The Great Depression was the worst economic slump ever in U.S. history, and one which spread to virtually all of the industrialized world. The depression began in late 1929 and lasted for about a decade. Many factors played a role in bringing about the depression; however, the main cause for the Great Depression was the combination of the greatly unequal distribution of wealth throughout the 1920's, and the extensive stock market speculation that took place during the latter part that same decade. The maldistribution of wealth in the 1920's existed on many levels. Money was distributed disparately between the rich and the middle-class, between industry and agriculture within the United States, and between the U.S. and Europe. This imbalance of wealth created an unstable economy. The excessive speculation in the late 1920's kept the stock market artificially high, but eventually lead to large market crashes. These market crashes, combined with the maldistribution of wealth, caused the American economy to capsize.
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The sub-prime mess, the huge risks taken by hedge funds, and the conflicts of interest that led to Enron are all the consequences of serial bouts of financial deregulation. Will we reverse field in time to prevent another 1929?
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The Glass-Steagall wall was devised to prevent a repeat of the 1920s' scams, in which banks made speculative investments, turned the debts into securities, and sold them off to unsuspecting investors with the blessing of the bank. With Glass-Steagall, commercial banks were tightly supervised and given access to federal deposit insurance, to keep savings secure and prevent runs on banks. Investment banks, meanwhile, were not government-guaranteed and were free to do more speculative transactions for consenting adult customers. But Roosevelt's newly created SEC subjected securities markets to much tighter structures against self-dealing and insider conflicts of interest.
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Hedged In
The hedge-fund story has close parallels to the sub-prime mess. A hedge fund is a nominally private investment fund designed to make very risky financial bets and reap unusually high returns. Hedge funds are free from the disclosures required of ordinary investment companies, thanks to a loophole that exempts narrowly-held funds that serve very wealthy people, no matter how large the fund or how risky its strategies.
As long as hedge funds were small players, some very smart strategists could reap very large returns by exploiting obscure pricing anomalies in financial markets, with little risk to the larger system. But in the booming 1990s, hedge funds exploded. By 2006, hedge funds and their unregulated cousins, private equity companies, were generating a third to a half of the business executed on Wall Street, and hedge funds held an estimated $1.5 trillion in assets.
In the low-yield environment of the post-2000 crash, everyone was hungry for higher returns. Pension funds, university endowments, and other traditionally prudent investors began to pour their money into hedge funds to get higher yields, driving the funds to make ever more dubious deals, or deals that involved improper insider trades or conflicts of interest, to satisfy investors and keep the money coming in.
Not surprisingly, hedge funds ran into a Lake Wobegon problem: Everybody can't be above average. By 2003, some hedge funds were still producing outsized returns, but the typical fund was no longer even beating the market averages. As the markets discovered in the collapse of August 2007, a lot of hedge funds using sophisticated computer models were making very similar bets. Rather than offsetting each other's risks, they were reinforcing them.
Today, hedge funds are being squeezed from both sides. Many of their investors want out, and a lot of their banks have stopped advancing them credit. The only thing stopping a hemorrhage of investor withdrawals are rules limiting how quickly investors can take their money and run. As their balance sheets worsen, hedge funds are forced to sell off assets, often for big losses. Several have taken big hits. A few smaller ones have gone bust. But a big hedge-fund collapse is the other shoe that hasn't yet dropped.
What would that be like? When Long Term Capital Management, a leading hedge fund of the roaring 1990s, collapsed in 1998, the Federal Reserve went to extraordinary lengths to prevent an economy-wide credit panic. Hedge funds use so-called derivatives to leverage their own capital at ratios unthinkable to ordinary investors -- 20 or even 50 to one. When LTCM suddenly found that its computer models had guessed wrong, so many banks were owed so much money by LTCM that if the fund simply ceased operations, the losses would have wiped out the capital of New York's major banks. So the Fed, technically exceeding its statutory authority, leaned on the big banks to simply buy the fund outright, liquidate its positions in orderly fashion, and eat about $4 billion in losses. Because hedge funds are unregulated, and LTCM was doing business with so many different banks, neither the Fed nor the other regulatory agencies had any idea of the degree of risk LTCM posed until the fund blew up and the Fed had to contain the damage.
