July 15, 2009
This evening’s discussion of the current financial and economic crisis will begin with an analysis of the factors which caused the crisis and , then, move on to a discussion of where we are now and conclude with a discussion of the factors that will determine where we go from here.
Causes of the Current Financial and Economic Crisis
The first major cause of the crisis was the relentless push for De-Regulation of financial markets over the last 30 years.
The push for de-regulation started during the presidency of Jimmy Carter. During its second half, the Carter administration tacked sharply rightward in both domestic and international policy. With the unrelenting urging of his Economic Czar, Alfred Kahn, Jimmy Carter implemented a wave of de-regulation across a variety of industries: the trucking industry, the airline industry, the railroad industry, and the banking and financial services industry. The de-regulation of the banking and financial industry erased rules, regulations, and guidelines that had been in place for decades.
The Carter administration’s de-regulation of the financial industry thus set the table, politically and operationally, for the de-regulatory push that would gain added momentum and scope during the next nearly 30 years.
The successor Reagan administration, in particular, and the administration of George Bush, Sr., were ideologically hostile to virtually any and all government regulation, oversight, and enforcement and moved the de-regulatory ball forward with unremitting zeal.
In addition to reining in the Securities and Exchange Commission, the Federal Deposit Insurance Corporation and other regulatory bodies from effectively carrying out their oversight and regulatory functions, the Reagan administration eviscerated long-existing anti-trust rules and regulations. This allowed enormous consolidation of power and size within the banking and financial industry as virtually all bank mergers and acquisitions were given the green light by the Reagan Justice Department. This led to the creation of mammoth financial institutions whose very size constitutes an inherent threat to the integrity and viability of the financial system and have, thus, been deemed “ too big to fail.”
The accession to power of the Democratic administration of Bill Clinton did nothing to slow, much less reverse, this de-regulatory freight train. Instead, the Clinton administration fervently backed several key measures that speeded the de-regulatory freight train along its course to inevitable catastrophe in the financial system.
The first of these measures was the repeal by Congress in 1999--- with the full and complete backing of Pres. Bill Clinton, Vice-President Al Gore and Treasury Secretary Lawrence Summers—of the Glass- Steagall Act ( This repeal was formally called the Financial Services Modernization Act.)
The Glass-Steagall Act, passed in 1933, was arguably the cornerstone of the financial reforms passed in the 1930s to correct the financial market conditions that led to the stock market crash and the Great Depression. Glass-Steagall created a firewall between commercial banking and investment banking, thus precluding any one financial institution from engaging in both sets of activities.
The repeal of Glass- Steagall in 1999 removed this crucial firewall and allowed commercial banks to go head-to-head with investment banks---- thus, propelling the commercial banks into the riskier lines of business that were previously the domain of the investment banks.
The second of the two major de-regulatory acts pushed by the Clinton administration that would prove to have such a crucial role in creating the current financial/economic crisis occurred in 2000. In 2000, with the fervent backing of Treasury Secretary Lawrence Summers, legislation was passed ( the Commodities Futures Modernization Act ) which allowed the unregulated trading of financial derivatives such as credit default swaps, which were derivative instruments that in a major way provided the financial fuel for the housing bubble. This legislation led to the explosion of the financial derivatives market so that, at the time of the implosion of the global financial markets in Sept. 2008, the total derivatives market in the U.S. was estimated to be roughly $ 750 trillion dollars------nearly 14 times the entire world’s total Gross Domestic Product of roughly 55 trillion dollars.
In addition, during the Clinton administration----- and with the full backing of the administration----- the two major government agencies involved in the housing market, Fannie Mae and Freddie Mac, moved away from their traditional exclusive focus on prime mortgages and began diverting an increasingly larger percentage of their assets to the purchase of subprime mortgages so that by the peak of the housing boom in 2005-2006 Fannie Mae and Freddie Mac were the leading purchasers in the country of subprime mortgages.
Of course, the juggernaut of de-regulation continued its headlong rush during the administration of George Bush Jr.
In 2004, the SEC overturned a rule in effect since 1975 that had required investment banks to maintain a debt-to-capital ratio of less than 15-to-1, thus limiting the amount of borrowed money and leverage investment banks could employ. The repeal of this longstanding 15-to-1 limit on leverage meant that investment banks were now free to leverage themselves to levels as high as 40-to-1. This hyper leverage not only made the investment banks more vulnerable when the housing bubble burst. It also enabled the banks to create far larger, far more complex networks of financial derivative instruments, with the result that their individual failure, or threat of failure, created systemic financial crises.
