NOTE: I don’t think any of my papers are very good. To be honest, I just kind of slapped most of them together very quickly at the last moment. To my surprise — I kept getting A’s. I post them here, but it’s not a pride thing. I just figured that since I paid good money to be forced to write them, I might as well get some use out of them. Use them as filler on my blog in between beer reviews and poop stories. Sigh.
If you actually read this monstrosity or other PAPERS I WAS FORCED TO WRITE and notice major errors — congratulations — you’re smarter than the professors at my college. Anyways, here’s a term paper for a business class.
The Consequence of Deregulation
A major cause of 2008’s “Great Recession” was a lack of regulation in the banking industry. The 2010 documentary Inside Job by Charles Ferguson insists that since the 1980s, the rise of the U.S. financial sector and decline of government intervention has led to a series of increasingly severe financial crises. The film states that this lack of control led to the September 2008 bankruptcy of the U.S. investment bank Lehman Brothers and the collapse of the world’s largest insurance company, AIG, causing a global financial catastrophe. The consequence was an international recession, which cost the world trillions of dollars.
This paper will focus on the deregulation and subsequent crash of the financial sector that led to the global economic crisis of 2008; which cost tens of millions of people their savings, their jobs, and their homes.
Brief History of Financial Deregulation (1921-2000)
The History Channel presentation Crash: The Next Great Depression lists the lack of regulation as a major cause attributed to the October 29th, 1929 disaster. President Hoover’s treasury secretary, Andrew Mellon believed the government should “keep its hands off business and the market should be given free reign.” Since the Securities and Exchange Commission was not yet devised, stock brokers made their own rules. Under Mellon, capital gains taxes, corporate income taxes, and taxes on the wealthy are all cut. The stock market crash on 1929 led to a decade of financial hardship for many Americans. The market fell about twenty percent (sixteen-million shares) and continued to decrease throughout the year. Mellon pledged “the fed would stand by as the market worked itself out.” A two and half billion dollar bailout plan in 1932 failed to solve the problem. In retrospect, earlier government intervention may have helped prevent the worst economic failure in American history.
After the Great Depression, the financial industry became tightly regulated. Also, as most banks were local businesses, they were prohibited from speculating with depositors’ savings. Investment banks, which handled stock and bond trading, were small, private partnerships.
In the 1980s, the financial industry exploded when investment banks went public. With full access to huge amounts of stockholder money, prominent players on Wall Street started getting rich. The Reagan administration, reinforced by economists and financial lobbyists, started a trend of financial deregulation that has lived on with every subsequent president. In 1982, the Reagan administration deregulated savings and loan companies, allowing them to make dangerous investments with their depositors’ money. By the end of the decade, hundreds of savings and loan companies had failed. This crisis cost taxpayers 124 billion dollars, and cost many investors their life savings.
Reagan’s theory was essentially “trickle down” economics borrowed from the 1920s Republicans (Harding-Coolidge-Hoover) and renamed “supply side.” The idea was that with tax rate cuts for the wealthy; everyone else will benefit. Reagan’s budget director David Stockman confided that the supply-side rhetoric “was always a Trojan horse to bring down the top rate.” Corporate and financial interests got extraordinary benefits from the Reagan administration; tax reductions and deregulation. His proposition–cut taxes regressively, double military spending, shrink government and balance the federal budget–looked dangerous from the start, but influenced the political climate for years to come (Greider.)
During the Clinton administration, deregulation continued under chairman of the Federal Reserve Alan Greenspan and treasury secretary Robert Rubin — the former CEO of the investment bank Goldman Sachs. By the late 1990s, the financial sector had consolidated into a few gigantic firms, each of them so large that their failure could threaten the whole system; and the Clinton administration helped them grow even larger.
The merger of Citicorp and Travelers set the stage for Congress’s effective revocation of the 1933 Glass-Steagall Act. The merger was a violation of the longstanding laws separating banking and insurance companies, but Citicorp and Travelers, exploited loopholes that gave them a temporary exemption. In 1999, Congress passed the Gramm-Leach-Bliley Act, known to some as the Citigroup Relief Act. It overturned Glass-Steagall, and cleared the way for future mergers.