In the nine years since LTCM collapsed, the industry has become hydra-headed. More than 9,000 hedge funds have opened up shop, and the kind of rescue that the Fed mounted in 1998 would not be possible today, according to one former senior official of the Fed, because the risks are now so diffuse. In principle, the authorities can monitor hedge funds by keeping tabs on the books of the so-called "counterparties" -- the banks that underwrite their activities. But bank examiners have not been able to keep up with hedge-fund innovations. The industry is a financial black box.
Repealing Roosevelt
Hedge funds, private equity companies, and the sub-prime mortgage industry have two big things in common. First, each represents financial middlemen unproductively extracting wealth from the real economy. Second, each exploits loopholes in what remains of financial regulation.
The Roosevelt schema of financial regulation was built around two principles -- disclosure and outright prohibition of inherent conflicts of interest. All publicly listed and traded companies were required to disclose to the Securities and Exchange Commission and to the public all financial information deemed "material" to investor decisions. The New Deal also prohibited stock trading based on insider information, and it created structural barriers against the kinds of temptations that ruined the economy in the 1920s. The most notable of these was the 1933 Glass-Steagall Act, which prohibited the same financial company from being both a commercial bank and an investment bank.
The Glass-Steagall wall was devised to prevent a repeat of the 1920s' scams, in which banks made speculative investments, turned the debts into securities, and sold them off to unsuspecting investors with the blessing of the bank. With Glass-Steagall, commercial banks were tightly supervised and given access to federal deposit insurance, to keep savings secure and prevent runs on banks. Investment banks, meanwhile, were not government-guaranteed and were free to do more speculative transactions for consenting adult customers. But Roosevelt's newly created SEC subjected securities markets to much tighter structures against self-dealing and insider conflicts of interest.
The New Deal also acted on the home mortgage front. Millions of people were losing their homes and farms to foreclosures, both creating human tragedies and deepening the Depression. In response, the Roosevelt administration literally invented the modern system of home finance. Pre–New Deal mortgages had typically been short-term notes, where most of the principal was due and payable at the end of a brief term, often just three to five years. The New Deal devised the modern long-term, fixed-rate, self-amortizing mortgage. Congress created the Federal Housing Administration to insure these mortgages and win their acceptance among lenders. It also created the Federal National Mortgage Association to sell bonds and buy mortgages, and thus replenish the funds of local lenders. And the New Deal devised a system of federal home loan banks to supervise and advance capital to savings and loan institutions. Deposit insurance was extended to government-supervised mortgage lenders.
The system worked like a watch, combining sound lending standards with expanded opportunity. The rate of home ownership rose from 44 percent in the late 1930s to 64 percent by the mid-1960s. Savings and loan associations almost always ran in the black, there were no serious scandals, and the government deposit-insurance funds regularly returned a profit.
Look Ma, No Hands
If you fast forward to 2000, much of this protective apparatus has been repealed. Regulators who didn't believe in regulation and a compliant Congress have allowed financial engineers to evade what remains. In the 1980s, regulators began allowing exceptions to Glass-Steagall. In 1999, Congress finally repealed it outright, permitting financial supermarkets like Citigroup to operate any kind of financial business they desired, and profit from multiple conflicts of interest. The scandals that pumped up the dot-com bubble of the late 1990s, as well as the most flagrant cases like Enron, and the crash that followed, were the result of the SEC and the bank regulators ceasing to police conflicts of interest. In the scandals of the 1990s, corporate CEOs, their accountants, and stock analysts working for their bankers, all conspired to puff up corporate balance sheets and pump up stock prices on which executive bonuses depended. This is a little harder today, thanks to the honest accounting requirements of the 2002 Sarbanes-Oxley Act (which the Bush administration hopes to water down). But the same kinds of conflicts and potentials for abuse exist when a mega-bank underwrites a leveraged buyout by an affiliated hedge fund, and then hypes the sale of securities when the fund is ready to sell the company back to the public.
Meanwhile, the once staid and socially directed system of providing home mortgages was seized by financial wise guys and turned into another casino. In the early 1980s, exploiting the Reaganite theme of government-bashing, the savings and loan industry persuaded Congress to substantially deregulate S&Ls -- which then speculated with government-insured money and lost many hundreds of billions, costing taxpayers upward of $350 billion in less than a decade.
