Barney Frank was on Morning Joe Tuesday. The interview was wide ranging and involved serious discussion of issues. Because of his seniority as the former chairman of the House Finance Committee and current ranking member, he can bring insight to the discussion. When he speaks, I make it a point to listen. He provides framing of subject in a manner that is understandable by the public. Also, we gain insight into what a major leader of the House is thinking.
Key issues discussed were:
- federal debt is a result of past mistakes by both parties
- NATO is a mechanism for Europe to outsource their military costs to the US
- we need a new model of medical care which involves more than Medicare
- clarifying end of life care considerations
- the need to re-evaluate the utility of NATO
- putting a missile shield in Poland to protect them from Iran is not our problem
- problems of Libya are more germane to countries within spitting distance of Libya while NATO wants us to step up with more
- Less defense spending could leave more money for health programs.
The Morning Joe, Barney Frank segment can be viewed here. The first part of the segment is information to set up for the discussion with Barney which starts at 4 minutes. The video is about 17 minutes which enables a good discussion. Joe basically conducts the interview and generally lets Barney make his points. He typically interrupts the conversation only for agreement or clarity.
A lot has been said regarding how large the Federal Debt is and how unsustainable it is. It is interesting to go back and look at the historical record. Data source is Historical Tables which are available on Office of Management and Budget (OMB) website. OMB is the president’s accounting organization. A wide range of information is available under Historical Records. This article focuses on Table 7.1 – Federal Debt at the end of the year 1940 to 2016. Click that entry and you get a download of an Excel spread sheet with a lot of information.
I do not do well in interpreting numerical tables. I like to plot them out to get a idea of what they are saying. We will only plot total debt in nominal terms and as a % of GDP. On the chart I confirm the recent years Federal Debt as reported by the Treasury.
Note that the years after 2010 are projections. The near term years in the future are pretty accurate. However the out years tend to change a lot simply because the budget gets modified . Note that the nominal debt has been growing every year dramatically since Reagan. Note that %GDP kind of gives a false impression of a reduction when in fact the Debt is climbing every year. It is useful to note that the rate of growth under Clinton is much lower. It dramatically increases under George Bush II . This is is because of prosecuting wars and tax cuts. Then, the Financial Crisis produces a more dramatic change projected to continue in the Obama years.
It is useful to look at the rate of change of the Debt curve. I approximate that by calculating the extra money we have to borrow each year. That is plotted in the next chart along with Nominal Debt available in the first chart.
The Deficit curve accentuates the borrowing activity by each president. Note that under Reagan and Bush I, the borrowing continues, It starts coming down in Bush I’s last year because he increased Taxes which cost him the election loss to Clinton.
Note that the Deficit continues to go down under Clinton because of increased taxes and a good economy despite the taxes. .
Then under George Bush II the deficit dramatically returns because of lower taxes and entering wars. It is interesting to note that the Republicans had control of the Senate from 2003 to 2007, under Bill Frist. They had control of the House from 1995 to 2007, under Gingrich and Hastert. So from 2003 to 2007 they had the House, Senate and the Presidency. 4 of the 8 years during the Bush II term. Some would argue that they had the Supreme Court also. The bottom line is that they had complete control of the budget and the debt still was out of control. Then the Financial Crisis hit in 2008, the result of deregulation in the Bush years.
So, when we hear the Republicans lament the Debt, we need to remember that a large part of it was due to Republican policies. If you insist on reducing taxes and conducting wars with borrowed money, you get the result we are currently experiencing.
I like to remind my sanctimonious Republican friends that the debt is mostly of their doing
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.
There is no doubt that we have had a major world wide financial collapse drastically affecting many innocent people in terms of livelihood and life long savings. It is fair to say that if the regulators had done their job, the country would have not had the hard landing that was experienced in 2008. The 2010 Financial Reform Bill kicked the can down to the Regulators for implementation and the bankers still have influence. This article takes a look at who the regulators were and how they did or did not do their job. The Obama people in the regulator domain are identified along with examples of Bush regulator failures. Hopefully this will give insight into what is being done to preclude another crisis
The financial industry has a gaggle of regulators, each with its politically protected turf.
From Wikopedia: Financial regulation is a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system.
Regulation is an unnecessarily a complex subject. It is important to understand that in some cases financial entities can choose their regulator. Some regulators were much more lenient and in many cases banks switched to them, hence the term Regulatory Arbitrage. The following are the major Federal regulators: FED, SEC, OCC, OTS, FDIC, CFTC and FINRA described below. Except for the FED, most of these organizations have direct or indirect ties to the Treasury organization.
