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The Federal Reserve plans to spend $700 billion (adding to our current $10.6 trillion deficit) to buy up mortgage-related debt from our ailing banks so the banks will be able to lend again. Credit is, after all, what America runs on. As Fed Chairman Ben Bernanke put it, this plan is “the last wrench in the toolbox” to fix our financial crisis. But how did we get here? Here’s where the blame game leads us…
Alan Greenspan
He had interest rates too low for too long, which resulted in the housing bubble. But what is too low too long? I don’t blame Greenspan, though he did push subprime lending, lauding the “innovation and structural change in the financial services industry … critical in providing expanded access to credit for the vast majority of consumers, including those of limited means.”
Consolidated Supervised Entities Program
In 2004 the SEC changed the rules under which banks with at least $5 billion of capital calculate their gross leverage ratios. It basically raised the leverage ratio to 30, from about half that. A leverage ratio measures the amount of debt a company has compared to its total capital. A leverage ratio of 30 means that 30% of a bank’s total capital is debt. The banks could take on more debt, which was good when times were good because it allowed them to make more transactions. However, high levels of debt means it takes only a small decline in the value of the firm for the bank to go bankrupt.
Five investment banks fell under the program: Goldman, Merrill, Lehman, Bear, and Morgan Stanley. It is noted that at the time of decline, Merrill had a leverage ratio of about 40, Lehman of 36.
Goodbye, Uptick Rule
In 2007, the SEC eliminated the “uptick rule,” which prohibited sellers from shorting a share when the stock was selling for lower than the previous trade. This rule was instituted after the Crash of 1929, as shorting was alleged to be the culprit of the crash. After research and assessment of the rule, the SEC suggested the uptick didn’t matter and lifted the ban. Now, shorting has been blamed for today’s crisis and has been put on a temporary ban.
Hedge Funds
Hedge funds aren’t as highly levered as investment banks, but they do a lot of shorting. Perhaps their ubiquity spurred the financial decline. They’ll pay whether or not that is the case. About 90% of hedge funds are currently losing money and that’s sure to increase with the advent of the short selling ban.
Ratings Agencies
It’s not the Fed’s job to allocate or assess risk, so we can’t truly blame Greenspan. But the job is someone’s responsibility. Whose? The ratings agencies, these government sanction oligopolies like Moody’s, S&P, and Fitch. See, the ratings agencies slapped high ratings on all of the Mortgage Backed Securities. An MBS is a bundle of a bunch of loans, some dodgy, some not, that are all rolled into one tradable security, like a stock. The Ratings Agencies rate all securities based on their level of risk. Again, the ratings are a lot like school grades: A good, B okay/bad, C junk. The Ratings Agencies aren’t regulated by the SEC, and so were not really watched throughout this whole game. So they were able to slap high ratings on risky MBS’ last year, and then downgrade AIG last week, putting the onus of bailing them out on you and me.
The SEC
The SEC was created in 1933 to protect small investors against securities fraud. It doesn’t have robust oversight over all financial entities, ratings agencies included, and is not really equipped for our financial world.
The Deregulatory Financial Modernization Act of 1999
In 1933, Congress established a set of banking regulations under the Glass Steagall Act. Thinking commercial banks (ones that take deposits from everyday citizens) caused the Crash of 1929, the act separated the commercial banks and the investment banks. This way investment banks would take on risky investments, and commercial banks could protect its members by not doing that. Before 1933, there were few investment banks and the Glass Steagall Act spurred Wall Street as we know (ahem, I mean knew) it.
The Glass Steagall Act was repealed, however, in 1999 under the Deregulatory Financial Modernization (Gramm-Leach-Bliley Act) Act. This allowed the commercial banks to take on the same risky bets that investment banks did. A commercial bank (one that sells to you and me, like Citigroup or WaMU) could trade Mortgage Backed Securities, Collateralized Debt Obligations, and other Structured Investment Vehicles. So basically, it allowed the guys that are usually safe and who hold my life savings to take on risky investments and get all mixed up in the mess too.
The Glass Steagall Act of 1933
Or you could blame the Glass Steagall Act of 1933 (mentioned above) itself, for really creating the stand alone investment bank in the US.
Be sure to read more of what Diana learned today here.
Comments (10)
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Brilliant article! Very informative. Way to summarize some really complicated and confusing information. I love Mental Floss!
