Authors: Barry Ritholtz
Bailout Nation (23 page)
Immediately after the CFMA legislation was passed, a few observers raised concerns. Frank Partnoy, a former derivatives trader at Morgan Stanley (now a law professor at the University of San Diego), is the author of
F.I.A.S.C.O.: Blood in the Water on Wall Street
, a 1997 book warning about the danger of derivatives. In 2000, referring to CFMA, he noted:
F.I.A.S.C.O.: Blood in the Water on Wall Street
, a 1997 book warning about the danger of derivatives. In 2000, referring to CFMA, he noted:
The new bill's second impact, in the swaps market, is less direct but still worrisome. The act ends an argument about whether swaps qualify for regulation by making it clear that they are not regulated if a participating company or individual has $10 million in assets. That means that the swaps activities of most companies and mutual funds are not regulated. Yet few investors know what swaps are. And there's almost no publicly available information about specific trades in this market, now bigger than many stock or bond markets. By contrast, futures trading takes place on exchanges; an investor can find closing quotes for futures in a newspaper's financial section.
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Even Partnoy's prescient fears failed to anticipate exactly how devastating the results of the legislation would be. The potential for financial Armageddon was unconscionably enormous (see
Figure 11.1
). The CFMA allowed unregulated, unsupervised, unreserved derivatives trades that were ultimately responsible for the biggest bankruptcies in American history. It created the monster that brought down several important companies.
Figure 11.1
). The CFMA allowed unregulated, unsupervised, unreserved derivatives trades that were ultimately responsible for the biggest bankruptcies in American history. It created the monster that brought down several important companies.
Figure 11.1
Outstanding Value of Credit Default Swaps
Outstanding Value of Credit Default Swaps
SOURCE: International Swaps and Derivatives Association
First came Bear Stearns, which collapsed in March 2008. Bear's total derivatives holdings were estimated at $9 trillion; JPMorgan Chase was believed to have had about 40 percent of Bear's exposure, leading numerous wags to surmise that was why JPMorgan bought Bear.
Lehman Brothers also had a decent-sized derivatives book, estimated at between $2 trillion and $4 trillion when it collapsed into bankruptcy in September 2008. The Lehman failure triggered waves of disruption in the CDS market.
Shortly after Lehman fell, AIG, the world's largest insurance company, followed. AIG was nationalized by Treasury and the Fed (in exchange for 79.9 percent of its stock) in October 2008. The $68 billion bailout was only the first of four U.S. government bailouts totaling over $175 billion as of March 2009.
Then there were the monoline insurersâAmbac, Financial Guaranty Insurance Company (FGIC), and MBIA Insurance Corporation. These were once highly profitable, low-risk, municipal bond insurance firms. Their businesses were demolished once they started dabbling in derivative products. Ambac lost 99 percent of its market cap. MBIA is marginally better, but still trading far below its former $25 billion peak valuation. Private bond insurer FGIC, once partly owned by General Electric and Blackstone, has long since given up any hopes of going public.
The thought process behind the CFMAâreally more of a religious beliefâwas that self-interested, rational market participants would not endanger themselves or their firms. No one, went the thinking, would knowingly engage in self-destructive, reckless behavior. Markets are perfectly efficient, humans are rational (not emotional), and financial firms and markets can self-regulate. In theory, Adam Smith's invisible hand keeps the worst impulses of bad players in check.
In the real world, however, things operated quite differently. Perfectly rational humans and perfectly efficient markets exist only in economics textbooks. In reality, this belief system is sheer, unadulterated nonsense. Compensation systems can get out of alignment with shareholder interests. Short-term profits often trump longer-term sustainability. Complexity is often ignored; risk is poorly understood.
What the deregulatory zealots have failed to understand is that we don't regulate markets; what we do is regulate the behaviors of the human beings who
work in those markets
. And humans need to know what is acceptable and allowable behavior. Without rules and guidelines, people misbehaveâand even more so when large sums of money are involved.
work in those markets
. And humans need to know what is acceptable and allowable behavior. Without rules and guidelines, people misbehaveâand even more so when large sums of money are involved.
The way markets manage to self-regulate companies that make bad decisions is by annihilating them. The theory that self-regulating markets would prevent these poor decisions from occurring in the first place is wrong; the market instead brutally punishes those who made bad risk management decisions. But prevention? Humans simply aren't that clever.
The belief that markets self-regulate reads like a bad joke: Two economists are walking across campus. The younger one points out a $20 bill on the ground. “Nonsense,” says the senior, tenured professor. “If there was $20 on the ground, someone would have picked it up.”
Self-regulating markets differ from our two economists in one major way: Bad jokes don't destroy economies.
The last six months have made it abundantly clear that voluntary regulation does not work.
âChristopher Cox, former chairman of the Securities and Exchange Commission, September 26, 2008
N
ot only are market participants not always rational, they often act inadvertently against their own best interests.
ot only are market participants not always rational, they often act inadvertently against their own best interests.
My favorite example: To ensure that Wall Street firms maintained adequate capital levels, the Securities and Exchange Commission employed what became known as the “net capital rule.” From 1975 to 2004, this was the primary tool used to prevent investment banks from taking on too much leverage. The rule limited their ratio of debt to net capital to 12 to 1; in other words, $12 was the maximum they could borrow for every $1 in capital.
