You Can’t Fix What You Don’t Understand:
How the Government Helped the Banks and Hedge Funds Wreck the Financial System
The crash of 2008 was foreseeable and preventable. Red flags were everywhere, but were ignored by the Greenspan led Federal Reserve as it pumped money into a classic asset bubble while the Comptroller of the Currency and the SEC stood by. Make no mistake. The Fed and the regulators responsible for overseeing our capital markets knew what was happening. They understood the dangers created by the enormous amounts of derivatives being traded between the few mega financial institutions which had come to dominate the United States financial services industry. They recognized the risks which were posed by the huge amounts of capital deployed by the unregulated hedge funds whose financial dealings were not open to scrutiny. They did not keep their knowledge secret, but routinely testified on these matters before Congress which, characteristically, did nothing.
The inflation and explosion of asset bubbles is not mysterious. Economists have identified scores, dating from the tulip mania and crash in Holland in the 1700s. The Crash of 1929 and the Great Depression of the 1930s resulted in the imposition of a comprehensive regulatory scheme over the securities industry and the separation of the brokerage and banking industries by the Glass-Steagall Act. The purpose of Glass-Steagall was to insulate each of these segments of the financial services industry from the risks attendant to the other’s business, and to insure that institutions in both industries were adequately capitalized. Investment banking and brokerage were separated from commercial and merchant banking. The federal government insured bank deposits up to certain limits and regulated participating banks to make sure that they did not engage in the kinds of unsound lending practices which would threaten them.
The Crash of 2008 occurred because the regulatory framework created in the 1930s was deliberately dismantled. By the turn of the century, the financial services industry was dominated by a handful of international banks offering a full range of banking, brokerage, investment banking and management services. The SEC had become a training ground for lawyers and accountants anxious to depart for high paying jobs in the private sector, run by bureaucrats who paid lip service to the integrity and efficiency of the financial markets but did nothing to protect them. Our financial system had become the plaything of a too-powerful central banker pumping excess cash into the system while issuing vague and meaningless pronouncements designed to obscure what was really going on. This was the result of decades of deregulation, repeal of Glass-Steagall, lax enforcement of existing laws, huge loopholes in SEC regulations, and the deliberate failure to impose any meaningful regulation on derivatives trading or the activities of hedge funds.
We cannot stop with the bland explanation that the Crash of 2008 was caused by the subprime lending crisis, though that is where the bubble was weakest. The subprime crisis occurred because mortgage bankers created loan products with substantial and unappreciated risks, failed to create underwriting standards appropriate to those products and in many cases, relaxed existing underwriting standards.1 The predicable result of this was an unusually high number of bad loans, which ultimately affected the entire financial system because the loans were securitized and sold to institutional investors. The mega banks and hedge funds then magnified these risks exponentially by selling each other credit default swaps (“CDSs”), the aggregate face amount of which is over $55 Trillion, more than four times the United States’ annual GDP. The uncertainty and doubt created by those risks, and the fact that they had been magnified and dispersed by CDS trading, lead to the collapse of Bear Stearns, then to the bailout of AIG and the adoption of the $700 Billion TARP in October, 2008.
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Following the dot-com bust and stock market decline, the Federal Reserve intentionally increased the money supply, lowering interest rates and keeping them at or near record lows. The continual lowering of interest rates and expansion of the money supply by the Fed provided the impetus for serial refinancing by homeowners, who could not resist lowering their payments at the same time that they cashed out some of their equity. Real estate prices skyrocketed at rates and to levels which were obviously not sustainable. Consumers were encouraged to “unlock their equity” to remodel their homes, send their kids to college, purchase cars and buy shoddy consumer goods manufactured in Asian sweatshops. The rise in the real estate prices and consumer spending of all this unlocked equity fueled the rise in all asset prices, including the stock market.