In 1989 when Congress reregulated S&Ls, the financial engineers just did another end run. Mortgage companies that were exempt from federal regulation came to dominate the mortgage lending business. This loop of the story begins in 1968 with the privatization of Roosevelt's Federal National Mortgage Association. In the wake of that move, investment bankers invented a daisy chain known as "securitization" of mortgage credit. Through securitization, a mortgage broker could originate a loan, sell it to a mortgage banker, who would then sell it to an investment bank like Salomon Brothers, who in turn would package the mortgages into securities. These were then evaluated and coded (for a fee) by private bond-rating agencies according to their supposed risk, and sold off to hedge funds or pension funds. Each of these worthies took their little cut, raising the cost of credit to the borrower. Rather than diffusing risks (a course that economic theory urges on a prudent capitalist nation), however, securitization concentrated them, because everyone was making the same bet on real-estate inflation.
In the sub-prime sector, you could get a loan without a full credit check, or even without income verification. The initial "teaser" rate would be low, but after a few years the monthly payment would rise to unaffordable levels. Both borrower and lender were betting on rising real-estate prices to bail them out, by allowing an early refinancing. But when a soft housing market dashed those hopes, the whole sub-prime sector crashed, and the damage spilled over into other financial sectors.
The Great Enabler
Ever since late July when the credit crunch in sub-prime mortgages became an economy-wide problem, all eyes have been on the Federal Reserve. None other than Milton Friedman, no friend of government meddling in the economy, blamed the Great Depression on the failure of the Fed in the 1930s to intervene aggressively enough. Financial writers have taken to quoting Walter Bagehot, the great financial journalist and commentator of the Victorian era, who correctly counseled that in a financial panic, the job of the lender of last resort is to flood the system with liquidity. This is what the Fed, somewhat belatedly, has been contriving to do.
At first, Chairman Ben Bernanke was reluctant to move too quickly, lest he signal that irresponsible speculators would be bailed out. Then, after pleas from Wall Street became urgent, and credit markets began freezing up in an old-fashioned panic, Bernanke moved.
In mid-August, the Fed flooded the financial markets with cheap money, in order to induce panicky creditors to keep lending and prevent an asset meltdown. Though the Fed's target rate on overnight inter-bank loans (the "federal funds" rate) was kept at 5.25 percent to avoid a sense of desperation, the actual rate fluctuated between 4.5 and 5 percent for several days, thanks to the tens of billions that the central bank poured into the markets.
Then, when that move failed to calm the markets, the Fed took the additional step of reducing the discount rate, the interest rate charged on money that banks borrow directly from the Fed itself. At this writing, the Fed is universally expected to cut the federal funds rate at its next scheduled meeting Sept. 18. The only question is how much.
How aggressively the Fed should move has been the subject of extensive commentary. If the Fed moves too slowly or doesn't cut enough, it ends up playing catch-up behind an advancing panic. If it moves too quickly or too generously, it just invites the next round of speculation with cheap money, and in passing might erode confidence in the none-too-robust dollar. But all of this commentary misses the larger point: If monetary policy is the only tool the government has at its disposal, the Fed can't possibly solve the larger crisis (or prevent the next one) by using interest rates alone.
Indeed, until Congress dismantled financial regulation, the Fed was not called upon to mount these heroic rescues, which have become so common in recent years. Until the 1960s, the central bank could keep interest rates low, confident that they would underwrite the growth of the real economy rather than risky financial speculation, for the simple reason that entire categories of speculation did not exist.
But during the past quarter-century, as deregulation has turned the economy into a casino, the Federal Reserve has had to mount major rescues at least six times. In the early 1980s, it bailed out the big New York banks, some of which lost more than the total amount of their capital in failed speculative third world loans; the money-center banks would have been adjudged insolvent if the Fed hadn't bent its usual capital-adequacy rules. Next, the Fed poured huge quantities of liquidity into financial markets after the stock market crash of 1987, in which the market lost more than 20 percent of its value in a single day. The Fed intervened again on several occasions after speculators destabilized several third world currencies and economies from Mexico to Malaysia. The Fed cleaned up after the aforementioned Long Term Capital Management collapse. It flooded markets with money after the dot-com crash and the attacks of September 11, and most recently in the credit crunch of summer 2007.
Indeed, markets have become so reliant on the Fed's bailouts that they even have a term for it -- "the Greenspan put." A put is a financial term meaning a right to sell a financial security at a predetermined price. The knowledge that the Fed would cheapen money in a crisis reassured speculators that they could always unload their paper. That awareness also influenced financial insiders to behave more recklessly.
