board77

If Glass-Steagall was reinstated, what would happen to all the behemoth hybrid institutions that were created after the repeal? Would these have to be broken up?

I am not opposed to that in principle, but what would the cost of that kind of thing be? Is it even feasible?

Having read some about Glass-Steagall, I'm convinced that one of the worst effects of the repeal was that it allowed these behemoth institutions that are "too big to fail" to be created in the first place. Maybe the GS act was repealed in the name of free markets, but it's not a free market if taxpayers end up having to support it.

Quote:

GRAMM'S STATEMENT AT SIGNING CEREMONY
FOR GRAMM-LEACH-BLILEY ACT
Sen. Phil Gramm, chairman of the Senate Committee on Banking, Housing and Urban Affairs, made the following statement today in a ceremony at the Eisenhower Executive Office Building, where President Clinton signed the Gramm-Leach-Bliley Act into law:
"The world changes, and Congress and the laws have to change with it.
"Abraham Lincoln used to like to use the analogy that old and outmoded laws need to be changed because it made about as much sense to continue to impose them on people as it did to ask a man to wear the same clothes he did when he was a child.
"In the 1930s, at the trough of the Depression, when Glass-Steagall became law, it was believed that government was the answer. It was believed that stability and growth came from government overriding the functioning of free markets.
"We are here today to repeal Glass-Steagall because we have learned that government is not the answer. We have learned that freedom and competition are the answers. We have learned that we promote economic growth and we promote stability by having competition and freedom.
"I am proud to be here because this is an important bill; it is a deregulatory bill. I believe that that is the wave of the future, and I am awfully proud to have been a part of making it a reality."

I'm glad that guy got nowhere near a high position in government, as was originally envisoned by McCain.

Government is not the answer. But neither are non-regulated financial behemoths. There's a happy medium.

Lidless wrote:

Giving out loans
Prior to the Act, lending institutions were very limited in what they could invest spare cash in. With the repeal, the spare cash could be used in more speculative, more risky investments - therefore generating a higher level of return from it.

With the investment division of a bank making more money, it meant that if the bank wanted to at least have the same overall level of return, the mortgage arm could afford to make riskier loans.

Here’s a simplified example. Skip if you hate numbers.

Suppose a bank has two divisions – investment and lending. The investment arm makes USD 2,000 on average, and the mortgage arm has funds of USD 100,000 to lend someone. With it, they expect to make USD 10,000 profit 97% of the time, and they expect the chance of a default to be 3%.

The bank’s overall expected return is 2,000 + (97% x 10,000) – (3% x 100,000) = USD 8,700.

Now suppose that the investment arm makes USD 3,100, not USD 2,000. What chance of a default are you prepared to take to still expect a return of USD 8,700 on average? The answer works out to be 4%:

3,100 + (96% x 10,000) – (4% x 100,000) = USD 8,700

I am still very confused by this (I've re-read several times now). For one, I don't understand the relationship you're suggesting between the "investment arm" and the "lending arm". Why would the behavior of one change the other? In your first example the lending arm can expect $6,700. In the second higher-risk example, they can only expect $5,600. Why would they choose the higher risk choice?

Quote:

I am still very confused by this (I've re-read several times now). For one, I don't understand the relationship you're suggesting between the "investment arm" and the "lending arm". Why would the behavior of one change the other? In your first example the lending arm can expect $6,700. In the second higher-risk example, they can only expect $5,600. Why would they choose the higher risk choice?

Let me tell you what I finally figured out. Let's say that if you stick to the safe loans, which have a 3% default rate, you can make 100 loans of $100 000. That means your expected profit is 100x6700 = 670 000. But if you start making more risky loans, you can suddenly make 200 loans of $100 000. Then your expected profit is 200x5600 = 1120 000. So even though your expected profit per loan is lower, your total profit will go up.

But to be honest with you I can't quite figure out exactly how this math then ties in with the investment arm thing.

yovargas wrote:

For one, I don't understand the relationship you're suggesting between the "investment arm" and the "lending arm". Why would the behavior of one change the other?