The nature of bubbles is that they burst. This one was no exception. In mid 2007, the default rate of subprime mortgages began to increase, particularly the “no doc” or “low doc” loans which could be obtained without verification of the borrower’s income. Some of these went into default even before a single payment was made. This did not come as a surprise to anyone with a rudimentary knowledge of the mortgage banking industry. The Office of the Comptroller of the Currency (“OCC”), among others, had warned the banks that subprime loans and the so called “non traditional” mortgage products such as interest only and negative amortization loans carried risks which the banks had ignored. The bankers knew that underwriting standards had deteriorated. In fact, the existence of products like the “no doc” and “low doc” loan actually institutionalized this deterioration by creating loan products which were underwritten according to standards which omitted crucial criteria and processes, such as verification of income and assessment of the borrower’s ability to make loan payments after the expiration of a low “teaser rate.”
Concerned by the rising defaults, the investment banks and hedge funds stopped buying new mortgages, and the commercial banks were caught with the last batch of risky mortgages they hadn’t sold yet. So they and the other banks which had provided financing to fund the subprime mortgages began to take steps to protect themselves. They made margin calls on the mortgage bankers under their warehouse lines, requiring them to put up additional cash. At the same time, and for the same reason, it became almost impossible to sell and securitize subprime mortgages. With no source of funding, and no ability to sell loans, subprime loans became unavailable. Other loans were affected as well. Alt-A loans, those which were from prime borrowers but were above the limit on loans purchased by Freddie Mac and Fannie May, also became unavailable. Real estate prices began to fall back down again. Thousands of new homes went unpurchased because financing was unavailable.
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The loans, good and bad, prime and subprime, had been sold as pools by commercial banks and mortgage brokers to investment banks and hedge funds, who had earned billions in fees by securitizing and selling them to investors. In the securitization process, the pools were divided into tranches. Interests in the individual tranches would then be sold to investors. For example, starting with a $100 million pool, a senior tranche of $10 million would be created with an interest rate of 5%. Although it represented 10% of the pool, it would have the right to receive greater than a 10% share of distributions until the stated return had been paid. The remaining 90% would then have a greater rate of return, subordinated to the right of the senior tranche to receive its return. The process would then be repeated one or more times, with the remaining 90%, creating another senior and junior tranche. This has been referred to as “slicing and dicing.” In reality, the practice has more resemblance to putting the loan pools through a Cuisinart, cutting them up into so many pieces that no one was sure how the defaults on the bad loans would flow down to affect the various tranches. Even worse, the securitization and tranching process cast doubt on who had the ability to modify or renegotiate loans to avoid foreclosure.
Once the mortgage profit machine was running smoothly, banks also used the money pumped into the system by the Fed to create pools of auto loans and credit card debt which they also securitized into multi-tranche pools. Like real estate loans, these were sold to institutional investors, including other banks. It was cheaper, and far easier, for them to acquire securitized interests in pools of asset backed securities (called “Collateralized Debt Obligations” or “CDOs”) than it was to generate the assets themselves.
The “mark to market” accounting rules require banks holding securities value the securities which they hold at the “market” price. This focuses the valuation on what would be realized in a sale of the security. Because these are “Level 3” assets with no trading market, the banks holding these securities are required to arrive at a “fair value” using a model based entirely on assumptions. This would almost be funny if the results weren’t so sad. Prior to the subprime crisis, the banks generally held these securities at “par” and were forced to drastically revalue them because it became clear that these valuations could not be justified.
The flaw in the “mark to market” rule is that it focuses entirely on what the assets could be sold for, and does not permit even an alternative valuation which focuses on reality. The reality is that these “toxic” assets are not being held for sale. The real value of a pool of loans to a holder who cannot sell them is the cash flow which they will generate, discounted to present value. It should not be difficult to arrive at an estimate of this value, particularly for financial institutions used to making these kinds of determinations. The banks are correct that that they are prohibited from doing this by the inflexibility of the mark to market rules. The SEC, which has jurisdiction to suspend and/or alter these rules on an emergency basis, has refused to do so. Congress, which is aware of this issue, is unable or unwilling to act.
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The battle to eviscerate and ultimately repeal Glass-Steagal began in late 1970s. In those halcyon days, customers went to a bank for deposit and checking accounts and home mortgages and other loans, and to a brokerage firm for investments and investment banking. The abolition of fixed commission rates in 1975 unleashed competition in the brokerage industry. New products proliferated, including money market funds with checking privileges. In the high interest rate environment of the late 1970s and early 1980s, banks could not compete with these new products and suffered from “disintermediation” as funds moved from bank deposit accounts to money market funds. They fought back by creating deposit accounts which mimicked the products, such as money market checking accounts, which the brokerage industry was using effectively to capture deposits, and by offering brokerage services in bank branches through affiliates.
