By Henry C K Liu
April 3, 2002
Alan Greenspan, chairman of the US Federal Reserve Board, frequently credits US growth in the 1990s to a rise in productivity made possible by advances in technology. Yet studies have shown that computerization did not stimulate much rise in industrial productivity in the 1990s. Industrial computerization was essentially in place long before 1995. The 1990s boom in the US was not an industrial boom but a financial boom. This was made possible by three developments: the deregulation of financial markets, the computerization of trading of financial instruments, and globalization, particularly financial globalization.
The entire structured finance (derivatives) phenomenon would not be possible without any one of the above mentioned developments. Structured finance in essence allowed an unprecedented explosion of credit, by unbundling risks for a wide range of risk-takers who sought corresponding compensatory returns. While hedging initially provided protection against volatility to individual market participants, it soon became a profit center for financial institutions. This led to the institutionalization of volatility as a market opportunity. Financial institutions actually sought volatility in the system to provide a continuous profit stream.
Creative accounting, whose peculiar logic evolved from structured finance, also made the traditional debt/equity ratio immaterial. Ways were devised for the large market participants to structure debt as hedges, through swaps that avoided taxes and balance-sheet liabilities. Swaps enabled borrowers legally to book loan proceeds as current operating income and loan liabilities as future capital expenditure that could be kept off the balance sheet, inflating current earnings. Circular counterparty risks suddenly became neutralized risk, and cash flow from swaps became net revenue. These practices are now known as Enronitis.
On the macro level, the global finance game has become a sure win for those who use dollars, especially those whose government issues dollars by fiat. The world market has become a place where the United States makes dollars and the rest of the world makes what dollars can buy. But after the Asian financial crisis of 1997, the whole world essentially adopted dollarization, if not directly, at least through hedges, albeit sometimes at prohibitive cost.
At that point, the US economy suddenly began to lose its exclusive dollar hegemony advantage because US entities were no longer the only ones with access to dollars nor could US transnationals avoid non-dollar revenue. To maintain the "strong dollar" monetary policy instituted by US treasury secretary Robert Rubin at the beginning of the Bill Clinton presidency, the US Federal Reserve progressively tightened dollar money supply throughout most of the 1990s. But this did not slow the US economy because structured finance permitted debt to expand without a corresponding expansion of equity. A strong dollar gave the US economy a boom in low-cost imports, while the US trade deficit merely forced foreign exporters to hold dollar reserves to finance the US debt bubble through a US capital account surplus. Japan did this for a whole decade, pushing its own economy into permanent recession while its dollar reserves mounted. Mainland China, Hong Kong and Taiwan took up the slack from Japan by 1995 and the three Chinese economies together now hold more dollar reserves than Japan does. China, starved for capital for domestic development, thus finds itself stuck with US$200 billion in US Treasury bills that pay 5 percent while it is forced to offer foreign direct investment high double-digit returns. The annual interest gap alone is in excess of $20 billion, which amounts to half of China's current annual foreign-capital inflow.
Growth in the 1990s came from a structural shift of the US economy from industrial capitalism to finance capitalism. Through financial globalization, the US shifted labor intensive manufacturing off US soil to low-wage locations, thus lowering the cost of manufactured products. Financial products and services and intellectual property valuation constituted most of the growth, making the US a consumer market of last resort for the whole world. London, Frankfurt, Paris, Tokyo, Hong Kong and Singapore became financial outposts of New York, sucking up dollar reserves to support the US debt bubble.
This game is ending, as the US consumer market becomes saturated and condemned to low single-digit growth, regardless of business cycles. The wealth effect from a tripling of equity value did not double consumption in the US, because aggregate demand is constrained by a widening income disparity. The rich have bought all the manufactured products they need and the working poor cannot afford to buy all they want. The wealth effect did double investment globally, reflected in the phenomenal rise in market capitalization of US transnationals and financial institutions, particularly in the so-called New Economy. The competition for credit favored double-digit growth markets in the developing countries, but the US continued to dominate global finance through its sophistication and innovation in finance and through dollar hegemony.
The problem is that all unregulated markets eventually self-destruct. Weak competitors are naturally forced off the market, leading to monopolies that are the result of market failure of competition. Yet regulation cannot cure the problem preemptively because remedial regulation only makes sense after disasters, never before.
There is increasing evidence that the real threat to China is not democracy or the market economy per se but the peculiar US version of these institutions. The 19th-century industrial capitalism that Marx observed no longer exists. Finance capitalism is a system in which capital is only a notional value upon which to build a gigantic mountain of hidden debt. Representative democracy and unregulated market fundamentalism in the US mode now work as legalized constitutional devices to disfranchise the poor and weak, both locally and globally.
Greenspan acknowledged this in his semiannual monetary policy report to the US Congress, before the Committee on Financial Services on February 27: "From one perspective, the ever-increasing proportion of our GDP [gross domestic product] that represents conceptual as distinct from physical value-added may actually have lessened cyclical volatility. In particular, the fact that concepts cannot be held as inventories means a greater share of GDP is not subject to a type of dynamics that amplifies cyclical swings. But an economy in which concepts form an important share of valuation has its own vulnerabilities." He was of course referring to Enronitis.
Greenspan's observation about the vulnerabilities of conceptual valuation was on target, although his warning of vulnerability was disproportionately misplaced. Even after the Enron and Global Crossing controversies, Greenspan continues to resist regulation, preferring to rely on market discipline. The risk is much higher than he admits.
Past records do not reliably project future vulnerability risk. Any risk manager knows that accidents are always waiting to happen. The fact that it has not happened in the past does not mean it will not happen in the future. In fact, with each passing day without an accident, the risk of borrowed time increases. Low probability is only a source of comfort if the impact is not fatal.
Also, what Greenspan did not say, but admitted by implication, was that finance capitalism is operating with less and less reliance on capital. Capital has become a notional value in structured finance. Credit is no longer anchored by equity but by circular hedges. Debt-to-equity ratio is no longer a relevant consideration. Practically all US major businesses nowadays, with their high debt leverage, would have negative real equity if the price/earning (P/E) ratio were to return to historical norms. Blue chips are being shut out of the unsecured short-term commercial paper market. Corporate credit ratings are inflated by exorbitant market capitalization value, which in turn reflects irrational P/E ratios. Even now, during what many on Wall Street contend to be a savage bear market, the Standard & Poor's 500 Index yields 25 times earnings. It would have to fall by another 41 percent to reach the median valuation prevailing since 1957.
Such a decline can happen in a period of days in this age of program trading and socialized risk, even with circuit breakers and trading curbs. When that happens, structured finance will be a sea of dead and wounded in counterparty casualties, regardless of who won and who lost.
Friday, September 7, 2007
Putting lipstick on pigs
By Peter Morici
The pope and US Federal Reserve chairman Ben Bernanke both rely on a higher force to motivate millions. The pope relies on faith in the Resurrection; poor Ben depends on the credibility of the bond market. The latter, ultimately, rests on the integrity of investment banks and bond-rating agencies, and those have proved faulty.
In the days of usury laws and regulated interest rates for savings accounts, mortgages in the United States were fairly straightforward. You went to a savings and loan association, it checked your credit, purchased an independent appraisal, and gave you the money. The bank either held the note or sold it to the Federal National Mortgage Association (popularly known as Fannie Mae) or perhaps an insurance company. The bank serviced the loan - it collected the payments, administered the escrow account and foreclosed if things turned sour. The bank loan officer had a strong incentive to be certain that the loan application was accurate. If not, it would come back to him.
Today, US loans go through complicated chains. Many more do not qualify to be sold to Fannie Mae, and many never pass through the granite confines of a community bank. Often an agent hanging around the real-estate office takes an application and forwards it to a mortgage company, which may or may not be his employer. The mortgage company processes the loan, and sells it to an investment bank, or similar entity, that bundles mortgages into bonds. The investment bank sells those securities to hedge funds, pension funds, mutual funds and other investors. As mortgages vary significantly in quality, mortgage-backed bonds are rated by Standard and Poor's and other rating agencies.
At each step along the way, information can be lost and temptations build up to understate the risk of default. The agent gets a big fee for writing the loan only if it is approved, so he puts the prospective homeowner in the best possible light and finds an appraiser who aggressively values homes.
Mortgage companies get their cut from origination fees and are able to push off the risk of default on to the ultimate purchasers of the bonds. Hence they are inclined to be lenient with agents.
Investment banks earn money on the spread between the interest rate charged borrowers and the interest rate on the bonds. The less risky bundles of mortgages that go into bonds appear, the lower the interest rates on the bonds and the more profits the mortgage bankers receive.
As we peel this onion, we are finding many purposeful compromises that look much like the insidious corruption that characterizes commerce in some countries. In essence, Wall Street manufactures bad bonds.
