In 1999, the Clinton administration, with the support of a majority of Democrats and Republicans, repealed the Glass-Steagall Act effectively allowing the merger of commercial and investment banking. "The Glass-Steagall Act is no longer relevant" Bill Clinton publicly declared. Nine years later, the collapse of the US housing market would trigger a global financial crisis.
The Glass Steagall Act was enacted in 1933 and introduced a series of banking reforms that were designed to control speculation by banks and other financial institutions that controlled deposit and investment monies. It was a consumer protection act with provisions to separate commercial and investment banking. Banks held depositors money and the purpose of the act was to keep it separate from the riskier investment market. If depositors wanted to invest, they could do so in investment markets but if not, they didn't have to worry about their money being at risk through their banking institution's actions. It was a policy that worked until the Glass Steagall Act was repealed and replaced by the Financial Modernization Act. With the support of the Clinton administration, the Financial Modernization Act effectively merged commercial and investing banking allowing banks to risk their depositors money.
Until the Clinton administration repealed the Glass Steagall Act, banks were restricted from doing some of the things they wanted to do. They were unable to risk huge pools of depositor's money on investments and speculation. After repealing the Glass Steagall Act and replacing it with Financial Modernization Act, commercial banks played a crucial role as buyers and sellers of mortgage-backed securities, credit-default swaps and other explosive financial derivatives. The Chinese firewall between investment and commercial banking had been torn down and billions in depositor savings were being risked by commercial banks on new financial products. Let's take a look at some of these products:
- 1) Subprime Mortgages: Banks pushed lenders to take on these products because they offered higher yields than traditional mortgage. Pools of higher yielding subprime mortgages were packaged into MBS and sold to investors lured by the higher yields.
- 2) Adjustable Rate Mortgages (ARM): Offered low teaser rates for limited time periods to entice home buyers. After the time period elapsed, rates would reset at a much higher market value.
- 3) Mortgage Backed Securities (MBS): Banks issuing loans would pool these assets together securitizing and selling them to other investors. Essentially, a mortgage backed security is a way for a bank to lend mortgages to its customers without having to worry about whether the customers have the assets to cover the loan. Instead, the bank acts as a broker between the home buyer and the investors willing to purchase securitized mortgages. Pools of higher yielding subprime mortgages made MBS more appealing to yield hungry pension funds.
- 4) Collateralized Debt Obligations (CDO): are a type of structured asset backed security (ABS) with multiple tranches that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed income underlying assets. Banks created and sold CDO's to investors while betting against them with CDS.
- 5) Credit Default Swaps (CDS): Are essentially an insurance policy on an asset. The holder of an asset buys a CDS to receive credit protection on their asset. Sellers of the CDS guarantee the credit worthiness of the debt security. For example, if an investor purchased a loan from the bank and the homeowner defaulted on payment, the investor would be protected from loss if they purchased a credit default swap against the asset. Financial institutions selling CDS did not limit the selling of the swaps to the holder of the asset. Anyone willing to purchase a credit default swap could bet against the solvency of an asset by purchasing a CDS earning the banks additional premiums.
- 6) Derivatives: A security whose price is dependent upon or derived from one or more underlying assets. Derivatives are generally used to hedge against risk. For example a Canadian investor could purchase a contract to buy US$ at a fixed exchange rate a year into the future.
Subprime mortgage (1) holders, unable to meet interest payments in an environment of rising rates defaulted on mass. MBS (3) and CDO (4) created by pooling thousands of individual subprime mortgages (1) together before being sold off to investors were overwhelmed by the number of loan defaults losing investors, including banks, billions of dollars. Savvy investors and banks holding CDS (5) as "insurance" profited from the collapse of MBS (3) and CDO (4). In later years, wave after wave of ARM (2) reset at higher rates leading to additional defaults. 4 years later, deleveraging is still taking place.
The result of reckless lending has been high unemployment and a slugish economy for the last 5 years. Record amounts of cash were injected into the system to prevent the collapse of companies deemed to big to fail. No one was held accountable for the collapse of the financial system. Rather than blaming the individual, you could say the financial collapse resulted from the actions of a collective of individuals encouraged to make poor decisions by a poorly designed system. Perhaps the responsibility lies in the hands of those who repealed the Glass Steagall Act, but that is another story.
No comments:
Post a Comment