The Gramm-Leach-Bliley Act of 1999 eliminated most of the obstacles to combining different financial activities in a single corporate structure. This largely ended the system of separation between investment and commercial banking and other financial services that had been the hallmark of the U.S. financial structure from 1933 (Wooley.) With this act, the banking systems now had the potential of becoming too big to fail.
The Products of Deregulation (2000-2006)
During the Clinton administration, deregulation and advances in technology led to a rise of complex financial products, called derivatives. Economists and bankers claimed they made markets safer. Instead, they made them unstable. Using derivatives, bankers could gamble on virtually anything. They could bet on a variety of things, including the bankruptcy of a company and the rise or fall of oil prices. By the late 1990s, derivatives were a 50-trillion-dollar unregulated market. By late 2000’s, rough estimates placed that number up to $600 trillion (Sheridan.)
In the pre-derivative world, when a homeowner paid their mortgage every month, the money went to their local lender. Since mortgages took decades to repay, lenders were careful about whom they lent to. In the new system, lenders sold the mortgages to massive investment banks. The investment banks combined thousands of mortgages and other loans — including student loans, car loans, and credit-card debt — to create complex derivatives, called collateralized debt obligations. The investment banks then sold the CDOs to investors.
With this new process, when homeowners paid their mortgages, the money went to investors all over the world. The investment banks paid rating agencies (Standard & Poors, Moody’s, etc.) to evaluate the CDOs, and many of them were given an AAA rating, which is the highest possible investment grade.
This made CDOs popular with retirement funds, which could only purchase highly rated securities. This system was a disaster waiting to happen. Lenders didn’t care anymore about whether a borrower could repay, so they started making riskier loans. The investment banks didn’t care, either; the more CDOs they sold, the higher their profits.
This caused the number of mortgage loans to quadruple in the early 2000s. There was a huge increase in the riskiest loans, called subprime. Subprime loans tend to have a higher interest rate than the prime rate offered on traditional loans. The additional percentage points of interest often translate to tens of thousands of dollars’ worth of additional interest payments over the life of a longer loan term (Subprime.) Yet, when thousands of risky subprime loans were combined to create CDOs, many of them still received AAA ratings.
Suddenly, hundreds of billions of dollars a year were flowing through the securitization chain. Since practically anyone could get a mortgage, home purchases and housing prices skyrocketed. Countrywide Financial, the largest subprime lender, issued 97 billion dollars’ worth of loans and Lehman Brothers was a top underwriter of subprime lending. The result was the biggest financial bubble in history.
During the bubble, the investment banks were borrowing heavily, to buy more loans, and create more CDOs. The ratio between borrowed money and the banks’ own money was called leverage. Most companies use debt to finance operations and increase their leverage to invest in business operations without increasing overall equity. The more these investment banks borrowed, the higher their leverage. While leverage can be used to help both the investor and the firm to invest or operate, it comes with greater risk. If an investor uses leverage to make an investment and the investment moves against the investor, the loss is much greater – as leverage amplifies both gains and losses (Leverage.) Despite this, Henry Paulson, the then CEO of Goldman Sachs, helped lobby the Securities and Exchange Commission to relax limits on leverage, allowing the banks to severely increase their borrowing in 2004.
Also in 2004, the world’s largest insurance company, AIG began selling huge quantities of derivatives, called credit default swaps. For investors who owned CDOs, credit default swaps acted like an insurance policy. An investor who purchased a credit default swap paid AIG a quarterly premium. If the CDO went bad, AIG promised to pay the investor for their losses. Unlike regular insurance, speculators could also buy credit default swaps from AIG in order to bet against CDOs they didn’t personally own.
Since credit default swaps were unregulated, AIG didn’t have to put aside any money to cover potential losses. Instead, AIG showered employees with huge cash bonuses as soon as contracts were signed. But if the CDOs later went bad, AIG would be left with the bill.
