The deleveraging – unwinding from debt – that is currently sending the U.S. financial markets reeling is but a symptom of the root problem in our economy. The sub-prime mortgage crisis that began in August 2007 was the starting point of a downward spiral in the United States’ economy. The repercussions of the sub-prime crisis shook many commercial banks, but investment banks were traumatized. Bear Stearns was the first investment bank that needed a financial rescue due to liquidity problems. The Federal Reserve stepped in and helped in the Bear Stearns sale to J.P. Morgan Chase by underwriting (or guaranteeing) the weakest of Bear Stearns debt. Another investment bank, Lehman Brothers, was allowed to go bankrupt due its liquidity problems. Merrill Lynch courted a buyer and, as of the date of this article, is being bought by Bank of America. Goldman Sachs and PaineWebber will become bank holding companies in order to expand their capital base. All major U.S. investment banks have quickly and dramatically changed. Why such a cataclysmic effect on this one particular area in the financial markets? One has only to look at the past in order to explain the present, and to gain an understanding of future events.
First, the past. The debt, or leveraging, that banks took on during the 1920s brought about the Great Depression that began in 1929. Congress understood the nature of the crisis and in 1933 enacted the Glass-Steagall Act to prevent another Great Depression. This law “prohibited commercial banks from collaborating with full-service brokerage firms or participating in investment banking activities”. (1) This Act protected bank depositors from the increased risks that are inherent in security transactions. For sixty-six years this law achieved what it was intended to achieve – safety and stability within the U.S. monetary system. The Glass-Steagall Act was repealed by Congress in 1999. In less than ten years the very conditions that brought about the Great Depression have again occurred in the U.S. banking system. Since the repeal of the Act, the clear lines separating commercial banking activities from investment banking activities and brokerage firms have disappeared. Thus, the U.S. now faces the situation that increased debt on the part of banks, all banks but particularly investment banks, now threatens the stability and even economic viability of the U.S. financial system. With the major investment banks having leverage rates of 25 to 1, or even 30 to 1, for capital on hand, they could not withstand a seizing up of credit as a result of the mortgage crisis. The banking system became a ‘house of cards’ where leverage was the unseen factor that would topple the uppermost layers, and end up threatening the entire structure.
As a result of the mortgage crisis, a few commercial banks that became illiquid have been taken over by the Federal Deposit Insurance Corporation. Even large commercial banks have been on shaky ground due to the distressed loans they held. Two government backed mortgage giants, Fannie Mae and Freddie Mac, had to be bailed out by U.S. taxpayers. And an even larger bail-out of the financial markets (read this the ‘banking system’) is being proposed by the government. Many financial analysts have identified unsound debt as the reason behind these troubled institutions.
It is true that the massive amount of debt owed in this country is unprecedented. Personal debt, corporate debt, investment debt, and government debt are all at record levels. But debt levels such as these do not occur without there being a significant shift in the philosophy behind the fiscal actions of individuals, businesses, and governing bodies. This shift culminated in the repeal of The Glass-Steagall Act and it is this philosophical shift that is the root of the problem behind the U.S. economic crisis.
Stability in the banking system has been a goal of the U.S. government since 1933. But this stability came at a price: it restrained greed and the ‘get rich quick’ mentality of the financial titans. After successful lobbying in 1999 for a repeal of the Glass-Steagall Act, bankers were now free to let their creative financial genius come up with all kinds of ways to make a profit. And make a profit they did: highly leveraged securities trading, securitization of mortgages, credit default swaps, and other exotic, complicated financial products brought unheard of gains.The sky was the limit. Sophistication was the plumb line. The titans were in control. The only problem was the fact that the profits were ephemeral. They were not real hard-dollar profits and they were not taking place in a real-world scenario. The Federal Reserve kept the federal funds rate so low during this time that real interest rates were negative. Thus, it paid to borrow money. But as even the least sophisticated financial person knows, the value of your debt is only as good as the ability of the person to repay. A business model that for years had depended on prudence in lending, on ascertaining the worthiness of credit customers, now became a free-for-all that did not consider the downside risk.Instead of protecting the stability of the monetary system, the interest of stockholders, and the vision of long-term success, financial players now looked to short-term profit and their own rise to riches.
