The Reckoning
Agency’s ’04 Rule Let Banks Pile Up New Debt
By STEPHEN LABATON
Published: October 2, 2008
“We have a good deal of comfort about the capital cushions at these firms at the moment.” — Christopher Cox, chairman of the Securities and Exchange Commission, March 11, 2008.
As rumors swirled that Bear Stearns faced imminent collapse in early March, Christopher Cox was told by his staff that Bear Stearns had $17 billion in cash and other assets — more than enough to weather the storm.
Drained of most of its cash three days later, Bear Stearns was forced into a hastily arranged marriage with JPMorgan Chase — backed by a $29 billion taxpayer dowry.
Within six months, other lions of Wall Street would also either disappear or transform themselves to survive the financial maelstrom — Merrill Lynch sold itself to Bank of America, Lehman Brothers filed for bankruptcy protection, and Goldman Sachs and Morgan Stanley converted to commercial banks.
How could Mr. Cox have been so wrong?
Many events in Washington, on Wall Street and elsewhere around the country have led to what has been called the most serious financial crisis since the 1930s. But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.
On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.
They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.
The five investment banks led the charge, including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary.
A lone dissenter — a software consultant and expert on risk management — weighed in from Indiana with a two-page letter to warn the commission that the move was a grave mistake. He never heard back from Washington.
One commissioner, Harvey J. Goldschmid, questioned the staff about the consequences of the proposed exemption. It would only be available for the largest firms, he was reassuringly told — those with assets greater than $5 billion.
“We’ve said these are the big guys,” Mr. Goldschmid said, provoking nervous laughter, “but that means if anything goes wrong, it’s going to be an awfully big mess.”
Mr. Goldschmid, an authority on securities law from Columbia, was a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes when he rewrote the nation’s corporate laws after a wave of accounting scandals. “Do we feel secure if there are these drops in capital we really will have investor protection?” Mr. Goldschmid asked. A senior staff member said the commission would hire the best minds, including people with strong quantitative skills to parse the banks’ balance sheets.
Annette L. Nazareth, the head of market regulation, reassured the commission that under the new rules, the companies for the first time could be restricted by the commission from excessively risky activity. She was later appointed a commissioner and served until January 2008.
“I’m very happy to support it,” said Commissioner Roel C. Campos, a former federal prosecutor and owner of a small radio broadcasting company from Houston, who then deadpanned: “And I keep my fingers crossed for the future.”
The proceeding was sparsely attended. None of the major media outlets, including The New York Times, covered it.
After 55 minutes of discussion, which can now be heard on the Web sites of the agency and The Times, the chairman, William H. Donaldson, a veteran Wall Street executive, called for a vote. It was unanimous. The decision, changing what was known as the net capital rule, was completed and published in The Federal Register a few months later.
With that, the five big independent investment firms were unleashed.
In loosening the capital rules, which are supposed to provide a buffer in turbulent times, the agency also decided to rely on the firms’ own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves.
Over the following months and years, each of the firms would take advantage of the looser rules. At Bear Stearns, the leverage ratio — a measurement of how much the firm was borrowing compared to its total assets — rose sharply, to 33 to 1. In other words, for every dollar in equity, it had $33 of debt. The ratios at the other firms also rose significantly.
The 2004 decision for the first time gave the S.E.C. a window on the banks’ increasingly risky investments in mortgage-related securities.
But the agency never took true advantage of that part of the bargain. The supervisory program under Mr. Cox, who arrived at the agency a year later, was a low priority.
The commission assigned seven people to examine the parent companies — which last year controlled financial empires with combined assets of more than $4 trillion. Since March 2007, the office has not had a director. And as of last month, the office had not completed a single inspection since it was reshuffled by Mr. Cox more than a year and a half ago.
The few problems the examiners preliminarily uncovered about the riskiness of the firms’ investments and their increased reliance on debt — clear signs of trouble — were all but ignored.
The commission’s division of trading and markets “became aware of numerous potential red flags prior to Bear Stearns’s collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain” capital standards, said an inspector general’s report issued last Friday. But the division “did not take actions to limit these risk factors.”
Drive to Deregulate
The commission’s decision effectively to outsource its oversight to the firms themselves fit squarely in the broader Washington culture of the last eight years under President Bush.
A similar closeness to industry and laissez-faire philosophy has driven a push for deregulation throughout the government, from the Consumer Product Safety Commission and the Environmental Protection Agency to worker safety and transportation agencies.
“It’s a fair criticism of the Bush administration that regulators have relied on many voluntary regulatory programs,” said Roderick M. Hills, a Republican who was chairman of the S.E.C. under President Gerald R. Ford. “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.”
As was the case with other agencies, the commission’s decision was motivated by industry complaints of excessive regulation at a time of growing competition from overseas. The 2004 decision was aimed at easing regulatory burdens that the European Union was about to impose on the foreign operations of United States investment banks.
The Europeans said they would agree not to regulate the foreign subsidiaries of the investment banks on one condition — that the commission regulate the parent companies, along with the brokerage units that the S.E.C. already oversaw.
A 1999 law, however, had left a gap that did not give the commission explicit oversight of the parent companies. To get around that problem, and in exchange for the relaxed capital rules, the banks volunteered to let the commission examine the books of their parent companies and subsidiaries.The 2004 decision also reflected a faith that Wall Street’s financial interests coincided with Washington’s regulatory interests.
“We foolishly believed that the firms had a strong culture of self-preservation and responsibility and would have the discipline not to be excessively borrowing,” said Professor James D. Cox, an expert on securities law and accounting at Duke School of Law (and no relationship to Christopher Cox).
