Why the 'Too Big to Fail' Doctrine Scares Me Today

First, the good news: thanks to the mortgage/credit crisis and the ensuing financial panic, we have created a new cadre of "mega banks" that are large, well capitalized and have come to the rescue of their ailing brethren in the financial services industry. All has been saved because of "charitable" takeovers of such ailing has-beens as Countrywide, Merrill Lynch, Wachovia and Washington Mutual.

We can all sleep again, knowing that the big boys are stable, and together control 67% of the mortgage market in terms of receivables on first and second liens. Here's how the servicing numbers shake out in terms of market share: Bank of America (21.68%), Wells Fargo (17.65%), Chase Home Finance (15.09%), CitiMortgage (8.49%) and Residential Capital LLC (4.14%).

Now for the bad news: the top five control 67% of the servicing market, which means in my book most of these firms are "too big too fail" just like Fannie and Freddie were. Think about it for a second: what if something goes wrong with Bank of America which now services $2 trillion in home mortgages for American consumers? I'm not saying BoA is in danger financially but we've created a financial system - for better or worse - where too much risk is in the hands of too few. There's something wrong with that.

Let's take Fannie Mae and Freddie Mac, for example. They own or guarantee $5.2 trillion of the nation's $9.6 trillion in U.S. housing debt, or 54%. That type of market share concentration should never have been allowed to happen. It creates a situation where the government cannot - for fear of a huge market disruption - allow something so big to fail.

As this edition of Mortgage Servicing News went to press the government had just announced it would use $250 billion of the $700 billion bailout bill money to invest in dozens of banks, including Bank of America, Wells, Chase and Citigroup. None of these firms were in immediate danger of failing but at the very least it can be argued that they were all partly nationalized.

Some of you remember the giant hedge fund Long Term Capital Management, the brainchild of John Meriwether, a former star bond trader at Salomon Brothers. LTCM went down during the Russian debt crisis in 1998 when it bet the wrong way on that nation's prospects. The Federal Reserve stepped in. Do you know why? Answer: LTCM had borrowed $125 billion from commercial banks. If LTCM went down so would its lenders, at least some of them.

The big question is how do you fix "too big to fail"? Do you put caps on how large an institution can grow or will lobbyists from the banking and financial service industries shoot that one down in the name of free market capitalism? Are we better off with a system where we have thousands upon thousands of smaller institutions where the risk can be spread around the nation?

I'm not sure the answer to these questions is yes. But I do sometimes wonder if we've made a huge mistake by even allowing such things as interstate banking. When I was a young cub reporter in the 1980s interstate banking was a hot issue. There were regional interstate banking "compacts" where a thrift in Massachusetts would be allowed to open up branches in Rhode Island and vice versa. In the old days a California bank or S&L could not open de-novo branches in New York.

Then the S&L crisis happened and lobbyists became involved and all of a sudden you had West Coast banks buying out East Coast ones, and North and South intermingling. Non-depository mortgage bankers, on the other hand, had the ability to open offices and lend anywhere in the U.S. - as long as they went through the proper licensing procedures. But this was also a time when non-banks were hemmed into making mostly FHA loans.

Times like this I wonder if we've made a huge mistake by allowing interstate banking and not putting caps on how much market share a company can have in terms of mortgage servicing and deposit gathering. We are dealing with the public's money - their mortgages and savings.

I'm not an expert on banking but I believe there's a 10% cap on one bank amassing more than 10% of all deposit accounts. I'm sure it's just a matter of time before the government grants an exception to this rule just so another bank can be saved. We've deregulated and we've changed old laws in the name of capitalism but look at what we created in 17 years time: a savings and loan crisis that cost the nation's taxpayers $120 billion and a mortgage/credit crisis that cost $700 billion. The last number, as you may've guessed, is just a downpayment.

Paul Muolo is executive editor of both Mortgage Servicing News and National Mortgage News. He can be e-mailed at Paul.Muolo@SourceMedia.com.

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