P emmell notesmeltdown notes 2010-01-27


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P emmell notesmeltdown notes 2010-01-27

  1. 1. Notes & Links on the Financial Meltdown Peter Emmel -1/26/2010 … still incomplete (I ran out of steam and have not added references for many of the players listed near the end of section 1. For sections 2 & 3 I have several good articles but have not had time to get their web links. Also, I haven’t had time to test all the links to make sure that the documents are still there. I have all of these and more on my computer as pdf files, and I can put them on a CD for anyone who is interested.) In my opinion, all the references listed here are worth reading to get an overall picture. However, if you want to get the most out of a short time … read the two Washington Post articles on page 3, and read the Columbia Review of Journalism pieces on pages 9 and 13. Then listen to the “Giant Pool of Money” program from This American Life (page 2). The other two TAL programs are just as interesting and cover different aspects. (The TAL site offers both audio and transcripts.) I’m no financial expert, but my Dartmouth BA in economics wasn’t purely a means to free my afternoons for skiing. The subject has a certain amount of interest for me, and I poke around now and then in the details behind the headlines – looking for sense behind the nonsense. This page is a collection of the most informative articles and resources I’ve found … along with my own ramblings on the subject. Admittedly, I have not covered the “de-regulators” point of view very well. I personally think that the results have pretty much discredited de-regulation. However, there is a continuum of regulation options, and the best long term solution is to reach a balance. We do not need a wholesale return to post-depression regulation levels. Instead, we need to back wisely away from the excessive de-regulation of the past few years. For this to happen, we need constructive bi-partisan legislative action- to get the best of both schools of thought. Dream on! Areas that interest me most are: 1) Who foresaw the breakdown? What did they say/do and when? And what came of it? We hear a lot about blame, but there must have been warnings and there must have been missed opportunities to soften or avert the mess. 2) What are the core problems with financial institutions & credit markets? We hear about weak mortgage borrowers, predatory/unscrupulous lending, incompetent/dishonest bank management, excessive leverage, toxic assets, regulatory failures. 3) What regulatory options & ideas are in play now … and who’s pushing for what? We hear that the interests of “Wall Street” held sway during the deregulation phase that enabled the meltdown, but where are those interests operating now as the regulation environment is being re-tooled? Page 11
  2. 2. ************* Background: For a primer on the meltdown and its “environment” the most entertaining and understandable reference comes from NPR’s “This American Life” show. The following three episodes are each 1hr long but they are very useful in understanding the big picture. You can download them via iTunes for 95 cents each or listen to them on-line for free at the following sites: "The Giant Pool of Money" 5/9/2008 http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1242 Explains the connection between world financial institutions and grass-roots mortgages. "Another Frightening Show About the Economy" 10/3/2008 http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1263 Explains some of the issues that tangle the "bailout" and recovery outlook. "Bad Bank" 2/27/2009 http://www.thisamericanlife.org/Radio_Episode.aspx?sched=1285 Explains banking and lending and the path to collapse. Taken together these 3 segments pretty much explain what happened ... and why fixing it will be an ugly process no matter what. Basically we’re seeing the contraction of a massive and unsustainable buildup of credit and its flip side - debt. There can't possibly be a stable solution without massive losses, and there's absolutely no equitable way to allocate the losses since they are the comeuppance from over a decade of expansion. Many who profited handsomely are already out of reach - along with their gains. And many who lost money were not simply “innocent victims” either. There was rampant speculation intermixed with shrewd investment at many levels. Attempts to get even basic commercial credit flowing again are foiled by: (a) the web of unresolved commitments among financial firms & investors who are all trying to minimize their losses and who are uncertain as to how much more taxpayer money will eventually be handed out to cover them and (b) creditors who are now more concerned with safety than with investment returns and are suspicious of any borrower other than Uncle Sam. Also, and I don’t know how big a deal this is, but many of the biggest players in the financial system are ideologically interested in seeing the Obama administration and the Democratic congress fail. I think the real tragedy is what was allowed to happen to ordinary people around the country – and not just in the "building boom" regions of Florida, California, Arizona and Nevada – as a result of the grass-roots boom in mortgages and re-financings. The frenzy to create mortgages for re-sale to Wall Street sent financing companies to appalling lows Page 22
