Page 1 of 5 THE POST-CRISIS OUTLOOK, Part 2 Banks in crisis: 1929 and 2007
By Henry C K Liu This is the second article in a series. Part 1:
The crisis of wealth destruction
The 1929 banking crisis that launched the Great Depression was caused by
stressed banks whose highly leveraged retail borrowers were unable to meet
margin calls on their stock market losses, resulting in bank runs from panicky
depositors unprotected by government insurance.
In the 1920s, there were very few traders other than professional technical
types. The average retail investors were in for the long-term, trading
infrequently, albeit buying on high margin. They
bought mostly to hold, based on expectations that prices would rise endlessly.
By contrast, the 1990s and 2000s were the decades of the day trader and
big-time institutions. Powerful traders in major investment banking houses
overwhelmed old-fashion investment bankers and gained control with their high
profit performance. They turned the financial industry from a funding service
to the economy into a frenzied independent trading machine. Many of the
investing public aspired to be a Master of the Universe, as caricatured in Tom
Wolf’s Bonfire of the Vanities, which was turned into a movie starring
Tom Hanks. Derivative trading by hedge funds was routinely financed through
broker dealers funded by banks at astronomically high leverage.
Greenspan - the Wizard of Bubble Land
The debt joyride was by no means all smooth sailing in a calm sea. Repeated
mini-crises were purposely ignored by regulators who should have known better.
Federal Reserve chairman Alan Greenspan, notwithstanding his denial of
responsibility in helping throughout the 1990s to unleash serial equity
bubbles, had this to say in 2004, three years before the 2007 tsunami of a
century, in hindsight after the bubble burst in 2000: "Instead of trying to
contain a putative bubble by drastic actions with largely unpredictable
consequences, we chose, as we noted in our mid-1999 congressional testimony, to
focus on policies to mitigate the fallout when it occurs and, hopefully, ease
the transition to the next expansion." The Greenspan Fed adopted the role of a
clean-up crew of otherwise avoidable financial debris rather than that of a
preventive guardian of public financial health. Greenspan's one-note monetary
melody throughout his 18-year-long tenure as the nation's central banker had
been when in doubt, ease.
LTCM - the crisis the Fed papered over
In the 1920s, there were no derivative markets. In the case of Long-Term
Capital Management (LTCM), the hedge fund that failed in 1998, the firm had
equity of US$4.72 billion and had borrowed more than $124.5 billion to acquire
assets of about $129 billion, for a debt-equity ratio of about 25 to 1. Even
that was conservative when compared with the 40 to 1 ratio used by investment
banks in the decade that followed.
LTCM had off-balance-sheet derivative positions with a notional value of about
$1.25 trillion, most of which were in interest rate derivatives such as
interest rate swaps, equaling 5% of the entire global market. LTCM also
invested in other derivatives such as equity options. LTCM eventually bailed
out by its counterparty creditors under the guidance of the New York Fed (see
The Folly of Deregulation, Asia Times Online, December 3, 2009.)
The Enron fraud
In the 1920s, there was no structured finance or securitization of debt. The
case some 80 years later of Enron, a large brave new energy trader, and its
spectacular bankruptcy marked the high watermark of legalized financial fraud.
The evidence is undeniable that the Enron scandal exposed critical flaws in the
entire financial system and the ineffective policing of US capital markets and
corporate governance. In a December 18, 2001, senate commerce Committee hearing
on the Enron collapse, Arthur Levitt, former Democratic head of the Securities
and Exchange Commission (SEC), characterized corporate financial statements as
"a Potemkin village of deceit". Senator Ernest Hollings, a Democrat from South
Carolina, characterized Enron chairman Kenneth Lay's political prowess as "cash
and carry government". Embarrassingly, the New York Times reported the
following day that Hollings had received campaign contributions from Enron and
its auditor Arthur Andersen dating from 1989.
Until Enron filed for bankruptcy in 2001, the system's top law firms and
accounting firms were providing professional opinion that what went on in Enron
was "technically" legal. The international dealings of Enron received unfailing
support from the US government. Many of the schemes undertaken by Enron and
other companies were devised by investment bankers who collected fat fees
advising their clients and who profited handsomely from providing financing for
schemes they knew were towers of mirage. It was known in the industry as
"finance engineering", and the vehicle was structured finance or derivatives
(see Capitalism's
bad apples: It's the barrel that's rotten, Asia Times Online, August 1,
2002).
Greenspan - Enron Prize recipient
Alan Greenspan, then chairman of the Federal Reserve since 1988, gave a lecture
at Stude Concert Hall sponsored by the James A Baker III Institute for Public
Policy on November 13, 2001. Following his lecture, he received the Baker
Institute's Enron Prize for Distinguished Public Service. The prize, made
possible through a generous and highly appreciated gift from the Enron
Corporation, recognizes outstanding individuals for their contributions to
public service.