Another regulatory breakdown this decade was the failure of banking regulators to crack down on predatory lending abuses by banks and other financial institutions regarding the issuance of sub-prime loans. Such enforcement activity would have protected homeowners and would have lessened considerably the current financial crisis. Thus, between 2002-2007, the Federal Reserve only took three formal actions against subprime lenders, while the Office of the Comptroller of the Currency, which has authority over 1,800 banks, similarly took only three consumer protection enforcement actions during that same period.
The final major regulatory failure pertained to the failure of the credit rating agencies to properly perform their intended function.
In discussing this regulatory issue, one has to turn attention to another major, non-regulatory cause of the financial implosion and economic crisis. That is securitization . In order to create another source of big, fast profits from the sub-prime lending boom, Wall Street lit upon the idea of securitizing all these sub-prime mortgages. Thus, these mortgages would be sliced up into tranches to be sold primarily to institutional investors throughout the U.S. and all across the globe. These securitized packages of sub-prime loans were highly attractive to investors because of their high yields and the prevailing belief that real estate prices would never fall.
However, in order to be successfully marketed and sold, particularly to institutional investors such as pension funds and college endowments, the investment banks needed these securitized sub-prime assets to be highly rated by the credit rating agencies. In order to maintain their relationship with the banks and ensure future business with the banks, the credit agencies were only too willing to give their seal of approval, giving AAA ratings to countless packages of these extremely risky securities.
This institutional failure and conflict of interest on the part of the credit rating agencies could have been prevented by the SEC. However, the Credit Rating Agencies Reform Act of 2006 reined in and undercut the SEC’s oversight authority, thus giving the credit rating agencies carte blanche.
While not falling precisely under the de-regulatory rubric of the aforementioned events, an ancillary event that played a big part in the current financial crisis was the explosive growth of the “ shadow financial market. ‘ Specifically, during the 1990s and this decade, a huge amount of financial activity moved away from regulated and transparent markets and institutions into the lightly regulated or entirely unregulated shadow financial market comprised of hedge funds, private equity funds, mortgage brokers, off-balance sheet structured investment vehicles, and the aforementioned financial derivate market.
The pivotal role of the evisceration of the regulatory system in creating the current economic crisis provides a natural segue to a second major cause of the crisis: Alan Greenspan, who was the Chairman of the Federal Reserve Board from 1987-2006.
If there were one person, and one person only, who could be cited as a causative agent of the financial/economic crisis, that person would be Alan Greenspan.
Greenspan deserves this ignominious distinction for two reasons.
First, as a disciple of Ayn Rand and as one who fervently worshipped at the altar of the Free Market, Greenspan pushed relentlessly for the dismantling of the regulatory structure outlined above and successfully fought against the institution of any regulations regarding the exploding financial derivates market and the shadow financial market.
Second, Alan Greenspan was the prime enabler of the stock market bubble in the second half of the 1990s and the real estate bubble in this decade.
By mid-1996, it was becoming apparent that the stock market was becoming enveloped in a speculative fever. Since much of this speculative fever was coming from individual investors who were rushing headlong into technology and internet stocks, it was also apparent that one of the key ways, if not the key way, that this speculative fever could be broken would be to raise margin requirements for purchases of stock. If one buys stock ,one only has to put down 50% of the total cost of the stock and can borrow the remaining 50% on margin. If the Fed raised the margin requirement to 75-80% of the total purchase price,or to 90% or even 100% of the purchase price, the buyer of stock would then have to put down 75-100% of his own money to purchase the stock rather than being able to borrow 50% from his broker on margin. This reduction in leverage would, by definition, have reduced the buying power that, during the remainder of the 1990s, would push stock prices to absurdly overvalued levels.
Minutes of the Federal Reserve Board’s Meeting in September 1996 reveal that Alan Greenspan stated at that Meeting that raising margin requirements for stock purchases would be “ the single most effective thing the Fed could do to end the speculative excess in the stock market.”
Thus, by failing to take the step that Greenspan, himself, acknowledged would put an end to the speculative excesses in the stock market, Alan Greenspan bears the ultimate responsibility for the stock market bubble of the late 90s and for the ensuing stock market crash and recession in the early part of this decade that resulted from the inevitable bursting of the stock market bubble.
Then, in order to mitigate the fallout from the stock market plunge and the recession, Greenspan flooded the financial system with liquidity and drove down interest rates to the lowest levels since 1958. By pumping so much liquidity into the financial system and keeping interest rates so low for so long, Greenspan created the economic conditions for the creation of the housing bubble in this decade.