“Letting the firms police themselves made sense to me because I didn’t think the S.E.C. had the staff and wherewithal to impose its own standards and I foolishly thought the market would impose its own self-discipline. We’ve all learned a terrible lesson,” he added.
In letters to the commissioners, senior executives at the five investment banks complained about what they called unnecessary regulation and oversight by both American and European authorities. A lone voice of dissent in the 2004 proceeding came from a software consultant from Valparaiso, Ind., who said the computer models run by the firms — which the regulators would be relying on — could not anticipate moments of severe market turbulence.
“With the stroke of a pen, capital requirements are removed!” the consultant, Leonard D. Bole, wrote to the commission on Jan. 22, 2004. “Has the trading environment changed sufficiently since 1997, when the current requirements were enacted, that the commission is confident that current requirements in examples such as these can be disregarded?”
He said that similar computer standards had failed to protect Long-Term Capital Management, the hedge fund that collapsed in 1998, and could not protect companies from the market plunge of October 1987.
Mr. Bole, who earned a master’s degree in business administration at the University of Chicago, helps write computer programs that financial institutions use to meet capital requirements.
He said in a recent interview that he was never called by anyone from the commission.
“I’m a little guy in the land of giants,” he said. “I thought that the reduction in capital was rather dramatic.”
Policing Wall Street
A once-proud agency with a rich history at the intersection of Washington and Wall Street, the Securities and Exchange Commission was created during the Great Depression as part of the broader effort to restore confidence to battered investors. It was led in its formative years by heavyweight New Dealers, including James Landis and William O. Douglas. When President Franklin D. Roosevelt was asked in 1934 why he appointed Joseph P. Kennedy, a spectacularly successful stock speculator, as the agency’s first chairman, Roosevelt replied: “Set a thief to catch a thief.”
The commission’s most public role in policing Wall Street is its enforcement efforts. But critics say that in recent years it has failed to deter market problems. “It seems to me the enforcement effort in recent years has fallen short of what one Supreme Court justice once called the fear of the shotgun behind the door,” said Arthur Levitt Jr., who was S.E.C. chairman in the Clinton administration. “With this commission, the shotgun too rarely came out from behind the door.”
Christopher Cox had been a close ally of business groups in his 17 years as a House member from one of the most conservative districts in Southern California. Mr. Cox had led the effort to rewrite securities laws to make investor lawsuits harder to file. He also fought against accounting rules that would give less favorable treatment to executive stock options.
Under Mr. Cox, the commission responded to complaints by some businesses by making it more difficult for the enforcement staff to investigate and bring cases against companies. The commission has repeatedly reversed or reduced proposed settlements that companies had tentatively agreed upon. While the number of enforcement cases has risen, the number of cases involving significant players or large amounts of money has declined.
Mr. Cox dismantled a risk management office created by Mr. Donaldson that was assigned to watch for future problems. While other financial regulatory agencies criticized a blueprint by Mr. Paulson, the Treasury secretary, that proposed to reduce their stature — and that of the S.E.C. — Mr. Cox did not challenge the plan, leaving it to three former Democratic and Republican commission chairmen to complain that the blueprint would neuter the agency.
In the process, Mr. Cox has surrounded himself with conservative lawyers, economists and accountants who, before the market turmoil of recent months, had embraced a far more limited vision for the commission than many of his predecessors.
‘Stakes in the Ground’
Last Friday, the commission formally ended the 2004 program, acknowledging that it had failed to anticipate the problems at Bear Stearns and the four other major investment banks.
“The last six months have made it abundantly clear that voluntary regulation does not work,” Mr. Cox said.
The decision to shutter the program came after Mr. Cox was blamed by Senator John McCain, the Republican presidential candidate, for the crisis. Mr. McCain has demanded Mr. Cox’s resignation.
Mr. Cox has said that the 2004 program was flawed from its inception. But former officials as well as the inspector general’s report have suggested that a major reason for its failure was Mr. Cox’s use of it.
“In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn’t oversee well enough,” Mr. Goldschmid said in an interview. He and Mr. Donaldson left the commission in 2005.
Mr. Cox declined requests for an interview. In response to written questions, including whether he or the commission had made any mistakes over the last three years that contributed to the current crisis, he said, “There will be no shortage of retrospective analyses about what happened and what should have happened.” He said that by last March he had concluded that the monitoring program’s “metrics were inadequate.”
He said that because the commission did not have the authority to curtail the heavy borrowing at Bear Stearns and the other firms, he and the commission were powerless to stop it.
“Implementing a purely voluntary program was very difficult because the commission’s regulations shouldn’t be suggestions,” he said. “The fact these companies could withdraw from voluntary supervision at their discretion diminished the mandate of the program and weakened its effectiveness. Experience has shown that the S.E.C. could not bootstrap itself into authority it didn’t have.”
But critics say that the commission could have done more, and that the agency’s effectiveness comes from the tone set at the top by the chairman, or what Mr. Levitt, the longest-serving S.E.C. chairman in history, calls “stakes in the ground.”
“If you go back to the chairmen in recent years, you will see that each spoke about a variety of issues that were important to them,” Mr. Levitt said. “This commission placed very few stakes in the ground.”
A version of this article appeared in print on October 3, 2008, on page A1 of the New York edition.
Showing posts with label Private Investment Banks. Show all posts
Showing posts with label Private Investment Banks. Show all posts
Sunday, December 21, 2008
Tuesday, November 11, 2008
Glass-Steagall: How About Housing?
Just as Congress was repealing Glass-Steagall in 1999, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.
Glass-Steagall: How About Housing?
The mess that resulted from letting investment and commercial banking join together after the repeal of Glass-Steagall...
In 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.
Glass-Steagall: the Banking Act of 1933
Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect...