But it gets worse. Large builders established mortgage-writing subsidiaries. When they built more houses than the market could absorb, those subsidiaries exaggerated the incomes and qualifications of buyers on loan applications, and pressed for exaggerated appraisals of their properties to move houses. Those entities operated on lines of credit and resold the loans to investment banks, which bundled them into bonds. Both the large builders and investment bankers had incentive to put lipstick on pigs.
Also, investment banks sought and received collaboration from bond-rating agencies in bundling mortgages of differing quality into bonds. In the process, bond raters such as Standard and Poor's were compromised.
Subprime mortgages are hardly the whole credit market, but the meltdown of their bonds cast a spotlight on the decaying integrity of investment banks and bond-rating agencies. These institutions underwrite and rate all manner of credit, and if they could be corrupted in the subprime-mortgage market, then all commercial paper and bonds become suspect.
Over the past several weeks, creditors have increasingly sensed they can't trust banks or bond-rating agencies, and they have fled to short-term Treasury securities. This was much worse than the collapse of mortgage companies that originated housing loans, because it caused all segments of the credit market to collapse.
Good businesses with sound cash flows couldn't borrow operating capital, and good companies faced escalating interest rates for new bond offerings. Together, those threaten to throw the US economy into recession.
For Bernanke, the corruption of the investment banks and bond-rating agencies is terrible news. It is akin to the pope learning Easter morning was a hoax.
Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the US International Trade Commission.
The pope and US Federal Reserve chairman Ben Bernanke both rely on a higher force to motivate millions. The pope relies on faith in the Resurrection; poor Ben depends on the credibility of the bond market. The latter, ultimately, rests on the integrity of investment banks and bond-rating agencies, and those have proved faulty.
In the days of usury laws and regulated interest rates for savings accounts, mortgages in the United States were fairly straightforward. You went to a savings and loan association, it checked your credit, purchased an independent appraisal, and gave you the money. The bank either held the note or sold it to the Federal National Mortgage Association (popularly known as Fannie Mae) or perhaps an insurance company. The bank serviced the loan - it collected the payments, administered the escrow account and foreclosed if things turned sour. The bank loan officer had a strong incentive to be certain that the loan application was accurate. If not, it would come back to him.
Today, US loans go through complicated chains. Many more do not qualify to be sold to Fannie Mae, and many never pass through the granite confines of a community bank. Often an agent hanging around the real-estate office takes an application and forwards it to a mortgage company, which may or may not be his employer. The mortgage company processes the loan, and sells it to an investment bank, or similar entity, that bundles mortgages into bonds. The investment bank sells those securities to hedge funds, pension funds, mutual funds and other investors. As mortgages vary significantly in quality, mortgage-backed bonds are rated by Standard and Poor's and other rating agencies.
At each step along the way, information can be lost and temptations build up to understate the risk of default. The agent gets a big fee for writing the loan only if it is approved, so he puts the prospective homeowner in the best possible light and finds an appraiser who aggressively values homes.
Mortgage companies get their cut from origination fees and are able to push off the risk of default on to the ultimate purchasers of the bonds. Hence they are inclined to be lenient with agents.
Investment banks earn money on the spread between the interest rate charged borrowers and the interest rate on the bonds. The less risky bundles of mortgages that go into bonds appear, the lower the interest rates on the bonds and the more profits the mortgage bankers receive.
As we peel this onion, we are finding many purposeful compromises that look much like the insidious corruption that characterizes commerce in some countries. In essence, Wall Street manufactures bad bonds.
But it gets worse. Large builders established mortgage-writing subsidiaries. When they built more houses than the market could absorb, those subsidiaries exaggerated the incomes and qualifications of buyers on loan applications, and pressed for exaggerated appraisals of their properties to move houses. Those entities operated on lines of credit and resold the loans to investment banks, which bundled them into bonds. Both the large builders and investment bankers had incentive to put lipstick on pigs.
Also, investment banks sought and received collaboration from bond-rating agencies in bundling mortgages of differing quality into bonds. In the process, bond raters such as Standard and Poor's were compromised.
Subprime mortgages are hardly the whole credit market, but the meltdown of their bonds cast a spotlight on the decaying integrity of investment banks and bond-rating agencies. These institutions underwrite and rate all manner of credit, and if they could be corrupted in the subprime-mortgage market, then all commercial paper and bonds become suspect.
Over the past several weeks, creditors have increasingly sensed they can't trust banks or bond-rating agencies, and they have fled to short-term Treasury securities. This was much worse than the collapse of mortgage companies that originated housing loans, because it caused all segments of the credit market to collapse.
Good businesses with sound cash flows couldn't borrow operating capital, and good companies faced escalating interest rates for new bond offerings. Together, those threaten to throw the US economy into recession.
For Bernanke, the corruption of the investment banks and bond-rating agencies is terrible news. It is akin to the pope learning Easter morning was a hoax.
Peter Morici is a professor at the University of Maryland School of Business and former chief economist at the US International Trade Commission.
CREDIT BUST BYPASSES BANKS (Part II)
PART 2: Bank deregulation fuels abuse
By Henry C K Liu
(See also Part 1: The rise of the non-bank financial system)
US Federal Reserve data show that the outstanding stock of US commercial paper has fallen by US$255 billion or 11% over the past three weeks, a sign that many borrowers have been unable to roll over huge amounts of short-term debt at maturity. Asset-backed commercial paper (ABCP), which accounted for half the commercial-paper (CP) market, tumbled $59.4 billion to $998 billion in the last week of August, the lowest since December. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest-rated asset-backed paper due by August 30 rose 0.11 percentage point to a six-year high of 6.15%.
Some analysts are comparing the current collapse of the CP market to the sudden drain on liquidity that occurred at the onset of the 2001 dotcom bust. Others are comparing the current crisis to the 1907 crash, when large trusts did not have access to a lender of last resort, as the Fed had not yet been established. Still others are comparing the current crisis to the 1929 crash, when the Fed delayed needed intervention.
Today, key market participants who dominate the credit market with unprecedented high levels of securitized debt operate beyond the purview of the Fed in the non-bank financial system, and these market participants do not have direct access to a lender of last resort when a liquidity crisis develops except through the narrow window of the banking system.
Banks get no respect
US banks are now unhappy about capital and debt markets, where they are no longer getting respect. Market analysts have been crediting capital and debt markets for the long liquidity boom, rather than bank lending. Banks' share of net credit markets, according to Fed data on flow of funds, dropped from a peak of more than 62% in 1975 to 26% in 1995 and was still falling rapidly, while securitization's share rose from negligible in 1975 to more than 20% in 1995 and more than 30% in 2006 and was still rising rapidly, with insurers and pension funds taking the rest.
Debt securitization in the first half of 2007 stood at more than $3 trillion, up from $2.15 trillion in 2006, $375 billion in 1985 and 156 billion in 1972. About $1.2 trillion is asset-backed securities. The biggest issuers are: Countrywide, $55 billion; Washington Mutual, $43 billion; and General Motors Acceptance Corp (GMAC), $40 billion. Big bank issuers are: JPMorgan Chase, $38 billion; Citibank, $29 billion; Barclays Bank, $29 billion. Big brokerage issuers are: Lehman Brothers, $37 billion; Merrill Lynch, $31 billion, Bear Sterns, $31 billion; and Morgan Stanley, $26 billion.
Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 Asian financial crisis primarily because of an underdeveloped debt-securitization market.
The Dow and interest rates
In February 2000, the Dow Jones Industrial Average (DJIA) closed below 10,000 - a psychological benchmark from a peak of 11,723 just four weeks earlier, and 10,000 was only a transitional barrier. Some bears predicted lack of support until 8,000. It was the first retreat from the 10,000 mark in 10 months, off 14.22% for the year, while the broader S&P 500 lost 9.25%.
On September 17, 2000, the DJIA fell 684.81 points to close at 8,920.70, largest dollar loss in history, down 7.13%. On October 9, the DJIA fell 215.22 points to close at 7,286.27. The market had declined 4,436.71 points, or 38%, from January 14, 2000, when it rose 140.55 to close at all time high of 11,722.98, the first close above both 11,600.00 and 11,700.00.
On May 16, 2000, the Fed Funds rate was raised to 6.5%. After that, the Fed began lowering it on January 3, 2001, and did so again 12 more times to 1% on June 25, 2003, and held it there - below inflation rate - for a full year, unleashing the debt bubble.
On July 19, 2007, the DJIA closed at 14,000.41, reaching a new all-time high. The DJIA had risen 6,714 points, or 92%, since the low point of 7,286.27 on October 9, 2002, in four years and 10 months. The US gross domestic product rose from $10.5 trillion in 2002 to $13.2 trillion in 2006, an increase of 30%. Asset prices outpaced economic growth by a multiple of three during that period.
