All about ideas…

Posts Tagged ‘credit crisis

Great Depression vs Great Recession

with one comment

The market crash of 1929 and the Great Depression were brought on by the very same behaviors that caused the Great Recession and financial crisis. Overconfidence in the belief that prices would never fall. Over-speculation. Debt levels too high. Leverage too great.

While the financial instruments that sparked this crisis did not exist, the euphoria brought on by rising profits and wealth caused everyone to “get in on the action.” Greed overcame prudence…and thoughts of risk were pushed aside as everyone told themselves the market will never fall.

Well, the market did crash in 1929 just as it did again in 2008.

Jesse’s Café Américain, an economy blog, wondered if the monetary expansion seen today as a response to the Great Recession had an historical equivalent in the Great Depression. He found it and offers, as well, his recommendations on changing the current economy. It follows closely what many other well respected economists are saying…and could help Congress in its financial regulatory deliberations if they were willing to take the advise of someone outside of the Beltway and Wall St.

Let’s take a look again at a prior period of dollar devaluation and monetary expansion in a period of deep recession, the period in the 1930’s in which the US departed from specie currency to facilitate the radical expansion of the monetary base.

monetarybase to 1939

As you can see, the Federal Reserve increased the monetary base in several steps, resulting in an aggregate increase of about 155% in four years. In this chart above one can also nicely see the contraction in the monetary base, the tightening, that caused a dip again into recession in 1937.

It is also good to note that the recession ended and the economy was in recovery prior to the start of WW II, which I would tend to mark from Hitler’s invasion of Poland in August, 1939. There was a military buildup in Britain before then, but I believe that the common assumption that only the World War could have ended the Great Depression was mistaken.

If real GDP is any indication, the recovery of the economy was underway, but somewhat anemic compared to its prior levels, reflected in a slow decline in unemployment. It is absolutely essential to remember that the US had become a major exporting power in the aftermath of the first World War. The decline therefore of world trade with the onset of the Depression hit the US particularly hard. But the recovery was underway, until the Fed dampened it with a premature monetary contraction that brought the country back into recession, a full eight years after the great crash. Such is the power of economic bubbles to distort the productive economy and foster pernicious malinvestment.[…]

The status quo has failed in its own imbalances and artificial distortions. But while avoiding bubbles in the first place through fiscal responsibility and restraint is certainly the right thing to do, plunging a country which is in the aftermath of a bubble collapse into a hard regime, such as the liquidationists might prescribe, is somewhat like taking a patient which has just had a heart attack and throwing them on a rigorous treadmill regimen. After all, running is good for them and if they had run in the first place they might not have had a heart attack, so let’s have them run off that heart disease right now. Seems like common sense, but common sense does not apply to dogmatically inclined schools of thought.

What the US needs to do now is reform its financial system and balance its economy, which means shrinking the financial sector significantly as compared to its real productive economy. This is going to be difficult to do because it will require rebuilding the industrial base and repairing infrastructure, and increasing the median wage.

The US needs to relinquish the greater part of its 720 military bases overseas, which are a tremendous cash drain. It needs to turn its vision inward, to its own people, who have been sorely neglected. This is not a call to isolationism, but rather the need to rethink and reorder ones priorities after a serious setback. Continuing on as before, which is what the US has been trying to so since the tech bubble crash, obviously is not working.

The oligarchies and corporate trusts must be broken down to restore competition in a number of areas from production to finance to the media, and some more even measure of wealth distribution to provide a sustainable equilibrium. A nation cannot endure, half slave and half free. And it surely cannot endure with two percent of the people monopolizing fifty percent of the capital. I am not saying it is good or bad. What I am saying is that historically it leads to abuse, repression, stagnation, reaction, revolution, renewal or collapse. All very painful and disruptive to progress. Societies are complex and interdependent, seeking their own balance in an ebb and flow of centralization and decentralization of power, the rise and fall of the individual. Some societies rise to great heights, and suffer great falls, never to return. Where is the glory that was Greece, the grandeur that was Rome?

Wall St dreams up a new speculation: Hollywood Stock Exchange

with one comment

Wall St. just can’t get over its addiction to speculation, regardless of the recent financial crisis that directly was caused by their speculation. Now, they’ve dreamed up another game of “roulette.”