The Glass-Steagall Act remained in force for six-and-a-half decades, ...
Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters...
Glass-Steagall: Bubble, Bubble...
Glass-Steagall Act: Capital & the Capitol
Banking Act of 1933, usually referred to as the Glass-Steagall Act.
In 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.
The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings. The Commodities Futures Modernization Act of 2000, for example, transformed the new mortgage-backed securities (MBS) into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.
Glass-Steagall Act: Riding Roughshod Across the Division of Banks
Glass-Steagall: How About Housing?
CURRENTLY we find ourselves in a mess that many are calling the most serious economic crisis since the Great Depression – if not worse, writes Doug Hornig, editor of Big Gold for Casey Research.
A mile-high mountain of paper profits has been set ablaze and reduced to ashes, choking investors who put their faith in houses, stocks, or commodities, or just about anything else you care to name.
The bad news is that no one completely understands what's going on; the good news is that, yes, a measure of sense can be made of the madness. Being armed with that bit of understanding should enable us to survive the tsunami...even prosper.
Glass-Steagall: the Banking Act of 1933
Until recently, average Americans were only dimly aware that there were two types of banks – the commercial banks nearby and the major investment banks located in faraway New York. Understanding the bank where they conducted business, with people they knew, was enough. The big, impersonal Wall Street banks – which dealt in higher-risk investments with potentially higher rewards – were for companies and the very rich only.
But while ordinary citizens thought very little about this distinction among the banks, the government did. Seventy-five years ago, as the Depression deepened, lawmakers were desperately trying to determine the causes of the crisis (read, looking for scapegoats). Some of the things they found were conflicts of interest and opportunities for fraud, all linked to the mixing of commercial and investment banking. So Congress decided to erect a "wall" between commercial and investment banking, and so passed the Banking Act of 1933, usually referred to as the Glass-Steagall Act.
Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect depositors in commercial banks, and it also forbade commercial banks from underwriting securities or acting as stockbrokers or dealers.
The Glass-Steagall Act remained in force for six-and-a-half decades, although various deregulatory measures and changes in exchange rules chipped away at it. Notably, in 1970 a rule excluding public companies from membership in the New York Stock Exchange was dropped. The last major private institution, Goldman Sachs, went public in 1999. This allowed investment banks to sell stock to any potential investor and greatly expand their capital base.
Over the last two decades of the 20th century, the financial industry lobbied vigorously for the repeal of the Glass-Steagall Banking Act. In 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.With one stroke of a pen, commercial bankers could begin turning their loans into investment products. (Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters.) So Wall Street investment banks were suddenly in the mortgage business. It would prove to be a marriage made somewhere significantly south of heaven.
Glass-Steagall: Bubble, Bubble...
We're not fans of government regulation, but a deregulated marketplace carries with it certain imperatives. Because it will only function as it should do in the absence of both criminal and boneheaded behavior. We can erect oversights meant to prevent the former and laws to punish it after the fact. But all the regulation in the world won't do much about the latter – the bone-headed behavior of some investors – since both market traders and the regulation itself may be boneheaded.
The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings. The Commodities Futures Modernization Act of 2000, for example, transformed the new mortgage-backed securities (MBS) into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.
Completing the trifecta, the Securities and Exchange Commission in 2004 waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under the new regulations, five companies – Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley – were granted an exemption, which they promptly used to lever up 20, 30, even 40 to 1.
That means $1 of equity underpinned up to $40 of investment risk. So a 2.5% drop in asset prices would wipe out the actual cash underlying a position...leaving only debt and losses.
Just as Congress was repealing Glass-Steagall in 1999, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.
Glass-Steagall: How About Housing?
Back in 1977, Congress had passed the Community Reinvestment Act, which had the goal of extending homeownership to the largest possible pool of Americans. Over the next 25 years, legislative supplements, a robust housing market, and aggressive government enforcement of "fairness in lending" combined to weaken bank standards regarding who did – or didn't – qualify for a loan.
But that was just the beginning. In an effort to end that recession in the new century's first years, the Greenspan Fed reduced interest rates to near zero and poured liquidity into the financial markets. At the same time, capital that had fled the stock market was looking for action. It found it in housing.
The commercial banks – and independent mortgagors like Countrywide Credit – were awash in cash. They started lending it, and every borrower's credentials were deemed excellent, even those with low income, bad credit, and no money for a down payment.
The perfect storm was building. But at first, boy! Did things ever look so rosy? The country's homeownership rate – 62.1% in 1960, rising to only 64.1% in 1994 – shot up to 68.9% by 2006.
As homeowner mania seized hold of the public imagination, people began treating their homes as ATMs. If they needed cash, they borrowed against their growing equity. Real estate speculators flipped houses like crazy. And why not, when there was no risk? Housing prices only head in one direction – up, Up, UP! Right?
It sure looked that way. The yearly average median price of an existing home went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to $147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, and despite recessions in the early '80s and early '00s, there wasn't a single down year for US housing as a national average in all of that time.
However, in 2007 housing became the latest bubble to burst, pricked by unrealistic prices, overbuilding, and the retreat from ultra-low interest rates. Concurrently, as house prices finally began to drop, a whole bunch of those no- or low-interest loans began to reset.
Glass-Steagall: Why Do Rational People Act So Stupid?
Despite the well-earned reputation of some Wall Street high rollers, bankers tend not to be a reckless lot, nor financial dunces. In general, they would rather deploy a large amount of capital into a safe, low-yield investment than put a small amount of capital into something with very high risk.
With the new environment, however, the game changed. Commercial bankers found themselves making loans to shakier and shakier recipients, while at the same time, the investment banks and their clients were clamoring for new investment products.
