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.

Banks Got Bailed Out, We Got Sold Out

Strike! Strike! Strike!
by ROB URIE

It was nearly half a century ago that Noam Chomsky, in his book American Power and the New Mandarins, described the Pentagon as a “Keynesian distribution device.” What he meant was the Pentagon is an integrated part of the American economy that provides products and financial support to American industry. In fact, the myth that the American economy functions via free markets serves capitalist extraction but is a completely misleading description of reality.

The wars in Iraq and Afghanistan are wars over resources, primarily oil. In the minds of war architects they may serve a broader geopolitical purpose, but that purpose is at its core economic–maintaining a ready supply of oil for multinational oil companies. The wars were estimated some years ago to cost several trillion dollars. This amount is to be borne by taxpayers, not to mention the human toll in lives and lost possibilities. Another way to phrase this is: “oil companies and military contractors got bailed out, we got sold out.”

When the bank bailouts began in early 2007 (earlier than the press has reported) they came at the end of nearly five decades of myth building about the American economy. They also came late in one of the greatest periods of capitalist extraction in history. Fifty years ago American workers produced most of the finished goods and services that we consumed and they were paid a proportion of what they produced that allowed a growing majority to live middle-class lives. Today American workers still produce most of what we consume but the wages increasingly go to a small group of economic elites who control the government through open graft and our national conversation through media ownership.

And the truth hidden in plain sight is the last thing the Koch brothers, Goldman Sachs, Exxon Mobil, Verizon or any other large corporation wants is free markets. All of these businesses were built on research funded by social wealth, products developed with social wealth, military excursions paid for with social wealth (and the blood of others) and bailouts funded with social wealth. The most effective revolution possible would “free” these organizations from the yoke of government by withdrawing social support and letting them fend for themselves.

The rest of the world has had few illusions about where American wealth comes from. The CIA has long functioned as an oil mafia undermining democratically elected and democratically functioning governments to control oil for private interests. The American military has been a tool of private American interests for most of its existence. And these government agencies are economies unto themselves receiving “black” budgets over which there is little oversight or accountability.

The bank bailouts fit neatly into this history—the transfer of social wealth for the purported purpose of providing a necessary economic function to the American people, the extension of credit. At an earlier period in history this claim might have been slightly less absurd. In the American economic system debt is money and money is debt. The problem today is that we’re full up on bank loans. Reviving private credit today only serves to further wealth extraction when debts cannot be repaid.

Despite their place in the national mythology, banks are only artifacts of this epic of capital consolidation. They are not the only, or even the main, protagonists. Were the banks to be successfully resolved, turned into utilities that do, for the first time in fifty years, serve a public purpose, the other modes of exploitative extraction would live on (e.g. the military). And the current critique of banks rests on the complaint that Americans are now being treated like America has long treated the rest of the world—like colonized citizens. For the benefit of the rest of the world this realization is probably a good thing. But or us, it is a rude awakening.

In reality, there was no resolution to the last crisis save bridging what could have been a temporary gap in banker bonuses. Many multiples of what anyone could ever pay has been gambled and only one banker need stub her toe or cut himself shaving and the gamble will be lost. The international financial system is as fragile as it has ever been and the only effective resolution before the next crisis hits would require rearranging the existing economic and political orders. This will not happen while so few are receiving so much of our social wealth.

Many bankers understand this. The race is on to take what remains before the next crisis erupts. News reports have the banks hiring private security forces, the new Pinkertons, to squash rebellion before it gains momentum. The surveillance state, built at our expense, is the servant of the bankers and corporate leaders. The bankers and corporations are the state. And even if one wanted to sit the next historical epic out, that option will be at the behest of history, not a choice that can be made by any one of us.

So, what to do? Step one is to stop contributing to our own demise. Strike May 1st. Strike May 2nd. Strike May 3rd. Strike until the power of economic extraction and exploitation is eliminated. Recognize that most of us have more shared interests with the poor and middle classes in other countries than we do with bankers and corporate executives in the U.S. Recognize that the values that the bankers and corporations have handed us are not our values, and are not even human values. Recognize that bankers and corporate executives can’t grow their own food, build their own houses, educate their own children or provide their own healthcare. Without us, they can’t do anything. Strike!

Wall Streets Reloads With Toxic Bonds

Financial Crisis, Round Two
by MIKE WHITNEY

“Despite the Dodd-Frank financial reform bill and its directive to address this issue, the problem of bank runs in the shadow system has not yet been solved.”
–Mark Thoma, Professor of Economics, University of Oregon, February 13, 2012.

Wall Street is at it again.

In the last few months, the nation’s biggest banks and investment firms have resumed the same perilous activities that crashed the financial system and plunged the economy into the deepest slump since the Great Depression. According to a number of recent reports, there’s been a steady uptick in the type of risky bond deals that preceded the repo market bank run in 2008 leading to the default of 106-year old financial giant Lehman Brothers. With interest rates locked at zero percent and gradual improvements in the economic data, investors have been scouring the markets for better returns on their investments. This search for higher yield has triggered a gold rush on risky assets which has increased the probability of another major cataclysm. Here’s the story from CNN Money:

“The risky bond deals that were a hallmark of the pre-financial crisis boom are staging a comeback as investors continue to hunt for ways to find higher rates of return. 

And companies are willing to meet the demand. Roughly $58 billion of high yield, or junk, bonds have been issued by 95 corporations since January. That’s the fastest start in 15 years, according to Dealogic. 

Investment grade bonds, which offer a lower, albeit more stable yield, have also continued to attract investor interest. Since January, about $150 billion of corporate bonds have been issued by 315 companies, according to Dealogic. While that’s slightly faster than the past two years, it’s well behind the pace set in 2007, 2008 and 2009.” (“Bonds: Risk is back!”, CNN Money)

Trillions of dollars in bailouts, subsidies and other corporate welfare has restored many of the Too Big to Fail banks back to health, allowing them to reengage in transactions which, once again, put both the financial system and the broader economy in danger. And, although there have been modest efforts to re-regulate the system–particularly Dodd-Frank–the new laws fall well-short of what’s needed to decrease the vulnerabilities in the shadow banking system or to increase confidence in the bonds that are at the center of this latest investment binge. Congress has failed to pass legislation that would improve the underwriting standards of the loans that are pooled in these bonds to make sure that borrowers have the ability to repay their debts. Absent stricter standards, there’s certain to be a repeat of the collapse in the secondary market which followed the implosion in subprime mortgages. It’s deja vu all over again. Here’s more from International Financing Review:

“As the credit crisis recedes and underwriting standards begin to loosen, bonds backed by consumer debt such as auto loans, credit card payments, and student loans are becoming increasingly risky, Moody’s said on Thursday. 

Relaxed underwriting standards, more complex structures, and new untested market participants are just three of the trends suggesting that risk is on the rise for some sectors of the asset-backed securities market, Moody’s said in a report…. 

With credit standards slipping in asset classes such as subprime auto loans, and risky crisis-era structural features showing up in transactions, credit rating agencies need to make sure they are keeping up with the deteriorating credit standards and rating the these bonds appropriately – which means withholding their coveted Triple A rating if it is not deserved, or making sure there are other features that mitigate the risks, said Moody’s.” (“As crisis fades, risk returns to asset-backed debt – Moody’s”, IFR)

Easy money, looser credit and poor underwriting standards: Where have we heard that before? And all this is by-design, the inevitable result of a monetary policy that feeds liquidity into an overbloated financial system that neither creates value nor provides capital for productive activity. The present arrangement merely transfers the wealth from working people to a class of investors who’ve become a danger to themselves and society. Here’s more from the IFR:

“The riskiness of securitizations is still low and has not approached the level it reached in the early to mid-2000s…ABS reached its issuance peak in 2006 at US$754bn. However, if the normal pattern of the credit cycle plays out, the easing of credit that took place in 2011 will persist into 2012 and beyond… 

Originators have begun to ease underwriting standards…. in sectors such as subprime auto-loan securitizations, where underwriting is returning to its pre-recession norm, losses on loan pools backing auto ABS are bound to increase.” (“As crisis fades, risk returns to asset-backed debt – Moody’s”, IFR)

As we have noted in earlier articles, subprime auto securitization and student loans represent most of the gains in the recent credit expansion. Loans that are bundled and sold to investors are used numerous times-over as collateral (rehypothecation) so that banks and financial institutions can maximize leverage. This same “gearing” process was all the rage until 2007 when two Bear Stearns hedge funds unexpectedly defaulted precipitating a run on the shadow system that wiped out over $4 trillion in equity in less than a year.

Other signs that Fed chairman Bernanke’s loosy-goosy monetary policy is inflating another asset bubble include the fact that banks have doubled the volume of their credit card solititations since 2010 “with an increased emphasis on offerings to individuals with less than pristine credit histories.” In other words, the banks don’t care whether they get their money back provided they can offload the unpaid debt onto gullible investors in the form of bundled loans. The former head of the FDIC, William Seidman, figured this scam out long before the dot.com bubble burst and issued this warning to regulators:

“Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”

If only someone had been listening.

IFR also reports that private equity high-rollers are joining in the fray by loading up on junk paper that promises slightly better returns than low yielding CDs or US Treasuries. Here’s the clip:

“The entrance of players … with higher risk profiles is a sign that competition for asset origination will increase”….Additionally, small originators and issuers with low credit quality have been getting back into the game, and their ability to honor representations and warranties may be limited."

