Transcript Financial Crisis 2007

Deregulation of
Financial & Electricity
Markets:
Two Failed Experiments,
Same Discredited Ideology
_____________________________________________________
Iowa Association of Municipal Utilities
Annual Conference
Holiday Inn Des Moines, IA
October 7, 2010
Presentation by
John M. Kelly
John M. Kelly & Associates, LLC
Bethesda, Maryland 20814
Telephone: 301.503.0042
Fax: 301.986.5199
E-mail: [email protected]
1
Financial Crisis: Jumble of Events, Outcomes,
Facts, and Players
Bankruptcies, Acquisitions &
Bailouts
Washington Mutual Acquisition
Bears Stern Acquit ion
Lehman Bankruptcy
Fannie and Freddie Mae Bailouts
AIG Bailout
Major Bank Bailouts (Citigroup;
Wells Fargo, JP Morgan Chase;
Goldman Sachs; Bank of America;
Morgan Stanley)
Etc. …
Financial Products
Credit default swaps
Interest rate swaps
Currency swaps
Collateralized debt obligations
Derivatives
Mortgaged backed securities
Securitization
Special Purpose Vehicles (SPVs)
Structured Finance
Special Investment Vehicles (SIVs)
Etc. …
Other
TARP, Bank Compensation, Rating Agency Complicity
Accounting Firms Complicity, GDP, Unemployment. Etc. …
I
2
Organizing Proposition

The financial industry regulation did not keep
pace with financial innovation, such as:

shadow banking;

derivatives; and

off-balance sheet financing.
3
Outline

What? (Crash)

How? (Vehicles)

Why?

Parallels in Electric Utility Industry Deregulation
4
The Great Recession: What – How -Why … in Brief
“Main Street’s economic murder at the hands of
financial behemoths who gambled recklessly with
taxpayer chips’ while paying Washington to look
the other way.”
Laurence Kotlikoff, Boston University
5
The Great Recession: What – How -Why … in Brief

“…A dozen or so banks that dominate the
financial system placed bets on complex
derivatives and exotic mortgages, that eventually
poisoned the economy and threaten the stability of
the entire financial system.”
Simon Johnson, MIT
6
What: Chronology of Major Events
2006 -- U.S. Home Construction Index drops 40%
2007
 Drop in home sales largest in 25 years;
 Bankruptcy Filings:
 New Century Financial, largest U.S. subprime
lender;
 Mortgage Lenders Network USA, 15th largest
subprime lender ($3.3 billion in loans);
 American Home Mortgage Investment Corp.
7
What: Chronology of Major Events
2007
 Merrill Lynch announces $5.5 billion loss
due to loss as a consequence of the
subprime crisis;

Countrywide Financial, largest mortgage
lender in the United States, stock drops 13% in
August.
8
What: Chronology of Major Events
2007
 Consortium of U.S. banks announce super fund of
$100 million to purchase mortgage-backed
securities;

Alan Greenspan acknowledges “a bubble in
housing;”

Federal Reserve:
 Cuts the discount rate by half a percentage
point in attempt to stabilize financial markets;

Injects $41billion into the money supply for
banks to borrow at a low rate.
9
What: Chronology of Major Events
2008
 March:



Bear Stearns shares plummet & obtains Fed
funding;
Bear Stearns acquired for $2/share by
JPMorgan Chase, avoiding bankruptcy;
June:

Senate Banking Committee Chairman
Christopher Dodd proposes a housing bailout.
10
What: Chronology of Major Events
2008
 September- November:
 Moody's and Standard and Poor's downgrades
AIG's credit rating;
 Federal lends $180 billion to AIG to avoid
bankruptcy – while AIG paying $165 million in
bonuses to executives and traders that caused
the collapse;
 Federal takeover of Fannie Mae and Freddie
Mac (owned or guaranteed half of the U.S.'s $12
trillion mortgage market).
11
What: Chronology of Major Events
2008
 September- November:

Merrill Lynch sold to Bank of America amidst
fears of a liquidity crisis;

Lehman Brothers files bankruptcy.
12
What: Chronology of Major Events
2008
 September—November
 Treasury and Fed meet with key legislators to
propose a $700 billion emergency bailout;

Fed lends $1.3 trillion directly to companies outside
the financial sector;

Fed lends $800 billion more to financial institutions
($600 billion to buy mortgage bonds issued or
guaranteed by Fannie Mae, Freddie Mac, and
Federal Home Loan Bank);

Average house price declined by over 20% from
mid-2006 peak.
13
What: Chronology of Major Events

June 2009 -- S.E.C. sues Countrywide Chief
Executive claiming he publicly reassured investors
about the quality of the company’s loans while at
the while he issued “dire” internal warnings &
sold $140 million of his own shares.