This extraordinary divergence shows more than the different economic fundamentals of the old and new economies. It shows the financial effect of a shift of importance from banks as funding intermediaries to the exploding capital and debt markets in which, with the advent of structured finance, the line between equity and debt has in effect been blurred.
Greenspan's forked-tongue pronouncements
Nasdaq companies rely less on banks for funds and were thus less affected by then Fed chairman Alan Greenspan's threats of interest-rate hikes. Greenspan had been vocal in explaining that his monetary-policy moves of rising Fed Funds rate targets were not specifically targeted toward "irrational exuberance" in the stock markets, but toward the unsustainable expansion of the US economy as a whole. But data show that the economy did not expand at the same rate as the rise of equity prices. Economic growth would be more sustainable with irrational exuberance in the stock market.
In the same breath, Greenspan decried the dangers of the wealth effect if it ever ended up heavier on the consumption side than on the investment side. It was a curious position, as most Greenspan's positions seem to be. The Greenspan gospel says asset inflation is good unless it is spent rather than used to fuel more asset inflation. He continued to restrain demand in favor of supply in an already overcapacity economy.
The need for demand management was argued by post-Keynesian economists who had been pushed out of the mainstream in recent decades by supply-siders. In housing, Greenspan was trapped in a classic dilemma of not knowing whether housing is consumption or investment. Homeowners have been living in an asset (thus consuming it) that rises in market value faster than the rise of their earned income. Home-equity loans enabled homeowners to monetize their housing investment gains to support their non-housing consumption.
It is hard to see how home prices rising higher than homebuyers can afford to pay can be good for any economy. Yet the Fed celebrates asset-price appreciation for shares and real estate, but treats wage rises like a dreaded plague.
Bifurcated markets
The so-called "bifurcated" market indices of the tech boom of the early 2000s indicated clearly that the Fed, whose sole monetary weapon was the Fed Funds rate, lost control of the new economy, which appears impervious to short-term interest-rate moves.
Under such conditions, the only way the Fed could restrain unsustainable economic expansion in one sector was to overshoot the interest-rate target to rein in an impervious Nasdaq at the peril of the whole economy. Interest-sensitive stocks were battered badly in 2000, including banks and non-bank lenders, such as GE, GMAC and Amex. This forced the Fed to keep Fed Funds rate at 1% for a whole year, from June 2003 to June 2004, to create the housing bubble. With the inflation rate at 2%, the Fed was in effect giving borrowers a net payment of $1,000 for every $100,000 borrowed between 2002 and 2003.
The peril of uneven profit sharing
Financial-services companies, including commercial banks, brokerage firms and mortgage lenders, investment-bank and non-bank financial companies such as GE and GMAC, had since produced some of the biggest profits in the recent bull market fueled by a liquidity boom.
The trouble with the financial sector making the bulk of the profit in the debt economy is that when newly created wealth is unevenly distributed to favor return on capital rather than through rising wages, it exacerbates the supply-demand imbalance, which can only be sustained by a consumer debt bubble. The public have insufficient income to consume all that the debt economy can produce from over-investment except by taking on consumer debt and home-equity debt.
Liquidity crunch only an early symptom
In recent weeks, the combination of sudden rise in interest rates due to a liquidity crunch and the hefty leverage employed by businesses in the financial sector has proved to be fatally hazardous to company cash flow and stock prices. Money-center banks and broker dealers, along with their hedge-fund customers, are most vulnerable because they are most exposed to interest-rate-related risks through products such as interest-rate swaps, default swaps and securitized mortgages. But this was just an early symptom, like an initial wave of high fever.
Lipper TASS reports that institutional and wealth private investors poured $41.1 billion into hedge funds in the second quarter of 2007, which through performance gains swelled industry assets to an estimated $1.67 trillion by the end of June. The aggregate hedge-fund performance of 5.19% by June 30 did not surpass market indices' rise for the period. The S&P 500 returned 6.28%, while the MSCI World TR returned 6.71%. The biggest inflows were for market-neutral long-short equity strategies, which gained $14.9 billion, followed by event-driven funds, which gained $12.2 billion. Multi-strategy funds gained $6.1 billion during the period. Strategies that posted net outflows included global macro-funds,
which bet on world currencies and sovereign debt and were down by $848 million, and managed futures, which were down by 686.7 million. Losses of this scale are bound to have structural effects.
The credit derivatives overhang
The most popular of all derivative products is the interest-rate swap, which in essence allows participants to make bets on the direction interest rates will take.
According to the US Office of the Comptroller of the Currency (OCC), interest-rate swaps accounted for three out of four derivative contracts held by US commercial banks at the end of 1999. The notional value of these swaps totaled almost $25 trillion; 2-3% of that reflected the banks' true credit risk in these products, or between $500 billion to $700 billion. The notional amount outstanding as of December 2006 in OTC (over the counter) interest-rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. A 1% move in the interest rate would alter interest payments in the amount of $4 trillion, albeit much the payment would be mutually canceling, unless in the case of counter-party default.
The Comptroller of the Currency Quarterly Report on Bank Derivatives Activities shows that US commercial banks generated a record $7 billion in revenues trading cash and derivative instruments in first quarter of 2007, up 24% from the first quarter of 2006, which at $5.7 billion had been the previous record. Revenues in the first quarter were 82% higher than in the fourth quarter. Net current credit exposure, the net amount owed to banks if all contracts were immediately liquidated, decreased $5.3 billion from the fourth quarter to $179.2 billion. The data for the third quarter of 2007 are expected to be very negative to reflect market turmoil since July.
The notional amount of derivatives held by US commercial banks increased $13.3 trillion to $144.8 trillion in the first quarter of 2007, 10% higher than in the fourth quarter and 31% higher than a year ago. Bank derivative contracts remain concentrated in interest rate products, which represent 82% of total notional value. The notional amount of credit derivatives, the fastest-growing product of the global derivatives market, increased 13% from the fourth quarter of 2006 to $10.2 trillion in first quarter in 2007. Credit default swaps represent 98% of the total amount of credit derivatives. Credit derivatives contracts are 86% higher than at the end of the first quarter of 2006. The largest derivatives dealers continue to strengthen the operational infrastructure for over-the-counter derivatives through a collaborative effort with financial supervisors, the OCC reports. Still, counter-party risk remains problematic.
Derivatives of all kinds weigh heavily on banks' capital structures. But interest-rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began - in fact, yields have risen 25% - these institutions now find themselves on the wrong side of an interest-rate gamble. Moreover, as interest rates rise, bank income diminishes from interest-rate-related businesses such as mortgage lending. Interest-sensitive sources of income will be the revenue disappointments in 2008, as in 2000, and as trading was in 1999.
Hedging feeds risk appetite
The impact of the demise of the Nasdaq index on the wealth effect was not total. Investment banks pitched to high-tech/Internet founders and early shareholders to hedge capital gains by signing away future upsides. For those high-tech swimmers who took advantage of the offers, this amounted to two-layer swimming trunks that allowed them to lose the top layer without risking being caught naked when the tide receded suddenly. It was the financial version of a flat-proof tubeless tire that can get you to the next service station or 50 kilometers (whichever is closer) in the event of a puncture. It does not, however, guarantee the driver the existence of a service station that has not been forced to close from operational losses within 50km.
Meanwhile, pension funds are forced to jettison their old-fashioned balanced portfolios in favor of structured finance strategies to seek higher returns. What the Greenspan Fed did was to penalize the general public by devaluing their future pension cash flow for the sins of the aggressively investing rich, who continued to add to their wealth with Greenspan's blessing as long as the risks of high returns were passed on to the system as a whole. This is what US economic democracy has come to.
Investor confidence low
Investors worldwide are unconvinced that the US Federal Reserve can succeed in stabilizing the US commercial-paper market, the latest and so far biggest shoe to drop in the spreading contagion from US subprime mortgages. Banks are suddenly exposed to unexpected risks as US asset-backed CP shrank by its biggest weekly percentage since November 2000 as investors shunned debt linked to mortgages and opted for the safety of Treasuries.
This means that investors prefer to lend money to the US government, despite historically high levels of fiscal deficit and national debt, than to financial institutions that seek profit from interest-rate arbitrage. Market preference for speculative investment has vanished. Banks are suddenly holding the bad end of a massive amount of speculative debt instruments. When new commercial paper is not sold to roll over the maturing debt, borrowers must draw on bank credit at a higher interest cost to prevent default, leaving banks with riskier debts that the market has rejected.
