Simon Johnson says the US government is encouraging the biggest US banks to once again over-leverage. Of course this is at our risk.
If shareholders are protected from being wiped out by the implicit too-big-to-fail guarantee, they should welcome the arrival of additional leverage as the economy improves. In fact, as the latest quarterly earnings results appear, the financial press has started to ask Goldman Sachs Group Inc. and other banks why they don’t increase their leverage even more.
Top bankers are also pressing hard for the right to increase dividend payments. That’s effectively a transfer from creditors and taxpayers tomorrow (because of the guarantee) to shareholders today.
Dimon also wants JPMorgan to become more global, especially by expanding more into emerging markets. U.S. Treasury Secretary Timothy Geithner endorsed this approach in an interview he gave to the New Republic, effectively arguing that we should want big, highly leveraged U.S. banks to make large bets on highly volatile emerging markets.
What could go wrong?
According to the report, Lehman used what amounted to financial engineering to temporarily shuffle $50 billion of troubled assets off its books in the months before its collapse in September 2008 to conceal its dependence on leverage, or borrowed money. Senior Lehman executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas, the chairman of the law firm Jenner & Block and a former federal prosecutor, who filed the report in connection with Lehman’s bankruptcy case.
Richard S. Fuld Jr., Lehman’s former chief executive, certified the misleading accounts, the report said.
Are these actions illegal? If so, will anyone do jail time for their role in the deception?
A New York Times story on former Goldman Sachs investment banker and former US Treasury official Neel Kashkari’s move to bond investment house Pimco reveals much about how US government bail-out policy helped many big investors. Pimco made $1.7 billion off of securities price appreciation when the US government decided to fully protect the value of Fannie Mae and Freddie Mac bonds.
It was also hard, however, not to notice that Pimco was a direct beneficiary of the Treasury Department’s actions. In 2008, when it appeared that Fannie Mae and Freddie Mac might fail, Mr. Gross saw an opportunity.
He moved Pimco’s flagship Total Return Fund heavily into mortgage-backed securities guaranteed by the two agencies. Then he vociferously advocated for the government to rescue them during television appearances on CNBC and elsewhere. On Sept. 7, 2008, the fund’s value soared by $1.7 billion when Mr. Paulson announced the government takeover of Fannie Mae and Freddie Mac. As part of his government duties, Mr. Kashkari worked on that rescue effort.
I wonder how much Goldman Sachs made off of that move and ditto for Bank Of America, Citibank, and the government of China for that matter.
That Pimco profit from the Fannie and Freddie bail-out is small stuff as compared to the $12.9 billion that Goldman Sachs made and/or avoided losing when the US government decided to make good on all the bond insurance policies that AIG had foolishly sold for pittances.
Goldman Sachs, which set a Wall Street profit record of $11.6 billion in 2007 and may have earned $11.4 billion this year, according to the average estimate of 15 analysts surveyed by Bloomberg, won new and larger concessions from taxpayers in 2008. This time it was the threat of a financial meltdown that prompted the U.S. government, with Paulson as Treasury secretary, and the Federal Reserve to supply an unprecedented amount of aid to firms deemed critical to the financial system, including Goldman Sachs.
The 140-year-old company received $10 billion in capital, guarantees on about $30 billion of debt and the ability to borrow cheaply from the Fed. The Fed’s bailout of American International Group Inc., and its decision to pay the insurer’s counterparties in full, funneled an additional $12.9 billion to Goldman Sachs.
I'd like to know what other large sums of money were made from the AIG and Fannie/Freddie bail-outs. It is my impression that some pretty big European banks were saved by the US government spending big on the AIG bail-out.
The worst thing about these bail-outs is not the profits earned by Goldman Sachs and Pimco at our expense. No, there's something worse that portends poorly for the future: These financial titans will be more reckless in the future because their financial contracts with big, weak, foolish counterparties did not cause them to lose billions of dollars. The moral hazard here is that the bubble will be even bigger next time and when Peak Oil hits the financial house of cards will really collapse next time.
