The cause of the financial crisis: government policies

There's been a lot of talk lately that the financial crisis was caused by a "failure of Capitalism," and that the solution is more regulation.

I believe government policies were the primary cause of the crisis, and that more regulation will make things worse, not better. I found a very interesting hour-long talk by John Allison, formerly CEO of BB&T Bank (a large bank in the southeast), where he lays out an argument that supports this view, and thought it might be of interest to summarize it here. In case you're not familiar with Allison, he's one of the few good and honest bankers out there.

http://www.youtube.com/watch?v=aSxA-vtjRx0

Here's a summary of his arguments:

[[MORE]]Federal Reserve

The government effectively nationalized the monetary system in 1913 with the creation of the Fed. Now that the government owns and controls the monetary system, so if there's a problem, they must be involved.

Before the Fed, most banks were leveraged about 1:1. After the Fed, commercial banks were leveraged 10:1, and investment banks were 30:1.

In the early stages of the crisis, residential real estate values fell by 20% in the US. That destroyed $500B+ in capital in the financial services industry. At 10:1 leverage, that destroyed $5 trillion in liquidity (lending capacity). Appx $200B of that capital was eventually replaced, though, so the net loss of liquidity was about $3T. There is a fear now of another $100B decline in RE values, which would be another $1T loss of liquidity.

Starting in the 1960s, the Vietnam war plus Johnson's Great Society plus a desire to not raise taxes resulted in the government using the Fed to print much more money. That eventually led to high inflation in the early 80s. Savings & Loans financed fixed rate mortgages with certificates of deposit (CDs). When interest rates were raised to fight inflation, the S&Ls costs went up hugely on the liability (CD) side, and they got killed; many S&Ls failed, eventually leading to the S&L crisis.

FDIC

When WaMu went under, the FDIC covered uninsured depositors, which caused WaMu debt holders to suffer huge losses. As a result, the capital markets for banks were effectively destroyed, since investors saw that they had no legal rights with regard to the Treasury, the Fed and the FDIC.

Pick-a-payment (negative amortization) mortgages were a product that was only made possible by the guarantees afforded by the FDIC. All of the major players have failed (Countrywide, WaMu, Golden West).

During the S&L crisis in the 80s, the FSLIC forced S&Ls to hedge their interest rate risk. However, that can't be done with home mortgages, since the banks can't force a prepayment. When interest rates eventually fell, the S&Ls lost billions more on their hedge positions. The FSLIC also strongly encouraged S&Ls to enter the commercial RE business. Since they had no experience in that business, even more S&Ls failed in the early 90s.

Housing Policy

When Fannie Mae and Freddie Mac (F&F) first came on the scene in the post-early-90s market, they drove many financial intermediaries out of prime mortgage markets, due to the government guarantees on debt that F&F had, which their competitors did not.

The Community Housing Act (CRA), passed by Congress, required 50% of F&F's portfolios to be in "affordable housing" -- which caused huge market distortions.

F&F were leveraged 1000:1 before they went broke, at which time they owed $5 trillion. That leverage, combined with the Federal guarantees, made their cost of capital well below their competitors'. As time went on, they also drove competitors out of the subprime market too, and pushed some of them, like Golden West, into the pick-a-payment business.

F&F made the broker origination model possible. Brokers fed Countrywide, WaMu, etc, who then fed F&F to meet "affordable housing" goals, which helped keep their support in Congress.

F&F are huge political contributors. Combined with the political desire to push "affordable housing," it was impossible to take any meaningful action against them, in spite of the fact that it was obvious years in advance that they were going broke.

Investment bankers created financial innovations under the belief that the Fed would keep the risk in the financial markets low. Eventually, the originate and sell model replaced originate and hold. Perverse incentives were created for originators, which encouraged first sloppiness, then outright fraud. On top of that, the ratings agencies made huge ratings mistakes. The investment bankers make irresponsible decisions based on "greedy", dumb, pragmatic thinking: i.e. short-term: irrational / lacks integrity / evasion / arrogance.