Fed accepts ABCP as discount window collateral
In the week to August 22, after the Fed lower the discount rate by 50 basis points to 5.75% on August 17, banks borrowed a daily average of only $1.2 billion from the Fed discount window, suggesting that banks were still unsure how to use the facility to lend to distressed clients. Officials at the New York Fed, the central bank's liaison with Wall Street, received inquiries from commercial banks on whether their clients' asset-backed commercial paper could be pledged as collateral at the discount window.
The New York Fed issued a statement "in response to specific inquiries" from money-center banks on Friday, August 24, that it "has affirmed its policy to consider accepting as collateral investment quality asset-backed commercial paper" for discount-window loans to ease the liquidity crisis faced by the banks to try to calm an essential part of the money market, the orderly functioning of which is critically needed to lubricate financial markets. But the statement only trimmed slightly the abnormally high average ABCP yield to 6.04%, still roughly 80 basis points higher than normal, even for those borrowers who could sell commercial paper at all, which normally would be at rates close to the Fed funds rate of 5.25%.
On the same day, the Fed eased regulations governing the relationship between Citibank NA, the US bank subsidiary of Citigroup Inc, and its broker-dealer subsidiary, Citigroup Global Markets Inc. The regulatory exemption allows Citibank to lend up to $25 billion to customers of the broker-dealer. Bank of America Corp received a similar easing.
Section 23A of the Federal Reserve Act and the Fed board's Regulation W limit the amount of "covered transactions" between a bank and any single affiliate to 10% of the bank's capital stock and surplus and the amount between a bank and all its affiliates to 20%. The banks have agreed to limit their lending under the exemption to $25 billion, which will constitute less than 30% of each bank's total regulatory capital.
The two banks, along with JPMorgan Chase & Co and Wachovia Corp, borrowed a total of $2 billion two days earlier in a symbolic show of support for the Fed's anemic actions, while noting that they still had access to cheaper funding than the new discount rate of 5.75%.
Until the repeal of the Glass-Steagall Act, banking regulation prohibited banks with federally insured deposits from operating brokerage subsidiaries. In the early part of the last century, individual investors had been repeatedly damaged by banks whose overriding interest was to profit from promoting stocks held by banks, rather than to enhance the interest of individual investors or protect the security of its depositors.
After the 1929 market crash, regulators sought to limit the conflicts of interest created when commercial banks underwrote stocks or bonds, which contributed to abuses that caused market crashes. A new law, known as the Glass-Steagall Act, banned commercial banks from underwriting securities, forcing banks to choose between being a regulated lender of high prudence or an underwriter-broker with high risk appetite. The law also established the Federal Deposit Insurance Corp (FDIC), insuring bank deposits, and strengthened the Federal Reserve's control over credit.
The 1933 Glass-Steagall Act became a key pillar of banking law by erecting a regulatory wall between commercial banking and investment banking. The law kept banks from participating in the equity markets, and equity market participants from being banks. The relevant measure of the Glass-Steagall Act is actually the Banking Act of 1933, containing the provision erecting a wall separating the banking and securities businesses. It also left a small loophole to allow the Federal Reserve to let banks get involved in the securities business in a limited way to relieve otherwise cumbersome operation.
Glass-Steagall (actually two acts arising from bills sponsored by Democratic senator Carter Glass and Democratic congressman Henry B Steagall) was born during the Great Depression. The US banking system was in shambles, with more than 11,000 banks having failed or had to merge, reducing the number of surviving banks by 40%, from 25,000 to 14,000. The governors of several states closed their state banks and in March 1933, president Franklin Roosevelt briefly closed all the banks in the United States. Congressional hearings conducted in early 1933 concluded that the trusted professionals of the financial markets - the bankers and brokers - were guilty of disreputable and dishonest dealings and gross misuse of the public trust.
Historians, while acknowledging the role of malfeasance, now understand that the chief culprit of bank failures was structural, with inadequate regulations that permitted market abuse to become regular practice. Unethical practices were legal, and competition was conducted under the law of the financial jungle.
The Banking Act of 1933 was the newly elected Roosevelt administration's response to the perceived shambles of the nation's financial and economic system. But the act did not address the structural weakness of the US banking system: unit banking within states and the prohibition of nationwide banking. This structure is a key reason for the failure of many US banks, some 90% of which were unit banks with less than $2 million in assets. The act instituted deposit insurance and the legal separation of most aspects of commercial and investment banking, the principal exception being allowing commercial banks to underwrite most government-issued bonds.
Carter Glass was then a 75-year-old senator who physically stood only 163 centimeters tall but was historically a towering figure. A former Treasury secretary, he was a founder of the Federal Reserve System and a vocal critic of banks that engaged in the risky business of investing in stocks. He wanted banks to stick to conservative commercial lending, and he exploited traditional anti-bank sentiments to push through changes. Henry Steagall, a rural populist from Ozark, Alabama, the Democratic chairman of the House Banking and Currency Committee, signed on to the bill to attach an amendment that authorized bank deposit insurance.
Senator Glass was convinced that banks should not be involved with securities underwriting or investment, as such activities violated basic rules of good banking. As intermediary custodians of money, banks' involvement in equity markets would lead to destructive speculation, as evidenced by the crash of 1929 with its bank failures and the subsequent Great Depression.
Curbing the natural monopolistic tendency of banks has been a common legislative theme throughout US history until the recent onslaught of economic neo-liberalism. During the 1930s and 1940s, US banks were regulated to stay within the basics of taking deposits and making secured loans funded by deposits.
Congress did not intervene until 1956, when it enacted the Bank Holding Company Act to keep financial-services conglomerates from amassing excessive financial power. That law created a barrier between banking and insurance in response to aggressive acquisitions and expansion by TransAmerica Corp, an insurance company that owned Bank of America and an array of other financial services businesses. Congress thought it improper for banks to risk possible losses from underwriting insurance. While many banks today can sell insurance products provided by insurers, banks are not permitted to take on the risk of underwriting.
TransAmerica began when a young entrepreneur named A P Giannini started a small bank known as the Bank of Italy, later to be known as Bank of America. Giannini acquired Occidental Life Insurance Co through TransAmerica Corp in 1930. The 1956 Bank Holding Company Act prohibited a company from owning both banking and non-banking entities. The company decided to divest itself of its bank holdings and keep its core life-insurance businesses and related services under the TransAmerica name. As a financial conglomerate, it acquired motion-picture studio and distributor United Artists, Trans International Airlines, and Budget Rent-A-Car.
The rise and fall of conglomerates
As private equity is the rage today, conglomerates were the new trend in the 1960s, exploiting a combination of low interest rates and recurring alternative cycles of bear/bull markets, which allowed the conglomerates to acquire companies in leveraged buyouts at temporarily deflated values with loans at negative real interest rates.
As long as the acquired companies had profits greater than the interest on the loans used to buy them, the overall leveraged return on investment (ROI) of the conglomerate grew spectacularly, causing the conglomerate's stock price to rise sharply within short periods. High stock prices allowed the conglomerate to borrow more money without altering its debt-to-equity ratio, with which to acquire even more companies. This led to a chain reaction that allowed conglomerates to grow very rapidly.
But when interest rates finally rose to catch up with inflation, conglomerate ROI fell when anticipated "synergies" from owning diversified businesses failed to live up to expectation and conglomerate shares fell in market value, forcing them sell off recently acquired companies to pay off loans to maintain the required debt-to-equity ratio.
By the mid-1970s, most conglomerates had been dismantled, as many private-equity deals are expected to be in coming months.
Attempts to repeal Glass-Steagall
Repeated unsuccessful attempts were made after 1933 by commercial bankers and sympathetic regulators to repeal or draft exceptions to those sections of Glass-Steagall Act that mandate separation of commercial and investment banking. As a result, the United States and Japan - which was forced to adopt laws similar to the US banking statues after World War II - alone among the world's major financial nations, legally require this separation. Japanese banks can engage in many securities activities, however, including underwriting and dealing in commercial paper and ownership of up to 5% of non-bank enterprises.
Beginning in the 1960s, US banks began lobbying Congress to allow them to enter the municipal-bond market. In the 1970s, deregulation allowed brokerage firms to encroach on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards. In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterpreted Section 20 of the Glass-Steagall Act, which bars commercial banks from being "engaged principally" in securities business, deciding that banks can only have up to 5% of gross revenues from investment banking business. The Fed board then permitted Bankers Trust, a commercial bank, to engage in certain CP transactions. In the Bankers Trust decision, the board concluded that the phrase "engaged principally" in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue.
In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of then-chairman Paul Volcker. The vote legalized as policy proposals from Citicorp, JPMorgan and Bankers Trust to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, vice chairman of Citicorp, had argued that three "outside checks" on corporate misbehavior had emerged since 1933 - a very effective Securities and Exchange Commission (SEC), knowledgeable investors, and very sophisticated rating agencies - to render the tight regulations unnecessary.