Amy
posted by Amy on 9-25-2008 at 12:51 pm
I blame all you idiots who bought stuff they couldnt afford. And now the homeowners are looking for handouts??? Hahahah, what a joke. I hope you all get whats coming to you. (Read: homeless) Next time understand what your doing and getting in to before you make a $100,000+ deal.
posted by David on 9-25-2008 at 1:58 pm
You forgot homeowners for buying homes they couldn’t afford. Wall Street wouldn’t have been able to package the mortgages had the mortgages not existed in the first place.
posted by Noah on 9-25-2008 at 2:06 pm
Leverage ratio doesnt measure amount of debt to total amount of capital (=total assets), it usually measures debt to total amount of equity. So a levereage ratio of 30 actually means that for each 1 unit in equity it has 30 units of debt, which means that 97% of total assets is debt (1/31 is the equity/total assets ratio..). So banks are heavily leveraged and their investments really can’t go too sour before they go bankrupt.
I would actually say that both rating agencies are to blame because they gave too good rating for the Special Purpose Vehicles. For instance MBOs and CDOs were actually seen as as risk free as government bonds due to their structure, which naturally wasn’t the case with a hindsight.
But I wouldn’t want to blame risk management and rating agencys only, i think that Greenspan (and here in europe ECB) as they have kept the cost of money too low during a huge economic boom due to low inflation, which was caused for instance by chinese imports. Keeping money cheap lead that investors needed to take more risk in order to get better return, which led to demand for risk, which lead that people didnt care that they took too much risk for too little return.
posted by european on 9-25-2008 at 2:31 pm
You forgot the Community Reinvestment Act which required lenders to make the risky loans to those who really can’t afford the homes they were buying. Once the act was strengthened by the Clinton administration in 1995 to the point that lenders were forced to enter loans that they normally would take the risk of entering, these businesses were operating outside of acceptable risk and Fannie Mae and Freddie Mac were created to prop up the entire industry.
The Bush administration attempted to correct this in 2003 but the legislation was blocked along party lines and went nowhere.
I remember speaking to a small bank loan officer about two years ago and she was telling me they are required to enter into a certain amount of home loans with JOBLESS people per year and report their compliance to the Community Reinvestment Act to the FDIC. What business would be willing to enter into such a significant investment as property and a house with someone who has absolutely NO means of giving the business a return on their investment?
posted by Mike on 9-25-2008 at 9:14 pm
You forgot the Community Reinvestment Act which required lenders to make the risky loans to those who really can’t afford the homes they were buying. Once the act was strengthened by the Clinton administration in 1995 to the point that lenders were forced to enter loans that they normally would take the risk of entering, these businesses were operating outside of acceptable risk and Fannie Mae and Freddie Mac were created to prop up the entire industry.
The Bush administration attempted to correct this in 2003 but the legislation was blocked along party lines and went nowhere.
I remember speaking to a small bank loan officer about two years ago and she was telling me they are required to enter into a certain amount of home loans with JOBLESS people per year and report their compliance to the Community Reinvestment Act to the FDIC. What business would be willing to enter into such a significant investment as property and a house with someone who has absolutely NO means of giving the business the return on their investment?
posted by Mike on 9-25-2008 at 9:17 pm
To be fair, some of the homeowners who got subprime mortgages were pressured into them. I know this partially because I was buying a house during the boom (found a great deal, though, house barely lost any value) and the mortgage broker tried to talk us into a lower rate. We didn’t accept, and it turns out that lower rate was an ARM, one that would’ve adjusted to a higher rate around now. Many people weren’t talked out of that rate, or were told that, yes, they could borrow with no money down.
Then again, there were also those people who really shouldn’t have bought at that point in time.
posted by NicoNico on 9-25-2008 at 9:50 pm
What? Discussion about the mortgage crisis void of knee-jerk partisan filtering and blame-shifting? Amazing. This thing is way too complicated (and frankly too serious) to point one judging finger in one direction. There’s a stack of greedy people and bad decisions a mile high and we’re all taking a hit because of it.
posted by Jamey on 9-26-2008 at 9:20 am
The SEC was actually established by the 1934 Securities Exchange Act. The Securities Act of 1933 required a Prospectus to be distributed prior to an IPO but did not establish a regulatory board.
Part of the reason behind the inaccurate ratings is the .com boom. Moody’s and S&P both using accountants auditing companies transactions to determine the companies risk and establish a rating. Due to the .com boom, these companies had to rapidly hire additional accountants and were forced to allow inexperienced accountants determine the ratings on investments.
As some investments with high ratings began to fail, it lowered consumer confidence across the board…after all if one company is mislabeled how many more are.
Consumer confidence is dangerously low…the lowest it’s been since 1929, and I think we all know what happened in 1929.
posted by Ryan on 9-27-2008 at 7:04 pm
“A leverage ratio of 30 means that 30% of a bank’s total capital is debt.”
If Diana Wolf actually believes this she shouldn’t be published on your site. Let’s just agree to assume that we cannot rely on what she says since it is at such variance with reality. A leverage ratio of 30 means something quite different than what she says.
posted by Ckrob on 3-23-2009 at 2:59 pm