Tuesday, March 27, 2012

Financial crisis: the result of increasing leverage and decreasing financial regulation

By co-incidence, both Bill Gross, a famous bond fund manager for PIMCO, and Bill Black, a well-known law professor, recently wrote about long-term trends in the financial markets.  Mr. Gross wrote about increasing leverage.  Mr. Black wrote about decreasing financial regulation.

The reason I am highlighting what they wrote is the trend of increasing leverage was reinforced by decreasing financial regulation.

As Mr. Gross said,
Whether you date it from the beginning of fractional reserve and central banking in the early 20th century, the debasement of gold in the 1930s, or the initiation of Bretton Woods and the coordinated dollar and gold standard that followed for nearly three decades after WWII, the trend towards financial leverage has been ever upward. 
The abandonment of gold and embracement of dollar based credit by Nixon in the early 1970s was certainly a leveraging landmark as was the deregulation of Glass-Steagall by a Democratic Clinton administration in the late 1990s, and elsewhere globally. 
And almost always, the private sector was more than willing to play the game, inventing new forms of credit, loosely known as derivatives, which avoided the concept of conservative reserve banking altogether. 
Although there were accidents along the way such as the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late 1990s, the Dot-coms, and ultimately global subprime ownership, financial institutions and market participants learned that policymakers would support the system, and most individual participants, by extending credit, lowering interest rates, expanding deficits, and deregulating in order to keep economies ticking. 
Please note that what Mr. Gross describes as being learned about how policymakers and financial regulators would support the system is all post the Federal Reserve's effort to break the back of inflation in the early 1980s.  Clearly, that effort led to a recession.

However, that inflation fighting effort plus the Regan presidency set in place the conditions necessary for the policymakers and financial regulators to pursue the support of the system Mr. Gross describes.

In his description of financial deregulation, Mr. Black starts with the Regan presidency and its contribution to ending financial regulation.  He then recounts the deregulatory efforts under both Republican and Democratic administrations.

The Garn-St Germain Act of 1982, which deregulated savings and loans (S&Ls) and helped drive the debacle, was passed with virtually no opposition.... 
The Competitive Equality in Banking Act of 1987 (CEBA) was the product of two cynical political deals. The context was that the Reagan administration refused to allow the Federal Savings and Loan Insurance Corporation (FSLIC) to admit that there was a crisis requiring governmental funds and refused to allow FSLIC to draw any funds on its Treasury credit line.  
We have certainly come a long way since then in the willingness to use taxpayer funds.
We had spent all but $500 million in the FSLIC fund closing some of the worst S&L control frauds.  The S&L industry had over $1 trillion in liabilities and was deeply insolvent, so we were running the insurance fund on fumes and dreading a potential nationwide run.... 
A potential run because depositors might think that the government was not going to back the deposit guarantee provided through the FSLIC.

Had the government simply reaffirmed its backing of the fund, there would have been no need to worry about a run on the S&Ls and the regulators would have been better positioned to deal with the insolvent firms.

Instead, the government pursued a policy endorsed by the industry.
The S&L control frauds saw the FSLIC recapitalization bill as an opportunity. They had disproportionate political power because political interference was their best guarantee of delaying our closure of their S&L. My contemporaneous joke was that the frauds’ always obtained their highest return on assets from their political contributions.... 
The first political deal was between the frauds and the League. It was called the “Faustian bargain.” The League agreed to support “forbearance” provisions drafted by the frauds’ lawyers that were cleverly designed to make it difficult for us to take enforcement actions and appoint receivers. The frauds agreed to stall passage of the bill and to support the League’s proposed reduction in FICO bond issuances to $5 billion.... 
The second cynical deal was struck in 1987 by the Reagan administration and Speaker Wright. Wright agreed to withdraw his opposition to the $15 billion size of the FICO bond issuance. Treasury Secretary Baker agreed that the administration would not reappoint Edwin Gray as Chairman of the Federal Home Loan Bank Board (Bank Board) and that the administration would not oppose the forbearance provisions, drafted by the frauds’ lawyers, which the House had added to the bill.... 
Ultimately of course, most of the insolvent S&Ls had to be closed.
In 1993, “Reinventing Government” had total bipartisan support. Vice President Al Gore led the Clinton administration effort. Reinventing government was premised on the view that government was a failure and the private sector was a success that the public sector should emulate. I will mention only two of the anti-regulatory policies that it led to in banking. 
In 1993, the Clinton administration killed the Bank Board’s loan underwriting rules that had proven successful and essential in stopping the S&L debacle and suing and prosecuting the control frauds that drove the crisis. The old rule is what we used in 1990-1991 to stop S&Ls that were making liar’s loans. This was the single most destructive rule change in banking rules in the most recent financial crisis....
The Gramm-Leach-Bliley Act of 1999, which repealed the Glass-Steagall Act, passed with overwhelming support and the active sponsorship of the Clinton administration and the Congressional leadership of both parties. The Glass-Steagall Act was adopted because we investigated the causes of the Great Depression, principally through the Pecora investigation, and found that combining investment and commercial banking led to conflicts of interest that produced recurrent abuses and helped trigger the crisis.... 
In the late 1990s, Brooksley Born, the head of the Commodities Futures Trading Commission (CFTC), realized that credit default swaps (CDS) posed a potential severe danger and sought to review whether the CFTC should adopt regulation to respond to the danger. The Clinton administration, Alan Greenspan, and the congressional leadership of both parties rushed to adopt the Commodities Futures Modernization Act of 2000. The 2000 Act passed with overwhelming support and created a regulatory black hole that Enron exploited to cause the 2001 California energy crisis and AIG executives exploited to become wealthy and drive AIG insolvent.
We can now add to this list of bipartisan financial deregulatory disasters the JOBS Act of 2012. I have explained in prior articles that the Act is the product of a feeding frenzy by lobbyists who are finally able to enact every fraud-friendly provision they ever dreamed of making law....
Mr. Black then discussed what political environment is necessary to adopt laws that actually address what is wrong with the financial system.
If the government exposes and sanctions the elite frauds that drive the crisis it can create (briefly) the political space for real reform legislation. 
If, however, the government fails to expose and hold accountable the elite ... political space for real reform will not be created and any reform bills may be large, but they will not be fundamental. 
This is the problem with passing the Dodd-Frank Act without providing the Financial Crisis Inquiry Commission ample resources and time to finish its investigation into the causes of the crisis first.

Mr. Black concludes by observing that
We are living with a public policy for financial regulation that closely resembles a ratchet. With rare exceptions immediately following fraud epidemics that become scandals, regulatory policy only moves in one direction further loosening restrictions. 
The more crises these failed anti-regulatory policies create, the looser the regulations become and the more severe the crises become. We are destroying our economy and other nations, particularly in Europe, are following our lead with equally self-destructive results. 
We have trashed a regulatory system that was the envy of the world.
A regulatory system that had and was intended to have as its foundation transparency.

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