Financial and economic crises — bought and paid for.

Our economy has driven off a cliff and most Americans have to be wondering how it happened. How did we go from a nation of steady and growing wealth to the financial abyss so fast?

The general reasons have been well publicized.  The people managing Wall Street investment banks, commercial banks and hedge funds made buckets of money by leveraging their firms to the hilt in order to gamble on exotic securities backed by bad loans. Then their house of cards collapsed and brought our economy down with it.

But why wasn’t there regulation and oversight to restrain all the irresponsible bets? Where were the federal government and its watchdog agencies?  A new report issued by the Consumer Education Foundation titled, “Sold Out – How Wall Street and Washington Betrayed America”, bluntly and with documentation, asserts that over the past 30 years, the financial interests spent more than $5 billion on influence peddling, $1.7 billion on political contributions and $3.4 billion on lobbying. It was worth every farthing!

The 231 page Report (including a 129 page list of who paid for preferential legislation and/or lax regulation and the persons who received the largesse is must reading. While this monumental failure of the regulators to regulate was a feature of the Republican Bush Administration (see, for example, my article cited below), the “sell out” also was in effect during the Clinton and Reagan eras.  The failure of government to protect us from the improper actions of the financial industry was a bi-partisan affair.

Basically, the banking and investment companies have suffered from self inflicted wounds.  Investment and commercial banks, hedge funds and major insurance companies made reckless bets using borrowed money. They created and trafficked in strange and poorly created investment vehicles that even their top executives and directors and stockholders didn’t understand. They hid risky investments in indecipherable reports.  They engaged in unconscionable predatory lending that offered huge profits for a time, but led to dire consequences when the loans proved worthless. They created, maintained and justified a housing bubble, the bursting of which has thrown the United States and the world into a deep recession, resulted in a foreclosure epidemic that has torn apart communities across the country.

How was this done?  By a partnership of executives armed with baskets of bribes and politicians of both parties willing – no,  anxious – to be bribed.

The Report from the Consumer Education Foundation lists a number of events that, in sum, were the cause of the problems that must be fixed by the Obama administration. The Executive Summary states the theme of the study and the two messages it sends.

First, the details matter. The report documents a dozen specific deregulatory steps (including failures to regulate and failures to enforce existing regulations) that enabled Wall Street to crash the financial system. Second, Wall Street didn’t obtain these regulatory abeyances based on the force of its arguments. At every step, critics warned of the dangers of further deregulation. Their evidence-based claims could not offset the political and economic muscle of Wall Street. The financial sector showered campaign contributions on politicians from both parties, invested heavily in a legion of lobbyists, paid academics and think tanks to justify their preferred policy positions, and cultivated a pliant media — especially a cheerleading business media complex.

There were, the Foundation states, 12 events that have led to the present problems.  This post will cover the first six of these events; my second will describe the remaining six. Essentially they all relate to a systematic move toward deregulation, the consequences of that move and the process by which big financial firms and their political allies maneuvered to achieve their deregulatory objective.  The subsequent and final post will cite chapter and verse of who paid for what and who took.  It is not a pretty picture, damning Republicans and Democrats alike.

I

In 1999, Congress repealed the Banking Act of 1933) and related laws, which prohibited banks

from offering investment banking and insurance services.  The year before, Citibank and insurance giant Travelers Group merged, a move that was illegal at the time, but for which they were given a two-year “pass” on the assumption that they would be able to obtain (purchase? Bribe?) a change in the law at a future date. They did just that! The new law helped create the conditions in which banks invested monies from checking and savings accounts into “creative” (i.e., risky but lucrative) financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that rocked the financial markets in 2008.

II

Banks and other financial institutions began excluding their more risky holdings, such as securitized mortgages, from their balance sheets.  This hid the true condition of the company to investors, allowed banks to appear far more solvent than they were. Another consequence was the banks didn’t have to hold capital reserves as against the risk of default — thus leaving them so vulnerable.

Off-balance sheet operations are permitted by Financial Accounting Standards Board

Rules written at the urging of big banks. The Securities Industry and Financial Markets

Association and the American Securitization Forum are among the lobby interests now blocking efforts to get this rule reformed.

III

A definition of “financial derivatives” is necessary for those of us not familiar with the term. It is a financial instrument whose value is determined by the value of an underlying financial asset, such as a mortgage contract, stock or bond, or by financial conditions, such as interest rates or currency values. The value of the contract is determined by fluctuations in the price of the underlying asset. Most derivatives are characterized by high leverage, meaning they are bought with enormous amounts of borrowed money. Traditional derivatives are not new, future contracts on commodities are commonplace.  These are traded openly in regulated open, public markets or exchanges. Financial derivatives, by contrast, are negotiated and traded privately (not on public exchanges) and are not subjected to public disclosure, government supervision or other requirements applicable to those traded on exchanges

“Financial Derivatives” were left unregulated at the insistence of the Clinton administration. In 2003, Warren Buffett called these exotic instruments “weapons of mass financial destruction“. And it was generally believed in the financial community that these Derivatives were a time bomb. The Commodity Futures Trading Commission (CFTC) has jurisdiction over futures, options and other derivatives connected to commodities. During the Clinton administration, the CFTC sought to exert regulatory control over financial derivatives. The agency proposal was strongly opposed by then Treasury Secretary Robert Rubin and, above all, Federal Reserve Board Chairman Alan Greenspan. They challenged the agency’s jurisdictional authority; and insisted that CFTC regulation might endanger existing financial activity.  Deputy Treasury Secretary Lawrence Summers told Congress that CFTC proposals would cast “a shadow of regulatory uncertainty over an otherwise thriving market.”

IV

Not only was the Executive branch of the government reluctant to regulate these derivatives, Congress was eager to join in the process. The deregulation — or non-regulation — of financial derivatives was settled by the Commodities Futures Modernization Act (CFMA). This law was engineered by Senator Phil Gramm and exempted financial derivatives from regulation and helped create the current financial crisis.

V

Some of the previous issues may seem esoteric.  But the next ones are not!   The Securities and Exchange Commission decided that bank regulation should be voluntary and regulated by the banks themselves.  The fox guarding the hen house!

In 1975, the SEC’s trading and markets division promulgated a rule requiring investment banks to maintain a debt-to-net capital ratio of less than 12 to 1. It forbid trading in securities if the ratio reached or exceeded 12 to 1, so most companies maintained a ratio far below it. In 2004, however, the SEC gave in to  big investment banks — led by Goldman Sachs, and its then-chairman, Henry Paulson — and authorized investment banks to develop their own net capital requirements in accordance with standards published by the Basel Committee on Banking Supervision. This essentially involved complicated mathematical formulae that imposed no real limits and was voluntarily administered. With this new freedom, investment banks pushed borrowing ratios to as high as 40 to 1, as in the case of Merrill Lynch. This “super leverage” not only made the investment banks more vulnerable when the housing bubble burst, it enabled the banks to create a more tangled mess of derivative investments.  In short, voluntary regulation was a complete failure.

VI

By 1988 international bank authorities had agreed to extent the rule of no-rule voluntary bank regulation worldwide; by a series of collective summits and  reports, collectively referred to as Basel I and II, banks throughout  the world were left to regulate themselves.  Not surprisingly, the results in other countries mirrored our own experience.

The story continues . . . .

[The substance of this post has been previously published in Examiner.com.]

Interested readers are referred to:

http://www.associatedcontent.com/article/211310/the_bush_administrations_disdain_for.html?cat=37

http://www.wallstreetwatch.org/reports/sold_out.pdf

Tags: us economy