The time has come for new year’s
resolutions. The House passed the Wall
Street Reform and Consumer Protection Act
of 2009 (H.R. 4173) on December 11, 2009.
It gives $4 trillion in “emergency
funding” to our largest banks during
the next financial crisis. Instead of reform,
Congress offers even bigger bailouts. Unless
we change direction, we will have another
crisis by 2015. Congress has made all the
wrong moves to guarantee it.
The economy did not just have a heart attack; we are
suffering from financial appendicitis. Instead of doing the
necessary
surgery, Congress is prescribing potent addictive painkillers.
How
did we get here? Housing is the largest component of our
economy. Cheap money from the Federal Reserve, crippling
of
states rights to reign in mortgage lenders, and failure to
enforce securities laws allowed the largest Ponzi scheme in
the history of the capital markets to flourish.
Wall Street’s shadow banking system gave mortgage lenders
large credit lines (similar to credit card debt) and packaged
the loans into private-label residential mortgage backed securitizations.
Most of each deal was rated “AAA,” since subordinated
investors absorbed the risk of a pre-agreed amount of loan
losses. But hundreds of billions of dollars in private-label
deals were backed by portfolios comprising risky fraud-riddled
loans. Most of the “AAA” investment was imperiled,
and subordinated “investment grade” components
were worthless. Wall Street disguised these toxic “investments” with
new value-destroying securitizations* and related credit derivatives.
Meanwhile,
collapsing mortgage lenders paid high dividends to shareholders
(old investors) and interest on credit lines
to Wall Street (old investors) with money raised from new investors
(perhaps your pension fund) in doomed securities. New money
allowed Wall Street to temporarily hide losses and pay enormous
bonuses. This is a classic Ponzi scheme.
The following is an
April 19, 2009 C-Span Video**:
When
you leverage fraud riddled fixed income securities priced at
100 cents on the dollar, there is nowhere to go but down
in a hurry. Confusion after the fraud fell apart led to a vicious
cycle of selling as investors and lenders shunned both good
and bad assets. The deflating debt bubble was followed by a
classic liquidity crunch resulting in a global crisis.
Wall
Street protests that it sold toxic assets to sophisticated
investors obliged to perform independent investigations of
the risk. That argument no longer applies. U.S. taxpayers became
unwilling unsophisticated investors funding Wall Street’s
bailout.
Other parties—mortgage bankers, credit rating agencies,
hedge funds, credit rating agency, insurers, mortgage brokers,
regulators, Congress, and the Federal Reserve Bank—were
supporting actors. If Wall Street’s financial meth labs
had been shut down earlier, the money machine would have stopped
running.
Recent arguments blame Fannie Mae and Freddie Mac, the indirect
mortgage lending giants. This is misguided. The largest slug
of new risky products and bad loans were created to fuel
Wall Street’s private-label securitizations. Fannie
and Freddie were more at the effect than the cause (not blameless,
but not the largest cause of the housing bubble). Now that
shadow banking is dead, they are being stuffed with even
more bad product to pick up the slack.
Fannie Mae and Freddie
Mac are the new motor for no-money-down mortgage loans and
a host of new problems. The fraudsters involved
with our last crisis went unpunished, and they will help create
our next crisis. This brewing fraud fest will result in greater
misery and systemic risk. Instead of reform, Congress responded
on Christmas Eve by agreeing to cover
unlimited loan losses.
Bank depositors' money is guaranteed, if deposits are below
the current FDIC deposit insurance limits. Banks did not
need to be bailed out to protect depositors. We bailed out
banks' other creditors with public money. We are printing
so much money that now depositors should worry about inflation.
Inflation
is the great destroyer. Inflation will wipe out investment
gains (and more) much more quickly than taxes. If
you earn, say, 5% on your deposits, 5% inflation will wipe
out your gains, (and you aren’t earning 5% on your deposits
or treasury notes in the first place). That is worse than any
current or proposed tax rate, since that would translate to
a 100% tax rate.
Wall Street, Fannie Mae, and Freddie Mac supply
a swinging door of jobs and paid projects for its financial
regulators,
Congressmen, appointed administration officials, and investigation
committee staffers. Many members of Congress and our Presidents
have received massive
campaign contributions funded by Wall Street. This dependence is known as “capture,” and
the result is that instead of reigning in Wall Street, dependent
thinking enables mayhem.
We have an alternative to bailouts,
one
that does not violate the spirit of democracy. Troubled
financial entities should
be put into receivership and restructured. Old shareholders
will be wiped out. Debt-holders will take a haircut (discount)
along with a debt for new equity swap to recapitalize the entity.
But the job won’t be complete until we separate high
risk activities from traditional banking in return
of Glass-Steagall,
indict fraudsters, snuff out systemic fraud, and allow honest
bankers to prosper.
After the Savings and Loan crisis of the
late 1980’s,
there were more than 1,000 felony indictments of senior officers.
Recent fraud is much more widespread and costly. The consequences
are much greater. Congress needs to fund investigations. Regulators
need to get tough on crime.
The fact that many U.S. banks stuck
to traditional banking and protected shareholders during this
crisis is under-publicized,
but their prudence worked.
We have the solutions. We need the
political will to implement them.
* Residential Mortgage Backed Securities (RMBS), Collateralized
Debt Obligations (CDOs and CDO-squared), Structured Investment
Vehicles
(SIVs),
Real
Estate
Mortgage
Investment
Conduits (REMICs and Re-REMICs), Asset Backed Commercial Paper
(ABCP), and related credit derivatives. Wall Street also engaged
in suspect securitizations of some credit card receivables,
auto loans, bank trust preferred securities, commercial real
estate loans, and a variety of corporate loans.
**When
asked whether or not certain individuals had done anything
illegal, I responded
that I did “not think anyone did
anything illegal, because Congress did not pass laws to make
it so,” because I did not want to scapegoat individuals.
I should have said: "That is up to the Department of Justice
to determine.”
JT
Note: Earlier I said we are at greater
risk for deflationary collapse than before our last crisis.
Washington is trying to stave off a massive deflationary collapse
by temporarily reinflating it with more inflationary wild cards.
Whether we get deflationary collapse followed by inflation
or just move straight to inflation, the economy is guaranteed
more pain.
Janet
Tavakoli is the president of Tavakoli
Structured Finance, a Chicago-based firm
that provides consulting to financial institutions
and institutional investors. Ms. Tavakoli
has more than 20 years
of experience in senior investment banking
positions, trading, structuring and marketing
structured financial products. She
is a former adjunct professor of derivatives
at the University of Chicago's Graduate
School of Business. She is the author of: Credit
Derivatives & Synthetic Structures (John
Wiley & Sons,
1998, 2001), Structured
Finance & Collateralized
Debt Obligations (John
Wiley & Sons, 2008).
Janet
Tavakoli's book on the global financial meltdown is Dear
Mr. Buffett: What An Investor
Learns 1,269 Miles From
Wall Street (Wiley 2009) Clients
of Tavakoli Structured Finance
have the benefit of proprietary consultation, which is
not available in any other paid or public forum. Clients
also commission proprietary research and analysis. TSF
makes some information available to the general public.Please
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