I have received such an enthusiastic response to my recent blog on charting the background to the financial crisis, so I thought I would expand the context and look at the failure of the regulatory process to prevent such a series of mishaps.
The Global Financial Crisis (GFC), or the second "Great Recession", is considered by many to be the worst financial crisis since the Great Depression of the 1930s. It began in the United States and has resulted in the collapse of large financial institutions, the enforced bailout of banks by national governments and downturns in stock markets around the world. In many areas, the housing market has also suffered. It contributed to the failure of key businesses, declines in consumer wealth estimated in trillions of U.S Dollars and a significant decline in economic activity, leading to a severe Global Economic Recession in 2008, from which we have not yet shown any sign of recovering.
The financial crisis was triggered by a complex interplay of corrupted valuations and massive liquidity problems in the U.S banking system in 2008. The bursting of the U.S. housing bubble, which peaked in 2007, caused the values of securities tied to U.S. house pricing to plummet, damaging financial institutions globally. Questions regarding bank solvency, declines in credit availability and damaged investor confidence had an impact on global stock markets, where securities suffered large losses during 2008 and early 2009. Economies worldwide slowed during this period, as credit tightened and international trade declined. Governments and central banks responded with unprecedented fiscal stimulus expansion and institutional bailouts.
The questions which must underlie these bald statements of fact ask for the reasons why the international banking system had been allowed to become so vulnerable to economic downturns. We were all used to hearing about the efficiency and effectiveness of our financial regulators, weren't we, those men and women who get paid significant salaries to regulate the activities of the financial sector, so what were they doing when the brown stuff arrived and the fan got switched on?
I my last blog, I looked at the impacts on the City of London by the policies of de-regulation in the financial sector introduced by Margaret Thatcher, as part of her attempts to re-engineer the dismantling of Socialism, and the creation of an 'equity-owning democracy'. Thatcher's vision was simple. If she could make everyone a shareholder, a mini-capitalist, by selling off vast swathes of formerly nationalised industries, by selling them their council houses, and by opening up the hitherto fiercely protected London market to international competition and foreign capital flows, she believed that they would all begin to benefit from the amount of money that would thereby be released, which would, in turn, discourage the new bourgeoisie from wanting to fall back into the arms of the old Labour barons and their Trade Union satraps.
We can look at that failure another time, when I will describe how an army of US mafia-backed share dealers flooded into London to part the unwary first-time share purchasers from their new acquisitions, but we must first examine the more fundamental underlying factors that led to the dismantling of the most important regulatory constraints on arrogance, ignorance and greed! (Many apologies to Show of Hands)!
"Greed is all right, by the way. I want you to know that. I think greed is healthy. You can be greedy and still feel good about yourself."
These words were spoken by Ivan Boesky, an American arbitrageur, in a speech he gave to a student audience at an American university back in the 1980's. Boesky would later be unmasked as a leading insider dealer and who was sent to prison for his criminal actions. The important thing is that Boesky enunciated what an awful lot of people in the financial sector also believed and practised.
In order for the greed factor to be fulfilled, the financial sector had to engineer a repeal of a lot of the laws that constrained dishonest and egregious behaviour in the financial markets. Inevitably, these moves were led by America, but they would soon have an immense impact upon the rest of the world and particularly in London.
Following the Wall Street Crash in 1929, and the era of Depression which followed, America watched as her once vibrant, but wholly unregulated markets wallowed in recession and bankruptcy. When Roosevelt was elected President, he set about immediately introducing the era of 'The New Deal' which sought to reinstate the American business and work ethic, which would enable Americans to find work, which would generate income and pay tax revenues, and he realised that one of the most vital requirements was the ability to control the financial markets, which had been allowed to get completely out of hand. He introduced a whole series of regulatory reforms for the banking sector, the securities sector, and set about reconstructing a series of market regulations whose aim was to require full disclosure of all salient facts, coupled with severe penalties for any breaches of those laws. At the same time, he did not seek to prevent individual investors from making fools of themselves, and he left alone any form of protectionist attempts to define what could and could not be sold in the markets. As long as the company concerned told investors what they intended to do with their money in clear and concise terms, they could offer virtually whatever scheme they liked.