FED – Federal Reserve System
From Wikopedia: Its duties today, according to official Federal Reserve documentation, are to conduct the nation’s monetary policy, supervise and regulate banking institutions, maintain the stability of the financial system and provide financial services to depository institutions, the U.S. government, and foreign official institutions.Current chairman is Ben Bernanke, the former chairman was Alan Greenspan. Much more on Mr Greenspan later.
SEC – Securities and Exchange Commission
From Wikopedia: It holds primary responsibility for enforcing the federal securities laws and regulating the securities industry, the nation’s stock and options exchanges, and other electronic securities markets in the United States. Mary Schapiro is the current Chair. Predesessors were; Christopher Cox – 2005-2009, William H. Donaldson – 2003-2005, Harvey Pitt – 2001-03
OCC – Office of Comptroller of the Currency
From Wikopedia: US federal agency established by the National Currency Act of 1863 and serves to charter, regulate, and supervise all national banks and the federal branches and agencies of foreign banks in the United States. Current Acting Chairman is John Walsh. Previous Chairman were John C. Dugan – (2005 – 2010) John D. Hawke, Jr. – (1998–2004)
OTS – Office of Thrift Supervision ( recently folded into OCC)
From Wikopedia: United States federal agency under the Department of the Treasury. It was created in 1989 as a renamed version of another federal agency (that was faulted for its role in the Savings and loan crisis). Like other US federal bank regulators, it is paid by the banks it regulates. The OTS was initially seen as an aggressive regulator, but was later lax. Declining revenues and staff led the OTS to market itself to companies as a lax regulator in order to get revenue.
FDIC – Federal Deposit Insurance Corporation
From Wikopedia: United States government corporation created by the Glass-Steagall Act of 1933. It provides deposit insurance, which guarantees the safety of deposits in member banks, currently up to $250,000 per depositor per bank. The FDIC insures deposits at 7,895 institutions. The FDIC also examines and supervises certain financial institutions for safety and soundness, performs certain consumer-protection functions, and manages banks in receiverships (failed banks).
Sheila Bair is the current chairman of the FDIC and is viewed as a serious regulator with the right incentives for all concerned.
CFTC – Commodity Futures Trading Commission
From Wikopedia: The stated mission of the CFTC is to protect market users and the public from fraud, manipulation, and abusive practices related to the sale of commodity and financial futures and options, and to foster open, competitive, and financially sound futures and option markets.
CFTC is considered to be the primary regulator for Credit Default Swaps in the Dodd Frank regulation scheme.
FINRA – Financial Industry Regulatory Authority
From Wikopedia: In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization (SRO). FINRA is the successor to the National Association of Securities Dealers, Inc. (NASD). Though sometimes mistaken for a government agency, it is a non-governmental organization that performs financial regulation of member brokerage firms and exchange markets.
Previously run by Mary Shapiro, FINRA has been critisized as being a ineffective regulator. Most notable was their (and SEC) allowing Bernie Madow to continue for 10 years to operate despite being warned by a whistle blower. When testifying before congress, the whistle blower (Harry Markopolos) said SEC was incompetent, FINRA was corrupt.
It must be said that Financial Regulation in the United States is done by committee of political bureauocrats. It is important to be aware of the fact that many of them are funded by fee’s assessed to the agencies they regulate. So opportunity for Regulatory Capture and Regulatory Arbitrage is prevalent in these agencies. The clear example is Office of Thrift Supervision bowing to their clients. The opposite example is that of Sheila Bair who tries to do the right thing for her clients despite critisizm.
The major objective of this article is to begin the process of understanding the financial market to enable intelligent discussion on the blog.
One of the major pillars of financial collapse was Derivatives. They are very complex financial instruments with a wide diversity. They are described by a gaggle of terminology used by the high priests of finance. Because of complexity most of the books on the collapse skirt the detail of the Derivative Market. After we get through some basic definitions, we will focus on Credit Default Swaps (CDS); a subset of the Derivatives offerings. We will see how the government created a non regulated environment where fraud, compromised regulators and incompetent people ran the Investment Financial community in a very high risk mode.
A Derivative is a financial instrument whose value is dependent on the value of another entity at a future time. Its primary function is to mitigate risk. A simple analogy would be your Home insurance. These policies guarantee that you will be remunerated if the value of your home falls due to fire, wind, or accident. A relatively small premium of money can mitigate a large potential financial catastrophe. State regulators are in charge of most regular Insurance products and solvency is less of an issue as adequate capital reserves are defined.