“Too Big To Fail” ensures that any investment in high-yield garbage bonds is a reasonably safe bet due to the fact that US taxpayers now guarantee Wall Street against any substantial loss. That implicit backstop includes all manner of financial institutions including insurers, PE, hedge funds etc. The Fed has wrapped its arms around the entire system while transferring trillions of dollars in red ink from the balance sheets of these foundering Wall Street casinos onto its own.

This below-the-radar surge in financial offal has spread to the same complex assets that were at the heart of the crisis, collateralized debt obligations or CDOs. The big boys–Goldman and Barclays–have been inquiring about the $47 billion in AIG assets held by the New York Fed. Some of these assets have already been sold off in, what appeared to many to be, secret auctions. Even so, there’s more dreck where that came from which has piqued the interest of other banks and brokerages. Here’s more from the Wall Street Journal:

“The $47 billion face value in assets, held by the Federal Reserve Bank of New York, are the same kinds of financial instruments that … caused record losses across the financial industry. Plunging values of the securities, called collateralized debt obligations, or CDOs, caused AIG’s near collapse and a government rescue in 2008. The $182 billion bailout was widely criticized because a chunk of taxpayer aid was funneled through AIG to large banks.

Now, amid rising investor demand for riskier, higher-yielding assets, attempts by Wall Street firms to buy those same assets may spark further controversy. Some large banks were on the winning end of bets with AIG over the instruments during the crisis, and benefited from the insurer’s bailout….

Banks that bought credit-default swaps from AIG on the CDOs had inundated AIG with demands for collateral when the housing downturn caused market prices of the CDOs to nose dive. The New York Fed’s move made more than a dozen U.S. and foreign banks whole on their bets with the weakened insurer. Some of those banks, including Goldman and Barclays, are now the same ones interested in buying the securities, people familiar with the matter said.” (“Banks Want Fed to Iron Out ‘Maiden’”, Wall Street Journal)

Wow. So all 12 banks were paid 100 cents on the dollar for bogus insurance policies (CDS) that were essentially worthless since AIG did not have the resources to repay the claims. And now these same banks want to buy the remaining AIG assets at firesale prices? That’s what you call the double whammy.

The reason that most people can’t grasp how serious these new developments are, is because their understanding of the financial crisis remains sketchy. The Crash of ’08 had less to do with subprime mortgages and Lehman Brothers than it did with the flawed architecture of a shadow system that performs the same tasks as traditional banking, but is unregulated, undercapitalized and hopelessly crisis-prone. ”What happened in September 2008 was a kind of bank run,” said Robert E. Lucas, of the Minneapolis Fed.

“Creditors lost confidence in the ability of investment banks to redeem short-term loans, leading to a precipitous decline in lending in the repurchase agreements (repo) market.” Yes, but there’s more to it than that. The reason that “creditors lost confidence” was because they knew the banks were using bonds that were comprised of dodgy loans to people who had no ability to repay the debt. In other words, there was a moment of enlightenment (when two Bear Stearns hedge funds stopped redemptions) when the main players suddenly realised that the entire $10 trillion shadow banking system and repo market was propped up on a foundation of pure quicksand. (ie–”bad loans”) That’s when the race for the exits began.

And now, not even 4 years later, the banks are at it again, buying up toxic bonds by the boatload. We’re back to Square One. Barring a dramatic reversal in the present policy, (which is extremely unlikely) it’s hard to see how another disaster can be averted.

Debt Ceiling Doomsday

Shadow Banking and the Repo Market
 By MIKE WHITNEY

"International markets are absolutely on tenterhooks, because up until now there really has been a pretty blithe assumption that sooner or later politicians would strike a deal, and it would probably be last-minute, but a deal would be done before Aug. 2.

What is really starting to think in right now is that not only is there a growing risk the rating agencies could downgrade U.S. debt, even if there is some kind of short-term Band-Aid solution, but secondly there may not even be a deal by August the 2nd. And so a lot of people in the financial markets right now are starting to look at what-if scenarios and creating plans for what they half-jokingly call doom day, potential -- or D-day, potential default day."

-- Gillian Tett, editor Financial Times, PBS Newshour

Okay, so we all knew that the cultists and screwballs who run the GOP were going to take this to the 11th hour, right? But who knew that once they got us out on the ledge, they wouldn't know how to cut a deal? Instead, Tea Party confederates seem determined to make sure the US plunges into the abyss. They want to add a balanced budget amendment to the current legislation which has no chance of getting it passed. President Barack Obama has already promised to veto the bill.

So, here we are, just 4 days away from the August 2 deadline, and no closer to a budget agreement than we were two months ago when this whole fiasco started. Only now, Wall Street is worried, the public is pissed off, and anyone holding US Treasuries around the world is starting to rethink their portfolio. On top of that, the markets have been pounded for 4 days straight, futures are falling like a stone, and the economic data is getting weaker and weaker all the time. (BEA reports that 2nd Quarter GDP came in at an anemic 1.3%) The last thing the country needs is another crisis to send the economy sprawling back into recession. Here's a clip from an article in the Financial Times:

"Wall Street's leading chief executives intervened in the US debt debate on Thursday, writing to President Barack Obama and Congress to warn of "very grave" consequences of a default and urging them to cut a deal "this week".

Lloyd Blankfein of Goldman Sachs and Jamie Dimon of JPMorgan Chase were among 14 chief executives of banks and insurers who signed the letter, along with Rob Nichols, the head of the Financial Services Forum, the umbrella association for the biggest financial groups in the US.

The letter said a default, which is still perceived as unlikely, or a downgrade from a triple-A credit rating, which analysts believe is increasingly likely, "would be a tremendous blow to business and investor confidence – raising interest rates for everyone who borrows, undermining the value of the dollar, and roiling stock and bond markets"….

Banks are concerned about a wide range of operational issues as well as the broader question of how the Fed would support the financial system if there were disruption caused by a failure to raise the debt ceiling.... they would like to know whether the Fed will support the refinancing of Treasury securities by stepping in and buying any unsold stock at auctions…. ("Bank chiefs send US debt default warning", Financial Times)

So, finally, the truth begins to emerge. The reason the debt ceiling has been headline news 24-7 is not because Granny might not get her Social Security check on time, but because Wall Street fatcats might lose some dough if a deal isn't worked out pronto. But doesn't suggest that the final outcome is not yet certain? In other words, if the Tea Party contingent refuses to fall in line behind Boehner, then August 2 might come and go with no deal, and that could trigger another Lehman Bros-type meltdown. Here's an excerpt from an article in the New York Times:

"The reverberations of Washington's impasse over a debt deal are already being felt in the short-term credit markets, a key artery of the economy that daily supplies trillions of dollars of credit. Over the last week, big banks and companies have withdrawn $37.5 billion from money market funds that invest in Treasury debt and other ultra-safe securities, the biggest weekly drop this year.

Meanwhile, in the vast market for repurchase agreements, in which many financial firms make short-term loans to one another, borrowers are beginning to demand higher yields.

These moves underscore how companies and big financial institutions are beginning to rethink their traditional view that notes issued by the United States Treasury are indistinguishable from cash, even though many experts say they think it is unlikely that the government would miss payments on its obligations.... ("Debt Ceiling Impasse Rattles Short-term credit markets", New York Times)

Sound familiar? This is what ignited the Crash of '08. There was a downgrading of mortgage-backed securities (MBS) and other structured debt instruments, liquidity vanished overnight, and, before you knew it, the markets were in freefall. And it all started with a run on the shadow banking system. And, that's what's happening right now. Here's a sampling of some of the articles popping up in the financial media.

Financial Times:

"US money market funds are stockpiling cash in case Congress fails to raise the debt ceiling, distorting the short-term market for US government debt and raising borrowing costs for banks and other financial institutions....

Banks are also holding more cash and US corporations are postponing decisions due to uncertainty about where to invest cash amid fears that a failure to raise the debt ceiling would trigger a credit rating downgrade and possible default....

Money market funds, which hold $338bn of US government debt, according to Citigroup, are also reducing the amount of time they are willing to lend. This could raise funding concerns for banks, as they are reliant on short-term borrowing in the repurchase or repo market." (Financial Times)

And this is from Naked Capitalism:

"...the Merc (more formally, the Chicago Mercantile Exchange) .... announced an increase in haircuts on Treasury and agency securities today.... But it increased haircuts even more on foreign sovereign debt. This will force players who have been using any of these assets as collateral that are also pretty fully leveraged to either cut their positions or put up more cash or other collateral." (Naked Capitalism)

And, lastly, from the New York Times:

"...In the commercial paper market, where companies raise funds for their short-term borrowing needs, buyers are also seeking shorter-term paper...

While money market fund managers say they are not seeing a sizable wave of redemptions yet, they are setting aside more cash, leaving it at custodial bank accounts in case investors demand their money back." ("Debt Ceiling Impasse Rattles Short-term credit markets", New York Times)

So there's a lot of hunkering down going on, which means that Wall Street isn't really sure how this thing is going to shake out. If there is a default on August 2, the US's debt would be downgraded requiring more collateral on roughly $4 trillion in Treasuries. Does anyone believe that the maxed out, capital-starved banks have that kind of money laying around?

Not likely. The Fed would have to step in a wrap its arms around the whole financial system again, like it did after Lehman blew up. Only this time, the rest of the world might not buy it. They might see that America's dysfunctional political system and it's bankcentric beggar-thy-neighbor monetary policy makes it an unsuitable steward of the global economic system. At the very least, the dollar's exalted position as the world's reserve currency would be called into question. Is that such a bad thing?

