As noted in an earlier post, this is the first of a four part series outlining our financial crisis. I felt that assessing government’s role in the current situation was a natural first step especially If they are the ones supposed to get us out of this mess, we should figure out if they helped us get into this mess . . . surprise, they did.Below are five elements key to empowering the government/regulation establishment that enabled certain segments of the financial system to bet as if they were in a Vegas casino. These five actions created what has been termed “the perfect storm” in creating our financial crisis. Poor legislation, lack of oversight, irresponsible corporate governance and short-sighted Fed management essentially laid the groundwork for the American public and Wall Street to cannibalize our financial system.
It is true that thousands of government employees/officials helped build the financial system casino, it is my opinion the following five government/regulatory officials are most responsible for the architecture and operation of our casino style financial system and its ultimate failure:
- Former U.S. Senator Phil Gramm (R-TX) (the casino developer)*
- Former U.S. President Bill Clinton (D) (the casino investor)
- Former Federal Reserve Chairman Alan Greenspan (the casino manager)
- Former SEC Chairman William H. Donaldson (the lazy gaming regulator)
- Former President George Bush (R) (the lazy chairman of the gaming commission)
* I had pictures but this terrible formatting system kept screwing up so I deleted them. I promise more eye candy next time.
The five enabling elements produced by the above government/regulatory officials are as follows:
- Enactment of Commodities Futures Modernization Act (2000)
- The passage of the Gramm-Leach-Bliley Act or the repeal of Glass Steagall (1999)
- Reform of the Community Reinvestment Act (1995)
- Reduction of the Prime Interest Rate by the Federal Reserve (2001-’03)
- Securities and Exchange Commission change to the “Net Capital Rule” (2004
1. Enactment of the Commodities Futures Modernization Act (CFMA) (2000)
Passage of the Commodities Futures Modernization Act (2000) allowed unregulated derivatives to run wild. You see, the reason we keep bailing out AIG is because the CFMA allowed companies like AIG to place tens of trillions of dollars in incredibly risky credit default swaps (a type of insurance policy and form of derivative) bets. Though the contracts governing these mind-bending investments are extremely hard to understand, their basic idea is very simple. Sellers of these credit default swaps promise to pay any losses to a bondholder in the event a bond issuer fails to pay back the original investment. In return the buyer pays a premium (just as a homeowner pays a premium for flood or fire insurance) to the issuer of the policy.
Unlike your homeowners insurance, credit default swaps are not regulated. Investors were allowed to buy insurance on bonds they didn’t even own, and companies like AIG are (were) allowed to write credit insurance many times over on the same bond. These bonds, many of them backed by subprime mortgages, often were rated triple-A by reputable organizations (like Moody’s), so no one expected them to default. Collecting premiums looked like easy money.
But when the housing bubble burst, companies (like AIG) had to begin making good on those credit default swaps. Worse, instead of just paying once, it had to pay many times over for the same defaulted bond. It’s like having your insurance company paying you back for your house after a fire 12 times rather than just once.
What is sad is that this could have been avoided. You see, after the 1998 collapse of Long Term Capital Management, a giant hedge fund that pioneered the use of derivatives, the Federal Reserve engineered a rescue plan to prevent the unwinding of risky bets from spreading to the larger financial system. That brought calls for tighter regulation of derivatives, including a push for greater derivatives regulation at the Commodity Futures Trading Commission, led by a former Wall Street attorney named Brooksley Born. But strong opposition to the proposal from then-Fed Chairman Alan Greenspan and senior Clinton administration officials sank the idea which can only be termed as grossly negligent at best and down-right criminal at worst.
As a response to this proposed regulation, CMFA and its companion Senate bill was sponsored by four Republican Congressman, one Democratic Congressman, four Republican Senators and two Democratic Senators. A co-sponsor on the bill happened to be Senator Phil Gramm, whom was 2008 Republican presidential nominee John McCain’s campaign co-chairman and primary financial policy advisor. He famously resigned his campaign chairmanship after his comment to the Washington Times calling the American public “a nation of “whiners” following that up with "You've heard of mental depression; this is a mental recession." So much for a mental recession . . .
Even after all the warnings, on Dec. 21, 2000, President Clinton signed into law the Commodity Futures Modernization Act, which further eased restrictions on derivatives like credit default swaps.
Lynn Stout, a UCLA professor who specializes in corporate governance and securities regulation, said, “For at least 150 years, these sorts of gambling contracts were unenforceable if they weren’t traded on an exchange. We eliminated 150 years of insurance regulation and derivatives regulation all in the name of rocket science and financial engineering.”
