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The mess
that resulted from letting investment and commercial banking join together
after the repeal of Glass-Steagall...
CURRENTLY we find
ourselves in a mess that many are calling the most serious economic crisis
since the Great Depression – if not worse, writes Doug Hornig, editor of Big Gold for Casey Research.
A mile-high mountain of paper profits has been set ablaze and reduced to
ashes, choking investors who put their faith in houses, stocks, or
commodities, or just about anything else you care to name.
The bad news is that no one completely understands what's going on; the good
news is that, yes, a measure of sense can be made of the madness. Being armed
with that bit of understanding should enable us to survive the tsunami...even
prosper.
Glass-Steagall: the Banking Act of
1933
Until recently, average Americans were only dimly aware that there were two
types of banks – the commercial banks nearby and the major investment
banks located in faraway New York.
Understanding the bank where they conducted business, with people they knew,
was enough. The big, impersonal Wall Street banks – which dealt in
higher-risk investments with potentially higher rewards – were for
companies and the very rich only.
But while ordinary citizens thought very little about this distinction among
the banks, the government did. Seventy-five years ago, as the Depression
deepened, lawmakers were desperately trying to determine the causes of the
crisis (read, looking for scapegoats). Some of the things they found were
conflicts of interest and opportunities for fraud, all linked to the mixing
of commercial and investment banking. So Congress decided to erect a
"wall" between commercial and investment banking, and so passed the
Banking Act of 1933, usually referred to as the Glass-Steagall Act.
Glass-Steagall created the Federal Deposit Insurance Corporation (FDIC) to
protect depositors in commercial banks, and it also forbade commercial banks
from underwriting securities or acting as stockbrokers or dealers.
The Glass-Steagall Act remained in force for six-and-a-half decades, although
various deregulatory measures and changes in exchange rules chipped away at
it. Notably, in 1970 a
rule excluding public companies from membership in the New York Stock
Exchange was dropped. The last major private institution, Goldman Sachs, went
public in 1999. This allowed investment banks to sell stock to any potential
investor and greatly expand their capital base.
Over the last two decades of the 20th century, the financial industry lobbied
vigorously for the repeal of the Glass-Steagall Banking Act. In 1999, they
got their way with the enactment of the Financial Services Modernization Act.
The door was opened to consolidation in the banking industry.
With one stroke of a pen, commercial bankers could begin turning their loans
into investment products. (Glass-Steagall had prevented them from selling
debt-backed securities for which they were the underwriters.) So Wall Street
investment banks were suddenly in the mortgage business. It would prove to be
a marriage made somewhere significantly south of heaven.
Glass-Steagall: Bubble, Bubble...
We're not fans of government regulation, but a deregulated marketplace
carries with it certain imperatives. Because it will only function as it
should do in the absence of both criminal and boneheaded behavior. We can
erect oversights meant to prevent the former and laws to punish it after the
fact. But all the regulation in the world won't do much about the latter
– the bone-headed behavior of some investors – since both market
traders and the regulation itself may be boneheaded.
The biggest factor here was the removal of Glass-Steagall prohibitions, but
there were two other important tweakings. The Commodities Futures
Modernization Act of 2000, for example, transformed the new mortgage-backed
securities (MBS) into a commodity, enabling them to be traded on futures
exchanges with little oversight by any federal or state regulatory body.
Completing the trifecta, the Securities and Exchange Commission in 2004
waived its leverage rules. Previously, broker/dealer net-capital rules
limited firms to a maximum debt-to-net-capital ratio of 12 to 1. But under
the new regulations, five companies – Goldman Sachs, Merrill Lynch,
Lehman Brothers, Bear Stearns, and Morgan Stanley – were granted an
exemption, which they promptly used to lever up 20, 30, even 40 to 1.
That means $1 of equity underpinned up to $40 of investment risk. So a 2.5%
drop in asset prices would wipe out the actual cash underlying a
position...leaving only debt and losses.
Just as Congress was repealing Glass-Steagall in 1999, the tech stock bubble
was inflating beyond sustainability. It would soon be pricked, ushering in a
brief recession during which investors began the hunt for the next big thing.
Glass-Steagall: How About Housing?
Back in 1977, Congress had passed the Community Reinvestment Act, which had
the goal of extending homeownership to the largest possible pool of Americans.
Over the next 25 years, legislative supplements, a robust housing market, and
aggressive government enforcement of "fairness in lending" combined
to weaken bank standards regarding who did – or didn't – qualify
for a loan.
