I. It isn' t about profit!
Conventional explanations to the current financial crisis tend to revolve around bankers' greed. Bankers been made scapegoats. In truth, it is the government which bears responsibility for the current crisis.
Why then have bankers been made scapegoats? Saisman cites a number of cases in which federal legislators, agency heads, and commissioners have led the movement to blame bankers, rather than government policies, for the banking system' s failings. Selfinterest provides an obvious motive. A question that remains to be answered is why the popular press have not been more discerning.
If there is anything more tragic than our current banking crisis, it is that the crisis is being blamed on the wrong group, on the bankers, instead of on the primary culprit, government intervention. The tragedy lies in falling to identify the fundamental cause of the problem, thereby ensuring its continuance. Bankers are not entirely innocent of wrongdoing in the present debacle, but to the extent that bankers have been irresponsible, it has been primarily government intervention that has encouraged them to be so. More widely, it is irresponsible government policy that has made the U.S. banking crises of the past century so frequent and seemingly so inevitable. Government has created these banking crises—sometimes inadvertently, at other times with full knowledge—by making it nearly impossible to practice prudent banking. Having done so, government has then pointed to bad banking practices as sufficient cause for still further interventions in the industry.
Virtually every one of the financial "innovations" which have wrecked the US financial system have been spearheaded by the US treasury (OTC derivatives, securitization, credit enhancements, etc…). These "innovations" were driven by the need to "prevent the collapse of the financial system through any means possible (including fraud)"
1) Monetary Policy
In a massive power grab, the treasury drafted a bit of legislation in 1934 called Gold Reserve Act, in which it gave itself tremendous powers at the expense of the Federal Reserve.
The Gold Reserve Act of 1934 hijacked control of the monetary policy by:
A) Transferring possession of all the nations gold to the treasury.
B) Giving the Treasury primary responsibility for official foreign exchange operations.
C) Creating the Exchange Stabilization Fund (ESF), a political slush fund under "the exclusive control of the Secretary of the Treasury" with broad statutory authority "to deal in gold, foreign exchange, and other instruments of credit and securities"
Below is an extract from the transcript of the hearings about the Gold Reserve Act of 1934, which show some of reactions at the time.
STATEMENT OF WALTER W. STEWART, MEMBER OF THE FIRM OF CASE, POMEROY & CO., NEW YORK CITY
Senator TOWNSEND. Would you mind stating what you think the effect of this bill, if passed as it is now written, would be on the Federal Reserve banks?
Mr. STEWART. It seems to me to shift fundamentally the responsibility from the Federal Reserve System to the Treasury in the only matters in which the control of currency and credit really matter, and that is with reference to the convertibility of the currency into gold or in foreign exchange, and to set up a competing influence in the operation of the stabilization fund that is equivalent to an open-market operation. In those two respects it seems to me to nullify, if not to scrap, the Federal Reserve System.
It not only takes that action, but in looking for some executive officer to place the responsibility upon it finds an executive officer which is bound to be subject to popular pressure from time to time, and of course a single lesson which is part of the management of currency is how frequently one has to do an unpopular thing, and the purpose of having a central bank independent is that it should be free from Government control, but it should have some protection in the management of our currency against the emergency of the moment.
I should have thought that any executive officer [ie: secretary of the treasury] faced with the responsibility of raising $6,000,000,000 in 6 months had a sufficient responsibility, without adding others of a somewhat conflicting character. I say " conflicting " deliberately, because he is under the necessity of raising this money, and under this bill under the necessity of maintaining the soundness of the money that he raises. I believe that in public finance it is just as unwise to put a large borrower in control of the currency as it has been demonstrated to be in private finance, and any view which runs to the contrary not only overlooks the entire experience in other countries in this matter but overlooks our own very recent experience.
The CHAIRMAN. DO you see any difficulty in the Reserve bank system operating if this were done, tranfer of the gold to the Treasury?
