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There's been a lot of talk lately that the financial crisis was caused by a "failure of Capitalism," and that the solution is more regulation.
I believe government policies were the primary cause of the crisis, and that more regulation will make things worse, not better. I found a very interesting hour-long talk by John Allison, formerly CEO of BB&T Bank (a large bank in the southeast), where he lays out an argument that supports this view, and thought it might be of interest to summarize it here. In case you're not familiar with Allison, he's one of the few good and honest bankers out there.
http://www.youtube.com/watch?v=aSxA-vtjRx0
Federal Reserve
The government effectively nationalized the monetary system in 1913 with the creation of the Fed. Now that the government owns and controls the monetary system, so if there's a problem, they must be involved.
Before the Fed, most banks were leveraged about 1:1. After the Fed, commercial banks were leveraged 10:1, and investment banks were 30:1.
In the early stages of the crisis, residential real estate values fell by 20% in the US. That destroyed $500B+ in capital in the financial services industry. At 10:1 leverage, that destroyed $5 trillion in liquidity (lending capacity). Appx $200B of that capital was eventually replaced, though, so the net loss of liquidity was about $3T. There is a fear now of another $100B decline in RE values, which would be another $1T loss of liquidity.
Starting in the 1960s, the Vietnam war plus Johnson's Great Society plus a desire to not raise taxes resulted in the government using the Fed to print much more money. That eventually led to high inflation in the early 80s. Savings & Loans financed fixed rate mortgages with certificates of deposit (CDs). When interest rates were raised to fight inflation, the S&Ls costs went up hugely on the liability (CD) side, and they got killed; many S&Ls failed, eventually leading to the S&L crisis.
FDIC
When WaMu went under, the FDIC covered uninsured depositors, which caused WaMu debt holders to suffer huge losses. As a result, the capital markets for banks were effectively destroyed, since investors saw that they had no legal rights with regard to the Treasury, the Fed and the FDIC.
Pick-a-payment (negative amortization) mortgages were a product that was only made possible by the guarantees afforded by the FDIC. All of the major players have failed (Countrywide, WaMu, Golden West).
During the S&L crisis in the 80s, the FSLIC forced S&Ls to hedge their interest rate risk. However, that can't be done with home mortgages, since the banks can't force a prepayment. When interest rates eventually fell, the S&Ls lost billions more on their hedge positions. The FSLIC also strongly encouraged S&Ls to enter the commercial RE business. Since they had no experience in that business, even more S&Ls failed in the early 90s.
Housing Policy
When Fannie Mae and Freddie Mac (F&F) first came on the scene in the post-early-90s market, they drove many financial intermediaries out of prime mortage markets, due to the government guarantees on debt that F&F had, which their competitors did not.
The Community Housing Act (CRA), passed by Congress, required 50% of F&F's portfolios to be in "affordable housing" -- which caused huge market distortions.
F&F were leveraged 1000:1 before they went broke, at which time they owed $5 trillion. That leverage, combined with the Federal guarantees, made their cost of capital well below their competitors'. As time went on, they also drove competitors out of the subprime market too, and pushed some of them, like Golden West, into the pick-a-payment business.
F&F made the broker origination model possible. Brokers fed Countrywide, WaMu, etc, who then fed F&F to meet "affordable housing" goals, which helped keep their support in Congress.
F&F are huge political contributors. Combined with the political desire to push "affordable housing," it was impossible to take any meaningul action against them, in spite of the fact that it was obvious years in advance that they were going broke.
Investment bankers created financial innovations under the belief that the Fed would keep the risk in the financial markets low. Eventually, the originate and sell model replaced originate and hold. Perverse incentives were created for originators, which encouraged first sloppiness, then outright fraud. On top of that, the ratings agencies made huge ratings mistakes. The investment bankers make irresponsible decisions based on "greedy", dumb, pragmatic thinking: i.e. short-term: irrational / lacks integrity / evasion / arrogance.
SEC
The SEC sets the accounting rules used by banks and large financial institutions. Changes in accounting policies artificially created fluctations in accounting results.
One of their rule changes was "fair value accounting," also known as mark-to-market. This concept is not in keeping with a free market, because it assumes a willing buyer, but not a willing seller. The result was that banks had to mark down assets to the value that deep-discounters were willing to pay, rather than keeping them at what they would be worth when the banks were willing to sell.
This impaired the market, because potential buyers couldn't be sure that huge markdowns wouldn't be required after they bought something; it generated accounting risk.
If fair value accounting was applied to all businesses in the US at year end 2009 as applied to financial intermediaries, 90% of them would be insolvent, given the lack of liquidity in the markets.
Another accounting system issue is the management of loan loss reserves. The normal policy is to build up reserves in good times. But the SEC forced the use of mathematical models which prevented that approach. The models looked back at past experience. As a result, banks had very low loan losses going into the crisis. Many initial losses happened as a result of raising loss reserves -- which would not have happened if not for the SEC.