September 2009 -- 14.4% of all mortgages
outstanding were either delinquent or in
foreclosure.
14
What: Economic Impacts

Real Gross Domestic Product
(billions of dollars)

2008(II)
$13,415
2009(II)
$12,902
Four percent drop – 1St Time GDP declined
since WWII
15
What: Economic Impacts

Fixed Investment:
(billions of dollars)
2008(II)
2009(III)
$ 775
$ 344 (-56%)

Residential:

Non-Residential:
1,604
1,269 (-21%)
16
What: Economic Impacts

Electricity Retail Sales (2008-2009):
(millions of kilowatt-hours)
2008
2009
%Change

U.S. -- 3,732,962 3,575,450
minus 4.2%

Iowa --
minus 6.1%
45,488
42,703
17
What: Economic Impacts

Stock Market:


Dow Jones Industrial Avg. fell from 14,093 (Oct
2007) to 6,627 (Mar 2009) – 53%;
Corporate Profits:

2007(IV)-2008(IV) declined from $1,353 billion to
$837 billion (38%).
18
What: Economic Impacts

Unemployment:


(Oct)
Unemployed

Unemployment rate
2005-7
7.2 million
4.8 %
2009
15.6 million
10.1%
19
What: Debt Burdens

U.S. private debt: 123% of GDP in 1981 versus 290%
in 2008;

2007 --Top five investment banks reported over
$4.1 trillion debt – about 30% of GDP;

2008 -- Fannie Mae and Freddie Mac owned or
guaranteed $5 trillion in mortgage obligations when
placed into conservatorship by the U.S. government.
20
How: Primary Vehicles

Structured Finance (MBSs and CDO’s);

Credit Default Swaps;

Subprime Lending.
21
How: Definitions

Securitization
 Financial assets brought together into interest-bearing
securities that are sold to investors.

Derivatives*
 Financial products whose value are determined from an
underlying reference rate (interest rates, foreign
currency exchange rates); an index (that reflects the
collective value of various financial products); or an
asset (stocks, bonds, and commodities.)
*(Warren Buffett referred to derivatives as “financial weapons of mass
destruction”)
22
How: Structured Finance:
Mortgage-Backed Securities (MBS)

MBS – Securitization of Mortgages;

MBS Volume:



1984 – $11 billion;
1994 – $200 billion;
2007 – $3 trillion
23
How: Structured Finance:
Collateralized-Debt Obligations (CDOs)

CDOs – Securitization of credit card,
commercial, and similar non-mortgages loans;

CDO Volume:
1978
Negligible
2007
$4.5 trillion
24
How: Structured Finance:
Credit Default Swaps (CDS)

CDS -- Financial contract that allows the transfer
of credit risk from one market participant to
another (more simply, insurance against default)

No requirement that buyer own the debt;

AIG insuring MBS against default (issuing CDS)
for $20,000 for $100 million coverage.
25
How: Structured Finance:
Subprime Lending
1993
2005

Mortgages:
24,000
1 million

Refinancings:
80,000
1.2 million

2007 -- Value of U.S. subprime mortgages
estimated at $1.3 trillion
26
How: Structured Finance:
Growth of Financial Sector

Financial sector and GDP:
 1978- 3.5% of GDP
 2007– 5.9% of GDP

Profit – 1980-2007:
 Non-Financial sector
250%;
 Financial Sector grew
800%.
27
How: Structured Finance:
Growth of Financial Sector

Average Compensation:
 1948-1979: Banking sector and private sector
roughly the same;


By 2007 banking sector’s average compensation
twice private sector’s;
Goldman Sachs – estimated average of
$750,000/employee in 2009
28
Why: Proximate Causes

Housing Bubble:
 Assumption that housing prices would continue to rise;
 Excessive Leverage by Homeowners and Financial
Institutions.