So bankers did what any conservative person would do. They hedged their bets. They bundled up their loans and sold the packages to the investment banks. The outcome was essentially the mortgage business being uprooted from the commercial banks and transplanted into the investment houses, which have far less restrictive requirements about reserve capital, far fewer limits on the buying and selling of securities, and far less regulatory oversight.
The investment banks did not set out, of course, to become landlords. They just wanted to sell some product for which there was a ready market. As capitalist ingenuity collided with profit motive, they found there was no shortage of products that could be created.
The mortgage bundles were sliced, diced, and repackaged into a bewildering array of securities, such as structured investment vehicles (SIVs), collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.
The extent of the slicing and dicing into what financial chefs refer to as tranches was such that the original mortgage might be tossed from buyer to buyer, or even itself split into parts. Each time a package was put together and sold, the seller stretched to get top dollar for each tranche, requiring the underlying assets to be risk-rated and then assigned real-world value. In the end, rating services had little idea what they were rating (we're being charitable here), and buyers had no idea what their purchase was really worth.
And always lurking in the background was the possibility that defaults on the mortgages supporting the entire process could have a profound ripple effect, given that these products became increasingly leveraged. Knowing this, traders invented credit default swaps (CDSs), those gnarly little creatures that morphed into Godzilla after 2004.
CDSs are an insurance policy, a way of dealing with fear, and a device for attenuating the risk inherent in trading products one may not fully understand. Those buying the protection pay an upfront amount and yearly premiums to the protection sellers, who agree in return to cover any loss to the face value of the security. The result is a private, two-party contract, devoid of regulatory oversight.
There are a bunch of nasty horseflies in this particular ointment. For one, the holder of that security (who is now "protected" by a CDS) might turn around and sell it to a third party, who might himself insure and resell it, and so on, creating an impossibly complex chain of ownership and obligation. Additionally, the CDS itself can be traded over the counter. Furthermore, any of the underlying assets might also get partitioned into different tranches, adding to the confusion. And finally, short sellers can work on just about any joint in the structure.
And here's the really big rub. Suppose the party providing the initial insurance protection – having already collected its upfront payment and premiums – doesn't have the money to pay the insured buyer when a default occurs. Or suppose the "insurer" goes bankrupt. In either instance, the buyer who thought he was protected finds himself left naked and alone.
However, that possibility seems not to have been considered as the financial world created an interlocking system of derivatives that not even a Cray supercomputer could sort out. The only certainty: it was an arrangement that depended on a robust economy and rising house prices.
Except, of course, things didn't work out that way.
When the housing slump hit, defaults in the relatively small subprime sector (less than 20% of mortgages) started a chain reaction that raced through the derivatives market, the effects compounding geometrically, until finally the world financial structure was facing collapse.
Glass-Steagall Act: Capital & the Capitol
When capital is allocated in a free market, it moves toward the productive, and the economy tends to prosper. By the same token, when it is misallocated, an economy can hit the skids.
We've had decades of misallocated capital in the United States. Instead of saving, we've been spending...and spending way beyond our means. Rather than investing in something productive, we've been gambling, taking on ever greater risks in the hope of the big payoff. Instead of creating the clean balance sheets that support stability – at all levels, personal, corporate, and governmental – we've piled up mountains of unsustainable debt.
The tragedy is that the prudent will suffer right along with the reckless. Misallocations of capital must be unwound, one way or another, before the economy can get back on its feet. It will be no simple task, and it's made even more difficult by those who put themselves in charge of the clean-up: certain residents of Washington, D.C.
At the center of the storm are two men who propose to save the nation, and they could hardly be more different.
Secretary of the Treasury Henry Paulson is the Street's guy. The former CEO of Goldman Sachs, the most powerful and successful investment bank, he brings a Wall Street insider's perspective to the table. However committed to public service he may be, he cannot be expected to act against the interests of his friends in the banking community.
And then there's Fed chairman Ben Bernanke, a pure academician. For better or worse, Bernanke's specialty is America's Great Depression, and he considers himself an expert on the subject. Above all else, he wants to be remembered as the guy who understood how to steer the country away from the shoals of a Second Great Depression.
But there is no question that Big Ben and Hammerin' Hank are trying to navigate in unfamiliar waters. Today's economy hardly mirrors that of a decade ago, much less the conditions of the 1930s. For one thing, the Glass-Steagall Act separating commercial from investment banks has been...and gone.
Back in the spring of 2007, as the initial cracks in the current structure began to appear, few were expecting the broken-levee crisis that has since unfolded. A handful of savants saw it coming and said so, but no one in the mainstream was listening. What was actually happening was that the first dominoes – subprime borrowers who should never have been approved – had begun to fall.
In and of themselves, they would have been little more than straws in the wind. But because of the multiplier effect of the derivatives market, their influence reached far beyond a few blown mortgages. As more and more debtors were unable to pay, mortgage-backed securities lost value. And then the securities based on the MBSs lost value. And then the CDS written and sold against them.
Here's where CDSs were in fact supposed to ride to the rescue. They didn't, for the simple reason that they had long since strayed far from their original insurance intent, and become primarily an instrument that gave derivatives market players access to an asset class (mortgages) without having to actually own the asset.
As MBS values were hammered by defaults on the underlying loans, buyers of CDS protection began trying to collect. That hit CDS sellers, who were being drained of cash. Further out, derivatives speculators who had bet the wrong way defaulted or went bankrupt, sending shockwaves back down the line. Slowly at first, and then with increasing speed, the capital necessary to keep the system alive started drying up.
