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     Apr 14, 2010
Page 2 of 5
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

Much of the precautionary measures instituted during the New Deal to prevent a reply of the 1929 crash, such as the separation of investment banking from commercial banking, requiring banks to be neutral intermediary of capital funds rather than profit-seeking market makers, in the form of the Banking Act of 1933 (Glass-Steagall), were repealed as a result of bank lobbying. Glass-Steagall was replaced by the Financial Services Modernization Act of 1999, (Pub.L. 106-102, 113 Stat. 1338, enacted November 12, 1999), aka the Gramm, Leach-Bliley Act (GLBA).

Wholesale credit market failure
Yet with the benefit of deposit insurance instituted during the New Deal remaining operative, the financial crisis that began in mid-2007 was caused not by bank runs from depositors but by a meltdown of the wholesale credit market when risk-averse sophisticated institutional investors of short-term debt instruments shied away en mass.

The wholesale credit market failure left banks in a precarious state of being unable to roll over their short-term debt to support their long-term loans. Even though the market meltdown had a liquidity dimension, the real cause of system-wide counterparty default was imminent insolvency resulting from banks holding collateral whose values fell below liability levels in a matter of days. For many large, publicly listed banks, proprietary trading losses also reduced their capital to insolvency levels, causing sharp falls in their share prices.

Citigroup shares fell from $70.80 in July 31, 2007 to $1.02 on March 4, 2009. Citigroup market capitalization dropped to $6 billion from $300 billion two years prior.

Citi shares were trading at $4.54 on April 2010 after having received $320 billion of bailout help from the Treasury in November 2008. Citigroup and Federal regulators negotiated a plan to stabilize the bank-holding company, with the US Treasury guaranteeing about $306 billion in loans and securities and investing about $20 billion directly in the company. The assets remain on Citi's balance sheet; the technical term for this arrangement is "ring fencing" or hypothecation, the dedication of the revenue of a specific tax for a specific expenditure purpose. In a New York Times op-ed, author Michael Lewis and hedge fund manager David Einhorn described the $306 billion guarantee as "an undisguised gift" without any real crisis motivating it.

From October 2008 to January 2009, the US Treasury provided Citigroup with three rounds of financial aid worth $45 billion. The bank said in December 2009 that it would pay back the money. The firm has to pay back $20 billion of the aid as the US government acquired 34% of Citigroup's capital. The government also imposed executive pay restrictions which the bank was eager to dodge fearing the exodus of "talented" employees. Even though the bank was optimistic about the plan, offering $15 billion in common stock, there were some within the bank who questioned whether the aid should be paid back so soon. Some government officials also voiced concerns that the US economy might head back into recession causing consumer credit losses and commercial real estate losses.

"The basic objective is to make sure as we exit ... we're leaving the capital position of the institutions stronger, not weaker," said US Treasury Secretary Timothy Geithner, as if merely stating the goal is as good as achieving it.

Tax deduction stealth bailout
Under the George W Bush administration, the Internal Revenue Service (IRS), an arm of the Treasury Department, changed a number of rules during the financial crisis to reduce the tax burden on financial firms and to encourage mergers, letting Wells Fargo cut billions of dollars from its tax bill by buying the ailing Wachovia. The government was consciously forfeiting future tax revenues from these companies as another form of assistance.

On December 16, 2009, the Bush government quietly agreed to forgo billions of dollars in potential tax payments from Citigroup as part of the deal to help wean the company from the massive taxpayer bailout that enabled it to survive its blunders that helped cause the financial crisis. The IRS issued an unusual exception to long-standing tax rules for the benefit of Citigroup and a few other companies that had been partially acquired by the government.

As a result of the exception, Citigroup will be allowed to retain billions of dollars worth of tax breaks that otherwise would decline in value when the government sells back its Citigroup stake to private investors. The Obama administration, in updating the exceptions, has said taxpayers are likely to profit from the sale of the Citigroup shares. Many accounting experts, however, are of the opinion that the lost tax revenue could easily outstrip those profits.

Treasury officials said the most recent change was part of a broader decision initially made to shelter companies that accepted federal aid under the Troubled Assets Relief Program from the normal consequences of such an investment. Officials also said the ruling benefited taxpayers because it made shares in Citigroup more valuable and asserted that, without the ruling, Citigroup could not have repaid the government at this time.

"This rule was designed to stop corporate raiders from using loss corporations to evade taxes, and was never intended to address the unprecedented situation where the government owned shares in banks," Treasury spokeswoman Nayyera Haq said. "And it was certainly not written to prevent the government from selling its shares for a profit."

