Background Article

Quick Summary of the U.S. Financial Meltdown

• 1864 (during the Civil War), the National Bank Act was passed creating a national bank system and allowing the chartering of national banks.
  
• Just after 1900 the Federal Reserve was established.  The Fed controls U.S. monetary policies, regulates state chartered banks and their non-banking subsidiaries, and foreign banking organizations.  The Fed also regulates the super banks created by the Financial Services Modernization of Act of 1999.
  
• Just after 1900 the Office of the Comptroller of the Currency (OCC) was set up as a bureau of the Treasury Department.  The OCC charters, regulates and supervises all national banks in the U.S. while also supervising the federal branches and agencies of all foreign banks.
  
• The Glass-Steagall Act of 1933 separated commercial banking from investment banking and created fire walls between the banking, brokerage and insurance industries.  This was one of the big lessons learned from the stock market crash of 1929 and the Great Depression which followed.
  
• In 1933 the Federal Deposit Insurance Corp (FDIC) was temporarily established and made permanent in 1935 as a means to protect depositors from losing savings should a bank become insolvent as thousands did during the Great Depression.
  
• In 1938 the Federal National Mortgage Association (FNMA) also known as Fannie Mae was established as a Government Sponsored Enterprise (GSE) under the Roosevelt Administration, to expand the flow of mortgage money by creating a secondary mortgage market.  Fannie Mae is a publicly traded company which operates under a congressional charter that directs it to increase the availability and affordability of home ownership for low, moderate and middle income Americans.  Fannie Mae purchases and guarantees mortgages from loan institutions.  Through this process it creates Mortgage Backed Securities (MBS).  Pension funds, insurance companies, mutual funds, 401K's, and foreign governments bought these MBSs in staggering numbers.  Fannie Mae also holds a large portfolio of its own and other institutions' MBS.  To fund this portfolio Fannie Mae borrows money.  This debt is known as Agency Debt.
  
• In 1970 Congress created another GSE known as the Federal Home Loan Mortgage Corporation (FHLMC) aka Freddie Mac..the little brother of Fannie Mae.  Freddie Mac does essentially what Fannie Mae does.  Both are able to borrow money from the federal government at lower rates than banks and other financial institutions.  Because of this Fannie and Freddie have grown to a point where they own or guarantee more than 50 per cent of all mortgages which originate in the U.S.
  

Both Fannie and Freddie became very large contributors to federal politicians.  All appointed CEO's of these two GSEs were given tens of millions of dollars in bonuses annually driven by lending more and more and more to more riskier borrowers.  In addition in 1999 under the Clinton Administration, many activist groups like ACORN threatened banks and other lending institutions with law suits and boycotts etc. if they did not lend more to lower income individuals.  Home ownership, they claimed, is a right not a privilege available to all Americans.  Many politicians supported this movement.  Lending institutions thus began lending to people who would otherwise have not qualified for a mortgage.  The assumption was that housing prices would continue to rise thus eventually providing home equity to the original poor credit risk individuals.

• The Office of Thrift Supervision (OTS) was appointed by the Treasury Dept to regulate the thrift institutions aka the savings and loan industry.
  
• The National Credit Union Association (NCUA) was set up to regulate the credit unions.
  
• The Securities and Exchange Commission (SEC) came into existence to protect investors and to maintain the integrity of the securities markets.

Almost all of these regulatory agencies came about as a result of lessons learned from the Great Depression 1929 to 1939.

• In 1978 President Jimmy Carter began to unravel federal regulations by deregulating the trucking, airline and railroad industries.  Ronald Reagan deregulated the natural gas and oil industries in the 1980's and George Bush Senior and Bill Clinton deregulated the electricity industry in the 1990's. Bill Clinton also deregulated the communications industry in the 1990's.  These actions spawned the Enron and Worldcom debacles leading to $100 billion in losses to investors.
  
• In 1982 the Depository Institutions Act under Ronald Reagan deregulated the Savings and Loan industry allowing them to compete with banks and other lending institutions.  The S&L industry went wild by taking on high risk loans.  The industry collapsed and led to indictments against people like Charles Keating.  Congress bought S & L assets (bail out) of up to $500 billion which led to a net loss to taxpayers of over $150 billion in the early 1990's.
  
