Wednesday, January 7, 2009


In my forthcoming book, The Myth of the Free Market: The Role of the State in a Capitalist Economy, I make it clear that government regulators had an idea what was happening, but stood by as market players promoted and took advantage of a weak regulatory environment. Knowledge of the dynamics that led to our current market meltdown goes all the way back to 1998! In a few words, the market meltdown should not be seen as a surprise, or a once in a lifetime event (as Alan Greenspan claims). The biggest players knew what was happening, and kept on pushing for more deregulation. It's hard to come to any other conclusion than these idiots saw it coming . . . What follows below is from Chapter 12 of my book.

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... [In 1998] the Federal Deposit Insurance Corporation issued a set of guidelines for member banks managing transactions that involved bundled loans that were sold as collateralized securities. Concerned that deposit-taking institutions had not exercised sufficient risk management when handling these loan contracts the F.D.I.C distributed a “Statements of Policy” at the beginning of 1998 making it clear collateralized security transactions were on their radar screen.

While it set out to reacquaint institutions with basic due diligence procedures, it also listed ways private firms could defraud F.D.I.C-backed institutions. More bluntly, the Statements of Policy (SOP) guidelines said private financial institutions weren’t always playing fair with F.D.I.C. backed institutions, especially when it came to complex financial instruments.

Among the embarrassingly basic rules of caution covered included “know your counterparty,” credit analysis, and credit limit reviews. The guidelines were so simple it was difficult to tell whether they were issued for the new finance guy at the local car dealership, or were really geared for seasoned, F.D.I.C. affiliated banking institutions.

Still, one thing stood out – in the wake of the 2008 market collapse – the 1998 SOP offered a Crow’s Nest view of what went wrong. Pointing to the tactics of subsidiaries belonging to “financially stronger and better-known firms” the SOP warns that larger corporations “may not be legally obligated to stand behind the transactions of related companies,” so the subsidiary may not be credit worthy. The F.D.I.C.’s advice? Don’t trust the other guys “character” or “integrity” until you get “the stronger firms” signature.

That this needed to be said should have raised red flags back in 1998. Incredibly, the guidelines get even more basic.

We all know when we purchase a new car we have to deal with the sales staff. We’re then shuffled off into cubicles where we have to deal with the finance and credit team, who also want to sell us stuff. There’s a reason why the dealerships keep these two positions apart. Sales staff, anxious to sell a car, will either lower credit standards or overlook red flags on a customer’s credit report. Not so in the F.D.I.C. institutions.

Apparently burned by too many conflict of interest transactions involving sales and finance pulling double duty, the F.D.I.C. found it necessary to remind banking institutions that credit evaluations for CDO transactions, for example, should be done by “individuals who routinely make credit decisions” and not those involved in sales. The F.D.I.C institutions were then provided with the incredibly sage advice that they should be on the look out for buyers who were already “overextended.”

Perhaps the greatest words of caution are saved for institutions inclined to believe CDO instruments could be used as market collateral. F.D.I.C. guidelines make it clear that simply because an institution has a CDO-affiliated instrument doesn’t mean it’s sitting on an asset whose book value is equal to its market value.

The 1998 guidelines suggests, for example, that if a $100 million CDO transaction has occurred that “experience has shown” the underlying product or contract “will not serve as protection” if the subsidiary fails, or if the firm does not have control over the security. Put more simply, the tone of the 1998 SOP guidelines tell us market players and the federal government knew that U.S. financial institutions were sitting on a financial powder keg long before the 2008 market melt down began . . .

- Mark

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