by midtowng | 2/11/2008 02:40:00 PM
Very few people have ever heard of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) or the Garn-St Germain Depository Institutions Act. But if you are old enough to drink then you most likely know something about the S&L Crisis of the late 80's and early 90's.
The S&L Crisis was called "the largest and costliest venture in public misfeasance, malfeasance and larceny of all time." The American taxpayer spent $124.6 Billion to clean up the mess.

While almost no one is paying attention, history is repeating itself.

The Roaring 20's

"The economic fundamentals are sound."
- Herbert Hoover

"The fundamentals of our nation's economy are strong."
- George Bush

On October 2, of last year economist and economic journalist Robert Kuttner testified before the House Financial Services Committee. The MSM has completely ignored what he had to say.

He mostly spoke about the history of banking regulation in America, a topic that would normally bore the average citizen to tears. However, his testimony wasn't just a history lesson. Kuttner's testimony was a warning.
Your predecessors on the Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934, laid the groundwork for the modern edifice of financial regulation. I suspect that they would be appalled at the parallels between the systemic risks of the 1920s and many of the modern practices that have been permitted to seep back in to our financial markets.
He went on to list the parallels between today's flawed financial system and the flawed financial system that led to the banking crisis of the early 1930's:

* asset bubbles built on high leverage ("where multi-layered holding companies allowed securities to be watered down, to the point where the real collateral was worth just a few cents on the dollar, and returns were diverted from operating companies and ratepayers.")

* securitization of credit ("Some people think this is a recent innovation, but in fact it was the core technique that made possible the dangerous practices of the 1920s.")

* excessive use of leverage in the stock and bond markets ("anybody who knows anything about derivatives or hedge funds knows that margin limits are for little people.")

* the corruption of the gatekeepers ("In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts.")

* the failure of regulation to keep up with financial innovation ("Today's examiner is not able to value a lot of the paper held by banks, and must rely on the banks' own models, which clearly failed to predict what happened in the case of sub-prime.")

* A last parallel is ideological - the nearly universal conviction, 80 years ago and today, that markets are so perfectly self-regulating that government's main job is to protect property rights, and otherwise just get out of the way.

We all know the history. The regulatory reforms of the New Deal saved capitalism from its own self-cannibalizing instincts, and a reliable, transparent and regulated financial economy went on to anchor an unprecedented boom in the real economy. Financial markets were restored to their appropriate role as servants of the real economy, rather than masters. Financial regulation was pro-efficiency. I want to repeat that, because it is so utterly unfashionable, but it is well documented by economic history. Financial regulation was pro-efficiency. America's squeaky clean, transparent, reliable financial markets were the envy of the world. They undergirded the entrepreneurship and dynamism in the rest of the economy.
Kuttner chastised Washington and the Federal Reserve for refusing to do their duty of regulating the markets for the benefit of the general public and nation.

His comparisons of 1929 to 2007 were disturbing and deserve a close look, but that is for another day. Instead I'm looking at the parallels of more recent history, between 1989 and 2008.

The Roaring 80's

The Fed's battle against high inflation during the 1970's led to high interest rates. S&L's were increasingly losing the battle for deposits to money-market funds. Plus, fixed rate mortgages written in the 1960's at much lower interest rates were increasingly unprofitable.
In 1978 Congress passed the Financial Institutions Regulatory and Interest Rate Control Act. It allowed S&L's to invest 5% of assets to such things as land development. It was a token reform, but it was the start of four years of deregulation.

In March of 1980, the Carter Administration raised ceiling on interest rates on deposit accounts, expanded the ability of S&L's to make ADC (acquisition, development, construction) loans, and raised deposit insurance from $40,000 to $100,000.
Then Reagan got elected.

Besides lowering the tax rates for the rich, Reagan's tax cuts of 1981 gave huge incentives for people to invest in real estate. The housing boom of the 1980's was on.
At the same time regulatory staff at the Federal Home Loan Bank Board are slashed. In 1983, a starting S&L examiner is paid only $14,000 a year. The average examiner has only two years on the job.
Meanwhile assets at S&L's in Texas and California are growing at unprecedented rates. Some tripled in size between 1982 and 1985. At the same time deposit requirements at S&L's had dropped from 5% to 3%. Generally accepted accounting principles (GAAP) are tossed aside and replaced by regulatory accounting principles (RAP).