We need to think of Derivatives as a “risk tool” meant to stabilize the financial businesses (markets). The wide variety of Derivatives creates confusion, so we are going to restrict our discussion to Credit Default Swaps (CDS). Anticipating problems with Sub Prime mortgages, Securities were insured by investors. It was the Credit Default Swaps inability to perform that was a party to the financial collapse after the Lehman bankruptcy. They did not have the financial reserves to back up the policies they wrote How did that happen?
For our discussion today, three government deregulation actions are relevant.
- 1999 Graham Leach Bliley Act repealed the 1933 Glass Steagall act. The Glass-Steagall Act prohibited any one institution from acting as any combination of an investment bank, a commercial bank, and an insurance company.
- 2000 Commodity Futures Modernization Act deregulated Derivatives creating a Wild West environment for “Derivatives financial innovation”. See this link for a excellent Brooksley Born interview
- April 28, 2004 SEC drastically relaxed leverage standards for the Big Five Investment Banks: Goldman, Merrill, Bear, Lehman and Morgan Stanly. This created a very high risk environment. The session can be viewed here.
Financial self regulation brought the system down in 8 years. Bush de-funded Federal regulation. Greed, incompetence and corruption reigned supreme. Enron people went to jail. As of 2010, under Obama only bit players have been jailed. Civil fines are a joke.
We need to understand the environment created by the above regulation changes to understand the role of CDS Derivative failure. We will concentrate on the Real Estate Industry
Traditionally, the real estate industry was handled by local banks who retained the loans. Their exposure to losses resulted in more careful origination of loans. For a long time, Fannie, Freddie and FHA were packaging (securitizing) mortgages and selling them to Investors. They enjoyed a good reputation because they had good loan origination standards. These were categorized as Prime mortgages. Generally these securities obtained a AAA rating which rarely changed. Good consistent returns were recorded with these products.
Early in the 2000 decade the Investment banks adopted the securitization model called Private Label Securities. They purchased their mortgages from unregulated brokers (Country Wide, Ameriquest etc) who had little or no standards regarding underwriting of loans. The private label market latched on to the fact that high risk “Sub Prime” loans carried higher interest rates, hence higher profits. They had no exposure to the failure of the loan as risk was passed on to the Investors. They simply collected the lucrative fee’s.
Investment Banks packaged the loans (millions and billion level). They paid the rating agencies (S&P. Moody and Fitch) for ratings structuring the packages to get AAA ratings. It is clear the rating agencies did not do their job as traditionally solid AAA ratings were changed as the packages started to fail. These packages were sold to the domestic and world markets. Trillions of dollars were involved. The banks simply passed the risk on to the investors and collected the origination and servicing fee’s
Risk could be mitigated by purchasing a CDS against the failure of the security. So if the security failed the investor was held harmless. Remember that as of 2000 the CDS market was unregulated. AIG – London Financial Services is the poster child of the CDS industry. AIG wrote most of the CDS contracts cheaply as they held inadequate reserves (in the event of a default) and had a good company rating based on the parent insurance company whose operations were regulated. Office of Thrift Supervision was the responsible regulator, but their presence was effectively non existent, Goldman Sachs (Hank Paulson as CEO) was one of their major clients.
However, late 2006 / 2007 AIG FP realized they were over exposed and got out of the market retaining the previous contracts. Recall in the unregulated market anyone could write CDS and the big banks did. As the Mortgage Backed Securities began to fail, the banks started writing CDS between the banks to mitigate risk always falsely believing the market would recover. This was necessary because When Bear and Lehman started to fail the banks were joined at the hip, guaranteeing each others toxic securities. Based on the 2004 SEC relaxing reserve requirements, that banks were leveraged up and things were starting to fail. In a leveraged market things get serious to critical in a matter of hours.
The daily, weekly and monthly credit markets froze up because nobody trusted anybody. Even GE was having trouble borrowing for daily operations. Andrew Ross Sorkin’s book—‘Too Big to Fail’— gives a good account of the scenario in 2008. Fannie and Freddie were in conservator ship, near bankruptcy Bear was bought on a fire sale by JP Morgan, Lehman was bankrupt, Merrill near bankruptcy was bought by Bank Of America and AIG had to be rescued by the Federal Government. Morgan Stanly and Goldman were within days of bankruptcy, but got bailed out by Warren Buffet and a Korean financial entity.