John Carney is right: a very large number of Americans is always going to be financially illiterate, and there’s nothing we can do about it.
More than half (and a growing proportion) of the American public have IQs below 100. But even an IQ of 100 isn't enough to understand how to buy stocks or what's a good mortgage.
Indeed, if we try too hard to do something about improving financial literacy, there’s a good chance we’ll only end up creating a new cohort of overconfident financial illiterates who think they understand things when they don’t.
This is why we need a Consumer Financial Protection Agency: to make sure that people buying financial products don’t end up buying something that’s going to end up exploding in their face.
During the era of Protestant ascendancy this might have worked. But the WASPs do not run things any more. Nowadays the supposedly pro-regulatory Democrats in Congress support usury. The government isn't capable of benign paternalism. A regulatory agency for consumer finance would likely be captured by the brain dead pro-diversity forces of political correctness. How can a regulatory agency protect people from loans they shouldn't take out when sensible regulations that provide useful protection would have "disparate impact" on NAMs? (i.e. a greater reduction in loans to minorities that have higher rates of defaults)
We have a cancer of know-nothing political correctness eating away at our ability to form rational government policies and that cancer is infecting more and more areas of policy.
Ryan Grim of the Huffington Post (yeah, left-wing but I'm not - so what) has written a good piece on how the US Federal Reserve employs and otherwise funds so many economists that the Fed stifles debate about Fed assumptions and policy.
The Federal Reserve, through its extensive network of consultants, visiting scholars, alumni and staff economists, so thoroughly dominates the field of economics that real criticism of the central bank has become a career liability for members of the profession, an investigation by the Huffington Post has found.This dominance helps explain how, even after the Fed failed to foresee the greatest economic collapse since the Great Depression, the central bank has largely escaped criticism from academic economists. In the Fed's thrall, the economists missed it, too. "The Fed has a lock on the economics world," says Joshua Rosner, a Wall Street analyst who correctly called the meltdown. "There is no room for other views, which I guess is why economists got it so wrong."
The tendency toward consensus and group-think is a big problem. Look at the housing bubble and the larger credit bubble. The vast bulk of professional economists did not recognize the problem. Some of those who did recognize it were not associated with either major universities or the Fed.
One can't simply dismiss this as left-wing carping at free market economists. Milton Friedman thought that the Fed's influence was not healthy.
Even the late Milton Friedman, whose monetary economic theories heavily influenced Greenspan, was concerned about the stifled nature of the debate. Friedman, in a 1993 letter to Auerbach that the author quotes in his book, argued that the Fed practice was harming objectivity: "I cannot disagree with you that having something like 500 economists is extremely unhealthy. As you say, it is not conducive to independent, objective research. You and I know there has been censorship of the material published. Equally important, the location of the economists in the Federal Reserve has had a significant influence on the kind of research they do, biasing that research toward noncontroversial technical papers on method as opposed to substantive papers on policy and results," Friedman wrote.
I'm struck by the fact that Alan Greenspan did not have an impressive set of private sector accomplishments. Timothy Geithner doesn't either. I wish more people who ascend to high positions in government first make their mark in ways totally independent of government-created status hierarchies. We need more people who are from the outside with proven records of accomplishment taking the reins of power.
In 2007, the damage was limited: there was a lot of fallout in the world of hedge funds, but the stock market continued to rise, and the systemic implications seemed to be contained. But the adoption of the Gaussian copula function was much more widespread than a bunch of hedge funds: it was embraced at pretty much every CDO origination and trading desk on Wall Street. And when the entire financial system starts using essentially the same model, the systemic devastation which can result is enormous.
The use of flawed mathematical models (and all financial models will have flaws) causes lemming-like behavior by banks. This leads to the kind of financial crisis we are passing through.