Presently, US Treasuries play a crucial role in short-term funding markets providing the bulk of Triple A collateral in the repo (repurchase agreement) market. If Treasuries are downgraded, then money markets, commercial paper, and interbank lending will all feel the stress. That will make borrowing more expensive causing a slowdown in credit. The knock-on effects will be felt throughout the economy. Another recession will be unavoidable.

Ironically, the Financial Stability Oversight Council, which was created by Dodd-Frank legislation, issued a report last week which pointed out the vulnerabilities in the current system. The FSOC warned that it "cannot predict the precise threats that may face the financial system" emphasizing much of what we have been talking about here. Here's a clip from the Wall Street Journal which explains what they found:

"In particular, the FSOC said weaknesses exist in the "triparty repo" market, in which banks make and receive short-term loans on a day-to-day basis. The repo market temporarily froze during the financial crisis, drying up a key source of funding for many Wall Street firms. The FSOC said critical overhauls are needed, including strengthening the collateral practices backing the securities that are being loaned and borrowed...

Regulators also warned risks still exist in money-market funds, which are used by individuals and corporations as a low-risk place for parking cash. To increase stability and reduce the funds' "susceptibility to runs,".... ("Watchdog Sees Financial Weak Spots", Wall Street Journal)

What the report is saying is that nothing has been fixed. Obama's efforts to reform the markets (and avert another bank run) has amounted to nothing. Shadow banking and the repo market are just as unstable and risky as ever. And that's what the debt ceiling flap is really all about. It's about a deregulated system that's been preserved because, well, because some very rich people like the way things are right now and to hell with the rest of us. That's why.

The Real Housewives of Wall Street

Why is the Federal Reserve forking over $220 million in bailout money to the wives of two Morgan Stanley bigwigs?

By Matt Taibbi - Rolling Stone

April 12, 2011

America has two national budgets, one official, one unofficial. The official budget is public record and hotly debated: Money comes in as taxes and goes out as jet fighters, DEA agents, wheat subsidies and Medicare, plus pensions and bennies for that great untamed socialist menace called a unionized public-sector workforce that Republicans are always complaining about. According to popular legend, we're broke and in so much debt that 40 years from now our granddaughters will still be hooking on weekends to pay the medical bills of this year's retirees from the IRS, the SEC and the Department of Energy.

Most Americans know about that budget. What they don't know is that there is another budget of roughly equal heft, traditionally maintained in complete secrecy. After the financial crash of 2008, it grew to monstrous dimensions, as the government attempted to unfreeze the credit markets by handing out trillions to banks and hedge funds. And thanks to a whole galaxy of obscure, acronym-laden bailout programs, it eventually rivaled the "official" budget in size — a huge roaring river of cash flowing out of the Federal Reserve to destinations neither chosen by the president nor reviewed by Congress, but instead handed out by fiat by unelected Fed officials using a seemingly nonsensical and apparently unknowable methodology.

Now, following an act of Congress that has forced the Fed to open its books from the bailout era, this unofficial budget is for the first time becoming at least partially a matter of public record. Staffers in the Senate and the House, whose queries about Fed spending have been rebuffed for nearly a century, are now poring over 21,000 transactions and discovering a host of outrages and lunacies in the "other" budget. It is as though someone sat down and made a list of every individual on earth who actually did not need emergency financial assistance from the United States government, and then handed them the keys to the public treasure. The Fed sent billions in bailout aid to banks in places like Mexico, Bahrain and Bavaria, billions more to a spate of Japanese car companies, more than $2 trillion in loans each to Citigroup and Morgan Stanley, and billions more to a string of lesser millionaires and billionaires with Cayman Islands addresses. "Our jaws are literally dropping as we're reading this," says Warren Gunnels, an aide to Sen. Bernie Sanders of Vermont. "Every one of these transactions is outrageous."

But if you want to get a true sense of what the "shadow budget" is all about, all you have to do is look closely at the taxpayer money handed over to a single company that goes by a seemingly innocuous name: Waterfall TALF Opportunity. At first glance, Waterfall's haul doesn't seem all that huge — just nine loans totaling some $220 million, made through a Fed bailout program. That doesn't seem like a whole lot, considering that Goldman Sachs alone received roughly $800 billion in loans from the Fed. But upon closer inspection, Waterfall TALF Opportunity boasts a couple of interesting names among its chief investors: Christy Mack and Susan Karches.

Christy is the wife of John Mack, the chairman of Morgan Stanley. Susan is the widow of Peter Karches, a close friend of the Macks who served as president of Morgan Stanley's investment-banking division. Neither woman appears to have any serious history in business, apart from a few philanthropic experiences. Yet the Federal Reserve handed them both low-interest loans of nearly a quarter of a billion dollars through a complicated bailout program that virtually guaranteed them millions in risk-free income.

The technical name of the program that Mack and Karches took advantage of is TALF, short for Term Asset-Backed Securities Loan Facility. But the federal aid they received actually falls under a broader category of bailout initiatives, designed and perfected by Federal Reserve chief Ben Bernanke and Treasury Secretary Timothy Geithner, called "giving already stinking rich people gobs of money for no fucking reason at all." If you want to learn how the shadow budget works, follow along. This is what welfare for the rich looks like.

In August 2009, John Mack, at the time still the CEO of Morgan Stanley, made an interesting life decision. Despite the fact that he was earning the comparatively low salary of just $800,000, and had refused to give himself a bonus in the midst of the financial crisis, Mack decided to buy himself a gorgeous piece of property — a 107-year-old limestone carriage house on the Upper East Side of New York, complete with an indoor 12-car garage, that had just been sold by the prestigious Mellon family for $13.5 million. Either Mack had plenty of cash on hand to close the deal, or he got some help from his wife, Christy, who apparently bought the house with him.

The Macks make for an interesting couple. John, a Lebanese-American nicknamed "Mack the Knife" for his legendary passion for firing people, has one of the most recognizable faces on Wall Street, physically resembling a crumpled, half-burned baked potato with a pair of overturned furry horseshoes for eyebrows. Christy is thin, blond and rich — a sort of still-awake Sunny von Bulow with hobbies. Her major philanthropic passion is endowments for alternative medicine, and she has attained the level of master at Reiki, the Japanese practice of "palm healing." The only other notable fact on her public résumé is that her sister was married to Charlie Rose.

It's hard to imagine a pair of people you would less want to hand a giant welfare check to — yet that's exactly what the Fed did. Just two months before the Macks bought their fancy carriage house in Manhattan, Christy and her pal Susan launched their investment initiative called Waterfall TALF. Neither seems to have any experience whatsoever in finance, beyond Susan's penchant for dabbling in thoroughbred racehorses. But with an upfront investment of $15 million, they quickly received $220 million in cash from the Fed, most of which they used to purchase student loans and commercial mortgages. The loans were set up so that Christy and Susan would keep 100 percent of any gains on the deals, while the Fed and the Treasury (read: the taxpayer) would eat 90 percent of the losses. Given out as part of a bailout program ostensibly designed to help ordinary people by kick-starting consumer lending, the deals were a classic heads-I-win, tails-you-lose investment.

So how did the government come to address a financial crisis caused by the collapse of a residential-mortgage bubble by giving the wives of a couple of Morgan Stanley bigwigs free money to make essentially risk-free investments in student loans and commercial real estate? The answer is: by degrees. The history of the bailout era reads like one of those awful stories about what happens when a long-dormant criminal compulsion goes unchecked. The Peeping Tom next door stares through a few bathroom windows, doesn't get caught, and decides to break in and steal a pair of panties. Next thing you know, he's upgraded to homemade dungeons, tri-state serial rampages and throwing cheerleaders into a panel truck.

It was the same with the bailouts. They started out small, with the government throwing a few hundred billion in public money to prop up genuinely insolvent firms like Bear Stearns and AIG. Then came TARP and a few other programs that were designed to stave off bank failures and dispose of the toxic mortgage-backed securities that were a root cause of the financial crisis. But before long, the Fed began buying up every distressed investment on Wall Street, even those that were in no danger of widespread defaults: commercial real estate loans, credit- card loans, auto loans, student loans, even loans backed by the Small Business Administration. What started off as a targeted effort to stop the bleeding in a few specific trouble spots became a gigantic feeding frenzy. It was "free money for shit," says Barry Ritholtz, author of Bailout Nation. "It turned into 'Give us your crap that you can't get rid of otherwise.' "

The impetus for this sudden manic expansion of the bailouts was a masterful bluff by Wall Street executives. Once the money started flowing from the Federal Reserve, the executives began moaning to their buddies at the Fed, claiming that they were suddenly afraid of investing in anything — student loans, car notes, you name it — unless their profits were guaranteed by the state. "You ever watch soccer, where the guy rolls six times to get a yellow card?" says William Black, a former federal bank regulator who teaches economics and law at the University of Missouri. "That's what this is. If you have power and connections, they will give you a freebie deal — if you're good at whining."

This is where TALF fits into the bailout picture. Created just after Barack Obama's election in November 2008, the program's ostensible justification was to spur more consumer lending, which had dried up in the midst of the financial crisis. But instead of lending directly to car buyers and credit-card holders and students — that would have been socialism! — the Fed handed out a trillion dollars to banks and hedge funds, almost interest-free. In other words, the government lent taxpayer money to the same assholes who caused the crisis, so that they could then lend that money back out on the market virtually risk-free, at an enormous profit.