But that was just the beginning. In an effort to end that recession in the
new century's first years, the Greenspan Fed reduced interest rates to near
zero and poured liquidity into the financial markets. At the same time,
capital that had fled the stock market was looking for action. It found it in
housing.
The commercial banks – and independent mortgagors like Countrywide
Credit – were awash in cash. They started lending it, and every
borrower's credentials were deemed excellent, even those with low income, bad
credit, and no money for a down payment.
The perfect storm was building. But at first, boy! Did things ever look so
rosy? The country's homeownership rate – 62.1% in 1960, rising to only
64.1% in 1994 – shot up to 68.9% by 2006.
As homeowner mania seized hold of the public imagination, people began
treating their homes as ATMs. If they needed cash, they borrowed against
their growing equity. Real estate speculators flipped houses like crazy. And
why not, when there was no risk? Housing prices only head in one direction
– up, Up, UP! Right?
It sure looked that way. The yearly average median price of an existing home
went from $23,000 in 1970, to $62,200 in 1980, to $97,300 in 1990, to
$147,300 in 2000 and crested at $221,900 in 2006. Astonishingly, and despite
recessions in the early '80s and early '00s, there wasn't a single down year
for US housing as a national average in all of that time.
However, in 2007 housing became the latest bubble to burst, pricked by
unrealistic prices, overbuilding, and the retreat from ultra-low interest
rates. Concurrently, as house prices finally began to drop, a whole bunch of
those no- or low-interest loans began to reset.
Glass-Steagall: Why Do Rational
People Act So Stupid?
Despite the well-earned reputation of some Wall Street high rollers, bankers
tend not to be a reckless lot, nor financial dunces. In general, they would
rather deploy a large amount of capital into a safe, low-yield investment
than put a small amount of capital into something with very high risk.
With the new environment, however, the game changed. Commercial bankers found
themselves making loans to shakier and shakier recipients, while at the same
time, the investment banks and their clients were clamoring for new
investment products.
So bankers did what any conservative person would do. They hedged their bets.
They bundled up their loans and sold the packages to the investment banks.
The outcome was essentially the mortgage business being uprooted from the
commercial banks and transplanted into the investment houses, which have far
less restrictive requirements about reserve capital, far fewer limits on the
buying and selling of securities, and far less regulatory oversight.
The investment banks did not set out, of course, to become landlords. They
just wanted to sell some product for which there was a ready market. As
capitalist ingenuity collided with profit motive, they found there was no
shortage of products that could be created.
The mortgage bundles were sliced, diced, and repackaged into a bewildering array
of securities, such as structured investment vehicles (SIVs), collateralized
debt obligations (CDOs), mortgage-backed securities (MBSs), and on and on.
The extent of the slicing and dicing into what financial chefs refer to as
tranches was such that the original mortgage might be tossed from buyer to
buyer, or even itself split into parts. Each time a package was put together
and sold, the seller stretched to get top dollar for each tranche, requiring
the underlying assets to be risk-rated and then assigned real-world value. In
the end, rating services had little idea what they were rating (we're being
charitable here), and buyers had no idea what their purchase was really
worth.
And always lurking in the background was the possibility that defaults on the
mortgages supporting the entire process could have a profound ripple effect,
given that these products became increasingly leveraged. Knowing this,
traders invented credit default swaps (CDSs), those gnarly little creatures
that morphed into Godzilla after 2004.
CDSs are an insurance policy, a way of dealing with fear, and a device for
attenuating the risk inherent in trading products one may not fully
understand. Those buying the protection pay an upfront amount and yearly
premiums to the protection sellers, who agree in return to cover any loss to
the face value of the security. The result is a private, two-party contract,
devoid of regulatory oversight.
There are a bunch of nasty horseflies in this particular ointment. For one,
the holder of that security (who is now "protected" by a CDS) might
turn around and sell it to a third party, who might himself insure and resell
it, and so on, creating an impossibly complex chain of ownership and
obligation. Additionally, the CDS itself can be traded over the counter.
Furthermore, any of the underlying assets might also get partitioned into
different tranches, adding to the confusion. And finally, short sellers can
work on just about any joint in the structure.
And here's the really big rub. Suppose the party providing the initial
insurance protection – having already collected its upfront payment and
premiums – doesn't have the money to pay the insured buyer when a
default occurs. Or suppose the "insurer" goes bankrupt. In either
instance, the buyer who thought he was protected finds himself left naked and
alone.
However, that possibility seems not to have been considered as the financial
world created an interlocking system of derivatives that not even a Cray
supercomputer could sort out. The only certainty: it was an arrangement that
depended on a robust economy and rising house prices.