• In 1999 the Gramm-Leach-Bliley Act effectively repealed the Glass-Steagall Act by allowing affiliations between banking and insurance and moved regulation from federal to local states. In addition financial holding companies were once again given the right to engage in both merchant and investment banking, and national banks were allowed to underwrite municipal bonds. So much for the lessons learned from the Great Depression.  This action was taken under the Clinton Administration to allow for one-stop-banking making banks able to provide all financial services. Treasury Secretary Robert Rubin who served under Clinton shepherded the Financial Services Modernization Act of 1999 through Congress which the Gramm-Leach-Bliley Act was part and thus completed the deregulation of the financial industry.  Ruben then left government shortly thereafter to take a top position in Citigroup where he led efforts to super-size Citigroup which would have been illegal under Glass-Steagall.
  
• In the early 21st Century investors, particularly foreign investors seeking higher yields, demanded more new fangled collateralized debt obligations (CDOs), which are complicated securities based on pools of other mortgages.. like the Mortgage Backed Securities (MBSs) issued by Fannie and Freddie Mac.  Because their make up is so complicated and diversified they are difficult to analyze.  Unfortunately these CDOs are often rated AA and AAA and were considered as safe as Treasury Bills.
  
• Not unlike the S & L debacle of the 1980's banks ran wild by trying to earn more and more money via more elaborate means.  So rather than merely create and market CDOs, financial firms embraced the innovation and chose to leverage (borrow) and buy up and hold CDOs themselves.   The money seemed too easy to resist.  Many of the investment banks held on to the higher risk loans within the CDO families since Fannie and Freddie or insurance companies like AIG guaranteed or insured against their failure.  Lehman Brothers, for example, was leveraged (borrowed) more than 30 to 1.  In addition, enter the insurance companies.  AIG sold Credit Default Swaps (CDS) derivatives designed to protect investors from failures.
  
• In 2007 housing values fell in overbuilt markets like Miami and Las Vegas, and supply overwhelmed demand.  The contagion spread, and many subprime borrowers (remember the political and activist pressure that began in 1999 to lend to people who would not otherwise qualify for a home mortgage?) find that their homes are worth less than their mortgages.  Consumers who were given big mortgages with little documentation and sometimes no money down began to default on loans that should never have been made in the first place.  Financial institutions like Washington Mutual and Countrywide Financial take the heat.  Fiscal comeuppance reared its ugly head.  Defaults rose, which sent prices further south.  The downward spiral began.
  
• Rising delinquencies meant that CDOs lost value, forcing banks to sell new stock to raise capital. But surprise: no one was buying CDOs.  The banks took write-downs; the rout began. AIG insurance could not possibly cover the losses.
  
• Banks have little money to lend and credit began to dry up.  The government orchestrated the shotgun marriage of Bear Stearns and J P Morgan Chase and wanted to pronounce the crisis over.   Wishful thinking.  Fannie and Freddie Mac have to be made federal wards to keep the global financial system whole and AIG began to fail.  Lehman Brothers went into bankruptcy and Merrill Lynch was bought out by Bank of America for pennies on the dollar and other banks like Wachovia are up for sale at fire sale prices.  The stock markets, unconvinced that the worst is over took a dive.
  
• What's next?  How about Hedge Funds.  What is a Hedge Fund? Well a Hedge Fund is a basically an investment strategy which started in 1949 by Alfred Jones.  He began an investment strategy monitoring how closely a stock's performance tracked against the broader market.  He split his holdings into two groups.  Good stocks that rose faster than the market in good times and declined slower than the market in bad times and bad stocks that did the opposite.  He took "long" positions on the former and "short" positions on the latter theoretically betting that he would make money whether the market went up or down.  Today Hedge Funds, which are unregulated, are funds that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk.  Hedge Fund strategies vary enormously. Are these funds in good shape and viable?  No ones knows.  The industry says not to worry.
  
• Derivatives - what are they? They are a security, such as an options or futures contract, whose value depends on the performance of an underlying security or asset. Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are generally used by institutional investors to increase overall portfolio return or to hedge portfolio risk. What is the size of the derivatives market and in what shape is it in? No one knows. Remember AIG and its derivative Credit Default Swaps (CDO)? They failed.

...to date $3.5 trillion dollars has been lost in the current financial crisis and add to this the risk of losing another $700 billion with the most recent government bailout.

Mickey Moulder
October 4, 2008

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