How Unregulated Banking Triggered the Crash of '08

Repo, Baby, Repo
by MIKE WHITNEY

“Repo has a flaw: It is vulnerable to panic, that is, ‘depositors’ may ‘withdraw’ their money at any time, forcing the system into massive deleveraging. We saw this over and over again with demand deposits in all of U.S. history prior to deposit insurance. This problem has not been addressed by the Dodd-Frank legislation. So, it could happen again.”

–Gary B. Gorton, Professor of Management and Finance, Yale School of Management (lifted from Repowatch)

Subprime mortgages did not cause the financial crisis, nor did the housing bubble or Lehman Brothers. The financial crisis originated in a corner of the shadow banking system called the repo market. That’s where the bank run occurred that froze the secondary market, sent prices on mortgage-backed assets plunging, and pushed the financial system into a death spiral. In the Great Crash of 2008, repo was ground zero, the epicenter of the global catastrophe. As analyst David Weidner noted in the Wall Street Journal, “The repo market wasn’t just a part of the meltdown. It was the meltdown.”
Regrettably, the Federal Reserve’s nontraditional monetary policies (ZIRP and QE) have succeeded in restoring the repo market to it’s precrisis level of activity, but without implementing any of the changes that would have made the system safer. Repo is as vulnerable and crisis-prone today as it was when the French bank PNB Paribas stopped redemptions in its off-balance sheet operations in 2007 kicking off the tumultuous bank run that would eventually implode the entire system and push the economy into the deepest slump since the Great Depression. By failing to rein in repo, the Fed has ensured that financial crises will be a regular feature in the future occurring every 15 or 20 years as was the case before banks were more strictly regulated and government backstops were put in place. Repo returns us to Wild West “anything goes” banking.

Why would the Fed be so reckless and pave the way for another disaster? We’ll get to that in a minute, but first, let’s give a brief explanation of repo and how the system works.

Repo is short for repurchase agreement. The repo market is where primary dealers sell securities with an agreement for the seller to buy back the securities at a later date. This sounds more complicated than it is. What’s really going on is the seller (primary dealers) are getting short-term loans from money market funds, securities firms, banks etc in order to maintain a position in securities in which they’re suppose to make markets. So, repo is like a loan that’s secured with collateral. (ie–the securities) It is a “funding mechanism”.

What touched off the Crash of 2008, was the discovery that the collateral that was being used for repo funding was “toxic”, that is, the securities were not Triple A after all, but subprime mortgage-backed gunk that would only fetch pennies on the dollar. So, when PNB Paribas stopped redemptions in its off-balance sheet operations on August 9, 2007, the rout began. Cash-heavy investors (like money markets) turned off the lending spigot, which reduced trillions of dollars of MBS to junk-status, precipitated massive fire sales of distressed assets that were dumped on the market pushing prices further and further down wiping out trillions in equity and reducing the financial system to a smoldering pile of rubble. That’s why the Fed stepped in, backstopped the system with explicit guarantees for both regulated and unregulated financial institutions and set about to reflate financial asset prices to their precrisis highs.

Newly appointed Fed chairman Janet Yellen summarized what happened in the panic in a speech she gave earlier this year. She said:

“The trigger for the acute phase of the financial crisis was the rapid unwinding of large amounts of short-term wholesale funding that had been made available to highly leveraged and/or maturity-transforming financial firms.”

In other words, the crisis began in repo. Unfortunately, Wall Street has fended off all attempts to fix the system, because repo is a particularly lucrative area of activity. And we are talking serious money here, too. Tri-party repo alone–which is a small subset of the larger repo market–represents “about $1.6 trillion in outstanding repos daily.” That means that the prospect of a big dealer dumping his portfolio of securities on the market at a moment’s notice igniting another panic, is never far away.

Why do banks borrow in the unregulated, shadow system instead of conducting their business in the light of day where regulators can check the quality of the underlying collateral, oversee the various transactions on public trading platforms, and make sure that capital requirements are maintained?