Cue your Billy Mays voice, because wait, there's more! A key aspect of TALF is that the Fed doles out the money through what are known as non-recourse loans. Essentially, this means that if you don't pay the Fed back, it's no big deal. The mechanism works like this: Hedge Fund Goon borrows, say, $100 million from the Fed to buy crappy loans, which are then transferred to the Fed as collateral. If Hedge Fund Goon decides not to repay that $100 million, the Fed simply keeps its pile of crappy securities and calls everything even.

This is the deal of a lifetime. Think about it: You borrow millions, buy a bunch of crap securities and stash them on the Fed's books. If the securities lose money, you leave them on the Fed's lap and the public eats the loss. But if they make money, you take them back, cash them in and repay the funds you borrowed from the Fed. "Remember that crazy guy in the commercials who ran around covered in dollar bills shouting, 'The government is giving out free money!' " says Black. "As crazy as he was, this is making it real."

This whole setup — in which millionaires and billionaires gambled on mountains of dangerous securities, with taxpayers providing the stake and assuming almost all of the risk — is the reason that it's insanely premature for Wall Street to claim that the bailouts have actually made money for the government. We simply can't make that determination until the final bill comes in on all the dicey securities we financed during the bailout feeding frenzy.

In the case of Waterfall TALF Opportunity, here's what we know: The company was founded in June 2009 with $14.87 million of investment capital, money that likely came from Christy Mack and Susan Karches. The two Wall Street wives then used the $220 million they got from the Fed to buy up a bunch of securities, including a large pool of commercial mortgages managed by Credit Suisse, a company John Mack once headed. Those securities were valued at $253.6 million, though the Fed refuses to explain how it arrived at that estimate. And here's the kicker: Of the $220 million the two wives got from the Fed, roughly $150 million had not been paid back as of last fall — meaning that you and I are still on the hook for most of whatever the Wall Street spouses bought on their government-funded shopping spree.

The public has no way of knowing how much Christy Mack and Susan Karches earned on these transactions, because the Fed has repeatedly declined to provide any information about how it priced the individual securities bought as part of programs like TALF. In the Waterfall deal, for instance, we know the Fed pledged some $14 million against a block of securities called "Credit Suisse Commercial Mortgage Trust Series 2007-C2" — but that data is meaningless without knowing how many units were bought. It's like saying the Fed gave Waterfall $14 million to buy cars. Did Waterfall pay $5,000 per car, or $500,000? We have no idea. "There's no way of validating or invalidating the Fed's process in TALF without this pricing information," says Gary Aguirre, a former SEC official who was fired years ago after he tried to interview John Mack in an insider-trading case.

In early April, in an attempt to learn exactly how much Mack and Karches made on the TALF deals, Sen. Chuck Grassley of Iowa wrote a letter to Waterfall asking 21 detailed questions about the transactions. In addition, Sen. Sanders has personally asked Fed chief Bernanke to provide more complete information on the TALF loans given not only to Christy Mack but to gazillionaires like former Miami Dolphins owner H. Wayne Huizenga and hedge-fund shark John Paulson. But Bernanke bluntly refused to provide the information — and the Fed has similarly stonewalled other oversight agencies, including the General Accounting Office and TARP's special inspector general.

Christy Mack and Susan Karches did not respond to requests for comments for this story. But even without more information about the loans they got from the Fed, we know that TALF wasn't the only risk-free money being handed over to Wall Street. During the financial crisis, the Fed routinely made billions of dollars in "emergency" loans to big banks at near-zero interest. Many of the banks then turned around and used the money to buy Treasury bonds at higher interest rates — essentially loaning the money back to the government at an inflated rate. "People talk about how these were loans that were paid back," says a congressional aide who has studied the transactions. "But when the state is lending money at zero percent and the banks are turning around and lending that money back to the state at three percent, how is that different from just handing rich people money?"

Those kinds of deals were the essence of the bailout — and the vast mountains of near-zero government cash turned companies facing bankruptcy into monstrous profit machines. In 2008 and 2009, while Christy Mack was busy getting her little TALF loans for $220 million, her husband's bank hauled in $2 trillion in emergency Fed loans. During the same period, Goldman borrowed nearly $800 billion. Shortly afterward, the two banks reported a combined annual profit of $14.5 billion.

As crazy as it is to lend to banks at near zero percent and borrow back from them at three percent, one could at least argue that the policy may have aided American companies by providing banks more cash to lend. But how do you explain the host of other bailout transactions now being examined by Congress? Like the Fed's massive purchases of securities in foreign automakers, including BMW, Volkswagen, Honda, Mitsubishi and Nissan? Or the nearly $5 billion in cheap credit the Fed extended to Toyota and Mitsubishi? Sure, those companies have factories and dealerships in the U.S. — but does it really make sense to give them free cash at the same time taxpayers were being asked to bail out Chrysler and GM? Seems a little crazy to fund the competition of the very automakers you're trying to rescue.

And then there are the bailout deals that make no sense at all. Republicans go mad over spending on health care and school for Mexican illegals. So why aren't they flipping out over the $9.6 billion in loans the Fed made to the Central Bank of Mexico? How do we explain the $2.2 billion in loans that went to the Korea Development Bank, the biggest state bank of South Korea, whose sole purpose is to promote development in South Korea? And at a time when America is borrowing from the Middle East at interest rates of three percent, why did the Fed extend $35 billion in loans to the Arab Banking Corporation of Bahrain at interest rates as low as one quarter of one point?

Even more disturbing, the major stakeholder in the Bahrain bank is none other than the Central Bank of Libya, which owns 59 percent of the operation. In fact, the Bahrain bank just received a special exemption from the U.S. Treasury to prevent its assets from being frozen in accord with economic sanctions. That's right: Muammar Qaddafi received more than 70 loans from the Federal Reserve, along with the Real Housewives of Wall Street.

Perhaps the most irritating facet of all of these transactions is the fact that hundreds of millions of Fed dollars were given out to hedge funds and other investors with addresses in the Cayman Islands. Many of those addresses belong to companies with American affiliations — including prominent Wall Street names like Pimco, Blackstone and . . . Christy Mack. Yes, even Waterfall TALF Opportunity is an offshore company. It's one thing for the federal government to look the other way when Wall Street hotshots evade U.S. taxes by registering their investment companies in the Cayman Islands. But subsidizing tax evasion? Giving it a federal bailout? What the fuck?

As America girds itself for another round of lunatic political infighting over which barely-respirating social program or urgently necessary federal agency must have their budgets permanently sacrificed to the cause of billionaires being able to keep their third boats in the water, it's important to point out just how scarce money isn't in certain corners of the public-spending universe. In the coming months, when you watch Republican congressional stooges play out the desperate comedy of solving America's deficit problems by making fewer photocopies of proposed bills, or by taking an ax to budgetary shrubberies like NPR or the SEC, remember Christy Mack and her fancy new carriage house. There is no belt-tightening on the other side of the tracks. Just a free lunch that never ends.

Why Another Financial Crash is Certain

How to Make $4 Trillion Vanish in a Flash
By MIKE WHITNEY

On August 9, 2007, an incident took place at a bank in France that touched-off a financial crisis that that would eventually wipe out more than $30 trillion in capital and thrust the world into the deepest slump since the Great Depression. The event was recounted in a speech by Pimco's managing director Paul McCulley, at the 19th Annual Hyman Minsky Conference on the State of the U.S. and World Economies. Here's an excerpt from McCulley's speech:

"If you have to pick a day for the Minsky Moment, it was August 9. And, actually, it didn’t happen here in the United States. It happened in France, when Paribas Bank (BNP) said that it could not value the toxic mortgage assets in three of its off-balance sheet vehicles, and that, therefore, the liability holders, who thought they could get out at any time, were frozen. I remember the day like my son’s birthday. And that happens every year. Because the unraveling started on that day. In fact, it was later that month that I actually coined the term “Shadow Banking System” at the Fed’s annual symposium in Jackson Hole.

“It was only my second year there. And I was in awe, and mainly listened for most of the three days. At the end....I stood up and (paraphrasing) said, ‘What’s going on is really simple. We’re having a run on the Shadow Banking System and the only question is how intensely it will self-feed as its assets and liabilities are put back onto the balance sheet of the conventional banking system.’”

BNP had been involved in credit intermediation, that is, it was exchanging bonds made up of mortgage-backed securities (MBS) for short-term loans in the repo market. It all sounds very complex, but it's no different than what banks do when they take deposits from customers and then invest the money in long-term assets. (aka--"maturity transformation") The only difference here was that these activities were not regulated, so no government agency was involved in determining the quality of the loans or making sure that the various financial institutions were sufficiently capitalized to cover potential losses. This lack of regulation turned out to have dire consequences for the global economy.

It took nearly a year from the time that subprime mortgages began to default en masse, until the secondary market (where these "toxic" bonds were traded) went into a nosedive. The problem was simple: No one knew whether the underlying mortgages were any good or not, so it became impossible to price the assets (MBS). This created, what Yale Professor Gary Gorton calls, the e coli problem. In other words, if even a small amount of meat is contaminated, millions of pounds of hamburger has to be recalled. That same rule applies to mortgage-backed securities. No one knew which MBS contained the bad loans, so the entire market froze and trillions of dollars in collateral began to fall in value.

