The Credit Bubble: Deregulation Gone Wild
West Berlin, Germany, June 12, 1987:
...if you seek liberalization: Come here to this gate! Mr. Gorbachev, open this gate! Mr. Gorbachev, tear down this wall!
Just a moment in time later, November 9, 1989, the wall did come down. From just one personal account pulled from the web;
...Looking around, I saw an indescribable joy in people's faces. It was the end of the government telling people what not to do.
For the role that America and Ronald Reagan played in that, it represented to many a moment that came to symbolize the best of what America had to offer. There's another side though, the economic one and specifically deregulation of the financial industry, where the aftermath of the transformational presidency that was Ronald Reagan hasn't exactly gone as planned. In regards to the current financial crisis described by many as the worst in multiple generations, billionaire investor George Soros stated here:
The cause of the current troubles dates back to 1980, when U.S. President Ronald Reagan and U.K. Prime Minister Margaret Thatcher came to power, Soros said. It was during this time that borrowing ballooned and regulation of banks and financial markets became less stringent. These leaders, Soros said, believed that markets are self-correcting, meaning that if prices get out of whack, they will eventually revert to historical norms. Instead, this laissez-faire attitude created the current housing bubble, which in turn led to the seizing up of credit markets...
Soros further opines elsewhere:
...regulations have been progressively relaxed until they have practically disappeared.
Let us take a journey just a bit deeper into that process. Note the similar themes in the episodes examined and how if one were to simply substitute a few words here and there, one might mistakenly think that the current credit crisis is being described. Whether attributed to South American philosopher George Santaya, or to Winston Churchill, "those who fail to learn from history are doomed to repeat it" sums it up just about right here.
One of the first targets of financial system deregulation in the Reagan administration was savings banks and commercial banks. As told by the FDIC:
December, 1982--Garn - St Germain Depository Institutions Act of 1982 enacted. This Reagan Administration initiative is designed to complete the process of giving expanded powers to federally chartered S&Ls and enables them to diversify their activities with the view of increasing profits. Major provisions include: elimination of deposit interest rate ceilings; elimination of the previous statutory limit on loan to value ratio; and expansion of the asset powers of federal S&Ls by permitting up to 40% of assets in commercial mortgages, up to 30% of assets in consumer loans, up to 10% of assets in commercial loans, and up to 10% of assets in commercial leases.
Among other things, some of which were surely helpful in order to adapt to market realities, according to the Social Studies Help Center, the effects of this bill were as follows:
- Deregulation practically eliminated the distinction between commercial and savings banks.
- Deregulation caused a rapid growth of savings banks and S&L's that now made all types of non homeowner related loans. Now that S%L's could tap into the huge profit centers of commercial real estate investments and credit card issuing many entrepreneurs looked to the loosely regulated S&L's as a profit making center.
- As the eighties wore on the economy appeared to grow. Interest rates continued to go up as well as real estate speculation. The real estate market was in what is known as a "boom" mode. Many S&L's took advantage of the lack of supervision and regulations to make highly speculative investments, in many cases loaning more money then they really should.
- When the real estate market crashed, and it did so in dramatic fashion, the S&L's were crushed. They now owned properties that they had paid enormous amounts of money for but weren't worth a fraction of what they paid. Many went bankrupt, losing their depositors money. This was known as the S&L Crisis.
- In 1980 the US had 4,600 thrifts, by 1988 mergers and bankruptcies left 3000. By the mid 1990's less than 2000 survived.
In less then 7 years after the initiation of this major banking deregulation, in February of 1989, President Bush (the first of course) unveiled the S&L bailout plan. As the Help Center puts it;
The S&L crisis cost about 600 Billion dollars in "bailouts." This is 1500 dollars from every man woman and child in the US.