It’s because the banks want to deploy all their capital, leverage up to their eyeballs and play fast-and-loose with the rules. Here’s what the New York Fed has to say on the topic:

“One clear motivation for intermediation outside of the traditional banking system is for private actors to evade regulation and taxes. The academic literature documents that motivation explains part of the growth and collapse of shadow banking over the past decade…

Regulation typically forces private actors to do something which they would otherwise not do: pay taxes to the official sector, disclose additional information to investors, or hold more capital against financial exposures. Financial activity which has been re-structured to avoid taxes, disclosure, and/or capital requirements, is referred to as arbitrage activity.” (“Shadow Bank Monitoring“, Federal Reserve Bank of New York Staff Reports, September, 2013)

In other words, the banks are conducting their operations in the shadows because it’s cheaper. That’s what this is all about. Here’s more from the same report:

“While the fundamental reason for commercial bank runs is the sequential servicing constraint, for shadow banks the effective constraint is the presence of fire sale externalities. In a run, shadow banking entities have to sell assets at a discount, which depresses market pricing. This provides incentives to withdraw funding—before other shadow banking depositors arrive.”

Okay, so when there’s a run on the local bank, the bank may have to offload some of its illiquid assets (real estate, commercial property, etc) to meet the increased demand of depositors who want their money, but they can also rely on government backing. (deposit insurance). But with shadow banking–like repo– it’s a bit different; the problem is fire sales. For example, when repo lenders–like the big money markets–demanded more collateral from the banks in exchange for short-term funding; the banks were forced to dump more of their assets en masse pushing prices lower, eroding their equity and leaving many of the banks deep in the red. This is how the panic wiped out Wall Street and cleared the way for the $700 TARP bailout. It all started in repo.

The point is, had the system been adequately regulated with the appropriate safeguards in place, there would have been no fire sales, no panic, and no crisis. Regulators would have made sure that the underlying collateral was legit, that is, they would have made sure that the subprime borrowers were creditworthy and able to repay their loans. They would have made sure that repo borrowers (the banks) had sufficient capital to meet redemptions if problems arose. And regulators would have limited excessive leveraging of the securitized assets.

Regulation works. It provides safety, stability, and security as opposed to panic, bankruptcy and severe recession which is the scenario that Wall Street’s profiteers seem to prefer. Now check this out from the NY Fed:

“While leveraged lending collapsed in 2008 from a peak of $680 billion in 2007, it has rebounded very quickly, and is now at record levels of volume, projected to be larger than $1 trillion in 2013…” (NY Fed)

How’s that for progress, eh? So, Bernanke’s reflation efforts have effectively restored the same shabby, poorly designed system to its former glory putting all of us at risk again. Here’s more:

“One area of concern, however, is the significant increase in the fraction of covenant lite loans, which have increased dramatically from 0 percent in 2010 to 60 percent in 2013. This deterioration in loan underwriting has come hand-in-hand with an increased presence of retail investors in the leveraged loan market, through both CLOs and prime funds, as relatively sophisticated investors, like banks and hedge funds, are exiting the asset class.” (New York Fed)

Great. So now we are seeing the same problems that emerged in 2004 and 2005 with subprime mortgages, that is, there’s so much liquidity in the system–thanks to the Fed’s zero rates and QE– that investors are dabbling in all-types of risky garbage that you wouldn’t normally touch with a 10 foot dungpole. Check this out from Testosterone Pit:

“Shadow banking loans are estimated to have reached $15 trillion in the US. And among them is a particularly hot category: lending to highly leveraged companies with junk credit ratings. … the NY Fed found that these loans are increasingly issued in a loosey-goosey manner, with low underwriting standards. And issuance has soared...

Layered into these crappy and risky loans are the crappiest and riskiest of all loans, namely “covenant-lite” loans. Their covenants are so watered down and so full of holes that investors have few if any protections in case of default. If the Fed ever allows reality to set, and these companies stumble under their load of debt or can’t refinance it at ridiculously low rates, investors can kiss their money goodbye.” …

these desperate small investors…have unknowingly made a quantum leap in risk – allowing the smart money, which hears the hot air hissing from the credit bubble, to bail out. This must be one of the proudest moments in Chairman Bernanke’s glorious tenure.” (“Fed: Hedge Funds, Banks Sell Crappiest Debt To Small Investors (Before Credit Bubble Blows Up) ” Testosterone Pit)

Nice, eh? So the big boys are planning to vamoose before the whole house of cards comes tumbling down. Meanwhile, Mom and Pop are about to get reamed for the umpteenth time when the Fed “tapers” and these covenant lite IEDs blow up in their face taking another sizable chunk out of their retirement savings. Way to go, Bernanke. Here’s more from the NY Fed report:

“Shadow credit transformation increased from only 5 percent of total credit transformation in 1945 to a peak amount of 60 percent in 2008 before declining to 55 percent in 2011.”

