism. It stimulated the economy in a lot of areas – in tourism, in vehicle purchases, in major purchases.
People were spending that equity like it was real money. In reality it was just an overheated market that shouldn’t have been. Eventually there were no more buyers to buy up this excess product, the bubble burst and the prices came way down.
In hindsight it looks so clear. At the time this was going on, especially in markets like Las Vegas where you had a lot of growth in the gaming sector and that was driving the economy, most professionals had no idea it was this overheated. You’d hear anecdotal stories – the cab driver who’d just bought his fifth property and he was making money off of it – and you knew that that probably wasn’t sustainable.
But it appeared to be a healthy economy and…I honestly don’t know anybody that actually predicted it would be this bad. Most of us felt like there was probably going to be a correction but I don’t think anybody believed it was going to be anywhere near what we experienced.
And that’s true of most bubbles. In the tech bubble companies were trading for multiples of earnings that didn’t even exist. The earnings weren’t even there yet and there were these massive multiples of what future earnings looked like for a company that seemed to have an unlimited potential for revenue.
If people buy into it, they’ll pay more and more and more until eventually the house of cards collapses. This truly was a house of cards. Not to use a pun but it couldn’t be more directly tied to that market that I think the analogy’s excellent. The housing market was tilted up and propped up by bad policy and an overreaction to bad policy and eventually that all came crumbling down.
NBC: Some people have talked about the Glass-Steagall Act [aka Banking Act of 1934] that was enacted in the 1930′s that regulates some banking activity [in part prohibiting commercial banks from offering investment services and investment banks from engaging in commercial activities] and was repealed in 1999. Do you think that should be restored?
JG: When Gramm-Leach-Bliley [repealing Glass-Steagall] came into effect in the late-1990’s allowing organizations to cross over into other areas – commercial banks to provide investment bank services, investment banks to provide professional real estate services – the intent was good. The intent was to streamline the process and the cost of delivering services to a client. Kind of that one-stop shop idea, the more services you can offer a client the simpler it is for the client.
The problem is, again, I think there’s a lot of fault to go around in how all of this played out. But there were more than ample regulations in place to control what did and did not happen as a result of that act. Unfortunately, they just weren’t being enforced.
There wasn’t as much oversight of adhering to those existing regulations at the time Glass-Steagall got signed. So I think that the people that pushed for the repeal of the Banking Act of 1934 that wanted to allow cross-over into other areas and that made sure there were appropriate levels of privacy and firewalls between the various organizations meant well by the consumer. I think it was the right act and the right steps to take. I just feel that there should have been a little more preparation in ensuring that controls were there.
We all make these mistakes so I’m not pointing fingers at the government. I’ve seen this happen in the private sector as well. You’re ready to roll something out. You know your clients have a demand for it. You think you’ve got the appropriate mechanisms in place to deliver the product and controls in place to manage the risk. Then after the fact you learn that maybe you weren’t really as far along with it as you should have been.
My best guess at what happened is that it was a well-thought idea, designed to better service the client. Unfortunately, there were probably very few people that could say, “I could foresee that companies would take full advantage of this.”
I’ll give you an example of where I think some of the problems occurred. When an investment bank doesn’t have the same capital requirements that a commercial bank does but they can act like a commercial bank, that’s a recipe for a problem.
When a commercial bank is required to have…6% [capital], which means it can take $100 million dollars of deposits in with $6 million of capital. An investment bank could have taken $100 million of investor dollars, 401(k) or retirement funds, with virtually no capital.
Now you extrapolate that to the billions and trillions that were out there and there was no safety net if a company failed. If they started losing money there was no equity. They didn’t have “skin in the game” so to speak. And yet they were allowed to act, in many ways, like a commercial bank. The difference being it wasn’t deposited money. It was retirement funds and other things.
So if the regulatory agencies that were responsible for overseeing the investment banking activities had been more aggressive in enforcing policies you probably wouldn’t have seen as much of what did ultimately happened. I don’t come from an investment banking background so I can’t tell you all of where they fell short but it’s abundantly clear that either there needed to be consistency in how the different types of financial services sector companies were regulated and requirements were consistent or there needed to be full enforcement of all of the policies that did exist…I don’t want to imply that all of the problems that occurred as a result of the repeal of the Banking Act were because of lack of regulatory oversight. It was one of a series of things that did or didn’t happen that contributed to it. There was certainly more than enough corruption in the system, bad people doing bad things, that there’s plenty of blame to go around.
I know that there’s kind of a popular feeling among conservatives that regulations are bad for business and there’s a feeling among liberals that you can’t have enough regulations. I will say I’m kind of in the middle there. I think that there are appropriate levels of regulations that need enforcement, especially for industries that have potential systemic impact on the economy.
I don’t think the problem was there was not sufficient regulation. I just don’t think there were sufficient controls on either side – on the regulator side or on the capital side, on the markets. Self-control, I think, would be the best way to describe it. That’s usually what turns into 23,000-page regulatory rewrites. When people don’t exercise appropriate ethics or self-control others need to step in and do it for them.
Tomorrow, Part II.
(Michael Chamberlain is Executive Director of Nevada Business Coalition.)