Sunday, July 18, 2010

Leadup to the Crisis: The Undoing of the Old System

Roosevelt's highly successful financial reforms first began to come under pressure in the 1970's, as inflation began to accelerate. Slowly and inconspicuously at first, several things began to chip away at the old financial order.

In 1968, when Fannie Mae was privatized, it was split. FNMA (Federal National Mortgage Association) was privatized and bought up private mortgages. The Government National Mortgage Association (Ginnie Mae) remained a governmental entity and bought up mortgages issued by governmental entities such as the FHA or the VA. It was Ginnie Mae that first got the idea of pooling mortgage payments and selling a portion of the income to investors in 1970. Fannie and Freddie soon followed. In 1977, a banker named Lew Ranieri introduced the privately securitized mortgage.

Another financial innovation of the 1970's was the first breach of the wall between commercial and investment banks, from the investment side -- the money market mutual fund. Investment firms began offering money market mutual funds as an alternative to bank accounts. These funds kept their shares constantly at $1 so that investors could withdraw whatever they put in at any time, just like a bank account. They made short-term, low-risk loans, known as commercial paper, to blue chip companies and, although not insured, were considered just as safe as a bank account. But they had better returns than a bank account, even a certificate of deposit. With inflation running high and rapidly eroding savings in bank accounts, banks found themselves more and more strapped for funds, including funds to finance home mortgages. (Money mutual funds did not finance home mortgages).

In the 1980's, these two innovations began to merge. Savings and Loans, the primary fianciers for home mortgages, were trapped between fleeing depositors, fixed rate loans, and rising interest rates. One response was the invention of the adjustable rate mortgage (ARM), a mortgage with interest that fluctuates with general interest rates. These began to be used in the early 1980's to cope with extremely high interest rates. Another was that S&L's began selling mortgages to Fannie, Freddie and the private securitizers and buying mortgage backed securities. Inexperienced in the world of high finance, S&L's did poorly. The ultimate failure of so many thrifts left a gaping hole in the finance of home mortgages.

As interest rates dropped after 1982, mortgage-backed securities began running into another problem. Defaults were still rare, but home owners were refinancing at lower rates or paying of their loans early. The made mortgage backed securities a less reliable source of income than anticipated. Securitizers responded by carving up securities into tranches (slices) setting priority in payment. Senior tranches got paid first, but at the lowest rate. As priority dropped, risk and return rose. By the mid-80's, other finance companies began to recognize that the principles of securitization did not have to be limited to home mortgages. They began expanding the practice to equipment leases, auto loans, credit cards, student loans, or anything else that required frequent payments.

A new finacial institution called a "special purpose vehicle," generally backed by an investment bank, arose to buy and securitize loans. High finance increasingly began establishing loan originators, not backed by any deposits, to make loans to be sold and securitized. It increasingly encroached on areas traditionally occupied by commercial banking, filling in the gap left by the failure of Savings and Loans, and funding car loans, credit cards, and other consumer loans. And how was all this financed, without deposits? Apparently by commercial paper, that is, by short-term loans from money market mutual funds, using the loans to be securitized as collateral.

Naturally with all these encroachments by high finance on commercial banking, commercial banks wanted to return the favor. Throughout the 1980's and '90's, the Federal Reserve increasingly allowed commercial banks to trade in stocks and issue commercial paper. Slowly, the wall became so eroded that repeal was little more than a formality. After repeal, "bank holding companies" were formed that could hold commercial banks, investment banks and insurance companies as separate subsidiaries. Commercial banks also began moving into the securitization business, establishing Structured Investment Vehicles (SIV's) to securitize their loans. SIV's were, in effect, a clever accounting gimmick that allowed banks to evade regulations requiring them to hold capital against their loans by "selling" these loans to SIV's that were actually owned by the bank. And what did banks do with the income from selling their loans? They invested it, often in securitized loans.

The risks of securitization are obvious, at least in hindsight. A company making loans to sell has strong incentives to think purely in terms of quantity, not quality. The buyer should have an incentive to impose strict quality control except that it, too, just intends to pass the loans along to someone else. And buyers of the securitized products assumed that even if there were some bad loans in there, tranching (prioritizing) payments should take the risk away. In short, quality control was Somebody Else's Problem. Worse, regulators also believed that securitized loans were safer than direct loans. Applying the eminently reasonable rule that banks should hold more capital the riskier a loan, they rated mortgages as riskier than mortgage backed security and therefore required more capital for direct loans than securitized loans. Banks understandably responded by securitizing more.

The dangers of such a system should have become apparent during the mid 1990's with a sort of a dress rehearsal crisis. Securitization of credit card loans made credit cards easier and easier to get. Once the privilege of people with an established income and credit rating, by the mid-'90's credit cards were being handed out like candy. Predictably enough, many new users ended up in over their heads and went bankrupt. Zandi regards unsupportable credit card debt as one of the causes of the 1998 LTCM financial crisis. The asset-backed securities market briefly froze during that crisis, but the larger economy was not harmed and, for the most part, did not even notice that it had happened.

Nonetheless, despite the prosperity of the 1990's (at least within the US), the evidence was growing that the finance system was running of control. These warning signs were ignored. In fact, at the end of the '90's, two pieces of legislation were passed that further deregulated an already dangerous system. In 1999, the Gramm-Leach-Bliley Act removed the Glass-Steagel wall between commercial banking and investment banking, a wall that (see above) had largely fallen anyhow. Some people blame the removal of the wall for the crisis, while many conservatives argue exactly the opposite, that it was removal of the wall that allowed commercial banks to rescue investment banks (as when Bank of America bought out Merrill Lynch). So far as I (as an Enlightened Layperson) can tell, the conservatives are right on this one.

More important was the Commodities and Futures Modernization Act of 2000, which effectively prevented regulation of financial derivatives. As for securitization, no one even seems to have regarded it as an issue.



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