FCIC Report is very Illuminating

The Financial Crisis Inquiry Commission (FCIC) is a congressional sponsored study into the reasons for the Financial Crisis. They were authorized by the President in May 2009. They have issued their final report and are disbanding. Google FCIC and you will find their information is being maintained by Stanford University. The published report is available on the website and at booksellers (ISBN 978-1-61039-041-5). It is more than 500 pages long. I have personally purchased about 15 books on the Financial Crisis over the last two years. (I know I should get a life). Each book discusses a separate segment of the crisis. This report is the most comprehensive book to date and is very readable by a person interested in the subject.

The commission was chaired by Phil Angelidies and former congressman Bill Thomas. There are eight additional commissioners appointed by the Democratic and Republican party. They had a staff of 60 people. They held hearings in Washington and locations in states hardest hit by the Real Estate bubble.

The first chapter summarizes their findings and they are quite illuminating on the many facets of the Financial Crisis. They dispel many myths and examples are provided below. One can definitely say we had less government in the Finance world. The evolved system was unsustainable. The end result was the crash of September 2008.
Conclusions of FCIC
1-The Financial Crisis was avoidable

Despite the “once in a 100 years” admonitions of regulators and politicians, this crisis was avoidable. The document does a thorough job, point by point highlighting and disputing the many actions in the last 20 years.

2-Failures in Financial Regulation and Supervision proved devastating to Financial markets

Greenspan was authorized to stop the writing of toxic mortgages despite the rising evidence that they were massive and detrimental. In 2004, the Federal Reserve could have denied loosening of capital reserves from 12/1 to 30/1. In other words, they would need $1 dollars in the bank for every $30 dollars of assets. This is considered very high leverage.  In 2000 the government declined to regulate Credit Default Swaps (Derivatives). Repeal of Glass-Steagle allowed mixing banks and Insurance companies. Citi bank was acquired by Travelers Insurance immediately. Under the regulation of the Federal Reserve Bank of NY (Tim Geithner) Citi was one of the first banks to get into trouble and require a massive government bailout.

3-Dramatic failures of corporate governance and risk management at important financial institutions, key cause of the crisis.

Many banks (not all) acted recklessly took on too much risk with too little capital to address the crisis, being very dependent on short term funding which evaporated as the crisis evolved. They were not able to raise capital to address demand claim of customer. In short they were not able respond to a run on the bank. This is called a liquidity event. Recall that Investment banks were lightly regulated and did not have access to the FED window for emergency loans. They relied on unproven software to evaluate their risks. In short they loaded up on Real Estate securities which turned toxic and they could not absorb the losses. This was done despite the fact that they knew the underwriting of the real estate loans was poor. Goldman Sachs recognized this and curtailed purchasing of bad loans and they survived.  The financial community was not able to police itself, requiring a massive government bailout. Risk people identified the problem and were ignored.

4-Excessive borrowing, risky investments and lack of transparency put the financial system on a collision course with the crisis.

Several Banks borrowed to the hilt, putting them in a vulnerable position.  If their investment experienced a 3% drop in the purchased asset, it could wipe out the firm because of liquidity issues. In 2007 Bear Stearns, Goldman Sachs, Lehman, Merrill Lynch and Morgan Stanley were operating on thin margins, Leverage margins were high, meaning that for every $40. dollars in assets, they only had $1. dollar in reserves to cover losses. Recall the SEC authorized 30 to 1. They were violating the guidance.

Exacerbating this was that much of the bank borrowing to finance purchases was from short term.  Much of this was overnight. Hence when the real estate securities started declining, the borrowing banks did not have collateral to sustain the loan. Recall that Warren Buffet loaned Goldman Sachs a lot of money for them to be able to have the liquidity. Bear Stearns and Lehman were not able tp get some one to loan them money. Merrill Lynch was purchased by Bank of America. Wachovia was purchased by Wells Fargo. Washington Mutual was purchased by JP Morgan. Transparency was a issue because of Derivatives, off balance sheet and Repo borrowing were hidden from view without protections. This along with the failing securities market created a panic experienced in September 2008. Overnight, funding to handle the bank runs dried up because the banks did not trust each other.

Another factor creating the problem was the banks paying employee’s (traders) huge lumped awards based on future earnings which did not materialize. Hence very risky transactions became the norm of banking. Because payoff’s were so large, the question of the employee acting in the long term interests of their boss’s was a valid discussion.

5-The government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic in the financial markets

Treasury, Federal Reserve and Federal Reserve Bank of NY were best positioned to observe the financial situation. They did not have a clear view of the system to be monitored. This was in part due to the lack of transparency. They thought risk was dispersed, in fact it was concentrated. Part of this was Derivatives which were not regulated hence opaque to the regulators. Derivatives interconnected the banks. Many sellers of derivatives had not capital reserve requirements. Hence when failures started happening, the banks were unable to pay claims.

Fannie and Freddy had capital ratios of 75 to 1. Hence they collapsed the same month that Lehman and AIG did.

To demonstrate their lack off understanding, Bernanke (FED), Paulson (Treasury) and Chris Cox (SEC) assured the public that the financial system was under control, in the month before the collapses of Bear, Fannie & Freddy, Lehman and AIG. If you think about it, Hank Paulson was a recent Goldman CEO and he should have had some idea on what was going on. In his book he claims he was blindsided. That shows how poorly the CEO’s and regulators understood their markets. Also the inconsistency in terms of bailing out firms created uncertainty in the financial markets causing everyone to pull back

6-Systemic breakdown in the accountability and ethics

Integrity and trust of the financial markets are essential to the well being of the nation. Notions of fair dealing, responsibility and transparency are key to the system. While not universal, we experienced a breach of standards in responsibility and ethics from the ground up to the corporate suites.