While Greenspan deserves blame for laying the economic foundation for the housing bubble, there were other key agents who played a critical role in creating the housing bubble.
The banks, mortgage lenders and other financial institutions effectively threw out the window any prudent lending standards or procedures. They failed to carry out any of the most basic due diligence in documenting a mortgage applicant’s income or assets, thus making loans to people who the most basic due diligence would have revealed to be clearly unqualified to purchase the house in question.
In addition, these lending institutions devised a patchwork of financially irresponsible, reckless mortgage products. No Down Payment Loans. Interest Only Loans. Negative Amortization Loans. Or Combinations of the above.
The other key agents in creating the housing bubble were the Appraisers. In countless cases, the appraisers would willfully sign off on inflated house prices, thus allowing the speculative madness to continue apace.
As one might assume, the motivating factor for the irresponsible actions of the mortgage lenders and the appraisers was money. There were big fees and commissions to be garnered from generating these toxic mortgages. If they turned bad several years down the road, that would be someone else’s problem.
And, of course, it was the bursting of the housing bubble that triggered the tsunami in the U.S. and global financial systems.
One final factor should be cited as a significant contributing factor to the current financial and economic crisis. That is the compensation system at the investment banks and other financial institutions. Specifically, the great majority of the compensation at these financial firms is comprised of bonuses rather than salary. And, the bonuses, in turn, were based on the current year’s performance. Thus, the compensation system was based upon short term rather than long-term performance of an investment, with the result that bankers were heavily incentivized financially to make increasingly risky bets regardless of their long-term consequences.
Having now analyzed the factors that led to this crisis, let’s look at where we are now and at what will determine what lies ahead.
WHERE WE ARE NOW/WHAT LIES AHEAD
While the U.S. and global financial systems have pulled back from the threat of collapse that loomed so large in September and October; while the credit markets, which is where this crisis started, have improved significantly; while the stock market, which is both a barometer and a determinant of the health of the economy, has staged an impressive upmove since March 9th; while the rate of deterioration in the overall economy has slowed down considerably, we are by no means out of the woods.
Housing foreclosures are projected to begin rising again shortly and to continue rising into 2010 and are, also, projected to hit increasingly hard in the high-end prime segment of the housing market. Delinquencies on credit card debt have been rising significantly in recent months and are projected to continue rising into 2010. The unemployment rate, currently at 9.4%, a level not seen since August 1983, is virtually guaranteed to cross the 10% threshold in the near future. And, of course, as we know the current unemployment rate is understated since it excludes discouraged workers, who, if they were included, would drive up the real unemployment rate to roughly 15%.
The decisive, forceful monetary and fiscal policy measures taken by the Federal Reserve and the government since the financial crisis exploded on Sept. 15th with the bankruptcy of Lehman Brothers deserve the lion’s share of the credit for the avoidance of a possible systemic financial collapse; for the significantly improved functioning of the credit markets, which are critical for the functioning of the overall economy; and for averting an even worse plunge in the economy than the already bad-enough downturn we have experienced to date.
However, we are now at a critical juncture. Just as it is imperative that the Federal Reserve and the government intervene quickly and powerfully at the earliest stage of a financial crisis to prevent it from cascading into a financial crash and economic Depression, so is it critical that the Fed and the government do not take their foot off the accelerator or tap on the brakes too soon.
This was a major policy error that the Fed and the Roosevelt administration made in 1936.
Virtually everyone thinks that the 1930s were an unmitigated downward financial and economic trajectory. However, in fact, the 1930s had three distinct segments.
The first segment , from the beginning of the stock market crash in the fall of 1929 through 1932 was a period of unmitigated hell that everyone associates with the worst images of the Depression and stock market crash. However, the nightmare scenario that played out during that period did so because of the policy failures of the Hoover administration and of the Federal Reserve. President Herbert Hoover and his Treasury Secretary Andrew Mellon, given their Republican laissez-faire ideology refused to provide any fiscal stimulus to the plunging economy. And, the Federal Reserve not only failed to provide the massive injection of liquidity that the financial system desperately required, but, instead, made the catastrophic policy mistake of reducing the money supply by 30% between 1930 and 1933. That was akin to failing to provide critically-needed oxygen to a patient who suffered a heart attack and, instead, putting
duct tape over his nose and mouth.