Salmon argues for limits on bank size and also do not let banks do thinks that their regulators can not understand.
My feeling is that the best way to go is to set some very clear and simple rules, much as the Spanish central bank did, and refuse to allow banks to build enormous businesses doing things that the regulators don’t understand. And secondly to place a cap on banks’ balance sheets — I think something around $300 billion is reasonable, and that there’s no reason why any bank should be bigger than that. Alternatively, if you are bigger than that, then you have to become much more constrained in what kind of activities you’re involved in: you should basically just be doing plain-vanilla deposit-taking, borrowing, and lending.
Regards bank size: Would we then just get lots of smaller banks making the same mistake? I'd like to know the mortgage default rates of the average small, medium, and large bank in 2008 and 2009. Did the smaller ones perform better?
Peter Eavis of the Wall Street Journal reports that banks expect much higher rates of loan defaults if the unemployment rate hits 10%.
Despite all the pain in the financial sector, bank executives' biggest fear has yet to materialize. Now, it is rearing its ugly head.
Bankers' worst nightmare is the unemployment rate climbing toward 10%, a level at which credit losses could balloon unpredictably because of high defaults among people with previously strong credit histories.
At higher unemployment rates people with high credit scores start defaulting. They have higher incomes and have borrowed more than the lower income people with low credit scores.
Also last week, Kelly King, chief executive of regional bank BB&T, said unemployment of 8% to 8.5% is "kind of manageable," but 9% to 10% would "have a dramatic impact on our scenarios."
Why the trepidation of going above 9%? Take a regular credit-card book. Past data show that a percentage-point increase in unemployment leads to roughly a percentage-point rise in the charge-off rate, the amount of defaulted loans written off at a loss.
But as unemployment exceeds 9%, bankers think charge-offs will start to increase by more than the increase in unemployment. The reason? A high rate could cause an unprecedented wave of defaults among prime borrowers, who tend to have bigger loan balances.
These comments from BB&T's CEO are coming from a bank that did not go hog wild and issue lots of loans to unqualified home buyers. (and unlike, say, the failed Merrill Lynch, the bank didn't go ahead with its bonuses either)
BB&T Corporation, which earned $1.5 billion in net income in 2008, said today that members of its executive team will not receive annual bonuses under its short-term incentive plan.
"We have traditionally set very difficult goals, and although we are among the top performers in the financial industry in 2008, we did not earn a bonus based on our targets," said Chief Executive Officer Kelly S. King. "This has been an extremely difficult economic environment, even for well-capitalized and profitable financial institutions."
BB&T is one of the strongest capitalized financial institutions in the industry. BB&T's Tier I capital ratio, a measure of financial strength and soundness, is 12.0 percent, significantly higher than the government's safety threshold of 6 percent. BB&T's total capital ratio is 17.1 percent, notably higher than the government's minimum ratio to be well capitalized of 10 percent.
Recently retired BB&T former CEO John Allison says the huge banking crisis was caused by US government policies.
Despite what the news media keep saying, capitalism and deregulation were not the causes of the financial meltdown.
Instead, BB&T CEO John Allison pointed the finger at government creations like the Securities and Exchange Commission (SEC), Federal Deposit Insurance Corporation (FDIC) and Fannie Mae and Freddie Mac, the two government-sponsored enterprises that failed last year. Allison was giving a lecture in Washington, D.C. Jan. 29 for the Ayn Rand Center for Individual Rights.
Allison cited a “religious belief in affordable housing” that led the government to institute the Community Reinvestment Act of 1977 (CRA) and later, during the Clinton years, to a huge expansion of Fannie and Freddie.
“In my opinion, I’m certain without Freddie Mac and Fannie Mae we could not have had the magnitude of misinvestment – we’d a had misinvestment but nothing like what we’ve had today,” Allison said.
