Tuesday, March 24, 2009

Credit Crisis: The Fox in the Hen house with the gate left open

March 24th, 2009

Credit Crisis: The Fox in the Hen house with the gate left open

In my opinion, the reason for the current credit crisis is because the Glass-Steagall Wall Act was repealed in 1999. Once lending banks and investment banks were allowed to merge and do business without the “firewall” it created an environment where poor asset management decisions were encouraged. Like the investment environment prior to the Great Depression, financial intuitions ended up lending money at rates almost less than what they were taken in deposits. A bank run during the Great Depression was just modernized with a run on mortgage backed securities alongside option trading.

The Glass-Steagall Act of 1933 was established by the FDIC to put a “firewall” between what a lending bank does vs. what an investment bank does such as trading. On November 12, 1999, the Gramm-Leach-Bliley Act repealed part of the Glass-Steagall wall Act opening up competition among banks, securities companies and insurance companies. The Gramm-Leach-Bliley Act allowed commercial and investment banks to consolidate such as merging Citibank with Travelers Group forming Citigroup to later combined operations with Smith Barney and a few other investment banks. At that moment in time, I recall President Bill Clinton stating that this repeal act allows banks and investment banks to be better able to compete against global competitors during the globalization error.

Earlier, the Savings and Loan (S&L) crisis had occurred in 1976 and again in 1980 mainly due to un-sound lending practices with loose credit terms. Banks were lending at say a 2 point higher interest spread than what they took money in from deposits. Many of these mortgages were fixed rate mortgages while the money coming in from deposits was at a variable rate. Eventually, longer term mortgage rates stopped declining for a period and shorter term interest rates started to rise ultimately eliminating that “net interest margin”. Banks who have many fixed rate loans were supposed to use interest rate “swaps” to swap their fixed rate interest streams with other banks for a variable rate stream. This allows a banks rate to rise with shorter term interest rates that they paid depositors for money to lend. To make up for these losses banks start to enact higher non-interest rate fees such as ATM fees, etc.. Ultimately, the S&L banks ended up with a bunch of toxic asset loans with a negative net interest rate margin.

On August 9, 1989, the Office of Thrift Supervision (OTS) was established as an agency of the United States Department of the Treasury. It’s the primary regulator of federal savings associations.

In 1989, The Resolution Trust Corporation (RTC) was a United States Government-owned asset management company charged with liquidating assets that had been assets of savings and loan associations (S&Ls) declared insolvent by the Office of Thrift Supervision. Between 1989 and mid-1995, the Resolution Trust Corporation closed or otherwise resolved 747 thrifts with total assets of $394 billion. This is not that much different that what is being proposed by the current President Barack Obama administration in which the government will purchase the toxic assets from the bank and liquidate them to willing buyers such as Private equity firms at discounted rates.

To summarize, if the Glass-Steagall Act of 1933 was still in place the investment banks that have been around for hundreds of years would not have blown up due to mortgage lending. The OTC would have stayed effective keeping lending institutions in check and asset management departments within lending banks would have been more cautious as to how they managed their capital structures due to regulation consequences.

Justin Davidson
Private-equity-Trader.com
Justin_davidson@yahoo.com

1 comment:

  1. Amen, brother. When they finally lifted Glass Steagall I knew we were going to get screwed at some point. All the SEC acts of 1934 were put in place to keep the big players from gaming system like they did in '29. By removing acts that were built as firewalls for individual investors assures not more vibrant capitalism but an ugly, misbegotten fixed game where gains are privatized and losses are "democratized".

    The real question is, are a democratic nation of capitalist or simply capitalists who mouth democracy when it's convenient?

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