So now the shadow players are generating more than half of all the nation’s credit via their dodgy, unregulated operations. Why? So a handful of ravenous banks can make bigger profits.

According to the Financial Stability Board (FSB) “credit intermediation that takes place in an environment where prudential regulatory standards and supervisory oversight are either not applied or are applied to a materially lesser or different degree than is the case for regular banks engaged in similar activities.” (FSB, 2011).

Read that over again. What they’re saying is that it’s a completely ridiculous, insane system. We’ve given the banks this outrageous privilege of creating private money out of thin air, (credit) and they spit in our face. They won’t even follow a few simple rules that would make the process safer for everyone. Keep in mind, that Dodd Frank does nothing to remedy the problems in repo.

One last thing (from the NY Fed):

“Intermediaries create liquidity in the shadow banking system by levering up the collateral value of their assets. However, the liquidity creation comes at the cost of financial fragility as fluctuations in uncertainty cause a flight to quality from shadow liabilities to safe assets. The collapse of shadow banking liquidity has real effects via the pricing of credit and generates prolonged slumps after adverse shocks.”

Repeat: “liquidity creation comes at the cost of financial fragility as fluctuations in uncertainty cause a flight to quality from shadow liabilities to safe assets.”

Can you believe it? The Fed doesn’t even try to deny what’s going on. They admit that letting the banks ratchet up their leverage increases “financial fragility ” which could precipitate another crash. (“flight to quality from shadow liabilities to safe assets.”) In other words, the Fed KNOWS the system is nuts, just like they know that it’s only a matter of time before the whole bloody thing blows up again and the economy goes off the cliff. Still, they’re not going to lift a finger to change the system.

Why?

You know why.

Because a few fatcats at the top like the way things are now, that’s why.

If that doesn’t make your blood boil, I don’t know what will.

The Lost Opportunities of Barack Obama

What Could Have Been

by ROBERT FANTINA

 

 

It was just three short years ago when much of the United States, and the rest of the world, thrilled to the idea of the ‘audacity of hope’ and ‘change we can believe in.’ After eight disastrous years of President George Bush, years of escalating poverty, war, fear and the hatred of the United States by much of the world, it seemed that a new day was about to dawn.

The man to usher in this Utopia was a young, African-American senator, a man who could galvanize a crowd with his moving, inspiring speeches. He promised a new beginning for the United States; voters, young and old, male and female, of all religious and ethnic groups, responded to his message.

Now, a year before the next presidential election, the hope and change that were promised are no more than tarnished political sound bites, the clever rhetoric of yet another politician in statesman’s clothing.

One can look at the continuation of two wars, the stalled economy, and the inequality of the tax structure that places the burden on the dwindling middle-class that can ill afford it, while the wealthy reduce their taxes through various advantages and loopholes.

And now, with the opportunity to show real world leadership, President Obama is prepared to once again cave in to the demands of special interests, at the expense of justice and humanity.

This week, Palestine will apply to become the 194^th member country in the United Nations. The achievement of this goal would be profound. Palestine would then be in a position of power, not equal with Israel, but having a voice far louder than it has ever had before. Just a year ago, Mr. Obama said he looked forward to Palestine’s membership in the U.N. within the next year. That, of course, was before Israel slapped the U.S. in the face once again, and expanded settlements on disputed territory, thus shutting down the already long-pointless negotiations.  Palestine, with no leverage to force Israel to negotiate seriously, decided to go to the U.N.

This may appear to be part of the ‘Arab Spring,’ this time of uprisings against, and the overthrows of, repressive governments in the Middle East. Mr. Obama has hailed these revolutions as the democratic actions that they are: popular movements of people finally fed up with the horrific actions of their oppressors. And now, one would think, a true U.S. statesman would welcome and encourage Palestine’s bid for membership in the U.N. A nation that has been occupied for generations, whose citizens suffer cruelly at the hands of their oppressors, is seeking relief for its people. Isn’t the U.S. the world’s brightest beacon of human rights?