Coming from Allison, a bank boss who managed to avoid many of the mistakes that many other banks made, this explanation gains credibility. George W. Bush and Karl Rove built upon CRA to make the disaster monumental in scope. Also see how the CRA, by controlling which banks became big, selected for reckless banks to become big.
Update: So will unemployment rise high enough to put the sound banks into trouble? Nouriel Roubini thinks things will get substantially worse.
Even as he wins plaudits for his prescience, Roubini, 50, says worse lies ahead. Banks face bigger credit losses than they realize, more financial companies will require state takeovers and the world economy will keep shrinking throughout 2009, he says.
“The consensus is catching up with me, but it’s still behind,” Roubini said in an interview in Davos. “I don’t know what some people are smoking.”
I am thinking a 3Q 2009 beginning of recovery is looking less likely. The later the recovery starts the higher the unemployment rate will go.
From just one bank the US taxpayers might be on the hook to the tune of $1000 per person. For net taxpayers the potential cost might be several times that amount. This assumes a worst case for future Citi losses.
Before long, anxious investors may start wondering which banks will be vulnerable next. If confidence fades, other big lenders will probably seek deals like Citigroup’s, in which the government has pledged to pick up potentially $290 billion in additional losses. Regulators drafted the plan with an eye to using it as a template for future bailouts.
But there's no guarantee that Citi won't come back with massive corporate loan losses or credit card losses. The people laid off in 2009 are going to default on more mortgages, car loans, credit card loans, and assorted personal loans.
There are other worries for Citigroup’s big rivals. Almost overnight, Citigroup went from being the sick man of the industry to an institution with an edge over its competitors. The government is guaranteeing $250 billion of risky assets and pumping an additional $20 billion into the bank.
With the government behind it, Citigroup may now be able to borrow money in the capital markets at lower interest rates than its peers.
This reminds me of Ford's position on a GM and Chrysler bail-out. Basically Ford is saying they have enough cash that they won't go bankrupt in 2009. But if GM and Chrysler get lower interest rate loans then it is only fair if Ford gets them too. Ford has a point. Lower costs of capital for competitors put it at a competitive disadvantage. Well, Citi's bailout puts JP Morgan Chase, Wells Fargo, and Bank of America at a competitive disadvantage. If they all get bailed out that puts all the smaller banks at a competitive disadvantage. The less efficient players survive and the more efficient players lose market share. That's bad.
But one of the problems with allowing a really big bank to fail is that large numbers of companies have their checking accounts with them. Deposit insurance does not cover their deposits since the payroll checking accounts and other accounts end up running into the millions and beyond.Companies will suddenly start bouncing checks which will cause their suppliers cash flow problems and this will propagate.
On the other hand, if the banks all get bailed out that cuts the incentive for avoiding risky lending. Plus, it becomes really expensive for the taxpayers. The mispricing of risk is incredibly expensive. We all pay for it.
The big open question at this point: How many big credit losses lie in the future for Citi, BofA, JPMorgan, and other banks? Will credit cards, corporate loans, and other kinds of loans cause new rounds of massive losses? Also, how can the banks be regulated in a way that reduces the size of future too-big-to-fail bailouts?
The bank’s downfall was years in the making and involved many in its hierarchy, particularly Mr. Prince and Robert E. Rubin, an influential director and senior adviser.
Citigroup insiders and analysts say that Mr. Prince and Mr. Rubin played pivotal roles in the bank’s current woes, by drafting and blessing a strategy that involved taking greater trading risks to expand its business and reap higher profits. Mr. Prince and Mr. Rubin both declined to comment for this article.
When he was Treasury secretary during the Clinton administration, Mr. Rubin helped loosen Depression-era banking regulations that made the creation of Citigroup possible by allowing banks to expand far beyond their traditional role as lenders and permitting them to profit from a variety of financial activities. During the same period he helped beat back tighter oversight of exotic financial products, a development he had previously said he was helpless to prevent.
So Robert Rubin did a lot of the regulatory loosening that the Bush Administration is blamed for doing.