Glass-Steagall Act: Riding Roughshod Across the Division of BanksEveryone is familiar by now with the institutions that have collapsed or been bought out or taken over by the government. The list of names is stunning: Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has undergone a transformation unimaginable a year ago. The big investment banks are gone – bankrupted or swallowed up by someone else. Even the two that remain standing, Goldman and J.P.Morgan, have had to reinvent themselves as bank holding companies to save their own hides, riding still further across the division of commercial and investment banking which Glass-Steagall set up.
The movement of capital among financial institutions is based not only on integrity but on confidence. Right now, that confidence has evaporated. Banks are carrying so much paper of indeterminate value that it's impossible to price in the risk of making a loan. So they aren't lending to each other, out of fear that they'll never get their money back. The credit market, upon which our economy depends, has seized up. When the government finally got around to admitting that there was a problem, it was already too late for any simple fix. So Washington had only two options: stand back and let the market sort things out...or take drastic, emergency action.
No one knows quite what to make of Washington's response to the credit crisis. Some are howling that it's socialism, others that it's fascism or, at best, corporatism, an unholy alliance of private enterprise and the state.
Whatever the name, there is no question that the government is boldly going where none has gone before, helping to bail out some financial institutions and seizing control of others.
The Treasury Department now has $700 billion – albeit with some strings attached – with which it can buy up toxic waste paper through the Troubled Asset Relief Program (TARP). Taking this direction, instead of making direct loans, allows the "assets" they buy to be resold somewhere down the road. And perhaps, the plan's defenders say, even at a profit. Like that's gonna happen!
Proceeding in ways never before tried, in early October the Fed announced it was opening the Commercial Paper Funding Facility. For the first time, it will buy unsecured paper debt. To facilitate this and to cover potential losses, the Treasury will deposit an unspecified amount at the Fed. This is in addition to the Treasury's own buying spree, and the Fannie Freddie conservatorship, and the expansion of the FDIC to cover deposits up to $250,000, a move likely to send that agency back to the Treasury for another fill-up.
So far, however, all the government's actions to date have accomplished precious little. For the time being, credit remains frozen. Banks are still making overnight loans to other banks, but only very selectively. The stock market, despite coming off its lows, is extremely volatile after enduring its worst crash ever. Commodities have sold off. States and municipalities are facing severe budget cuts and, in some cases, bankruptcy. Money markets are in trouble. Pensions and retirement funds are at risk. And recession, or worse, looms increasingly large on the horizon.
Nor is the crisis purely an American problem. Much of the US bad paper was sold to gullible Europeans, and world economies and markets are so interconnected that if one sneezes, someone else catches a cold. Already there have been big bailouts in Germany and the United Kingdom. The Irish government recently announced it was guaranteeing all bank deposits, which attracted a flood of money from elsewhere in the European Union, enraged other members of the EU and raising questions of how long that shaky confederation can endure as each country charts its own path through the economic minefield.
This is a once-in-a-lifetime event, a train to nowhere, and it will cause no end of suffering. Since we can't stop it, we'll do the next best thing, which is to protect ourselves. That means assessing the likely fallout from the government's meddling in the market, and developing guidelines for the best way to ride out the hurricane.
Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been studying the unfolding crisis for years. Based on his work, this is what we foresee:
More financial institutions will collapse. So will many hedge funds. Money market funds are also shaky; although the government will do all it can to keep them solvent, those that invest in anything but Treasury bills are at risk.
The economy will fall into recession. By most lights, it's already here. It won't be brief, and there is even a chance that despite all the Fed's pump priming, we could drop into a depression. For however long credit remains tight, business will be unable to function normally, and the consumer-driven economy will grind to a halt.
The whole structured finance model under which we've been operating is broken. The packaging of mortgages and other forms of consumer debt is impossible when no one will buy the packages. The trillions of dollars of outstanding mortgage derivatives will have to be unwound somehow.
Without debt leverage, private equity financing is dead. Raising money for business start-ups or expansion will be extremely challenging. IPOs will be few and far between. Leveraged buyouts are gone. Mergers and acquisitions will mostly be limited to distress sales.
At best, the government will succeed at what it's trying to do, i.e., stave off a depression, by sacrificing the dollar and allowing a fairly high level of inflation. If we're lucky, it won't turn into hyperinflation.
Interest rates are going up. On the day of the coordinated, worldwide rate cut, the Fed lowered its discount rate by 50 basis points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%. The Fed's credibility is about shot, in other words, as it has debased its own balance sheet by swapping good debt for bad. With more than half of its reserves gone, it could itself become the subject of a Treasury Department bailout.
It is highly likely that the era of US economic dominance, when the almighty Dollar served as the reserve currency of the world, is drawing to a close.
But on the bright side...well, there is no bright side. The hole that we've dug for ourselves will take a while to climb out of, and it won't be easy. But at least you can protect yourself.
Protecting your assets is not just a buzzword anymore, it's mandatory if you want to keep yourself and your family financially safe in these tough times...which will only get tougher in the near future.
Doug Casey, 10 Nov '08
Glass-Steagall: How About Housing?
The mess that resulted from letting investment and commercial banking join together after the repeal of Glass-Steagall...
In 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.
Glass-Steagall: the Banking Act of 1933
Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect...
The Glass-Steagall Act remained in force for six-and-a-half decades, ...
Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters...
Glass-Steagall: Bubble, Bubble...
Glass-Steagall Act: Capital & the Capitol
Banking Act of 1933, usually referred to as the Glass-Steagall Act.
In 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.
The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings. The Commodities Futures Modernization Act of 2000, for example, transformed the new mortgage-backed securities (MBS) into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.
Glass-Steagall Act: Riding Roughshod Across the Division of Banks
Glass-Steagall: How About Housing?
CURRENTLY we find ourselves in a mess that many are calling the most serious economic crisis since the Great Depression – if not worse, writes Doug Hornig, editor of Big Gold for Casey Research.
