I just want to share some insight about regulation in the financial sector. I worked on Wall St. during the 1980’s, in fact I worked at Bear Stearns which if you’ve been following the whole financial debacle of the past year, you know what happened to them. They were one of the most successful pioneers of derivatives. What derivatives are are securities that are based on other securities such as mortgages. What Bear Stearns did was to buy mortgages from mortgage consolidators such as Freddie Mac and Ginnie Mae. Because mortgages as a financial instrument are very unpredictable because you never know whether someone is going to live in a house forever and pay off the whole mortgage over 20 or 30 years or sell the house and pay off the mortgage. Such uncertainties drastically affect the actual value of the mortgage over time. So what Bear Stearns did was to create a secondary instrument that would contain for instance, all the first year payments from 100 mortgages. Because they have statistical data on prepayment of mortgages, having many mortgages in the instrument allows it to be more statistically predictable. So what happened on Wall St. is that the brokerage houses created these derivatives and sold them to investors many of whom were banks.
The problem was, although they had some statistical predictability, they were subject to extreme fluctuations due to changes in lets say the housing market for mortgage derivatives. However, they were rated as bonds are by bond rating agencies who bought into the statistical predictability and the real truth is that it was virtually impossible to really predict their value. Now on Wall St. and at banks there is a system in place mandated by the government that governs how securities are valued so that buyers can be reasonably certain about what it is they are buying. The problem is, that derivatives being the new kid on the block were not covered by existing regulation and with their proliferation, the pressure from Wall St. and the banks on Washington was to look the other way and not regulate these financial instruments. When the real estate market hiccuped, the value of these derivatives took a nose dive. Many banks and brokerages who are regulated to hold a certain amount of capital to back up their outstanding obligations were using these derivatives as the backing capital. As long as the financial institution did not try to redeem these instruments, they could basically assign any value to them that they wanted to, but if they sold them, suddenly they now had a real value, and that value was actually a fraction of their stated value or the value at which they were bought. Suddenly the institution was severely under capitalized and in danger of failure. This is the situation today. Only now what is capitalizing the banks is government dollars. So where did these dollars come from? The government issues treasuries which are debt instruments and they are bought often by foreign governments (China is our biggest creditor). Doing this is like printing money. What happens when you print money is that every other piece of money falls in value, the more money you print. This is what is called inflation. The money is worth less. Suddenly you have to pay more today for something that cost much less last year. So printing money is an invisible tax on everyone who holds the money. Try traveling outside the US and see how much your money will buy today. You will have a severe shock. So the government under Bush and now Obama is devaluing the currency to save the financial sector from some extremely bad business decisions. This is what FDR did in 1933 to pull the US out of the great depression.
So back to the topic of regulation. We have enough experience in the 20th century to see what lack of regulation does vs. what regulation does. The great depression was a result of a similar era of unregulated speculation. As a result the banking and brokerage sector was regulated in 1933 by the Glass-Steagal Act that was designed to prevent unregulated speculation. In simple terms, it tried to make sure that things were accurately valued and that there was enough actual financial leverage in the system to accommodate the market fluctuations that are part of the system. It also did many other things to separate banks who handle money from the brokerages that create financial instruments. This system worked very well until the country took a swing to the right and those who were pushing for less regulation got their way. In 1980 the Depository Institutions Deregulation and Monetary Control Act deregulated some of the activities of the Savings & Loan Banks. The result was that the banks were able to buy real estate and use that to satisfy their holdings requirements. When the housing market took a nosedive, the S & L’s went belly up and came crawling to Washington and it took an act of congress to bail them out and of course we know who paid the bill.
The next venture into deregulation was the Gramm-Leach-Bliley Act in 1999 which set the stage for the current debacle on Wall St. The Gramm-Leach-Bliley Act allowed consolidation among banks and brokerages. This led to the creation of a shadow banking system run out institutions like Bear Stearns and Lehman Bros. which operated as banks without the regulation that banks operate under. Because they were capitalized by many of these risky financial instruments, when the housing market started to falter, these entities went belly up. It’s important to note that in terms of capitalization these entities had grown in the eight years after 1999 to such a size in volume of money being lent in the system that they accounted for something like 40% of all money being lent. When they disappeared, there was nothing to replace them and the whole financial system ground to a halt. This was a primary and direct result of deregulation.
This is a statement from the G20 “Declaration of the Summit on Financial Markets and the World Economy," dated 15 November 2008:
“During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.”
As stated above, the “regulatory actions” over the past 30 years have been deregulatory in nature and as stated in the section on derivatives, the state of regulation did not keep up with the evolution of financial instruments. In sum, the problem is not too much regulation but the absence of regulation that created the conditions that led to the collapse of the global banking system in 2008.
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