Friday, September 19, 2008

Financial Meltdown: Part I

Well, I think it’s about time I weighed in on the current financial crisis. Sorry this took me so long, but I needed time to do some real research to sort through all the opinions. What follows is an analysis of the root causes and history behind this crisis, as well as who to blame (because blaming people is so much fun!). This is part I of II, because the next post will assess the government’s response and what should be done.

First off, let’s get one thing clear. This is not the fault of the Bush Administration. Frankly, the only real things the Bush Administration did to contribute were (a) allow deregulation to stay around and (b) spend too much money on ill-founded wars. Their fault lies in overextending the government’s resources so they don’t have the resources to properly handle what they’ve been given. This crisis has been building since before Bush was elected.

If we can’t blame “everyone’s favorite target,” then who can we blame? No one person is 100% responsible, but a significant portion of the blame is shared by Alan Greenspan and the Republican Congress of 1999-2000. Each of these entities shares some responsibility the twin causes of the current crisis: the housing bubble and deregulation.

Let’s start with the easy case, and the immediate cause of this crisis: the housing bubble. The fault for the housing bubble lies squarely on the shoulders of the Federal Reserve. That means Alan Greenspan. Housing prices have declined 20% since this crisis began, but that’s only half of the 70% increase in real terms they saw from 1973-2007 (170%*-20% = -34%). In comparison, housing prices remained steady in real terms from 1948-1973 (source: CEPR). This has a direct correlation with average fixed-rate mortgage rates and the federal funds rate over that period. Mortgage rates peaked in 1981 at around 16-18%, and have steadily declined since. It’s understandable that Paul Voelcker would want to begin lowering these rates; the initial spike was a monetary policy move to stem the inflation of the late 1970s, and rates needed to come back down eventually. However, Greenspan continued the trend through 1992, with the federal funds rate bottoming at 3%. Since 1992, the funds rate has not peaked above 6.5%, and has remained below 6% for the majority of that time. In essence, Greenspan allowed the economy to overheat, precipitating the tech bubble burst, and now the housing bubble, by keeping the cost of credit at artificially low rates, allowing companies and homeowners to live beyond their means for an extended period of time. Eventually, that time runs out.

The second case, deregulation, is a little more complicated. However, if we want to play the blame game, the majority of the blame falls on three Republican Congressmen: Representatives James Leach (R-IA) and Tom Biley (R-VA) and Senator Phil Gramm (R-TX). These three gentlemen were behind one monumentally foolish piece of regulation: the “Gramm-Leach-Biley Financial Services Modernization Act of 1999” (official Senate site). Gramm-Leach-Biley repealed part of the “Glass-Steagall Act of 1933.” To begin with, let me provide a little history.

The Glass-Steagall Act was an extremely important piece of New Deal legislation intended to combat the collapse of the financial sector that precipitated the Great Depression. It had two crucial provisions: (1) establishing the Federal Deposit Insurance Corporation (FDIC), which insures bank deposits up to a value of $100,000, and (2) prohibiting bank holding companies from owning investment banks, insurance corporations, securities firms, hedge funds, etc. The first key provision, the FDIC, is still in place. But Gramm-Leach-Biley repealed the second key provision, allowing the merger of mortgage banks with insurance, investment, and commercial banking services. For example, shortly after Gramm-Leach-Biley was passed, Citibank became Citigroup following its acquisition of Travelers Group (an insurance company). It is worth noting that Gramm-Leach-Biley was passed with well over a 2/3 majority and was veto-proof.

Now, why is all of this so bad? Doesn’t this simply make the financial sector more dynamic and flexible? Shouldn’t that be a good thing? Well, another word for “dynamic and flexible” is “volatile”.

Sometimes, a piece of legislation is put in for a legitimate reason. The reason for the Glass-Steagall provisions was to prevent another run on the banks, like the one that happened in 1929-1930. The FDIC ensures that people get their money, even if a bank collapses, and the separation of savings banks from commercial and investment banks prevented banks from taking huge losses on speculative investments and using people’s savings to back them up. Gramm-Leach-Biley changed all that, allowing the merger of the different classes of institutions. (Sidenote: European and Japanese systems allow the merged types too, but have a significant government dialogue and oversight over the types of investments made, which helps to minimize volatility and ensure longer-term investment goals.)

So what happened in the crisis? In order to raise capital, the savings/mortgage bank subsidiaries of financial corporations (e.g. the Citibank portion of Citigroup) issue mortgages. The investment portions of different corporations (e.g. Bear Stearns, Lehman Brothers) then packaged a number of mortgages into securities – including blending subprime and prime mortgages together under one risk rating – and purchased portions of those securities to provide extra operating capital to the banks, allowing the mortgage banks to make more loans (including mortgages). After all, the excess money had to go somewhere! The insurance portions of the new conglomerates (e.g. AIG, Travelers Group) then insure the risk of taking on these new mortgage-backed securities in case of default. The conglomerates are then faced with risk from the same mortgages in three different sections of their books. Originally, this was hailed as “risk-diversifying,” and in cases of normal operation, it might be – after all, in a period of stable housing, it provides a measure of security as mortgages are felt to be safe. Unfortunately, it happened during a housing bubble, and further exacerbated the number of mortgages being offered. Eventually, you run out of reliable clients. Some people don’t own houses because their credit isn’t good enough and they don’t have the income (I should know, I’m a graduate student!)

So, the subprime housing bubble bursts. Now, rather than losses being confined to one sector, they are magnified throughout the entire financial system. Bear Stearns was the first to fall, then Lehman Brothers, then AIG, and Merrill Lynch. Only two of the original five investment firms have escaped relatively unscathed – the largest two, Morgan Stanley and Goldman Sachs. Even the quasi-public mortgage backers – Fannie Mae and Freddie Mac – have needed a bailout. Quite simply, deregulation was a mistake, premised on a foolish assumption that growth can happen indefinitely. Well, it can’t. The market needs to undergo periodic corrections, and regulation exists to make sure that those corrections don’t cause the whole system to collapse. More on this and the government response in the next post.