The point is not that the Fed should turn its back when financial markets are on the verge of replicating the Great Crash. The point is that the Fed has become the chief enabler of a dangerously speculative economy. It is simply not possible to get the right balance of financial prudence and financial liquidity using monetary policy alone. That's why we once had a more carefully regulated economy.
The Fed, as the designated lender of last resort, does have more arrows in its quiver than monetary policy. It has certain regulatory powers -- but has been loath to use them. For example, the Fed has residual powers to crack down on the credit terms of sub-prime lenders who sell mortgages in financial markets (virtually all of them). For the better part of a decade, the late Federal Reserve Governor Ned Gramlich, who was the Board of Governors' most expert member on housing and mortgage markets, warned Chairman Alan Greenspan about lowered credit standards and the risks of a housing bubble.
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So in summary what has caused this crisis. The STUPID FEDERAL GOVERNMENT!
Too much deregulation.
The big push by democrates for low income family unsecured loans.
Our congress and presidents have set us up again for a DEPRESSION.
Its is comming. All in congress are not to blame. Congressional hearings were held.
Democrates were warned about freddie mac and fannie mae.
Nothing was done except get a bill out of committee by the republicans. No floor vote.
It seems now that with a little research we could have seen it comming. I think most people didn't want to see it comming or care.
Everyone thinks of the fed like insurance. When the insurance company goes belly up
the pot will run dry. It looks like its about to run dry. People are and will panic.
In the end people are like lemmings to some extent.
If we do go into a depression some people will have to learn to grow their own again.
Lets face it, we all can make do on a lot less. We can survive in spite of some
IDIOTS in congress paving the way for dr greed to pocket all he can while he can.
Dr greed is about to find out his stocks aint worth what they use to be.
Check out the price of gold. Panic has begun. A run on the bank has begun..the fed.
The bank will sonner or later close its doors. The next question is will obama or mccain declare marshall law?
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Oh by the way this is all to convenient for the purpose of propelling the empty suit
into the white house. The empty suit is like a blank check to many Americans. The timing of this crisis is very odd. Too odd to ignore for me. I do think people are
working behind the scenes to assure the community organizer will organize America
into a socialist society. Obama won't get elected because of his town meetings thats
for sure. He will be elected for 2 reasons. The democratic controlled congress
generated financial crisis and.....you guessed it White Guilt some of the same people who do and would buy
carbon credits to save us from something that does not exist global warming. Remember
if there is not a crisis the liberal democrates will create one. Its kind of like
telling us that 15 hurricanes will hit next year and not one did, which by the way did happen. Speculation leads to panic and panic leads to an empty suit and socialism. Its that simple forrest. (StoryReports)
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After reading the above it is enough to make one panic.
Keep in mind also the information which I have reproduced below:
We have gone beyond a subprime mortgage crisis. We are, let’s face it, in the midst of a global financial crisis. But it is important for investors to differentiate between the risks they face as shareholders in financial institutions and the risks they face as depositors or insurance holders in the larger banks and financial groups. In extremis, shareholders can and will be wiped out, as they have been in the case of Lehman Brothers and the likes of Northern Rock. But banks and insurers obviously hold a special place in the broader economy, and depositors and holders of insurance have every reason to believe that they will, by and large, be made whole in the event of a commercial banking or insurance group’s insolvency. The challenge for the international banking system is that there are very few private entities with either the capital or the willingness to support ailing rivals. The alternative – sovereign wealth funds – will be increasingly unpalatable as suppliers of emergency capital of last resort, particularly during a US election year. Which leaves the taxpayer to bail out the larger and more significant financial firms that are unable to work through their problems in an orderly fashion.
The financial markets are currently in a process of adjusting, rather painfully, to this new and more uncertain environment. The prices of multiple types of assets are reflecting not necessarily radically worse prospects, but forced, distressed selling on the part of many financial institutions and funds as those organisations scramble to raise liquidity. Some superb longer term opportunities will inevitably arise out of the panic.
As before, we would reiterate the significance of a sound, diversified and balanced investment approach. The world is not ending, though certain members of the investment banking community evidently are, as independent entities at any rate.
Imagine asking the empty suit for advice on investing. Uh, oh uh uh, oh, uh oh oh, eh.
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