StrategyDriven Editorial Perspective

They say the road to hell is paved with good intentions. In 1825, to deal with the “Indian Problem,” the US Congress formed a region known as “Indian Country,” lands West of the Mississippi (today Oklahoma). Their intentions were good.

“The removal of the tribes from the territory which they now inhabit would not only shield them from impending ruin, but promote their welfare and happiness,” President James Monroe told Congress on January 27. He went so far as to say that without a defined Indian country “their degradation and extermination will be inevitable.”

It’s heartening to know that at least some of the President’s contemporaries could see through his good intentions. New York County District Attorney Hugh Maxwell and twelve other prominent New Yorkers wrote in a pamphlet published in1825 that “the American Indians, now living upon lands derived from their ancestors and never alienated or surrendered, have a perfect right to the continued and undisturbed possession of these lands,” and the “removal of any nation of Indians from their country by force would be an instance of gross and cruel oppression.”

History was not on Mr. Maxwell’s side, nor with his attempts to reform the financial industry a few years later. His prosecution of the Life & Fire Insurance Company, whose owners Jacob Barker, et al perpetuated a fraud that led to the Panic of 1826, resulted in a hung jury. (Eventually, Mr. Maxwell’s efforts did lead to comprehensive reform, including: financial reporting requirements, accounting standards, and defined roles & responsibilities for directors, according to Professor Eric Hilt in a paper about the Panic of 1826.)

Mr. Maxwell’s rationality was no match for his era’s good intentions. For what lead Life & Fire’s directors to commit fraud in the first place was in part driven by a desire (so they claimed) to extend credit to high-risk borrowers being ignored by traditional banks. When those borrowers started to default en masse, fraud appeared to be the only way to repay their investors, but unfortunately, even that didn’t work.

Why was an insurance company doing a bank’s work? In the 19th century, banking was the most profitably industry in America, and incumbent banks fought hard to protect their profits. To open a new one involved special-act charters and bitter legislative battles. Would-be owners required both political and financial capital, which few had in equal measure.

Enterprising merchants like Mr. Barker started circumventing these laws by forming insurance companies whose charter empowered them to lend their capital. In so doing, they created a new financial product called a post note. A typical post note transaction went as follows: a borrower approached an insurance company and requested a six-month IOU of $1000, minus a discount of say 3%. The borrower would then sell the discounted $970 post note on the money market, also paying a discount to the post note purchaser of say $30, receiving $940 in cash.

After six months, the borrower would repay the insurance company’s IOU of $1000. The insurance company would repay the money market investor’s post note of $970, yielding a $30 profit for both the insurance company and the investor.

While rates and terms varied, it was not unusual for post notes to trade at yields of 2 percent per month or more, compared to banks that were lending at yields of five percent per year, Professor Hilt’s research found. Needless to say, these products were very profitable as long as default rates were low.

But higher yield meant higher risk, since borrowers who sought out post notes did so because they did not qualify for the less expensive credit from traditional banks. Despite their dubious quality, the corporate guaranty by the insurance company created a ...

This year, 2013, marks the 100th anniversary of the Federal Reserve System, and central bankers are taking a historical perspective. That is “good advice in general,” Fed Chairman Ben Bernanke told attendees at the Fourteenth Jacques Polak Annual Research Conference, in Washington, D.C earlier this month. “An appreciation of the parallels between recent and historical […]

This year, 2013, marks the 100th anniversary of the Federal Reserve System, and central bankers are taking a historical perspective. That is “good advice in general,” Fed Chairman Ben Bernanke told attendees at the Fourteenth Jacques Polak Annual Research Conference, in Washington, D.C earlier this month.

“An appreciation of the parallels between recent and historical events greatly influenced how I and many of my colleagues around the world responded to the crisis,” Mr. Bernanke said.

He went on to describe the similarities between the banking crisis of 1907 – the one that inspired the formation of the Federal Reserve – and the more recent 2008 financial crisis.

Both fit the archetype of a classic financial panic, Bernanke said. Both crises started in an economy in recession and both suffered from a sudden lack of liquidity.

In 1907, money was tight in part due to the rebuilding of San Francisco. After the Bank of England raised its discount rate, causing more gold to flow out of the US, New York was left with unusually low monetary reserves just as it entered the cash-intensive harvest season, explained Ellis Tallman and Jon Moen in a 1990 article about the Panic in the Atlanta Fed’s Economic Review.