It is, if conditions are right. If the lobbyists and organizations that line the campaign coffers of the U.S.’s elected officials approve; if it will not alienate some vocal constituency; if it will produce photo ops that can be used in a future election, then the U.S. will always endorse any democratic movement for human rights.

Unfortunately, these conditions are not often met. South American countries that elect leftist presidents; Middle Eastern countries that elect leaders hostile to U.S.’s pets: these democratic movements must not be tolerated. Capitalist democracy that supports the needs of the rich over anyone else (thus following the U.S. model), and that doesn’t offend Israel, will always be endorsed. Any other version of democracy isn’t really, in the eyes of the U.S., democracy at all.

Can anyone imagine a United States where its leaders did what was right, rather than what was politically expedient? Where the safety nets for the poor were strengthened, even if it meant that the local CEO had to keep his or her Mercedes for two years, instead of just one? Where there was something more important than individual power?  Where ego took a back seat to service?

It is difficult to visualize such a United States. Many people believed, however naively, that the U.S. was on the verge of such an actuality as the inauguration of Mr. Obama approached, back in January of 2009. That seems, today, so long ago. While Mr. Obama cannot be blamed for all of the problems that continue to plague the country, he must take responsibility for many of them. For the first two years of his term, his party controlled both houses of Congress. During that time, his major achievement was a watered-down national health care policy, better, certainly, than what the U.S. had before, but a far cry from what other countries, such as Canada (where this writer resides), have. But costly, wasteful and useless wars were not ended; the infamous prison at Guantanamo Bay was not closed, although its population was reduced. The tax cuts that Mr. Bush gave to the wealthy were not removed, further sinking the country into economic ruin.

The hapless Mr. Obama seems to be like the prize-fighter who just doesn’t know how to use his strength. When the Republicans shriek ‘class warfare’ about a modest proposal to tax the wealthy at the same rate as the middle-class, Mr. Obama says barely a word in protest.  When Israel spits in the face of the U.S., expanding settlements in disputed territory against the expressed wishes of the U.S., Mr. Obama still continues to say, with a straight face, that a negotiated settlement between the Israelis and Palestinians is the only way to peace.

The Palestinian’s latest effort for justice will, in all likelihood, be rebuffed at the Security Council, where the U.S. has vowed to veto it. But it will be accepted by the General Assembly, which will not provide the same advantages as recognition by the Security Council, but will still be a game-changer for the Middle East.  The U.S., of course, will once again be on the wrong side of justice and human rights. But the powerful lobbyists will be pleased, and in twenty-first century America, that is one of the only constituencies that counts. The other important constituency can be found at your local country club, enjoying its various amenities.

Obama's Campaign vs Obama's Presidency

Finance Myths

The Wrong Crisis
By DEAN BAKER

Most economists and financial experts would give the banking system in Spain high marks. It is well regulated and well capitalized. In September of 2008, when the financial world was melting down following the collapse of Lehman Brothers, Spain was relatively unaffected. Yet the unemployment rate in Spain today is more than 20 percent.

Clearly there is more to the story of the current worldwide economic slump than the flame out of Bear Stearns, Lehman, and AIG. But the Financial Crisis Inquiry Commission (FCIC), tasked by Congress with determining the causes of that slump, isn't giving us the more complete picture.

The problems with the FCIC's report, released at the end of January, stem from the Commission's very inception: it was focused on the wrong topic. The FCIC investigated risky investments, lax regulation, excessive leverage. And it downplayed the more mundane, but vastly more important, collapse of the housing bubble.

The FCIC was set up to investigate a sidebar rather than the real story. Given the definition of its mission, the Commission did a reasonably good job. However, its 662-page report is a distraction from the real reasons why 25 million Americans are unemployed, underemployed, or have given up looking for work altogether. The real story doesn't require 662 pages; it can easily be summed up in a few paragraphs.

We knew the bubble was coming . . .

The story of the downturn is the story of the $8 trillion housing bubble and its collapse. This bubble was driving the economy in the last decade in the same way that the stock bubble drove the economy in the late '90s. Just as the collapse of the stock bubble led to a recession in 2001, the collapse of the housing bubble led to a recession in 2007. Both collapses and the resulting economic fallout were predictable. They also could have easily been avoided if those in charge of economic policy (e.g., Fed Chairmen Alan Greenspan and Ben Bernanke) had been doing their jobs.