Remember how Barack Obama was supposed to be about change? Obama is appointing former proteges of Robert Rubin. Meet the new boss. Same as the old boss.
Geithner is a protege of Summers' and of former Clinton administration Treasury chief Robert E. Rubin.
Will Geithner demonstrate more sense at the Treasury than Rubin did at CitiGroup?
More fundamentally: Will the bankers and the regulators learn enough lasting lessons from this disaster to prevent it from happening again for a few decades?
Robert Rubin doesn't want to admit he is part of problem. More top people in the bailed out banks should be fired.
I am shocked that Alan "irrational exuberance" Greenspan is shocked by this credit crisis. He ought to know better. Surely he knew that housing became overpriced compared to various historical ratios of housing prices versus income and rents. Surely he knew that personal indebtedness was reaching dangerous levels. Yet look at former Federal Reserve Chairman Alan Greenspan's recent Congressional testimony about his shock at the financial crisis.
"As I wrote last March, those of us who have looked to the self-interest of lending institutions to protect shareholders' equity (myself especially) are in a state of shocked disbelief... Such counter-party surveillance is a central pillar of our financial markets' state of balance. If it fails, as occurred this year, market stability is undermined."
He demonstrates a hubris in the power of elites reacting to markets to make correct decisions. Greenspan ignores the agency problems with CEOs and other top executives. They get bigger incentives for success than rewards for avoiding failure. Their bonuses aren't based on multi-year achievements. They find too many ways to boost earnings in the short run at the expense of the long run. They have captive boards that can't control them. Corporate governance has serious flaws.
Mr. Greenspan's thinking contains some serious contradictions. First off, his long-running claim to economic understanding does not come as a result of an impressive history of competing in the private sector. His power and influence came chiefly as a result of an appointment in government. Government is what he professes to trust less than the private sector. But he's Mr. Government himself. So why should he trust his own judgments?
Second, most of the economic growth that happened while he was chairman of the Fed came as a result of large numbers of decisions in the private sector. He doesn't deserve veneration for being Fed Chairman for this period of economic growth - at least if he takes seriously his own view of the relative importance of the private sector and government.
Third, he is now shown to have been incredibly wrong. In a speech in 2005 what Greenspan hailed as innovations by the private sector were in fact a disaster waiting to happen.
A brief look back at the evolution of the consumer finance market reveals that the financial services industry has long been competitive, innovative, and resilient. Especially in the past decade, technological advances have resulted in increased efficiency and scale within the financial services industry. Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants. ...
... For example, information processing technology has enabled creditors to achieve significant efficiencies in collecting and assimilating the data necessary to evaluate risk and make corresponding decisions about credit pricing.
"It was the failure to properly price such risky assets that precipitated the crisis," Greenspan said, by encouraging investors worldwide to look at U.S. subprime loans as a "steal" rather than an uncertain bet that relied on escalating home values. "The whole intellectual edifice . . . collapsed in the summer of last year."
Fannie Mae and Freddie Mac are creatures created by the US government and are continually pressured by the US government. They intervened in the subprime market and distorted that market. At the same time federal regulators, politicians, newspapers, and political activists pressured banks and other financial institutions to issue risky debt to help non-Asian minorities (NAMs) buy houses and other things they couldn't afford to buy. These were big distortions in the market that a supposed free marketeer like Greenspan ought to have recognized and factored into his thinking. But he obviously didn't.
Other important market distortions emanated from East Asian governments buying up debt in the US. The Chinese government maintains a currency peg against the US dollar. The Chinese government enforces rules on Chinese banks and Chinese businesses so that US dollars flowing into China to buy goods get converted into local currency in a way that builds up foreign reserves. The resulting (unsustainable and damaging) trade deficit distorts US capital markets. The Chinese purchase of US bonds distorts the US money supply and US credit markets. That too distorted the market and caused a big mispricing of debt and risk. Why didn't Greenspan recognize the importance of huge market distortions caused by governments? Because he's become too much the government insider.