Except, of course, things didn't work out that way.
When the housing slump hit, defaults in the relatively small subprime sector
(less than 20% of mortgages) started a chain reaction that raced through the
derivatives market, the effects compounding geometrically, until finally the
world financial structure was facing collapse.
Glass-Steagall Act: Capital &
the Capitol
When capital is allocated in a free market, it moves toward the productive,
and the economy tends to prosper. By the same token, when it is misallocated,
an economy can hit the skids.
We've had decades of misallocated capital in the United States. Instead of saving,
we've been spending...and spending way beyond our means. Rather than
investing in something productive, we've been gambling, taking on ever
greater risks in the hope of the big payoff. Instead of creating the clean
balance sheets that support stability – at all levels, personal, corporate,
and governmental – we've piled up mountains of unsustainable debt.
The tragedy is that the prudent will suffer right along with the reckless.
Misallocations of capital must be unwound, one way or another, before the
economy can get back on its feet. It will be no simple task, and it's made
even more difficult by those who put themselves in charge of the clean-up:
certain residents of Washington,
D.C.
At the center of the storm are two men who propose to save the nation, and
they could hardly be more different.
Secretary of the Treasury Henry Paulson is the Street's guy. The former CEO
of Goldman Sachs, the most powerful and successful investment bank, he brings
a Wall Street insider's perspective to the table. However committed to public
service he may be, he cannot be expected to act against the interests of his
friends in the banking community.
And then there's Fed chairman Ben Bernanke, a pure academician. For better or
worse, Bernanke's specialty is America's Great Depression, and
he considers himself an expert on the subject. Above all else, he wants to be
remembered as the guy who understood how to steer the country away from the
shoals of a Second Great Depression.
But there is no question that Big Ben and Hammerin' Hank are trying to
navigate in unfamiliar waters. Today's economy hardly mirrors that of a
decade ago, much less the conditions of the 1930s. For one thing, the
Glass-Steagall Act separating commercial from investment banks has been...and
gone.
Back in the spring of 2007, as the initial cracks in the current structure
began to appear, few were expecting the broken-levee crisis that has since
unfolded. A handful of savants saw it coming and said so, but no one in the
mainstream was listening. What was actually happening was that the first dominoes
– subprime borrowers who should never have been approved – had
begun to fall.
In and of themselves, they would have been little more than straws in the
wind. But because of the multiplier effect of the derivatives market, their
influence reached far beyond a few blown mortgages. As more and more debtors
were unable to pay, mortgage-backed securities lost value. And then the
securities based on the MBSs lost value. And then the CDS written and sold
against them.
Here's where CDSs were in fact supposed to ride to the rescue. They didn't,
for the simple reason that they had long since strayed far from their
original insurance intent, and become primarily an instrument that gave
derivatives market players access to an asset class (mortgages) without having
to actually own the asset.
As MBS values were hammered by defaults on the underlying loans, buyers of
CDS protection began trying to collect. That hit CDS sellers, who were being
drained of cash. Further out, derivatives speculators who had bet the wrong
way defaulted or went bankrupt, sending shockwaves back down the line. Slowly
at first, and then with increasing speed, the capital necessary to keep the
system alive started drying up.
Glass-Steagall Act: Riding
Roughshod Across the Division of Banks
Everyone is familiar by now with the institutions that have collapsed or been
bought out or taken over by the government. The list of names is stunning:
Bear Stearns, Countrywide Credit, MBIA, Fannie Mae, Freddie Mac, AIG, Lehman
Brothers, Washington Mutual, Merrill Lynch, Wachovia. Wall Street has
undergone a transformation unimaginable a year ago. The big investment banks
are gone – bankrupted or swallowed up by someone else. Even the two
that remain standing, Goldman and J.P.Morgan, have had to reinvent themselves
as bank holding companies to save their own hides, riding still further
across the division of commercial and investment banking which Glass-Steagall
set up.
The movement of capital among financial institutions is based not only on
integrity but on confidence. Right now, that confidence has evaporated. Banks
are carrying so much paper of indeterminate value that it's impossible to
price in the risk of making a loan. So they aren't lending to each other, out
of fear that they'll never get their money back. The credit market, upon
which our economy depends, has seized up. When the government finally got
around to admitting that there was a problem, it was already too late for any
simple fix. So Washington
had only two options: stand back and let the market sort things out...or take
drastic, emergency action.
No one knows quite what to make of Washington's
response to the credit crisis. Some are howling that it's socialism, others
that it's fascism or, at best, corporatism, an unholy alliance of private
enterprise and the state.
