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How the Financial Crisis Happened

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The U.S. financial meltdown has created a worldwide crisis. Ironically, worldwide scared money is still flowing into U.S. Treasury obligations as a safe haven. This permits more U.S. borrowing, but by drying up credit overseas creates financial crises in other countries.

I've been posting for several years on pieces of the origins of this financial crisis. Now Robert Weissman and others have attempted to put together an overall picture of what happened in Sold Out: How Wall Street and Washington Betrayed America, produced by Essential Information and the Consumer Education Foundation.

The report describes 12 deregulatory moves, which it links along the way to $5 billion spent in 1998-2008 on U.S. federal campaign contributions and lobbying expenditures (Weissman is editor of the Washington, D.C.-based Multinational Monitor, and director of Essential Action). Here they are, with a few comments from me:

1. Repeal of Glass-Steagall: The 1999 repeal of the Glass-Steagall Act helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that led many of the banks to ruin and rocked the financial markets in 2008.

Comment: The 1999 law finished the teardown of the last remaining piece of the wall between banks and investment banks. The great Senator Carter Glass was a leader in Congress both of the successful effort to create the Federal Reserve System in 1913 and of the 1933 Glass-Steagall law that forbids banks from engaging in investment banking, merchant banking or insurance activities (it also created the FDIC - that part of the law, as amended, fortunately remains). Former Federal Reserve Chairman Paul Volcker has said he thinks one of the first things that needs to be done to fix the system is to restore the wall between investment banking and commercial banking.

2. Off-the-Books Bank Accounting: Holding assets off the balance sheet generally allows companies to avoid disclosing "toxic" or money-losing assets to investors in order to make the company appear more valuable than it is.

Comment: In his memoir of his years as Chairman of the SEC, Arthur Levitt, Jr. complains about the huge lobbying effort by accounting firms.

3-4. CFTC Blocked from Regulating Derivatives: Financial derivatives are unregulated. By all accounts this has been a disaster. Warren Buffett warned they represent "weapons of mass financial destruction". They have amplified the financial crisis. The Commodity Futures Trading Commission (CFTC) sought to exert regulatory control over financial derivatives during the Clinton era, but failed to get the authority. The non-regulation of financial derivatives was again assured in 2000, with the Commodities Futures Modernization Act.

Comment: These two steps were crucial. They were victories for "financial innovation" - i.e., non-regulation. Passage of the Commodities Futures Modernization Act under the leadership of Senator Phil Gramm prohibited any incursion by the CFTC into regulating financial derivatives.

5-6. Excessive Capital Leveraging Was Encouraged. In 1975, the Securities and Exchange Commission (SEC) promulgated a rule requiring investment banks to maintain a debt-to-net-capital ratio of less than 15 to 1. In simpler terms, this limited the amount of borrowed money the investment banks could use. In 2004, however, the SEC succumbed to a push from the big investment banks, led by Goldman Sachs, and authorized investment banks to develop net capital requirements based on their own risk assessment models. With this new freedom, investment banks pushed ratios to as high as 40 to 1. Meanwhile global bank regulators, in a program known as Basel II, should have been tightening up capital requirements but, influenced by the banks themselves, have been moving in the opposite direction, toward letting commercial banks rely on their own internal risk-assessment models.

Comment: Bank examiners are supposed to look carefully at the loan portfolios of banks to ensure Adequacy of Bank Capital. But investment banks' being allowed to have debt-to-net-capital ratios as high as 40 to 1 creates huge potential for meltdown.

7-9. No Predatory Lending Enforcement: Banking regulators retained authority to crack down on predatory lending abuses, but they sat on their hands. The Federal Reserve took three formal actions against such abuses in 2002-2007, while the Office of Comptroller of the Currency took three in 2004-2006. When the states sought to fill the vacuum created by federal non-enforcement of consumer protection laws against predatory lenders, the Feds stepped in and prohibited states from enforcing consumer-protection rules against nationally chartered banks. Under the doctrine of "assignee liability," anyone profiting from predatory lending practices should be held financially accountable. With some limited exceptions, however, assignee liability does not apply to mortgage loans.

Comment: Bank supervision was lax. It happens when everyone seems to be making money.

10. Fannie and Freddie Enter Subprime. Fannie Mae and Freddie Mac were dominant purchasers in the subprime secondary market. The Government-Sponsored Enterprises were followers, not leaders, but they did end up taking on substantial subprime assets -- at least $57 billion. The purchase of subprime assets was a break from prior practice, justified by theories of expanded access to homeownership for low-income families and rationalized by mathematical models allegedly able to identify and assess risk. Fannie and Freddie are responsible for their own demise.

11. Bank Merger Mania: Megabanks achieved too-big-to-fail status. While this should have meant they be treated as public utilities requiring heightened regulation and risk control, other deregulatory maneuvers enabled them to combine size, explicit and implicit federal guarantees, and reckless high-risk investments.

12. Credit Rating Agency Failure:
Wall Street packaged mortgage loans into pools of securitized assets and then sliced them into tranches. The resultant financial instruments were attractive to many buyers because they promised high returns. But pension funds and other investors could only enter the game if the securities were highly rated. The credit rating agencies enabled these investors to enter the game, by attaching high ratings to securities that actually were high risk. The Credit Rating Agencies Reform Act of 2006 gave the SEC insufficient oversight authority. The SEC must give an approval rating to credit ratings agencies if they are adhering to their own standards -- even if the SEC knows those standards to be flawed.

Comment:Some of these 12 contributing factors are more important than others. The role of Basel II may not have been great. But one way to find signposts to the way out of the financial-market mess we are in is to get some agreement on just how we got here. The new report provides a framework for this discussion.

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