Mr. STEWART. Yes; I see not only the conflict that it seems to me likely to arise, but apart from the mere shadow of itself a mechanism functioning as a clearing agency which has not any of the authority left for the control of the credit and currency position.
The Gold Reserve Act Of 1934 stripped the Fed of virtually all monetary authority. While it did recover some independence in 1951, it was never the same.
The Treasury, on the other hand, has abused its new monetary authority since receiving it in 1934, demonstrating the folly of putting the nation largest borrower (the treasury) in charge of protecting the value of money.
2) Over-The-Counter (OTC) derivatives
The Treasury has been active in OTC derivative markets since 1961. Thanks to the Gold Reserve Act Of 1934, the Treasury gained the ability to conduct open market operations (to buy and sell securities, derivatives, etc), and it has not been squeamish about using its new authority.
When the refusal of the administration of U.S. President Lyndon B. Johnson to pay for the Vietnam War and its Great Society programs through taxation resulted huge budgets deficits and rampant inflation, the treasury began intervening secretly to prop up the dollar using OTC derivatives (forward contracts). The Fed Debate in the 1960s over Sterilized Foreign Exchange Intervention reveals the extent of the Treasury' s forward operations.
2. THE EXCHANGE STABILIZATION FUND
In 1961, the Exchange Stabilization Fund (ESF) of the U.S. Treasury began to intervene in the foreign exchange markets. Its ability to intervene, however, was limited by its resources. In 1934, Congress had created the ESF with the Gold Reserve Act. Congress capitalized it with $2 billion of the profits created by that Act' s revaluation of gold from $20.67 to $35.00 per ounce. It put the ESF under the control of the Treasury and authorized it to intervene in the foreign exchange markets to stabilize the value of the dollar. …
Because so much of its resources were tied up, the ESF intervened mainly in the forward markets [The forward market is the OVER-THE-COUNTER (OTC) financial market in contracts for future delivery]. In that way, it would only need foreign exchange if it had to close out a position at a loss. “Reference was made to the extent of operations of the ESF in the forward market, as opposed to spot transactions, and Mr. Coombs [manager of the New York Fed' s foreign exchange desk] said the basic reason was that the ESF was short of money” (Board of Governors 1962, p. 169). The dollar often traded at a large discount in the forward market. The Treasury entered into commitments to furnish foreign currencies in the future in order to reduce this discount. In doing so, it hoped to encourage individuals to hold dollar-denominated assets by reassuring them that the dollar would not depreciate in value.
… In an attempt to encourage Italian commercial banks to hold dollars rather than turn them over to the central bank, the ESF entered into $200 million in forward contracts. The forward commitments of the ESF in lira and Swiss francs amounted to $346.6 million in early 1962.
Forward commitments, however, carried the risk of loss if the dollar did not appreciate. Given the risk exposure due to the size of its forward commitments, the Treasury felt that the ESF had insufficient cash on hand. To provide it with additional cash, the Treasury wanted the Fed to buy the ESF' s foreign currencies such as the deutsche mark… [(The Fed agreed to do so)]
A Treasury memo (Foreign 1962; U.S. Treasury 1962b, p. 2) noted
Total resources of the Fund at the present time amount to about $340 million. Against these resources there are outstanding $222 million in Exchange Stabilization agreements with Latin American countries, and some additional agreements may be made from time to time. The free resources of the Stabilization Fund are consequently quite small. . . . Spot holdings of foreign exchange now amount to about $100 million . . . . These spot holdings must in general be thought of as providing backing for outstanding forward exchange contracts (currently about $340 million equivalent). The entrance of the Federal Reserve System into foreign exchange operations will therefore provide particularly needed resources.
While $346.6 million forward contracts might not seem like a lot today, back in 1962 it easily made the Treasury/ESF the biggest player of OTC derivative markets.
OTC derivatives are political crack
A determined secretary of the treasury can achieve any economic outcome he wants using OTC derivatives (in the short run). Low inflation, a strong dollar, easy credit, low interest rates… anything is possible. Like crack, OTC derivatives produces a “high” which allows a secretary to (temporarily) defy economic reality.