Greenspan's speech to an admiring audience offered an assessment of what lay
ahead for the energy industry. In the wake of the September 11 attacks that
year and the then weakened state of the economy, Greenspan stressed the need
for policies that ensure long-term economic growth. "One of the most important
objectives of those policies should be an assured availability of energy," he
said.
Greenspan said this imperative has taken on added significance in light of
heightened tensions in the Middle East, where two-thirds of the world's proven
oil reserves reside. He noted that the Baker Institute was conducting major
research on energy supply and security issues.
Looking back at the dominant role played by the US in world oil markets for
most of the industry's first century, Greenspan cited John D Rockefeller and
Standard Oil as the origin of US pricing power, notwithstanding that the nation
saw fit to break up the Rockefeller/Standard Oil trust in 1911. Following the
breakup, Greenspan said, this power remained with American oil companies and
later with the Texas Railroad Commission. This control ended in 1971 when
remaining excess capacity in the US and oil pricing power shifted to the
Persian Gulf. Greenspan was saying better Standard Oil than the Organization
for Petroleum Exporting Countries (OPEC). He seemed oblivious to the
development since the 1973 oil embargo that US oil companies had been working
hand in glove with OPEC producers to keep oil prices high.
The power of markets against market power
"The story since 1973 has been more one of the power of markets than one of
market power," Greenspan said. He noted that the projection that rationing
would be the only solution to the gap between supply and demand in the 1970s
did not happen. While government-mandated standards for fuel efficiency eased
gasoline demand, he said that observers believed market forces alone would have
driven increased fuel efficiency. Greenspan appeared to be the only one who
sincerely believed that a free market existed or could exist for the trading of
oil. All oil traders know that the price of oil is one of the most manipulated
components in world trade.
"It is encouraging that, in market economies, well-publicized forecasts of
crises more often than not fail to develop, or at least not with the frequency
and intensity proclaimed by headline writers," Greenspan said, crediting free
markets with mitigating the oil crisis.
As it turned out, the California energy crisis of rolling blackouts was not
caused by Middle East geopolitics. It was the handy work of fraudulent trading
strategies.
Greenspan against reform
All though the 1990s and early 2000s, there were much talk of reform that led
nowhere near what was actually needed. Less than a decade later, a financial
crisis that Greenspan characterized as the market failure of a century imploded
with a big bang.
On Greenspan's 18-year watch at the Fed, assets of government-sponsored
enterprises (GSE) ballooned 830%, from $346 billion to $2.872 trillion. GSEs,
particularly Fannie Mae and Freddie Mac, are financing entities created by the
US Congress to fund subsidized loans to certain groups of borrowers such as
middle- and low-income homeowners, farmers and students. Agency mortgage-backed
securities (MBSs) surged 670% to $3.55 trillion. Outstanding asset-backed
securities (ABSs) exploded from $75 billion to more than $2.7 trillion.
Greenspan presided over the greatest expansion of speculative finance in
history, including a trillion-dollar hedge-fund industry, bloated Wall Street
firm balance sheets approaching $2 trillion, a $3.3 trillion daily repo
(repurchase agreement) market, and a global derivatives market with notional
values surpassing an unfathomable $220 trillion.
Granted, notional values are not true risk exposures. But a swing of 1% in
interest rate on a notional value of $220 trillion is $2.2 trillion,
approximately 20% of US gross domestic product (GDP). Much of the derivative
trade were hedged, meaning the risks were mutually canceling. But the hedges
only would hold without counterparty default. All that was needed to unleash a
systemic failure was for the weakest link to fail. Greenspan created a
situation that permitted the market to speculate on risks that it could not
afford.
Having released synthetic credit of dangerously high notional value, Greenspan
raised the Fed funds rate target from its lowest point of 1% set on June 23,
2003, to 4.50% on January 31, 2006, to dampen inflation expectations, before
retiring as chairman. Ben Bernanke, his successor as of February 1, 2006,
continued increasing the Fed funds rate target in three more steps to 5.25% on
June 29, 2006, the cumulative effect adding aggregate interest payments to the
financial system greater than US GDP in 2006.
That was like striking a match to light a candle in a dark kitchen filled with
leaked gas. Under such fragile conditions, there was little wonder that the
market collapsed a year later. (See
Why the US subprime mortgage bust will spread (to the global finance
system), Asia Times Online, March 16, 2007, written at a time when mainstream
opinion was that the housing market crisis, being geographically disaggregated,
would not spread.)
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