This is in contrast to an earlier, almost ‘small-town’ model that pervaded the banking industry. Banking during the middle decades of the twentieth century was relationship based. Customers hoping to acquire a loan went to their neighbor banker. They shared asset information, annual income figures, noted stability of employment, and listed other debts they owed. In addition to this information, the person himself was seen as someone worthy of credit or not. In some small towns as late as the 1980s credit was extended based on a family name or ‘whose son are you’? The ‘name’ or reputation of a person was a part of the credit application process. Bankers and other lenders exercised due diligence to make sure that the money they loaned could be repaid. These credit managers knew they were responsible to others in relationship with them: either shareholders, company owners, or their families, if the business was family owned.
Over the past decade this model gradually changed. No longer was ability to repay a crucial factor. The egalitarian mind-set that all people were worthy of loans married the fact-oriented, results-driven, bottom-line focus of short-term profit. Sophistication in the financial services field had arrived, and with it an excitement about new ways to make money; lots of it; quickly. Banks and mortgage companies made loans based on sketchy or no information about ability to repay. (The bulk of these loans became the ‘sub-prime’ crisis that started the August 2007 financial crisis.) These loans were then bundled together and sold as investment instruments (in essence, making a security out of a promissory note to pay). While loans are assets on a bank’s books, they mimic bonds (or debt instruments) when securitized and sold to individuals. They are still an asset to the purchaser of the securitized debt instrument, but, unlike true bonds, they have a value that is hard to establish and a risk factor that is hard to evaluate.
Because of the dependent relationship across financial markets of these debt instruments and the way they were, as we know now, incorrectly viewed as strong assets, once the borrowers of the money defaulted on the loans (or the real estate backing these mortgages became less valuable), then their decreasing cash flow or decreasing asset value began stressing the holders of this debt. Just image, on a very simple level, that someone owes you $10. You depend on that to be repaid to you next Tuesday, so you purchase an $8 wagon that you will pay for next Wednesday. The person from whom you purchased the wagon sees a chance to make money on more wagons, so he asks the wagon maker to build him another wagon that he will pay for next Thursday. You know what is going to happen… The person who owed you the $10 could not repay on Tuesday (and may never repay you). You are unable to pay for your $8 wagon on Wednesday; the wagon seller cannot pay on Thursday for the new wagon he ordered from the wagon maker. The income lost is multiplied through these actions, and distrust starts to form in business relationships. In a small way, this is what has happened in the financial markets and among the banking system. Loans that were weak and resulted in default or devaluing rippled throughout the economy, affecting everyone’s cash position. Why? Debt is just a promise to repay a certain amount of money at a certain time. Without the fulfillment of this promise, liquidity (cash or cash equivalent) dries up and distrust develops. Although the relationship model that helped achieve quality loans was abandoned, the results of the new model are being revealed in such a way as to show its weakness. The result of this new ‘bottom-line’ model is being revealed in the one fundamental required for all relationships: trust. One can’t get around it: Even the financial world must be based on relationships.
The leaders in the financial world are now looking to the U.S. government for a bail-out due to results that came from their own lack of wisdom. That this bail-out will occur is a strong probability.The extent of the bail-out is still to be determined. One fact is quite certain. If the bail-out occurs, it will still not remove the effects that will naturally occur as a result of the current financial situation. It may delay the results, but an economic earthquake is still certain. If no bail-out from the government comes, there will be an intense recession and, quite possibly, a U.S. depression. If the bail-out does occur, there may for a time be a period of deflation and an apparent stability. This will probably last from three to five years. After this time, the results of the huge debt taken on by the government in order to fund this bail-out will appear. Because of its budget deficit and huge financial debt as a result of a trillion dollar plus bail-out, the U.S. will become a ‘sub-prime’ borrower itself (2). Other countries will know this and will stop buying U.S. treasurys (which fund U.S. debt). With no outside source of funds available to repay debt, the U.S. treasury will have to start printing money. This will cause inflation, then hyper-inflation, then a collapse of the dollar and with it, the U.S. monetary and economic system. While the situation in the financial world may be serious now, if the government bails out unwise bankers, investment and commercial, then future prospects to the economy are dire. Excess debt, as has been shown, always ends in disaster. If we value the relationship with our children, their children, and others, we will work to strengthen our own financial situation to mitigate the effects of the coming catastrophe.
The Histor Companies can help you develop a strategy to successfully navigate the coming economic stresses.
Copyright 09/2008, Cheryl Nester. All Rights Reserved.
Investopedia, The Glass-Steagall Act
"Will Bailout Spur Inflation? Hedge That Bet”, September 23, 2008, The Wall Street Journal, Dow Jones and Company.