A fractional reserve banking system requires government regulation by its nature. Objectivists therefore oppose fractional reserve banking. The Objectivists do not see Greenspan as a free marketeer.
Yaron Brook, executive director of the Ayn Rand Center for Individual Rights, today issued the following commentary:
Opponents of the free market are giddy at Alan Greenspan's declaration that the financial crisis has exposed a "flaw" in his "free market ideology." Greenspan says he is "in a state of shocked disbelief" because he "looked to the self-interest of lending institutions to protect shareholder's equity"--and it didn't.
But according to Dr. Yaron Brook, executive director of the Ayn Rand Center for Individual Rights, "any belief Greenspan ever had in truly free markets was abandoned long ago. While Greenspan long ago wrote in favor of a truly free market in banking, including the gold standard that such markets always adopt, he then proceeded to work for two decades as leader and chief advocate of the Federal Reserve, which continually inflates the money supply and manipulates interest rates. Advocates of free banking understand that when the government inflates the currency, it artificially increases prices and causes booms in certain sectors of the economy, followed by inevitable busts. But not only did Greenspan lead the inflation behind the .com bubble and the real estate boom, he blamed the market for their treacherous collapses. Greenspan should have recognized that what he wrote in 1966 of the boom preceding the 1929 crash applied here: 'The excess credit which the Fed pumped into the economy spilled over into the stock market--triggering a fantastic speculative boom.' Instead, he superficially blamed 'infectious greed.'
"Should it be any shock that Greenspan now blames the free market for today's meltdown--rather than the Fed's policies, which fueled an inflationary housing boom, which rewarded reckless lenders and borrowers from Wall Street to Main Street? Greenspan didn't mention the word 'inflation' once in his testimony.
"Whatever Greenspan's economic philosophy is, it is not anything resembling a free market."
Whether a gold-based banking system is practical I have my doubts. But I think the Objectivists are right to see serious flaws in Greenspan's idea of a free market. Though, I must add, I see serious flaws in Objectivism.
Update: I would like to know when the leaders of either political party will come right out in public and say that our 5% of GDP trade deficit is another unsustainable problem that needs to be dealt with. When are they going to admit we are living beyond our means and that foreign governments are helping to cause the trade deficit?
In addressing these many uncertainties, Immelt has hammered home the message of GE's commitment to its sacred triple-A rating. He took several steps to conserve capital, such as deciding not to increase the dividend next year and suspending the stock buybacks; Moody's (in which Buffett's Berkshire Hathaway is the largest shareholder) and Standard & Poor's immediately reaffirmed their ratings on the company.
But Immelt may be fighting a battle that investors no longer care so much about. The credibility of bond ratings in general tumbled when it was revealed that securitized subprime mortgages had been rated double- or triple-A. GE's rating clearly meant nothing to investors who bid credit default swaps on company bonds up to a price of 700 basis points (the price subsided recently to about 500). Remember, triple-A means creditworthiness on a par with that of the U.S. Treasury, and credit default swaps on Treasury bonds have never traded above 35 basis points. The message of the markets: The rating agencies can say what they like; we'll decide for ourselves.
The US Securities and Exchange Commission released a report critical of the ratings agencies in July 2008. But what the SEC does is less important than what the market has decided: the ratings agencies can not be trusted. Unfortunately, a AAA rating still affects a financial institution's legal ability to hold a security. So while the market has lost trust in the ratings agencies the unrealistic ratings still have real impact.
Did a change in bank regulations by the SEC and FASB cause the financial crisis? The requirement to use mark-to-market valuations on all mortgage-backed securities (MBS) might have caused the bank solvency crisis.
In recent years, firms were required by the Securities and Exchange Commission and the Federal Accounting Standards Board to use for all the MBS on their books.