Whatever the name, there is no question that the government is boldly going
where none has gone before, helping to bail out some financial institutions
and seizing control of others.
The Treasury Department now has $700 billion – albeit with some strings
attached – with which it can buy up toxic waste paper through the
Troubled Asset Relief Program (TARP). Taking this direction, instead of
making direct loans, allows the "assets" they buy to be resold
somewhere down the road. And perhaps, the plan's defenders say, even at a
profit. Like that's gonna happen!
Proceeding in ways never before tried, in early October the Fed announced it
was opening the Commercial Paper Funding Facility. For the first time, it
will buy unsecured paper debt. To facilitate this and to cover potential
losses, the Treasury will deposit an unspecified amount at the Fed. This is
in addition to the Treasury's own buying spree, and the Fannie Freddie
conservatorship, and the expansion of the FDIC to cover deposits up to
$250,000, a move likely to send that agency back to the Treasury for another
fill-up.
So far, however, all the government's actions to date have accomplished
precious little. For the time being, credit remains frozen. Banks are still
making overnight loans to other banks, but only very selectively. The stock
market, despite coming off its lows, is extremely volatile after enduring its
worst crash ever. Commodities have sold off. States and municipalities are
facing severe budget cuts and, in some cases, bankruptcy. Money markets are
in trouble. Pensions and retirement funds are at risk. And recession, or
worse, looms increasingly large on the horizon.
Nor is the crisis purely an American problem. Much of the US bad paper
was sold to gullible Europeans, and world economies and markets are so
interconnected that if one sneezes, someone else catches a cold. Already
there have been big bailouts in Germany
and the United Kingdom.
The Irish government recently announced it was guaranteeing all bank
deposits, which attracted a flood of money from elsewhere in the European
Union, enraged other members of the EU and raising questions of how long that
shaky confederation can endure as each country charts its own path through
the economic minefield.
This is a once-in-a-lifetime event, a train to nowhere, and it will cause no
end of suffering. Since we can't stop it, we'll do the next best thing, which
is to protect ourselves. That means assessing the likely fallout from the
government's meddling in the market, and developing guidelines for the best
way to ride out the hurricane.
Some consequences are already baked in the cake. Casey Research Chief Economist Bud Conrad has been
studying the unfolding crisis for years. Based on his work, this is what we
foresee:
- More financial institutions will collapse. So will many hedge funds.
Money market funds are also shaky; although the government will do all
it can to keep them solvent, those that invest in anything but Treasury
bills are at risk.
- The economy will fall into recession. By most lights, it's already
here. It won't be brief, and there is even a chance that despite all the
Fed's pump priming, we could drop into a depression. For however long
credit remains tight, business will be unable to function normally, and
the consumer-driven economy will grind to a halt.
- The whole structured finance model under which we've been operating
is broken. The packaging of mortgages and other forms of consumer debt
is impossible when no one will buy the packages. The trillions of
dollars of outstanding mortgage derivatives will have to be unwound
somehow.
- Without debt leverage, private equity financing is dead. Raising
money for business start-ups or expansion will be extremely challenging.
IPOs will be few and far between. Leveraged buyouts are gone. Mergers
and acquisitions will mostly be limited to distress sales.
- At best, the government will succeed at what it's trying to do,
i.e., stave off a depression, by sacrificing the dollar and allowing a
fairly high level of inflation. If we're lucky, it won't turn into
hyperinflation.
- Interest rates are going up. On the day of the coordinated,
worldwide rate cut, the Fed lowered its discount rate by 50 basis
points, yet the yield on the 10-year Treasuries rose from 3.5 to 3.7%.
The Fed's credibility is about shot, in other words, as it has debased
its own balance sheet by swapping good debt for bad. With more than half
of its reserves gone, it could itself become the subject of a Treasury
Department bailout.
- It is highly likely that the era of US economic dominance, when the
almighty Dollar served as the reserve currency of the world, is drawing
to a close.
But on the bright
side...well, there is no bright side. The hole that we've dug for ourselves
will take a while to climb out of, and it won't be easy. But at least you can
protect yourself.
Protecting your assets is not just a buzzword anymore, it's mandatory if you
want to keep yourself and your family financially safe in these tough
times...which will only get tougher in the near future.
Doug Casey
Caseyresearch.com
Doug Casey
is chairman of Casey Research, LLC., one of the nation’s oldest and
most respected organizations dedicated to providing independent investors
with unbiased research on opportunities to earn extraordinary profits by
being just ahead of the crowd. BIG GOLD,
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