Commentary: Bank bailouts worked

No one should be surprised that Wall Street is paying big bonuses, and that politicians and people are outraged about it. But who expected the banks to pull off such a fast turnaround?

Most corporate recoveries are years in the making. General Motors' revival, if it comes at all, will be a long slog. But some banks that took taxpayer money — and paid it back with interest — are world-beaters again.

A year ago, the big banks were supposedly staring into the abyss. Lehman Bros. had failed, credit markets seized up, and a global financial meltdown was looming. Central bankers jumped into action, and the U.S. government approved a $700 billion bailout.

Well, it worked. The economy stabilized, and despite the pain of double-digit unemployment, the banks are raking it in again.

Goldman Sachs posted its biggest profit ever in 2009 — $13.4 billion, almost six times larger than the year before. Wells Fargo's bottom line followed the same arc, rising almost fivefold. JP Morgan Chase doubled its profit, after a $12 billion increase in interest income.

Small businesses may complain that loans are harder to get, and consumers are angry about rising credit card rates. But after the easy-credit era created a giant debt bubble, it’s only natural that lending standards get tougher.

Banks are benefiting from less competition today. A number of big players were crumbling as the markets collapsed in 2008 and had to be acquired, often with a government push. Merrill Lynch, Bear Stearns, Countrywide Mortgage, Wachovia and Washington Mutual are now parts of larger banks.

Big banks also have a major stake in the stock and bond markets, which had a roaring 2009. Goldman, for instance, reported $23 billion from fixed income, currency and commodity trading, compared with less than $4 billion in 2008.

"Banks still have a lot of leverage, and that amplifies their returns," said Thomas Moeller, who teaches finance at Texas Christian University. "When times are good, they’re really good."

Strong banks are vital to a recovery, so we should root for their success and hope they're a leading indicator for the rest of the economy. But if their rapid improvement marks a return to the old days, watch out.

Big banks got into trouble by betting on mortgage-backed securities, derivatives and other exotic instruments. When the investments went bad, the feds had to ride to the rescue, because some banks were deemed "too big to fail."

In essence, they could play aggressively, even recklessly, because they had a federal safety net.

"They're playing government blackjack," C.R. "Rusty" Cloutier, chief executive of Midsouth Bank in Lafayette, La., told me. "The government puts up the bet, and the banks pocket the money if they win."

Cloutier went to Washington recently to testify to a panel investigating the financial crisis. He represented community bankers and said that smaller banks focused on relationships, rather than transactions.

"We know our customers and operate under the quaint but effective practice of only lending money to people who can pay it back," he told the panel.

Wall Street is a pay-for-performance culture, and big bonuses follow rising profits. But the widespread criticism has had an effect. Goldman, for one, said it will donate $500 million from its bonus pool to charity. It’s still paying each employee an average of nearly $500,000, a 46 percent increase.

A federal pay czar caps compensation at companies that still have taxpayer money. But those rules affect only a sliver of workers — about 75 out of 663,000 at three Wall Street firms, said John Benson of the Web site, efinancialcareers.com.

Bonuses are not inherently bad, not unless they create the wrong incentives.

"Most bonuses are based on growth, not long-term performance, so that’s what banks got," said Scott MacDonald, who teaches banking at Southern Methodist University.

Last week, President Barack Obama renewed his push to reform the financial services industry. He wants to bar banks from operating hedge funds and proprietary trading if their deposits are backed by taxpayers. And he wants to strengthen liquidity requirements and oversight, so one bank's failure won't threaten the entire economy.

"Never again will the American taxpayer be held hostage by a bank that is too big to fail," Obama said.

He also took a shot at companies returning to their "old practices" and reporting "soaring profits and obscene bonuses."

"The American people have paid a very high price," Obama said. "We simply cannot return to business as usual."

To Cloutier, the community banker, the answer is to break up the banks. Reduce them to maybe one-quarter of their current size, and he says much of the risky behavior will go away. If not, the bad bets will wash out without requiring a federal rescue.

It's good news that big banks are making big profits, because they're crucial to a broader recovery. It's even comforting to be arguing about bonuses again, because they're cheaper than bailouts.

But one way or another, the model has to change, and before people forget how we got into the mess in the first place.