In the beginning…
In 1933, a new law called the Glass-Steigal act built a wall between investment organizations and
commercial banking operations to avoid and head off the problems that had originally caused the
In the late 90s, Clinton was under enormous pressure to relax the restrictions on the banking and
investment community. The primary dike in their way was Glass-Steigal. Part of the impetus here,
was that Alan Greenspan had, for so long now (at that time) been simply lowering interest rates to
continue goosing the economy – but the when we hit about zero % as the prime rate, there was no
where else to go and something had to be done to keep the money merry-go-round spinning.
The Camel and the Straw
So Senator Phil Grahm and his supporters authored the Grahm-Leach-Bliley act (GLBA), which
essentially dismantled the Glass-Steigal. In 1999, under pressure by a majority Republican
Congress and (to a certain extent) left powerless by the Monica Lewinsky fiasco, a neutered
President Clinton allowed the passage of Senator Grahm’s legislation. As an aside, Clinton has
now claimed that he does not think passage of the act contributed in a major way to the current
crisis, and, ironically, the legislation allowed for a component of the bailout (the purchase of
Merril Lynch by BofA) that would have been considerably more difficult, if possible at all, while
Glass-Steigal was in effect. It remains, however, a keystone point (if wonky and difficult to
understand) that this deregulation was the genesis of the dance that commenced thereafter.
A Perfect Blend
Another interesting parallel problem was that mortgage rules and restrictions had been eliminated
in a host of minor deregulatory moves where, it seems, no one anticipated the “perfect storm” they
would create when the whole became greater than the sum of the parts. Two of the most damaging
issues were the rise and mass sale of reverse-mortgage loans with teaser rates (pay only 1% for the
first year!) combined with No-Doc loans (No Document, meaning that you could simply say, “I
make [x]” and not have to prove it) – meaning that people who could not afford a traditional
mortgage could now purchase a big house on the assumption that the value would go up, they’d be
able to sell in a couple years at a big profit and they didn’t even need to prove that they could
afford the entry rate. (A reverse mortgage has the interesting effect that it is still at the real interest
level of the loan, but since you only pay the teaser rate of 1% for a year, the 5.5% unpaid interest
gets lumped back into your capital investment hence the “reverse” part of the mortgage).
So now, Fannie Mae and Freddie Mac, which do not actually directly lend money, but in fact back
up people that do, were now being forced to accept mortgages that were considerably less secure
than before. They, along with other organizations that purchased mortgages were beginning to
have lots of tiny pinholes in their portfolio that didn’t look very good.
The Genesis of a Monster
So came the creation of Mortgage Backed Securities (MBS), which are a direct result of the
GLBA. These huge and confusing packages were essentially lots and lots of mortgages (think
dozens of thousands) into a single package that could now be sold to investment firms as a
security, rather than a retail mortgage, again, normally controlled and restricted to the commercial
Here’s where it started to get interesting: houses that bought these securities would dismantle them
and reconstruct them into new securities – using complicated and utterly incomprehensible
mathematics created by academics, mathematicians and physicists (Really! Even Physicists!) the
mortgages and security bundles were recombined into packages that were sold yet again, and
again. Obviously, along the way the effort was to eliminate the risk inherent in such securities
from MY firm and pass them on to others. Unfortunately, the mechanisms were so pervasive and
ubiquitous that while I was selling one out my front door, the investment people on the back side
of my operation are buying some from other vendors. The net result was a convoluted web of bad
mortgages spread not just across our banking, investment and insurance companies, but in fact
around the world.
Then it got really bad.
The next problem was that people started to catch on that these were crappy securities, so how to
sell them and get them off the books? Well, insure them of course! Sell them with insurance that
will “guarantee” to another investor that they’ll get the assets in the investment as well as
insurance that they won’t lose value! But how to do this? Insurance is regulated like crazy, so a
new mechanism was necessary.
Enter, Credit Default Swaps (CDS). This essentially allowed investment houses to “swap” money
for risk against a security – since they used the word “swap” it is not insurance, but the action is
the same. So now there’s people betting on the come, that these MBS would not fail and they’d
walk away with the insurance/swap money paid.
Next problem: the housing bubble that kept driving prices up, up, up was now beginning to deflate
and houses were not being sold at the rate or value initially hoped. And the adjustable rate
mortgages and reverse mortgages that people had purchased were now adjusting – in some cases
people’s monthly note went up as much as 200% in a single month. No longer able to pay the rate
but unable to sell the home, they began to default. And default they did, to the tune of about 1.5
million homes by the beginning of this year.
Now banks that held these mortgages were suddenly in a crunch: there were no longer receiving
the income from mortgages, but still needed to have lots of cash on hand for the swing loans and
credit lines that a VAST number of American businesses rely on to operate. As the MBSs failed,
they started to call in the CDSs, putting insurance holders into a bad place, because they never
thought there’d be such an amount of failure. As they failed and were unable to pay the MBS
holders the MBS holders began to fail.
Finally it was like a house of cards that no longer had any support – as critical banking and
investment first started failing they caused the failure of others… which began to infect the entire
rest of the world, which meant that international credit started to dry up furthering the tailspin.
The financial “Bail Out” package that is so confusing to everyone is essentially a mechanism to try
and stop the tailspin. By lending money to investment and banking institutions, then can continue
to support businesses with their credit lines and swing loans, keeping people in business – because
the next step in this maelstrom is that businesses start going out of business en masse – meaning
more unemployment, meaning more mortgage defaults… meaning more failed securities, meaning
more credit default swap failures, meaning more failed financial institutions, meaning less
available money and trust, meaning more tightening of the financial system, meaning more
businesses going out of business… it’s pretty ugly.
If you made it this far I’m impressed and grateful. There was a lot of research that went into that.
Note that at virtually every turn in this fiasco, it was the lack of regulation that allowed something
to slip outside of a safe band. Republicans can argue all day long that it’s regulation that inhibits
business growth, but in this case, we can see that the lack of regulation allowed businesses to
essentially eat themselves. The argument is made that “Banks know and understand risk better
than the government, so we should allow them to do what they think is best.” Well, it just doesn’t
seem so in this case, now does it?
At the core of all this is a greed-based ponzi scheme – or a sort of pyramid party where the first
people into the MBSs made out like frigging bandits, and the people that came to the pyramid
party late got left holding the bag.
Ironically, it is the Republicans that say We The People suffer greater taxes because regulation
inhibits industry. I submit that we’re paying WAY more now because the lack of regulation
allowed the shark that is rampant, unrestricted capitalism to eat itself.
|posted on Friday, March 20, 2009 at 11:11 am