  3. 3. in their sales approach and terms. The low water mark were the "NINA loan" - No Income No Assets – which were even worse than the so-called "Liar's Loan" because they didn't even ask you about income or assets, they only checked your credit rating and asked whether you had a job. The default risk was passed along to whoever bought the mortgage ... and the "derivatives" that Wall Street produced from it ... so there was no down-side risk for the original lender. This is exactly the kind of thing that government regulation is supposed to discourage - predatory business practices that take advantage of unsophisticated citizens who probably should know better but are too easily sucked in by the "opportunity" to cash in – in this case on the run-up in value of their homes in an "endlessly rising" market. Enough people made money in the early years of the housing boom that it began to seem as if "everyone" could get in on it. There were numerous TV shows and books about how best to "flip" homes. In my opinion, that's where the most serious public pain comes from. Investment losses are more bearable than evaporation of home equity that leads to difficulties carrying mortgages – especially when payment levels reset after low “introductory” terms expire. The most serious overall economic fallout from all this is the commercial credit freeze-up - due to lack of confidence in bank balance sheets (i.e. fear of hidden toxic assets). Inability to borrow money is a severe handicap for ordinary businesses of all kinds. I think the most informative articles on the build-up to the crash appeared in The Washington Post last October (10/15) and December (12/16). What Went Wrong? (Washington Post 10/15/2008) http://www.washingtonpost.com/wp- dyn/content/article/2008/10/14/AR2008101403343.html The Frenzy (Washington Post 12/16/2008) http://www.washingtonpost.com/wp- dyn/content/article/2008/12/15/AR2008121503561.html They give not only the financial industry story but also the regulatory climate that enabled and supported it. The story begins in the late 1990s, when the Commodity Futures Trading Commission headed by Ms. Brooksley Born became concerned about potential problems posed by the emerging (unregulated) “over-the-counter” trade in "derivatives" - especially Credit Default Swaps (CDS), which eventually grew into the biggest-ever engine of leverage. The CFTC proposed regulating them through exchange trading, but the idea was shot down at the time by Fed Chairman Greenspan and Clinton’s financial/economic brain trust. The idea sputtered along in Congress but never got another chance after the Bush administration arrived. It’s hard to get a handle on the numbers, but it appears that at one point there were some $60 trillion in CDS contracts outstanding on less than $2 trillion in underlying debt. That's like having your home insured separately by 30 different people! Who in their right mind ever thought that could last ??? The answer, of course, is that none of them ever though (publicly, at least) that it would ever come to a crunch. Page 33
  4. 4. Personally, I think it’s time to stop pumping money and start opening up the books. Auditing and publishing balance sheets of banks and major corporations would now do more to facilitate credit than all that money. It would restore trust in trustworthy outfits and identify firms that actually should be shunned and perhaps allowed to fail - or at least be put on a “balance sheet clean-up” regimen. If it could be done as part of the re- habilitation process for the recently-discredited rating agencies that were a big part of the problem, so much the better. Just a thought. There’s more from the Washington Post at: http://www.washingtonpost.com/wp-srv/business/risk/index.html This is actually the “main page” for the full set of articles that includes the two referred to above (which constitute parts I and III of the set). The other parts refer to dubious actions by specific regulators (Part II) and the fascinating play-by-play on the rise and fall of AIG’s Financial Products operation (Part IV). An interesting bit from the AIG story is the role that then-NY-Atty-General Elliot Spitzer’s investigation played. He had evidence of fraud (that later led to convictions) in AIG deals that apparently had nothing to do with the now-notorious FP group. However, the resulting 2005 ouster of long-time CEO Hank Greenberg and the simultaneous down- grading of AIG’s credit rating began a cascade of CDS collateral calls that eventually swamped the company. Here’s a concise summary from the NY Superintendent of Insurance, Eric Dinallo in the 3/30/09 Financial Times: http://www.ft.com/cms/s/0/3b94938c-1d59-11de-9eb3-00144feabdc0.html? nclick_check=1 Here’s an overall timeline – in excruciating detail: http://en.wikipedia.org/wiki/Subprime_crisis_impact_timeline 1a) WHO FORESAW BIG PROBLEMS AND