Deregulation was coming fast and furious. Local ownership requirements for S&L's were repealed and the number of required stockholders were dropped all the way down to one. Buyers could use land instead of cash. Then in December 1982, the Garn-St Germain Depository Institutions Act was passed which effectively deregulated the industry. This was a Reagan Administration proposal that passed with broad bi-partisan support, and was a leading cause of the crisis. At the same time states were also deregulating the S&L's, especially California and Texas.
In March 1983 Edwin Gray becomes Chairman of the Federal Home Loan Bank Board, and he begins to slowly roll back the deregulations of the previous years. But the damage was already done.

In March of 1985, the Governor of Ohio declared a bank holiday for all S&L's in Ohio after the Home State Savings Bank of Cincinnati appeared to be insolvent. A few months later a wave of S&L failures strike Maryland.
It's the beginning of the end for S&L's, but few realize it yet.
Chairman Gray tries to roll out more regulations and limit taxpayer liability, but is often blocked by the courts and failed to gain much support on Capital Hill.

In 1986 oil prices collapse, and with it real estate prices in Texas and Oklahoma collapse as well. By 1987 losses at Texas S&Ls comprise more than one-half of all S&L losses nationwide.
The GAO declares FSLIC fund insolvent by at least $3.8 billion. Attempts at recapitalization have been stalled in Congress by S&L bank lobbyists that oppose efforts by regulators to roll back deregulation.

In June 1987, Edwin Gray finally resigns in disgust. But not before he is summoned to meet Senator John McCain and four other senators (Dennis DeConcini, Alan Cranston, John Glenn, and Donald Riegle) where they questioned the appropriateness of Bank Board investigations into Charles Keating's Lincoln Savings and Loan. The failure of Lincoln Savings and Loan cost taxpayers $2 Billion.
Silverado S&L failed in 1988 with a cost to taxpayers of $1.6 Billion.
A month earlier the Bank Board begins phasing out the remains of the RAP accounting standards and replacing them with GAAP standards. However, the successor of Edwin Gray, Danny Wall, put a stop to this until January 1989.

George H.W. Bush got election in 1988 without ever having to discuss the building S&L crisis in the debates.
In August 1989 the Federal Home Loan Bank Board was dissolved and the Resolution Trust Corporation was created to deal with the S&L mess. It's job was to liquidate the S&L assets, almost entirely real estate and mortgages.
Investigations later found that 20% of all S&L failures were caused by fraud and insider transactions.
During the Savings and Loan Crisis, from 1986 to 1995, the number of US federally insured savings and loans in the United States declined from 3,234 to 1,645. This was primarily, but not exclusively, due to unsound real estate lending.
The Non-Roaring 30's
"Congress was concerned that commercial banks in general and member banks of the Federal Reserve System in particular had both aggravated and been damaged by stock market decline partly because of their direct and indirect involvement in the trading and ownership of speculative securities.

The legislative history of the Glass-Steagall Act shows that Congress also had in mind and repeatedly focused on the more subtle hazards that arise when a commercial bank goes beyond the business of acting as fiduciary or managing agent and enters the investment banking business either directly or by establishing an affiliate to hold and sell particular investments."
- Supreme Court ruling, Investment Company Institute v. Camp, 1971

On June 16, 1933, President Roosevelt signed into law the second and most important of the Glass-Steagall acts.
Democratic Senator Carter Glass and Democratic Congressman Henry B. Steagall were the authors of this bill. Senator Glass had pushed through the creation of the Federal Reserve 20 years earlier.
Glass was the driving force behind the Banking Act of 1933, while Congressman Steagall only signed on once bank deposit insurance was added to the bill.
This act separated investment and commercial banking activities. At the time, "improper banking activity", or what was considered overzealous commercial bank involvement in stock market investment, was deemed the main culprit of the financial crash. According to that reasoning, commercial banks took on too much risk with depositors' money.
As a collective reaction to one of the worst financial crises at the time, the GSA set up a regulatory firewall between commercial and investment bank activities, both of which were curbed and controlled. Banks were given a year to decide on whether they would specialize in commercial or in investment banking. Only 10% of commercial banks' total income could stem from securities; however an exception allowed commercial banks to underwrite government-issued bonds. Financial giants at the time such as JP Morgan and Company, which were seen as part of the problem, were directly targeted and forced to cut their services and, hence, a main source of their income.
The spirit of New Deal regulation didn't end in 1933. In 1956 Congress passed the Bank Holding Company Act. This act did two major things: 1) prevent banks from buying banks in other states, and 2) creating a wall between insurance and banking. Even though banks could, and can still, sell insurance and insurance products, underwriting insurance was forbidden.
This was significant because it prevents banks from owning the majority of major industrial enterprises, like in Japan and Germany.