As more subprime borrowers started to default on their loans, that quickly eroded the value of many MBS pools. Major banks and financial firms around the globe have taken writedowns topping $500 billion in the last year, as a result.
For this reason, some have argued that fixing the rule would solve the credit crisis.
"The SEC has destroyed about $500 billion of capital by their continued insistence that mortgage-backed securities be valued at market value when there is no market," said William Isaac, a former chairman of the FDIC.
"And because banks essentially lend $10 for every dollar of capital they have, they've essentially destroyed $5 trillion in lending capacity," he added.
The argument here is that declining market values on MBS caused banks to sell them causing further price drops and basically a vicious cycle where the MBS became grossly undervalued and the banks insolvent. Could this really be the cause?
I suspect this crisis was caused by a Perfect Storm. Government pressures to lower lending standards certainly helped. So did innovations in new kinds of financial instruments which in 2003 Warren Buffett labeled "financial instruments of mass destruction" which were creating "mega-catastrophic risk" for the economy (if only US Presidents, US Congressmen, and federal regulators were as wise as Warren). But an assortment of regulatory changes set up dominoes for a fall. The account rule described above was just another domino in a row.
Modest proposal: Hank Paulson's proposed fund for buying up toxic securities should have a rule: The CEO of any financial institution that wants to sell to that fund should resign his position. A new CEO should do the actual selling of the securities.
People should pay with their jobs for the financial disaster which they've helped to create.
Also, Congress should make Barney Frank and Chris Dodd resign for protecting Fannie Mae and Freddie Mac for years. Again, I want accountability for mistakes.
Julie Satow of the New York Sun reports a 2004 US Securities and Exchange Commission rules change contributed to the failure of investment banks.
The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.
The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.
Keep in mind that this is not the main cause of the financial crisis. Countrywide Financial, Washington Mutual, Fannie Mae, and Freddie Mac (among others) got into trouble due to the mortgage bubble and poor lending practices.
You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.
Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1.
In the Winter 2000 edition of the City Journal Howard Husock reported how Bill Clinton's Administration forced banks to loan large sums of money to high risk projects in inner cities. This is part of a multi-decade trend where the Democrats in Congress and the White House forced banks to lower their investment standards in order to supposedly help poor people.
The Clinton administration has turned the Community Reinvestment Act, a once-obscure and lightly enforced banking regulation law, into one of the most powerful mandates shaping American cities—and, as Senate Banking Committee chairman Phil Gramm memorably put it, a vast extortion scheme against the nation's banks. Under its provisions, U.S. banks have committed nearly $1 trillion for inner-city and low-income mortgages and real estate development projects, most of it funneled through a nationwide network of left-wing community groups, intent, in some cases, on teaching their low-income clients that the financial system is their enemy and, implicitly, that government, rather than their own striving, is the key to their well-being.
The CRA's premise sounds unassailable: helping the poor buy and keep homes will stabilize and rebuild city neighborhoods. As enforced today, though, the law portends just the opposite, threatening to undermine the efforts of the upwardly mobile poor by saddling them with neighbors more than usually likely to depress property values by not maintaining their homes adequately or by losing them to foreclosure. The CRA's logic also helps to ensure that inner-city neighborhoods stay poor by discouraging the kinds of investment that might make them better off.
Fannie Mae and Freddie Mac had accounting scandals in 2003 and 2004. Wall Street Journal editor Paul Gigot got wind of an accounting scandal at Fannie and Fannie mobilized many allies on Wall Street to hit back at the WSJ for reporting the scandal. The reporting turned out to be highly accurate.
My battles with Fan and Fred began with no great expectations. In late 2001, I got a tip that Fannie's derivatives accounting might be suspect. I asked Susan Lee to investigate, and the editorial she wrote in February 2002, "Fannie Mae Enron?", sent Fannie's shares down nearly 4% in a day. In retrospect, my only regret is the question mark.