Meanwhile, just a few years before the S&L crisis culminated in a massive U.S. taxpayer bailout, the deregulators, undeterred, had set their sight on a far bigger prize, the elimination of barriers between investment banks and commercial banks, as represented by the Glass-Steagall act, which was put in place as a response to the stock market crash of 1929 and the ensuing Great Depression. Just months before the famous Reagan Berlin Wall speech noted above, the Federal Reserve began to set the stage, acting against the objections of its Chairman. Note how precient some of the comments from 1987 are for today's situation. As chronicled here by Frontline:
In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies. Volcker is unconvinced, and expresses his fear that lenders will recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. For many critics, it boiled down to the issue of two different cultures - a culture of risk which was the securities business, and a culture of protection of deposits which was the culture of banking.
Later in 1987 though, the deregulation proponents get a powerful new voice. In August 1987, Ronald Reagan appoints Ayn Rand disciple and strong believer in Laissez-faire markets, Alan Greenspan to become chairman of the Federal Reserve Board, thereby setting in place a series of events that would ultimately lead to the financial industry tearing down its Glass-Steagall wall. Unlike the wonders of the elimination of the Berlin Wall though, the results here were far less positive. Lets follow a few of the tidbits as told once again by Frontline:
In January 1989, the Fed Board approves an application by J.P. Morgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole.
In 1990, J.P. Morgan becomes the first bank to receive permission from the Federal Reserve to underwrite securities.
In 1991, the Bush administration puts forward a repeal proposal, winning support of both the House and Senate Banking Committees, but the House again defeats the bill in a full vote.
In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting.
In August 1997, the Fed eliminates many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The Board states that the risks of underwriting had proven to be "manageable," and says banks would have the right to acquire securities firms outright.
In 1997, Bankers Trust (now owned by Deutsche Bank) buys the investment bank Alex. Brown & Co., becoming the first U.S. bank to acquire a securities firm.
In 1998, the stakes are raised, as the financial industry goes for the juggular. Again from Frontline:
On April 6, 1998, Weill and Reed announce a $70 billion stock swap merging Travelers (which owned the investment house Salomon Smith Barney) and Citicorp (the parent of Citibank), to create Citigroup Inc., the world's largest financial services company, in what was the biggest corporate merger in history. The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law....Following the merger announcement on April 6, 1998, Weill immediately plunges into a public-relations and lobbying campaign for the repeal of Glass-Steagall and passage of new financial services legislation.
Ultimately, the efforts succeeded:
After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic.
Fresh off of this "victory", incredulously, the man who was charged with being the banking systems chief regulator, Fed Chairman Alan Greenspan continued to lead the charge towards a completely unregulated financial system as he turned his sites towards championing the growth of unregulated derivatives. From a February 2000 New York Times article:
The Federal Reserve chairman, Alan Greenspan, urged Congress today to encourage the growth of complex financial contracts known as derivatives...United States laws impede its development, Mr. Greenspan said in testimony...
The ensuing years saw the accelerating phenomenon where, with the last major regulatory impediment removed, and more importantly perhaps, not replaced with any form of updated regulation, the credit bubble accelerated, fueled heavily by the explosive growth in unregulated derivatives. In early 2007, Financial Sense described the parabolic growth occurring in unregulated derivatives since 1999:
For the latest data ended 1H 06, the prior six month growth in worldwide OTC notional derivatives outstanding was a little in excess of $72 trillion, standing at $370 trillion as of 6/30/06, up from $298 trillion at 2005 year end. For a bit of perspective, total planet Earth did not have $72 trillion in total derivatives outstanding eight years ago, and now we're growing by that total amount in six months.
The result of this is that today we have what is called the $516 trillion shadow banking system, the "secret banking system built on derivatives and untouched by regulation" according to the worlds largest bond fund manager, Bill Gross.