Because neither arm is independent. They are governed by head office that wanted a certain overall rate of return on the funds they had. Whilst one arm, the investment arm (ie division), suddenly increased their returns because they were freed up to invest in things other than blue-chip AAA rated safe investments (which had low return), it meant that the lending arm could carry out riskier lending themselves and still get an overall rate of return for the bank the same as before if not better.

Ordinarily a stand alone division does not have full control over what they do. Xerox have three divisions: printer sales, maintenance and paper / cartridge supplies. The printer sales actually run at a loss because the real money is made from the other two divisions. If the head of printer sales decided to increase the price of sales so he would run at a profit, it would hurt the other two divisions too much.

The same is true for Parker pens - it's the refills that make the money. The same is true for Gillette and the razor handles - it's the expensive razor heads that have to be replaced that really makes the profits. It's also true for many cellphones. It's the line rentals and conection fees that generate the profit. Cellphones are sometimes given away.

It's even true where one division relies on supplies from another division where say production is split in two. Head office set a transfer price between the two that encourages behaviour that maximises profit for the company as a whole.

Banks could have kept the lending criteria as before and pound for pound have made a higher return, but they would not have grown year on year as much since they would have been lending less than otherwise. They calculated that it was growth that increased the share price of the bank, not the return. It was better to be seen steady-eddy having a 6% return but growing 30% a year, as opposed to an 8% return and not really growing much at all. You’d be ripe for acquisition by another larger bank and no one in head office wanted that.

Faramond wrote:

But if you start making more risky loans, you can suddenly make 200 loans of $100 000. Then your expected profit is 200x5600 = 1120 000. So even though your expected profit per loan is lower, your total profit will go up.

Almost. From what you say, there is nothing stopping banks from doing this in the first place other than the capital they had. (By law, casinos have to have enough cash in the vault to cover every chip on the table. There is a similar law to that for banks called Basel II, or the Capital Adequacy Directive, and even that was being relaxed in 2007).

The point I’m trying to make is that banks could not be seen to having a lower rate of return from one year to the next as would happen with your example. The share price would dive. But the extra money being made by the investment arm allowed riskier loans to be made by the lending arm. And with house prices rising so much above wage inflation, risky loans were becoming, and had to become, industry standard to keep up the same level of growth if not exceed it. These risky, or ‘subprime’ loans rose from 5% of the market at the beginning of the decade to around 30% at the time of the crash.

It fuelled itself. Everything was magnified. The repeal of the GSA took the seatbelt off the driver and now we're in hospital instead of just a bloody nose.

Quote:

Almost. From what you say, there is nothing stopping banks from doing this in the first place other than the capital they had.

Yes, exactly. The same thought occured to me, and I knew there was something I was missing, which is why I ended my post on a confused note. I think I understand now. Maybe.

Thank you, Liddy.

But I have a couple of questions:

Quote:

And the only reason banks were lending on riskier terms was because the investment arm had the shackles taken off by the repeal of the Glass-Steagall Act in 1999.

1) Isn't it the case that the 1994 and 1996 revisions to the CRA encouraged (and in some cases via litigation forced) banks to issue ever more subprimes? And, in a related matter, didn't Fannie and Freddie's loosened underwriting requirements provide a ready-made secondary-market sump into which lenders could dump dubious subprimes?

2) What are you thoughts on Basel II and the mark-to-market rule? It strikes me that MtM created a dangerous positive-feedback loop which both inflated the bubble and accelerated its crash, since it tended to first over- and then understate nominal asset value.

The losses from Fannie and Freddie would never have been enough on their own to cause the serious injury to the economy that other bits of deregulation like Glass-Steagal repeal did. But for some reason, fannie & Freddie have become the right wing poster child of their version of "what went wrong". They want to pretend that there was no such thing and deregulation or weakening of government regulation since that is their idealogy from day one.

SF, I just love the way you make categorical statements concerning subjects about which you know less than nothing.

This is confusing. But I think I kinda sorta understand. I still have one big question, though.

