10/29/2008 05:12 am ET Updated May 25, 2011

Who's To Blame For the Mess We're In?

Because this mess has happened on the Republicans watch they are going into massive spin mode. While their stories are easily dismissed by, well, facts, their rationalizations are still getting into mainstream political dialog. So.....

There are a ton of great theories being floated right now. A few of them are laughable. Two that stand out are the following:

-- The Community Reinvestment Act caused financial institutions to lend to people who weren't credit worthy. This is crap. The CRA was signed into law in 1977 -- over 20 years before the current crisis. The second problem with this theory is the CRA only applies to banks and thrifts. Most of the mortgage lending during the last boom came from -- mortgage lenders who aren't regulated by CRA. I explained this all in more detail here.

-- The theory that not putting Fannie and Freddie under a new super-regulator in 2005 caused the problem. The problem here is this administration is notoriously lax with any regulatory oversight. They're been asleep at the switch for 8 years (how many food recalls have we had? Or toys? How many mortgage brokers are being investigated by the FBI for fraud?) This is also laughable. But it is also easily disproven thanks to a a Baron's article on Fannie and Freddie:

Note, too, that Fannie and Freddie have nonpareil lobbying operations and formidable political strength, owing to their hefty donations and penchant for hiring former political operatives. Besides, the agencies claim they've landed in their current predicament through no fault of their own. As Freddie Mac Chairman and CEO Richard Syron recently put it, the GSEs have been hit by a "100-year storm" in the housing market, accentuated by some higher-risk mortgages that they were forced to buy to meet government affordable-housing targets.

The latter contention is more than disingenuous. A substantial portion of Fannie's and Freddie's credit losses comes from $337 billion and $237 billion, respectively, of Alt-A mortgages that the agencies imprudently bought or guaranteed in recent years to boost their market share. These are mortgages for which little or no attempt was made to verify the borrowers' income or net worth. The principal balances were much higher than those of mortgages typically made to low-income borrowers. In short, Alt-A mortgages were a hallmark of real-estate speculation in the ex-urbs of Las Vegas or Los Angeles, not predatory lending to low-income folks in the inner cities.

There are several culprits who share responsibility.

The Federal Reserve for lowering interest rates to 0% after adjusting for inflation. Lower the price of anything available for sale and people will buy more of it. That's exactly what happened. Household debt exploded. Total household debt outstanding increased from $7.6 trillion in 2001 to $14 trillion in the second quarter of this year. That's a huge increase. Most of it was .... mortgage debt, which increased from $5.3 trillion to $10.6 trillion over the same time period. All of that debt had to go somewhere -- namely the balance sheet of every financial company on the planet.

Here's a great summation:

The Federal Reserve, which has encouraged excessive borrowing, is to blame for the credit crunch that has gripped world markets for more than a year, Marc Faber, the author of the Gloom Boom & Doom Report, told CNBC on Tuesday.

"About 15 percent of U.S. households have negative equity. Who supplied the leverage into the system? It's called the Federal Reserve Board," Faber said.

"If I'm the drug dealer I'm not responsible that everybody takes drugs, but I facilitate it, especially if I give it out free of charge, I can enlarge the market share, and that's what the Fed has done."

Any economist who says "I had no idea low interest rates would lead to this" is lying through his teeth.

Then there is the lack of regulatory enforcement of, well any laws. The Federal Reserve was warned about the effects of lack of regulation several times over the last expansion:

Edward M. Gramlich, a Federal Reserve governor who died in September, warned nearly seven years ago that a fast-growing new breed of lenders was luring many people into risky mortgages they could not afford.

But when Mr. Gramlich privately urged Fed examiners to investigate mortgage lenders affiliated with national banks, he was rebuffed by Alan Greenspan, the Fed chairman.

In 2001, a senior Treasury official, Sheila C. Bair, tried to persuade subprime lenders to adopt a code of "best practices" and to let outside monitors verify their compliance. None of the lenders would agree to the monitors, and many rejected the code itself. Even those who did adopt those practices, Ms. Bair recalled recently, soon let them slip.

And leaders of a housing advocacy group in California, meeting with Mr. Greenspan in 2004, warned that deception was increasing and unscrupulous practices were spreading.

John C. Gamboa and Robert L. Gnaizda of the Greenlining Institute implored Mr. Greenspan to use his bully pulpit and press for a voluntary code of conduct.

"He never gave us a good reason, but he didn't want to do it," Mr. Gnaizda said last week. "He just wasn't interested."

In a recent Baron's column, Barry Ritholtz of the Big Picture blog added some great points:

1998: Long Term Capital Management was undercapitalized, used enormous amounts of leverage to purchase all manner of thinly traded, hard-to-value paper. It failed, and under the authority of the Federal Reserve a "private-sector" rescue plan was cobbled together. Had these bankers suffered big losses from LTCM, they might have thought twice before jumping into the exact same business model of undercapitalized, overleveraged, thinly traded, hard-to-value paper. Instead, they reaffirmed Benjamin Disraeli's famous aphorism: "What we learn from history is that we do not learn from history."