Steve Pearlstein of the Washington Post writes today:

Investors learned this week of Wall Street’s latest attraction — a new “futures” market where anyone from casual moviegoers to Hollywood moguls would be able to wager on the success of upcoming movies.

In many ways, the Hollywood Stock Exchange is simply the logical extension of the recent trend in financial markets, which have long since outgrown their original purpose — to raise capital for real businesses — and have now turned themselves into high-tech casinos offering endless opportunity for speculation.

The rationale for this market in movie futures is roughly the same as the one offered for stock and commodities futures, or credit-default swaps or even the market in “synthetic” CDOs, those securities designed to mimic the performance of the real-life packages of mortgages and other debt instruments. Apologists talk about how much “liquidity” they bring to these markets, magically lowering costs and moderating price swings while allowing all manner of businesses to hedge their risks. And because these markets can accomplish these things with absolutely no unpleasant side effects, it is folly to even consider regulating them and stifling this wealth-producing innovation.

To understand what hogwash this all is, take a closer look at the Hollywood Stock Exchange, which the New York Times reported will soon be launched by Cantor Fitzgerald.

A growing number of leading economists are sounding a warning that banks are not as sound as their public relations pronouncements state. They still have all those millions, if not billions, of dollars of worthless securities on their balance sheets, but they’ve been assiduously ignoring them. Rather than embrace yet more speculative ventures, Wall St. needs to figure out to clean up their balance sheets. Any additional losses – or even higher interest rates – could lead to another bank collapse. If Wall St. is betting that the American taxpayer will open their collective wallet again, they’re in for a rude surprise.

Today only about 39% of investments go to providing capital for new business ventures. The rest goes towards one form of speculation or another. Yet, America and Congress are still enthralled with Wall St. which is why the Street has been able to thwart any meaningful regulation this long after the world financial collapse that led to the Great Recession. Already, Europe and Asia are pushing the U.S. government to restrict derivatives, CDOs and other speculative instruments because of the harm they’ve already caused.

So, when will the U.S. finally begin to realize that Wall St. isn’t that much different anymore than a Vegas casino? A clear message, through tough reforms, needs to be sent to Wall St.: clean up your house of cards or die; you won’t gamble with our money any more.

Strong, sound financial regulations needed now!

leave a comment »

Simon Johnson is Ronald A. Kurtz Professor of Entrepreneurship at Sloan School of Management at MIT and former Chief Economist at the IMF as well as co-founder of Baseline Senerio with James Kwak. In last May’s issue of The Atlantic, Johnson wrote about the recent financial collapse. Although the article is five pages long, the following excerpts explain some of the problem with achieving true financial reform and why Congress and the voters need to change their attitudes towards the financial industry and enact sound, effective regulations now rather than later.

The crash has laid bare many unpleasant truths about the United States. One of the most alarming, says a former chief economist of the International Monetary Fund, is that the finance industry has effectively captured our government—a state of affairs that more typically describes emerging markets, and is at the center of many emerging-market crises. If the IMF’s staff could speak freely about the U.S., it would tell us what it tells all countries in this situation: recovery will fail unless we break the financial oligarchy that is blocking essential reform.

But there’s a deeper and more disturbing similarity: elite business interests—financiers, in the case of the U.S.—played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive. The government seems helpless, or unwilling, to act against them.

Top investment bankers and government officials like to lay the blame for the current crisis on the lowering of U.S. interest rates after the dotcom bust or, even better—in a “buck stops somewhere else” sort of way—on the flow of savings out of China. Some on the right like to complain about Fannie Mae or Freddie Mac, or even about longer-standing efforts to promote broader homeownership. And, of course, it is axiomatic to everyone that the regulators responsible for “safety and soundness” were fast asleep at the wheel.