Yet in the current liquidity crisis, it has become clear that all three of these "outside checks" failed in recent years to protect both the public interest and the orderly function of markets. The SEC has largely been ineffective in preventing corporate fraud and market abuse, investors have been unable to understand fully the risk of complex financial instruments pushed on them by confused if not unprincipled brokers, and rating agencies fell far short in accurately rating the true risk embedded in debt instruments they rate.
Volcker opposes repeal
Paul Volcker (Fed chairman 1979-87) feared that if the easing were approved, banks would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. It was the financial equivalent of letting the camel's foot
into the tent. But he was outvoted and since then, the history of finance capitalism has been the triumph of the security industry's aggressive culture of risk over the banking industry's prudent culture of security.
In March 1987, the Fed approved an application by Chase Manhattan to engage in underwriting commercial paper. While the board remained sensitive to concerns about mixing commercial banking and underwriting, it reinterpreted the original congressional intent by focusing on the words "principally engaged" to allow for some securities activities for banks. The Fed also indicated that it would raise the limit from 5% to 10% of gross revenues at some point in the future to increase competition and market efficiency.
Greenspan supports repeal
In August 1987, Alan Greenspan, a director of JPMorgan and a proponent of banking deregulation, was appointed chairman of the Federal Reserve board. Greenspan put the full power of his new position toward advocating bank deregulation by asserting its necessity to help US banks become global financial powers in the context of the US push for financial globalization.
In January 1989, the Fed board approved a joint application by JPMorgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marked a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business was still at 5%. Later in 1989, the board issued an order raising the limit to 10% of revenues, referring to the April 1987 order for its rationale.
JPMorgan jumpstart
In 1990, JPMorgan became the first bank to receive permission from the US Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10% revenue limit. In 1984 and 1988, the Senate passed legislation that would ease major restrictions under Glass-Steagall, but in each case the more populist House of Representatives blocked passage.
In 1991, the administration of president George H W Bush put forward a proposal for repeal of Glass-Steagall, winning support of both the House and Senate banking committees, but the House again defeated the bill in a full vote. Again in 1995, the House and Senate banking committees approved separate versions of legislation to repeal Glass-Steagall, but conference negotiations on a compromise fell apart.
Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.
In December 1996, with the vocal public support of chairman Alan Greenspan, the Federal Reserve board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25% of their business in securities underwriting, up from 10%. This expansion of the loophole initially created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall in effect rendered the act obsolete, in view of explosive growth of banking. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25% limit on revenue, since banks are much larger institutions as compared with security firms. However, the law remained on the books and, along with the Bank Holding Company Act, continued to impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.
In August 1997, the Fed further eliminated many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The board stated that the risks of underwriting had proved to be "manageable" and allowed banks the right to acquire securities firms outright. In 1997, Bankers Trust, now owned by Deutsche Bank, bought the investment bank Alex Brown & Co, becoming the first US bank to acquire a securities firm.
The demise of Glass-Steagall
In February 1998, Sandy Weill of Travelers Insurance approached Citicorp's John Reed on a merger. The transaction had to work around remaining regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent a merger of insurance underwriting, securities underwriting, and commercial banking. The pending merger in effect gave regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.
The Fed gave its approval to the Citicorp-Travelers merger on September 23. The Fed's press release indicated that "the board's approval is subject to the conditions that Travelers and the combined organization, Citigroup Inc, take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal ... The Board's approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act."
After the merger announcement on April 6, 1998, Weill immediately launched a lobbying and public relations campaign for the repeal of Glass-Steagall and passage of new financial services legislation known as the Financial Services Modernization Act of 1999. "Modernization" was a euphemism for total deregulation for the brave new world of financial globalization.
The House Republican leadership wanted to enact the measure in the current session of Congress. While the administration of then president Bill Clinton generally supported Glass-Steagall "modernization", there were concerns that mid-term elections in November could bring in new Democrats less sympathetic to changing the populist laws. In May 1998, the House passed legislation by a narrow vote of 214-213 that allowed the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee voted 16-2 to approve a compromise bank-overhaul bill. Despite this new momentum, Congress was still not certain to pass final legislation before the end of its session.
As the final push for new legislation heated up around election time, lobbyists raised the issue of financial modernization with a fresh round of political fundraising. Indeed, in the 1998 mid-term election, the finance, insurance, and real-estate industries, known as the FIRE sector, built a bonfire of more than $200 million on lobbying and more than $150 million in political donations. Campaign contributions were targeted to members of congressional banking committees and other committees with direct jurisdiction over financial-services legislation.
After 12 attempts in 25 years, Congress finally repealed Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hailed the change as the long-overdue demise of a Depression-era relic. Opponents saw it as the root of a future depression.
Repeal leads to current credit crisis
What nobody expected, not even the most fervent opponents to bank deregulation, was that the repeal of Glass-Steagall would pave the way to the emergence of the non-bank financial system, which took off like a fighter jet off the deck of an aircraft carrier with the advent of deregulated global financial markets, which eventually rendered both banks and their central-bank lenders of last resort irrelevant in a brave new world of finance.
Just days after the US Treasury Department signed on to support the repeal of Glass-Steagall, treasury secretary Robert Rubin, a former co-chairman of Goldman Sachs, accepted a top position at Citigroup as vice chairman. The previous year, Weill had called Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, "You're buying the government?" Rubin could have added: "With debt?" The answer, while never reported, could have been: "No, the whole world."
The world that Weill bought with debt from the non-bank financial system is now in a severe credit crisis with an irrelevant banking system that needs to have $1.3 trillion put back into the banks' balance sheets. Even if the Fed bails out the banks by easing bank reserve and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades.
Cash may be king in a liquidity crisis, but in a credit crisis, a king may echo William Shakespeare's Richard III: "A horse, a horse, my kingdom for a horse."
This is the final article of a two-part analysis.
By Henry C K Liu
(See also Part 1: The rise of the non-bank financial system)
US Federal Reserve data show that the outstanding stock of US commercial paper has fallen by US$255 billion or 11% over the past three weeks, a sign that many borrowers have been unable to roll over huge amounts of short-term debt at maturity. Asset-backed commercial paper (ABCP), which accounted for half the commercial-paper (CP) market, tumbled $59.4 billion to $998 billion in the last week of August, the lowest since December. Total short-term debt maturing in 270 days or less fell $62.8 billion to a seasonally adjusted $1.98 trillion. The yield on the highest-rated asset-backed paper due by August 30 rose 0.11 percentage point to a six-year high of 6.15%.
Some analysts are comparing the current collapse of the CP market to the sudden drain on liquidity that occurred at the onset of the 2001 dotcom bust. Others are comparing the current crisis to the 1907 crash, when large trusts did not have access to a lender of last resort, as the Fed had not yet been established. Still others are comparing the current crisis to the 1929 crash, when the Fed delayed needed intervention.
Today, key market participants who dominate the credit market with unprecedented high levels of securitized debt operate beyond the purview of the Fed in the non-bank financial system, and these market participants do not have direct access to a lender of last resort when a liquidity crisis develops except through the narrow window of the banking system.
Banks get no respect
US banks are now unhappy about capital and debt markets, where they are no longer getting respect. Market analysts have been crediting capital and debt markets for the long liquidity boom, rather than bank lending. Banks' share of net credit markets, according to Fed data on flow of funds, dropped from a peak of more than 62% in 1975 to 26% in 1995 and was still falling rapidly, while securitization's share rose from negligible in 1975 to more than 20% in 1995 and more than 30% in 2006 and was still rising rapidly, with insurers and pension funds taking the rest.
Debt securitization in the first half of 2007 stood at more than $3 trillion, up from $2.15 trillion in 2006, $375 billion in 1985 and 156 billion in 1972. About $1.2 trillion is asset-backed securities. The biggest issuers are: Countrywide, $55 billion; Washington Mutual, $43 billion; and General Motors Acceptance Corp (GMAC), $40 billion. Big bank issuers are: JPMorgan Chase, $38 billion; Citibank, $29 billion; Barclays Bank, $29 billion. Big brokerage issuers are: Lehman Brothers, $37 billion; Merrill Lynch, $31 billion, Bear Sterns, $31 billion; and Morgan Stanley, $26 billion.
Asia, including Japan, which still funds its economies mostly through banks, could not recover quickly from the 1997 Asian financial crisis primarily because of an underdeveloped debt-securitization market.
The Dow and interest rates
In February 2000, the Dow Jones Industrial Average (DJIA) closed below 10,000 - a psychological benchmark from a peak of 11,723 just four weeks earlier, and 10,000 was only a transitional barrier. Some bears predicted lack of support until 8,000. It was the first retreat from the 10,000 mark in 10 months, off 14.22% for the year, while the broader S&P 500 lost 9.25%.