By late 2006, Goldman had taken things a step further. It didn’t just sell toxic CDOs; it started actively betting against them at the same time it was telling customers that they were high-quality investments. By purchasing credit default swaps from AIG, Goldman could bet against CDOs it didn’t own, and get paid when the CDOs failed.
Goldman Sachs bought at least 22 billion dollars of credit default swaps from AIG. It was so much that Goldman realized that AIG itself might go bankrupt; so they spent 150 million dollars insuring themselves against AIG’s potential collapse. Then, in 2007, Goldman went even further. They started selling CDOs specifically designed so that the more money their customers lost, the more money Goldman Sachs made. Goldman Sachs sold at least 3.1 billion dollars’ worth of these toxic CDOs in the first half of 2006. The CEO of Goldman Sachs at this time was Henry Paulson, the highest-paid CEO on Wall Street (Inside Job.)
Calls for Regulation
An attempt to regulate the derivative market was made in 1998. Brooksley Born graduated first in her class at Stanford Law School and after running the derivatives practice at Arnold & Porter, Born was appointed by President Clinton to chair the Commodity Futures Trading Commission, which oversaw the derivatives market. In May of 1998, the CFTC issued a proposal to regulate derivatives.
“When I was chair of the Commodity Futures Trading Commission, I became aware of how quickly the over-the-counter derivatives market was growing, how little any of the federal regulators knew about it,” Born stated in a PBS interview. “We were seeing some very dangerous things happening in that market. There were some major fraud cases. There was use of over-the-counter derivatives to manipulate the price of commodities.”
Born continued later in the interview, “I was not sure how much understanding there was of the derivatives markets by the other regulators. And in fact, one of the things we tried to do in the President’s Working Group meetings was to explain our markets and what the concerns were. There was very little interest in doing this. The markets were doing very well; the country was very prosperous. There was a lot of financial innovation in this area. In fact, I know Alan Greenspan at one point in the late’90s said that the most important development in the financial markets in 90’s was the development of over-the-counter derivatives (Interview.)”
Clinton’s Treasury Department shot down Born’s 1998 proposal. In December of 2000, Congress passed the Commodity Futures Modernization Act. Written with the assistance of financial-industry lobbyists, it banned the regulation of derivatives.
In 2004, the FBI began to issue warnings about the prevalence of mortgage fraud. They reported inflated appraisals, doctored loan documentation, and other fraudulent activity.
In 2005, the IMF’s chief economist, Raghuram Rajan, warned that dangerous, illegal incentives could lead to a crisis. In 2005, Rajan delivered a paper at the annual Jackson Hole Symposium, an elite banking conference, titled Has Financial Development Made the World Riskier?
The paper focused on incentive structures that generated huge cash bonuses based on short-term profits, but which imposed no penalties for later losses. Rajan argued that these incentives encouraged bankers to take risks that might eventually destroy their own firms, or even the entire financial system.
“What can policymakers do? While all the interventions can create their own unforeseen consequences, these risks have to be weighed against the costs of doing nothing and hoping that somehow marks with deal with these concerns. I offer some reasons why markets may not get it right, though, of course, there should be no presumption that regulators will.” Rajan wrote. “Opportunities can be used for good and for bad. This is why it is so critically important to get incentives right. Given the possibility of perverse incentives coming together in some states, a risk management approach to financial regulation will be important to attempt to stave off such states through the judicious operation of monetary policy and through macro-prudential measures.”
Many others expressed concern over a possible crisis before the collapse, and most warnings went unchecked. By 2008, home foreclosures hit the roof, and the securitization food chain imploded. Lenders could no longer sell their loans to the investment banks; and as the loans went bad, dozens of lenders failed. The market for CDOs collapsed, leaving the investment banks holding hundreds of billions of dollars in loans, CDOs, and real estate they couldn’t sell.