Boy does that sound familiar -- undercapitalized, massive leverage and hard to value assets. That is exactly what is happening right now on a systemic basis. That describes literally every major player in the financial market right now. Instead of letting LTCM fail, Greenspan rode to the rescue (like a good free-market advocate) arranging a deal. If you are wondering why financial market players currently think they can get a bail-out, look no further than this event.

The Financial Services Modernization Act repealed Glass-Steagall, a law that had separated the commercial-banking industry from Wall Street, and the two industries, plus insurance, came together again. Banks became bigger, clumsier, and hard to manage. Apparently, risk-management became all but impossible, even as banks had greater access to larger pools of capital.

Boy was this a big one and incredibly important to understand. Let's start by looking at the difference between commercial and investment banking.

From Wikipedia:

Commercial banks engaged in the following activities:

* processing of payments by way of telegraphic transfer, EFTPOS, internet banking or other means
* issuing bank drafts and bank cheques
* accepting money on term deposit
* lending money by way of overdraft, installment loan or otherwise
* providing documentary and standby letter of credit, guarantees, performance bonds, securities underwriting commitments and other forms of off balance sheet exposures
* safekeeping of documents and other items in safe deposit boxes
* currency exchange
* sale, distribution or brokerage, with or without advice, of insurance, unit trusts and similar financial products as a "financial supermarket"

From Wikipedia:

On behalf of the bank and its clients, the primary function of the bank is buying and selling products. Banks undertake risk through proprietary trading, done by a special set of traders who do not interface with clients and through Principal Risk, risk undertaken by a trader after he buys or sells a product to a client and does not hedge his total exposure. Banks seek to maximize profitability for a given amount of risk on their balance sheet. An investment bank is split into the so-called Front Office, Middle Office, and Back Office.

In other words, one is conservative (commercial banks) and one is aggressive (investment banking). Both serve important functions. But both are very different.

More importantly, banking is incredibly important to the economy as a whole and hence should be managed very conservatively. Banks are financial intermediaries -- meaning they stand between savers and borrowers. Banks take a large number of small savers, pool the assets and then loan them out in larger amounts of money. If anything interferes with this process businesses can't get loans leading to an economic slowdown. Investment banking is far more aggressive. Here, firms basically are trying to buy assets at a low price and sell them at a high price. This is also a vitally important economic function but also noticeably different from commercial banking -- it is a far riskier.

The reason these two areas of finance were separated was to essentially keep bankers playing a conservative game. But by allowing these two types of very different business models to join together commercial banking was now exposed to the far riskier business of investment banking. This means the possibility of risk to the commercial bank was higher. That partially explains why the commercial banking sector is completely frozen right now -- they took on investment banking risks. Which is really stupid.

Barry continues:

2000: The Commodities Futures Modernization Act defined financial commodities such as "interest rates, currency prices, and stock indexes" as "excluded commodities." They could trade off the futures exchanges, with minimal oversight by the Commodity Futures Trading Commission. Neither the Securities and Exchange Commission, nor the Federal Reserve, nor any state insurance regulators had the ability to supervise or regulate the writing of credit-default swaps by hedge funds, investment banks or insurance companies.

Let's back-up a bit. What is a "credit default swap" (or CDS)? Let's go to Wikipedia:

A credit default swap (CDS) is a credit derivative contract between two counterparties, whereby the "buyer" or "fixed rate payer" pays periodic payments to the "seller" or "floating rate payer" in exchange for the right to a payoff if there is a default[1] or "credit event" in respect of a third party or "reference entity".

If a credit event occurs, the typical contract either settles by delivery by the buyer to the seller of a (usually defaulted) debt obligation of the reference entity against a payment by the seller of the par value ("physical settlement") or the seller pays the buyer the difference between the par value and the market price of a specified debt obligation, typically determined in an auction ("cash settlement").

Let's put this in perspective. First, an option is a contract to buy or sell a specific amount of a security at a specific price at a specific time. Suppose you purchase 100 shares of a stock at $100/share. You are convinced it is going up but want protection in case it goes down. You sell an option to someone. They agree to buy your 100 shares at 90 in three months. If the stock doesn't go to 90, the option expires and you pocket the premium. If the stock goes down you have downside protection. This is standard risk management. It's been around since the early 1970s.

A credit default swap is essentially an option on a financial instrument that doesn't have a an option publicly available. Here think "debt instruments -- corporate bonds, mortgage backed bonds etc.... Like stock options, CDS are a great idea because they allow bond managers to hedge risk. What makes them dangerous is when they are unregulated and traded in a private shadow market because we have no idea who has written how many contracts on what securities.

Need further proof of why an unregulated CDS market is bad? OK -- I have three letters for you: AIG. It was there exposure to the CDS market that led Washington to bail them out to the tune of $85 billion.

So let's review:

1.) Bailing out LTCM set a very bad precedent

2.) Deregulation exposed banks to unnecessary risks

3.) Deregulation led to the development of an entire shadow market in CDSs

4.) Lowering interest rates to 0% after inflation led to massive speculation in real estate

5.) Lack of any regulatory oversight encouraged outright fraud

All of these combined led to a terrible problem that we are now paying for.