By the mid-1990s, the landscape had been transformed. Though Glass-Steagall had not yet been repealed, regulators succumbing to bank pressure had effectively eviscerated it by interpreting the law to allow banks to engage fully in those businesses through affiliated or controlled entities. One stop shopping for banking and brokerage services had become common, as had bank ownership of brokerage firms and brokerage firm ownership of banks.
The repeal of Glass-Steagall in 2000 went beyond simply legalizing what had been standard operating procedure for some time. It affirmatively prohibited the SEC from regulating the so-called “derivatives” which Warren Buffet has famously and correctly termed “weapons of financial mass destruction.” As their name suggests, derivatives are securities which are based on other securities or commodities or indexes. Derivatives, unlike other securities, do not raise or increase capital. They are two party contracts in which one party pays now for the other’s (called the counterparty) agreement to do something in the future, based upon the price of the underlying securities, commodities or indexes. The original purpose of derivatives was to hedge risk. Someone who owns, or has the right to purchase an asset, at a particular price, sells the right to acquire the asset to a third party at a set price. The consideration received effectively reduces the seller’s cost of the asset, reducing the capital at risk. At the same time, the buyer is protected from a rise in price in the asset without actually acquiring it, because he has the right, but not the obligation, to buy the underlying asset at the strike price. Put and call options are examples of simple derivatives.
In the 1990s, banks began to use complex derivatives to hedge against the risks which were created by fluctuating interest rates. By that time, almost all assets (loans) held by banks carried variable interest rates. When interest rates were rising, the rates on deposits would rise faster than the rates on loans, compressing the “spread” – the difference between the rate paid on deposits and the amount earned on loans. Derivatives were useful to address these kinds of problems. However, since the mid 1990s, derivatives have been increasingly traded by hedge funds and other pools of capital not to hedge risk, but for speculation and for the billions of dollars in fees which they generate for the banks that issue them. The phenomenal growth of derivatives trading was well known. Official reports of the Office of the Comptroller of the Currency, issued quarterly describe in detail the growth of outstanding derivatives from $17 trillion in 1995 to over $175 trillion on June 30, 2008 and the billions in fees earned by the five major banks which were responsible for over 95% of derivatives trading.
Yes, trillions. That’s because a large portion of these derivatives were bought for speculative purposes by hedge funds and other investors who had no interest in the underlying assets. Others were bought by the mega banks in order to hedge the risk from their sale of derivatives to their customers or simply for speculation. The result of this practice is that the face amount of the total outstanding derivatives, the “notional” amount, is many times the value of the underlying assets. The banks and hedge funds have so-called “netting” agreements between them which are supposed to provide a mechanism for arriving at a “net” derivative liability between the parties to the netting agreement. The OCC tracks the notional amount of derivatives issued and then tries to calculate the total exposure to loss from derivatives trading according to data supplied by the banks which calculate their “true” exposure after taking into account “netting” agreements. However, the hedge funds are not required to report this information to the OCC, so the OCC has only one side of many transactions and no information at all on many others. This makes its reporting anecdotal at best and useless at worst.
The most dangerous derivative is the “Credit Default Swap” or “CDS” – essentially insurance against a default of the underlying debt security. The security holder enters into a contract with a counterparty which provides specified protection in the event of default. The counterparty then enters into a similar contract with third party in order to hedge the risk which it undertook, creating “swap” of risk. This “swapping” process is then repeated as the third party enters into a CDS with a fourth party and so on.
CDSs are not traded on exchanges. They are negotiated and traded in the over the counter market by approximately a dozen global banks, hedge funds and insurance companies centered in New York and London. CDSs are often traded by hedge funds which do not own the underlying debt. A hedge fund purchasing a CDS on bonds which it does not own has “shorted” that debt security, speculating that it will go into default. An institution which issues a CDS is betting that the underlying debt will not go into default. Because of the risk swap daisy chain, the “notional” amount of the CDSs issued on the debt of a typical issuer of corporate debt, is a multiple of the face amount of the underlying debt securities. The International Swaps and Derivatives Association estimates the notional value of outstanding CDSs issued by FDIC insured institutions at $55 trillion as of June 30, 2008, more than 4 times the United States’ $13 trillion annual GDP and more than five times the total national debt. The actual amount is greater than this because, as with other derivatives, CDSs issued by hedge funds and foreign banks are not included.