Mr. Raines reacted with immediate fury, denouncing us in a letter to the editor as "glib, disingenuous, contorted, even irresponsible," and that was the subtle part. He turned up on CNBC to say, in essence, that we had made it all up because we didn't want poor people to own houses, while Freddie issued its own denunciation.
The companies also mobilized their Wall Street allies, who benefited both from promoting their shares and from selling their mortgage-backed securities, or MBSs. The latter is a beautiful racket, thanks to the previously implicit and now explicit government guarantee that the companies are too big to fail. The Street can hawk Fan and Fred MBSs as nearly as safe as Treasurys but with a higher yield. They make a bundle in fees.
At the time, Wall Street's Fannie apologists outdid themselves with their counterattack. One of the most slavish was Jonathan Gray, of Sanford C. Bernstein, who wrote to clients that the editorial was "unfounded and unsubstantiated" and "discredits the paper." My favorite point in his Feb. 20, 2002, Bernstein Research Call was this rebuttal to our point that "Taxpayers Are on The Hook: This is incorrect. The agencies' debt is not guaranteed by the U.S. Treasury or any agency of the Federal Government." Oops.
Massachusetts House Democrat Barney Frank has been one of Capitol Hill's biggest defenders of Fannie and Freddie. Frank has consistently tried to make Fannie and Freddie even bigger - putting taxpayers on the hook for even bigger real estate bubbles and bigger losses.
Mr. Frank contends that he favored "very strong reform" of Fannie Mae and Freddie Mac, even before Democrats took over Congress after the 2006 elections. To adapt a famous phrase, this depends on what the meaning of "reform" is. Mr. Frank did support a bill that he and others on Capitol Hill described as reform. But on the threshold reform issue -- limiting the size of the portfolios of mortgage-backed securities (MBS) that the two companies could hold -- Mr. Frank was a stalwart opponent.
In fact, Mr. Frank was publicly arguing for an increase in the size of their combined $1.4 trillion portfolios right up to the day they were bailed out. Even now, after he's been proven wrong about a taxpayer guarantee, he opposes Treasury's planned reduction in the size of the portfolios starting in 2010, according to a quote attributed to him in this newspaper last week. "Good luck on that," he reportedly said. Mr. Frank's spokeswoman hung up the phone when we sought confirmation Tuesday.
Arnold Kling says Fannie and Freddie were under pressure from Congress (primarily Democrats like Barney Frank) to buy more of the subprime mortgages that led to their massive losses. If Fannie and Freddie (Government Sponsored Enterprises or GSEs) had purchased fewer of those mortgages then fewer of those mortgages would have been issued.
However, the GSEs have recently suffered large credit losses on loans that were not of investment quality. These low-down-payment loans were similar to the subprime mortgage loans that fueled the boom and bust cycle in housing. It is not clear why the GSEs chose to purchase these loans, since they are outside of the GSE charters. One story has it that they were afraid of losing market share. Another story I have heard is that the GSEs were under pressure from Congress to do more to provide funds for “affordable housing,” and the GSEs interpreted this as requiring more high-risk lending.
As a result of these high-risk loans, the GSEs ran into difficulty, reporting large losses. This in turn made investors nervous, so that the interest rates that the GSEs had to pay to borrow in order to fund their portfolios went up. Historically, the GSEs had been able to pay unusually low interest rates so that they could afford to hold assets with lower rates of return than other institutions, such as banks, could afford.
I see Congress as the biggest author of this crisis. But Congress critters are pointing at Wall Street. Barney Frank in particular deserves to lose his seat in the election this fall.
When it collapsed, Lehman had about a 30:1 debt-to-equity ratio, meaning it had borrowed $30 for every dollar in capital it held. Morgan Stanley currently has a debt-to-equity ratio of 30:1, while Goldman Sachs has one of about 22:1.
Bank of America, on the other hand, currently has about an 11:1 leverage ratio, while JPMorgan has about 13:1 and Citigroup about 15:1.