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Two of the biggest banks that failed, Wachovia and Washington Mutual got into trouble mainly by making risky loans to homeowners. Two large banks with investment banking arms, JP Morgan and Wells Fargo, resisted taking government money and arguably could have weathered the storm without it. BankAmerica nearly met the same fate of Wachovia and Washington Mutual but not because they bought Merrill Lynch but for their large investment in Countrywide Mortgage a plain vanilla mortgage company. It would be better to focus our research on some of the reasons that these failures happened at all. Deregulation has had strong government backing since and before even the Reagan Administration. We will look at the most current governmental easing starting with the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994. This bill eliminated previous restrictions on interstate banking and branching. This was the first link in the foundation of allowing big regional banks to merge and acquire other banks while moving to a national platform.

GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 253 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 Deregulation Timeline/ Key Events Sherman, Matthew. “Short History of Financial Deregulation in the U.S., Center for Economic Policy and Research,” July 2009, [p.1.] 1996 - Fed Reinterprets Glass-Steagall. After several revisions bank holding companies were allowed to earn up to 25% of their revenues in Investment banking. 1998 – Citicorp-Travelers Merger, creates Citigroup, Inc. merges a commercial bank with an insurance company [Travelers owned Salomon, Smith Barney investment banks] to form the world’s largest financial services company. 1999 – Gramm-LeachBliley Act—with support from Alan Greenspan, Federal Reserve Chairman, Treasury Secretary Rubin and his successor Lawrence Summer, repeals Glass-Steagall. 2000 – Commodities Futures Modernization ActPassed with support from the Clinton Administration, including Treasury Secretary Lawrence Summers and bi partisan support in Congress. This bill prevented the Commodity Futures Trading Commission from regulating most over-the-counter- [non Listed instruments] derivative contracts, including credit default swaps [CDO’s]. 2004 – Voluntary Regulation- the SEC proposes a system of voluntary regulation under the Consolidated Supervised Entities program, allowing investment banks to hold less capital in reserve and increase leverage. A pattern was emerging that eventually led to bank and investment bank failures.

Investment banks were policing themselves more and more with less oversight by the SEC and Federal Reserve. This atmosphere allowed investment banks to increase leverage from 12-1 to 33-1, this leveraging works wonders in a rising asset environment but downward spiraling of asset values leads to dire consequences very quickly.

–  –  –

Financial Services Leverage Kwak, James. “What Did the SEC Really Do in 2004?” www.baselinescenario.com /2012/01/30 Hands off Regulation A rapid growth in the new types of derivatives instrument posed a major problem to regulatory agencies and removed any transparency that had here- to- fore existed. The financial industry developed a wide range of derivative instruments in the 1990’s, most of which were not regulated, this growth continued unabated and accelerated in the first decade of the 21st century. The most important of these derivatives were credit default swaps [CDS] which were effectively a form of bond insurance, where the insurer would bear the risk in the event of a bond default. In a completely unregulated market, derivative trading ballooned from a total outstanding nominal value of $106 trillion in 2001, to a value of $531 trillion in 2008. Capital requirements were allowed to drift significantly lowe as result of S.E.C. actions in 2004 as reported in an article published by a former S.E.C official. SEC rule 15c3-1 allowed some financial firms to hold less capital and dramatically increase their leverage from 12-1 to 33-1. This move was in response to the existing regulatory ratio guidelines followed in Europe and was intended to help the 5 largest US investment banks remain competitive on a global basis. Before the rule change the broker-dealer was limited in the amount of debt it could incur, to about 12 times its net capital, though various reasons broker-dealers operated at significantly lower ratio. If, however, Bear Stearns and other large broker-dealers had been subject to the “typical haircuts on their securities positions” and aggregate indebtedness restriction, and other provisions for determining required net capital under the traditional standards, they would have not been able to incur their high debt leverage without substantially increasing their capital base.

Growing Tsunami Comparative Financial Leverage

–  –  –

An atmosphere of accommodative monetary policy, friendly bipartisan support for deregulation spanning two decades and an easing of regulatory oversight led to an appetite for increased leverage. This increased leveraging was in somewhat a response to the cries of shareholders for greater returns and a leveling of the playing field with European banks that routinely had leverage ratios even exceeding 40-1. The 2004 rule allowed the Investment banks to pile up debt at an unprecedented rate while at the same time weakening regulatory oversight. It allowed, for the first time the S.E.C. to have a window on the bank’s risky investments in mortgage related securities; unfortunately the agency never took true advantage of that part of the bargain. Christopher Cox who became the new Chairman of the S.E.C. a year later never considered this a high priority. The commission assigned seven people to examine parent companies—which in 2007 controlled financial empires with combined assets of more than $4 trillion [at the time of the article in October 2008 not a single inspection had been made since the division was reshuffled]. The 2004 decision reflected a faith that Wall Street’s financial interests coincided with Washington’s regulatory interests.” In retrospect, the tragedy is that the 2004 rule making gave us the ability to get information that would have been critical to sensible monitoring, and yet the S.E.C. didn’t oversee well enough” Mr. Goldschmid an S.E.C Commissioner and authority on securities law from Columbia University, said in an interview.