The new law cleared the way for an explosion in credit default swaps. In the first half of 2001, there were $632 billion in credit default swaps outstanding, according to the International Swaps and Derivatives Association. By the second half of 2007, that number was up 100-fold — to more than $62 trillion.
This single legislative act laid the groundwork for the near collapse of our entire banking system, in turn, the entire world economy.
2. The Passage of the Gramm-Leach-Bliley Act or Repeal of Glass Steagall
The repeal of Glass-Steagall (1999) allowed depository banks to become far more intertwined with Wall Street. Glass Steagall was created under the New Deal and established the FDIC and regulated banks and controlled speculation. The repeal was actually executed by the passage of the Gramm-Leach-Bliley Act (sponsored by Republicans Sen. Gramm, Rep. Leach and Rep. Bliley - see that Gramm name again?) which allowed commercial and investment banks to consolidate.
The law was passed to legalize these mergers on a permanent basis; Glass Steagall was created to make sure this was not possible.
The bill was virtually dead until Democrats agreed to support the bill after Republicans agreed to strengthen provisions of the anti-redlining (a common credit exclusionary practice in low-income, minority communities) Community Reinvestment Act (yes, the one act everyone seems to point to as the housing bubble culprit – I’ll write to that later) and address certain privacy concerns. In the end it was supported by both Republicans and Democrats and President Bill Clinton signed it into law. (Hey it’s Billy again!)
Upon signing the act President Clinton said the act “establishes the principles that, as we expand the powers of banks, we will expand the reach of the [Community Reinvestment] Act".
There has been ardent defense of the act as helping to soften the current crisis but in combination with CFMA I personally think repeal of Glass Steagall made it worse. If you had one or the other alone the crisis may have been avoided but the combination of the two fed each other to create a larger problem and ultimately hurt more than it helped.
3. Expansion of the Community Reinvestment Act (CRA) of 1977
Expansion of the Community Reinvestment Act pressured banks to provide loans to under-qualified applicants and vastly expanded the subprime home mortgage lending and low-down payment lending. Although I’m not completely convinced this expansion was the cause of the housing collapse I do think it was the catalyst that started irresponsible lending practices.
The original intent of the Community Reinvestment Act was to eliminate lending and credit discrimination in lower-income predominantly minority communities. The CRA was viewed as an extension of the Fair Housing Act (1968), Equal Credit Opportunity Act (1974) and Home Mortgage Disclosure Act (1975). This was in response to pressure from community groups and the increasing deterioration of American cities. Before the act there were severe shortages of credit available to low- and moderate-income neighborhoods. In their 1961 report, the U.S. Commission on Civil Rights found that African-American borrowers were often required to make higher down payments and adopt faster repayment schedules (not a good thing!). The commission also documented blanket refusals to lend in particular areas (redlining). The "redlining" of certain neighborhoods originated with the Federal Housing Administration (FHA) in the 1930s. The "residential security maps" created by the Home Owners' Loan Corporation (HOLC) for the FHA were used by private and public entities for years afterward to withhold mortgage capital from neighborhoods that were deemed ‘unsafe.’” CRA was created to eliminate these issues.
In 1995, the Clinton administration revised the CRA to increase pressure on banks to make more loans to risky borrowers. In 1997, the first pool of subprime mortgages was securitized (by Bear Stearns!).
The law regulating Fannie Mae and Freddie Mac was rewritten to reduce their capital requirements, meaning they would become riskier. Some critics were concerned about the risk, but Congressman and Financial Services Committee member Barney Frank (D-MA) in 2003 said, ''These two entities -- Fannie Mae and Freddie Mac -- are not facing any kind of financial crisis. The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.''
At the height of the real estate boom, the United States set record home ownership rates. Politicians, including President Bush, bragged about their success at getting Americans into their own homes. As recently as August 2007, the President boasted that he was helping Americans get homes with lower down payments and higher loan limits.
CRA, a law developed to help a relatively small segment of the population access affordable credit was opened up to everyone. Predatory lending practices preyed upon the poor and ignorant while the upper-middle class was buying homes in places like Las Vegas, Denver, Orlando as investments increasing already inflated real estate markets. Combine that with the Federal Reserve’s rate reductions which forced most people, including middle-class homebuyers, to use a variable rate mortgage with little to no money down to afford houses priced at 50 to 100 percent more than they should have been. Then buyers were sold the promise of being able to refinance or sell their house at a profit before the rate changed. Ultimately the housing market reversed and vast numbers of homeowners were upside down in their homes. Combine that with the CMFA, credit default swaps and the entire $62 trillion derivative market became “toxic” assets and created huge problems in banks’ ability to lend money and made banking insurance companies (like AIG) liable for the risk taken by the banks.
