Friday, April 4, 2008

The Credit Bubble, Deregulation Gone Wild and Saving the Financial Industry from Itself

West Berlin, Germany. June 12, 1987;

"...if you seek liberalization: Come here to this gate! Mr.
Gorbachev, open this gate! Mr. Gorbachev, tear down this wall!"

Just a moment in time later, November 9, 1989, the wall did come down. From just one personal account pulled from the web;

"...Looking around, I saw an indescribable joy in people's faces. It was the end of the government telling people what not to do"

For the role that America and Ronald Reagan played in that, it represented to many a moment that came to symbolize the best of what America had to offer. There's another side though, the economic one and specifically deregulation of the financial industry, where the aftermath of the transformational presidency that was Ronald Reagan hasn't exactly gone as planned. In regards to the current financial crisis described by many as the worst in multiple generations, billionaire investor George Soros stated here;

"The cause of the current troubles dates back to 1980, when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power, Soros said. It was during this time that borrowing ballooned and regulation of banks and financial markets became less stringent. These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms. Instead, this laissez-faire attitude created the current housing bubble, which in turn led to the seizing up of credit markets..."

Soros further opines elsewhere;

"...regulations have been progressively relaxed until they have practically disappeared".

Let us take a journey just a bit deeper into that process. Note the similar themes in the episodes examined and how if one were to simply substitute a few words here and there, one might mistakenly think that the current credit crisis is being described. Whether attributed to South American philosopher George Santaya, or to Winston Churchill, "those who fail to learn from history are doomed to repeat it" sums it up just about right here.

One of the first targets of financial system deregulation in the Reagan administration was savings banks and commercial banks. As told by the FDIC;

"December, 1982--Garn - St Germain Depository Institutions Act of 1982 enacted. This Reagan Administration initiative is designed to complete the process of giving expanded powers to federally chartered S&Ls and enables them to diversify their activities with the view of increasing profits. Major provisions include: elimination of deposit interest rate ceilings; elimination of the previous statutory limit on loan to value ratio; and expansion of the asset powers of federal S&Ls by permitting up to 40% of assets in commercial mortgages, up to 30% of assets in consumer loans, up to 10% of assets in commercial loans, and up to 10% of assets in commercial leases."

Among other things, some of which were surely helpful in order to adapt to market realities, according to the Social Studies Help Center, the effects of this bill were as follows;

  • Deregulation practically eliminated the distinction between commercial and savings banks.
  • Deregulation caused a rapid growth of savings banks and S&L's that now made all types of non homeowner related loans. Now that S%L's could tap into the huge profit centers of commercial real estate investments and credit card issuing many entrepreneurs looked to the loosely regulated S&L's as a profit making center.
  • As the eighties wore on the economy appeared to grow. Interest rates continued to go up as well as real estate speculation. The real estate market was in what is known as a "boom" mode. Many S&L's took advantage of the lack of supervision and regulations to make highly speculative investments, in many cases loaning more money then they really should.
  • When the real estate market crashed, and it did so in dramatic fashion, the S&L's were crushed. They now owned properties that they had paid enormous amounts of money for but weren't worth a fraction of what they paid. Many went bankrupt, losing their depositors money. This was known as the S&L Crisis.
  • In 1980 the US had 4,600 thrifts, by 1988 mergers and bankruptcies left 3000. By the mid 1990's less than 2000 survived.
In less then 7 years after the initiation of this major banking deregulation, in February of 1989, President Bush (the first of course) unveiled the S&L bailout plan. As the Help Center puts it;

"The S&L crisis cost about 600 Billion dollars in "bailouts." This is 1500 dollars from every man woman and child in the US."

Meanwhile, just a few years before the S&L crisis culminated in a massive U.S. taxpayer bailout, the deregulators, undeterred, had set their sight on a far bigger prize, the elimination of barriers between investment banks and commercial banks, as represented by the Glass-Steagall act, which was put in place as a response to the stock market crash of 1929 and the ensuing Great Depression. Just months before the famous Reagan Berlin Wall speech noted above, the Federal Reserve began to set the stage, acting against the objections of its Chairman. Note how precient some of the comments from 1987 are for today's situation. As chronicled here by Frontline;

"In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures - a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking."

Later in 1987 though, the deregulation proponents get a powerful new voice. In August 1987, Ronald Reagan appoints Ayn Rand disciple and strong believer in Laissez-faire markets, Alan Greenspan to become chairman of the Federal Reserve Board, thereby setting in place a series of events that would ultimately lead to the financial industry tearing down its Glass-Steagall wall. Unlike the wonders of the elimination of the Berlin Wall though, the results here were far less positive. Lets follow a few of the tidbits as told once again by Frontline;

"In January 1989, the Fed Board approves an application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole"

"In 1990, J.P. Morgan becomes the first bank to receive permission from the Federal Reserve to underwrite securities"

"In 1991, the Bush administration puts forward a repeal proposal, winning support of both the House and Senate Banking Committees, but the House again defeats the bill in a full vote."