WHAT DID THEY DO ABOUT IT? Many people foresaw problems with the expansion of credit in general and the growth of credit derivative securities in particular. A 1994 analysis and report by the GAO (Government Accountability Office) focused on the dangers of derivative securities, and many voices were heard on the subject. Warnings were all around (see links below), but those calling for increased regulation and transparency were discredited in various ways by those with either an ideological opposition to regulation or a specific vested interest in the trend. There were even dramatic cautionary events to point to and say “SEE!” In 1998 the near- collapse of a giant hedge fund (Long Term Capital Management) was triggered mainly by over-exposure to derivative securities. The Federal Reserve convinced financial Page 44
  5. 5. institutions to pool together in a private bailout … and to tighten their “voluntary” controls on excessive risk-taking. Greenspan and others hailed the move as a demonstration of the industry’s ability to police itself. Legislation (such as amendments to the Commodity Exchange Act) that looked like a response to concerns about credit risk was actually designed to shelter financial firms from regulation. The following links give an idea of what was said by some of the many who foresaw problems and tried to do something about them. Brooksley Born (CFTC chief 1996 - 1999) Prophet & Loss – Stanford Alumni News 2009- Biography and in-depth interview, with details surrounding her warnings and the steps that Greenspan, Rubin, Summers and others took to bury them: http://www.stanfordalumni.org/news/magazine/2009/marapr/features/born.html The Woman Greenspan, Rubin & Summers Silenced – The Nation 10/9/2008: http://www.thenation.com/blogs/edcut/370925/the_woman_greenspan_rubin_summers_s ilenced Brooksley Born Vindicated as Swap Rules Take Shape – Bloomberg 11/13/2008: http://www.bloomberg.com/apps/news?pid=20601109&sid=aXcq.r6xLf4g&refer=home Born’s congressional testimony to Senate subcommittee on 2/11/1997 regarding a bill to amend the Commodity Exchange Act (S157) – warning that the bill (promoted by the financial industry and its powerful friends) would lead to trouble: http://www.cftc.gov/opa/speeches/opaborn-3.htm Born’s congressional testimony on the corresponding House bill (H.R. 467) on 4/15/1997: http://www.cftc.gov/opa/speeches/opaborn-9.htm Byron Dorgan (D-N.D. Senate ____-present) Fought for improved regulation and oversight legislation: http://www.washingtonmonthly.com/features/1994/199410.dorgan.html http://www.washingtonmonthly.com/archives/individual/2009_03/017452.php http://www.huffingtonpost.com/ari-melber/sex-spitzer-derivatives-u_b_179306.html Dorgan’s book “Reckless” – about the meltdown – was a big letdown to me. I was expecting a tell-all about the legislative headwinds he fought against and the people and arguments on both sides. But I could not finish it because it is page after page of polemic and platitudes. Page 55
  6. 6. Ed Gramlich (Fed Governor from _____ - ______) Brighton native who lobbied for better regulation: http://www.washingtonpost.com/wp- dyn/content/article/2007/09/05/AR2007090502503.html Ed Markey (D-MA House of Representatives) Sponsored regulation bill(s) that died in debate due to strong head-winds from free- market proponents and financial industry lobbying. Warren Buffet (Very successful investor - Berkshire Hathaway) Commentary on derivative securities from Warren Buffet’s 2002 annual report to share holders in his company: www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf George Soros (Very successful investor) Sheila Bair (FDIC chief ______ - present) “Fix Rates to Save Loans” NYT 10/19/2007 http://www.nytimes.com/2007/10/19/opinion/19bair.html Sheila Bair’s prescription for helping out homeowners with problem mortgages Sheila Bair interviewed on Frontline (12/3/2008): http://www.pbs.org/wgbh/pages/frontline/meltdown/interviews/bair.html Sean Egan (Egan-Jones Rating Co) Principal of one of the few “independent” bond rating agencies (as opposed to Standard & Poor’s, Moody’s and Fitch). He testified numerous times in congress and wrote extensively about the problem of having bond-rating agencies paid by the firms whose bonds they are rating. His firm is paid by the investors who depend on ratings in assessing the risk levels in bonds they invest in. <I have several of Egan’s congressional testimony transcripts but have not been able to get the web links> 1b) WHO DISMISSED OR RESISTED THE WARNINGS – thereby letting the problems grow and multiply? Alan Greenspan (Fed Chmn ____ - ____ ) “Taking a Hard Look at a Greenspan Legacy” – NY Times 10/9/2008 http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html Page 66