Moral Hazard

Both commercial and investment banks are awarded government protection, without consideration for their risk taking via liberal lending practices and use of derivative instruments. The safety net provided to banks by the federal government actually protected commercial banks from suffering severe financial consequences when the mortgage market began to collapse. Making the country’s exposure worse, was the activity which took place outside the traditional banking system, whereby private financial markets had willingly financed unprecedented amounts of leverage in more loosely supervised firms such as Bear Sterns, Lehman and AIG. In fact moral hazard became a global issue as the European Central Banks provided liquidity to the banks in Britain. “Never in the field of financial endeavor has so much money been owed by so few to so many. And one might add so far with little real reform.” Mervyn King, Governor of the Bank of England, October 20, 2009 The Effect of Diminished Reserve Requirements and Declining Real Estate Prices on U.S. Banks A drive for increased revenue combined with relaxed regulation and lower reserve requirements were major contributors to the banking crisis. The seeds of the Great Recession of 2008 were sewn with the advent of investment banks going from private to public partnerships in the late 1990’s. The availability of public capital as opposed to the traditional partnership structure created the incentive for banks to take on everincreasing risk. Striving to compete in a more aggressive global landscape they embraced the more relaxed reserve requirements. This, combined with the technology that allowed Quantitative Analysts, or Quants, the means to create new derivative structures, forged a path that ultimately led to a banking calamity.

Global competitors, such as Deutsche Bank and Union Bank of Switzerland were using depositors’ commodities-based wealth to strengthen their balance sheets. Concurrent with relatively relaxed regulations, made foreign banks more competitive thus giving them a business advantage and allowed them to attract valuable domestic talent. At the same time, the burgeoning hedge fund industry (who was also significant political donors) was demanding greater leverage from these U.S. Banks. The proprietary desks at these banks offered that leverage and mimicked those trades. New regulations allowed these banks to take on increased leverage, in some cases, approaching approximately thirty to one.

These banks relied on faulty statistical analysis to justify greater leverage. Housing prices had consistently increased in value without any dramatic retracement (see chart). This was mostly due to the fact that housing GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 256 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 values have never experienced a significant downward trend in over fifty years. Value at Risk measurements that rely on standard distribution models, severely understated the probability of the significant decrease in housing stock assets. This risk was exacerbated by more accommodative lending standards in the mortgage industry. In the past, the traditional lending models more accurately assessed collateral. Banks, now funded with public money and relaxed reserve requirements, were more eager to offer mortgages to less credit worthy borrowers.

United States Census Bureau

Quantitative modeling was employed to create a derivative structure that would enhance the offering of Collateralized Debt Obligations (CDO’s). These CDO simulations used pools of mortgages that were assigned to different tranches according to their risk parameters. Using public money, the banks are able to generate significant commission revenue by packaging and selling these securities with buyers both domestically and offshore. Using enhanced leverage requirements, they purchased these securities for their own account trying to drive their revenue base higher, allowing them to be more globally competitive.

These derivatives were mostly accounted for off balance sheet which further camouflaged the extent of the risk to the banking sector. Increase leverage allowed the banks proprietary desks to act like the hedge funds they serviced. The use of this leverage ultimately worked to their disadvantage. In comparison to the Long Term Capital debacle of the 1980’s, the use of leverage proved ruinous. The rapid decline of housing prices tested a foreclosure system that was here to fore never stressed on a national or global scale. This created a system where the collateral backing these securities could not be judicially seized, creating more destruction. Ultimately, Investment Banks looking to increase their revenues in order to increase compensation levels, and to attract talent, employed ever increasing credit relying on mispriced VAR models and lenient reserve requirements and regulations. Credit rating agencies only magnified the problem by overstating their ratings on these CDO’s. Finally, the system for monetizing these bad real estate-based investments failed. This confluence of events, embodied by the need to create revenues to satisfy the public investor, set the stage for the debacle of 2008.

In the final analysis, it was the relaxation of reserve requirements that led to the Great Recession. Allowing banks to increase leverage, in some cases up to 33 to 1, a very small negative movement in the price of an underlying security would lead to the catastrophic losses experienced by the major bulge bracket firms.

This leveraging, allowed by the 2004 relaxation, provided steroidal stimulus to investment banks dealing with investor expectation and overseas competition, where leverage of 40 to 1 had become the norm.

GCBF ♦ Vol. 11 ♦ No. 1 ♦ 2016 ♦ ISSN 1941-9589 ONLINE & ISSN 2168-0612 USB Flash Drive 257 Global Conference on Business and Finance Proceedings ♦ Volume 11 ♦ Number 1 Derivative trading exploded and oversight diminished and this allowed for an overabundance of leveraged induced profits. As long as the markets kept advancing the Investment banks were witnessing huge increases in profits but this turned into an incredible and insurmountable burden when markets began to unwind. None of the firms adequately established reserves that could reflect the possible adverse outcome that was about to unfold. This ‘Black Swan’ began to spread its wings and the leverage, which had provided the profits, came home to roost with a vengeance. If indeed, even with the 33 to 1 ratios, there would have been little ripple effect if the Investment banks had set up the proper reserves to reflect the VAR. If these safeguards were established then the compensation level would have been in line with historical norms and not hysterical levels. The revenues were paid out as bonuses as they were recorded on the books instead have held in abeyance until the contracts came due or the risk abated significantly. Glass Steagall had less to do with these phenomena then was popularly assumed but was clearly the step child of the reason mentioned previously, Not just deregulation, which should be a boon to competition and aid the end user, but regulation that was not sufficiently enforced Leveraging that would lead to disastrous conclusions, this had been established as a fait acompli of irresponsibility during the Long Term Capital debacle, so it was not an unexpected or new paradigm.

Establishing payouts based upon recording of business as opposed to completion and closure of the transactions.

Not setting up reserves to counteract even the most damaging occurrences Commercial paper rates resulting from the downgrades that made it impossible for some firms to survive, indeed some firms were not able to issue Commercial paper at any rate.

These losses were particularly acute at Lehman Brothers and Bear Stearns and led to their failures.

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