On September 17, 2000, the DJIA fell 684.81 points to close at 8,920.70, largest dollar loss in history, down 7.13%. On October 9, the DJIA fell 215.22 points to close at 7,286.27. The market had declined 4,436.71 points, or 38%, from January 14, 2000, when it rose 140.55 to close at all time high of 11,722.98, the first close above both 11,600.00 and 11,700.00.
On May 16, 2000, the Fed Funds rate was raised to 6.5%. After that, the Fed began lowering it on January 3, 2001, and did so again 12 more times to 1% on June 25, 2003, and held it there - below inflation rate - for a full year, unleashing the debt bubble.
On July 19, 2007, the DJIA closed at 14,000.41, reaching a new all-time high. The DJIA had risen 6,714 points, or 92%, since the low point of 7,286.27 on October 9, 2002, in four years and 10 months. The US gross domestic product rose from $10.5 trillion in 2002 to $13.2 trillion in 2006, an increase of 30%. Asset prices outpaced economic growth by a multiple of three during that period.
This extraordinary divergence shows more than the different economic fundamentals of the old and new economies. It shows the financial effect of a shift of importance from banks as funding intermediaries to the exploding capital and debt markets in which, with the advent of structured finance, the line between equity and debt has in effect been blurred.
Greenspan's forked-tongue pronouncements
Nasdaq companies rely less on banks for funds and were thus less affected by then Fed chairman Alan Greenspan's threats of interest-rate hikes. Greenspan had been vocal in explaining that his monetary-policy moves of rising Fed Funds rate targets were not specifically targeted toward "irrational exuberance" in the stock markets, but toward the unsustainable expansion of the US economy as a whole. But data show that the economy did not expand at the same rate as the rise of equity prices. Economic growth would be more sustainable with irrational exuberance in the stock market.
In the same breath, Greenspan decried the dangers of the wealth effect if it ever ended up heavier on the consumption side than on the investment side. It was a curious position, as most Greenspan's positions seem to be. The Greenspan gospel says asset inflation is good unless it is spent rather than used to fuel more asset inflation. He continued to restrain demand in favor of supply in an already overcapacity economy.
The need for demand management was argued by post-Keynesian economists who had been pushed out of the mainstream in recent decades by supply-siders. In housing, Greenspan was trapped in a classic dilemma of not knowing whether housing is consumption or investment. Homeowners have been living in an asset (thus consuming it) that rises in market value faster than the rise of their earned income. Home-equity loans enabled homeowners to monetize their housing investment gains to support their non-housing consumption.
It is hard to see how home prices rising higher than homebuyers can afford to pay can be good for any economy. Yet the Fed celebrates asset-price appreciation for shares and real estate, but treats wage rises like a dreaded plague.
Bifurcated markets
The so-called "bifurcated" market indices of the tech boom of the early 2000s indicated clearly that the Fed, whose sole monetary weapon was the Fed Funds rate, lost control of the new economy, which appears impervious to short-term interest-rate moves.
Under such conditions, the only way the Fed could restrain unsustainable economic expansion in one sector was to overshoot the interest-rate target to rein in an impervious Nasdaq at the peril of the whole economy. Interest-sensitive stocks were battered badly in 2000, including banks and non-bank lenders, such as GE, GMAC and Amex. This forced the Fed to keep Fed Funds rate at 1% for a whole year, from June 2003 to June 2004, to create the housing bubble. With the inflation rate at 2%, the Fed was in effect giving borrowers a net payment of $1,000 for every $100,000 borrowed between 2002 and 2003.
The peril of uneven profit sharing
Financial-services companies, including commercial banks, brokerage firms and mortgage lenders, investment-bank and non-bank financial companies such as GE and GMAC, had since produced some of the biggest profits in the recent bull market fueled by a liquidity boom.
The trouble with the financial sector making the bulk of the profit in the debt economy is that when newly created wealth is unevenly distributed to favor return on capital rather than through rising wages, it exacerbates the supply-demand imbalance, which can only be sustained by a consumer debt bubble. The public have insufficient income to consume all that the debt economy can produce from over-investment except by taking on consumer debt and home-equity debt.
Liquidity crunch only an early symptom
In recent weeks, the combination of sudden rise in interest rates due to a liquidity crunch and the hefty leverage employed by businesses in the financial sector has proved to be fatally hazardous to company cash flow and stock prices. Money-center banks and broker dealers, along with their hedge-fund customers, are most vulnerable because they are most exposed to interest-rate-related risks through products such as interest-rate swaps, default swaps and securitized mortgages. But this was just an early symptom, like an initial wave of high fever.
Lipper TASS reports that institutional and wealth private investors poured $41.1 billion into hedge funds in the second quarter of 2007, which through performance gains swelled industry assets to an estimated $1.67 trillion by the end of June. The aggregate hedge-fund performance of 5.19% by June 30 did not surpass market indices' rise for the period. The S&P 500 returned 6.28%, while the MSCI World TR returned 6.71%. The biggest inflows were for market-neutral long-short equity strategies, which gained $14.9 billion, followed by event-driven funds, which gained $12.2 billion. Multi-strategy funds gained $6.1 billion during the period. Strategies that posted net outflows included global macro-funds,
which bet on world currencies and sovereign debt and were down by $848 million, and managed futures, which were down by 686.7 million. Losses of this scale are bound to have structural effects.
The credit derivatives overhang
The most popular of all derivative products is the interest-rate swap, which in essence allows participants to make bets on the direction interest rates will take.
According to the US Office of the Comptroller of the Currency (OCC), interest-rate swaps accounted for three out of four derivative contracts held by US commercial banks at the end of 1999. The notional value of these swaps totaled almost $25 trillion; 2-3% of that reflected the banks' true credit risk in these products, or between $500 billion to $700 billion. The notional amount outstanding as of December 2006 in OTC (over the counter) interest-rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. A 1% move in the interest rate would alter interest payments in the amount of $4 trillion, albeit much the payment would be mutually canceling, unless in the case of counter-party default.
The Comptroller of the Currency Quarterly Report on Bank Derivatives Activities shows that US commercial banks generated a record $7 billion in revenues trading cash and derivative instruments in first quarter of 2007, up 24% from the first quarter of 2006, which at $5.7 billion had been the previous record. Revenues in the first quarter were 82% higher than in the fourth quarter. Net current credit exposure, the net amount owed to banks if all contracts were immediately liquidated, decreased $5.3 billion from the fourth quarter to $179.2 billion. The data for the third quarter of 2007 are expected to be very negative to reflect market turmoil since July.
The notional amount of derivatives held by US commercial banks increased $13.3 trillion to $144.8 trillion in the first quarter of 2007, 10% higher than in the fourth quarter and 31% higher than a year ago. Bank derivative contracts remain concentrated in interest rate products, which represent 82% of total notional value. The notional amount of credit derivatives, the fastest-growing product of the global derivatives market, increased 13% from the fourth quarter of 2006 to $10.2 trillion in first quarter in 2007. Credit default swaps represent 98% of the total amount of credit derivatives. Credit derivatives contracts are 86% higher than at the end of the first quarter of 2006. The largest derivatives dealers continue to strengthen the operational infrastructure for over-the-counter derivatives through a collaborative effort with financial supervisors, the OCC reports. Still, counter-party risk remains problematic.
Derivatives of all kinds weigh heavily on banks' capital structures. But interest-rate swaps can be especially toxic when interest rates rise. And since only a few business economists predicted a jump in rates for the first half of the year when 1999 began - in fact, yields have risen 25% - these institutions now find themselves on the wrong side of an interest-rate gamble. Moreover, as interest rates rise, bank income diminishes from interest-rate-related businesses such as mortgage lending. Interest-sensitive sources of income will be the revenue disappointments in 2008, as in 2000, and as trading was in 1999.
Hedging feeds risk appetite
The impact of the demise of the Nasdaq index on the wealth effect was not total. Investment banks pitched to high-tech/Internet founders and early shareholders to hedge capital gains by signing away future upsides. For those high-tech swimmers who took advantage of the offers, this amounted to two-layer swimming trunks that allowed them to lose the top layer without risking being caught naked when the tide receded suddenly. It was the financial version of a flat-proof tubeless tire that can get you to the next service station or 50 kilometers (whichever is closer) in the event of a puncture. It does not, however, guarantee the driver the existence of a service station that has not been forced to close from operational losses within 50km.
Meanwhile, pension funds are forced to jettison their old-fashioned balanced portfolios in favor of structured finance strategies to seek higher returns. What the Greenspan Fed did was to penalize the general public by devaluing their future pension cash flow for the sins of the aggressively investing rich, who continued to add to their wealth with Greenspan's blessing as long as the risks of high returns were passed on to the system as a whole. This is what US economic democracy has come to.
