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The American Recession Part 2: Is That Bull Still Loose?

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“This Is Not Keller Zebel, It’s a Dog With Fleas Pal”

The phrase “Too Big To Fail” is used to describe systemic risk, the idea that a single institution’s failure could provoke subsequent failures in its own sector and throughout the general economy. This idea became increasingly popular with the onset of the crisis in 2008, but the ability for banks to grow to that size, comes from three pieces of legislation that predate it: The Depository Institutions Deregulation and Monetary Control Act (1980), The Garn-St. Germain Depository Institutions Act (1982) and the Gramm-Leach-Bliley Act (1999). These three laws, each allowed (in increasing degree) different types of financial institutions to merge or acquire one another, which had been prohibited by provisions in the Banking Act of 1933, resulting in the emergence of entities like Citigroup (Citibank + Travelers Insurance Group) and JPMorgan Chase (JPMorgan & Co. + Chase Bank).After 1999, investment banks could create securities that used the assets held by the commercial banks they acquired or merged with (e.g mortgage loans or savings accounts) as collateral; creating a link between consumer finance and the stock market. The insurance industry also played a major role in this system, since investment banks could create insurance derivatives to serve as hedges against risk and sell these instruments to other firms.

The primary problem was the links created between market dynamics in U.S. stock markets, and consumer accounts. Banking houses had created investment products valued with various types of consumer capital liike FDIC insured savings deposits or residential mortgage loans and had a vested interest in not only accumulating more capital, but maintaining the stability of the underlying asset values. Thus, actions like dramatic increases in interest rates on mortgage loans or lower borrowing criterion became increasingly common as financial firms attempted to either maintain or increase the value of their asset-backed securities. Deregulation of financial markets enabled the development of these conglomerate institutions and helped to hasten the expansion of the asset-backed securities market at the heart of the crisis.

Dodd-Frank does create the Financial Stability Oversight Council to monitor the banking system for systemic risk factors but there is no part of that law that properly addresses the ability of financial companies to acquire and merge across industries, nor does it address the existence of institutions that are already Too Big To Fail. Particularly the surviving five banks of the housing crisis: JPMorgan Chase, Bank of America, Goldman Sachs, Citigroup and Wells Fargo, (who collectively hold assets that amount to 56% of the entire U.S. economy) are of that class because they were recipients of failing firms like Bear Stearns or Wachovia. For a law inteded to better safeguard consumers from Wall Street, the separation of these institutions is essential because this type of regulation helps to prevent investment banks from using consumers’ money as collateral for speculative purposes.

Chris Cox, This One’s For You

The Uptick Rule was a federal regulation that governed how shares of a given company should be sold short. Short Selling is a type of trade where the investor sells shares of stock that he/she doesn’t actually own, figuring that the price per share will decrease to a level where a profit can be made once the same number of shares is repurchased at a later date. Generally, large short interest in any company is a sign that investors anticipate a drop in the share price, and often too much short interest can marr a company’s reputation in the marketplace. The Uptick Rule, another product of the Great Depression, prohibited investors from short selling until the price of the short exceeded the last traded share price primarily to prevent a company from being “shorted” to death. Conveniently, the Uptick Rule was repealed in 2007, just in time for a major financial panic to take hold on Wall Street.

The most visual period of the housing crisis was the severe decline in share prices on every major U.S. index, particularly in the financial stocks. Bear Stearns, Washington Mutual and IndyMac were among the first to be affected by market speculation over hidden toxic debt on the balance sheet, and when fears reached a fever pitch, investors “shorted” so many shares that the company lost more than half its value in less than a week. As the toxic debt fears permeated the entire financial system, so did the shorts, to the point that rumors of toxic debt could send any stock into a freefall because investors would shift their capital from long to short, thus driving down the share price. In response, the Federal Reserve, Treasury, and Congress were forced to devise a last minute recapitalization plan (which evolved into TARP) to keep value in the financials and attempt to restore confidence in the banking sector.