A mile-high mountain of paper profits has been set ablaze and reduced to ashes, choking investors who put their faith in houses, stocks, or commodities, or just about anything else you care to name.
The bad news is that no one completely understands what's going on; the good news is that, yes, a measure of sense can be made of the madness. Being armed with that bit of understanding should enable us to survive the tsunami...even prosper.
Glass-Steagall: the Banking Act of 1933
Until recently, average Americans were only dimly aware that there were two types of banks – the commercial banks nearby and the major investment banks located in faraway New York. Understanding the bank where they conducted business, with people they knew, was enough. The big, impersonal Wall Street banks – which dealt in higher-risk investments with potentially higher rewards – were for companies and the very rich only.
But while ordinary citizens thought very little about this distinction among the banks, the government did. Seventy-five years ago, as the Depression deepened, lawmakers were desperately trying to determine the causes of the crisis (read, looking for scapegoats). Some of the things they found were conflicts of interest and opportunities for fraud, all linked to the mixing of commercial and investment banking. So Congress decided to erect a "wall" between commercial and investment banking, and so passed the Banking Act of 1933, usually referred to as the Glass-Steagall Act.
Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to protect depositors in commercial banks, and it also forbade commercial banks from underwriting securities or acting as stockbrokers or dealers.
The Glass-Steagall Act remained in force for six-and-a-half decades, although various deregulatory measures and changes in exchange rules chipped away at it. Notably, in 1970 a rule excluding public companies from membership in the New York Stock Exchange was dropped. The last major private institution, Goldman Sachs, went public in 1999. This allowed investment banks to sell stock to any potential investor and greatly expand their capital base.
Over the last two decades of the 20th century, the financial industry lobbied vigorously for the repeal of the Glass-Steagall Banking Act. In 1999, they got their way with the enactment of the Financial Services Modernization Act. The door was opened to consolidation in the banking industry.With one stroke of a pen, commercial bankers could begin turning their loans into investment products. (Glass-Steagall had prevented them from selling debt-backed securities for which they were the underwriters.) So Wall Street investment banks were suddenly in the mortgage business. It would prove to be a marriage made somewhere significantly south of heaven.
Glass-Steagall: Bubble, Bubble...
We're not fans of government regulation, but a deregulated marketplace carries with it certain imperatives. Because it will only function as it should do in the absence of both criminal and boneheaded behavior. We can erect oversights meant to prevent the former and laws to punish it after the fact. But all the regulation in the world won't do much about the latter – the bone-headed behavior of some investors – since both market traders and the regulation itself may be boneheaded.
The biggest factor here was the removal of Glass-Steagall prohibitions, but there were two other important tweakings. The Commodities Futures Modernization Act of 2000, for example, transformed the new mortgage-backed securities (MBS) into a commodity, enabling them to be traded on futures exchanges with little oversight by any federal or state regulatory body.
Completing the trifecta, the Securities and Exchange Commission in 2004 waived its leverage rules. Previously, broker/dealer net-capital rules limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under the new regulations, five companies – Goldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanley – were granted an exemption, which they promptly used to lever up 20, 30, even 40 to 1.
That means $1 of equity underpinned up to $40 of investment risk. So a 2.5% drop in asset prices would wipe out the actual cash underlying a position...leaving only debt and losses.
Just as Congress was repealing Glass-Steagall in 1999, the tech stock bubble was inflating beyond sustainability. It would soon be pricked, ushering in a brief recession during which investors began the hunt for the next big thing.
Glass-Steagall: How About Housing?
Back in 1977, Congress had passed the Community Reinvestment Act, which had the goal of extending homeownership to the largest possible pool of Americans. Over the next 25 years, legislative supplements, a robust housing market, and aggressive government enforcement of "fairness in lending" combined to weaken bank standards regarding who did – or didn't – qualify for a loan.
But that was just the beginning. In an effort to end that recession in the new century's first years, the Greenspan Fed reduced interest rates to near zero and poured liquidity into the financial markets. At the same time, capital that had fled the stock market was looking for action. It found it in housing.
The commercial banks – and independent mortgagors like Countrywide Credit – were awash in cash. They started lending it, and every borrower's credentials were deemed excellent, even those with low income, bad credit, and no money for a down payment.
The perfect storm was building. But at first, boy! Did things ever look so rosy? The country's homeownership rate – 62.1% in 1960, rising to only 64.1% in 1994 – shot up to 68.9% by 2006.
As homeowner mania seized hold of the public imagination, people began treating their homes as ATMs. If they needed cash, they borrowed against their growing equity. Real estate speculators flipped houses like crazy. And why not, when there was no risk? Housing prices only head in one direction – up, Up, UP! Right?
It sure looked that way. The yearly average median price of an existing home went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to $147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, and despite recessions in the early '80s and early '00s, there wasn't a single down year for US housing as a national average in all of that time.
However, in 2007 housing became the latest bubble to burst, pricked by unrealistic prices, overbuilding, and the retreat from ultra-low interest rates. Concurrently, as house prices finally began to drop, a whole bunch of those no- or low-interest loans began to reset.
Glass-Steagall: Why Do Rational People Act So Stupid?
Despite the well-earned reputation of some Wall Street high rollers, bankers tend not to be a reckless lot, nor financial dunces. In general, they would rather deploy a large amount of capital into a safe, low-yield investment than put a small amount of capital into something with very high risk.
With the new environment, however, the game changed. Commercial bankers found themselves making loans to shakier and shakier recipients, while at the same time, the investment banks and their clients were clamoring for new investment products.