Derivatives, especially CDSs, were touted as ways of reducing risk and enhancing the efficiency of securities and commodities markets. Alan Greenspan literally gushed about them in his testimony before the Senate in 2000: “These instruments allow users to unbundle risks and allocate them to the investors most willing and able to assume them.” This is the kind of bullshit Greenspan made his career on. It sounds good. You separate all the risks and then enter into agreements with other parties to assume the risks that you “unbundled.” You pay a premium to that person, just like insurance, for protection against the specified risk for a period of time. Sounds like insurance, right? The difference is that the person you are paying to assume the risk has nobody looking over their shoulder to make sure that they can pay you if the event that you insured against happens. Instead of figuring out and attempting to quantify the risk which it has agreed to pay you for, your counterparty goes to a third party and buys protection on the same or a similar risk. The fatal flaw in this model is that the risk doesn’t go away, although everyone acts as if it had. The unbundled risk is still there, it’s just been transferred around like a kited check. The likelihood that the risk will occur hasn’t lessened. In fact, a new risk has been created – the risk that your counterparty won’t be able to perform.
CDSs became the Achilles heel of the financial system because they magnified by exponential factors the liability associated with the underlying debt. Nobody really knows the amount of the underlying debt affected, but it is clearly a small fraction of the almost unimaginable $55 trillion in outstanding CDSs. We also know that not all of the underlying debt will go into default, and that even loans which do go into default are usually not a complete loss. However, by multiplying existing risk and creating the new risk of counterparty failure to perform, the issuance of CDSs on mortgage and asset backed debt securities exposed the financial system to systemic risk – the risk that a failure of one institution could threaten the functioning of the system.
The financial environment promoted the spread and abuse of CDSs and other derivatives because they were virtually unregulated. They remained that way because derivatives trading generates billions of dollars every quarter for the banks. OCC reports show that banks generated $6 billion from derivatives trading in the third quarter of 2008 alone, even as the credit markets froze and the stock market crashed.
By the late 1990s, both the SEC and the Commodity Futures Trading Commission were making noises about imposing regulation on derivatives trading, but the industries’ benefactors in Congress made sure that the SEC wouldn’t interfere, passing the Gram-Leach-Bliley Act which specifically prevented the SEC from enacting regulation on CDS trading. Greenspan led opposition to bringing derivatives under the umbrella of the Commodity Futures Trading Commission, testifying before Congress that this would “…create risks to counterparties in OTC contracts and, indeed, to our financial system that simply are unacceptable.” Greenspan didn’t see fit to explain how regulation of CDSs or other derivatives would create those risks. In fact, the opposite was true. Failure to regulate CDSs permitted the banks, hedge funds and insurance companies to buy, sell and trade CDSs without any interest in the underlying debt, permitting investors to speculate on whether the issuers of the debt would default. It also allowed the banks, hedge funds and insurance companies to issue CDSs without adequately reserving (if they reserved at all) for claims which might be made under the CDSs which they had issued.
The failure to regulate CDSs prevented anyone from determining with any degree or accuracy the totality of the risks which had been “unbundled” and who would ultimately bear responsibility in the event of a default. This was perhaps the single most important factor in precipitating the liquidity crisis which led to the Crash of 2008. Bear Stearns, weakened by the failure of one of its hedge funds in the summer of 2007, collapsed in March 2008 when counterparties to its CDSs became concerned that it would not be able to perform. They requested “novations” – the substitution of another party for Bear under the CDSs which it had issued. Although Bear Stearns had hedged CDSs which it had issued with CDSs from other banks, the mega banks and hedge funds which participated in the CDS risk-kiting daisy chain weren’t stupid. They knew that the unbundled risk was somewhere. They also knew what they didn’t know – that they had no idea where the kited risk would land.