"In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting."

"In August 1997, the Fed eliminates many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The Board states that the risks of underwriting had proven to be "manageable," and says banks would have the right to acquire securities firms outright."

"In 1997, Bankers Trust (now owned by Deutsche Bank) buys the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm."

In 1998, the stakes are raised, as the financial industry goes for the juggular. Again from Frontline;

"On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world's largest financial services company, in what was the biggest corporate merger in history. The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law....Following the merger announcement on April 6, 1998, Weill immediately plunges into a public-relations and lobbying campaign for the repeal of Glass-Steagall and passage of new financial services legislation"

Ultimately, the efforts succeeded;

"After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic."

Fresh off of this "victory", incredulously, the man who was charged with being the banking systems chief regulator, Fed Chairman Alan Greenspan continued to lead the charge towards a completely unregulated financial system as he turned his sites towards championing the growth of unregulated derivatives. From a February 2000 New York Times article;

"The Federal Reserve chairman, Alan Greenspan, urged Congress today to encourage the growth of complex financial contracts known as derivatives...United States laws impede its development, Mr. Greenspan said in testimony..."

The ensuing years saw the accelerating phenomenon where, with the last major regulatory impediment removed, and more importantly perhaps, not replaced with any form of updated regulation, the credit bubble accelerated, fueled heavily by the explosive growth in unregulated derivatives. In early 2007, Financial Sense described the parabolic growth occurring in unregulated derivatives since 1999;

"For the latest data ended 1H 06, the prior six month growth in worldwide OTC notional derivatives outstanding was a little in excess of $72 trillion, standing at $370 trillion as of 6/30/06, up from $298 trillion at 2005 year end. For a bit of perspective, total planet Earth did not have $72 trillion in total derivatives outstanding eight years ago, and now we're growing by that total amount in six months."

The result of this is that today we have what is called the $516 trillion shadow banking system, the "secret banking system built on derivatives and untouched by regulation" according to the worlds largest bond fund manager, Bill Gross.

Further, in getting back to the current credit crisis, here we are today, in somewhat of a repeat of the S&L deregulation followed by bailout scenario, in that we have the Glass-Steagall deregulation followed in a similar amount of time by the bailout brigade. This time though, the stakes are much higher. The great engine and facilitator (U.S. large investment banks) of the most potent financial market in the entire free world are literally reduced to begging, hat in hand, for the government to bail them out, whether via historically unprecedented access to the government's balance sheets via the Federal Reserve, via an unprecedented bailout by the U.S. government of investment banking firm Bear Stearns, or even by the apparent various forms of directly pleading for a bailout to banks. One example of the bailout plea is characterized here, via the New York Times, by Howard P. Milstein, chairman and chief executive of New York Private bank;

"If banks of all sizes could regain their capital immediately and easily, it would be a tremendous benefit to the American economy. The federal government could make this happen by entering into an arrangement with American banks that hold subprime mortgages...Here’s how it would work: The government would guarantee the principal of the mortgages for 15 years. And in exchange the banks would agree to leave their “teaser” interest rates on those loans in effect for the entire 15 years. "

In regards to the Bear Stearns bailout, according to Timothy F. Geithner, president of the Federal Reserve Bank of New York;

“We judged that a sudden, disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy,” Mr. Geithner said in prepared remarks, adding that stock markets and home prices could have fallen significantly in the event of a collapse. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings, and rising unemployment..."

Is this what we have reduced our financial system to? Where it is so weak and fragile that the failure of a single investment bank threatens a widespread financial calamity. If so, how did we let it reach this point? In my mind, extremist laissez-faire deregulation surely played a heavy part.

So where do we go from here? By no means am I advocating that we turn back time and reinstall the regulations that previously existed "as is". Further, of course regulation can just as easily go too far (see India here). Free markets are constantly evolving and innovating. Rather then always turning to deregulate though, perhaps its time to work more towards liberalization & modernization but not to the point of removing the systems of checks and balances that helped to make America the great economic power that it is. Although of course we can never know, perhaps even Reagan himself would think that deregulation has gone too far. For isn't he the one who said "Trust but verify"?


Wenqing said...

Dear Mr. Wenzel,

I do enjoy your thoughtful description of the deregulation process and its impact to the current financial crisis.

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