Henry C.K. Liu continues his analysis of the global post-crisis economy by examining how the banking industry of the 1920s became the byzantine financial sector of today.
The 1929 banking crisis that launched the Great Depression was caused by stressed banks whose highly leveraged retail borrowers were unable to meet margin calls on their stock market losses, resulting in bank runs from panicky depositors who were not protected by government insurance on their deposits.
In the 1920s, there were very few traders beside professional technical types. The typical retail investors were long-term investors, trading only infrequently, albeit buying on high margin. They bought mostly to hold based on expectations that prices would rise endlessly.
By contrast, the two decades of the 1990s and 2000s were decades of the day trader and big time institutional traders. New powerful traders in major investment banking houses overwhelmed old fashion investment bankers and gained control of these institutions with their high profit performance. They turned the financial industry from a funding service to the economy into a frenzy independent trading machine. Many of the investing public aspired to be the Master of the Universe, as caricatured in Tom Wolf's Bonfire of the Vanity, which was turned into a movie starring Tom Hanks. Derivative trading by hedge funds was routinely financed through broker dealers funded by banks at astronomically high leverage.
Greenspan - the Wizard of Bubble Land
But the debt joyride was by no means all smooth sailing in a calm sea. Repeated mini crises were purposely ignored by regulators who should have known better. Greenspan, notwithstanding his denial of responsibility in helping throughout the 1990s to unleash serial equity bubbles, had this to say in 2004, three year before the 2007 tsunami of a century, in hindsight after the bubble burst in 2000: "Instead of trying to contain a putative bubble by drastic actions with largely unpredictable consequences, we chose, as we noted in our mid-1999 congressional testimony, to focus on policies to mitigate the fallout when it occurs and, hopefully, ease the transition to the next expansion." The Greenspan Fed adopted the role of a clean-up crew of otherwise avoidable financial debris rather than that of a preventive guardian of public financial health. Greenspan's one-note monetary melody throughout his 18-yesr-long tenure as the nation's central banker had been when in doubt, ease.
LTCM - the Crisis that the Fed Papered Over
In the 1920s, there were no derivative markets. In the case of Long Term Capital Management, the hedge fund that failed in 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion to acquire assets of around $129 billion, for a debt-equity ratio of about 25 to 1. But even that it was conservative when compared to the 40 to 1 ratio used by investment banks in the 2000s.
LTCM had off-balance-sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps, equaling to 5% of the entire global market. LTCM also invested in other derivatives such as equity options. LTCM was bailed out by its counterparty creditors under the guidance of the NY Fed. (Please see my December 3, 2009 series: Reform of the OTC Derivative Market - Part One: The Folly of Deregulation)
The Enron Fraud
In the 1920s, there was no structured finance or securitization of debt. The case of Enron, a large brave new energy trader, and its spectacular bankruptcy marked the high watermark of legalized financial fraud. The evidence is undeniable that the Enron scandal exposed critical flaws in the entire financial system and the ineffective policing of US capital markets and corporate governance. In a December 18, 2001 Senate Commerce Committee hearing on the Enron collapse, Arthur Levitt, former Democratic head of the Securities and Exchange Commission (SEC), characterizes corporate financial statements as "a Potemkin village of deceit". Senator Ernest Hollings, a Democrat from South Carolina, characterized Enron Chairman Kenneth Lay's political prowess as "cash and carry government". Embarrassingly, the New York Times reported the following day that Hollings had received campaign contributions from Enron and its auditor Arthur Andersen dating from 1989.
Until Enron filed for bankruptcy in 2001, the system's top law firms and accounting firms were providing professional opinion that what went on in Enron was "technically" legal. The international dealings of Enron received unfailing support from the US government. Many of the schemes undertaken by Enron and other companies were devised by investment bankers who collected fat fees advising their clients and who profited handsomely from providing financing for schemes they knew were towers of mirage. It was known in the industry as "finance engineering" and the vehicle was structured finance or derivatives. (Please see my August 1, 2002 article: Capitalism's bad apples: It's the barrel that's rotten)
Greenspan - Enron Prize Recipient
Chairman of the Federal Reserve since 1988, Alan Greenspan gave a lecture at Stude Concert Hall sponsored by the James A. Baker III Institute for Public Policy on November 13, 2001. Following his lecture, he received the Baker Institute's Enron Prize for Distinguished Public Service. The prize, made possible through a generous and highly appreciated gift from the Enron Corporation, recognizes outstanding individuals for their contributions to public service.
Greenspan's speech offered an assessment of what lies ahead for the energy industry to an admiring audience. In the wake of the September 11 attacks and the then weakened state of the economy, Greenspan stressed the need for policies that ensure long-term economic growth. "One of the most important objectives of those policies should be an assured availability of energy," he said.