Further, in getting back to the current credit crisis, here we are today, in somewhat of a repeat of the S&L deregulation followed by bailout scenario, in that we have the Glass-Steagall deregulation followed in a similar amount of time by the bailout brigade. This time though, the stakes are much higher. The great engine and facilitator (U.S. large investment banks) of the most potent financial market in the entire free world are literally reduced to begging, hat in hand, for the government to bail them out, whether via historically unprecedented access to the government's balance sheets via the Federal Reserve, via an unprecedented bailout by the U.S. government of investment banking firm Bear Stearns, or even by the apparent various forms of directly pleading for a bailout to banks. One example of the bailout plea is characterized here, via the New York Times, by Howard P. Milstein, chairman and chief executive of New York Private bank:
If banks of all sizes could regain their capital immediately and easily, it would be a tremendous benefit to the American economy. The federal government could make this happen by entering into an arrangement with American banks that hold subprime mortgages...Here’s how it would work: The government would guarantee the principal of the mortgages for 15 years. And in exchange the banks would agree to leave their “teaser” interest rates on those loans in effect for the entire 15 years.
In regards to the Bear Stearns bailout, according to Timothy F. Geithner, president of the Federal Reserve Bank of New York:
"We judged that a sudden, disorderly failure of Bear would have brought with it unpredictable but severe consequences for the functioning of the broader financial system and the broader economy," Mr. Geithner said in prepared remarks, adding that stock markets and home prices could have fallen significantly in the event of a collapse. Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings, and rising unemployment...
Is this what we have reduced our financial system to? Where it is so weak and fragile that the failure of a single investment bank threatens a widespread financial calamity. If so, how did we let it reach this point? In my mind, extremist laissez-faire deregulation surely played a heavy part.So where do we go from here? By no means am I advocating that we turn back time and reinstall the regulations that previously existed "as is".
Further, of course regulation can just as easily go too far (see India here). Free markets are constantly evolving and innovating. Rather then always turning to deregulate though, perhaps its time to work more towards liberalization & modernization but not to the point of removing the systems of checks and balances that helped to make America the great economic power that it is.
Although of course we can never know, perhaps even Reagan himself would think that deregulation has gone too far. For isn't he the one who said "Trust but verify"?
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This article has 24 comments:
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mrtaxx
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47 Comments
My Website
Apr 06 05:05 AMSo it's suggested that people, mortgage co.'s and banks etc. who may have commited fraud by enhancing their income on mortgage applications and doing whatever other shnanagins they did, should get away with it, get great mortgage rates and all the other American taxpayers should pay for it. Now that's simply wrong because their problems should not be my problems and the problems on honest people and bankers. However I would not mind this 15 year plan being done if those who committed fraud and other shananagins and wanted to live and stay in their homes gave up their appreciaition in those homes in full or to some extent after the 15 years to pay back the reduction they received in interest rates by the rates not being increased after the teaser rate period ended.
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Mark Wenzel
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3 Comments
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Apr 06 07:28 AM"So it's suggested that people, mortgage co.'s and banks etc. who may have commited fraud by enhancing their income on mortgage applications and doing whatever other shnanagins they did, should get away with it, get great mortgage rates and all the other American taxpayers should pay for it. Now that's simply wrong"
Also, the quote that you mention in your response is from a bank chief executive (see above). I was using it as an example of what the deregulation that the banks fought so hard for has resulted in for them.
As for the answers, it looks probable that some sort of bailout will occur. If so, I'm just suggesting that whether they believe it or not, some sort of checks and balances on investment banks in terms of standardization, increased transparency, capital requirements, etc. as well as some increased diligence in enforcing existing regulations (fed choosing to basically ignore mortgage shenanigans) at all banks will help everybody, taxpayers and the banking system.
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iThinkBig
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1003 Comments
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Apr 06 07:34 AM-
peterthepainter
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82 Comments
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Apr 06 08:48 AMwe sit here like birds in the wilderness - gobsmacked!
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runner
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5 Comments
Apr 06 09:30 AM-
lindlou
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9 Comments
Apr 06 09:46 AM-
WeezieBenobi
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9 Comments
Apr 06 11:58 AMUntil there is some real teeth and real consequences (as in jail time, fines exceeding the payout and barring from the financial industry) this behavior will continue. Having Uncle Sam subsidize this lemonade stand isn't going to make the kids play fair.