  7. 7. “Fed Shrugged as Subprime Crisis Spread”- NY Times 12/8/2007 http://www.nytimes.com/2007/12/18/business/18subprime.html Phil Gramm (R-TX Senate) Bob Rubin (Treas Secy _____ - _____ ) Arthur Levitt (SEC chmn ____-_____) Larry Summers (Treaury Secy _____-_____) The “quants” who created & developed the models and deals: Howard Sosin (co-founder of what became AIG Financial Products) Randy Rackson (co-founder of what became AIG Financial Products) Gary Gorton (consultant to AIGFP) Look up: December, 1982--Garn - St Germain Depository Institutions Act of 1982 enacted. … Reagan-era S&L deregulation that enable the S&L crisis & subsequent $600B bailout. CONTEMPORANEOUS PRESS COVERAGE & COMMENTARY A very good digest of what the press said as the situation developed – with editorial comment in hindsight – can be found in these links from the Columbia Review of Journalism: http://www.cjr.org/cover_story/power_problem.php?page=all&print=true http://www.cjr.org/the_audit/derivatives_echo_chamber.php?page=all&pr …includes links to an important 1994 GAO study of derivative investment securities that identified many of the potential problems that later became keys to the meltdown. Debate over this report triggered the legislative activities of the late nineties, in which promoters of greater transparency and oversight lost to the de-regulators. Also has a link to a now-famous commentary – known as “derivatives-as-WMD”- by Warren Buffet. NY Times (12/15/1998) on regulating derivative securities following the near collapse & (private) bailout of Long Term Capital Management (giant hedge fund with huge investments in “derivatives”): http://www.nytimes.com/1998/12/15/business/on-regulating-derivatives-long-term- capital-bailout-prompts-calls-for-action.html NY Times (9/5/1999) reports on repeal of Glass-Steagall Act of1933 http://www.nytimes.com/1999/11/05/business/congress-passes-wide-ranging-bill-easing- bank-laws.html NY Times (9/30/1999) reports on easing of credit standards by Fannie Mae http://www.nytimes.com/1999/09/30/business/fannie-mae-eases-credit-to-aid-mortgage- lending.html Page 77
  8. 8. Clarence Page (Chicago Tribune 8/28/2008): Good intentions fed the housing side of the crisis… http://archives.chicagotribune.com/2008/sep/28/news/chi-oped0928pagesep28 One of many “we told you so” reports all over the web: Multinational Monitor Editor’s Blog: http://www.multinationalmonitor.org/editorsblog/index.php?/archives/108-We-Told- You-So.html Refers to long article by the same author called ”Sold Out” published through Wall Street Watch and tag-lined “$5 BILLION IN POLITICAL CONTRIBUTIONS BOUGHT WALL STREET FREEDOM FROM REGULATION, RESTRAINT” http://www.wallstreetwatch.org/soldoutreport.htm … this site has links to the full (3MB) report and an “executive summary.” I don’t know if this is accurate or complete but it focuses on one important aspect, namely the relationship between public interest and political influence. 2) WHAT ARE THE CORE PROBLEMS WITH FINANCIAL INSTITUTIONS & CREDIT MARKETS? It never made sense that a few billion dollars worth of mortgage loans to under-qualified homebuyers could bring down the global financial system. Our son is one of the ”players” in global commercial property finance. In 2007-8 he kept trying to explain to me how “securitization” leveraged these debts and shifted their risk up the food chain into the financial world. He also explained how these securities buried the original loans inside “layered” packages of bonds that would be impossible to unravel in a hurry. The result was a multi-trillion dollar credit market floating on a relatively small number of original loans. Things were fine as long as defaults stayed within the assumptions built into the bond pricing, but “teaser” mortgage rates began to reset and put stress on weaker borrowers. Excesses built up in the housing market and prices stopped rising, which took away the relief valve of selling the building to pay the mortgage. Defaults and foreclosures exceeded bond market assumptions and began to trigger credit default insurance payouts among investment banks. Big insurers like AIG turned out to be under-capitalized and eventually were not able to pay off their contracts. The interconnectedness of these contracts put most of the worlds major banks at risk of serious losses and possible bankruptcy from inability to maintain their cash flows. This crisis-level situation developed very quickly in the summer of 2008, as the depth and breadth of co-dependency became clear. In retrospect, it seems clear that the “invisibility” of this co-dependency was a major problem that should be addressed by regulation. However, another view is that if banks were privately held (instead of having publicly-traded stock) they would have self- regulated this – presumably because they would have feared the consequences for ”their own” money from excessive leverage. Page 88