But these various policies—lightweight regulation, cheap money, the unwritten Chinese-American economic alliance, the promotion of homeownership—had something in common. Even though some are traditionally associated with Democrats and some with Republicans, they all benefited the financial sector. Policy changes that might have forestalled the crisis but would have limited the financial sector’s profits—such as Brooksley Born’s now-famous attempts to regulate credit-default swaps at the Commodity Futures Trading Commission, in 1998—were ignored or swept aside.
The great wealth that the financial sector created and concentrated gave bankers enormous political weight—a weight not seen in the U.S. since the era of J.P. Morgan (the man). In that period, the banking panic of 1907 could be stopped only by coordination among private-sector bankers: no government entity was able to offer an effective response. But that first age of banking oligarchs came to an end with the passage of significant banking regulation in response to the Great Depression; the reemergence of an American financial oligarchy is quite recent.

…the American financial industry gained political power by amassing a kind of cultural capital—a belief system. Once, perhaps, what was good for General Motors was good for the country. Over the past decade, the attitude took hold that what was good for Wall Street was good for the country. The banking-and-securities industry has become one of the top contributors to political campaigns, but at the peak of its influence, it did not have to buy favors the way, for example, the tobacco companies or military contractors might have to. Instead, it benefited from the fact that Washington insiders already believed that large financial institutions and free-flowing capital markets were crucial to America’s position in the world.
…the government’s velvet-glove approach with the banks is deeply troubling, for one simple reason: it is inadequate to change the behavior of a financial sector accustomed to doing business on its own terms, at a time when that behavior must change. As an unnamed senior bank official said to The New York Times last fall, “It doesn’t matter how much Hank Paulson gives us, no one is going to lend a nickel until the economy turns.” But there’s the rub: the economy can’t recover until the banks are healthy and willing to lend.

Written by Valerie Curl

March 4, 2010 at 8:59 AM

Melt-down: how it happened and why

with one comment

Most financial products and the working of Wall Street are well outside of my knowledge arena. But I recognize that I need to learn the why and how financial markets work so I understand the proposed regulations and how they will affect me in the future.

To that end, I found these papers.


Financial Markets,Lecture 2

Time for a new resolution trust authority to deal with “TBTF” banks?

with one comment

Few people have the experience and respect of Paul Volcker, now chairman of the president’s Economic Recovery Advisory Board. Volcker’s op-ed in the NY Times Sunday edition not only makes considerable sense but may be a way out of the “too big to fail” financial market mess that now plagues the world markets.

banks with cutout illustration

Artist: Brian Cronin, NYTimes

What we do need is protection against the outliers. There are a limited number of investment banks (or perhaps insurance companies or other firms) the failure of which would be so disturbing as to raise concern about a broader market disruption. In such cases, authority by a relevant supervisory agency to limit their capital and leverage would be important, as the president has proposed.

To meet the possibility that failure of such institutions may nonetheless threaten the system, the reform proposals of the Obama administration and other governments point to the need for a new “resolution authority.” Specifically, the appropriately designated agency should be authorized to intervene in the event that a systemically critical capital market institution is on the brink of failure. The agency would assume control for the sole purpose of arranging an orderly liquidation or merger. Limited funds would be made available to maintain continuity of operations while preparing for the demise of the organization.

To help facilitate that process, the concept of a “living will” has been set forth by a number of governments. Stockholders and management would not be protected. Creditors would be at risk, and would suffer to the extent that the ultimate liquidation value of the firm would fall short of its debts.

To put it simply, in no sense would these capital market institutions be deemed “too big to fail.” What they would be free to do is to innovate, to trade, to speculate, to manage private pools of capital — and as ordinary businesses in a capitalist economy, to fail.

Congress should be listening to Volcker and acting on his recommendations rather than playing political games with the security of American and world finances. Economic security is a requirement for businesses as well as families. Right now, the trust in that economic security is lost. Even the participants of the World Economic Forum in Davos recognized that not only has the game changed, but that the rules must change to prevent the next collapse.

Written by Valerie Curl

January 31, 2010 at 4:22 PM

Too big to fail – 1984 version

with one comment

Aspen Institute: Overcoming Short-termism

Aspen Institute: Overcoming Short-termism

The first rule of a blog is to write about what people are interested in reading. So, in complying with that rule, here is more financial information that I suspect most people – and most certainly not this old bird – did not know about.