Housing prices rose dramatically starting in the mid-'90s, around the same time the stock bubble began to inflate. At their peak, nationwide housing prices were more than 70 percent higher than the long-term trend in prices suggested they ought to be. This surge in prices drove the economy both directly, by fueling a massive construction boom, and indirectly, by spurring consumption.

Residential construction accounted for 3–4 percent of GDP in the early and mid-90s. It topped out at more than 6 percent of GDP in 2005. This construction boom led to enormous overbuilding and historically high vacancy rates. When the bubble burst, it was inevitable that construction would plunge to levels well below normal until the excess housing could be absorbed by the economy. This meant a falloff of close to $600 billion in annual demand.

There was also a bubble in non-residential real estate. This non-residential bubble lagged a bit, but followed the same predictable pattern as the residential bubble: a building boom produced enormous overcapacity and a dive in construction after the bust. Non-residential construction is down by more than one-third as a share of GDP since its peak, leading to the loss of another $100 billion in annual demand.

The collapse of the housing bubble also reduced consumption through what is known as the "housing wealth effect." The housing wealth effect is estimated at five to seven cents on the dollar, meaning that homeowners will on average increase their annual consumption by between five and seven cents for every additional dollar of housing they own. This means that the $8 trillion of housing-bubble wealth implied an increase in annual consumption of between $400 and $560 billion. Now that most of the bubble wealth is lost, so is this consumption.

The total reduction in annual demand as a result of the collapse of the bubbles in residential and non-residential real estate is close to $1.2 trillion, or 8 percent of GDP. There is nothing in the economist's bag of tricks that easily replaces such a large loss in demand. This is why anyone who noticed the housing bubble should have recognized that catastrophe loomed.

And the bubble was hard to miss. For a hundred years, U.S. housing prices tracked the overall rate of inflation. This is a long trend, especially in the largest market in the world. Economists don't expect to see a break from such a trend without fundamental shifts in the market.

No such shifts occurred. There was nothing on the demand side that could plausibly explain the sudden rise in house prices. Income growth was good in the late '90s, but in keeping with growth during post–World War II boom, three decades that saw no increase in real house prices. And incomes stopped rising in the oughts, in any case. The population grew during this period, but the rate of household formation was much slower than in the '70s and '80s, when the baby boomers were having children and buying their first homes.

If demand wasn't surging, perhaps there were new supply constraints? Not likely, given near-record levels of construction and record-setting vacancy rates, which were visible as early as 2002.

Finally, that there was no notable increase in rents during this period shows conclusively that house prices were not being driven by the fundamentals of the housing market: if there were fundamental economic factors driving up home prices, then rent prices would have increased apace. In short, there was no excuse for anyone in a policy-making position to miss the housing bubble.

. . . And we could have done something about it

There were many people well position to rein in the bubble. The first and simplest course of action for the Federal Reserve, the Treasury, and other actors in government would have been to warn of the bubble by documenting its existence and detailing the damage that the economy and individual investors would suffer from its collapse.

The second route that the Fed and other regulators could have pursued was to crack down on the bad lending behavior that fueled the bubble. The slipshod practices and outright fraud that were the basis of many loans were not secrets.

Remarkably, Greenspan gave these shenanigans his stamp of approval and praised the inventiveness of the financial industry. Just when the market was really going crazy in 2004, the Securities and Exchange Commission (SEC) responded by easing the leverage restrictions on investment banks. If the SEC had gone the other way and tightened restrictions, it could have saved the country a great deal of pain.

Finally, the Fed could have burst the bubble at any point by raising interest rates. High interest rates are the enemy of bubbles everywhere, and the Fed, under Greenspan and Bernanke, could have ensured the quick impact of raising rates by tying them to the extent of the bubble. In this scheme the initial rate hike could be accompanied by a Fed announcement that the rate hikes would continue until housing prices fell to their pre-bubble levels. This would have caught the attention of mortgage issuers and investment bankers and the suckers buying their junk.

Finance Myths

Much of this story is in the FCIC report but only as background. The foreground is the collapse of Lehman and AIG and the near meltdown of the financial system in the fall of 2008. The scenes of Bernanke and then-Treasury Secretary Henry Paulson warning of the end of the world if Congress didn't immediately pass the Troubled Assets Relief Program (TARP) occupy center stage.