Predictably, the use of OTC derivatives, like crack, has some rather nasty “withdrawal symptoms”, as was discovered by the treasury in 1978.
TREASURY CONFESSES TO STUPIDITY AND SHORTSIGHTEDNESS
A prime contemporary example of the cost of the treasury mindset to the American taxpayer was revealed earlier this year. On 19 April 1978 Anthony M. Solomon, Trilateral commissioner and under secretary of the treasury for monetary affairs went cap-in-hand before the House Subcommittee on International Trade Investment and Monetary Policy, to confess to what Solomon called “some fairly important developments;” that is, the treasury had lost its shirt gambling in Swiss francs since 1961. [By 1979 the Treasury had sustained total losses of $1,134.6 million as a result of its forward operations.]
Leaving the US Treasury in control of with Exchange Stabilization Fund in the presence of an unregulated OTC derivative market with no congressional oversight is like leaving a pile of crack in the room of a drug addict. How can any secretary of the treasury, in seeking to give his president what he wants (low inflation, no recessions, etc), resist the temptation OTC derivatives offer when there is historical precedence to justify their use? After all, dealing with consequences of those OTC derivatives will be the problem of the next secretary of treasury.
On that note I want to look at what happened in the 1990s. The decade began with the apparent collapse of the financial system, as captured by the FDIC chart below showing new bank failures.
Who would have guessed that economy would suddenly start booming, eliminating the financial system insolvency problem? Thanks to the “matchless” performance of Robert Rubin' s Treasury, the 1990s ended up seeing the strongest economy in recent memory.
Strangely enough, the "matchless" performance of Robert Rubin's Treasury coincided with the rapid growth of OTC derivatives during the 1990s.
Also coincidentally, the treasury was the most vehement opponent of derivative regulation in the 1990s.
“[Brooksley] Born' s battle behind closed doors was epic, Kirk finds. The members of the President' s Working Group vehemently opposed [derivatives] regulation — especially when proposed by a Washington outsider like Born.
“I walk into Brooksley' s office one day; the blood has drained from her face,” says Michael Greenberger, a former top official at the CFTC who worked closely with Born. “She' s hanging up the telephone; she says to me: ‘That was [former Assistant Treasury Secretary] Larry Summers. He says, “You' re going to cause the worst financial crisis since the end of World War II.”…
To go back to the metaphor above, this is like returning to the drug addict' s room to find several pounds of crack gone and the drug addict bouncing off the walls in a euphoric craze shouting, “don' t touch the crack! It will be a disaster if you touch the crack!”
Finally, in a June 2003 transcript, the Federal Reserve's Trading Desk (which is also used by the Exchange Stabilization Fund) revealed that "Auctioning derivatives is something we already have experience doing." Would it be fair to ask exactly HOW that experience was acquired?
Securatization is another “financial innovation” pioneered by the federal government.
the mortgage securities market was initially a government-created phenomenon. In 1968, Congress created the Government National Mortgage Association (CNMA) to sell securities backed by mortgages guaranteed through government programs of the Federal Housing Administration (FHA) and the Veterans Administration (VA). One purpose was to get these mortgages off the books of the Federal government so that the Administration would not have to keep coming back to Congress to request increases in the debt ceiling, for these requests created opportunities for Congress to express frustration with the Vietnam War as part of this process of trying to trim the government' s balance sheet, Fannie Mae was sold to private investors.