Subprime was the spark that lit the fuse, but subprime wasn't big enough to bring down the whole financial system. That would take bigger ructions in the shadow banking system. Here's an excerpt from an article by Nomi Prins which explains how much money was involved:

"Between 2002 and early 2008, roughly $1.4 trillion worth of sub-prime loans were originated by now-fallen lenders like New Century Financial. If such loans were our only problem, the theoretical solution would have involved the government subsidizing these mortgages for the maximum cost of $1.4 trillion. However, according to Thomson Reuters, nearly $14 trillion worth of complex-securitized products were created, predominantly on top of them, precisely because leveraged funds abetted every step of their production and dispersion. Thus, at the height of federal payouts in July 2009, the government had put up $17.5 trillion to support Wall Street's pyramid Ponzi system, not $1.4 trillion." ("Shadow Banking", Nomi Prins, The American Prospect)

Shadow banking emerged so that large cash-heavy financial institutions would have a place to park their money short-term and get the best possible return. For example, let's say Intel is sitting on $25 billion in cash. It can deposit the money with a financial intermediary, such as Morgan Stanley, in exchange for collateral (aka MBS or ABS), and earn a decent return on its money. But if a problem arises and the quality of the collateral is called into question, then the banks (Morgan Stanley, in this case) are forced to take bigger and bigger haircuts which can send the system into a nosedive. That's what happened in the summer of 2007. Investors discovered that many of the subprimes were based on fraud, so billions of dollars were quickly withdrawn from money markets and commercial paper, and the Fed had to step in to keep the system from collapsing.

Regulations are put in place to see that the system runs smoothly and to protect the public from fraud. But banking without rules is more profitable, so industry leaders and lobbyists have tried to block the efforts at reform. And, they have largely succeeded. Dodd-Frank – the financial reform act -- is riddled with loopholes and doesn't really resolve the central issues of loan quality, additional capital, or risk retention. Banks are still free to issue bogus mortgages to unemployed applicants with bad credit, just as they were before the meltdown. And, they can still produce securitized debt instruments without retaining even a meager 5 per cent of the loan's value. (This issue is still being contested) Also, government agencies cannot force financial institutions to increase their capital even though a slight downturn in the market could wipe them out and cause severe damage to the rest of the system. Wall Street has prevailed on all counts and now the window for re-regulating the system has passed.

President Barack Obama understands the basic problem, but he also knows that he won't be reelected without Wall Street's help. That's why he promised to further reduce "burdensome" regulations in the Wall Street Journal just two weeks ago. His op-ed was intended to preempt the release of the Financial Crisis Inquiry Commission's (FCIC) report, which was expected to make recommendations for strengthening existing regulations. Obama torpedoed that effort by coming down on the side of big finance. Now, it's only a matter of time before another crash.

Here's an excerpt from a special report on shadow banking by the Federal Reserve Bank of New York:

"At the eve of the financial crisis, the volume of credit intermediated by the shadow banking system was close to $20 trillion, or nearly twice as large as the volume of credit intermediated by the traditional banking system at roughly $11 trillion. Today, the comparable figures are $16 and $13 trillion, respectively.....The weak-link nature of wholesale funding providers is not surprising when little capital is held against their asset portfolios and investors have zero tolerance for credit losses." ("Shadow Banking", Federal Reserve Bank of New York Staff Report)

So, between $4 to $7 trillion vanished in a flash after Lehman Brothers blew up. How many millions of jobs were lost because of inadequate regulation? How much was trimmed from output, productivity, and GDP? How many people are on now food stamps or living in homeless shelters or struggling through foreclosure because unregulated financial institutions were allowed to carry out credit intermediation without government supervision or oversight?

Ironically, the New York Fed doesn't even try to deny the source of the problem; deregulation. Here's what they say in the report: "Regulatory arbitrage was the root motivation for many shadow banks to exist."

What does that mean? It means that Wall Street knows that it's easier to make money by eliminating the rules....the very rules that protect the public from the predation of avaricious speculators.

The only way to fix the system is to regulate all financial institutions that act like banks. No exceptions.

Shadow Banking Makes a Comeback

Reflating High-Risk Assets 

By MIKE WHITNEY

Credit conditions are improving for speculators and bubblemakers, but they continue to worsen for households, consumers and small businesses. An article in the Wall Street Journal confirms that the Fed's efforts to revive the so-called shadow banking system is showing signs of progress. Financial intermediaries have been taking advantage of low rates and easy terms to fund corporate bonds, stocks and mortgage-backed securities. Thus, the reflating of high-risk financial assets has resumed, thanks to the Fed's crisis-engendering monetary policy and extraordinary rescue operations.

Here's an excerpt from the Wall Street Journal:

"A new quarterly survey of lending by the Federal Reserve found that hedge funds and private-equity funds are getting better terms from lenders and that big banks have loosened lending standards generally in recent months. The survey, called the Senior Credit Officer Opinion Survey, focuses on wholesale credit markets, which the Fed said functioned better over the past quarter." ("Survey shows credit flows more freely", Sudeep Reddy, Wall Street Journal)

In contrast, bank lending and consumer loans continue to shrink at a rate of nearly 5 per cent per year. According to economist John Makin, there was a "sharp drop in credit growth, to a negative 9.7 per cent annual rate over the three months ending in May." Bottom line; the real economy is being strangled while unregulated shadow banks are re-leveraging their portfolios and skimming profits.  Here's more from the WSJ:

"Two-thirds of dealers said hedge funds in particular pushed harder for better rates and looser nonprice terms, and they said some of the funds got better deals as a result....(while) The funding market for key consumer loans remained under stress, with a quarter of dealers reporting that liquidity and functioning in the market had deteriorated in recent months."  ("Survey shows credit flows more freely", Sudeep Reddy, Wall Street Journal)

As the policymaking arm of the nation's biggest banks, the Fed's job is to enhance the profit-generating activities of its constituents. That's why Fed chair Ben Bernanke has worked tirelessly to restore the crisis-prone shadow banking system. As inequality grows and the depression deepens for working people, securitization and derivatives offer a viable way to increase earnings and drive up shares for financial institutions. The banks continue to post record profits even while the underlying economy is gripped by stagnation.

Central bank monetary policy is largely responsible for the worst financial crisis since the Great Depression. Low interest rates and an unwillingness to reign in over-leveraged banks and non-banks triggered a run on the shadow system that left many depository institutions insolvent. Eventually, the Fed was able to stop the bleeding by providing trillions of dollars in emergency relief and by issuing blanket government guarantees on complex bonds and securities that are currently worth roughly half of their original value. The Fed is now reconstructing this same system without any meaningful changes. The upward transfer of wealth continues as before. 

The Federal Reserve Bank of New York's  own report confirms that securitization and massive leveraging contributes to systemic instability. Here's an excerpt from the FRBNY's "The Shadow Banking System: Implications for Financial Regulation":

"The current financial crisis has highlighted the growing importance of the “shadow banking system,” which grew out of the securitization of assets and the integration of banking with capital market developments. This trend has been most pronounced in the United States, but it has had a profound influence on the global financial system.....Securitization was intended as a way to transfer credit risk to those better able to absorb losses, but instead it increased the fragility of the entire financial system by allowing banks and other intermediaries to “leverage up” by buying one another’s securities." ("The Shadow Banking System: Implications for Financial Regulation", Tobias Adrian and Hyun Song Shin, Federal Reserve Bank of New York)

The former President of FRBNY, William Dudley, made similar comments in a recent speech. He said, "This crisis was caused by the rapid growth of the so-called shadow banking system over the past few decades and its remarkable collapse over the past two years.”

The system can be fixed by imposing capital and liquidity requirements on shadow banks and by maintaining strict underwriting standards on loans. Regulators need additional powers to check up on institutions which presently operate outside their purview. Any institution that poses a risk to the rest of the system must be regulated by the state. Unfortunately, the Fed opposes such changes because they threaten the profit-margins of its constituents. The Fed is paving the way for another catastrophe.

Securitization creates strong incentives for fraud. Prior to the Lehman Bros. default, structured securities, like bundled loans, were in great demand because investors were looking for Triple-A bonds with higher yields than US Treasuries and CDs. Bogus ratings convinced investors that mortgage-backed securities, asset-backed securities, and collateralized debt obligations were "risk free" when, in fact, many of the loans were made to applicants who had no ability to repay their debts. As foreclosures soared, financial intermediaries demanded more collateral for the short-term loans which provided funding for the banks. That pushed asset prices down and slowed liquidity to a trickle. When the wholesale credit markets crashed, panicky investors ran for the exits.  The meltdown in subprime was the spark that set the shadow system ablaze.  

Even so, Bernanke has fought all attempts to strengthen regulations, raise capital requirements, or tighten lending standards. Thus, the pieces of the shadow system have been reassembled with no fundamental change. Now it appears that the Fed's bubblemaking efforts are starting to pay off. Here's a clip from an article in the Wall Street Journal which clarifies the point:

"Even as lenders struggle to pull themselves out of the credit crisis, signs of a new and potentially dangerous infatuation with risky borrowers are emerging. From credit cards to auto loans to mortgages, the hunger for new business as the crisis ebbs is causing some financial institutions to weaken lending standards and woo borrowers who mightn't be able to pay..... 

“Credit-card issuers mailed 84.8 million offers of plastic to U.S. subprime borrowers in the first six months of this year...Fannie Mae, seized by the U.S. government in 2008 to avert the mortgage company's failure, launched an initiative in January that allows some first-time home buyers to get a loan with a down payment of as little as $1,000....The thawing securitization market for auto loans is helping AmeriCredit increase its loan staff and dealer network...Kathleen Day, a spokeswoman for the Center for Responsible Lending, said the consumer group is "seeing banks re-enter the subprime market at a steady clip and make loans to borrowers who don't have the ability to repay. 