Socialize the risk, but privatize the profits. The sad thing is that they're using the 'poor homeowner' and the 'average American' as the rally point; omitting that this bailout will do far more to impoverish the country than letting things go its natural way.
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easyed
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3 Comments
Apr 06 12:37 PMshifting the blame to free market Leaders. If he told the truth he would point out that Carter & the Donkey Congress forced Financial Co.'s to make loans to people in spite of poor credit history. Which of course Backfired like most Govt. interference in Markets.
As Adolf Hitler said: Tell a lie, loud & often, & the masses will beleve it to be the Truth.
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Mark Wenzel
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3 Comments
My Website
Apr 06 01:20 PM"Carter & the Donkey Congress forced Financial Co.'s to make loans to people in spite of poor credit history."
Good point. Both sides of the aisle were aboard for this though, and the idea is not without merit, i.e. helping the less advantageous. My belief though, is that these types of initiatives make it even more imperative that the regulators are both diligent and empowered to regulate. Appointing an idealogue like Greenspan to chairman of the Fed, and then having both sides of the aisle reappoint him seems to me a bit like appointing an athiest to head a church...doesn't make any sense (I'm not at all commenting on Mr. Greenspan's religious beliefs, just simply making an analogy). How about a game of "who said that";
"And so what are the barriers that we can deal with here in Washington? Well, probably the single barrier to first-time homeownership is high down payments. "
"We want 5.5 million more homeowners by..."
"I've asked Congress to fully fund an American Dream down payment fund which will help a low-income family to qualify to buy"
"I called upon the private sector to help us and help the home buyers. We need more capital in the private markets for first-time, low-income buyers"
...George W. Bush June, 2002
www.whitehouse.gov/new...
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William Eichler
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10 Comments
Apr 06 01:30 PMespecially...it is gone. Perhaps the government will bankrupt the issuers of the debt it took on from private parties...one can hope.
Obviously some new rules need to be established...perhaps over-
sight should be concentrated. As always, the S&L scandal being the poster-child for this, government aid for failure but no limits on economic behavior eventually leads to disaster.
This is inherent to free-market testing of economic behavior. It is not a condemnation of Capitalism that extremes are reached [that would be like complaining about your weather because it got too hot or too cold]. It is something to be aware of and to be avoided...not an easy task, for regulators or Capitalists.
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Chrisfs
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1 Comment
Apr 06 01:42 PMAnd BTW what's been happening to rating companies ?
Standard and Poors and the lot, those "very sophisicated" companies that rated some of those tranches as basically high quality goods. Where is the economic fallout for them that's suppose to be the market's enforcement mechanism against crappy rating companies?
A fanatical belief in either Communism or Free Markets is doomed to cause disaster for everyone while fanatics sit around and chant "it's not our fault, it's not our fault". Neo-cons and Libertarians are the present day Bolsheviks
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sivere
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123 Comments
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Apr 06 02:49 PMWe, the taxpayers are going to pay no matter how badly things get messed up. This is the responsibility. The constitution gives us (through our representatives) the authority. Let's use it.
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Kunst
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711 Comments
Apr 06 03:29 PMThe root of much of America's financial woes is continual deficit spending, in good times and bad. As a result we are up to our eyeballs in debt and hugely dependent on our creditors, not all of whom may always have our best interests at heart. This poses a mortal danger to our future, but both politicians and the public continue to live in fantasyland. The end result will be very unpleasant.
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Regulate
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7 Comments
Apr 06 03:32 PM-
"Magazine-Cover-Indicator" Indi...
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40 Comments
Apr 06 04:03 PM-
gramps2
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113 Comments
Apr 06 05:22 PMBefore you start expanding regulatory power, you need to ask why the regulators made almost no use of their existing powers. You need to establish that existing powers are insufficient -- as opposed to just unused.