In banking, the primary principle was enunciated as 'keep the depositors' money completely segregated from the activities of the investment bankers, and this was ensured by the terms of the Glass-Steagall Act, which maintained a rigid separation of function between retail and wholesale banks.
In the years that followed, the greed merchants began to chip away at these protections. This is a short time line of their actions.
Many critics have argued that the regulatory framework did not keep pace with financial innovation, such as the increasing importance of the shadow banking systems, derivatives and off-balance sheet financing. A recent OECD study in 2011 suggested that bank regulation based on the Basel accords encourages unconventional business practices and contributed to or even reinforced the financial crisis. In other cases, laws were changed or enforcement weakened in parts of the financial system. Key examples include:
- The Depository Institutions Deregulation and Monetary Control Act 1980 (DIDMCA) which phased out a number of restrictions on banks' financial practices, broadened their lending powers, and raised the deposit insurance limit from $40,000 to $100,000 (raising the problem of moral hazard), otherwise defined as a situation where there is a tendency to take undue risks because the costs are not borne by the party taking the risk. Banks rushed into real estate lending, speculative lending, and other ventures just as the economy soured.
- In October 1982, U.S. President Ronald Reagan signed into law the Garn-St.Germain Depository Institutions Act, which provided for adjustable rate mortgage loans, began the process of banking deregulation, and contributed to the savings and loans crisis of the late 1980s/early 1990s.
- In November 1999, U.S. President Bill Clinton signed into law the Gramm-Leach-Bliley Act, which repealed part of the Glass-Steagall Act of 1933. This repeal has been criticized for reducing the separation between commercial or retail banks (which traditionally had fiscally conservative policies) and investment banks (which had a more risk-taking culture).
- In 2004, the U.S. Securities Exchange Commission relaxed the net capital rule, which enabled investment banks to substantially increase the level of debt they were taking on, fuelling the growth in mortgage-backed securities supporting subprime mortgages. The SEC has conceded that self-regulation of investment banks contributed to the crisis. Affordable home ownership, especially for African-American and Hispanic borrowers, who had traditionally found it difficult and expensive to get a mortgage, was a key policy goal of the Clinton administration and one enthusiastically carried forward by President Bush. A laudable aim - but there is evidence that it led to severe political pressure on mortgage providers to lower their lending standards, spawning the now infamous "NINJA" loans for borrowers with "No Income, no Job or Assets."
- The mortgage finance company Fannie Mae was also being urged to fulfil its mission of helping low income homeowners by buying up more and more risky loans. This political pressure, as well as rock-bottom interest rates and unscrupulous lending practices, helped to inflate the sub-prime housing bubble.
- Financial institutions in the shadow banking system are not subject to the same regulation as depository banks, allowing them to assume additional debt obligations relative to their financial cushion or capital base. This was the case despite the Long Term Capital Management debacle in 1998, where a highly-leveraged shadow institution failed with systemic implications.
- Shadow banking is the collection of financial entities, infrastructure and practices which support financial transactions that occur beyond the reach of existing state sanctioned monitoring and regulation. It includes entities such as hedge-funds, money-market funds and structured investment vehicles (SIV). Investment banks may conduct much of their business in the shadow banking system (SBS), but they are not SBS institutions themselves.
· The core activities of investment banks are subject to regulation and monitoring by central banks and other government institutions - but it has been common practice for investment banks to conduct many of their transactions in ways that don't show up on their conventional balance sheet accounting and so are not visible to regulators or unsophisticated investors. For example, prior to the financial crisis, investment banks financed mortgages through off-balance sheet securitisations and hedged risk through off-balance sheet credit default swaps.