Investor confidence low
Investors worldwide are unconvinced that the US Federal Reserve can succeed in stabilizing the US commercial-paper market, the latest and so far biggest shoe to drop in the spreading contagion from US subprime mortgages. Banks are suddenly exposed to unexpected risks as US asset-backed CP shrank by its biggest weekly percentage since November 2000 as investors shunned debt linked to mortgages and opted for the safety of Treasuries.
This means that investors prefer to lend money to the US government, despite historically high levels of fiscal deficit and national debt, than to financial institutions that seek profit from interest-rate arbitrage. Market preference for speculative investment has vanished. Banks are suddenly holding the bad end of a massive amount of speculative debt instruments. When new commercial paper is not sold to roll over the maturing debt, borrowers must draw on bank credit at a higher interest cost to prevent default, leaving banks with riskier debts that the market has rejected.
Fed accepts ABCP as discount window collateral
In the week to August 22, after the Fed lower the discount rate by 50 basis points to 5.75% on August 17, banks borrowed a daily average of only $1.2 billion from the Fed discount window, suggesting that banks were still unsure how to use the facility to lend to distressed clients. Officials at the New York Fed, the central bank's liaison with Wall Street, received inquiries from commercial banks on whether their clients' asset-backed commercial paper could be pledged as collateral at the discount window.
The New York Fed issued a statement "in response to specific inquiries" from money-center banks on Friday, August 24, that it "has affirmed its policy to consider accepting as collateral investment quality asset-backed commercial paper" for discount-window loans to ease the liquidity crisis faced by the banks to try to calm an essential part of the money market, the orderly functioning of which is critically needed to lubricate financial markets. But the statement only trimmed slightly the abnormally high average ABCP yield to 6.04%, still roughly 80 basis points higher than normal, even for those borrowers who could sell commercial paper at all, which normally would be at rates close to the Fed funds rate of 5.25%.
On the same day, the Fed eased regulations governing the relationship between Citibank NA, the US bank subsidiary of Citigroup Inc, and its broker-dealer subsidiary, Citigroup Global Markets Inc. The regulatory exemption allows Citibank to lend up to $25 billion to customers of the broker-dealer. Bank of America Corp received a similar easing.
Section 23A of the Federal Reserve Act and the Fed board's Regulation W limit the amount of "covered transactions" between a bank and any single affiliate to 10% of the bank's capital stock and surplus and the amount between a bank and all its affiliates to 20%. The banks have agreed to limit their lending under the exemption to $25 billion, which will constitute less than 30% of each bank's total regulatory capital.
The two banks, along with JPMorgan Chase & Co and Wachovia Corp, borrowed a total of $2 billion two days earlier in a symbolic show of support for the Fed's anemic actions, while noting that they still had access to cheaper funding than the new discount rate of 5.75%.
Until the repeal of the Glass-Steagall Act, banking regulation prohibited banks with federally insured deposits from operating brokerage subsidiaries. In the early part of the last century, individual investors had been repeatedly damaged by banks whose overriding interest was to profit from promoting stocks held by banks, rather than to enhance the interest of individual investors or protect the security of its depositors.
After the 1929 market crash, regulators sought to limit the conflicts of interest created when commercial banks underwrote stocks or bonds, which contributed to abuses that caused market crashes. A new law, known as the Glass-Steagall Act, banned commercial banks from underwriting securities, forcing banks to choose between being a regulated lender of high prudence or an underwriter-broker with high risk appetite. The law also established the Federal Deposit Insurance Corp (FDIC), insuring bank deposits, and strengthened the Federal Reserve's control over credit.
The 1933 Glass-Steagall Act became a key pillar of banking law by erecting a regulatory wall between commercial banking and investment banking. The law kept banks from participating in the equity markets, and equity market participants from being banks. The relevant measure of the Glass-Steagall Act is actually the Banking Act of 1933, containing the provision erecting a wall separating the banking and securities businesses. It also left a small loophole to allow the Federal Reserve to let banks get involved in the securities business in a limited way to relieve otherwise cumbersome operation.
Glass-Steagall (actually two acts arising from bills sponsored by Democratic senator Carter Glass and Democratic congressman Henry B Steagall) was born during the Great Depression. The US banking system was in shambles, with more than 11,000 banks having failed or had to merge, reducing the number of surviving banks by 40%, from 25,000 to 14,000. The governors of several states closed their state banks and in March 1933, president Franklin Roosevelt briefly closed all the banks in the United States. Congressional hearings conducted in early 1933 concluded that the trusted professionals of the financial markets - the bankers and brokers - were guilty of disreputable and dishonest dealings and gross misuse of the public trust.
Historians, while acknowledging the role of malfeasance, now understand that the chief culprit of bank failures was structural, with inadequate regulations that permitted market abuse to become regular practice. Unethical practices were legal, and competition was conducted under the law of the financial jungle.
The Banking Act of 1933 was the newly elected Roosevelt administration's response to the perceived shambles of the nation's financial and economic system. But the act did not address the structural weakness of the US banking system: unit banking within states and the prohibition of nationwide banking. This structure is a key reason for the failure of many US banks, some 90% of which were unit banks with less than $2 million in assets. The act instituted deposit insurance and the legal separation of most aspects of commercial and investment banking, the principal exception being allowing commercial banks to underwrite most government-issued bonds.
Carter Glass was then a 75-year-old senator who physically stood only 163 centimeters tall but was historically a towering figure. A former Treasury secretary, he was a founder of the Federal Reserve System and a vocal critic of banks that engaged in the risky business of investing in stocks. He wanted banks to stick to conservative commercial lending, and he exploited traditional anti-bank sentiments to push through changes. Henry Steagall, a rural populist from Ozark, Alabama, the Democratic chairman of the House Banking and Currency Committee, signed on to the bill to attach an amendment that authorized bank deposit insurance.
Senator Glass was convinced that banks should not be involved with securities underwriting or investment, as such activities violated basic rules of good banking. As intermediary custodians of money, banks' involvement in equity markets would lead to destructive speculation, as evidenced by the crash of 1929 with its bank failures and the subsequent Great Depression.
Curbing the natural monopolistic tendency of banks has been a common legislative theme throughout US history until the recent onslaught of economic neo-liberalism. During the 1930s and 1940s, US banks were regulated to stay within the basics of taking deposits and making secured loans funded by deposits.
Congress did not intervene until 1956, when it enacted the Bank Holding Company Act to keep financial-services conglomerates from amassing excessive financial power. That law created a barrier between banking and insurance in response to aggressive acquisitions and expansion by TransAmerica Corp, an insurance company that owned Bank of America and an array of other financial services businesses. Congress thought it improper for banks to risk possible losses from underwriting insurance. While many banks today can sell insurance products provided by insurers, banks are not permitted to take on the risk of underwriting.
TransAmerica began when a young entrepreneur named A P Giannini started a small bank known as the Bank of Italy, later to be known as Bank of America. Giannini acquired Occidental Life Insurance Co through TransAmerica Corp in 1930. The 1956 Bank Holding Company Act prohibited a company from owning both banking and non-banking entities. The company decided to divest itself of its bank holdings and keep its core life-insurance businesses and related services under the TransAmerica name. As a financial conglomerate, it acquired motion-picture studio and distributor United Artists, Trans International Airlines, and Budget Rent-A-Car.
The rise and fall of conglomerates
As private equity is the rage today, conglomerates were the new trend in the 1960s, exploiting a combination of low interest rates and recurring alternative cycles of bear/bull markets, which allowed the conglomerates to acquire companies in leveraged buyouts at temporarily deflated values with loans at negative real interest rates.
As long as the acquired companies had profits greater than the interest on the loans used to buy them, the overall leveraged return on investment (ROI) of the conglomerate grew spectacularly, causing the conglomerate's stock price to rise sharply within short periods. High stock prices allowed the conglomerate to borrow more money without altering its debt-to-equity ratio, with which to acquire even more companies. This led to a chain reaction that allowed conglomerates to grow very rapidly.
But when interest rates finally rose to catch up with inflation, conglomerate ROI fell when anticipated "synergies" from owning diversified businesses failed to live up to expectation and conglomerate shares fell in market value, forcing them sell off recently acquired companies to pay off loans to maintain the required debt-to-equity ratio.
By the mid-1970s, most conglomerates had been dismantled, as many private-equity deals are expected to be in coming months.