Even if you make the Fed into an absolute dictator, what good would it do if they don't use their powers (for good)?
The problem isn't deregulation (which never happened except on paper). The problem is the regulations we already have were not enforced.
The government had to choose between collecting higher taxes on bubble homes, or enforcing the existing rules. The government repeatedly chose higher taxes by turning a blind eye to a problem they knew about all to well.
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Chris Marshall
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52 Comments
Apr 07 04:33 AMIf the Treasury stands behind the debt, the Government has greater debt and will, eventually raise taxes to reduce the deficit.
If they do nothing, the debt falls to its true value, banks and monolines fold, and equities/ bonds/pensions fall in value. This means higher pension contributions for the consumer, among other things.
This is without the effect of unemployment, and lack of confidence, on the markets.
Some form of action needs to be taken against the executives, to curb the excessive risk profiles of the banks. I would suggest letting a regional bank and a small investment fold as warnings, and try the executives under SOX.
Ultimately players will only change their risk/reward views, if the risk is being jailed,fined, and barred from the industry, on their release.
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flow5
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408 Comments
Apr 07 10:28 AMTo gauge the significant size of this agency's activity, in 1935 the total book value of equity capital (including the RFC investment) for all commercial banks was $3.6 billion. New RFC bank investment effectively ended by late 1935, and banks gradually REPURCHASES the government's stock out of their earnings (privatize) when the banks subsequently returned to profitability...& others.
This article opened up "pandora's box". Keynes & his desciples maintained that commercial banks were financial intermediaries. So this Keynesian interpretation inspired the enactment of the DIDMCA of March 31st 1980.
This act provided the legal basis to convert 38,000 financial intermediaries into 38,000 commercial banks. Lending by commercial banks is inflationary. Lending by financial intermediaries is not.
But the "show stopper" is that today, legal reserves are no longer binding. But the obstruction is bigger.
The Act didn't provide direct control over the volume of legal reserves & reserve ratios of all money creating institutions, e.g., pass-thru's: Interbank demand deposits (IBDDs) owned by the repondent banks, held by correspondent banks, and redeposited with the Reserve banks. In order to prevent the PYRAMIDING of reserves, a 100% reserve ratio would have to be applied to these accounts.
In due course, under this Act, our means-of-payment money supply will swell, until it approximates M-3. I.e, since 1942, money creation is a system process. I.e., no bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand. This is the process by which the primary money supply is evolving.
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flow5
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408 Comments
Apr 07 11:44 AMOriginators frequently realized losses on the principle, through acceptance & substitution, based on the terms of a new loan (maximum of 80% of appraised value). The scope of operations translated into current figures, would be loans to 10 million homeowners, for $1.4 trillion (equal to all existing subprime mortgages).
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cromag
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31 Comments
Apr 07 11:11 PM-
Refuse to buy overpriced
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8 Comments
Apr 08 09:18 PMWatch for a buyers strike that will bring the economy to its knees. I make 80K/year, I have 110K in savings, and a credit score of 780. I was considering buying a house, until Congress began talking about a price fix. Now I absolutely refuse to buyor even rent. I will live in a tent in the woods and save my money until Congress abadons its attempt at a price fix. Its the principal. Millions for defense, not one penny in tribute!
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richard McDonough
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1 Comment
Oct 10 02:45 PM-
LisaLisa47
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2 Comments
My Website
Oct 19 01:14 AMThe odds are that sadly, none of the people who were involved in the whole mortgage mess will be prosecuted. And yes, there were, are and always will be a double standard, because if this had all been initiated, and promoted by the Republican Party, you know darn well that they would have been indicted and convicted by a jury of their peers.
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LisaLisa47
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2 Comments
My Website
Oct 19 01:20 AMHmmm...I wouldn't believe any of his words, knowing some of his other, less-than-credible statements -- including one that he believes he is God. Uh-huh...right. The man belongs in a padded cell and a straight jacket.