SEC

The SEC sets the accounting rules used by banks and large financial institutions. Changes in accounting policies artificially created fluctations in accounting results.

One of their rule changes was "fair value accounting," also known as mark-to-market. This concept is not in keeping with a free market, because it assumes a willing buyer, but not a willing seller. The result was that banks had to mark down assets to the value that deep-discounters were willing to pay, rather than keeping them at what they would be worth when the banks were willing to sell.

This impaired the market, because potential bank buyers couldn't be sure that huge markdowns wouldn't be required after they bought something; it generated accounting risk.

If fair value accounting was applied to all businesses in the US at year end 2009 as applied to financial intermediaries, 90% of them would be insolvent, given the lack of liquidity in the markets.

Another accounting system issue is the management of loan loss reserves. The normal policy is to build up reserves in good times. But the SEC forced the use of mathematical models which prevented that approach. The models looked back at past experience. As a result, banks had very low loan losses going into the crisis. Many initial losses happened as a result of raising loss reserves -- which would not have happened if not for the SEC.

The ratings agencies (S&P, Moody's and Fitch) are a government sanctioned monopoly, backed by the SEC. They did a terrible job rating mortgage instruments. The market responded by saying maybe they also failed at rating all sorts of other securities; there was a loss of confidence in the rating system, and liquidity suffered as a result.

As an example, in the Auction Rate Municipal Bond Market insurance companies MBIA and Ambac provided funds to municipal projects such as hospital expansions. They also held a lot of mortgage debt. When mortgage debt ratings were found faulty, Ambac and MBIA's ratings remained AAA -- a failure of the ratings agencies. When this was noticed by the market, the source of funds for the insurance agencies dried up. Without sound ratings, how would an overseas investor expect to know whether some municipal project was financially sound?

The rating agencies also failed when it came to CDOs and related credit instruments. Investment banks split them into separately saleable groups. They were making money selling A, B and C traunches. Then the Fed inverted the yield curve. Borrowing short at a high yield in order to buy long at a lower yield meant there would be a loss.

The only assets the banks could hold that had a positive spread were the high-yielding Cs. The banks thought "the economy is projected to do well; just hold the Cs for now and sell them later." But the traunches were not rated correctly: A, B and C were really D-, F and F-. When the market started coming down, there were 100% losses on the Cs. Merrill Lynch, for example, got caught in this and took huge losses.

Misregulation, not deregulation

Regulatory cost was at an all-time high at the peak of the bubble in 2005 - 2007. Sarbanes Oxley (SOX) was supposed to eliminate fraud in the wake of WorldCom and Enron -- but the banking industry already had their own version of SOX imposed back in 1990 in response to the S&L crisis.

The banking industry spends about $5B/yr complying with the Patriot Act. No terrorists have been captured as a result, nor are any likely to be in the future.

There is an irrational belief in "models"; the risk in the tails of the assumed Gaussian curve aren't as small as the math would lead you to believe. Also, a 1% chance of something happening doesn't mean it will never happen.

Models don't capture human behavior, particularly under stress. The Fed's models did not predict a recession, much less one of the current magnitude. Wachovia and Citigroup both failed when using models to manage risk.

BASEL uses models to determine how much cash banks should hold. As a result, European banks had much less capital than US banks, so they went down even faster.

Regulatory compliance is a huge misdirection of management energy -- away from running their businesses effectively and safely to making bureaucrats happy who know little or nothing about the industry.

Banks regulators have actually tightened lending standards. The myth is that regulators are trying to encourage banks to make more loans. That might be true for the people at the top, but not the regulators. If you're a regulator, the worst thing that can happen is for one of your banks to get into trouble. So, there's a perverse incentive: be extremely conservative, including tightening credit standards.

