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I.
It isn’t about profit!
Conventional
explanations to the current financial crisis tend to revolve around bankers'
greed. Bankers been made scapegoats. In truth, it is the government which bears responsibility for the current
crisis.
Why
then have bankers been made scapegoats? Saisman cites a number of cases in
which federal legislators, agency heads, and commissioners have led the
movement to blame bankers, rather than government policies, for the banking
system’s failings. Selfinterest provides an obvious motive. A
question that remains to be answered is why the popular press have not
been more discerning.
If there is anything more tragic than our current banking crisis, it
is that the crisis is being blamed on the wrong group, on the
bankers, instead of on the primary culprit, government intervention. The
tragedy lies in falling to identify the fundamental cause of the problem,
thereby ensuring its continuance. Bankers are not entirely innocent of
wrongdoing in the present debacle, but to the extent that bankers have been
irresponsible, it has been primarily government intervention that has
encouraged them to be so. More widely, it is irresponsible government
policy that has made the U.S. banking crises of the past century so frequent
and seemingly so inevitable. Government has created these banking
crises—sometimes inadvertently, at other times with full
knowledge—by making it nearly impossible to practice prudent
banking. Having done so, government has then pointed to bad
banking practices as sufficient cause for still further interventions in the
industry.
Virtually every
one of the financial "innovations" which have wrecked the US
financial system have been spearheaded by the US treasury (OTC derivatives,
securitization, credit enhancements, etc…). These
"innovations" were driven by the need to "prevent the collapse
of the financial system through any means possible (including fraud)"
1) Monetary Policy
In a massive power grab, the treasury drafted a bit of legislation in 1934
called Gold Reserve Act, in which it gave itself tremendous powers at the
expense of the Federal Reserve.
The Gold Reserve Act of 1934 hijacked control of the monetary policy by:
A) Transferring possession of all the nations gold to the treasury.
B) Giving the Treasury primary responsibility for official foreign exchange
operations.
C) Creating the Exchange Stabilization Fund (ESF), a political slush fund
under "the exclusive control of the Secretary of the Treasury" with
broad statutory authority "to deal in gold, foreign exchange, and other
instruments of credit and securities"
Below is an extract from the transcript of the hearings about the Gold Reserve Act of 1934,
which show some of reactions at the time.
STATEMENT
OF WALTER W. STEWART, MEMBER OF THE FIRM OF CASE, POMEROY & CO., NEW YORK
CITY
…
Senator TOWNSEND. Would you mind stating what you think the effect of this
bill, if passed as it is now written, would be on the Federal Reserve banks?
Mr. STEWART. It seems to me to shift fundamentally the
responsibility from the Federal Reserve System to the Treasury in the only
matters in which the control of currency and credit really matter,
and that is with reference to the convertibility of the currency into gold or
in foreign exchange, and to set up a competing influence in the
operation of the stabilization fund that is equivalent to an
open-market operation. In those two respects it seems to me to nullify,
if not to scrap, the Federal Reserve System.
It not only takes that action, but in looking for some executive officer
to place the responsibility upon it finds an executive officer which is
bound to be subject to popular pressure from time to time, and of
course a single lesson which is part of the management of currency is
how frequently one has to do an unpopular thing, and the
purpose of having a central bank independent is that it should be free from
Government control, but it should have some protection in the
management of our currency against the emergency of the moment.
…
I should have thought that any executive officer [ie: secretary of the
treasury] faced with the responsibility of raising $6,000,000,000 in 6 months
had a sufficient responsibility, without adding others of a somewhat conflicting
character. I say " conflicting " deliberately, because he
is under the necessity of raising this money, and under this bill under the
necessity of maintaining the soundness of the money that he raises.
I believe that in public finance it is just as unwise to put a large
borrower in control of the currency as it has been demonstrated to be
in private finance, and any view which runs to the contrary not only
overlooks the entire experience in other countries in this matter but
overlooks our own very recent experience.
…
The CHAIRMAN. DO you see any difficulty in the Reserve bank system operating
if this were done, tranfer of the gold to the Treasury?