Thus by the late 50's America had one of the most heavily regulated financial industries in the world. It also had the strongest and least corrupt financial industry in the world. It was a system that other nations copied and envied.

The decline of Glass-Steagall

On November 12, 1999, Congress passed the Gramm-Leach-Bliley Financial Services Modernization Act. It was the culmination of decades of efforts by the largest banks of America to roll back the New Deal banking regulations.
Senator Phil Gramm, chair of the Senate Banking Committee, later joined UBS Warburg, the investment arm of a huge Swiss bank. Treasury Secretary Robert Rubin became an executive with Citigroup.

The financial industry had been chipping away at Glass-Steagall for years, starting in 1983 when BankAmerica acquired Charles Schwab. In 1987, Citicorp, J.P. Morgan, and Bankers Trust received permission from the Federal Reserve to underwrite municipal bonds, mortgage-backed securities, and commercial paper.
Earlier in the 90's commercial banks began to be allowed to get into investment banking and investment banks were allowed into stock and insurance brokerage. Gramm-Leach-Bliley eliminated the rest of the New Deal regulations and have led to a massive amount of consolidation in the financial industry.

But the real story is best told with some charts.

Notice the geometric growth of risky asset-backed securities (usually with mortgages) after 1999.

Notice the enormous growth in housing prices, a bubble that dwarfed even the real estate bubbles of the 1920's and 1980's.

This is the chart you want to pay particular attention to.
From the American Revolution until 1997, this country had produced about $20 Trillion of financial market credit (i.e. debt). In the last 10 years the amount of financial industry debt has more than doubled.

When financial markets leverage themselves this much, they are making risky investments designed to maximize profits. It works great on the way up. It also maximizes losses on the way down.

The similarities are too obvious to ignore.
Both the S&L debacle and today's financial crisis started with deregulation in the financial industry.
Both times the banks poured money into risky investments, usually real estate, with mountains of borrowed capital.
Both times complicated financial vehicles were created that even industry insiders failed to fully understand.
Both times the regulators were either blocked by Washington, corrupted, non-existent, or some combination.
Both times, when things started to blow up, they asked for a taxpayer bailout, and Washington couldn't move fast enough to serve their true masters. Examples are here and here.

I find it amazing that even after the S&L meltdown that not only were there no meaningful banking regulations put in place, but the pace of banking deregulation actually accelerated. Is there no better example of the financial industry's power over our government? The financial industry are the true masters of the real economy these days, not its servants.

Remember the fallout from the Enron and Worldcom meltdown in 2001-2002? Remember all the calls for regulations to prevent this happening again? What happened? Nothing! Nada! Our government has been bought and sold by eastern banks, and that means that taxpayers will be bailing out the banksters yet again. Only this time the price tag will be many times larger.



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Blogger workshop on 2/15/2008 10:21 AM:

What do you expect when you have as president a guy who was apparently guilty of insider trading several times?

But, of course, it's not just W's fault. I heard or read (I can't remember where) an economist declaring that most economists, if they were candid, would admit that THEY don't fully understand what a derivative is.


Anonymous Mark R on 1/30/2009 9:00 PM:

I was just reading sites that were blaming the S and L crisis on the New Deal and Carter. Good to see the distinctions you point out about while Carter was responsible for the 1978 FIR Interest Rate Control Act, Reagan then slashed taxes for the wealthy, reduced regulators, and encouraged the Garn-St. Germain DI Act.
It is important to know history, along with political psychology to see how revisionism works. The bias to the truth reveals the distortions every time.
Great job and thanks again.