Even after the collapse of 2008, much regulation is needed. In 2011, American Banker published an article called “Let’s At Least Try to Regulate Derivatives,” by Andrew Kahr. Andrew states that there’s no legislation or regulation yet in place that directly addresses the demonstrated potential of derivatives to distort demand for real assets and in fact pump demand for bad assets. To solve this he offers this advice to the government: regulate explicitly and examine competently banks’ off-balance-sheet contracts. Reduce the incentive for torrid marketing of derivatives that results from lack of centralization of trading and the consequently excessive risk-free spreads for “dealers.” Expose counterparty liabilities and regulate them.
The New York Times also recently took note of this derivative problem. On March 27th, 2012 they released an article titled “A Long Road to Regulating Derivatives.” The article states that if there is one lesson from the financial crisis to be learned, it’s that unregulated derivatives are prone to failure. The multitrillion-dollar market is still dominated by a handful of big banks, and regulation is a slow work in progress. The writer argues that properly regulated, derivatives — financial instruments that hedge risk — help to stabilize the economy. Unregulated, they are all too easily converted into tools for vast speculation, as demonstrated by their role in inflating the real estate bubble, amplifying the bust and provoking the bailouts. Unreformed, they will cause havoc again.
The article cites the crucial Dodd-Frank requirement that most derivatives be traded on an open exchange, with prices visible before deals are made — as a valid solution. The condition would minimize the practice of trading derivatives as private bilateral contracts, in which the price is whatever the bank says it is. Over a year ago, the C.F.T.C. sensibly proposed a system in which buy and sell offers would be electronically posted and widely accessible. In response, industry lobbyists and some lawmakers have made the absurd argument that open trading would hurt banks’ flexibility to continue doing business as usual.
Conclusion and Opinion
On September 7th, 2008, Henry Paulson announced the federal takeover of Fannie Mae and Freddie Mac, two giant mortgage lenders on the brink of collapse. When the world’s largest insurer, AIG, looked to be the next to collapse, the government deemed it “too big to fail” and stepped in with an 85 billion dollar infusion (Crash.)
On September 17th, AIG was taken over by the government. One day later, Paulson and current Federal Reserve Chairman Ben Bernanke asked Congress for 700 billion dollars to bail out the other failing banks. The bailout legislation does nothing to stem the tide of layoffs and foreclosures. Unemployment in the United States and Europe quickly rises to ten percent. The recession accelerates, and spreads globally.
American families borrowed to finance their homes, their cars, their healthcare, and their children’s educations. In 2009, as unemployment hit its highest level in 17 years, Morgan Stanley paid its employees over 14 billion dollars; and Goldman Sachs paid out over 16 billion. In 2010, bonuses were even higher.
As of mid-2010, not a single senior financial executive had been criminally prosecuted, or even arrested. Not a single financial firm had been prosecuted criminally for securities fraud or accounting fraud. The Obama administration has made no attempt to recover any of the compensation given to financial executives during the bubble (Inside Job.)
For decades, the American financial system was stable and safe. But with deregulation, banks were allowed to build a massive house of cards. When it tumbled, the American people were left to pick up the mess. I fully agree with the Dodd-Frank act and feel like the public has the right to know how derivatives are being traded (even if we aren’t necessarily smart enough to understand the process.) The banks claim that open trading would affect their ability to do business as usual. After the “Great Recession” of 2008, I think that’s a privilege that deserves to be taken away.
Works Cited: (THIS GETS REALLY JUMBLED WHEN I COPY AND PASTE INTO WORDPRESSSSSSSSSSS)
“A Long Road to Regulating Derivatives.” New York Times 25 Mar. 2012: 12. Business
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Wilson). Web. 22 Mar. 2012.
Crash: The Next Great Depression? 2008. DVD. The History Channel, 2008.
Greider, William. “The Gipper’s Economy.” Nation 278.25 (2004): 5-6. OmniFile Full
Text Select (H.W. Wilson).
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“Interview: Brooksley Born.” PBS. PBS. Web. 22 Mar. 2012.
“Leverage.” Web. 22 Mar. 2012 Web. 20 Mar. 2012.
Rajan, R. G. “Has Finance Made the World Riskier?” European Financial Management. 2006.
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Sheridan, Barrett. “600,000,000,000,000?” The Daily Beast. Newsweek/Daily Beast,
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