Financial Crisis

Photo of Coit Tower mural segment, Banking and Law, by George Harris

Former Federal Reserve Chair Arthur Burns' prescient warning in 1987 about the growing risk of a system-wide financial crisis:

“A special concern about the larger banks arises from the growing process of securitization in financial markets . . . .  Moreover, there is a danger that some – perhaps many – banks may be tempted to seek out higher-risk loans in an effort to raise the average yield of their portfolios.

Other problems for regulators arise from the current process of financial innovation.  Given the novelty of the transactions in which banks are engaging, their extraordinary diversity, and their frequent changes in form, the larger banks must be finding it extremely difficult to develop a record of experience to guide them along safe lines in current operations.  The history of some innovations is as yet much too brief for a firm assessment, and since all of the experience has been accumulated during a period of relative prosperity, its relevance to any future period of economic adversity is uncertain.  Indeed, since the enormous complexity of some banking transactions makes them the natural province of financial technicians skilled in higher mathematics, one might wonder how fully the chief executive officers of our major banks appreciate the precise extent to which their banks’ solvency is on the line in any month or, for that matter, on any day. . . . " 

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Photo: Segment of George Harris' mural "Banking and Law" (1934), Coit Tower, San Francisco

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Geithner approved full price bailout of A.I.G.'s bank trading partners, says NY Fed General Counsel; analysts say payout could have been done at fraction of that cost

Newly released documents show Federal Reserve officials were "deeply divided" over the structure of the bailout of American International Group (A.I.G.), reports the NY Times ("A Rift at the Fed Over the Bailout of A.I.G." 1/23/10) "The Fed’s decision to pay A.I.G.’s trading partners in full on tens of billions of dollars in contracts has been controversial because many analysts say they believe the government could have negotiated a price for a fraction of that amount, reducing taxpayer funds used in the rescue. Similar contracts were being settled at heavy discounts in other deals where the government was not involved", says the Times.

Current Obama administration Treasury Secretary Timothy Geithner, who at the time was president of the New York Federal Reserve, approved the 100% on the dollar payoff of A.I.G.'s trading partner banks, according to the Times, citing the NY Federal Reserve's General Counsel, Thomas C. Baxter, and other sources. As the A.I.G. bailout was worked out, on September 16, 2008, Geithner joined in phone calls to "top financial executives, including Lloyd Blankfein of Goldman Sachs, Jamie Dimon of J.P. Morgan Chase and Vikram Pandit of Citigroup", according to the Washington Post ("New York Fed documents reveal more detail about AIG bailout", 1/24/10)

Fortune reported that the banks that benefitted from the A.I.G. bailout included Goldman Sachs, Merrill Lynch International, and others. (See CNN.money / Fortune, "Revealed: 15 AIG bailout counterparties" 3/9/09) (See also, Bloomberg.com, "Goldman, Merrill Collect Billions After Fed's AIG Bailout Loans" 9/29/08.) A.I.G. ultimately disclosed that the biggest payouts went to Goldman Sachs and the French bank, Societe Generale, according to the Wall Street Journal. ("N.Y. Fed Told AIG to Shield Payouts," 1/8/10)

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The Financial Crisis

There's been a lot of pretending, in the media and in our government, that nobody saw this financial crisis coming. That's simply not true. Former Fed Chair Arthur Burns, for one, warned of almost every single risky aspect being engineered into the financial system that would lead to the current crisis, and he did so more than 20 years ago. (See sidebar at right.) Burns cautioned about the risks inherent in the complex securitizations being fabricated, the difficulties assessing the risks in new financial products that were constantly being invented, the possibility that the "failure of a single major bank may precipitate ‘systemic’ failure", and that, with the internationalization of finance, any such financial shock could spread across the world with "alarming speed."

The current financial crisis was sparked in the summer of 2007 with the collapse of the subprime mortgage market, and the more general bursting of the speculative housing bubble.  As the U.S. Treasury has itself acknowledged, the bursting of this bubble generated losses for investors and banks which “were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of complex securitization products, some of whose risks were not fully understood.” (Go to Treasury press release #tg-65, 3/23/09. )

Recognition of the role of the housing bubble, lax underwriting standards by lenders and the proliferation of complex securitization products only acknowledges part of the origins of the crisis, however.  This crisis is largely the result of financial deregulation by U.S. politicians and regulators. This financial deregulation has been taking place for about 30 years, during Democratic and Republican administrations, but it really gathered momentum under Presidents Clinton and Bush, and the Congress that served alongside them.

This dangerous deregulation included the 1999 enactment, under Clinton, of the Gramm-Leach-Bliley Act (a/k/a the Financial Services Modernization Act), repealing the Glass-Steagall Act. The Gramm-Leach-Bliley Act ended the legal separation of investment banking and commercial banking that had been put into place in the 1930s by Glass-Steagall to protect against some of the speculative depradations of that era. A year later, Clinton also signed the Commodity Futures Modernization Act, pushed by Senator Phil Gramm and others. As the New York Times noted (11/17/08), the “Commodity Futures Modernization Act . . . would open the door to unregulated trading of credit default swaps, the financial instruments blamed, in part, for the current economic meltdown.”

The federal regulators at the SEC would compound the problem on April 28, 2004, by changing the "net capital rule" to allow some of the country's largest investment banks an exemption from old regulations limiting the amount of debt they could take on. (See the 10/2/08 NY Times report on this rule change, and how it came about at NY Times Report.)

Five investment banks "led the charge" for the SEC rule change "including Goldman Sachs, which was headed by Henry M. Paulson Jr. Two years later, he left to become Treasury secretary", reported the Times. (In the final months of the Bush administration, when the financial catastrophe ensued, in part, due to the uncapped investment bank leveraging Goldman Sachs had lobbied for, Paulson, now Treasury Secretary, would arrange a massive public bailout of some of the largest commercial and investment banks, including Goldman Sachs.)

After the SEC's 2004 rule change, investment banking firm Bear Stearns would push its borrowing ratio (leverage ratio) to 33:1, that is, $33 borrowed for every $1 it actually had in equity (its own money), according to the Times. This dangerous level of borrowing allowed by the SEC not only placed these investment banks at risk, it placed at risk many of the investors they borrowed from, and ultimately, it placed at risk funds from the U.S. taxpayer. Within four years, the Federal Reserve would step in with $29 billion in public funds to back a hastily arranged takeover of the near-bankrupt Bear Stearns, as just one of the multi-billion dollar bailout deals the Federal Reserve and the U.S. Treasury have rigged up to save the banks.

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Fore more background on the financial crisis, go to Resources on the Financial Crisis.

Page last modified 1/24/10