More than subprime mortgages I think the real issue was the creation of teaser-rates which provided what are called introductory rates on adjustable rate mortgages (subprime and non-subprime) that would go up at a later date (like from $1000 a month to $4000 a month). Some have tried to blame teaser-rates on CRA, but the act only applied to commercial banks. A majority of this crisis’s teaser-rate loans were made by unregulated originators not subject to the act. Teaser-rate mortgages first became widespread after President Bush took office which means it was not a provision of CRA but more a financial tool to increase the number of loans being offered and generated.
In addition, I think CRA only pushed commercial banks in a natural direction. Lending to high-risk applicants has been the profit center for most mortgage and credit card companies for the past 20 years. Banks and creditors were making money on higher credit rates so I don’t think they would have stopped even if the government didn’t expand, or repealed, the 1995 CRA provision. Nonetheless CRA helped accelerate the crisis.
4. The Prime Interest Rate reduction by the Federal Reserve (2001-’03)
Alan Greenspan, The Oracle as many came to call him (myself included), is showing himself to be nothing more than a shell game operator. For all his brilliance, Alan Greenspan is as much at fault as anyone in the financial meltdown. Under his watch, the Federal Reserve helped drop the Prime Interest Rate from 9.5% to 4% between 2001 and 2003.
This action created two effects:
1) A mad scramble for yield. Or in other words, get money out of various bond markets quickly to gain the most profit.
2) An enormous housing boom which later tanked as interest rates went up and adjustable rate mortgages adjusted.
There is no direct affect from Prime Rate on mortgage rates but in general terms as the Prime Rate drops so do the mortgage rates.
5. Securities and Exchange Commission change in the “Net Capital Rule” - allowing the five big investment banks to leverage up from 12-to-1 to 35-to-1 or more (2004)
In April of 2004, the big five investment banks (Morgan Stanley, Goldman Sachs, Merrill Lynch, Lehman Brothers and Bear Stearns) met with the requested an exemption for their brokerage units from an old regulation that limited the amount of debt the could take on. Led by then Goldman Sachs CEO Henry Paulson (yes THAT Henry Paulson – Bush Treasury Secretary) the banks made requested the Securities and Exchange Commission to make available billions of dollars held in reserve as a rainy day fund against losses on their investments. Releasing them would be provided to the parent company, opening up their ability to invest in (you guessed it) mortgage-backed securities, credit default swaps, other credit derivatives and a number of other strange, overly engineered financial instruments.
On April 28, five members of the SEC met to consider the “urgent plea” of the big investment banks. After 55 minutes of discussion, which can now be heard on the Web site of the agency, the chairman, William H. Donaldson, called for a vote. A unanimous decision was made, changing what was known as the net capital rule, allowing the big five to leverage up from 12-to-1 to 35-to-1 (or more!!!!). That means for every one dollar of equity they could take on $35 of debt.
The only person in the meeting to question the move was Harvey J. Goldsmith, an authority on securities law from Columbia, and known for being a behind-the-scenes adviser in 2002 to Senator Paul S. Sarbanes (Sarbanes-Oxley Act 2002) when he rewrote the nation’s corporate laws after a wave of accounting scandals.
Mr. Goldsmith was assured this exception was only for the big banks. His prophetic retort “We’ve said these are the big guys, but that means if anything goes wrong, it’s going to be an awfully big mess,” was met with laughter in the room.
With that, the five big independent investment firms were allowed to enter into the most speculative and dangerous activity imaginable. To make it worse they SEC relied on the banks to police themselves and use their own computer risk modeling. The SEC had the opportunity to review and watch the banks as they took on more risk but it didn’t, they didn’t find it to be a priority.
This was how Washington’s bureaucratic culture was during the Bush administration. Laissez-faire oversight, a push for widespread deregulation and closeness to business and industry made those who were charged with oversight to not do their jobs. This was not only the case with the SEC but also from the Consumer Product Safety Department to Environmental Protection Agency.
“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 SEC. under President Gerald R. Ford. “The problem with such voluntary programs is that, as we’ve seen throughout history, they often don’t work.”
“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. “Letting the firms police themselves made sense to me because I didn’t think the SEC 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.”
And that is how the banks found themselves begging for money in the Spring and Fall of 2008. With a simple vote of five people in a small room and a stroke of a single pen the financial world fate was sealed.
*****
Reverse any, a few or all of the above and the total systemic damage is significantly less.
My next post will be going after those in the private sector that helped create the mess.
