Tuesday, October 27, 2009
Connecting the Dots
I connected some dots yesterday. I read an article online, and that led me to another article. That led me, in turn, to several Wikipedia entries, and when I was done, I'd discovered a few interesting connections that had not been obvious to me before. I knew most of the individual pieces of information, but I hadn't seen the big picture. I hadn't connected the dots. Here are the links to yesterday's reading list in the order that I read them. Kind of odd. The bibliography coming before the article instead of the other way around.
Obama Team Ignores Volcker at its Peril. by Bill Fleckenstein on MSN Money
Volcker Fails to Sell a Bank Strategy by Louis Uchitelle at the NY Times
Glass-Steagall Act on Wikipedia
Gramm-Leach-Bliley Act on Wikipedia
Community Reinvestment Act on Wikipedia
Some of you might see where this is leading. I chose to read the Fleckenstein article because the title intrigued me. Paul Volcker is the 82 year old former Chairman of the Federal Reserve Board under Ronald Reagan who is often credited with having had the insight and the courage to raise interest rates to rein in the runaway inflation of the Carter years. He is currently the head of the president's Economic Recovery Advisory Board. This is the same advisory board, by the way, that includes General Electric CEO Jeff Immelt. I only mention this because some of you may be familiar with this group as Glenn Beck frequently refers with derision to the potential conflict of interest that Immelt's position on the board represents. But anyway, the crux of Fleckenstein's article was basically to highlight and support the position of Louis Uchitelle's NY Times article, to wit: Paul Volcker is an advocate of re-regulating large financial institutions to limit the combination of banking, insurance, and investment activities in one enterprise, but his advice is being ignored by the Obama administration. He's essentially saying we should bring back Glass-Steagall in some form. That's a bold step, but Volcker's opinion should count for something. Volcker is saying that if Glass-Steagall hadn't been abandoned, Citigroup, and Bank of America, and many of the other huge financial conglomerates couldn't have gotten so big, and they couldn't have used FDIC guaranteed depositor's money to participate in the riskier areas of the market, essentially placing bets that would make them rich if they won, and make taxpayers poor if they lost. Or as it has been referred to elsewhere, privatizing the profits, and socializing the losses.
So here's a short history lesson. In 1933, during the Great Depression, Congress passed the Glass-Steagall Act. Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC), to guarantee the public's bank deposits and restore confidence in banks. But its main goal was to prevent a recurrence of some of the most egregious banking practices that are widely believed to have led to the market crash of 1929 and the subsequent bank failures of the 1930's. Most famous of the restrictions imposed on the banks was a prohibition on any financial institution from participating in more than one of the following three businesses: Commercial banking, investment banking, and insurance underwriting. In 1999, the Gramm-Leach-Bliley Act essentially removed these restrictions allowing the banks to incorporate the other riskier activities into their business model. So for instance, Citicorp, which used to be just a bank, could merge with insurer Travelers Group which had already merged with or bought investment houses Salomon, Shearson, and Smith Barney. Citicorp thereby became Citigroup, a huge financial behemoth, and a major participant in the recent financial meltdown.
That's the short history. The black and white version. Now let's add a little color. When financial deregulation/reform was being debated in Congress in 1999, the Senate and the House each passed their own version of the bill, and so it went to a conference committee which had a difficult time reconciling the two versions. In order to garner more Democratic support for the joint bill, Republicans agreed to measures that would strengthen the pre-existing Community Reinvestment Act (CRA). Congress originally passed the CRA in 1977 to reduce discriminatory credit practices called redlining. Banks would routinely refuse to offer loans and other banking services to residents in certain neighborhoods if those neighborhoods demonstrated a higher than acceptable default rate. Charted on a map of the community, the "bad areas" would be surrounded by a red line, hence the name. Even people and businesses that were otherwise creditworthy might be refused banking services if they lived within the red lines. Democrats argued that this effectively discriminated against low income and minority borrowers. Democrats insisted that a provision be added to the Gramm-Leach-Bliley financial reform legislation to further enhance the ability of the CRA board to influence banks to provide riskier loans in the name of equality in lending. In order to coerce banks into making loans that they did not feel were good risks, the legislation that emerged out of conference stipulated that any application from a financial institution seeking a merger, an acquisition, or additional branch expansion would not be favorably considered if any of the entities had a less than satisfactory rating on its most recent CRA exam. This tremendously increased the leverage that the CRA board had on the lending practices of banks. The CRA essentially had veto authority over any bank expansion activity. They could compel (blackmail) the banks to do their bidding as regards high risk lending or face the consequences of restrictive regulatory decisions. The CRA used this authority to promote their agenda of expanding low income and minority home ownership, by compelling banks to make risky loans that they might not otherwise have made. Further promoting these risky practices, Democrats in Congress turned a blind eye to the increasing warning signs at Fannie Mae and Freddie Mac. These were the quasi federal agencies that were buying these bad mortgages from the originating banks using funds raised by selling bonds with an implied federal guarantee. We know how that movie ended. When inflated housing prices started to decline, highly leveraged individuals started defaulting on mortgages they could never afford in the first place. Fannie and Freddie, were left holding larger and larger numbers of non performing mortgages, and soon could not make the payments on the bonds they had issued to buy these ill conceived obligations. The bonds, having an implied guarantee from the federal government, couldn't be allowed to default, so the taxpayer stepped in at huge expense to make good on the debt.