So bankers did what any conservative person would do. They hedged their bets. They bundled up their loans and sold the packages to the investment banks. The outcome was essentially the mortgage business being uprooted from the commercial banks and transplanted into the investment houses, which have far less restrictive requirements about reserve capital, far fewer limits on the buying and selling of securities, and far less regulatory oversight.
The investment banks did not set out, of course, to become landlords. They just wanted to sell some product for which there was a ready market. As capitalist ingenuity collided with profit motive, they found there was no shortage of products that could be created.
The mortgage bundles were sliced, diced, and repackaged into a bewildering array of securities, such as structured investment vehicles (SIVs), collateralized debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.
The extent of the slicing and dicing into what financial chefs refer to as tranches was such that the original mortgage might be tossed from buyer to buyer, or even itself split into parts. Each time a package was put together and sold, the seller stretched to get top dollar for each tranche, requiring the underlying assets to be risk-rated and then assigned real-world value. In the end, rating services had little idea what they were rating (we're being charitable here), and buyers had no idea what their purchase was really worth.
And always lurking in the background was the possibility that defaults on the mortgages supporting the entire process could have a profound ripple effect, given that these products became increasingly leveraged. Knowing this, traders invented credit default swaps (CDSs), those gnarly little creatures that morphed into Godzilla after 2004.
CDSs are an insurance policy, a way of dealing with fear, and a device for attenuating the risk inherent in trading products one may not fully understand. Those buying the protection pay an upfront amount and yearly premiums to the protection sellers, who agree in return to cover any loss to the face value of the security. The result is a private, two-party contract, devoid of regulatory oversight.
There are a bunch of nasty horseflies in this particular ointment. For one, the holder of that security (who is now "protected" by a CDS) might turn around and sell it to a third party, who might himself insure and resell it, and so on, creating an impossibly complex chain of ownership and obligation. Additionally, the CDS itself can be traded over the counter. Furthermore, any of the underlying assets might also get partitioned into different tranches, adding to the confusion. And finally, short sellers can work on just about any joint in the structure.
And here's the really big rub. Suppose the party providing the initial insurance protection – having already collected its upfront payment and premiums – doesn't have the money to pay the insured buyer when a default occurs. Or suppose the "insurer" goes bankrupt. In either instance, the buyer who thought he was protected finds himself left naked and alone.
However, that possibility seems not to have been considered as the financial world created an interlocking system of derivatives that not even a Cray supercomputer could sort out. The only certainty: it was an arrangement that depended on a robust economy and rising house prices.
Except, of course, things didn't work out that way.
When the housing slump hit, defaults in the relatively small subprime sector (less than 20% of mortgages) started a chain reaction that raced through the derivatives market, the effects compounding geometrically, until finally the world financial structure was facing collapse.
Glass-Steagall Act: Capital & the Capitol
When capital is allocated in a free market, it moves toward the productive, and the economy tends to prosper. By the same token, when it is misallocated, an economy can hit the skids.
We've had decades of misallocated capital in the United States. Instead of saving, we've been spending...and spending way beyond our means. Rather than investing in something productive, we've been gambling, taking on ever greater risks in the hope of the big payoff. Instead of creating the clean balance sheets that support stability – at all levels, personal, corporate, and governmental – we've piled up mountains of unsustainable debt.
The tragedy is that the prudent will suffer right along with the reckless. Misallocations of capital must be unwound, one way or another, before the economy can get back on its feet. It will be no simple task, and it's made even more difficult by those who put themselves in charge of the clean-up: certain residents of Washington, D.C.
At the center of the storm are two men who propose to save the nation, and they could hardly be more different.
Secretary of the Treasury Henry Paulson is the Street's guy. The former CEO of Goldman Sachs, the most powerful and successful investment bank, he brings a Wall Street insider's perspective to the table. However committed to public service he may be, he cannot be expected to act against the interests of his friends in the banking community.
And then there's Fed chairman Ben Bernanke, a pure academician. For better or worse, Bernanke's specialty is America's Great Depression, and he considers himself an expert on the subject. Above all else, he wants to be remembered as the guy who understood how to steer the country away from the shoals of a Second Great Depression.
But there is no question that Big Ben and Hammerin' Hank are trying to navigate in unfamiliar waters. Today's economy hardly mirrors that of a decade ago, much less the conditions of the 1930s. For one thing, the Glass-Steagall Act separating commercial from investment banks has been...and gone.
Back in the spring of 2007, as the initial cracks in the current structure began to appear, few were expecting the broken-levee crisis that has since unfolded. A handful of savants saw it coming and said so, but no one in the mainstream was listening. What was actually happening was that the first dominoes – subprime borrowers who should never have been approved – had begun to fall.
In and of themselves, they would have been little more than straws in the wind. But because of the multiplier effect of the derivatives market, their influence reached far beyond a few blown mortgages. As more and more debtors were unable to pay, mortgage-backed securities lost value. And then the securities based on the MBSs lost value. And then the CDS written and sold against them.
Here's where CDSs were in fact supposed to ride to the rescue. They didn't, for the simple reason that they had long since strayed far from their original insurance intent, and become primarily an instrument that gave derivatives market players access to an asset class (mortgages) without having to actually own the asset.
As MBS values were hammered by defaults on the underlying loans, buyers of CDS protection began trying to collect. That hit CDS sellers, who were being drained of cash. Further out, derivatives speculators who had bet the wrong way defaulted or went bankrupt, sending shockwaves back down the line. Slowly at first, and then with increasing speed, the capital necessary to keep the system alive started drying up.