While reading Jennifer Taub’s abstract Enablers of Exuberance: Legal Acts and Omissions that Facilitated the Global Financial Crisis , I came across the case of Continental Illinois. I’d never heard of this company before. For all I knew it was a railroad company. But it wasn’t. It was a huge bank that failed during the Reagan Administration.

On May 9, 1984, Continental Illinois, Chicago’s largest bank and one of the top ten banks in the US, began a frantic battle to counter reports that it was on the brink of insolvency from a combination of bad loans and funding liquidity risk.

At the root of the crisis lay a massive portfolio of energy sector loans that had begun to turn sour on Continental when the US oil and gas sectors lurched into recession in 1981. The $33-billion asset bank had compounded its mistakes by lending large amounts to lesser-developed countries prior to the August 1982 start of the major LDC crisis of the 1980s.

With investors and creditors spooked by rumours that the bank might fail or be taken over, Continental was quickly shut out of its usual domestic and international wholesale funding markets.

By May 17, regulatory agencies and the banking industry had arranged billions of dollars in emergency funding for the stricken giant. And in a move that remains controversial almost 20 years later, the Federal Deposit Insurance Corporation tried to stem the bleeding away of the banks funds by extending a guarantee to uninsured depositors and creditors at the bank giving credibility to the notion that some banks should be considered too big to fail.
Ambit ERisk

To stem greater market risk which the Reagan Government and FDIC deemed far too great for the banking industry and the economy at large, the FDIC took over the bank, eventually owning 100% of the bank. After pouring millions into the bank, the bank, after more than 2 years, was sold to Bank of America which enabled B of A to expand its banking into the Midwest.

As noted in a case study by Wharton’s School of Finance (University of Penn), the federal government knew long before the 2008 financial collapse what the systemic risks were to the economy from a “too big to fail” financial institution. And those who’ve been in Congress for decades knew as well.

The collapse of Continental Illinois National Bank and Trust was a watershed event in modern banking history that holds lessons for both bank risk managers and regulators. It showed how quickly the revelation of credit problems at a well-regarded bank could turn into a liquidity problem that jeopardized not only the survival of the bank itself, but also, in the view of the US regulators, the financial system. It is widely, if controversially, cited as a prime modern example of systemic risk.

The run on Continental was global and began when traders in Tokyo refused to roll-over their inter-bank placements with Continental. By the time markets opened in the US, Continental Illinois was no longer a viable institution. The U.S. authorities improvised a series of increasingly desperate bail-out measures including the guarantee of uninsured depositors and creditors of the bank, but these measures failed to restore confidence in the institution. Continental remains the largest institution ever to have been rescued by the Federal Deposit Insurance Corporation. Indeed, during Congressional testimony surrounding the intervention in Continental, the regulatory authorities admitted that the ten other largest US banks were also “too big to fail.” The ultimate resolution of Continental Illinois – the so-called Continental divide – has become the prototype for numerous good bank/bad bank restructurings around the world.

What I find inconceivable to understand is why former-Senator Phil Gramm promoted the overturn of Glass-Steagall. I understand that Sen. Gramm is a free-marketer, but he was in the Senate long enough to understand the consequences of an unregulated investment industry when combined with commercial and retail banking.

In 1933, in the wake of the 1929 stock market crash and during a nationwide commercial bank failure and the Great Depression, two members of Congress put their names on what is known today as the Glass-Steagall Act (GSA). This act separated investment and commercial banking activities. At the time, “improper banking activity”, or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors’ money. Additional and sometimes non-related explanations for the Great Depression evolved over the years, and many questioned whether the GSA hindered the establishment of financial services firms that can equally compete against each other. We will take a look at why the GSA was established and what led to its final repeal in 1999.

Reasons for the Act – Commercial Speculation
Commercial banks were accused of being too speculative in the pre-Depression era, not only because they were investing their assets but also because they were buying new issues for resale to the public. Thus, banks became greedy, taking on huge risks in the hope of even bigger rewards. Banking itself became sloppy and objectives became blurred. Unsound loans were issued to companies in which the bank had invested, and clients would be encouraged to invest in those same stocks.