“There is no doubt that the credit supply still is tight....But some lenders are starting to take more chances on consumer loans. Many financial institutions that survived the credit crisis and resulting recession are desperate for earnings growth." ("Signs of Risky Lending Emerge" Ruth Simon, Wall Street Journal)

Financial system instability is no accident. It's Central Bank policy.  As financial institutions discover they can no longer count on organic growth in the real economy to increase profits, (because consumers are too strapped to spend freely)  they will rely more heavily on dodgy accounting, bogus ratings, opaque debt-instruments, high-frequency trading and lax lending standards. This is the shadowy regime that Bernanke is trying so hard to rebuild. The Fed is laying the groundwork for another disaster.

Dallas Fed's Fisher Rages Against Too Big To Fail...

...Says Only Way To Remove Systemic Risk Is Shrinking The Megabanks
 
by Tyler Durden on 06/03/2010

In a speech before the SW Graduate School of Banking, Dallas Fed's Richard Fisher comes out swinging, blasting his boss Ben Bernanke and his policy of globalized moral hazard: "Let me make my sentiments clear: It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system. It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises." And just in case listeners missed the point, he followed up: "Just this morning, the Washington Post summarized the impasse that inevitably blocks treatment of the TBTF pathology. In an article on preparation for this weekend’s Group of 20 talks on bank reform, it was noted that “some” participants “remain hesitant to lean too hard on banks they consider vital to their national economies.” This hesitancy only perpetuates the problem: The longer authorities delay the process, the more engrained behemoth financial institutions become; the more engrained they become, the less extricable they are. And so the debilitating disease of TBTF spreads. What appears “vital” becomes “viral” and grows ever more threatening to financial stability and economic stability."

Fischer implicitly supports Ted Kaufman's proposal, which failed in the corrupt and Chris Dodd subservient Senate, that had proposed a very sensible size limitation on banks:

Some counter that even if all banks were made small or mid-size (or at least not TBTF), systemic threats—and thus the incentive for regulators to step in and save financial institutions—would not disappear. For instance, if a lot of small banks got into trouble simultaneously—or, as I like to say, forgot they had already been to the Ocean View Restaurant before and made the same bad bets at the same time—one might expect the central bank and regulators to protect bank creditors, extending TBTF protections once again. As the argument goes, breaking up big banks may be necessary but is possibly not sufficient—policymakers still must grapple with the possibility of many smaller banks getting into trouble at the same time, causing a “systemic” problem.

I consider this argument hollow for a few reasons.

First, even if this possibility turned out to be true, the threat of a loss from more isolated difficulties would mean creditors could reasonably expect losses in certain circumstances—a situation unlike TBTF.

Second, going by what we see today, there is considerable diversity in strategy and performance among banks that are not TBTF. Looking at commercial banks with assets under $10 billion, over 200 failed in the past few years, and as we have seen, failures in the hundreds make the news. Less appreciated, though, is the fact that while 200 banks failed, some 7,000 community banks did not. Banks that are not TBTF appear to have succumbed less to the herd-like mentality that brought their larger peers to their knees.

We saw similar diversity during the Texas banking crisis of the late 1980s. Small banks had diverse risk exposures. The most aggressive ones failed, while the more conservative did not.[11]

Some have also pointed to the Great Depression as a period when many small banks got into trouble at the same time. That situation seems less relevant to the policy questions we face today. Those failures were the result of a liquidity crisis that brought down both nonviable and viable banks. Such a liquidity crisis among small banks would be unlikely today, as we now have federal deposit insurance, which protects deposits for funding. And, I might add, the Federal Reserve has demonstrated quite effectively over the past two years that we not only have the capacity to deal with liquidity disruptions but also the ability to unwind emergency liquidity facilities when they are no longer needed.

The point is this: The arguments against shrinking the largest financial institutions are found wanting. And sufficient or not, ending the existence of TBTF institutions is certainly a necessary part of any regulatory reform effort that could succeed in creating a stable financial system. It is the most sound response of all. The dangers posed by institutions deemed TBTF far exceed any purported benefits. Their existence creates incentives that will eventually undermine financial stability. If we are to neutralize the problem, we must force these institutions to reduce their size.
I do not want to be naïve here. I am not suggesting that our banking system devolve into institutions like the Bailey Building and Loan Association in It’s a Wonderful Life. Large institutions have their virtues. They can offer an array of financial products and services that George Bailey could not. A globalized, interconnected marketplace needs large financial institutions. What it does not need, in my view, are a few gargantuan institutions capable of bringing down the very system they claim to serve.

Unfortunately, in preserving the dictatorial nature of the Federal Reserve system, Ben Bernanke will neither listen to Hoenig, who earlier said a rate hike to 1% by the end of the summer is critial, nor to Fisher, whose suggestion will destroy any hope of Bernanke's true employers can ever have of reaping the kinds of bonuses they are used to, and hope to extract from the middle class at least one more time before the ponzi house of cards collapses once and for all.

Full speech:

Richard W. Fisher

Financial Reform or Financial Dementia? 
Remarks at the SW Graduate School of Banking 53rd Annual Keynote Address and Banquet
Dallas, Texas
June 3, 2010

I understand from Scott MacDonald that tonight is the 53rd annual keynote address and banquet of the SW Graduate School of Banking—an impressive anniversary, which reminds me of a story.

A couple is deciding where to dine on their 10th wedding anniversary. They settle on the Ocean View Restaurant because that is where the beautiful, hard-bodied people go. On their 20th anniversary, they discuss where to celebrate, and they agree again on the Ocean View because the wines and the food are superb. For their 30th, they return to the Ocean View once more, having agreed that, as they sit there in silence, the view from the terrace is second to none. On their 40th anniversary, they agree that the Ocean View is just right because it has wheelchair access and an elevator to get them to the porch overlooking the ocean. On their 50th, they want to do something truly special to celebrate. So they decide to go to the Ocean View … because they have never been there before.

Most of you are bankers—many, graduates or future graduates of this fine school. My message to you tonight is to remember where we have been. We have collectively been to hell and back. Let’s not go there again. Let’s remember that bankers should never succumb to what is trendy or fashionable or convenient but should instead focus on what is sustainable and in the interest of providing for the long-term good of their customers.

You gather tonight on the eve of a conference of key members of the House of Representatives and the Senate of the United States seeking to agree upon legislation to foster financial reform.[1] This evening, I am going to discuss this reform initiative. I do so, as always, speaking my own mind, making clear that I speak for nobody else at the Fed (something that is usually patently clear). I do so as one of only a few members of the Federal Open Market Committee who have been practicing commercial bankers. And I do so in the belief that it is always best to speak the truth to political convention.

In their unicameral sessions, the House and Senate have cleared away a lot of the underbrush of who does what to whom. As it now stands—due in significant part to the efforts of Sen. Hutchison of Texas and her colleague Sen. Klobuchar of Minnesota—my colleagues and I at the Federal Reserve will have responsibility for regulating, in some fashion, banking organizations across the spectrum, from community and regional banks to money center banks to thrift holding companies. I believe we are best suited for such responsibility. We have been battle hardened by the crises of both the 1980s here in Texas and this most recent episode, which threatened to bring the system of market capitalism to the brink. Yet, at the same time, I have some concerns about our ability to deal with the most vexing of the issues presented by the recent crisis: the issue of institutions that are considered “too big to fail” (or, if you prefer the acronym that has become commonplace, TBTF).

The Not-So-Shadow System
It has become popular to blame recent financial problems on the so-called shadow banking system. This, however, is an obfuscation. The heavily advertised distinction between commercial banks and the shadow banking system is, in many ways, false.

Take, for example, one of the most well-known and problematic phenomena of the shadow banking world: structured investment vehicles, or SIVs. Despite repeated claims to the contrary, SIVs were not distinct from commercial banks. Many SIVs actually originated from the very core of the commercial banking system—dominated in size by the largest banks—where bank regulation was presumably the strongest. Make no mistake: Big banks created SIVs. They supported SIVs with credit and liquidity enhancements. They marketed and invested in SIVs. And once the crisis hit, big banks were forced to bring SIVs onto their balance sheets. In this way, the presumed distinction between the commercial banking system and the so-called shadow banking system is false.

It is also a widely held misperception that SIVs escaped regulatory treatment. Regulators knew about them and even applied capital requirements to them. Unfortunately, those regulatory requirements were woefully inadequate. The favorable regulatory treatment granted to many of these vehicles was, in many cases, what accounted for their existence. The vehicles were created not so much for an economic purpose, but rather to minimize regulatory capital requirements.

SIVs and other programs sponsored by big banks were also exposed to runs. In contrast to other members of the shadow banking system—like hedge funds—SIVs had inadequate mechanisms in place to protect their liquidity.

I do not wish to single out SIVs. They are just one example of the excess to which large institutions succumbed. We are well aware of the alphabet soup of acronyms, including CDOs and CLOs, that contributed to the crisis, along with an excessive degree of faith in the ability of complex statistical models to mathematize risk taking.

Dealing with TBTF
Of course, recent financial problems have not been limited to large institutions and their opaque operations. As you in this room know all too well, regional and community institutions have faced their own difficulties, especially in the context of construction lending. Smaller banks that have realized debilitating losses have failed. When they got into deep trouble, regulators took them over and resolved them.