In the more recent crises, Bernanke explained, liquidity started to dry up when housing prices declined, and subprime mortgage defaults rose in 2007. As the underwriting weaknesses of subprime portfolios became known, banks stopped lending to each other, paralyzing credit markets. By 2008, losses from these portfolios were causing banks to fail.

In both crises, a tinder-dry credit environment made them vulnerable to sparks. In 1907, the fire started when F. Augustus Heinze and C.F. Morse tried and failed to corner the stock of the United Copper Company. The investigation into the scam revealed an intricate web of corrupt bankers and brokers. (Heinze was president of Mercantile National Bank, and Morse served on seven New York City bank boards.) When the president of the second largest trust in the country was implicated in the copper cornering con, depositors started a run on Knickerbocker Trust.

Without a central bank, the availability of liquidity depended on the discretion of firms and private individuals, Bernanke explained. The Lehman Brothers moment of 1907 came when New York’s financiers, led by J.P. Morgan, were unable to value the trusts, and refused to ‘bail out’ Knickerbocker. (Unregulated and a relatively new innovation, trusts were the ‘toxic assets‘ of the 1907 crises. Trusts, however, were financed by consumer deposits, while the toxic asset of 2008 were securities contracts held by investment banks.)

Their refusal prevented other institutions from offering aid, and depositors started a massive run on banks and trusts, exacerbating the liquidity crises. (In 2008 a loss of confidence in the banking system did not turn into a consumer run on banks primarily because of FDIC deposit insurance.)

Morgan et al realized that a failure of the trusts could spread to the entire financial system, and they ultimately convinced John D. Rockefeller and others to pony up enough cash to stabilize the markets.

Similarly, American lawmakers eventually agreed that failure of the nation’s largest financial institutions was not an option, and passed the $700 billion

The Federal Deposit Insurance Corporation has served as an integral part of the nation’s financial system since its inception in 1933. Our trust in this institution is so strong that it is rare to find someone with a checking account in a bank that lacks an FDIC placard in the window. Nonetheless, the failure and […]

The Federal Deposit Insurance Corporation has served as an integral part of the nation’s financial system since its inception in 1933. Our trust in this institution is so strong that it is rare to find someone with a checking account in a bank that lacks an FDIC placard in the window. Nonetheless, the failure and resolution of Texas-based First RepublicBank, reminds us that the hand of government can harm as well as help when it wrestles the invisible hand of the market.

More than an insurer of accounts up to $250,000, the FDIC also regulates financial institutions and serves as a receiver in bankruptcy. The latter role was codified in the Federal Deposit Insurance Act of 1950, which provided the FDIC “additional powers to both expedite the liquidation process for banks and thrifts in order to maintain confidence in the nation’s banking system,” the FDIC’s Resolution Handbook explains.

RepublicBank merged with InterFirst Corporation in June 1986, and formed First RepublicBank Corporation, the largest bank holding company in the Southwest at the time. Then FDIC Chairman William Seidman expressed concern about the merger of two weak banks, “however, without the merger, both banks were more likely to fail, and they would cost even more [apart] than if they failed together,” Seidman recalled in his memoir Full Faith and Credit1.

Seidman’s concerns were warranted. With both banks highly concentrated in the weak Texas real estate market, the deal ended up helping neither bank. As the bank’s losses mounted, depositors fled. Just nine months after the merger was completed, the FDIC had to step in to resolve the failing institution, and at $3.9 billion, it was the most costly bank failure in FDIC history.

Though much can be blamed on the poor condition of the bank’s assets, some of the government’s deal-making “proved to have some room for improvement,” according to the FDIC’s review2.

Included in the resolution was a servicing agreement between the FDIC and NCNB Corporation of Charlotte, NC, the acquiring bank of First Republic’s assets, which required the FDIC to cover costs associated with managing the troubled asset pool. This agreement turned out to be a major source of income for NCNB, and gave them an incentive to hold on to the assets rather than liquidate when the market strengthened. All told, the FDIC paid $1.9 billion in management fees to NCNB.

Another issue was taxes. The IRS had negotiated with NCNB (and no other bidders) $700 million in tax savings with the acquisition. A letter from the IRS allowed the acquirer to treat the deal as a “tax-free reorganization and to carry forward losses from the failed banks to offset future income,” according to the FDIC’s analysis3. These tax savings allowed NCNB to compete aggressively in the Texas market, offering above-market deposit rates and below-market loan rates.

