By Arnold Kling
Gillian Tett’s book on the financial crisis is the one that I would recommend at this point. Some notes and excerpts below.
This may reflect my biases, but what I took away from the book was the co-ordination between regulators and market participants in promoting securitization and exotic financing techniques. Today, the regulatory community whines about the systemic risk that financial technology created. At the time, the regulators were approving and encouraging the process. Today, regulators complain about the “shadow banking system.” At the time, they were encouraging the dispersal of risk and saying that it made the system more resilient.Glass-Steagall did not apply to banks in other countries, so branches in the UK could evade those regulations.
In August of 1996, the Fed issued a statement suggesting that banks be allowed to reduce capital using credit derivatives.
The creation of collateralized debt obligations (CDO’s) resulted in the creation of tranches, dubbed “super-senior,” that took the residual risk–presumably small–in the CDO. A constant source of concern was which institutions would hold the super-senior tranches. Often, these tranches were retained by banks. The cumulative exposure became disturbingly large.
The OCC and the Fed said that banks could keep those tranches themselves, while giving these tranches only a 20 percent risk weight. This helped make the concept work. The “concept had pulled off a dance around the Basel rules.”
Also, banks did not need to hold capital for lines of credit with a duration of less than one year. Thus, a bank could create a SIV (structured investment vehicle) to hold mortage securities and give the SIV a 364-day line of credit without having to hold capital.
Citibank sold super-senior risk tranches to its SIV’s along with “liquidity puts,” meaning that Citi would buy back those tranches if anything went bad. Another tactic to evade capital requirements.
many derivatives experts were too cerebral to play the type of internal corporate games needed to rise to the top at most banks.
Can you say, “suits vs. geeks divide?”
In 2004, the SEC voted 5-0 to eliminate leverage limits on investment banks.
The IMF annual report in 2006 said that new financial technology (securitization, credit derivatives, and so forth) “has helped to make the banking and overall financial system more resilient.” However, analysts at the Bank for International Settlements (BIS) took a different view, saying that the financial system was now “more vulnerable to boom and bust cycles.”
In 2007, Jamie Dimon could change course at JP Morgan to reduce exposure. “Central bankers and regulators, by contrast, were trapped in vast bureaucratic machines.”
In late 2007, the “liquidity puts” at Citi caused their exposure to super-senior to more than double in just a few weeks.
A NY Fed report in 2007 calculated that SIVs held $2.2 trillion in assets, hedge funds held $1.8 trillion, the five big investment banks held $4 trillion, the five biggest bank holding companies held $6 trillion, and other banks held $4 trillion.
By early 2009, 2/3 of the mortgage-backed Collateralized Debt Obligations were in default ($300 billion), with one quarter already liquidated.
JP Morgan had watched jealously as Goldman Sachs used political connections. So in 2009 one could find Al Gore and Tony Blair as paid advisors.
what is needed is a return to the seemingly dull virtues of prudence, moderation, balance, and common sense.