We might have expected a similar treatment of big banks. But we would have been wrong. Regulators have, for the most part, tiptoed around these larger institutions. Despite the damage they did, failing big banks were allowed to lumber on, with government support. It should come as no surprise that the industry is unfortunately evolving toward larger and larger bank size with financial resources concentrated in fewer and fewer hands.

Based on these considerations, coupled with studies suggesting severe limits to economies of scale in banking, it seems that mostly as a result of public policy—and not the competitive marketplace—ever larger banks have come to dominate the financial landscape. And, absent fundamental reform, they will continue to do so. As a result of public policy, big banks have become indestructible. And as a result of public policy, the industrial organization of banking is slanted toward bigness.

Big banks that took on high risks and generated unsustainable losses received a public benefit: TBTF support. As a result, more conservative banks were denied the market share that would have been theirs if mismanaged big banks had been allowed to go out of business. In essence, conservative banks faced publicly backed competition.

Let me make my sentiments clear: It is my view that, by propping up deeply troubled big banks, authorities have eroded market discipline in the financial system.

The system has become slanted not only toward bigness but also high risk. Consider regulators’ efforts to impose capital requirements on big banks. Clearly, if the central bank and regulators view any losses to big bank creditors as systemically disruptive, big bank debt will effectively reign on high in the capital structure. Big banks would love leverage even more, making regulatory attempts to mandate lower leverage in boom times all the more difficult. In this manner, high risk taking by big banks has been rewarded, and conservatism at smaller institutions has been penalized. Indeed, large banks have been so bold as to claim that the complex constructs used to avoid capital requirements are just an example of the free market’s invisible hand at work. Left unmentioned is the fact that the banking market is not at all free when big banks are not free to fail.

It is not difficult to see where this dynamic leads—to more pronounced financial cycles and repeated crises.

This is the threat that legislators are now attempting to address in the financial reform bill. A widely noted feature of this legislative effort is the fairly broad scope for regulatory discretion.

For instance, under the proposed legislation, systemically important companies are required to submit a “living will.” According to the legislation, these firms are “to report periodically to the [Fed’s] Board of Governors, the [Financial Stability Oversight] Council, and the [FDIC] the plan of such company for rapid and orderly resolution in the event of material financial distress or failure.”[2]

If the Board and FDIC find the plan deficient, the bill calls for the company to resubmit an alternative approach within a set time frame. Failure to resubmit the resolution plan could result in the imposition of more stringent capital, leverage or liquidity requirements or restrictions on growth and activities. Furthermore, the Board and FDIC, in consultation with the council, may direct the firm “to divest certain assets or operations identified by the Board of Governors and the [FDIC], to facilitate an orderly resolution.”[3]

The legislation also requires that a Credit Exposure Report be submitted “periodically” on “the nature and extent to which the company has credit exposure to other significant nonbank financial companies and significant bank holding companies; and … the nature and extent to which other significant nonbank financial companies and significant bank holding companies have credit exposure to that company.”[4]

The new Financial Stability Oversight Council is directed to “make recommendations to the [Fed’s] Board of Governors concerning the establishment of heightened prudential standards for risk-based capital, leverage, liquidity, contingent capital, resolution plans and credit exposure reports, concentration limits, enhanced public disclosures, and overall risk management” for systemically important institutions.[5]

The name of the game, here, is regulatory discretion.

There are—as there always are—criticisms. Some feel, for instance, that while regulators are being given more authority, they are also being given ambiguous, if not conflicting, directives that would leave the specter of TBTF lurking in the background. For instance, the bill states that it seeks “to provide the necessary authority to liquidate failing financial companies that pose a significant risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.”[6] It also directs the FDIC to “ensure that the shareholders of a covered financial company do not receive payment until after all other claims … are fully paid.”[7] However, the bill goes on to state that in the disposition of assets, the FDIC shall “to the greatest extent practicable, conduct its operations in a manner that … mitigates the potential for serious adverse effects to the financial system.”[8]

Language that includes a desire to minimize moral hazard—and directs the FDIC as receiver to consider “the potential for serious adverse effects”—provides wiggle room to perpetuate TBTF.

Criticisms aside, this is the path our legislative powers have laid out for dealing with the issue of TBTF. Regulators must now decide exactly how they will travel down that path.

There appear to be three major ways to navigate proposed policy making toward big banks: (1) the regulate ’em camp, (2) the resolve ’em camp and (3) the shrink ’em camp.

Let’s examine these one by one.

Regulate ’Em
First, we have the “regulate ’em” camp. While it is certainly true that ineffective regulation of systemically important institutions—like big commercial banking companies—contributed to the crisis, I find it highly unlikely that such institutions can be effectively regulated, even after reform.

To be blunt: Simple regulatory changes in most cases represent a too-late attempt to catch up with the tricks of the regulated—the trickiest of whom tend to be large. In the U.S. financial system, what passed as “innovation” was in large part circumvention, as financial engineers invented ways to get around the rules of the road. There is little evidence that new regulations, involving capital and liquidity rules, could ever contain the circumvention instinct.

The history of regulatory capital requirements is not a distinguished one:[9]

• In 1864, the National Bank Act set minimum capital requirements, but these attempts at quantifying capital adequacy were unsuccessful. Over the years, such efforts continued at both the state and federal level, but without much success.
• By the 1950s, it was concluded that static capital requirements could only interfere with the more comprehensive analyses required to obtain a complete picture of a bank’s ability to absorb losses.
• In 1981, the federal banking agencies responded to diminishing bank capital positions by introducing numerical capital requirements, as the judgment-based approach to capital regulation had proven insufficient. But before long, authorities felt the need to revise these new numerical requirements, as they failed to differentiate between banks according to risk and invited capital arbitrage.
• In 1988, the central banks of the G-10 adopted risk-based capital requirements, as embodied in the Basel Accord. It did not take long before the need for change was felt once again as the original accord proved a blunt instrument that did not differentiate properly among various risk types and allowed significant avenues for capital arbitrage, particularly through loan securitization.
• In response, authorities began crafting Basel II. However, before it could be fully implemented, the risks taken through loan securitization blew up, producing the most severe financial crisis since the Great Depression.
• And as we know all too well, even if Basel II had gone into full effect, it would not have contained risk effectively nor created a sufficient buffer against losses.
• Thus, policymakers have been busily constructing what may be thought of as Basel III.

Regulatory reform discussions portray the need to control systemic risk as a new game in town—as if it were a new responsibility that need only be assigned. This is not the case: Bank regulators have long viewed the containment of systemic risk as a primary rationale for capital requirements. The problem is that capital regulation has rarely been truly successful.

Requiring additional capital against risk sounds like a good idea but is difficult to implement. What should count as capital? How does one measure risk before an accident occurs? And how does one counteract the strong impulse of the regulated to minimize required capital in highly complex ways? History has shown these issues to be quite difficult. While we do not have many examples of effective regulation of large, complex banks operating in competitive markets, we have numerous examples of regulatory failure with large, complex banks.

So, you might say I am a skeptic of regulation alone.

Resolve ’Em
In my opinionated view, a traditional regulatory response—while well-intentioned—cannot, by itself, fully address the threat of TBTF. So we turn to the “resolve ’em” camp.

The argument goes something like this: If deeply troubled large banks are allowed to fail, the banking industry could evolve toward a market-driven structure. During the recent crisis, regulators lamented the lack of a formal resolution process for large and complex financial organizations, claiming it reduced their options and tied their hands. So it follows that a resolution regime whereby regulators can economically resolve failed big banks might be the ticket. In this case, there will be no more TBTF.

Unfortunately, imposing creditor losses at a failing big bank, while simultaneously avoiding market disruptions, involves more than a bit of sophistry. Realistically, it would be difficult to accomplish both at the same time. Based on experience, one of these goals will take precedence over the other. And history shows which goal typically wins.

The sad truth is that when the chips are down, regulators become reluctant to put their money where their mouths are—or more precisely, they become too eager to put their money where they said they would not. Few, if any, policymakers have been willing to let large banking organizations fail, thereby missing an opportunity to impose significant losses on failed institutions’ creditors. We know from intuition and experience that any financial institution deemed TBTF will not be allowed to fail in the traditional sense. When such an institution becomes troubled, its creditors are protected in the name of market stability. The TBTF problem is exacerbated if the central bank and regulators view wiping out big bank shareholders as too disruptive, extending this measure of protection to ordinary equity holders.

In the recent crisis, authorities protected both—uninsured creditors and shareholders of big banks. While uninsured creditors received the greatest protection, regulators even partnered with existing shareholders through the injection of public funds. This program eventually spread to banks of all sizes, but its initial focus was the very largest banks. True, many large-bank shareholders sustained severe losses—but they were not zeroed out. They and their institutions have lived to see another day.

Why should we think the future could, realistically, be any different—especially with even bigger banks that dominate the financial landscape today?

A credible big-bank resolution process that imposes creditor losses will be difficult to enforce, especially when regulators are explicitly directed to mitigate disruptions to the financial system, as they are in the proposed reform bill. And there remain the technical problems of resolution, such as the difficulty of quickly estimating a rate of recovery on a large and complex banking organization and paying it out to creditors. Countless issues like this remain unaddressed. For instance, how would a resolution regime market assets of a failed big bank? Major business lines presumably would be kept intact to preserve value and maximize recovery. But if one large organization were simply sold to another, the industry could become more concentrated than before. That is exactly what happened during the crisis as large failing firms were sold to other large firms.