The banks and the regulators knew that the failure of one of the dozen or so CDS dealers and traders would cause the failure of others which would lead to a collapse of financial markets. They all knew that the notional amount of CDSs were many times the ultimate liability. They were aware of the OCC’s calculations of the net derivative liability of the banks they regulated, but they also knew that this was only part of the picture and that foreign banks, hedge funds and insurance companies were not included. In short, they knew there was a lot they didn’t know and that’s why they were so nervous. That’s why they acted so quickly when Bear began to fail, essentially forcing the sale of bear to JPMorgan Chase at price so absurdly low that it had to be renegotiated a week later.
The near failure of Bear and its sale to JPMorgan Chase signaled to all the fragility of the system and its vulnerability to the vicissitudes of the CDS market. Liquidity in the financial system is supplied by short term interbank borrowings. This allows banks to keep on hand only the cash which they need, lending excess cash to other banks and borrowing from other banks when necessary. Fearing a collapse of one or more other CDSs dealers, the banks began to hoard cash. This had eerie similarities to the Fall of 1929, when banks began to withdraw funds from the call market. The bailout of AIG in September did nothing to instill confidence. It was seen not as a sign that the government would intervene if necessary, but as confirmation that future failures were likely. Banks continued to hoard cash. The highly leveraged hedge funds had nowhere to look for cash other than sales of listed securities, increasing downward pressure on stock prices.
Fearful that a complete collapse of the financial system was imminent, Federal Reserve Chairman Bernanke and Treasury Secretary Paulson slapped together a plan to infuse $700 billion into the banking system by purchasing “troubled” assets. The government would buy the asset backed securities which were in default, or likely to default. The CDS market would calm down because participants would know that defaults were less likely. The taxpayers would get paid back because the asset backed securities would be bought for less than the present value of the income stream they would generate. It sounded good but it didn’t work because no quick and easy way could be found to value the assets which would be acquired. The $700 billion allocated was of no good to the financial system sitting in the Fed’s accounts. The medicine would be of no use until it was injected and the patient seemed near death.
Paulson and Bernanke realized that this strategy wouldn’t work and abandoned it in favor of a plan to inject capital by buying redeemable preferred stock, starting with an infusion of approximately $100 billion into Bank of America, JPMorgan Chase, Citigroup and Wells Fargo on October 28, 2008. Though this was supposed to unfreeze the credit markets by freeing up cash for loans, there were no requirements as to how the money was to be spent. Not a single one. Unlike the voting preferred stock the Bank of England bought in British banks, the stock Paulson and Bernanke bought in U.S. banks has no voting power, so they have no control over how the banks use that money. This plan hasn’t worked either. Although interest rates on conforming real estate loans are low, funds are scarce and non-conforming loans are expensive and hard to get. Commercial loans are still hard to get as the banks increasingly tighten standards.
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We have looked to the bankers who are at the controls of the financial system to clean up the mess which they created. Predictably, those bankers have done everything they can to protect the banks from realizing the losses which everyone knows are floating around the financial system. The Paulson-Bernanke plan did not work because it did not require realization of the underlying losses or specify amounts of additional lending. Instead, it provided capital on a no questions asked basis to cover losses estimated under the “mark to market” rules. Efforts to revive the system must be based on recognition of reality. That means losses must be realized, not postponed. Delinquent loans must be renegotiated or foreclosed and the resulting losses must be realized by the security owners. It will then be clear which banks require capital infusions and, more importantly, how much they need.
Two simple modifications of bankruptcy law and securities regulation could accomplish this quickly. Congress should pass pending legislation which would give bankruptcy judges the express power to reduce, or “cram down” the amount of mortgages to the value of the underlying real estate. It should also amend the “mark to market” rules to provide financial institutions the flexibility to value CDOs not held for sale at the estimated net present value of the income stream which they will produce.
The TARP capital infusions have encouraged the recipient banks to delay realization of losses, the exact opposite of what needs to happen. The losses will not go away and everyone knows it. The magnitude of the actual losses is not known, and cannot be known until the losses are realized. What needs to be done is simple. These two simple changes will not cost billions in taxpayer money. They should be implemented immediately, before another $300 billion, or $500 billion, is shoveled out in yet another ill-conceived, futile effort to delay the inevitable. Once the losses are realized, we can sort out which banks need saving and whether saving them will be worth the price.