Then, in 1933, with the assumption of power by the Roosevelt administration and a new Federal Reserve chairman in place, the government and the Fed totally reversed the disastrous fiscal and monetary policies of the Hoover administration. The Roosevelt administration implemented a massive fiscal stimulus program and the Fed injected the massive doses of liquidity the financial system desperately needed. The result was that both the economy and the stock market registered solid double-digit gains from 1933 to 1936.
However, in late 1936, both the Fed and the Roosevelt administration did an about-face and took their feet off the accelerator and started applying the monetary and fiscal brakes. The result was that both the stock market and the economy renewed their decline in 1937 and 1938.
The Fed reversed course in 1936 because it was worried that the huge amount of liquidity it had pumped into the financial system could create future inflation. The Roosevelt administration reversed course because of worries about the federal budget deficits resulting from its massive federal spending.
We hear those same concerns being voiced today, mostly from Congressional Republicans and right-wing media voices, who are urging the Fed to reverse course and tighten monetary policy and urging the Obama administration to reverse course and curtail its ambitious fiscal stimulus program.
Hopefully, Fed Chairman Ben Bernanke, Treasury Secretary Tim Geithner, and President Obama do not heed these hawkish, misguided cries. If they learn from the mistakes of 1936 and do not heed those cries, then, I think there is a strong possibility the economy and the stock market will experience a stronger recovery than is anticipated. If they do heed those cries, then, we could be in for considerably more economic pain, for a considerably longer period of time.
The second major factor that is going to determine our financial and economic future is whether Congress and the Obama administration will have the political will to withstand the intense lobbying pressure---- and the inducement of big campaign contributions----- that is sure to come from the financial industry and put into effect the network of strong regulation and oversight necessary to try to ensure that we do not experience a cataclysmic financial crisis like this again.
Some of the regulatory reforms that we would need to see would be:
1) The identification and increased regulation of financial institutions that pose a systemic risk;
2) Significantly reducing the leverage that financial institutions can use;
3) Supervision of the shadow financial system of hedge funds, private equity groups, and mortgage lenders;
4) Significantly reduce the amount of financial derivatives that financial institutions can employ and require transparency of financial derivative holdings and transactions;
5) Create a new system for federal and state regulation of mortgages and other consumer credit products;
6) Reform the credit rating system;
7) Create an executive pay system at financial institutions that discourages excessive risk taking.
The next several months will be critical and will provide us with the answer as to whether Congress and the Obama administration have the political will to enact this critically-needed strong regulatory system. If they do have the will and do what is necessary, then the financial system will emerge from this crisis on a stronger and more solid footing. However, if they do not have the will to do what has to be done, then the financial system and the economy will remain vulnerable to a future crisis of equal, or greater, magnitude than the cataclysm of last fall.
Despite what may appear to be the case at first glance, because of the sheer magnitude of the 88-page proposal put forth this week, the Obama administration’s Regulatory Reform Plan is not cause for great encouragement that the fundamental structural reforms that are needed will be enacted.
A potentially major problem pertains to what is, effectively, the centerpiece of the Obama Plan: namely, significantly remaking and increasing the power and scope of the Federal Reserve to make the Fed the supreme supervisor of systemically significant financial institutions and, thus, in effect, the overall stability of the financial system. The problem with this is apparent since the Fed exercising its regulatory due diligence would be entirely dependent on the ideological and political proclivities of its members, particularly its Chairman. As the record of Alan Greenspan makes abundantly clear, if we were to have another Chairman such as Greenspan, the Fed could hardly be depended upon to prosecute vigorously its crucial regulatory functions.
Another major problem is that the Obama Plan does not deal with the type of derivatives that caused so much of the problem with derivatives in general. Specifically, it does nothing to address so-called “ bespoke derivatives “ which are customized, one-of-a-kind products, as opposed to standardized derivative products. It was the “ bespoke derivatives “ which were responsible for a disproportionate share of the financial carnage caused by financial derivatives in general.
This failure of the Obama Plan to deal with the core of the derivative problem is part of an overall problem with the Obama Plan according to a number of sources in Washington who have studied these regulatory issues thoroughly. These sources---- at the Economic Policy Institute and the Multinational Monitor, among others-----have stated that, while the “ headline proposals “ of the Obama Plan sound good, the problem is that, when you start analyzing the substance behind each of the proposals, there is a lot less than meets the eye.
And, of course, another major problem is the political process that lies ahead. The Obama proposals will be bandied about for the next few months by Congress. And, as stated previously, the banking and financial industry will be exerting enormous lobbying pressure----pressure greatly strengthened by the lure of big campaign contributions-----to water down significantly an Obama Plan that already has significant shortcomings and potential problems.