The struggle for financial regulatory reform in Washington will fail if the debate continues to focus mainly on the bookends of the crisis -- the original subprime shock and the eventual federal bailout. Although both were very serious problems, even more serious was the near collapse of the American financial system that came in between.
A healthy financial system would have been able to absorb the subprime shock, like a well-conditioned fighter who's able to take a punch and remain standing. But our financial system, wildly overleveraged, crumpled after just one blow. If we don't fix the leverage problem, everything else will be for naught.
Over the past several decades, rising debt levels characterized just about every part of the American economy. But total debt outstanding rose particularly fast in the financial sector, surging from $578 billion (21% of GDP) in 1980 to $17 trillion (118% of GDP) in 2008. In the years leading up to the crash, moreover, financial firms increased their leverage to dizzying heights, piling ever more debt on a dangerously thin foundation of capital. Among domestic investment banks, gross leverage ratios grew from about 23-to-1 in the first quarter of 2001 to over 30-to-1 in the fourth quarter of 2007. And that's just what was visible on their balance sheets. Off-balance-leverage rose dramatically higher, with contingent liabilities (including AIG's notorious credit default swaps) inflating hidden leverage to truly extraordinary levels.
Greatly compounding the problem was that much of this leverage was based on very short-term debt, creating the potential for bank runs if confidence ebbed. Much of the leverage was also concentrated at firms that had grown spectacularly in a short time. Bear Stearns, for example, had grown its assets more than 10-fold from 1990 to 2007.
Unfortunately, it was the biggest (and most highly leveraged) financial institutions that played the greatest role not only in inflating the bubble on the way up but also in driving the panic on the way down. As asset prices started to fall as a result of the subprime mess, many of these super-sized financial firms had no choice but to sell -- and sell massively -- to keep their already thin capital base from vanishing altogether.
Had the large financial firms been better capitalized to begin with, the catastrophic fire sales that brutalized the markets in 2008 could well have been avoided, or at least kept to a minimum. But in companies that were so highly leveraged, even small losses on their overall portfolios could wipe out their capital -- a prospect that left them no choice but to intensify their selling as the subprime turmoil deepened. Indeed, had the terrifying downward spiral not been stabilized through aggressive federal action, the nation's financial system might have collapsed altogether, greatly worsening the recession and driving unemployment even higher -- and perhaps far higher -- than what we've experienced so far.
What will it take to prevent such a calamity from ever happening again? We should certainly address the bookends of the crisis: common-sense regulation of consumer and mortgage lending would help to prevent another subprime fiasco; and the creation of new tools for dealing with major financial firms that fall into distress could reduce the need for another bailout. These are critical steps. But by far the most important thing we can do is make our financial system strong enough to withstand a significant shock, and that means limiting leverage, particularly at the nation's largest financial firms.
Fortunately, the House bill passed in December already contains language capping the leverage of "systemically significant" financial institutions at no more than 15-to-1. (Full disclosure: I suggested the provision, and worked with Representative Jackie Speier who shares my concern about leverage and sponsored the relevant amendment in committee.) It is now imperative that the Senate adopt this provision, or even tighten it, perhaps taking the limit down to 10-to-1.
Congress should also impose strict limits on these firms' short-term borrowing and off-balance-sheet activity, and require them to maintain sufficient liquidity as well. Combined with a tough leverage cap, such rules will help ensure that an unexpected shock -- whether from the mortgage sector or someplace else -- will never again threaten to bring down the broader financial system and inflict so much pain on the America people.
For those who worry that limiting leverage is somehow inconsistent with American tradition, it is worth remembering that the nation's founders strictly limited bank leverage in their own time, frequently at less than 4-to-1. Although bank runs remained a problem in early America because of the absence of deposit insurance, the dangers of high leverage were already well appreciated. Let's not lose sight of that wisdom now.
Crossposted with the Baseline Scenario.
This Program is very different than anything that has been implemented or even considered. It is based upon patent-pending technology and uses market forces to make all parties involved work together to a common goal – paying-off (not modifying) the existing mortgage.
Basics of the Program: Homeowner monthly payment bid matched with Investor interest rate requirement which develops principal amount that Servicer can accept (or not) to pay-off the existing mortgage. If accepted, Homeowner gets new Time-Out Mortgage, Investor get new hybrid security Home Certificate that looks like a Certificate of Deposit than is insured (zero-subsidy fund) with possible bonuses.
This program has been reviewed by many knowledgeable experts and, so far, has passed with flying colors. A nice feature of the Program is that FMV of Home is not considered in developing the existing mortgage pay-off amount or new monthly payment.
One potential problem - banks are not involved. Traditionally, banks have provided mortgage loans to finance residential real estate transactions. This process allows Homeowners to get institutional real estate financing without going to a bank. This could be hard to overcome politically. This could less of an issue if use is restricted to "problem loans".
This is a serious out-of-the box solution to a very serious problem. I would greatly appreciate any comments you may have. Contact me for “off the record” information.
Jerry
complete-anonymity.cz.tc
The media are still giving a lot of space to the Republican "don't think" shills of Rogue Finance
(BoA, Goldman Sachs, AIG...), there are armies of highly "toxic" lobbyists... Public space is poisoned by the most heinous, manipulative propaganda in favour of the financial felons!
