blagophilia

I was asked by a friend to elaborate on my take on the economic woes we have been seeing over the last year. I am going to attempt to, over the next few posts, tie everything together. I am not an economist and I defer to their expertise where appropriate. What I am is an IT professional that works in the financial industry. I work for what is called an Inter-dealer Broker. What we do is handle trades between financial institutions. We allow banks and others to trade with each other anonymously. We handle many different markets. In my day to day duties I work closely with the business side maintaining the trading systems they use, implementing and planning new systems, and helping turn their requirements into reality. I deal with both voice and electronic broking. It’s from this perspective that I present my take on things.

Our current economic status is really a combination of at least three different problems combined. In the past we have seen each of these come up in mostly isolated circumstances. But now they’ve all hit hard in a combination that has just amplified and exacerbated the situation. What we have can be broken down to the Wall Street Meltdown, the Housing Market Collapse, Energy price fluctuations, and the US Auto Industry crisis. We also have the contributing/resulting scenarios of the weak dollar and unemployment. In some cases we have a chicken and the egg situation here too. Since I deal with mostly Wall Street I am going to start with them.

Wall Street

Over the last six months we’ve has a series of event that have hit the Street pretty hard. It’s caused massive instability in the world markets, taken down some well-known giants, and rippled out to touch many lives. Wall Street is not the entire economy but it is perhaps the most susceptible to what is happening. The industry lives and dies by the current state of things, more importantly it hinges on the perception of how things are going and the news of the day. Bad numbers can tank the market, good numbers can buoy it to new heights. If you look at the last year you can see the effect based on the volatility seen in the fluctuations day to day. The chart below shows the last year for the Dow. I grabbed the below from google – real time chart.

One thing to remember, traders are a skittish lot, they are very much alpha types, and they tend to be insular with a strange herd mentality at times. This environment has done nothing but amplify the problems really. So what are the problems? Well to understand the problems we have to go back to when the framework for them was put in place. In this case we need to go back pretty far.

De-Regulation is the Word.

 
Our current situation can be traced back to the Energy Crisis of the 1970’s. One of the outgrowths of that was the de-regulation of the Oil industry. This opened the door to later de-regulation of many of the areas that are having the problems we see today. Did they mean to do this? I don’t think so, but the slippery slope can be invoked here. It was really under Reagan, and then Clinton, and finally G.W. Bush that the pieces were put into place to allow things to happen. We can look to three events that encapsulate it.
 

 

 

1. The S&L Scandals
2. Sub-Prime/bank de-regulation
3. The rise of CDS markets with no regulation.

The S&L Scandals

The S&L really was not the cause of what we see today. What it did do though was set a precedent for bailing out the financial industry. It would probably have not been as easy to do what has been done today otherwise. I won’t really touch on this otherwise. But as I said it was the example.

Sub-Prime and Bank De-regulation

This is really a major cause of what we have. The Mortgage Crisis, I no longer will call it sub-prime since it goes well beyond that, can be traced in part to this as well. What many are pointing to as the defining moment here was in 1999. Phil Gramm helped push through the Gramm-Leach-Bliley Act which then President Clinton signed into law. If you look at the votes they were pretty much along party lines in both the House and the Senate. The act was supposed to help modernize the industry and allow it to be competitive. What it really did was create a free for all. G-L-B rolled back provisions of the Glass-Steagall Act.

Glass-Steagall was a direct result of the Great Depression and did many things to help protect the system from itself. G-S created the FDIC, added regulation of banks and interest rates, and forced a split between commercial and investment banking. While some parts of the act had been repealed over the years the root of it remained strong until 1999.

What the 1999 act did was allow banks to consolidate into larger entities. It tore down the wall that used to exist between private/commercial banking and investment banking. It also now allowed one company to provide not only these services but also insurance. In essence it destroyed any separation between three root aspects of the financial industry. For my take on the sub-prime problems you can read about it here and here.

So what we now have is a situation where the following can occur:

1. A bank can now have an investment and a commercial arm in the same house.
2. Banks can easily buy up smaller banks.

This is bad on so many levels it amazes me that it was ever allowed. The outcome we see today was pretty obvious really.

A commercial bank is really much more stable than any investment bank because of risk. Commercial banks tend to be heavily regulated in regards to risk. They are also FDIC-insured. This means that the money they have is pretty safe overall. Not much can be done to destroy this. Investment banks lack a lot of this because the customer is knowingly taking a risk. It also used to be that the kinds of risk investment banks could take were regulated. Can you guess what could happen when the investment arm of a bank takes too big a risk and fails? Well Wamu is a great example of this really. If the bank fails then the Federal Government is now on the hook for all those commercial, insured accounts.

Now imagine what happens when you also allowed a lot of smaller, regional banks to be bought up? This consolidation means such a failure is no longer isolated to a region. This kind of failure now has national implications. You don’t have a local bank in Washington state failing, you have multiple banks failing in multiple states. This means potentially hundreds of thousands of accounts for up to $100k each need to be funded by the FDIC. The FDIC cannot, I guarantee you, cover this. This is what this little bit of de-regulation gave us. A nice huge window for a tarpit of epic proportions. Anyone looking at long term affects could have, and should have seen this. It makes me wonder what they were thinking at the time.