Mr. STEWART. Yes; I see not only the conflict that it seems to me
likely to arise, but apart from the mere shadow of itself a
mechanism functioning as a clearing agency which has not any of the authority
left for the control of the credit and currency position.
The Gold Reserve
Act Of 1934 stripped the Fed of virtually all monetary authority. While it
did recover some independence in 1951, it was never the same.
The Treasury, on the other hand, has abused its new monetary authority since
receiving it in 1934, demonstrating the folly of putting the nation largest
borrower (the treasury) in charge of protecting the value of money.
2) Over-The-Counter (OTC) derivatives
The Treasury has been active in OTC derivative markets since 1961. Thanks to
the Gold Reserve Act Of 1934, the Treasury gained the ability to conduct open
market operations (to buy and sell securities, derivatives, etc), and it has
not been squeamish about using its new authority.
When the refusal of the administration of U.S. President Lyndon B. Johnson to
pay for the Vietnam War and its Great Society programs through taxation
resulted huge budgets deficits and rampant inflation, the treasury began
intervening secretly to prop up the dollar using OTC derivatives
(forward contracts). The Fed Debate in the 1960s over
Sterilized Foreign Exchange Intervention
reveals the extent of the Treasury’s forward operations.
2. THE
EXCHANGE STABILIZATION FUND
In 1961, the Exchange Stabilization Fund (ESF) of the U.S. Treasury
began to intervene in the foreign exchange markets. Its ability to
intervene, however, was limited by its resources. In 1934, Congress had
created the ESF with the Gold Reserve Act. Congress
capitalized it with $2 billion of the profits created by that Act’s
revaluation of gold from $20.67 to $35.00 per ounce. It put the ESF under
the control of the Treasury and authorized it to intervene in the foreign
exchange markets to stabilize the value of the dollar. …
Because so much of its resources were tied up, the ESF intervened
mainly in the forward markets [The forward market is the
OVER-THE-COUNTER (OTC) financial market in contracts for future delivery]. In
that way, it would only need foreign exchange if it had to close out a
position at a loss. “Reference was made to the extent of
operations of the ESF in the forward market, as opposed to spot transactions,
and Mr. Coombs [manager of the New York Fed’s foreign exchange desk] said
the basic reason was that the ESF was short of money” (Board of
Governors 1962, p. 169). The dollar often traded at a large discount in the
forward market. The Treasury entered into commitments to furnish foreign
currencies in the future in order to reduce this discount. In doing so, it
hoped to encourage individuals to hold dollar-denominated assets by
reassuring them that the dollar would not depreciate in value.
… In an attempt to encourage Italian commercial banks to hold
dollars rather than turn them over to the central bank, the ESF entered
into $200 million in forward contracts. The forward
commitments of the ESF in lira and Swiss francs amounted to $346.6
million in early 1962.
Forward commitments, however, carried the risk of loss
if the dollar did not appreciate. Given the risk exposure due to the
size of its forward commitments, the Treasury felt that the ESF had
insufficient cash on hand. To provide it with additional cash, the Treasury
wanted the Fed to buy the ESF’s foreign currencies such as the deutsche
mark… [(The Fed agreed to do so)]
A Treasury memo (Foreign 1962; U.S. Treasury 1962b, p. 2) noted
Total resources of the Fund at the present time amount to about $340
million. Against these resources there are outstanding $222 million in
Exchange Stabilization agreements with Latin American countries, and some
additional agreements may be made from time to time. The free resources of
the Stabilization Fund are consequently quite small. . . . Spot holdings of
foreign exchange now amount to about $100 million . . . . These spot
holdings must in general be thought of as providing backing for outstanding
forward exchange contracts (currently about $340 million equivalent).
The entrance of the Federal Reserve System into foreign exchange operations
will therefore provide particularly needed resources.
While $346.6
million forward contracts might not seem like a lot today, back in 1962 it
easily made the Treasury/ESF the biggest player of OTC derivative markets.
OTC derivatives are political crack
A determined secretary of the treasury can achieve any economic outcome he
wants using OTC derivatives (in the short run). Low inflation, a strong
dollar, easy credit, low interest rates… anything is possible. Like
crack, OTC derivatives produces a “high” which allows a secretary
to (temporarily) defy economic reality.