Here again, there’s not much substantial for this in Dodd-Frank. The FSOC is tasked with enforcing standards of market discipline, but the restoration of the Uptick Rule would do more to support the underlying strength of markets. The rule would prevent the unabated short selling of a shares, which can effectively bankrupt a company and do it faster than just selling the stock.

Straw Houses for Straw Buyers

In finance, a Special Purpose Vehicle (also called Special Purpose Entity) is a subsidiary whose purpose is to acquire, manage, and finance a specific pool of assets. Legally, the SPV can continue to operate if its parent company fails or enters bankruptcy but the asset classes that it manages are kept separate from the balance sheet of its parent. As such, financial insitutions use SPVs to remove certain types of debt from their balance sheets, which helps to make the company more appealing to investors. Interestingly enough, use of SPVs gained notoriety (and infamy) after Andrew Fastow, former CFO of Enron Corporation, used them to hide millions in liabilities to defraud investors.

SPVs served as the debt/liability shelters for trillions in derivatives and were, for a time, able to mask the fact that major U.S. financial institutions had steep debts, and not near enough capital to justify a high asking price for their shares.Because the subsidiary company can mask the debt of its parent, financial institutions could inflate their profits year over year, not to mention hide their activites from federal regulators since the parent companies balance sheet doesn’t reflect the SPV’s assets. In the housing crisis, SPVs were particularly noxious because they made it extremely difficult to determine the original issuer of a given asset-backed security, convoluting the process of recapitalizing failing firms.

Dodd-Frank does have provisions for determining the original holder or issuer of a security, but has no rules governing accounting for these vehicles or prohibiting their creation. Ideally, SPVs should be illegal, because they enable purposeful accounting irregularities and hide debt from investors and regulators, information essential to investor protection and forecasting systemic risk. However, it may be more reasonble to introduce regulation that requires assets and liabilities of SPVs to be included on the balance sheets of their parent companies, in order to provide investors and regulators with a more complete picture of a given financial company’s condition.

Overall, there is a lot Dodd-Frank does to improve the regulatory efficiency of our financial system. Thirty years of deregulatory polcy created an unstable foundation upon which the entire U.S. banking system nearly collpased and the country sorely needed regulatory reform. However, the fact that financial institutions can still make use of SPVs to hide debt, that investors can short firms to death, and there’s no real resolution of Too Big To Fail, indicates Dodd-Frank falls short of its mission to safeguard the U.S. financial system against systemic risk, and other byproducts of the age of deregulation.

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About Alexander J Smith III

  • Igor

    Excellent article, Alexander!

    This is the best concise article I have read ANYWHERE, including some prestigious journals, that clearly and completely describes the mal-administrations of policy that lead to our dire situation.

    Of course, the policies of de-regulation were stupid fantasies that enabled determined crooks to hide their nefarious activities and shelter themselves personally from loss while putting Americans savings at risk and looting their assets to deploy in high stakes gambles that only they could collect on the upside.

    Of course there’s little hope that we can re-institute the regulatory regime that protected the sheep from the wolves after the Great Depression: the republicans are constitutionally unable to admit that they were wrong, dead wrong, to advocate the childish notions of Friedman and Greenspan, etc. As long as they had willing tools like Reagan and Bush (and Clinton!) to pass their greedy and selfish laws they could hide behind the financial barricades they erected for themselves and be spared any discomfort while the middleclass was looted.

    And now they have the nerve to promote this cheat Romney, who says he’ll restore the looting environment of Bush, and, in case you’re not broke enough, send troops into Syria!

    Not broke enough from trillions squandered in Iraq and Afghanistan? Have no fear, Romney will squander whatever measly dollars you have left in Syria!

    And if that’s not enough, the Israelis have promised to start a war with Iran which we will necessarily be drawn into.

    ALL the former wealth of America will be buried under the blowing sands of Iraq, Afghanistan, Syria and Iran! Except for the portion converted into gold by the scoundrels who planned and executed both the re-distribution of wealth to the rich and the wasting wars of the middle-east.

    Not only wealth will be buried under those sands, but also the bodies of American soldiers sent off to die in vain wars by lying for-hire politicians.