The ratings agencies (S&P, Moody's and Fitch) are a government sanctioned monopoly, backed by the SEC. They did a terrible job rating mortgage instruments. The market responded by saying maybe they also failed at rating all sorts of other securities; there was a loss of confidence in the rating system, and liquidity suffered as a result.
As an example, in the Auction Rate Municipal Bond Market insurance companies MBIA and Ambac provided funds to municipal projects such as hospital expansions. They also held a lot of mortgage debt. When mortgage debt ratings were found faulty, Ambac and MBIA's ratings remained AAA -- a failure of the ratings agencies. When this was noticed by the market, the source of funds for the insurance agencies dried up. Without sound ratings, how would an overseas investor expect to know whether some municipal project was financially sound?
The rating agencies also failed when it came to CDOs and related credit instruments. Investment banks split them into separately saleable groups. They were making money selling A, B and C traunches. Then the Fed inverted the yield curve. Borrowing short at a high yield in order to buy long at a lower yield meant there would be a loss.
The only assets the banks could hold that had a positive spread were the high-yielding Cs. The banks thought "the economy is projected to do well; just hold the Cs for now and sell them later." But the traunches were not rated correctly: A, B and C were really D-, F and F-. When the market started coming down, there were 100% losses on the Cs. Merrill Lynch, for example, got caught in this and took huge losses.
Misregulation, not deregulation
Regulatory cost was at an all-time high at the peak of the bubble in 2005 - 2007. Sarbanes Oxley (SOX) was supposed to eliminate fraud in the wake of WorldCom and Enron -- but the banking industry already had their own version of SOX imposed back in 1990 in response to the S&L crisis.
The banking industry spends about $5B/yr complying with the Patriot Act. No terrorists have been captured as a result, nor are any likely to be in the future.
There is an irrational belief in "models"; the risk in the tails of the assumed Gaussian curve aren't as small as the math would lead you to believe. Also, a 1% chance of something happening doesn't mean it will never happen.
Models don't capture human behavior, particularly under stress. The Fed's models did not predict a recession, much less one of the current magnitude. Wachovia and Citigroup both failed when using models to manage risk.
BASEL uses models to determine how much cash banks should hold. As a result, European banks had much less capital than US banks, so they went down even faster.
Regulatory compliance is a huge misdirection of management energy -- away from running their businesses effectively and safely to making bureaucrats happy who know little or nothing about the industry.
Banks regulators have actually tightened lending standards. The myth is that regulators are trying to encourage banks to make more loans. That might be true for the people at the top, but not the regulators. If you're a regulator, the worst thing that can happen is for one of your banks to get into trouble. So, there's a perverse incentive: be extremely conservative, including tightening credit standards.
I believe government policies were the primary cause of the crisis, and that more regulation will make things worse, not better. I found a very interesting hour-long talk by John Allison, formerly CEO of BB&T Bank (a large bank in the southeast), where he lays out an argument that supports this view, and thought it might be of interest to summarize it here. In case you're not familiar with Allison, he's one of the few good and honest bankers out there.
http://www.youtube.com/watch?v=aSxA-vtjRx0
Federal Reserve
The government effectively nationalized the monetary system in 1913 with the creation of the Fed. Now that the government owns and controls the monetary system, so if there's a problem, they must be involved.
Before the Fed, most banks were leveraged about 1:1. After the Fed, commercial banks were leveraged 10:1, and investment banks were 30:1.
In the early stages of the crisis, residential real estate values fell by 20% in the US. That destroyed $500B+ in capital in the financial services industry. At 10:1 leverage, that destroyed $5 trillion in liquidity (lending capacity). Appx $200B of that capital was eventually replaced, though, so the net loss of liquidity was about $3T. There is a fear now of another $100B decline in RE values, which would be another $1T loss of liquidity.
Starting in the 1960s, the Vietnam war plus Johnson's Great Society plus a desire to not raise taxes resulted in the government using the Fed to print much more money. That eventually led to high inflation in the early 80s. Savings & Loans financed fixed rate mortgages with certificates of deposit (CDs). When interest rates were raised to fight inflation, the S&Ls costs went up hugely on the liability (CD) side, and they got killed; many S&Ls failed, eventually leading to the S&L crisis.
FDIC
When WaMu went under, the FDIC covered uninsured depositors, which caused WaMu debt holders to suffer huge losses. As a result, the capital markets for banks were effectively destroyed, since investors saw that they had no legal rights with regard to the Treasury, the Fed and the FDIC.
Pick-a-payment (negative amortization) mortgages were a product that was only made possible by the guarantees afforded by the FDIC. All of the major players have failed (Countrywide, WaMu, Golden West).
During the S&L crisis in the 80s, the FSLIC forced S&Ls to hedge their interest rate risk. However, that can't be done with home mortgages, since the banks can't force a prepayment. When interest rates eventually fell, the S&Ls lost billions more on their hedge positions. The FSLIC also strongly encouraged S&Ls to enter the commercial RE business. Since they had no experience in that business, even more S&Ls failed in the early 90s.
Housing Policy
When Fannie Mae and Freddie Mac (F&F) first came on the scene in the post-early-90s market, they drove many financial intermediaries out of prime mortage markets, due to the government guarantees on debt that F&F had, which their competitors did not.