For the most part, it worked fine. Firms maintained sufficient liquidity to meet their needs; banking disasters were few and far between. But bankers were agitating for a less restrictive leverage rule. They were complaining to the SEC that this excessive regulation was costly. To them, the rules were limiting their return on equity. Loosening the net cap rules would let them leverage their capital further, and therefore earn greater profits. Sure, it would increase their risksâsignificantly soâbut “Hey, we're a bunch of smart guysâwe can handle it.”
Or so the investment banks argued.
In 2004, the five biggest investment banksâGoldman Sachs, Merrill Lynch, Lehman Brothers, Bear Stearns, and Morgan Stanleyâgot their wish. Led by Goldman Sachs CEO Hank Paulsonâthe future Treasury Secretary/bailout kingâthe SEC acquiesced to grant them (and only them) a special exemption. At the time, it was (ironically) called “the Bear Stearns rule.” The firms with a market capitalization over $5 billion would no longer be governed by 12-to-1 net cap rules.
As soon as this exemption was passed, the collection of brainiacs that ran the five big firms promptly levered up 30, 35, even 40 to 1. You read that rightâafter 30 years of effective risk management, at the first opportunity they whacked up the leverage as far as they could.
Thus we learn that the tragic financial events of 2008 and 2009 are not an unfortunate accident. Rather, they are the results of a conscious SEC decision to allow these firms to legally violate net capital rules that had existed for decades, limiting broker-dealers' debt-to-net-capital ratio to 12-to-1. You couldn't make this stuff up if you tried.
Writing in the
American Banker
, Lee A. Pickard, former director of SEC's trading and markets division and an author of the original net capital rule in 1975, declared:
American Banker
, Lee A. Pickard, former director of SEC's trading and markets division and an author of the original net capital rule in 1975, declared:
The SEC's basic net capital rule, one of the prominent successes in federal financial regulatory oversight, had an excellent track record in preserving the securities markets' financial integrity and protecting customer assets. There have been very few liquidations of broker-dealers and virtually no customer or interdealer losses due to broker-dealer insolvency during the past 33 years.
Under an alternative approach adopted by the SEC in 2004, broker-dealers with, in practice, at least $5 billion of capital (such as Bear Stearns) were permitted to avoid the haircuts on securities positions and the limitations on indebtedness contained in the basic net capital rule. Instead, the alternative net capital program relies heavily on a risk management control system, mathematical models to price positions, value-at-risk models, and close SEC oversight.
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In Latin, we call that
Res ipsa loquitur
â“the thing speaks for itself.” All five exempt brokers no longer exist in their prior forms. As a result of the Bear Stearns rule, Bear Stearns was the first to go belly-up. Lehman became the largest bankruptcy in American history, and Merrill Lynch, on the verge of blowing up, scrambled to sell itself on the cheap to Bank of America. Morgan Stanley and Goldman Sachs received capital injections from the Feds, and had to change their status to commercial banksâto make it easier to obtain even more government bailout money.
Res ipsa loquitur
â“the thing speaks for itself.” All five exempt brokers no longer exist in their prior forms. As a result of the Bear Stearns rule, Bear Stearns was the first to go belly-up. Lehman became the largest bankruptcy in American history, and Merrill Lynch, on the verge of blowing up, scrambled to sell itself on the cheap to Bank of America. Morgan Stanley and Goldman Sachs received capital injections from the Feds, and had to change their status to commercial banksâto make it easier to obtain even more government bailout money.
Relying on the self-interest of individuals and firms to prevent egregiously reckless and irresponsible behavior only served to enrich senior management at the expense of shareholders, taxpayers, and employees.
So much for
that
idea.
that
idea.
T
he newfangled lend-to-securitize mortgage originators discussed previously were covered by a patchwork of state regulations. They should also have been supervised by the Federal Reserve.
he newfangled lend-to-securitize mortgage originators discussed previously were covered by a patchwork of state regulations. They should also have been supervised by the Federal Reserve.
Only they weren't.
At the Fed, Chairman Alan Greenspan
purposefully
chose not to supervise these new mortgage makers. This was yet another example of Greenspan's free-market beliefs blinding him to the simple realities of the real world. One of the duties of the Federal Reserve is to supervise banking and lending. However, the Fed chief did not believe these lenders needed any supervision. Remember, he believed that market forces would make these lenders police themselves.
purposefully
chose not to supervise these new mortgage makers. This was yet another example of Greenspan's free-market beliefs blinding him to the simple realities of the real world. One of the duties of the Federal Reserve is to supervise banking and lending. However, the Fed chief did not believe these lenders needed any supervision. Remember, he believed that market forces would make these lenders police themselves.
Not only did the Fed do nothing about these changes in lending standards, they were actually praised by Greenspan. Here is what he said in 2005:
Innovation has brought about a multitude of new products, such as subprime loans and niche credit programs for immigrants
. . .
. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers
...
. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending
. . .
fostering constructive innovation that is both responsive to market demand and beneficial to consumers.
11
. . .
. With these advances in technology, lenders have taken advantage of credit-scoring models and other techniques for efficiently extending credit to a broader spectrum of consumers
...
. Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending
. . .
fostering constructive innovation that is both responsive to market demand and beneficial to consumers.
11
There was a reason why some people in the past had been denied credit: They simply could not afford the homes they tried to purchase. Any mortgage structure that ignores the borrower's ability to service the loan is destined for failure.
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