Glass-Steagall Act: Riding Roughshod Across the Division of BanksEveryone is familiar by now with the institutions that have collapsed or been bought out or taken over by the government. The list of names is stunning: Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has undergone a transformation unimaginable a year ago. The big investment banks are gone – bankrupted or swallowed up by someone else. Even the two that remain standing, Goldman and J.P.Morgan, have had to reinvent themselves as bank holding companies to save their own hides, riding still further across the division of commercial and investment banking which Glass-Steagall set up.
The movement of capital among financial institutions is based not only on integrity but on confidence. Right now, that confidence has evaporated. Banks are carrying so much paper of indeterminate value that it's impossible to price in the risk of making a loan. So they aren't lending to each other, out of fear that they'll never get their money back. The credit market, upon which our economy depends, has seized up. When the government finally got around to admitting that there was a problem, it was already too late for any simple fix. So Washington had only two options: stand back and let the market sort things out...or take drastic, emergency action.
No one knows quite what to make of Washington's response to the credit crisis. Some are howling that it's socialism, others that it's fascism or, at best, corporatism, an unholy alliance of private enterprise and the state.
Whatever the name, there is no question that the government is boldly going where none has gone before, helping to bail out some financial institutions and seizing control of others.
The Treasury Department now has $700 billion – albeit with some strings attached – with which it can buy up toxic waste paper through the Troubled Asset Relief Program (TARP). Taking this direction, instead of making direct loans, allows the "assets" they buy to be resold somewhere down the road. And perhaps, the plan's defenders say, even at a profit. Like that's gonna happen!
Proceeding in ways never before tried, in early October the Fed announced it was opening the Commercial Paper Funding Facility. For the first time, it will buy unsecured paper debt. To facilitate this and to cover potential losses, the Treasury will deposit an unspecified amount at the Fed. This is in addition to the Treasury's own buying spree, and the Fannie Freddie conservatorship, and the expansion of the FDIC to cover deposits up to $250,000, a move likely to send that agency back to the Treasury for another fill-up.
So far, however, all the government's actions to date have accomplished precious little. For the time being, credit remains frozen. Banks are still making overnight loans to other banks, but only very selectively. The stock market, despite coming off its lows, is extremely volatile after enduring its worst crash ever. Commodities have sold off. States and municipalities are facing severe budget cuts and, in some cases, bankruptcy. Money markets are in trouble. Pensions and retirement funds are at risk. And recession, or worse, looms increasingly large on the horizon.
Nor is the crisis purely an American problem. Much of the US bad paper was sold to gullible Europeans, and world economies and markets are so interconnected that if one sneezes, someone else catches a cold. Already there have been big bailouts in Germany and the United Kingdom. The Irish government recently announced it was guaranteeing all bank deposits, which attracted a flood of money from elsewhere in the European Union, enraged other members of the EU and raising questions of how long that shaky confederation can endure as each country charts its own path through the economic minefield.
This is a once-in-a-lifetime event, a train to nowhere, and it will cause no end of suffering. Since we can't stop it, we'll do the next best thing, which is to protect ourselves. That means assessing the likely fallout from the government's meddling in the market, and developing guidelines for the best way to ride out the hurricane.
Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been studying the unfolding crisis for years. Based on his work, this is what we foresee:
More financial institutions will collapse. So will many hedge funds. Money market funds are also shaky; although the government will do all it can to keep them solvent, those that invest in anything but Treasury bills are at risk.
The economy will fall into recession. By most lights, it's already here. It won't be brief, and there is even a chance that despite all the Fed's pump priming, we could drop into a depression. For however long credit remains tight, business will be unable to function normally, and the consumer-driven economy will grind to a halt.
The whole structured finance model under which we've been operating is broken. The packaging of mortgages and other forms of consumer debt is impossible when no one will buy the packages. The trillions of dollars of outstanding mortgage derivatives will have to be unwound somehow.
Without debt leverage, private equity financing is dead. Raising money for business start-ups or expansion will be extremely challenging. IPOs will be few and far between. Leveraged buyouts are gone. Mergers and acquisitions will mostly be limited to distress sales.
At best, the government will succeed at what it's trying to do, i.e., stave off a depression, by sacrificing the dollar and allowing a fairly high level of inflation. If we're lucky, it won't turn into hyperinflation.
Interest rates are going up. On the day of the coordinated, worldwide rate cut, the Fed lowered its discount rate by 50 basis points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%. The Fed's credibility is about shot, in other words, as it has debased its own balance sheet by swapping good debt for bad. With more than half of its reserves gone, it could itself become the subject of a Treasury Department bailout.
It is highly likely that the era of US economic dominance, when the almighty Dollar served as the reserve currency of the world, is drawing to a close.
But on the bright side...well, there is no bright side. The hole that we've dug for ourselves will take a while to climb out of, and it won't be easy. But at least you can protect yourself.
Protecting your assets is not just a buzzword anymore, it's mandatory if you want to keep yourself and your family financially safe in these tough times...which will only get tougher in the near future.
Doug Casey, 10 Nov '08
Monday, October 20, 2008
Instead of focusing on Freddie and Fannie. why don’t you go further?
Take a look at the trial, that has resumed TODAY, 10-20-08, inCOlumbus Ohio? National Century Financial Enterprises , Inc. dubbed by Federal Prosecutors as ‘larger than Enron’ !
Do you have a clue what this is all about? Do you know who the last executive in this trial, James K Happ, is? Or where he came from?
More importantly, who he worked for prior to his employment at NCFE?
Take a look at the trial, that has resumed TODAY, 10-20-08, inCOlumbus Ohio? National Century Financial Enterprises , Inc. dubbed by Federal Prosecutors as ‘larger than Enron’ !
Do you have a clue what this is all about? Do you know who the last executive in this trial, James K Happ, is? Or where he came from?
More importantly, who he worked for prior to his employment at NCFE?
Subscribe to:
Posts (Atom)