· The volume of transactions in the shadow banking system grew dramatically after the year 2000. By late 2007 the size of the SBS in the U.S. exceeded $10 trillion. By late 2009 the United States SBS had shrunk to under $6 trillion due to increased regulation, changes in business practice, and pressure from investors who in some cases no longer wanted their funds to be used in the shadow banking system. Globally, a study of the 11 largest national shadow banking systems found that they totalled to $50,000bn in 2007, fell to $47,000bn in 2008 but by late 2011 had climbed to $51,000bn, just over its estimated size before the crisis. Overall, the world wide SBS totalled to about $60 trillion as of late 2011.
- Regulators and accounting standard-setters allowed depository banks such as Citigroup to move significant amounts of assets and liabilities off-balance sheet into complex legal entities called structured investment vehicles, masking the weakness of the capital base of the firm or degree of leverage or risk taken. One news agency estimated that the top four U.S. banks had to return between $500 billion and $1 trillion to their balance sheets during 2009. This increased uncertainty during the crisis regarding the financial position of the major banks. Off-balance sheet entities were also used by Enron as part of the scandal that brought down that company in 2001.
- As early as 1997, Federal Reserve Chairman Alan Greenspan fought to keep the derivatives market unregulated. With the advice of the President's Working Group on Financial Markets, the U.S. Congress and President allowed the self-regulation of the over-the counter (OTC) derivatives market when they enacted the Commodity Futures Modernisation Act, 2000. Derivatives such as credit default swaps (CDS) are used to hedge or speculate against particular credit risks. The volume of CDS outstanding increased 100-fold from 1998 to 2008, with estimates of the debt covered by CDS contracts, as of November 2008, ranging from US$33 to $47 trillion. Total (OTC) derivative notional value rose to $683 trillion by June 2008. Warren Buffet famously referred to derivatives as "financial weapons of mass destruction" as early as 2003.
'...Consider the terrible consequences of the 'anything goes' Bush Administration, whose irresponsible non-regulation of the financial institutions has led to this crisis...'
Those words, from the Democratic Speaker of the House of Representatives Nancy Pelosi, sum up the charge against George W Bush (no economist he) - that in the eight years of his presidency he actively pursued policies of deregulation which caused the biggest financial and economic meltdown since the Great Depression. It is indeed a grim legacy for President Bush to contemplate in retirement. He presided over a widespread failure of regulation and, the US authorities did little to prevent the sale of millions of mortgages to people who could never afford them. They failed to police the market in mortgage-backed securities which has now collapsed with such devastating consequences. And credit default swaps, those multi-billion-dollar bets on other people going bust, went virtually unregulated, but I have tried to show in this timeline that the rot had set in long before Bush was elected, although he undoubtedly exacerbated the process.
Remember, all those US banking institutions had branches in the now de-regulated London market, and everyone knew the levels of salaries the US banks were paying, and more importantly, the level of bonuses. No-one wanted to be left behind in this Lemming-like rush to the financial cliff edge, and the impact of all these de-regulatory changes were making themselves felt in London. This is why Gordon Brown was so willing to be persuaded to soft-pedal on the regulatory requirements for British banks, because the crooked bankers were telling him that if they didn't offer the same level of financial services, then business would drift to the US banks; and if they didn't pay the same salaries and bonuses, then their staff would follow suit.
It all became one vast self-fulfilling prophecy, with Brown and Balls presiding over a market of fantasy finance, while the investment bankers filled their boots, put it up their nose or down their throats.
And when it all went tits-up, dear reader, you and I were left to bail out the whole rotten edifice with our hard-earned tax-payer's money, just so that the fat-cats could continue to live their worthless lives in a manner to which they had long been accustomed. This is why your savings cannot even keep pace with inflation because interest rates are so low in an attempt to encourage lending, which the banks are unwilling to do, but your credit card interest rates are at usurious levels. This is why your business cannot get a loan; this is why your children will probably never be able to afford a house in the town in which they grew up; this is why any pension you might hope to realise is worth less every day as the Government prints more and more money to push into these worthless banks; and this is why you should never, ever be willing, ever again to believe a thing these institutions tell you, because they are institutional liars and scoundrels and grow more and more like organised crime families every day.