Explosion in Structured Finance & Subprime mortgage
lending;

Assumption that mathematical financial models accurately
measure risk;

Low interest rates.
29
Why: Proximate Causes:
Housing Bubble

Boom and Bubble based on:
 Creating;

Packaging; and

Selling/Marketing DEBT
30
Why: Proximate Causes:
Debt Burden of Homeowners

Home equity extraction:
 $627 billion in 2001 versus $1.428 trillion in
2005

U.S. home mortgage debt relative to GDP:
 46% during in 1990s versus 73% in 2008

Household debt as a percentage of annual
disposable personal income:
 27% in 1990 versus 77% in 2007
31
Why: Proximate Causes:
Debt Burden of Financial Institutions

Financial Sector Borrowing:


1978 -- Borrowed $13 for every $100 borrowed
by the real economy (households and nonfinancial companies);
2007 – Borrowed $51 for every $100 borrowed
by real economy;
32
Why: Proximate Causes:
Housing Bubble

Housing market collapse:

Defaults on home mortgages reach historic
highs;

Housing prices plunge;

Drop in new construction;
33
Why: Proximate Causes:
Housing Bubble

Housing market collapse:

Banks highly leveraged in risky assets incur
large losses;

Banks lack sufficient cash flow to supply
funds to commercial credit markets;

AIG can’t make payments on CDS claims,
etc.
34
Why: Fundamental Causes

Deregulation – Light Regulation – Non-Regulation;

Change in banks’ economic role and incentives;

Political Influence ;

Ideology
35
Why: Fundamental Causes:
Forgotten/Ignored Economic History

Panic of 1907;

Pujo Commission (Brandeis, Other People’s
Money);

1930s Reforms (Glass-Steagall separates
commercial and investment banking; FDIC;
SEC; etc.)
36
Why: Fundamental Causes:
Forgotten/Ignored Economic History

1956 --Bank Holding Company Act;

1966 – Fed given authority to regulate rates of
Thrifts;

1968 – Truth in Lending Act;

1970 – Fair Credit Reporting Act.
37
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

1982 – Garn-St. Germain Act:
 S&Ls expand into commercial banking;
 S&Ls invest in corporate bonds;
 State banks to issue adjustable rate mortgages;
 Merger between banks and S&Ls in different
states;
 Lifted restrictions on loan-to-value ratios.
38
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

1984 – Secondary Mortgage Enhancement Act:

Removed tax and state impediments to issuance of MBS;

1986 – Fed allows commercial banks to set up
affiliated companies to deal in securities;

1994 Riegle Act – Eliminates many restrictions on
interstate banking
39
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation



1993 – CFTC exempts most over-the-counter
derivatives from regulation;
1999 -- Gramm-Leach-Bliley Act allowed
combination of commercial and investment
banking and insurance – effectively repealing
major section of Glass-Steagall Act
2000 – Federal regulation of over-the-counter
derivatives prohibited
40
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

Other:

Accounting standard-setters allowed depository
banks to move significant amounts of assets and
liabilities off-balance sheet;

Credit rating agencies made changes to models that
allowed for greater risk;

Proprietary trading
41
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

Other:



SEC relaxed the net capital rule enabling
investment banks to increase their levels of debt;
Shadow banking system not subject to the same
regulation as depository banks;
1991 – FDIC Improvement Act – Gave Fed
authority to lend to investment banks in time of crisis.
42
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

Repeal of Glass-Steagall at top of bank deregulation
wish list:
 1998 -- Travelers and Citicorp: merger of a major
insurance company that owned and investment bank
with a major commercial bank;

However -- Glass-Steagall required Citigroup to break
itself up in two years.
43
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

1999 – Congress obliged w/ Gramm-LeachBliley Act :
 Created a new category of financial holding
companies authorized to engage in any
activities that are financial in nature -including banking, insurance, and securities.
44
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation

CFTC versus Banks, Fed, Treasury, and White
House (Brooksley Born (CFTC Chair) v.
Greenspan, Rubin, & Summers.)