But the end-of-the-world scenario invented by the Paulson-Bernanke team was a charade designed to save the Wall Street banks. Had their scenario come to pass, the financial system might have shut down temporarily—most likely for no more than a few days—which would have been followed by the Fed restarting the system with a flood of liquidity. This is more or less what happened in Iceland, where GDP is now growing again at a healthy pace.

To be clear, a shutdown of the financial system would be a terrifying event, best to avoid. But the idea that this would have led to a second Great Depression—a decade of double-digit unemployment—is complete nonsense. We know how to reflate the economy.

The suggestion that the prolonged downturn is explained in any important way by the financial crisis is absurd. Consumers may be pessimistic about the state of the economy, but the reason they are not spending is that they lost trillions of dollars of housing wealth. The saving rate is still under 6 percent. This is up from near zero at the peak of the housing bubble, but it is still down from its postwar average of close to 8 percent. Instead of asking why consumers aren't spending, we should be asking why they aren't saving more.

All this talk of saving the financial system, and the FCIC's inordinate concern for its role in our current economic woes, give undue credence to another narrative that's great for banks, but harmful to the rest of us. Faced with the fact that banks aren't lending much, some influential voices, such as Bernanke and National Economic Council Director Gene Sperling, have taken to decrying a supposed "credit crunch." But financial institutions are not nearly as constrained as people think. Larger firms are well capitalized; they aren't lending to small businesses because what looked like a good bet during days of 4.5 percent unemployment is a lot less attractive now, when unemployment is twice as high.

The large firms that dominate the economy are sitting on trillions of dollars in cash and can borrow as much as they like directly on credit markets at extraordinarily low interest rates. If there really were great investment opportunities that small businesses couldn't pursue due to their lack of access to credit, we would expect to see the Wal-Marts and Starbucks of the world expanding like crazy to take advantage of their competitors' temporary weakness. However, this is not happening, therefore access to credit clearly is not the issue.

The real story is the lack of demand outlined earlier. The solution is simple: the government should spend lots of money. Simple, that is, except for the political obstacles. That is why the FCIC report is a distraction, one more item contributing to the myth that the country is suffering primarily from a financial crisis.

The national obsession with finance goes beyond the specific events of the crisis. Americans have this misplaced notion that a giant, largely unregulated finance industry is good for us, and we too-readily assume that the success of finance is the success of the nation. That's why the industry routinely threatens to go overseas in response to increased regulation or taxation—and gets what it wants. But apart from the fact that this is a bluff in most cases, why should we care if the titans of finance packed up and left?

The United States has seen its textile industry go overseas, along with much of its steelmaking, auto manufacturing, and even software programming. Why should we be any more concerned about buying our financial services from a foreign bank or insurer than we are about buying our clothes from a foreign manufacturer? There certainly is no economic theory that says this would be a problem.

Even the treatment of the stock market as a measure of economic well-being results from a peculiar obsession with finance. In principle the stock market is supposed to measure the value of future corporate profits. Expected future profits may rise because people are more optimistic about the overall state of the economy. In this sense rising stock prices could be viewed as positive for everyone, but only if associated with the belief that the bigger pie gets distributed widely.

However, investors may expect higher profits because they anticipate a redistribution of income from wages or taxpayers to corporate profits. In this case, there would be no reason for the vast majority of the public, who own little or no stock, to be celebrating an increase in the stock market. Growth of that sort would imply lower, not higher, living standards for them.

Remarkably, many people who consider themselves progressives now view the stock market as a measure of the health of the economy rather than an imperfect measure of the wealth of the rich. These people are also convinced that the world would have ended if the 2008 chain of bank collapses had put Wall Street out of business. This sloppiness of thought radically curtails the room for progressive policy.

The FCIC's focus on finance contributes to this view. There is a lot of good and important material in the report; clearly there are many rich bankers who belong behind bars. The reputations of Greenspan and Bernanke should be permanently tarnished thanks to their incompetence in managing the economy. But at the end of the day, the picture the FCIC presents of the economic crisis and the economy is one that is badly skewed toward the finance-centric view that dominates political debate and prevents headway on the economic concerns that matter to the vast majority of working—and out-of-work—people.