Attempts to repeal Glass-Steagall
Repeated unsuccessful attempts were made after 1933 by commercial bankers and sympathetic regulators to repeal or draft exceptions to those sections of Glass-Steagall Act that mandate separation of commercial and investment banking. As a result, the United States and Japan - which was forced to adopt laws similar to the US banking statues after World War II - alone among the world's major financial nations, legally require this separation. Japanese banks can engage in many securities activities, however, including underwriting and dealing in commercial paper and ownership of up to 5% of non-bank enterprises.
Beginning in the 1960s, US banks began lobbying Congress to allow them to enter the municipal-bond market. In the 1970s, deregulation allowed brokerage firms to encroach on banking territory by offering money-market accounts that pay interest, allow check-writing, and offer credit or debit cards. In December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterpreted Section 20 of the Glass-Steagall Act, which bars commercial banks from being "engaged principally" in securities business, deciding that banks can only have up to 5% of gross revenues from investment banking business. The Fed board then permitted Bankers Trust, a commercial bank, to engage in certain CP transactions. In the Bankers Trust decision, the board concluded that the phrase "engaged principally" in Section 20 allows banks to do a small amount of underwriting, so long as it does not become a large portion of revenue.
In the spring of 1987, the Federal Reserve Board voted 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of then-chairman Paul Volcker. The vote legalized as policy proposals from Citicorp, JPMorgan and Bankers Trust to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities. Thomas Theobald, vice chairman of Citicorp, had argued that three "outside checks" on corporate misbehavior had emerged since 1933 - a very effective Securities and Exchange Commission (SEC), knowledgeable investors, and very sophisticated rating agencies - to render the tight regulations unnecessary.
Yet in the current liquidity crisis, it has become clear that all three of these "outside checks" failed in recent years to protect both the public interest and the orderly function of markets. The SEC has largely been ineffective in preventing corporate fraud and market abuse, investors have been unable to understand fully the risk of complex financial instruments pushed on them by confused if not unprincipled brokers, and rating agencies fell far short in accurately rating the true risk embedded in debt instruments they rate.
Volcker opposes repeal
Paul Volcker (Fed chairman 1979-87) feared that if the easing were approved, banks would recklessly lower loan standards in pursuit of lucrative securities offerings and market bad loans to the public. It was the financial equivalent of letting the camel's foot
into the tent. But he was outvoted and since then, the history of finance capitalism has been the triumph of the security industry's aggressive culture of risk over the banking industry's prudent culture of security.
In March 1987, the Fed approved an application by Chase Manhattan to engage in underwriting commercial paper. While the board remained sensitive to concerns about mixing commercial banking and underwriting, it reinterpreted the original congressional intent by focusing on the words "principally engaged" to allow for some securities activities for banks. The Fed also indicated that it would raise the limit from 5% to 10% of gross revenues at some point in the future to increase competition and market efficiency.
Greenspan supports repeal
In August 1987, Alan Greenspan, a director of JPMorgan and a proponent of banking deregulation, was appointed chairman of the Federal Reserve board. Greenspan put the full power of his new position toward advocating bank deregulation by asserting its necessity to help US banks become global financial powers in the context of the US push for financial globalization.
In January 1989, the Fed board approved a joint application by JPMorgan, Chase Manhattan, Bankers Trust, and Citicorp to expand the Glass-Steagall loophole to include dealing in debt and equity securities in addition to municipal securities and commercial paper. This marked a large expansion of the activities considered permissible under Section 20, because the revenue limit for underwriting business was still at 5%. Later in 1989, the board issued an order raising the limit to 10% of revenues, referring to the April 1987 order for its rationale.
JPMorgan jumpstart
In 1990, JPMorgan became the first bank to receive permission from the US Federal Reserve to underwrite securities, so long as its underwriting business does not exceed the 10% revenue limit. In 1984 and 1988, the Senate passed legislation that would ease major restrictions under Glass-Steagall, but in each case the more populist House of Representatives blocked passage.
In 1991, the administration of president George H W Bush put forward a proposal for repeal of Glass-Steagall, winning support of both the House and Senate banking committees, but the House again defeated the bill in a full vote. Again in 1995, the House and Senate banking committees approved separate versions of legislation to repeal Glass-Steagall, but conference negotiations on a compromise fell apart.
Attempts to repeal Glass-Steagall typically pit insurance companies, securities firms, and large and small banks against one another, as factions of these industries engage in turf wars in Congress over their competing interests and over whether the Federal Reserve or the Treasury Department and the Comptroller of the Currency should be the primary banking regulator.
In December 1996, with the vocal public support of chairman Alan Greenspan, the Federal Reserve board issued a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25% of their business in securities underwriting, up from 10%. This expansion of the loophole initially created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall in effect rendered the act obsolete, in view of explosive growth of banking. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25% limit on revenue, since banks are much larger institutions as compared with security firms. However, the law remained on the books and, along with the Bank Holding Company Act, continued to impose other restrictions on banks, such as prohibiting them from owning insurance-underwriting companies.
In August 1997, the Fed further eliminated many restrictions imposed on "Section 20 subsidiaries" by the 1987 and 1989 orders. The board stated that the risks of underwriting had proved to be "manageable" and allowed banks the right to acquire securities firms outright. In 1997, Bankers Trust, now owned by Deutsche Bank, bought the investment bank Alex Brown & Co, becoming the first US bank to acquire a securities firm.
The demise of Glass-Steagall
In February 1998, Sandy Weill of Travelers Insurance approached Citicorp's John Reed on a merger. The transaction had to work around remaining regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent a merger of insurance underwriting, securities underwriting, and commercial banking. The pending merger in effect gave regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.
The Fed gave its approval to the Citicorp-Travelers merger on September 23. The Fed's press release indicated that "the board's approval is subject to the conditions that Travelers and the combined organization, Citigroup Inc, take all actions necessary to conform the activities and investments of Travelers and all its subsidiaries to the requirements of the Bank Holding Company Act in a manner acceptable to the Board, including divestiture as necessary, within two years of consummation of the proposal ... The Board's approval also is subject to the condition that Travelers and Citigroup conform the activities of its companies to the requirements of the Glass-Steagall Act."
After the merger announcement on April 6, 1998, Weill immediately launched a lobbying and public relations campaign for the repeal of Glass-Steagall and passage of new financial services legislation known as the Financial Services Modernization Act of 1999. "Modernization" was a euphemism for total deregulation for the brave new world of financial globalization.
The House Republican leadership wanted to enact the measure in the current session of Congress. While the administration of then president Bill Clinton generally supported Glass-Steagall "modernization", there were concerns that mid-term elections in November could bring in new Democrats less sympathetic to changing the populist laws. In May 1998, the House passed legislation by a narrow vote of 214-213 that allowed the merging of banks, securities firms, and insurance companies into huge financial conglomerates. And in September, the Senate Banking Committee voted 16-2 to approve a compromise bank-overhaul bill. Despite this new momentum, Congress was still not certain to pass final legislation before the end of its session.
As the final push for new legislation heated up around election time, lobbyists raised the issue of financial modernization with a fresh round of political fundraising. Indeed, in the 1998 mid-term election, the finance, insurance, and real-estate industries, known as the FIRE sector, built a bonfire of more than $200 million on lobbying and more than $150 million in political donations. Campaign contributions were targeted to members of congressional banking committees and other committees with direct jurisdiction over financial-services legislation.
After 12 attempts in 25 years, Congress finally repealed Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hailed the change as the long-overdue demise of a Depression-era relic. Opponents saw it as the root of a future depression.
Repeal leads to current credit crisis
What nobody expected, not even the most fervent opponents to bank deregulation, was that the repeal of Glass-Steagall would pave the way to the emergence of the non-bank financial system, which took off like a fighter jet off the deck of an aircraft carrier with the advent of deregulated global financial markets, which eventually rendered both banks and their central-bank lenders of last resort irrelevant in a brave new world of finance.
Just days after the US Treasury Department signed on to support the repeal of Glass-Steagall, treasury secretary Robert Rubin, a former co-chairman of Goldman Sachs, accepted a top position at Citigroup as vice chairman. The previous year, Weill had called Rubin to give him advance notice of the upcoming merger announcement. When Weill told Rubin he had some important news, the secretary reportedly quipped, "You're buying the government?" Rubin could have added: "With debt?" The answer, while never reported, could have been: "No, the whole world."
The world that Weill bought with debt from the non-bank financial system is now in a severe credit crisis with an irrelevant banking system that needs to have $1.3 trillion put back into the banks' balance sheets. Even if the Fed bails out the banks by easing bank reserve and capital requirements to absorb that massive amount, the raging forest fire in the non-bank financial system will still present finance capitalism with its greatest test in eight decades.
Cash may be king in a liquidity crisis, but in a credit crisis, a king may echo William Shakespeare's Richard III: "A horse, a horse, my kingdom for a horse."
This is the final article of a two-part analysis.
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