Congress should hurry up to pass a new version of Glass-Steagall because all hell is about to break loose.
THERE IS NO SECOND CHANCE.
We will be lucky to survive this crisis but hard times will be with us for years to come.
If there is no reform in regulating and supervising the market, another crisis is just around the corner.
You miss the toxic asset, the AAA securitization of subprime mortgages that were sold to investment banks to be peddled at horrendous horrendous fees. If Toyota sold crap like that... do you think they'd be allowed to do business in America??? How about moodys, std & poors, and fitch the ratings agencies? Have they been lined up and sumarily executed at sunrise? (I exaggerate for affect only) How, pray tell...professor, could mortgage loans that had already been closed and funded (their economic impact being made in the local market place) be sold at profit to investment banks who would slice, dice, blend, and create wonderful securities with diversification of risk (all of which had the blessing of professordom, eh?) that would go on to the marketplace at another killing of profit for the bears lehmans morgans etc and continue with an income stream with AAA ratings.
Something tells me that leverage was not the problem. I mean your solution for this is kind of like stating that Madoff's investment pool of other people's money should have had assets verified? We all know that is way way too complicated, eh?
Where were all the business and economics professors when the Greenspan fed ran negative real interest rates? Absorbed in myopia during the raging fire of speculation?
A fed funds policy by the fed of no lower than 5.0% would have precluded the rampant speculation and the problem would never gained the air to implode.
My personal opinion is that what matters even more than limits on leverage (in America or elsewhere) is to make sure that the bankruptcy and solvency regime matches the leverage (or the risk adjusted leverage).
From this perspective, credible 'living wills' might be even more helpful towards financial stability when it comes to systemically relevant financial institutions, and cramdown legislation when it comes to homeowners.
In the meantime, I find myself yielding to the temptation to smugly point out that I lost only 5% of our retirement in the meltdown, compared to billions -- was it 30% -- lost by 6 Harvard managers handling the Harvard endowment, thanks apparently to my having been denied a Harvard education. Some portion of our losses may yet return in a class action suit that fights the fraudulent claims that tripped investors. It's a small comfort, considering the broad damage that's been done to the people of the nation that I love. Bank leverage is such a small part of it. Thanks for allowing me to air the bitterness.
Moreover, do you honestly think that all Harvard professors subscribe to the exact
same belief systems, with regard to Economics or anything else?
Your statement that Bank Leverage played a 'small part in it' is entirely unsubstantiated.
If you have any facts to back up that assertion, those facts would have been a far more persuasive
argument than the attempted vilification of Harvard.
Every major bank seems to have disregarded reality, soliciting and packaging loans of questionable quality. Particularly Robert Rubin,economics Harvard, was on the forefront of leading and benefiting from egregious abuse of a public captured by the hype about homes being the way to financial security. Bernanke, Harvard, inherited a mess but exhibited clueless or complicit behavior. Henry Pauson - Harvard MBA. Jeffrey Immelt, GE, Harvard, sucked deeply from the well of financial exploitation, then admitted that the service economy idea was flat wrong and that Americans were taken for granted.
How many more do I have to identify? It was not just the leverage, it was home buyer and wage earner abuse. Harvard people had the power to sweet talk government into whatever they wanted but mostly don't even seem to feel a pang of regret. I don't need that evidence to be thrilled that I saved myself while Harvard endowment managers fell on their faces. Look, I will probably vote Democratic for the rest of my life, but I insist that the people of this nation deserve better from business leaders.
Among the Harvard educated or affiliated are not only its former presidents like Summers, but also people like NYT columnist Frank Rich and Obama.
It doesn't make a lot of sense to try to hold the school responsible for their offspring (although I would love to see Oxford university withdrawing that Ph.D. from Frank Luntz - but that's just my personal opinion).
There may be valid criticism - for example it is said that it might be too easy for the wealthy to earn a degree a Harvard - but you can't just blame the nation's fate on Harvard. That's too simple.
AIG probably drew no Harvard graduates whatsoever -- rather its greed and stupidity was exploited by investment bankers, who, between Harvard Blankfein and Harvard Paulson, could see it coming but couldn't or wouldn't imagine how to contain the potential damage before it was too late. Is it asking too much for brilliance to include heroism and maybe even self-sacrifice? It is no wonder that the public has come to believe that all on Wall Street are nothing but greedy and self-serving. Whether that opinion is right or wrong, it is disdain that was earned.
Spending money you don't have, be it on a house, or stock, or ANYTHING else is the best way to get into trouble, weather you're a human being or quasi-human being (i.e. corp) gets you into trouble. This crisis was the result of rampant brain-washing (or advertising) to many entities. Doncha remember, Greed is Good!
It's OK to buy a car or house or company you can't afford, you'll get a raise next year. Inflation will make the money you spend this year not look like so much next year. Usually....
We've been conditioned to think that "going into debt today makes for a better tommorrow". Saving up for something is so 1950's. Gambling is what it really is, and always has been. Hence downpayments, or margin calls, to "lessen" the gamble.