Background on the Crisis
The repeal of the Glass-Steagall Act was proposed by Travelers CEO Sandy Weill in the late '90s. The idea was to break down the wall between banks and brokerages, allowing cross-marketing of financial services. On one level the concept made a lot of sense: banks could more actively market retirement vehicles whose need was demostrated by the dearth of retirement savings in America among the rapidly aging boomers. Banks had failed to service this market, as securities sales weren't a high profit area; the higher volumes at brokerages, coupled with more lucrative commission models, gave them a competitive advantage.
Weill's Travelers was an insurance company which had expanded into retailing brokerage. By incorporating Smith Barney (Traveler's brokerage arm) to Citibank branches, Weill hoped to build a cross-marketing financial powerhouse that could offer one-stop shopping for mutuals funds, annuities, insurance, stocks, and banking accounts. The overlapping markets meant that customers could be served more efficiently, at lower cost, than had been the case with traditional banks. Things worked well, at first.
Then the end of Glass-Steagall presented its first major challenge in the stock market of late '90s, when stock analysts talked up stocks that their brokerage divisions were eager to sell. The temptation to hype tech stocks was simply too high to resist at the research departments of newly combined bank/brokerages. This conflict of interest was being investigated by the SEC in 2001, when WTC 7 collapsed, perfectly into its footprint, faster than the speed of gravity. Inside WTC 7 were the offices of the Securities and Exchange Commission. Inside their offices was a safe which apparently containing the evidence of wrongdoing by the major brokerages, evidence that the brokers and analysts were misrepresenting stocks to investors, and contributing to the hype. When WTC 7 inexplicably collapsed, somehow vaporizing the safe, thousands of investigations ended (link), although the SEC has not specified which ones.
Once the analysts' conflict of interest had been realized, and reforms enacted, next came the challenge of keeping brokers honest about the debt they were selling. Brokers who sold the stock and debt of the companies their investment banking divisions were underwriting would talk up their new offerings, as to make them more saleable.
The real ghosts haunting the repeal of Glass-Steagall have been the investment banks. In newly merged bank/brokerages, private offerings made by investment banking divisions were channeled through brokers, creating a conflict of interest in understating the risk. Of course the brokers wanted to sell stock and debt, to make more commissions, and the investment bankers were eager to exaggerate the potential profits presented by their new offerings, and diminish the risks to make the offering more successful (and thus entice more would-be issuers to use their services instead of their competitors.)
The bull run in the housing market had opened up huge new opportunities in the bundling of mortgage-backed securities. Derivatives based on these SIVs or "structured investment vehicles" became a huge source of fees for bank/brokerages, who in turn traded derivates and swaps amongst themselves, under the belief that they were reinsuring the risk. While banks did take an extra step of insuring their mortgage-backed securities against default, they relied on other banks for insurance and companies like Ambac and MBIA, who could only do so much to protect defaults in a broad credit crisis like we face.
With so many Collateralized Debt Obligations (CDOs) and unregulated credit default swaps floating about, part of a $600 trillion derivatives market, investment banks were drawn into the lucrative ends of both issuing and insuring debt. Credit default swaps are arrangements between an insurer and purchaser of some form of debt that guarantees payment upon default in exchange for a lucrative fee.
The credit default swaps were supposed to cover the possibility of a default, but became a vehicle for increasing the sales of derivates by reducing the perceived level of risk. Meanwhile, the market grew so huge that one default could trigger a much broader failure as the so-called insurance couldn't cover the costs of multiple, simultaneous defaults, each of which could cause more defaults as borrowers in the first ring default and can't pay their creditors. This is the contagion Paulson and the Fed fear.
How big will it get?
Just how bad could the liquidity crisis become? Well if the banks aren't able to collect on their loans, lending will contract. Also, banks will be paying more interest out to their creditors, which in addition to other banks include foreign investors, who will be reluctant to loan more. Borrowing more from foreigners is the fuel that allows our country to sustain its massive budget and trade deficits. Without their loans, we suffer economically and whatever capital we have available ends up flowing out of the country to pay our creditors (instead of using our new borrowings to cover our interest.)
The big crisis we now face is a combination of the failure of investment bankers to control their greed, accelerated by escalating defaults that weren't anticipated by well compensated Wall Street investment bankers during rosier times.
Subprime securities compromise only a portion of the $600 trillion derivatives market. Here is Daniel Amerman, writing for Safe Haven:
"Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines."
Amerman's article goes on to describe in detail how commissions are paid--an essential component of understanding how financial markets work. Built into the credit derivatives market is a predisposition to understate risk. Here's Amerman again, form the point of view of an investment banker hungry for a large bonus:
"The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction..." See Amerman's chart for an idea how credit derivatives could pay off big.
With so many banks insuring each others' derivatives products, the whole banking industry faces collapse. Unfortunately, risks assessments treated the risk of default of one debt security independent of the risk of other defaults. Amerman explains:
"...this model assumes that each company is an independent risk. Kind of like insuring 50 homes against the chance that an electrical fault will cause one house to burn. But what if the problem is not an electrical fire, but a wildfire burning out of control, and the homes you are insuring are on a bone-dry hillside in Southern California? The risks are no longer independent, and instead of losing on just one insurance contract - you lose on 20 out of the 50 contracts."
(Note: You can view every article as one long page if you sign up as an Advocate Member, or higher).