Effects of the Act – Creating Barriers
Senator Carter Glass, a former Treasury secretary and the founder of the U.S. Federal Reserve System, was the primary force behind the GSA. Henry Bascom Steagall was a House of Representatives member and chairman of the House Banking and Currency Committee. Steagall agreed to support the act with Glass after an amendment was added permitting bank deposit insurance (this was the first time it was allowed).

As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks’ total income could stem from securities; however, an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income. By creating this barrier, the GSA was aiming to prevent the banks’ use of deposits in the case of a failed underwriting job.

Even though Glass himself later stated his Act “was an overreaction to the crisis” and the Act should be overturned, many in the financial industry pushed for it being overturned immediately, stating that they could effectively police themselves.

The limitations of the GSA on the banking sector sparked a debate over how much restriction is healthy for the industry. Many argued that allowing banks to diversify in moderation offers the banking industry the potential to reduce risk, so the restrictions of the GSA could have actually had an adverse effect, making the banking industry riskier rather than safer. Furthermore, big banks of the post-Enron market are likely to be more transparent, lessening the possibility of assuming too much risk or masking unsound investment decisions. As such, reputation has come to mean everything in today’s market, and that could be enough to motivate banks to regulate themselves.

Obviously, the profit motive, especially for short term gains and personal profit, over-rode the self-imposed industry policing effort. As the Aspen Institute stated in their paper of September 9, 2009,

We believe a healthy society requires healthy and responsible companies that effectively pursue long-term goals. Yet in recent years, boards, managers, shareholders with varying agendas, and regulators, all, to one degree or another, have allowed short-term considerations to overwhelm the desirable long-term growth and sustainable profit objectives of the corporation. We believe that short-term objectives have eroded faith in corporations continuing to be the foundation of the American free enterprise system, which has been, in turn, the foundation of our economy. Restoring that faith critically requires restoring a long-term focus for boards, managers, and most particularly, shareholders—if not voluntarily, then by appropriate regulation.

Steven Pearlstein, Washington Post Business Editor, reminds us

It’s been a year since the onset of a financial crisis that wiped out $15 trillion of wealth from the balance sheet of American households, and more than two years since serious cracks in the financial system became apparent. Yet while the system has been stabilized and the worst of the crisis has passed, little has been done to keep another meltdown from happening.

Even the modest regulatory reform effort launched with much fanfare back in the spring is now bogged down by bureaucratic infighting and special interest lobbying. And back on Wall Street, the wise guys are up to their old tricks, suckering investors into a stock and commodity rally, posting huge profits on their trading desks and passing out Ferrari-sized bonuses. The Wall Street Journal reports they’ve even cranked up the old structured-finance machine, buying up claims to life insurance proceeds and packaging them into securities.

The roots of this short-termism go back to the 1980s, with the advent of hostile takeovers mounted by activist investors. This newly competitive “market for corporate control” promised to reinvigorate corporate America by replacing entrenched, mediocre managers with those who could boost profits and share prices. In theory, the focus was on increasing shareholder value; in practice, it turned out to mean delivering quarterly results that predictably rose by double digits to satisfy increasingly demanding institutional investors. Executives who delivered on those expectations were rewarded with increasingly generous pay-for-performance schemes.

As fund managers grew more demanding of the short-term performance of corporate executives, investors became more demanding of the short-term performance of fund managers. To deliver better returns, managers responded by moving money from bonds and blue-chip stocks to alternative investments — real estate, commodities, hedge funds and private equity funds — where there was more risk, higher leverage and bigger fees. In time, the managers of these alternative investment vehicles began looking for new strategies to improve their results, and Wall Street was only too willing to accommodate with a dizzying new array of products.

At times, it seemed to work spectacularly. During the late ’80s, the late ’90s, and again during the recent boom, investors earned record returns and corporate executives and money managers earned record pay packages. But after the bubble burst in each cycle, the gains to investors turned out largely to have been a mirage, while the gains of the executives and the money managers remained largely intact.

It is all well and good to vow that compensation schemes will be changed so that executives and money managers sink or swim with their investors, but there is a limit to how far those incentives can be aligned. While these new and improved financial markets promise greater efficiency and liquidity — except, of course, when they don’t — it’s now clear that the benefits of all that efficiency and liquidity are captured largely by the Wall Street middlemen rather than their customers, or the economy as a whole.