Interest rate manipulation

The problem with central banks like the Fed is that they distort the markets by setting interest rates at artificial levels. That sends incorrect signals to investors and businesses. For example, low interest rates cause business valuations to rise, so stocks go up. Or apparently cheap money might allow a business to justify a loan or an expansion that wouldn't be possible if rates were higher. That's the boom phase. What happens next is that when the economy gets "overheated" (high inflation), the central banks raise rates. Things then start to unwind: company valuations drop, new loans are no longer affordable, etc. That's the contraction (recession) phase.

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On a gold standard with full-reserve banking, interest rates are always set at free-market levels -- so businesses and individuals are receiving correct, undistorted information about the economy. Rates also tend to be more consistent. Longer-term planning becomes possible; 99 yr loans again become feasible, for example. The business cycle also goes away: no more booms and busts, because the assumptions underlying investments and other spending don't suddenly turn out to be untrue.

Video: How Money is Created and Destroyed

I made a short video that summarizes the mysteries and magic behind the process of money creation and destruction.

Please have a look, and let me know what you think.

Bank Non-borrowed Reserves

There was a recent opinion piece by Carolyn Baum on Bloomberg: How Non-Borrowed Reserves Became a Sexy Subject.  While I agree with the basic facts presented by the author, I also think she leaves out a couple of important points, including why the TAF was created in the first place.

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In reference to the fact that non-borrowed reserves for US banks have recently gone negative, she said:

Reserves can be borrowed (from the Fed's discount window) or non-borrowed (supplied via the Fed's daily open market operations). It matters not one whit to the Fed where the banks acquire the reserves they require. If they borrow directly from the Fed, they don't need to tap the interbank, or fed funds, market.

Right. The Fed Funds market and the Discount Window both count as borrowed reserves. Non-borrowed reserves come from open market operations, where the purchase of treasury securities in the open market injects cash into the economy, which, when deposited into banks becomes reserves, since it's backed by government debt rather than commercial debt.

When the proceeds from open market operations are deposited into the banking system, they don't have a choice about whether to call those funds reserves. That's what they are, period. So the first thing that's interesting here is that banks needed to borrow more of their reserves than they have received through open market operations. Why would that happen?

The answer comes with a statement near the end of the article:

Some of the concern is justified, he said, given banks' massive losses and writedowns on subprime loans.

Exactly. Those losses destroy reserves. The only option banks have to replace the lost reserves is to borrow them. But other banks weren't lending much through Fed Funds, and the Discount Windows requires short-term, high-quality (AAA) assets, which were in short supply. So the TAF was created to fill the gap.

Open market operations probably could have been used to ultimately achieve the same effect, but the effect isn't instant, and the Fed has no control over which banks the resulting funds are deposited in. The fact that some banks have bigger problems than others was, I'm sure, another contributor to the creation of the TAF.

Executive Order 11110

There is a rumor that's been circulated in several videos and books that JFK was assassinated because he signed Executive Order 11110, which supposedly stripped the Federal Reserve of its power to loan money to the Treasury at interest.
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The truth is that Executive Order 11110 authorized the printing of $4B in silver certificates, should the occasion arise -- it had nothing to do with stripping anything from the Fed, and it wasn't even an instruction to actually do the printing, only an authorization to do so. A similar order had been written in 1957, just six years before.

JFK did nothing that threatened the Federal Reserve in the slightest. He was a life-long socialist and globalist; he helped devalue the dollar and transfer American wealth to foreign countries.

Executive Order 11110 was later rescinded by Reagan with Executive Order 12608 in 1987, well past the time when silver certificates were withdrawn from circulation and when the US went completely off of the silver and gold standards after Nixon backed out of the Bretton Woods agreement in 1971.

Why a declining dollar matters

When interest rates are not set by market forces, the result is mis-directed investment. The Fed is currently holding interest rates artificially low. In recent years, this has resulted in booms in the stock market and in housing. Low interest rates also impact the value of the dollar, since holders of dollars would be motivated to sell them and buy currencies where they can invest at higher interest rates.