Predictably, the use of OTC derivatives, like crack, has some rather nasty
“withdrawal symptoms”, as was discovered by the treasury in 1978.
TREASURY
CONFESSES TO STUPIDITY AND SHORTSIGHTEDNESS
A prime contemporary example of the cost of the treasury mindset to the
American taxpayer was revealed earlier this year. On 19 April 1978 Anthony M.
Solomon, Trilateral commissioner and under secretary of the treasury for
monetary affairs went cap-in-hand before the House Subcommittee on
International Trade Investment and Monetary Policy, to confess to what
Solomon called “some fairly important developments;”
that is, the treasury had lost its shirt gambling in Swiss francs since
1961. [By 1979 the Treasury had sustained total losses of $1,134.6
million as a result of its forward operations.]
Leaving the US
Treasury in control of with Exchange Stabilization Fund in the presence of an
unregulated OTC derivative market with no congressional oversight is like
leaving a pile of crack in the room of a drug addict. How can any secretary
of the treasury, in seeking to give his president what he wants (low
inflation, no recessions, etc), resist the temptation OTC derivatives offer
when there is historical precedence to justify their use? After all, dealing
with consequences of those OTC derivatives will be the problem of the next
secretary of treasury.
On that note I want to look at what happened in the 1990s. The decade began
with the apparent collapse of the financial system, as captured by the FDIC
chart below showing new bank failures.
Who would have guessed that economy would suddenly start booming, eliminating
the financial system insolvency problem? Thanks to the
“matchless” performance of Robert Rubin’s Treasury, the
1990s ended up seeing the strongest economy in recent memory.
Strangely enough, the "matchless" performance of Robert Rubin's
Treasury coincided with the rapid growth of OTC derivatives during the 1990s.
Also coincidentally, the treasury was the most vehement opponent of derivative regulation in
the 1990s.
“[Brooksley]
Born’s battle behind closed doors was epic, Kirk finds. The
members of the President’s Working Group vehemently opposed
[derivatives] regulation — especially when proposed by a
Washington outsider like Born.
“I walk into Brooksley’s office one day; the blood has drained
from her face,” says Michael Greenberger, a former top official at
the CFTC who worked closely with Born. “She’s hanging up the
telephone; she says to me: ‘That was [former Assistant Treasury
Secretary] Larry Summers. He says, “You’re
going to cause the worst financial crisis since the end of World War
II.”…
To go back to the
metaphor above, this is like returning to the drug addict’s room to
find several pounds of crack gone and the drug addict bouncing off the walls
in a euphoric craze shouting, “don’t touch the crack! It will be
a disaster if you touch the crack!”
Finally, in a June 2003 transcript, the Federal Reserve's Trading Desk (which
is also used by the Exchange Stabilization Fund) revealed that "Auctioning
derivatives is something we already have experience doing." Would
it be fair to ask exactly HOW that experience was acquired?
3) Securitization
Securatization is another “financial innovation” pioneered by the
federal government.
the
mortgage securities market was initially a government-created phenomenon. In
1968, Congress created the Government National Mortgage Association (CNMA) to
sell securities backed by mortgages guaranteed through government programs of
the Federal Housing Administration (FHA) and the Veterans Administration
(VA). One purpose was to get these mortgages off the books of the
Federal government so that the Administration would not have to keep coming
back to Congress to request increases in the debt ceiling, for these
requests created opportunities for Congress to express frustration with the
Vietnam War as part of this process of trying to trim the government’s
balance sheet, Fannie Mae was sold to private investors.
By the early 1980s, S&Ls needed a new source of funds.