“The government has created a monster,” Chris Williston, the president of the Texas Independent Bankers Association, told American Banker in 19904.

In stepping up when banks fail, the FDIC provides “an element in the readjustment of our financial system more important than currency, more important than gold, and that is the confidence of the people,” President Franklin D. Roosevelt said in 1933. But the example of First RepublicBank reminds us that infusing government into any market-based transactions can change the outcome for better and for worse. In restoring public confidence, the more invisible our government can be, perhaps the better.

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While we voice concerns about debt and spending, we also need to be mindful of the state of employers, particularly small business and their struggles to remain competitive and viable. Statistically small business, employers of at least 50 percent of our workforce, are struggling, and eager to get your business. They are begging to serve […]

While we voice concerns about debt and spending, we also need to be mindful of the state of employers, particularly small business and their struggles to remain competitive and viable. Statistically small business, employers of at least 50 percent of our workforce, are struggling, and eager to get your business. They are begging to serve you while balancing unclear taxes, health insurance obligations, and uncertain ability to make payroll. Public project labor agreements (PLAs) provide another hurdle, unless their employees choose to pay union dues.

Here is the ugly truth for small business employers without union workers…

As the result of $50 Million in Hurricane Sandy damage, the New Jersey Senate passed Bill S24251 that approves PLAs. That means that non-union employers will not be included in the bidding process for public work or state funded contracts unless there is a collective bargaining (union) contract representing employees. This is not only bidding preference, this is a freeze small businesses out of competitive bidding unless their employees pay union dues.

In other words, non-union contractors have no place in this public work, period. The NJ Senate Bill S2425 enhanced their existing law in New Jersey for PLAs to include roads, bridges, and water treatment. The bill was introduced and sponsored by Senate President Steve Sweeney, former vicinity president of Iron Workers District Council of Philadelphia. This is a stark contradiction to Sweeney’s inaugural goals including “encourage shared public services among local governments as a way to reduce spending… and make the state business friendly.”2 This Senate Bill is hardly a cost saving, business friendly measure.

Further, in support of unions, on February 6, 2009, President Obama signed an executive order reversing George H. W. Bush’s prohibition on the requirement for project labor agreements on federal projects.3 Obama claimed “it was the government’s policy to encourage the use of labor agreements to avoid misunderstandings about the cost of labor and to ensure that one contractor’s workforce problems during a project not delay other teams involved in the contract.” What it does not address is the freezing out of non-union bidders and the increases in taxpayer costs.

Statistically speaking, only 13.2 percent of the 2012 U.S. private construction workforce belongs to unions.4 This information represents that 87 percent of this employment sector are non-union employees, a solid supposition that they are from the small business sector.

Is this precipitating and/or worsening the status quo with small business? The success of small business is largely measured on their ability to hire and maintain employees. Their success for work is neither viable nor likely considering PLAs. According to the 2012 Year End Economic Report of the National Small Business Association,

* Just over one-third (38 percent) anticipate their firms will grow in the coming year—the lowest this indicator has been since we began asking this question in December 2009;

* Hiring remains stagnant with the number of small-business owners who project decreases to their employment size in the coming year rising from 12 percent to 16 percent;5

The reality is that there is a major difference between supporting unions and taking away legitimate bidding power from small contractors and family owned, non-union businesses. And, the competitive bidding process is in place to assure the best look at products, quality of services, at the best price. Competitive bidding is most often used by government agencies that are required by law to open contracts for bid and must award business to the lowest bidder. This is intended to ensure impartiality in buying decisions and assure the best price.

Further included in a PLA is the stipulation that may require even non-union contractors to...

Spend well this Christmas/Holiday Season and be merry. But ‘tis the season for budgeting for the New Year as well. Unless otherwise averted, your Christmas/Holiday or otherwise discretionary budget will fade next year to infinity and beyond. The trend is that American holiday spending has diminished over the past 10 years from $1,037.00 in 2002 […]

Watching media coverage of ‘business’ in the United States, one might imagine he is living in a socialist country where capitalism is almost a crime. From certain sectors of the media and within the circles of certain political campaigns we hear cries of anger at the ‘wealthy’ and the need for business owners to pay […]

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