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In addition to provoking booms (and the inevitable busts that follow), a less visible, but equally important effect of artificially low interest rates is a massive transfer of wealth from the US to countries with stronger currencies. This happens in several ways. Capital flight for interest / yield reasons, as described above. Imported goods become more expensive, transferring wealth from US consumers to those companies in the form of increased cash flow. And the sale of US-based dollar-denominated assets at artificially low prices -- which is the reason why so much US infrastructure is now owned by overseas investors (refineries are owned by the Arabs, much of Los Angeles downtown is owned by the Japanese, etc). Those transactions are transfers of wealth because they are happening at below-market prices.

The interesting thing is that this is exactly what happened in the years before the Great Depression in 1929. The Fed artificially lowered interest rates in an intentional move to prop up the British economy. Massive amounts of wealth were transferred to England. The low rates triggered stock market speculation with a resulting boom & bust. The economy couldn't recover quickly after the stock market crash because the foundational strength was gone. The difference today is that the amount of wealth being moved out of the country is much greater -- which leads one to believe that the ultimate result has the potential of being much worse....

How to abolish the Fed?

G. Edward Griffin, in his book "The Creature from Jekyll Island", outlines a plan for eliminating the Federal Reserve. Although I don't agree with his bi-metalism, it's otherwise a well thought-out approach, and nothing in it would be especially time consuming. Here's a short summary, modified slightly to reflect a gold-focused approach instead:

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1. Repeal the legal tender laws


2. Define a "new" dollar in terms of gold


3. Restore free coinage at the US Mint (where you can bring in raw gold and exchange it for gold coins)


4. Pay off the Federal Debt with Federal Reserve Notes created for that purpose


5. Freeze the supply of Federal Reserve Notes


6. Pledge the government's hoard of gold to be used as backing for all FRNs in circulation


7. Determine the weight of all gold owned by the US Government and calculate the total value of that supply in terms of new dollars


8. Determine the number of FRNs in circulation and calculate the new dollar value of each one by dividing the value of the precious metals by the number of notes


9. Retire all FRNs from circulation by offering to exchange them for new dollars at the calculated ratio


10. Convert all contracts based on FRNs to new dollars at the same ratio


11. Issue gold certificates. In exchange for FRNs, recipients will have the option of taking coins or Treasury Certificates, which are 100% backed (the certificates will become the new paper currency)


12. Abolish the Federal Reserve System. It would be possible to allow it to continue to operate as a check-clearinghouse, but not as a central bank


13. Introduce free banking. Banks should be deregulated and cut loose from Federal bailouts. The FDIC and other similar organizations should be phased out. Banks should be required to keep 100% reserves for demand deposits

Distortions in the teaching of US History

Most of what you learned in HS history is either useless (out of context names and dates), a distortion, or an outright lie. HS American history is supposed to make students proud of their country, but tries to do so in a completely backwards way. None of the bad things, struggles or controversies are included. It's really pathetic.

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The list of disortions and lies is very long, but just for example, did you know:

• Columbus and most of the world in 1492 knew the world was round.


• People from Africa and other parts of Europe came to North America before Columbus.


• Columbus was responsible for plundering Haiti, including the death or enslavement of hundreds of thousands of natives.


• The population of the Americas may have been around 100 million before European settlers arrived in the early 1600s, compared to 70 million in Europe.


• As many as 96% of American natives were killed by a massive pandemic brought from Europe.


• Residents of Europe in the early 1600s rarely bathed because they thought it was unhealthy, but native Americans were very clean.


• Thanksgiving, as celebrated by many Americans, is a myth -- a religous ritual. Almost nothing in the myth happened as it is presented in history books.


• Hitler was elected to office by popular vote.

Similarly, a lot of "common knowledge" about the Federal Reserve is based on historical inaccuracies. The Federal Reserve is a private banking cartel. They are not the "protectors of the public" that they make themselves out to be. In reality, they are the protectors of the big banks. This isn't "conspiracy". This fact can be easily supported with a long list of historical references. And of course that's only the tip of the iceberg...