The more fundamental problem, as the Aspen panel reminds us, is that the components of modern finance — the securities, the trading and investment strategies, the financing techniques, the technology, the fee structures and the culture in which they operate — are all designed to work together to maximize short-term results. And, in such a self-reinforcing system, it is very difficult to change any one feature without changing all the rest.

The problem we face regarding financial markets is not limited to Wall St investment banks. It is systemic. And it must be changed, both through better, more effective regulation and through the understanding of large investors – pension fund managers, etc. – that slower, sustained growth is preferable to market bubbles and quick profits that inevitably harm the overall economy.

Written by Valerie Curl

September 17, 2009 at 5:55 PM

On creating new financial regulations

leave a comment »

This morning while scanning the NY Times for news and interesting, little known information, I discovered an abstract by Jennifer Taub of the University of Mass. at Amherst. In Enablers of Exuberance: Legal Acts and Omissions that Facilitated the Global Financial Crisis, Ms Taub argues that the financial market crash of 2008 is the direct result of a deregulation based more on an ideological idea that on sound and realistic fiscal policies. In the abstract, she writes:

After the bust, these Legal Enablers helped the middlemen to not just walk away unscathed, but wealthier than ever, and to leave the rest of society bereft. Uncertainty about the bankruptcy treatment of complex instruments and transnational structures made commercial bankruptcy through Chapter 11 less viable, thus the “middlemen” financial firms received massive taxpayer-funded bailouts. Meanwhile, Chapter 13 after the 1993 Court decision, prevented consumers from down-sizing underwater mortgages. Finally, the ability for ultimate investors to seek redress has been eroded through securities laws changes and legal doctrines shielding fiduciaries from liability.

This paper contends that if we wish to restore investor confidence and sustain a stable financial system, we must stop enabling the excessive leverage and speculation that create cycles of irrational exuberance followed by financial panics. Specifically, it recommends that we eliminate the loopholes that allow unregistered investment pools broad discretion to operate in the shadows, without transparency or supervision, to engage in self-dealing or related-party transactions, to inaccurately value and inadequately protect assets and to take on excessive leverage and illiquid portfolio holdings. This surpasses the Obama Administration’s proposal to bring hedge fund advisers under the Investment Advisers Act. In addition to the disclosure and enforcement that would affect hedge funds and advisers under that bill, this paper recommends revisiting the substantive protections of the Investment Company Act that apply to mutual funds. While the federal securities laws generally used mandated disclosure and enforcement as tools to regulate conduct, the country learned in 1929 and again in 2008 that regarding investment pools, disclosure is not enough. Substantive restrictions are more effective tools to protect pools of other people’s money. As part of this recommendation, the myth of the sophisticated investor and the private offering are confronted.

Second, this paper suggests that we avoid allowing devices, like credit default swaps, initially designed to minimize and distribute risk to be used for speculation or gambling. Third, it advises that we change our Bankruptcy Code to allow lien-stripping under Chapter 7 and 13, thus discouraging poor underwriting and inflated home valuations and protect the most vulnerable from the impact of the financial system abuses. Fourth, we should remove the obstacles that shield corporate officers, directors and others from liability for enabling destructive behavior.

This paper will also address the arguments that might be offered that would resist these reforms. These include, among others: (1) that we should not regulate hedge funds because they did not cause the GFC; (2) sophisticated investors can take care of themselves; (3) human nature (i.e. greed) cannot be successful constrained; (4) government regulation is ineffective and undermines business growth; (5) lien-stripping is too expensive and creates moral hazard; and (6) one should not second guess the behavior of corporate directors and managers trying to operate in the midst of a market-wide correction or collapse.

The crisis has passed but the problems that caused the crash remain. Nothing has changed and Wall St. has returned to the same old behavior that led to the crash. And the gatekeepers still don’t know what to do.

With all the Tea Parties crowds screaming about the deficit, the ruination of the economy, the loss of jobs and retirement funds and socialism, the time to revise regulatory laws is ripe to restore confidence in financial markets and the power of the government to keep the players honest.

Written by Valerie Curl

September 17, 2009 at 12:02 PM

%d bloggers like this: