First, I am not a financial analyst or even a very sophisticated investor. I just wanted to know what happened and, after reading this book, I think I know. Ms Gelinas is a financial analyst and seems to have spent quite a bit of time thinking about what happened and how we might start to put things back together. It began with the changes in banking in the 1980s, largely I believe (although she does not say so) due to inflation. For decades, the savings and loan had a business model of borrowing from savers at four percent interest and lending to homeowners at six percent interest. All that changed when inflation drove those savers, including me, to look for higher returns to compensate for the loss of value from inflation. Most of the evil that followed, in my opinion not hers, can be traced to this phenomenon. Now that I have demonstrated how naive I am, let's consider her book.
She describes the history of the crash in 1929 as a consequence of irrational exuberance and unregulated financial manipulation during the 1920s. She describes, for example, the fall of Sam Insull who built Commonwealth Edison into a modern utility but lost track of all the financing until, in the wake of 1929, it collapsed and took thousands of savers' investments with it. She compares Insull to Enron, a valid comparison, I think. She describes the regulatory steps that were taken by Roosevelt's administration and how it stabilized the financial world for 70 years.
The story of the 2008 collapse begins in 1984 with the rescue of the Continental Illinois Bank. Here began the "too big to fail" story. Two things happened here that led to the crisis. One was the decision to bail out all depositors, including those whose deposits exceeded the FDIC maximum. Secondly, the FDIC guaranteed the bond holders, as well. Thus began the problem of moral hazard. Another feature of this story was the role of Penn Square Bank, which had gone under two years earlier in the wake of the oil price collapse, which devastated many of its poorly collateralized loans in the oil industry. Both banks had been caught seeking higher returns through risky investments. Penn Square, however, had been allowed to collapse. Continental was rescued and that began a trend that the author lays out in detail through most of the rest of the book. It was here, in Chapter three, that I began to underline and take notes. Continental had relied on large amounts of short term money from uninsured depositors. That would be seen again and again in the years to come.
The fact that large banks would be rescued placed small banks at a disadvantage and they complained. Congress, in the first of many well intentioned but useless measures, passed a bill that prohibited the FDIC from protecting uninsured depositors but they added the fatal proviso that exempted "systemic risk" situations. At this point, Charles Schumer, then a Congressman, opposed allowing banks to enter the securities business. The 1984 legislation ignored his concern and the wall was lifted a bit between investment banks and conventional banks. By 1999, when the Glass Steagall Act was largely repealed, Schumer had switched his position to favor the change.
The investment banks took a major step as they became publicly traded companies. This began with Dean Witter in 1972 and Morgan Stanley took the step in 1986. Now, the traders would be risking someone else's money and this was a fateful decision. The author points out that Brown Brothers Harriman remained a partnership in which partners risk their own capital and it has not gotten into trouble with the speculation of the 90s and beyond. By 1993, the six largest commercial banks earned 40% of their profits in trading. Corporate financial services became a larger and more powerful part of the economy. I'm sure I am not the only one who has noted the coming and going of major New York financial figures to and from administrations of both parties.
The next step was the securitization of debt, especially home mortgages but also credit card debt and auto loans. She points out how this resembles Insull and Enron in that long term obligations were rolled into securities and sold to acquire immediate profits. No longer did banks service their own loans. More money could be earned by lending the money several times over. Initially, the risk of the securitized mortgages was early retirement of the debt to refinance at lower rates. In 1986, a drop in interest rates brought an early crisis. At the time, no one dreamed that the next big crisis would be not the risk of early repayment but the risk of default.
She describes the junk bond phenomenon and the development of derivatives. Finally comes the credit default swaps and the stage was set. An opportunity was missed in 1999 and 2000 when the head of the Commodity Futures Trading Commission, Brooksley Born, tried to regulate over-the-counter derivatives. Congress passed the Commodity Futures Modernization Act, which barred such regulation and set the stage for the next act, the real estate bubble and collapse. By 2000, the unregulated OTC derivatives markets, which had not existed a decade before, totaled $95 trillion. These were unregulated and there were no margin or capital requirements.
I would have to summarize the whole book, which is only 250 pages, to describe all the points she makes about how this happened. Read it yourself. I will summarize her suggestions for next steps now that the fall has taken place.
An opportunity was missed in the summer of 2008 when Merrill Lynch sold some mortgage backed assets at 22 cents on the dollar. The price was low but nobody knew what the right price was. Allowing these fire sales to proceed would begin to establish a market for these securities. The TARP plan put a stop to this as no one would sell to private bidders when the government would pay a higher price. That was a big mistake and it was soon decided to merely give the banks the money as valuation proved impossible without a market. Some banks that were not in dire straits were forced to take money to conceal which banks were the most shaky. All these were mistakes. Artificially inflated asset values are part of the problem and will delay resolution.
There needs to be a mechanism for bankruptcy of these interconnected institutions. She discusses some options. The markets have been weakened by changes in contract law, especially the Chrysler bailout when senior creditors were forced to the back of the line. She points out that there would have been no outcry about AIG bonuses if the company had been liquidated in some modified bankruptcy proceeding. She wants better disclosure of risk and part of that is regulation of all the exotic derivative products that will remain. There is no possibility that we could go back to the era of Glass Steagall. Times have changed. To big to fail must end. With all the interlocking financial instruments like CD Swaps and other derivatives, that will require a complex system to unwind such networks. On page 177, she recommends a division of failed institutions into two entities, one holding the toxic assets. I believe this is the Swedish "Bad Bank" concept although she doesn't use that term.
The bubble was also stimulated by errors on the part of bond rating agencies that "rented" their AAA ratings, in her estimation. This allowed abuse of the securitization process as tranches of weak loans were sold paired with tranches of "good" loans and the capital requirements differed between the "good" or AAA rated tranches and the lower rated tranches. When the crisis came, the ratings did not work and she recommends that capital requirements for institutions holding such instruments be the same regardless of rating.
For a very inexperienced amateur in finance, this has been a very interesting book and a quick read although I have marked places to read again. I could also see it as very useful for college courses in basic finance. I highly recommend it.
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- Reviewed in the United States on November 9, 2009