The AIG story is discussed in this newspaper article ‘Behind Insurer’s Crisis, Blind Eye to a Web of Risk’.
It is interesting to know that just before the 2008 collapse, the rating agencies down graded AIG forcing them to hold more reserves. They were forced to raise cash in a collapsing market. In a high leverage industry, when it rains it pours.
Investors can buy CDS on securities even though they do not own the security. This is equivalent to a neighbor buying insurance on your house. So if you know that a Mortgage Backed Security has a lot of high risk loans in it and is headed to failure, you buy a CDS anticipating the default. Michael Lewis’ book—‘The Big Short’–is all about the people who anticipated the failures and bought CDS products. A Bloomberg video interviews Lewis and it provides a lot of insight into the mess that evolved.
I look to Dakinkat, Gillian Tett, Yves Smith, and Janet Tavakoli on technical issues of Derivatives. Lewis’ forte is being able to write to the general public. His book gives a lot of insight to the CDS market nuances. It is interesting that Smith and Tavakoli consider Lewis to be a light weight. Yet, his book sales exceed theirs.
To get a notion of the size of the CDS market we need to look at these numbers. The size of our national economy this year is roughly $15 trillion. The whole world GDP is about $56 trillion. At the time of the 2008 failure, the size of the Credit Default Swaps (CDS) market was $64 trillion. The exposure at the time of the collapse was huge. The magnitude of the Naked CDS is not known, but is understood to be huge.
Given that the unregulated CDS underwriters were prone to not provide adequate capital reserves for defaults, there was a massive liquidity problem, hence the government had to step in and bail out the likes of AIG and banks who wrote these products.
The whole CDS market is described as being part of the Casino Gambling image in the financial markets
The Dodd Frank Bill has a moderate approach for Derivatives Regulation. However it is up to the regulators for implementation and the banks are attempting to minimize the impact of regulation. This is documented by two recent NYT articles.
A short summary of the above articles is that the big banks are attempting to save their Oligopoly through the Risk Committees of the Clearing Houses. This is being done by imposing high capital reserve requirements for participants. This has the effect of limiting competition which limits price competition and transparency. The elephant in the room is the risk committee’s saying certain derivatives are to complex to be cleared. This gets us right back to where we were in the financial crisis. Over the Counter non clearing house products are the most profitable and open to risk.
In the spirit of Brooksly Born regulation, It has been proposed that Derivatives be run using a Clearing House or a Exchange Trading Requirement.
From The Economist:
Clearing House: A clearing requirement is a requirement that all eligible derivatives be cleared on a central clearinghouse (also known as a central counterparty, or CCP). A clearinghouse provides critical counterparty risk mitigation by mutualizing the losses from a clearing member’s failure, netting clearing members’ trades out every day, and requiring that parties post collateral every day. Clearinghouses also centralize trade reporting, and can provide any level of post-trade transparency to the OTC derivatives markets that your heart desires — same-day trade reporting, including prices, aggregate and counterparty-level position data, etc. Virtually all of the harmful opacity and murkiness of the current OTC derivatives markets can be ended with just a clearing requirement — that is, a clearing requirement is a prerequisite for getting rid of the harmful opacity in OTC derivatives
Exchange Trading: An exchange-trading requirement, on the other hand, is simply a requirement that all eligible derivatives use a particular type of trade execution venue: exchanges (also known as “boards of trade”)..The exchange is just the trade execution venue (think NYSE vs. Nasdaq). The only thing that an exchange-trading requirement adds to the clearing requirement is “pre-trade price transparency.”
The clearing house is obviously the better because it brings a degree of financial integrity and transparency. It certainly is the more expensive of the options, but its cost is minuscule when we think of the financial collapse.
However based on the articles above, it is clear that the big bankers are attempting to preserve their oligopoly in terms of the CDS market. They also want to preserve the option to take the market back to the opaque high risk environment because of profit opportunities. The Opaque Over the Counter market is the biggest threat to the stability of the market
In Dodd – Frank, the CFTC and SEC have co-jurisdiction The CFTC commission seems to be moving to the bankers view. SEC has been relatively quiet on this subject
We need to remember that Mary Schapiro (SEC) and Gary Gensler (CFTC) were part of the problem before the 2008 Financial Crisis. It remains to be seen how well they address the problem. Will they do the right thing or are they financial industry moles?