“Those who fail to learn from history…

…are doomed to repeat it”. Winston Churchill’s advice is very timely because it seems like 60 years is about as long as we can go before having to RE-learn the important lessons from The Depression.

The repeal of the The Banking Act of 1933 (AKA The Glass-Steagall Act) in 1999 was the beginning of the failure that ultimately led us to where we are now. One of the big lessons that the Crash and Depression taught us was that banks who took deposits and made loans should be separated from investment houses so that problems on Wall St. wouldn’t wipe out the whole financial system. When we unlearned the lesson in ’99 the banks and Wall St. had a heyday of buying each other up in a rush to create ‘financial super markets’. The idea was that once you came in to deposit your paycheck, they could sell you a few stocks, bonds, mutual funds and even some insurance.

Eventually we ended up with a couple of these huge financial institutions and the smaller regional players followed suite, merging and buying each other up to get big enough to stay competitive with the giants. Those from the Northwest may remember when Washington Mutual was a regional savings bank in the Puget Sound area and ran ads saying that they were your friendly local bank and would never do the bad things that the huge evil banks do.

Unfortunately the net result of combining low risk depository institutions with high risk investment houses is that the banks now had Wall St. risk and could be endangered by the very threats that we learned to keep them separated from. Worse yet, a handful were allowed to get “too big to fail” which meant taxpayers, open your wallets when the inevitable happened on the investment side.

The second lesson we unlearned was allowing the SEC to fail to enforce the rules against naked shorting. As far back as the Securities Exchange Act of 1934 speculators who wanted to make a bet that the value of a particular stock would fall had to borrow and have it in their possession within three days the stock that they were shorting. ‘Shorting’ a stock is the opposite of buying a stock hoping it will go up, the stock is sold first and bought back later theoretically at a lower price. For example ABCo is shorted at $100 and bought back later at $50. The profit is the difference less the cost of borrowing. Having to borrow the stock first meant that there was a limited supply of a stock and therefore speculators only had so much fire power in driving down the price to create their profits. When there is no limit on the amount of shorting that can be done to a stock, speculators can crush a stock or even a whole market sector. The SEC had the rules in place, but failed to enforce them. When this is combined with the next lesson un-learned the effects can and were devastating.

Unlearned lesson #3, the SEC repeals the uptick rule in July ’07. Instituted in 1938 to prevent ‘bear raids’ by then SEC Commissioner Joseph Kennedy Sr. (Yes, the Kennedy dad was the first SEC commish partly because he knew all there was to know about stock manipulation). The ‘uptick rule’ was another rule limiting the ability of speculators to perform a bear raid (drive down a stock) by requiring the price had to move up at least a fraction before successive short positions are initiated. Since the repeal in ’07 the S&P 500 has fallen more than 50%, certainly not only because of bear raids but the ability to pile on a falling stock clearly shows up in the volatility in the markets which has risen to all time highs in the last year.

I hate to use the word synergy in the negative but the combination of these three unlearned lessons built a huge bonfire under the banking system. Add the accelerant of the mortgage mess created by congress forcing Fannie and Freddie to back loans to sub-prime borrowers* all that was needed was a match. The spark came from the crash of the securitized debt markets and woof! Up went the flames, down went the banks and trillions of our childrens’ earnings were turned into tax dollars.

The problem is that banks, the heart of our financial system were allowed to stuff themselves full Wall St. speculations, when those ‘investments’ value declined the banks’ balance sheets were damaged and that damage was compounded when speculators began their bear raiding, which further damaged the balance sheets causing them major shortfalls in the capital they are required to have. Even worse, because they are considered market savvy ‘investment banks’ they were allowed to leverage their assets three or four times more than back when a bank was a conservative institution for the preservation of depositors’ money. Leverage is all good on the way up but it’s a killer on the way down. So now as the downward cycle began their balance sheets were being eroded four times faster and there were no limits on the raiders.

With their assets (stock value + loan portfolio) disappearing unchecked it’s no wonder that ‘banks’ don’t have any money to lend, even the bailout money must go towards propping up the balance sheet. As Harry Truman said: “The only thing new in the world is the history you don’t know”

Giovanni Isaksen
Ashworth Partners Ltd.

*I want to correct an oft quoted but factually wrong statement in the seventh paragraph of my post: “…the mortgage mess created by congress forcing Fannie and Freddie to back loans to sub-prime borrowers.” While Fannie and Freddie were mandated to support low income borrowers A. they were never mandated to support loans that couldn’t be repaid (See “FDIC’s Bair Sets to Shatter CRA Myth” here: http://bit.ly/vzVRuf); B. The amount of subprime loans has accounted for only 5% of their losses and occurred after the meltdown (See Thomas & Van Order (2011): “A Closer Look at Fannie Mae and Freddie Mac: What We Know, What We Think We Know and What We Don’t Know” here http://bit.ly/u3JuH9).

With the benefit of data and hindsight it is clear that the simultaneous growth and deflation of asset bubbles in equities, residential and commercial real estate as well as those occurring around the world cannot be blamed solely on the Community Reinvestment Act or CRA.

“This bold claim [that the GSEs caused the meltdown], however, is not substantiated by persuasive analysis… The GSEs did generate large losses, but their bad investments in housing loans followed rather than led the crisis; most of those investments involved purchases or guarantees made well after the subprime and housing bubbles had been expanded by private loans and were almost about to burst.

Even then, the GSEs’ overall purchases and guarantees were much less risky than Wall Street’s: their default rates were one fourth to one fifth those of Wall Street and other private financial firms. A further review of other literature shows that Clinton’s goals to increase “affordable lending” had little to do with the risks the GSEs took. The FCIC, for example, argued that in several years these goals were largely met by the GSEs’ standard loans with traditional down payments.

Although they were set up originally by the federal government, the GSEs have been private companies for roughly the last forty years. They are traded on the stock market and were on a hunt for profits like much of Wall Street, in part because their executives’ bonuses were linked to earnings per share. Even so, by comparison with other companies they restrained their risk. Private firms on Wall Street and mortgage companies across the nation, uncontrolled by adequate federal regulation, unambiguously caused the crisis as they expanded in the 2000s. They were the ones who “came to blow up the American economy.”

This is not to say that the GSEs’ way of doing business was sensible or that their losses—up to $230 billion—can be justified.” Madrick and Partnoy “Did Fannie Cause the Disaster?” (2011) here: http://bit.ly/rJ1sQz

“Did Fannie and Freddie buy high-risk mortgage-backed securities? Yes. But they did not buy enough of them to be blamed for the mortgage crisis. Highly respected analysts who have looked at these data in much greater detail… including the nonpartisan Government Accountability Office, the Harvard Joint Center for Housing Studies, the Financial Crisis Inquiry Commission majority, the Federal Housing Finance Agency, and virtually all academics, have all rejected the… argument that federal affordable housing policies were responsible for the proliferation of actual high-risk mortgages over the past decade. Min (2011) see here: http://bit.ly/tW57pC.

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