For example defaults on mortgages in a matter of months after taking out the loan  doubled from summer of 2006 to late 2007. This says the people never had the capacity to pay. Income of the borrower was not checked or ignored. This happened in a climate of rising fraud due to lowering standards in the loan brokering business. The number of Suspicious Activity Reports filed by depository banks increased 20 fold between 1995 and 2007. Lenders wrote loans that they knew borrowers could not pay.

The commission place special responsibility with public leaders who were entrusted to run regulatory agencies. Individuals sought and accepted positions of significant responsibility and obligations. This includes the chief executives of companies who drove us to the crisis. Nobody at the top said no. Tone at the top does matter. One example of this was SEC Chris Cox de funded the compliance legal team.

7-Collapsing mortgage lending standards and mortgage securitization pipeline lit and spread the flame of contagion and crisis.

Mortgage lender set the bar so low that borrowers statements were accepted on faith. Often the lender knew the borrower could not make payments. During the first half of 2005 one fourth of the loans were interest only. During the same year, 68% of loans made by Countrywide and Washington Mutual were sub prime (low credit scores) Option ARM loans which went toxic.

These trends were not secret. The FED (Greenspan) was warned from many quarters on the existence of poor underwriting standards. He ignored the warnings believing the free market would correct itself. The Office of Comptroller of Currency and Office of Thrift Supervision prohibited (preempted) states from prosecuting underwriting  fraud. This was to be done at the Federal Level, because banks were national. But it never happened. (Editors note: Google OCC Preemption for more information)

8-Over the counter Derivatives contributed significantly to this crisis.

The enactment of legislation to prohibit regulation of Derivatives was a key turning point to the crisis. (editors note: Google Brooksley Born Frontline to see a full video describing the fiasco)

Derivatives are often described to be like your home insurance. If the house catches fire, you get paid. In a similar manner, if a security defaults, the Derivative pays. They differ in two major area’s. States require home insurers to maintain reserve margins to enable paying claims. Derivative sellers do not have to maintain reserve margins. This was the big problem with AIG, they did not have reserves to pay claims when the securities defaulted.

People can purchase home insurance only if they own a home. Neighbors cannot buy policies on your house. Not so in the Derivatives business. Anybody can buy a Derivative on any Security. If some one feels a security is going to fail, they can purchase Derivatives on those securities. These are called Naked Derivatives This phenomena is described by Michael Lewis in his book called The Big Short. Billions of dollars were involved with betting on securities not owned by the Derivative purchaser. Banks would offload risk by purchasing Derivatives on securities they own. This was often described a Casino Banking.

This contributed to the interconnectivity of banks. Not having reserves backing up the contract, contributed to the collapse of the financial system. When the housing bubble popped, Derivatives were at the center of the storm. Lack of transparency in a unregulated market was a major problem.

9-Failure of Credit Rating agencies were essential cogs in the wheel of financial destruction

The three credit rating agencies (Standard and Poor, Fitch and Moody’s) were key enablers of the financial meltdown.  They provided the AAA ratings on security packages.

For example, between 2000 and 2007, Moody’s rated nearly 45,000 Securities as AAA. Historically AAA ratings do not change. The results were disasters. Ultimately at Moody’s 83% of mortgage securities were down graded after being in the system for a period of time. Some people like Pension Funds were required to own only AAA securities. They were forced to sell into a fire storm market.

Many factors created this. Rating fee’s were paid for by the banks. They shopped the ratings among the three agencies which created a competition for market share. There was no effective oversight and standards degenerated. Flawed computer models contributed to bad decisions.

Note at the end of the Conclusions chapter:

“When this commission began its work 18 months ago, some imagined that the events of 2008 and their consequences would well behind us by the time this report was issued. Yet more than two years after the federal government intervened in a unprecedented manner in our financial markets, our country finds itself grappling with the aftereffects of the calamity. Our financial system is, in many respect still unchanged from what existed on the eve of the crisis.”

We need to understand that the above problems with large Investment Banks, Commercial Banks, and unregulated Loan Broker originators.

Investment banks were: Bear Sterns, Lehman, Merrill Lynch, JP Morgan, Goldman Sachs and Morgan Stanly.  The banks with strike through were bought on fire sales or are going through bankruptcy. Previously Investment banks were lightly regulated and did not have access to the Fed windows for emergency funding. All Investment Banks have converted to Bank Holding companies which are subject to more regulation and access to the Fed Window for emergency loans

Large Commercial banks are:  Washington Mutual, Indymac, Wachovia, Bank of America and City Group. Lined through items were purchased by other banks along with some costing FDIC money to take the losses in the closing process.

Unregulated Loan Broker originators are: New Century Financial, Country wide ( BOA), WMC Mortgage (GE), First Franklin (Merrill Lynch), Wells Fargo, Home Mortgage, Option One (H&R Bloc), Freemont Investment and Loan, Washington Mutual, CitiFinancial (Citigroup). All of these people originated sub prime loans which defaulted. Some have gone bankrupt or were absorbed by their sponsor companies.

We need to remember that Enron management went to jail. Sarbanes Oxley was put into place with significant responsibility put on the corporate senior officers and  Boards of Directors regarding risk with criminal penalties for non compliance. High risk wa obviouly in play in the failed banks. Nobody has yet been prosecuted by the Bush or Obama administrations. Despite the fraud and violations of Sarbanes Oxley, nobody has gone to jail for the Financial Crisis. The Financial Lobbyists still reign supreme in Washington, fighting regulation.

The Republican and Democratic leadership still favor the Banks. We are left with the conclusions that our government is incompetent or corrupt. The Financial industry is not capable of regulating itself.