The Community Housing Act (CRA), passed by Congress, required 50% of F&F's portfolios to be in "affordable housing" -- which caused huge market distortions.
F&F were leveraged 1000:1 before they went broke, at which time they owed $5 trillion. That leverage, combined with the Federal guarantees, made their cost of capital well below their competitors'. As time went on, they also drove competitors out of the subprime market too, and pushed some of them, like Golden West, into the pick-a-payment business.
F&F made the broker origination model possible. Brokers fed Countrywide, WaMu, etc, who then fed F&F to meet "affordable housing" goals, which helped keep their support in Congress.
F&F are huge political contributors. Combined with the political desire to push "affordable housing," it was impossible to take any meaningul action against them, in spite of the fact that it was obvious years in advance that they were going broke.
Investment bankers created financial innovations under the belief that the Fed would keep the risk in the financial markets low. Eventually, the originate and sell model replaced originate and hold. Perverse incentives were created for originators, which encouraged first sloppiness, then outright fraud. On top of that, the ratings agencies made huge ratings mistakes. The investment bankers make irresponsible decisions based on "greedy", dumb, pragmatic thinking: i.e. short-term: irrational / lacks integrity / evasion / arrogance.
SEC
The SEC sets the accounting rules used by banks and large financial institutions. Changes in accounting policies artificially created fluctations in accounting results.
One of their rule changes was "fair value accounting," also known as mark-to-market. This concept is not in keeping with a free market, because it assumes a willing buyer, but not a willing seller. The result was that banks had to mark down assets to the value that deep-discounters were willing to pay, rather than keeping them at what they would be worth when the banks were willing to sell.
This impaired the market, because potential buyers couldn't be sure that huge markdowns wouldn't be required after they bought something; it generated accounting risk.
If fair value accounting was applied to all businesses in the US at year end 2009 as applied to financial intermediaries, 90% of them would be insolvent, given the lack of liquidity in the markets.
Another accounting system issue is the management of loan loss reserves. The normal policy is to build up reserves in good times. But the SEC forced the use of mathematical models which prevented that approach. The models looked back at past experience. As a result, banks had very low loan losses going into the crisis. Many initial losses happened as a result of raising loss reserves -- which would not have happened if not for the SEC.
The ratings agencies (S&P, Moody's and Fitch) are a government sanctioned monopoly, backed by the SEC. They did a terrible job rating mortgage instruments. The market responded by saying maybe they also failed at rating all sorts of other securities; there was a loss of confidence in the rating system, and liquidity suffered as a result.
As an example, in the Auction Rate Municipal Bond Market insurance companies MBIA and Ambac provided funds to municipal projects such as hospital expansions. They also held a lot of mortgage debt. When mortgage debt ratings were found faulty, Ambac and MBIA's ratings remained AAA -- a failure of the ratings agencies. When this was noticed by the market, the source of funds for the insurance agencies dried up. Without sound ratings, how would an overseas investor expect to know whether some municipal project was financially sound?
The rating agencies also failed when it came to CDOs and related credit instruments. Investment banks split them into separately saleable groups. They were making money selling A, B and C traunches. Then the Fed inverted the yield curve. Borrowing short at a high yield in order to buy long at a lower yield meant there would be a loss.
The only assets the banks could hold that had a positive spread were the high-yielding Cs. The banks thought "the economy is projected to do well; just hold the Cs for now and sell them later." But the traunches were not rated correctly: A, B and C were really D-, F and F-. When the market started coming down, there were 100% losses on the Cs. Merrill Lynch, for example, got caught in this and took huge losses.
Misregulation, not deregulation
Regulatory cost was at an all-time high at the peak of the bubble in 2005 - 2007. Sarbanes Oxley (SOX) was supposed to eliminate fraud in the wake of WorldCom and Enron -- but the banking industry already had their own version of SOX imposed back in 1990 in response to the S&L crisis.
The banking industry spends about $5B/yr complying with the Patriot Act. No terrorists have been captured as a result, nor are any likely to be in the future.
There is an irrational belief in "models"; the risk in the tails of the assumed Gaussian curve aren't as small as the math would lead you to believe. Also, a 1% chance of something happening doesn't mean it will never happen.
Models don't capture human behavior, particularly under stress. The Fed's models did not predict a recession, much less one of the current magnitude. Wachovia and Citigroup both failed when using models to manage risk.
BASEL uses models to determine how much cash banks should hold. As a result, European banks had much less capital than US banks, so they went down even faster.
Regulatory compliance is a huge misdirection of management energy -- away from running their businesses effectively and safely to making bureaucrats happy who know little or nothing about the industry.
Banks regulators have actually tightened lending standards. The myth is that regulators are trying to encourage banks to make more loans. That might be true for the people at the top, but not the regulators. If you're a regulator, the worst thing that can happen is for one of your banks to get into trouble. So, there's a perverse incentive: be extremely conservative, including tightening credit standards.
Are all bankers, or most bankers, or only a few bankers good and honest? I'd like to know before I make my next savings deposit.
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