Click here to see video of Congress in denial of problems at Fannie and Freddie
The analogy of the perfect storm is inescapable. The combination of multiple factors, each posing a limited threat in and of itself, coming together at the same time to create an overwhelming disaster. The Federal Reserve lowers interest rates to aid the economic recovery from the dot.com stock market crash in 2000. Low rates promote a feeding frenzy in home purchasing creating a bubble in that market. Glass-Steagall is eliminated. That allows banks to get bigger, as in too big to fail. It allows them to take on risky investments, and do it with taxpayer (FDIC) guaranteed depositor money. The very legislation that eliminated Glass-Steagall is, by coincidence, the same legislation that puts the teeth into the CRA. Banks are compelled to make riskier and riskier loans to over-extended buyers at the height of the bubble. They are further encouraged to make these loans because Fannie and Freddie, acting under pressure from Congress, are buying them up as fast as they can. Risk takers at the big banks do their part by creating complicated and mysterious derivatives such as collateralized mortgage obligations (CMO's). Rating agencies who don't have a clue what the potential hazards are with this toxic paper bless it with a triple A credit rating. And it all works just fine until housing prices start to drop. Then it all comes crashing down. As Warren Buffet says, "Only when the tide goes out do we get to see who has been swimming naked."
I had most of this information prior to yesterday morning. I already knew about how low interest rates led to the housing bubble. I knew that banks had capitalized on the frenzy with risky loans and riskier derivatives. I knew that, with Congress' encouragement, the CRA and Fannie and Freddie had played a role, as had the rating agencies. I knew a little bit about Glass-Steagall and Gramm-Leach-Bliley. But until today, I had never seen the relationships between all these different factors. I hadn't seen the bigger picture; the flow of events; the cause and effect. I had never connected the dots.
So what happens now? Is Paul Volcker right? Should we re-regulate the financial institutions ala Glass-Steagall? Congress and the Obama administration are contemplating financial reform to ensure that something like the recent crisis doesn't happen again. They apparently favor a regime that keeps the bank structure as it is in this post Glass-Steagall world, but imposes complex layers of regulation and bureaucracy to limit the potential for a repeat disaster. Separating the entities as Volcker suggests sounds simpler. Should the KISS rule be applied here? Keep It Simple Stupid? Or was H.L. Mencken correct when he said, "For every complex problem there is an answer that is clear, simple, and wrong?" I'm not proposing an answer, just proposing the question.
Click here to hear bank analyst Chris Whalen on an alternative solution. This guy is really good. I understand about half of what he says. Starts at 49:10 into the video---about 14 minutes.
Perhaps as important as the question of how we change the regulation of the financial industry, is the question of should we change it. For many, this might be a no brainer considering what we've just been through. But when I consider the issue, I'm coming from the point of view of a libertarian. As a matter of principle, I prefer to err on the side of less government intervention in the free market as opposed to more. But what of the equally vital principle of protecting the interests of the taxpayer and the consumer? Its worthwhile to consider the merits of all the arguments. A balance must be struck between the two competing principles. If the FDIC provides a guarantee of the banks' depositor funding, then the government has an obligation to limit the risk that can be taken with taxpayer guaranteed money. Certainly, FDIC guarantees are not going away. Furthermore, if the banks, abetted by the rating agencies, provide inadequate or fraudulent disclosure of the risks they are taking with investors money, then that is surely a matter for government intervention. Laissez faire does not imply abandoning the consumer to dishonest practices on the part of the financial industry.
This is not a partisan issue. Democrats are largely to blame for the abuses associated with the Community Reinvestment Act and the lax regulation of Fannie and Freddie. But Republicans are largely responsible for Gramm-Leach-Bliley and the repeal of Glass-Steagal protections. The real culprit here is probably the financial services industry itself and the tremendous lobbying clout that it commands. The big banks also contribute heavily to both Republican and Democratic lawmakers. Both parties have been co-opted by money from the financial industry. This is more an integrity in government issue that a partisan issue. I wish I could say that I had confidence that our political class had the vision and the integrity to get this right. I do not believe they do. When the last dots are connected, my guess is we'll find ourselves well shy of a sensible resolution.