Greenspan said that this imperative has taken on added significance in light of heightened tensions in the Middle East, where two-thirds of the world's proven oil reserves reside. He noted that the Baker Institute is conducting major research on energy supply and security issues.
Looking back at the dominant role played by the United States in world oil markets for most of the industry's first century, Greenspan cited John D. Rockefeller and Standard Oil as the origin of US pricing power, notwithstanding the nation saw fit to break up the Rockefeller/Standard Oil trust. Following the breakup of Standard Oil in 1911, he said this power remained with American oil companies and later with the Texas Railroad Commission. This control ended in 1971 when remaining excess capacity in the US and oil pricing power shifted to the Persian Gulf. Greenspan was saying better Standard Oil than OPEC. He seemed oblivious to the development since the 1973 oil embargo that US oil companies have been working hand in glove with OPEC producers to keep oil prices high.
The Power of Markets against Market Power
"The story since 1973 has been more one of the power of markets than one of market power," Greenspan said. He noted that the projection that rationing would be the only solution to the gap between supply and demand in the 1970s did not happen. While government-mandated standards for fuel efficiency eased gasoline demand, he said that observers believe market forces alone would have driven increased fuel efficiency. Greenspan appeared to be the only one who sincerely believed that a free market existed or could exit for the trading of oil. All oil traders know that the price of oil is one of the most manipulated components in world trade.
"It is encouraging that, in market economies, well-publicized forecasts of crises more often than not fail to develop, or at least not with the frequency and intensity proclaimed by headline writers," Greenspan credited free markets with mitigating the oil crisis.
As it turned out, the California energy crisis of rolling blackouts was not caused by Middle East geopolitics. It was the handy work of Enron fraudulent trading strategies.
Greenspan against Reform
All though the 1990s and early 2000s, there were much talk of reform that led nowhere near what was actually needed. Less than a decade later, a financial crisis that Greenspan characterized as the market failure of a century imploded with a big bang.
On Greenspan's 18-year watch at the Fed, government-sponsored enterprises (GSE) assets ballooned 830%, from $346 billion to $2.872 trillion. GSEs, namely Fannie Mae and Freddie Mac, are financing entities created by the US Congress to fund subsidized loans to certain groups of borrowers such as middle- and low-income homeowners, farmers and students. Agency MBSs (mortgage-backed securities) surged 670% to $3.55 trillion. Outstanding ABSs (asset-backed securities) exploded from $75 billion to more than $2.7 trillion.
Greenspan presided over the greatest expansion of speculative finance in history, including a trillion-dollar hedge-fund industry, bloated Wall Street firm balance sheets approaching $2 trillion, a $3.3 trillion daily repo (repurchase agreement) market, and a global derivatives market with notional values surpassing an unfathomable $220 trillion. Granted, notional values are not true risk exposures. But a swing of 1% in interest rate on a notional value of $220 trillion is $2.2 trillion, approximately 20% of US gross domestic product (GDP). Grated that much of the derivative trades were hedged, meaning the risks are mutually canceling. But the hedges would only hold without counterparty default. All that was needed to unleash a systemic failure was for the weakest link to fail. Greenspan created a monetary situation that permitted the market to speculate on risks that it could not afford.
Having released synthetic credit of dangerously high notional value, Greenspan raised the Fed funds rate target to 5.25% on June 29, 2006 from its lowest point of 1% set on June 23, 2003, to dampen inflation expectations, adding aggregate interest payments to the financial system greater than US GDP in 2006. That was like striking a match to like a candle in a dark kitchen filled with leaked gas. Under such fragile and explosive conditions, there was little wonder that the market collapsed a year later. (Please see my March 16, 2007 article: Why the US sub-prime mortgage bust will spread to the global finance system, written at a time when mainstream opinion was that the housing market, being geographically disaggregated, would not spread.)
Much of the precautionary measures instituted during the New Deal to prevent a reply of the 1929 crash, such as the separation of investment banking from commercial banking, requiring banks to be neutral intermediary of capital funds rather than profit-seeking market makers, in the form of the Banking Act of 1933 (Glass-Steagall), were repealed, as a result of bank lobbying. Glass-Steagall was replaced by the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999), aka the Gramm, Leach-Bliley Act (GLBA).
Wholesale Credit Market Failure
Yet with the benefit of deposit insurance instituted during the New Deal remaining operative, the current financial crisis that began in mid-2007 was caused not by bank runs from depositors, but by a melt down of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.
The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, public-listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices.
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Roosevelt Institute Braintruster Henry C.K. Liu is an independent commentator on culture, economics and politics.