All of this ignores a still-greater problem: Even if an effective resolution regime can be written down, chances are it might not be used. There are myriad ways for regulators to forbear. Accounting forbearance, for example, could artificially boost regulatory capital levels at troubled big banks. Special liquidity facilities could provide funding relief. In this and similar manners, crisis-related events that might trigger the need for resolution could be avoided, making resolution a moot issue. TBTF would continue, in any case.

Consider the idea of limiting any and all financial support strictly to the system as a whole, thus preventing any one firm from receiving individual assistance. Many have argued such a restriction would minimize the possibility of bank bailouts. Even under this restriction, however, support for large institutions at the expense of smaller peers could live on. If authorities wanted to support a big bank in trouble, they would need only institute a systemwide program. Big banks could then avail themselves of the program, even if nobody else needed it. Systemwide programs are unfortunately a perfect back door through which to channel big bank bailouts.

Or consider the so-called living wills introduced in the financial reform bill. These presumably might serve as a type of instruction manual or roadmap for resolving a large failed bank. But, quite unfortunately, large banking companies have organized themselves in ways that entail significant spillovers to other financial firms and the economy, thereby making a bailout, in many cases, the only credible choice for policymakers. Legislators have attempted to work around this pitfall, requiring changes to large banking companies whose wills are found wanting—prior to a crisis. This could, if used properly, reduce to tolerable levels the spillovers that would result from the imposition of creditor losses. Regardless, even after requested changes have been made, if these wills are still lacking, the associated firms will be TBTF.

Again, in my view, enhanced resolution regimes, by themselves, are not enough to end TBTF. Even a combination of enhanced regulation and resolution would likely be inadequate. The temptation to use regulatory discretion to avoid disruptions is just too great.

Shrink ’Em
This leaves us with only one way to get serious about TBTF—the “shrink ’em” camp. Banks that are TBTF are simply TB—“too big.” We must cap their size or break them up—in one way or another shrink them relative to the size of the industry.

In its latest version, the financial regulatory reform bill has left regulators (specifically, the Board of Governors and the Federal Deposit Insurance Corp.) with the authority to impose greater restrictions on firms whose living wills are not credible. That authority, as I mentioned previously, could include “[divesting] certain assets or operations … to facilitate an orderly resolution.”[10] I would argue that regulators should freely use this broad authority to commit credibly to resolution with creditor losses by reducing big banks’ size and interconnectedness.

(You can see why my stance on TBTF hardly endears me to audiences on Wall Street. I am given to quoting Winston Churchill in response. He said that “in finance, everything that is agreeable is unsound and everything that is sound is disagreeable.” It is most disagreeable to the big bank, big money lobby to countenance restrictions on size, and hence it is the perceived wisdom that this approach is disagreeable. And yet it is perhaps the most sound approach of all those proffered.)

Some counter that even if all banks were made small or mid-size (or at least not TBTF), systemic threats—and thus the incentive for regulators to step in and save financial institutions—would not disappear. For instance, if a lot of small banks got into trouble simultaneously—or, as I like to say, forgot they had already been to the Ocean View Restaurant before and made the same bad bets at the same time—one might expect the central bank and regulators to protect bank creditors, extending TBTF protections once again. As the argument goes, breaking up big banks may be necessary but is possibly not sufficient—policymakers still must grapple with the possibility of many smaller banks getting into trouble at the same time, causing a “systemic” problem.

I consider this argument hollow for a few reasons.

First, even if this possibility turned out to be true, the threat of a loss from more isolated difficulties would mean creditors could reasonably expect losses in certain circumstances—a situation unlike TBTF.

Second, going by what we see today, there is considerable diversity in strategy and performance among banks that are not TBTF. Looking at commercial banks with assets under $10 billion, over 200 failed in the past few years, and as we have seen, failures in the hundreds make the news. Less appreciated, though, is the fact that while 200 banks failed, some 7,000 community banks did not. Banks that are not TBTF appear to have succumbed less to the herd-like mentality that brought their larger peers to their knees.

We saw similar diversity during the Texas banking crisis of the late 1980s. Small banks had diverse risk exposures. The most aggressive ones failed, while the more conservative did not.[11]

Some have also pointed to the Great Depression as a period when many small banks got into trouble at the same time. That situation seems less relevant to the policy questions we face today. Those failures were the result of a liquidity crisis that brought down both nonviable and viable banks. Such a liquidity crisis among small banks would be unlikely today, as we now have federal deposit insurance, which protects deposits for funding. And, I might add, the Federal Reserve has demonstrated quite effectively over the past two years that we not only have the capacity to deal with liquidity disruptions but also the ability to unwind emergency liquidity facilities when they are no longer needed.

The point is this: The arguments against shrinking the largest financial institutions are found wanting. And sufficient or not, ending the existence of TBTF institutions is certainly a necessary part of any regulatory reform effort that could succeed in creating a stable financial system. It is the most sound response of all. The dangers posed by institutions deemed TBTF far exceed any purported benefits. Their existence creates incentives that will eventually undermine financial stability. If we are to neutralize the problem, we must force these institutions to reduce their size.

I do not want to be naïve here. I am not suggesting that our banking system devolve into institutions like the Bailey Building and Loan Association in It’s a Wonderful Life. Large institutions have their virtues. They can offer an array of financial products and services that George Bailey could not. A globalized, interconnected marketplace needs large financial institutions. What it does not need, in my view, are a few gargantuan institutions capable of bringing down the very system they claim to serve.

Europe and TBTF
Of course, we are not the only ones dealing with the monstrous challenges of TBTF. Our friends across the Pond are also focused on the risks posed by institutions that have grown dangerously large (called “systemically important financial institutions,” or SIFIs). Despite Europe’s longstanding accommodation of, and preference for, large banking organizations in the universal banking model, the European Central Bank has become fairly forthright about the problem.

Unfortunately, in attempting to address TBTF, the European Union is falling into the regulate ’em and resolve ’em camps, leaning toward capital regulation and enhanced resolution regimes as a way to limit systemic risk. Given Europe’s prevailing universal banking model, policymakers have so far stayed well outside the shrink ’em camp.

But even while policymakers in Europe debate ways to tackle TBTF, the risks posed by big, interconnected banks are materializing once again, as the adverse effect of rising sovereign credit risk on euro-area banks has led to renewed concerns about systemic risk.

Moreover, Europe’s extensive public support of the banking sector under TBTF policy has left authorities with challenging questions about how to disengage this support fully without disrupting the nascent financial recovery. All these policy questions serve to illustrate the harsh tradeoffs and intractable complexities arising from the public–private intermingling entailed by TBTF.

Conclusion 
For our capitalist system to work properly, it is important that successful risk taking be rewarded and equally important that unsuccessful risk taking be penalized. Legislators have done their level best over the past few months to, in effect, solidify this principle in our system.

That said, the race is far from over. Regulators now must pick up the baton and head for the finish line, using the authorities granted them in a manner that will ensure the safety and soundness of our system in the future. I would like to see us not waste this opportunity for true reform.

Just this morning, the Washington Post summarized the impasse that inevitably blocks treatment of the TBTF pathology. In an article on preparation for this weekend’s Group of 20 talks on bank reform, it was noted that “some” participants “remain hesitant to lean too hard on banks they consider vital to their national economies.”[12] This hesitancy only perpetuates the problem: The longer authorities delay the process, the more engrained behemoth financial institutions become; the more engrained they become, the less extricable they are. And so the debilitating disease of TBTF spreads. What appears “vital” becomes “viral” and grows ever more threatening to financial stability and economic stability.

I know the night is long, and I apologize for imposing the ponderous thoughts of a central banker upon you at this late hour. But go back to our aging couple and their fondness for the Ocean View Restaurant. In September, we will celebrate the 26th anniversary of the first announcement of the government’s TBTF policy. In September 1984, the Comptroller of the Currency testified before Congress that the government would not allow any of the nation’s 11 largest banks to fail. The Comptroller did, however, stress the need to find a way to deal with the potential failure of large institutions, and here we are today having failed to do so.[13] We can now keep kicking the can of TBTF down the road until dementia sets in and the banking system is made rotten by a refusal to acknowledge the pathology at the heart of the problem. Or we can use the occasion of the recent financial crisis to deal with it forthrightly while we are still vigorous and vital. I prefer the latter approach.

About the Author

Richard W. Fisher is president and CEO of the Federal Reserve Bank of Dallas.

Notes

The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.

1. As of the date of this speech, the tentative timeline shows the first open meeting scheduled for Wednesday, June 9.
2.  Sec. 165 of the Senate bill.
3. Sec. 165 of the Senate bill.
4. Sec. 165 of the Senate bill.
5. Sec. 112 of the Senate bill.
6. Sec. 204 of the Senate bill.
7. Sec. 206 of the Senate bill.
8. Sec. 210 of the Senate bill.
9. For a brief history of capital regulation leading up to Basel II, see “Basel and the Evolution of Capital Regulation: Moving Forward, Looking Back,” Federal Deposit Insurance Corp., Jan. 14, 2003.
10.  Sec. 165 of the Senate bill.
11. “Texas Banking Conditions: Managerial Versus Economic Factors,” by Jeffery W. Gunther,Financial Industry Studies, Federal Reserve Bank of Dallas, October 1989, pp. 1–18.
12. “Geithner Urges Swift ‘Global Agreement’ on Financial Reforms to Support Recovery,” by Howard Schneider, Washington Post, June 3, 2010, p. A12.
13. “U.S. Won’t Let 11 Biggest Banks in Nation Fail,” by Tim Carrington, Wall Street Journal, Sept. 20, 1984.