Early 1998 – Born proposes “concept paper” to
review whether over-the-counter derivative should
be regulated
45
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation




Bankers meet w/ Fed, Treasury, and White House
and all oppose;
May 1998 – Born releases paper;
July 1998 – House Banking Committee Hearing:
Greenspan, Treasury, and major banks oppose Born
inquiry;
Oct. 1998 -- Congress approves moratorium on
derivative regulation
46
Why: Fundamental Causes:
Deregulation, Light Regulation, and
Non-Regulation



1999 – Born did not seek reappointment;
Nov. 1999 – Presidential Working Group report on
derivatives said that over-the-counter derivatives
should be excluded from federal regulation;
Dec. 2000 – Commodity Futures Modernization Act
essentially exempted OTC derivatives from federal
regulation
47
Why: Fundamental Causes:
Change in Banks Economic Roles and
Incentives

Banks Primary Economic Roles are:
 Facilitate efficient transmission of credit from
lenders to borrowers w/ productive investment
opportunities (Intermediation);

Manage the supply of credit;

Assess risk
Why: Fundamental Causes:
Change in Banks Economic Roles and
Incentives


Federal government’s guarantee of the banking
system – previously limited to commercial banks –
effectively extended to investment banks;
Bank assets could now be invested in risky assets w/
the real prospect that losses would be picked up by the
FDIC/U.S. Taxpayers (e.g. Moral Hazard).
49
Why: Fundamental Causes:
Change in Banks Economic Roles and
Incentives

Before bank investors and employers enjoyed
profits and losses – now much of losses absorbed
by taxpayers (e.g. Moral Hazard);

Banks and other financial institutions became
more interested in making loans, selling them in
the form of structured securities than in
economic purpose.
50
Why: Fundamental Causes:
Political Influence

“... The banks – hard to believe in a time
when we’re facing a banking crisis that many
of the banks created – are still the most
powerful lobby on Capitol Hill. And they
frankly own the place.”
Senator Richard Durbin, April 2009
51
Why: Fundamental Causes:
Political Influence

Blocked:

Volker Rule (separation of commercial and
investment bank activities);

Immediate appointment of Elizabeth Warren
52
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

Not just business avarice at work …

Economic ideology made deregulation, light
regulation, and non-regulation acceptable and
easier for politicians to acquiesce to financial
industry requests.
53
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

“… Lenders are now able to quite efficiently judge the risk
posed by individual applications [subprime mortgages]
and price that risk appropriately.”

“… Improvements have lead to rapid growth of subprime
mortgage lending … roughly 10 percent of … all
outstanding mortgages … up from just 1 or 2 percent in …
1990s.

Alan Greenspan,
Fall 2005
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

Greenspan Doctrine: “Government regulation
[of financial institutions] risks undermining
private regulation and financial stability.”
Donald Kohn, Fed vice chair
55
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

“... Professional counterparties to privately negotiated
contracts ... have demonstrated their ability to protect
themselves from losses from fraud, and counterparty
insolvencies.”

“... Aside from safety and soundness regulation of
derivatives dealers in the banking or securities laws,
regulation of derivatives transactions that are
privately negotiated by professionals is unnecessary.”
Alan Greenspan
56
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

IMF Economist Raguram Rajan questioned:

Whether deregulation and innovation had
increased risk rather than decreased risk in the
financial system.
Paper presented at Kansas City Federal
Reserve Bank Symposium, August 2005.
57
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

Response to Rajan:


Greenspan Doctrine: “Government regulation [of
financial institutions] risks undermining private
regulation and financial stability.” Donald Kohn,
Fed vice chair
“…The basic, slightly lead-eyed premise of
[Rajan’s] paper [is] misguided.” Larry Summers
58
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

“These amendments are intended to reduce regulatory
costs for broker-dealers by allowing very highly
capitalized firms that have developed robust internal
risk management practices to use those risk
management practices, such as mathematical risk
measurement models, for regulatory purposes.”
SEC Final Rule, Aug. 2004
59
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government

