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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.
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1933 (Glass-Steagall), were repealed as a result of bank lobbying.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
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
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
"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
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
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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