Some Examples

You can see the direct effects of this de-regulation in the AIG bailout, the WAMU implosion, and the moves by Goldman-Sachs and Morgan Stanley to become commercial banks. We’ll start with AIG.

AIG Gets Bailed Out

AIG, the American Insurance Group, is one of the largest insurance companies in the world. It’s classed as the eighteenth largest company in the world. While the main cause of AIG’s problems can be traced to the CDS/CDO market it is the de-regulation when combined with the no regulation of CDS that actually allowed it to happen. AIG was heavily involved with underwriting of many mortgages and derivative swaps. They were able to underwrite a number of credit default swaps and mortgages that they should not have been. They also had up to $20BN in risk related to Goldman. While Goldman has said this risk was immaterial many think otherwise.

This was a case of a small part of AIG imperiling the whole. Their insurance arm was actually pretty much OK. It was the section dealing with CDS and MBS that was the risk. This is the chronology of events from what I can tell regarding AIG:

1. De-regulation of MBS/Banks
2. AIG gets involved with CDS and MBS.
3. AIG starts making lots of money, everyone is happy.
4. The sub-prime crisis hits. CDS/CDO is hit as well.
5. AIG takes a hit in it’s credit rating due to fears relating to this.
6. AIG posts a large loss as a result as people start selling off/dumping AIG stock.
7. The Federal Reserve moves to save AIG by in effect nationalizing the company.
8. Goldman makes a move to become a commercial bank.
9. AIG reveals ties to Goldman to the tune of $20BN.

That is a pretty simple line of events regarding what happened with AIG. Here is how it occurred. AIG had through its London side been purchasing a number of CDO and CDS notes. When things starting going downhill the overall credit rating of AIG was downgraded. Now when this happens a company has to provide some kind of collateral against the owned debt with its various trading partners. Being over-leveraged AIG had a liquidity crisis. Simply put AIG didn’t have the cash or capital to actually cover the loss.

AIG, if we had regulation, would not have even been allowed to buy up these things. They’d have not been able to get involved in such a risky market. Nor would they have been able to deal with Goldman in the way they did for these. A footnote to this is we are STILL bailing them out. The bill keeps growing and growing. We are up to about $150BN so far.

The Washington Mutual(Wamu) Implosion

Washington Mutual is a prime example of the other half of the de-regulation equation. In this case what can happen when you no longer enforce a separation between commercial and investment banking combined with the removal of protections from bank consolidation. The wall was put up at the end of the Great Depression for good reason. It was meant to help protect banks and their customers. In 1999 these walls were removed.

Washington Mutual was heavily involved with mortgages – buying them up and selling them. I recall them taking over mine back in 2000 when I bought a condo. They also were part of the trend of consolidation of banking in general. This would prove to be fatal to them for similar reasons AIG ran into trouble. Wamu had since the 90’s acquired about thirty different banks, loan companies, and investment groups. They ended up loaning a lot of money to people and other banks. From what I have read it had about $670BN in total loans it was servicing for itself and others. It had about $300BN in actual assets though. Also about 75% of it’s loans were for outside banks. This put it in a precarious position really.

A quick Wamu Timeline

1. Wamu buys up all sorts of banks/groups
2. Wamu starts loaning lots of money to lots of people and banks.
3. Sub-prime crisis starts
4. Wamu realizes a problem starts shutting down some of their lending.
5. Wamu secures some funding to keep going
6. Credit rating is dropped, they now owe a lot of money.
7. Wamu blows up and is shutdown.

What happened next was just like AIG. WAMU suffered from a credit rating downgrade and had to now cover all those loans they had out. They could not do so and people panicked. What you had then was a run on the bank of sorts. People starting pulling their money out and things spiraled. True to form the US Government did something not connected to what they were doing elsewhere. Instead of bailing them out they let them fail. They just controlled the failure, secured the debt and let it go away. Unlike Lehman, WAMU no longer exists, they have been shutdown. Their assets have been sold off to others. Chase for example has picked up a number of their commercial banking accounts.

What is interesting here is that at the end of 2007 they took steps to control their home mortgage lending. Scaling it back quite a bit. They also had to seek external sources of funding in mid-2008. So my guess is they knew it was coming and did something to try and stave it off. But they were playing with fire the whole time. Personally, I am just glad their idiotic commercials are no longer playing.

How Similar They Were

AIG and Wamu both suffered from the same thing though they had very different fates. They both were able to over-extend themselves through buying up debt to an insane degree. They created a situation where they could potentially owe much more than they actually had. Being who they were though their final fates were very different. AIG was deemed too important to fail, Wamu not so much.

My next post will talk about Goldman, CDS/CDO and the wonders of it all.

How This Affected The Street

What has this done to Wall Street? Well to an already battered market you now had an insane amount of uncertainty being fueled. If AIG and Wamu could go under who would be next? All this money that they had what about their trading partners? What about the people who were loaned the money? What about all these people who used to be employed by these companies? You see the spiral effect happening now.

Some More Information

AIG’s 150B bailout is just a start

Sub Prime Post 1

Sub Prime Post 2

Technorati Tags: aig, bailout, finance, regulation, The Economy, wall street, wamu, washington mutual

Tags:   aig · bailout · finance · regulation · The Economy · wall street · wamu · washington mutualNo Comments