“Financial innovation has improved access to
credit, reduced costs and increased choice. We
should not attempt to impose restrictions on credit
providers so onerous that they prevent the
development of new products and services in the
future.”
Ben Bernanke, April 2009
60
Why: Fundamental Causes:
Ideology: Efficacy of Markets and the
Role of Government (or, Ideology
morphs into Theology)

“The injunction of Jesus to love others as ourselves is
a recognition of self interest. … We have to tolerate
inequality as a way of achieving greater prosperity
and opportunity for all.”
Brian Griffiths, Goldman Sachs, St. Paul’s
Cathedral, London, Oct. 2009
61
Electric Utility Industry Deregulation
Average Revenue per KWH (All Sectors)
1990 - 2007
12
14
Selected South-Atlantic States
6
8
10
Cents
10
8
6
Cents
12
14
Selected Mid-Atlantic States
1990
1995
2000
2005
Year
2010
1990
1995
2000
2005
2010
Year
MD
DC
NC
NJ
DE
GA
SC
62
Electric Utility Industry Deregulation
(All Sectors, Prices in cents/kWh)
1996
2008
Cents Chg
% Chg
DE
DC
6.9
7.4
12.4
13.1
5.5
5.7
79.7
77.0
MD
NJ
7.0
10.5
13.0
14.4
6.0
3.9
85.7
37.1
GA
NC
SC
6.4
6.5
5.7
8.8
8.0
7.9
2.4
1.5
2.2
37.5
23.1
38.6
Deregulated
Regulated
63
Electric Utility Industry Deregulation
Summary of Stock Holding Period Returns (%)
(1995-2005)
10 yrs. 5 yrs. 3 yrs.
Regulated
10
9
9
S&P 500
7
5
10
Exelon
Constellation
SGE
PPL
Allegheny
22
13
19
17
7
27
22
13
18
3
30
19
20
23
60
64
Electric Utility Industry Deregulation
Exelon
PSGE
PPL
Allegheny
2007
29.4
18.3
24.1
19.9
2008
29.3
13.1
17.5
14.7
Regulated Utilities
8.1
8.8
65
Selected MISO States, All Sectors, Prices
in Cents/kWh
State
1998
2008
Cents Chg
% Chg
IL
7.5
9.3
1.8
24.0
IN
5.3
7.1
1.8
34.0
MI
7.1
8.9
1.8
25.4
MN
5.7
7.8
2.1
36.8
IA
6.0
6.9
0.9
15.0
66
Disturbing Parallels: Financial and
Electric Utility Industry Deregulation

Deregulation/Light Regulation:
 Federal & State ;
 Holding Company Acts;
 Securitizations;
 Effective Abdication of Regulatory Responsibility of just
& reasonable prices:
 Indirect Regulation (SEC, FERC);
 Reliance on indirect measures of
success/competitiveness (per se growth in derivative
trading; growth in wholesale trades, etc.);
67
Disturbing Parallels: Financial and
Electric Utility Industry Deregulation

Mergers;

Prices & Profits;

Industry Influence:


Political;
Conventional Wisdom
68
Disturbing Parallels: Financial and
Electric Utility Industry Deregulation

Ideology of Competitive markets:
 Assumption that markets are
effectively/sufficiently competitive;

Forgot/Ignored:
 Economic History;
 Basic requirements for effective competition
69
Summing Up …

So what?

Concentration of economic and political
power in industries “affected with the public
interest”;

Excessive profits and prices;

Risky investments w/ Other People’s Money;
70
Summing Up …

So what?

Financial institutions “Too Big to Fail”;

Prospect of future major recessions and taxpayer bailouts
71
Summing Up …

“They were careless people, Tom and Daisy – they
smashed up things and creatures and then
retreated back into their money and their vast
carelessness ... and let other people clean up the
mess they made.”
F. Scott Fitzgerald, The Great Gatsby
72
References: Financial Sector

Krugman, Paul. The Return of Depression Economics and
the Crisis of 2008.

Johnson, Simon, and James Kwak, 13 Bankers: The Wall
Street Takeover and the Next Financial Crisis.

Shiller, Robert J, Irrational Exuberance.

Stiglitz, Joseph E., Freefall: America, Free Markets, and the
Sinking of the World Economy