Monday, December 8, 2008


In one of my previous posts, “Market Stupidity: An Act of God?” I made it clear that we had solid evidence that private market players were cheating FDIC-backed institutions as far back as 1998. The primary method for cheating these taxpayer-backed institutions was tied to complex financial instruments (CDOs) that were really nothing more than bets. These bets were then backed by insurance-like products (CDSs) that accepted money but offered little to no insurance.

If we’re looking for an analogy think about betting on a football team. You don’t own the team, but you have a vested interest in how the team does. But you become a gambling addict and start betting on all the college games too. You've got a problem. Then imagine going out and getting insurance for your bets. Your bookie encourages it all. Sounds kind of shady, right? It is/was.

So, how did we get to this point? While there’s enough blame to go around, I’ve made it clear in previous posts that on a general level we can start with a business and political culture that supported debt, bailouts, and deregulation. I’ve discussed the history of debt and bailouts elsewhere. In this post I’ll focus on four deregulation "developments" that paved the way for America’s private players to destroy the American economy.

1. 1980s, THE “GENIE ACTS”: In the early 1980s the financial industry received what amounted to 3 wishes from Congress. Among these wishes were legislation that allowed the Savings & Loan industry to sell the home mortgage contracts they had on the books at both a loss, and a profit. How can this be, you ask? Simple, by allowing S&Ls to write-off their losses the U.S. Congress effectively stuck the American taxpayer with industry losses. IMPACT: This propped up the secondary market, where many of the messy mortgage loans that plague our economy today picked up steam.

2.1987, THE “LET-THE BANKS-DO-WHAT-THEY-WANT” ACT: In 1987 the Federal Reserve granted commercial banks – which are FDIC insured – the authority to invest in (“underwrite”) new municipal and mortgage-related securities. In effect they said, “Sure, go ahead and invest your money … it’s not like you’re playing with taxpayer money.” Ooops. IMPACT: The commercial banking sector slowly came to depend on mortgage backed assets – which many blame for this current economic mess – as their primary earning tool, jumping from about 28 percent of bank earnings in 1985 to more than 60 percent in 2005

3. 1999, “LET’S-DO-1929-ALL-OVER-AGAIN-ACT”: Also known as the Financial Services Modernization Act (FSMA). After the stock market crashed in 1929 federal officials learned that commercial banks were “investing” depositor’s money as if they were investment banks, and with little regard for their client’s financial security. Insurance companies got into the act too. So Congress enacted the Glass-Steagall Act in 1933 to forever banish commercial banks and insurance companies from acting like investment banks in the future. IMPACT: By allowing insurance companies, commercial banks, and investment banks to get into each others business, the Financial Services Modernization Act killed Glass-Steagall, and helped heat up a financial feeding frenzy.

4. 2004, HANK PAULSON DOES A NUMBER ON AMERICA: In 2004 Goldman Sach’s then CEO, Hank Paulson, led a then powerful group of financial players into SEC’s offices. They were looking for a break. They wanted the SEC to allow them to “invest” beyond a debt-equity ratio of 12 to 1. They needed to become more competitive, so they said. Their request was granted. When Bear Stearns and Merrill Lynch collapsed they had debt to equity ratios of 33: 1 and 40: 1. Is it any wonder that Hank Paulson wanted a free hand to distribute taxpayer money? He’s also trying to clean up his role in the mess.IMPACT: When the SEC said "yes" to Paulson's request they effectively said it was OK to run up debt on market bets on dubious (and largely unregulated) products. We now have a new market equation: Deregulation + Debt = Bailout.
So this is what we have. America’s secondary markets get a deregulatory shot in the arm from favorable legislation in the early 1980s. Commercial banks see this and want to try their luck in the Mortgage Backed Securities market. The feds oblige them. Other financial institutions see that more profits can be made with more deregulation. So they get Congress to repeal Glass-Steagall. This eliminates fire walls and effectively takes us back to 1929. Hank Paulson and friends then get the SEC to allow them to borrow, gamble and run up debt like drunken sailors (the CDS market grew from about $1 trillion in 2000 to between $45-65 trillion by 2006).

There’s more. Lot’s more (which I discuss in my forthcoming book, The Myth of the Free Market). But the point here is that the financial mess we see before us was caused by greedy people acting like idiots.

On the positive side this tells us that Alan Greenspan's contention that the US has been hit by some kind of uncontrollable "once-in-a-lifetime" event is way off-base. We do have control over this stuff. Greenspan is only trying to absolve himself when he makes statements like this.

It will be expensive, but we can fix this.

- Mark

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