When working as spokeswoman for Representative John Salazar, Democrat of Colorado, Nayyera Haq joined with 22 other Muslims aides on Capitol Hill to form the Congressional Muslim Staffers Association, after hearing a radio interview in which Tom Tancredo, a Colorado Republican, in response to a question on what should be done if Muslim terrorists attacked the United States, suggested bombing Islam's holy sites, including Mecca. "That's when I realized there was something really wrong," said Ms Haq. "Not just with members of congress, but as Americans and our approach to dealing with 'others'."

Byzantine partisan politics
The Democrat-controlled congress, concerned that the lame-duck Bush Treasury was bypassing congress to rewrite tax laws, passed legislation early in 2009 that reversed the ruling that benefited Wells Fargo in 2008 and restricted the ability of the IRS to make further changes. A Democratic aide to the senate finance committee, which oversees federal tax policy, said the Obama administration, just as the Bush administration did, had the legal authority to issue the new exception, but now Republican aides to the committee say they are reviewing the issue.

A senior Republican staffer now questions the Obama administrations's echo of the Bush rationale. "You're manipulating tax rules so that the market value of the stock is higher than it would be under current law," said the aide, speaking on the condition of anonymity. "It inflates the returns that they're showing from TARP and that looks good for them." Never mind that TARP had first been initiated by Republican Treasury secretary Henry Paulson.

The Obama administration and some of the nation's largest banks have hastened to file for separation in recent months. Bank of America, followed by Citigroup and Wells Fargo, agreed to repay federal aid. While the healthiest banks had already escaped earlier this year, the new round of departures involves banks still facing serious financial problems. It seems obvious that executive pay restriction has much to do with the mad rush to independence.

The banks say the strings attached to the bailout, including limits on executive compensation, have restricted their ability to compete and return to health. Executives also have chafed under the stigma of living on the federal dole. President Obama chided 11 of the nation's top bankers at the White House for not trying hard enough to make small-business loans.

The Obama administration also is eager to wind down a bailout program that has become one of its largest political liabilities in this season of populist discontent. Officials defend the program as necessary and effective under emergency conditions, but the president has acknowledged that the bailout is "wildly unpopular" and officials have been at pains to say they do not relish helping banks that seem to be milking the crisis for narrow advantage.

The root cause of excess debt for both crises
Both bank crises, though 80 years apart, have the same root cause of excess debt, but the contours of the crises are quite different.

In both crises, the function of the stock market as a venue for raising capital was distorted to one where most of the investing population expected to make unearned fortunes by speculating on stock prices. Capital formed from savings became dissatisfied with a fair return from sound, long-term investment based on economic fundamentals. Instead, highly leverage capital began to seek outsized returns from risky assets technically driven to high prices in debt-financed bubbles in hope of selling them to latecomer investors for spectacular profit before inflated prices expectedly returned to normal levels. Prices continued to rise in an expanding bubble as a result of escalating mass speculation, creating an unrealistic expectation that prices could only rise from artificially generated high demand over limited supply.

But prices could not continue to rise without fundamental growth, and fundamental growth cannot take place without sound long-term investment to increase productivity that keeps income rising. As soon as asset prices began to fall from correction on an overbought market, a large number of highly leveraged institutional speculators were forced to liquidate with high losses. Bankers and brokers continued to act as market cheerleaders, calling every decline as merely market corrections that were windows of buying opportunity, while the smart money was unloading their excess risk onto unsuspecting and less-informed speculators worldwide. Structured finance also allowed conservative institutional investors to invest in highly rated derivatives of subprime loans.

Worse still, in the 2007 crisis, much of the institutional money came from pension funds of the working population whose savings were seeking high returns from risky speculative financial derivatives of the population's own highly leveraged debts, mainly in bloated housing and consumer credit sectors that were not supported by stagnant debtor income.

Both crises, though 80 years apart, involved banking system failures brought on by an abrupt loss of confidence in a market infested with excessive leverage. The 1929 crisis manifested itself first in the retail markets, while the 2007 crisis began in the wholesale markets. Yet the leverage was much higher in 2007 and the face amount of exposure much bigger. In 1920, the average leverage was 10 times. To put it another way, the margin set at was 10%, which meant $10 of equity for every $100 of speculative trade. In 2007, the going leverage has risen to 40 times, or $10 of equity for every $400 of speculative trade.

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