They could not sell their mortgages without incurring losses that would have exposed
their insolvency. Instead, with the approval of regulators, investment
bankers concocted a scheme under which a savings and loan would pool
mortgages into securities which would be guaranteed by Freddie Mac. The
S&L would retain the security and use it as collateral to borrow in the
capital market. However unlike an outright sale of the mortgages, the
securitized mortgage transaction would not trigger a write-down of the
mortgage assets to market values. The accounting treatment of mortgage
securities, in which they were maintained at fictional book-market values,
enabled the S&Ls to keep a pretense of viability as they borrowed against
their mortgage assets, Fannie Mae soon joined Freddie Mac in undertaking
these transactions,
Thus, from the largely by anomalies in accounting treatment and
regulation. GNMA was developed in order to move mortgages off the
government’s books, even though government was still providing
guarantees against default. Congress created Freddie Macto work
around the problems caused by regulation Q and interstate banking
restrictions. And the growth in securitization by Freddie Mac and
Fannie Mae was fueled by the desire of regulators to allow S&Ls to raise
funds using their mortgage assets without having to recognize the loss in
market value on those assets. Mortgage securitization did not
emerge organically from the market. Instead, it was used by
policy makers to solve various short term problems.
Securitization failed to prop up the S&L industry.
Simply put, the
securitization was designed as a mechanism for transferring illiquid
mortgages from balances sheet of insolvent institutions to investors. It
NEVER was about “home ownership”, but always about bailing out
financial institutions (as well as the federal government’s growing
exposure to the mortgage/housing market). The real purpose of housing
legislations is as clear as day is when considering be found in their names:
The Emergency Home Finance Act of 1970
The Emergency Housing Act of 1975
The Emergency Housing Assistance Act of 1983
The Emergency Housing Assistance Act of 1988
Is home ownership an emergency?
The government's desire to patch up the banking sector has been the leading
force behind securitization. In the early 1990s, the Resolution Trust Corp
(RTC), created to deal with the Savings & Loan Crisis, took this packaging of loans to a new extreme.
The
federal government is turning increasingly to Wall Street to unload the
enormous loan portfolio it has inherited from failed savings and loans, a
strategy that some experts say looks good now but could
cost taxpayers billions of dollars over the next few years if it backfires.
Instead of selling the loans directly to investors, the Resolution
Trust Corp. is packaging loans together and selling bond-like securities
backed by income from the loans. The difference is, when the
government sells a loan, it usually takes a loss on the transaction but it
also washes its hands of the problem. Under the new plan, called
"securitization," there is a greater risk that losses could
continue to show up years from now.
…
The investments the RTC is creating are modeled after the securities
sold by institutions such as the Federal National Mortgage Association
(Fannie Mae), which are backed by conventional home mortgages, with
the monthly payments providing income to the investors.
The RTC, however, is taking this approach in an entirely
new direction with its offerings of securities backed by large
commercial loans of varying quality.
Even riskier are soon-to-be marketed RTC securities backed by
problem loans whose borrowers are not making payments or have
defaulted. Dubbed "Ritzy Maes" by Wall Street because of their
resemblance to Fannie Mae securities, the RTC bonds pay a higher rate of
return than U.S. Treasury securities.
…
4) Credit
Enhancement (turning toxic debt into AAA securities)
Credit
Enhancement refers to the process of “transforming” high risk,
impaired, loans into low risk investment grade bonds. It was the
Treasury’s “Brady Bonds” which provided Wall Street the
recipe for credit enhancement.
It was
the creation of the Brady Bond that provided the recipe for the extension of
many of these structured loans to emerging markets. A
Brady Bond is a variety of structured derivative package in which the
developing country (Mexico was the first) uses foreign exchange reserves as
equity capital to create an investment company.
... It was only the interest payments to be paid after the second year
that … carried foreign exchange and sovereign credit risk. The Brady
structure thus provided complicated market valuation, it also
provided an infinite number of possibilities for rearranging the
various pieces of the bond into more attractive cash flow structures.
… the final result would be to transform high risk, impaired,
syndicated loans of banks to Latin American governments into low risk
investment grade bonds that could be sold to institutional investors,
with a profit from the credit rating differential as well as fees and commissions.
This is called credit enhancement, and investment banks
quickly extended the Brady principle to other types of developing country
debt. …
… Again, the result was that US institutional investor funds were
being invested in emerging market debt, earning above market interest rates,
without their balance sheets necessarily reflecting the actual risk involved.
…
…
Eric de Carbonnel
Market Skeptics
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