  9. 9. Everyone has a diagnosis and a prescription, but how can you tell which ones are on the right track. The answer is that we’ll never know for sure. I hope that Hank Paulson writes a complete and honest memoir of his role. I think he saw matters clearly (though he was in the dark about the details of what was on the balance sheets of key financial players – and the interconnectedness that was buried there). Meanwhile we have to read what we can and pay better attention to the news – and listen for the voices that are out of the mainstream. One thing to remember is that during the run-up to the melt down we all were feeling good about the value of our investment accounts and our homes. Even near the end, even though we heard noises about a credit crunch and regulations were being debated, these rumblings were consistently dismissed by authorities like Greenspan and others. Also we thought that Wall Street was “somebody else’s money” and did not directly threaten us. I think we also bought the idea that “sub-prime borrowers” were also somebody else. As it happens, I know two people whose mortgage applications were falsified by the lenders in ways that made the loans look better (from an investor’s point of view) than they actually were. In one case the borrower was persistent enough to get the recurring “errors” corrected in the final closing documents. In the other case the borrower bowed to the bank’s encouragement to” let it go…and ended up with far more mortgage debt than he could afford. I think the primary issue with financial markets – and our form of capitalism in general – is our political polarization on the question of government’s proper role. I haven’t confirmed this, but I’m told that even the sainted Ayn Rand acknowledged the value of regulation in the public interest, to take care of the rough edges of unfettered free enterprise. We need our politicians to bargain and compromise with one another to devise regulatory environment that protects the public interest without hampering free enterprise. Instead, we get obstructionism and partisanship that serves only the big-donor interests that lead to re-election. Meanwhile, here are a few links that shed light on the bigger picture: Economic background: For a numerical view of one of the most important background trends that has been at work in our economy for the past few decades, take a look at this article: Wealth, Income, and Power by G. William Domhoff September 2005 (updated December 2006) http://sociology.ucsc.edu/whorulesamerica/power/wealth.html?print It’s not intended as a meltdown explanation but I think it’s a key fundamental underlying factoring our economic – and political – environment. It shows the acceleration in income and wealth gaps that coincide with the age of de-regulation. Books: Page 99
  10. 10. There is a heap of books coming out on the financial meltdown. Some are reportage, some are memoirs, some are insider narratives. Some are broad and some are narrow. Some are scholarly and some are populist. I have only read three so far. One of those (Dorgan’s “Reckless”) was a waste of time, but the other two are excellent. They are: “Fool’s Gold” by Gillian Tett (2009) (Reporter and Assistant Editor at The Financial Times). Follows the derivatives group at JP Morgan from their invention of the most notorious credit derivative securities. It’s a fascinating narrative as well as an expose of the practices that constituted the ”Shadow” banking system that grew up in the lax regulatory environment of the 80s and 90s and exploded catastrophically in the “oh ohs.” Tett had been reporting on this for years in the Financial Times, and her style is both informative and entertaining. Here’s an interview and an excerpt: http://www.npr.org/templates/story/story.php?storyId=104130944 Here’s a review: http://www.nytimes.com/2009/06/14/books/review/Barrett-t.html “Liar’s Poker” by Michael Lewis (1989) (former bond trader at Salomon Brothers, now a reporter/commentator at Bloomberg). Highly entertaining and eye-opening personal memoir of his years as a bond trader in the wild and woolly world of high-stakes investments that leveraged what should have been simply a US housing bubble into a global financial meltdown. He resigned and wrote the book in 1989, thinking that the craziness he experienced had to come to an inevitable blowout soon. Little did he know it would inflate for another nine years! He thought his book would be a cautionary tale, but instead it became an inspiration for a new generation of creative financial “engineers” and traders. Here’s a more recent follow-up article he wrote for Portfolio.com (12/2008): http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of- Wall-Streets-Boom/ It gives the flavor of the story and re-connects with some of the characters from the book. 3) WHAT REGULARTORY & LEGISLATIVE OPTIONS ARE IN PLAY NOW … and who’s pushing for what? I wish I had more to offer here. Opinions are all over the map, and the legislative machinations are not in the open. With so much to lose and gain, it’s not possible to get good objective information. Here are a couple of sources that at least give some idea of what’s on the table and who’s behind what. The Columbia Journalism Review has interesting commentary on reporting of the banking lobby’s efforts to shape new regulations that should be applied. These are from April-May-June, 2009: Page 1010
  11. 11. http://www.cjr.org/the_audit/ft_wall_street_sees_a_new_shel.php?page= http://www.cjr.org/the_audit/an_inoculation_for_wall_street.php?page=a http://www.cjr.org/the_audit/wsj_keeps_a_close_watch_on_the.php?pag NY Times reports on banks fighting (i.e. lobbying against) new rules: http://www.nytimes.com/2009/06/01/business/01lobby.html Page 1111