By the early 1980s, S&Ls; needed a new source of funds. They could not sell their mortgages without incurring losses that would have exposed their insolvency. Instead, with the approval of regulators, investment bankers concocted a scheme under which a savings and loan would pool mortgages into securities which would be guaranteed by Freddie Mac. The S&L; would retain the security and use it as collateral to borrow in the capital market. However unlike an outright sale of the mortgages, the securitized mortgage transaction would not trigger a write-down of the mortgage assets to market values. The accounting treatment of mortgage securities, in which they were maintained at fictional book-market values, enabled the S&Ls; to keep a pretense of viability as they borrowed against their mortgage assets, Fannie Mae soon joined Freddie Mac in undertaking these transactions,
Thus, from the largely by anomalies in accounting treatment and regulation. GNMA was developed in order to move mortgages off the government' s books, even though government was still providing guarantees against default. Congress created Freddie Macto work around the problems caused by regulation Q and interstate banking restrictions. And the growth in securitization by Freddie Mac and Fannie Mae was fueled by the desire of regulators to allow S&Ls; to raise funds using their mortgage assets without having to recognize the loss in market value on those assets. Mortgage securitization did not emerge organically from the market. Instead, it was used by policy makers to solve various short term problems.
Securitization failed to prop up the S&L; industry.
Simply put, the securitization was designed as a mechanism for transferring illiquid mortgages from balances sheet of insolvent institutions to investors. It NEVER was about “home ownership”, but always about bailing out financial institutions (as well as the federal government' s growing exposure to the mortgage/housing market). The real purpose of housing legislations is as clear as day is when considering be found in their names:
The Emergency Home Finance Act of 1970
The Emergency Housing Act of 1975
The Emergency Housing Assistance Act of 1983
The Emergency Housing Assistance Act of 1988
Is home ownership an emergency?
The government's desire to patch up the banking sector has been the leading force behind securitization. In the early 1990s, the Resolution Trust Corp (RTC), created to deal with the Savings & Loan Crisis, took this packaging of loans to a new extreme.
The federal government is turning increasingly to Wall Street to unload the enormous loan portfolio it has inherited from failed savings and loans, a strategy that some experts say looks good now but could cost taxpayers billions of dollars over the next few years if it backfires. Instead of selling the loans directly to investors, the Resolution Trust Corp. is packaging loans together and selling bond-like securities backed by income from the loans. The difference is, when the government sells a loan, it usually takes a loss on the transaction but it also washes its hands of the problem. Under the new plan, called "securitization," there is a greater risk that losses could continue to show up years from now.
The investments the RTC is creating are modeled after the securities sold by institutions such as the Federal National Mortgage Association (Fannie Mae), which are backed by conventional home mortgages, with the monthly payments providing income to the investors.
The RTC, however, is taking this approach in an entirely new direction with its offerings of securities backed by large commercial loans of varying quality.
Even riskier are soon-to-be marketed RTC securities backed by problem loans whose borrowers are not making payments or have defaulted. Dubbed "Ritzy Maes" by Wall Street because of their resemblance to Fannie Mae securities, the RTC bonds pay a higher rate of return than U.S. Treasury securities.
4) Credit Enhancement (turning toxic debt into AAA securities)
Credit Enhancement refers to the process of “transforming” high risk, impaired, loans into low risk investment grade bonds. It was the Treasury' s “Brady Bonds” which provided Wall Street the recipe for credit enhancement.
It was the creation of the Brady Bond that provided the recipe for the extension of many of these structured loans to emerging markets. A Brady Bond is a variety of structured derivative package in which the developing country (Mexico was the first) uses foreign exchange reserves as equity capital to create an investment company.
... It was only the interest payments to be paid after the second year that … carried foreign exchange and sovereign credit risk. The Brady structure thus provided complicated market valuation, it also provided an infinite number of possibilities for rearranging the various pieces of the bond into more attractive cash flow structures.
… the final result would be to transform high risk, impaired, syndicated loans of banks to Latin American governments into low risk investment grade bonds that could be sold to institutional investors, with a profit from the credit rating differential as well as fees and commissions. This is called credit enhancement, and investment banks quickly extended the Brady principle to other types of developing country debt. …
… Again, the result was that US institutional investor funds were being invested in emerging market debt, earning above market interest rates, without their balance sheets necessarily reflecting the actual risk involved. …