Liddy wrote:

Quite often the underlying detail of what the underlying assets on an investment were was not made clear – these loans were packaged, renamed, and rebranded.

For a while this has seemed to me to be the true core of the issue. There's nothing inherently wrong that I can see about choosing to make riskier loans. The problem lies when nobody seemed to bother checking what the risk actually was. This is what I don't understand. Why would anybody buy assets that nobody understands the value of? It seems to me that it wasn't so much the repeal of the act that made this happen - it could've been okay as long as the players involved bothered to asses the risks correctly. Free markets can only work if people know the value of what their buying. But they didn't. Why??

And as an aside, I'm curios to hear what CG thinks of this. You've often said that the repeal of the Glass-Steagall Act was categorically not a reduction in regulation but what Lidless describes seems exactly that. The leash on investments was loosened - aka deregulation. No?

solicitr - do you have something to bring here or just wiseguy comments?

Yovargas - your question about deregulation is answered in the following authoritative report.

Allow me to be the adult here:

Notice that the number one item cited is what Lidless has pointed out with Glass -Steagall repeal . Also take notice that the favorite whipping boy of the radical right - Fannie & Freddie only make it to number 10 on the list and even with the damage they caused it concludes

Quote:

"Fannie and Freddie are not responsible for the financial crisis. They are responsible for their own demise, and the resultant massive taxpayer liability."

But they gave loans to ...... folks that the Right does not want to get loans so they became a target of the Right wing critics and the only ones they would blame for the economic failure.
It was all the fault of those greedy poor folks who wanted to own a home like the rest of us... or so we are led to believe by the Right.

But lets put aside our favorite whipping boys and look at things objectively for a minute or two. This serious report should be read by anyone looking for causes of this mess

The Executive Summary minces no words in their main finding:


Quote:
"This Report has one overriding message: financial deregulation led directly to the financial meltdown."

http://www.afterdowningstreet.org/node/40531" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank

Quote:

Quote:
"Sold Out: How Wall Street and Washington Betrayed America," a report released by Essential Information and the Consumer Education Foundation details a dozen crucial deregulatory moves over the last decade -- each a direct response to heavy lobbying from Wall Street and the broader financial sector, as the report details. Combined, these deregulatory moves helped pave the way for the current financial meltdown.

Here are 12 deregulatory steps to financial meltdown:

1. The repeal of Glass-Steagall
The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagall Act of 1933 and related rules, which prohibited banks from offering investment, commercial banking, and insurance services. In 1998, Citibank and Travelers Group merged on the expectation that Glass-Steagall would be repealed. Then they set out, successfully, to make it so. The subsequent result was the infusion of the investment bank speculative culture into the world of commercial banking. The 1999 repeal of Glass-Steagall helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that led many of the banks to ruin and rocked the financial markets in 2008.

2. Off-the-books accounting for banks
Holding assets off the balance sheet generally allows companies to avoid disclosing “toxic” or money-losing assets to investors in order to make the company appear more valuable than it is. Accounting rules -- lobbied for by big banks -- permitted the accounting fictions that continue to obscure banks' actual condition.

3. CFTC blocked from regulating derivatives
Financial derivatives are unregulated. By all accounts this has been a disaster, as Warren Buffett's warning that they represent "weapons of mass financial destruction" has proven prescient -- they have amplified the financial crisis far beyond the unavoidable troubles connected to the popping of the housing bubble. During the Clinton administration, the Commodity Futures Trading Commission (CFTC) sought to exert regulatory control over financial derivatives, but the agency was quashed by opposition from Robert Rubin and Fed Chair Alan Greenspan.

4. Formal financial derivative deregulation: the Commodities Futures Modernization Act
The deregulation -- or non-regulation -- of financial derivatives was sealed in 2000, with the Commodities Futures Modernization Act. Its passage orchestrated by the industry-friendly Senator Phil Gramm, the Act prohibits the CFTC from regulating financial derivatives.

5. SEC removes capital limits on investment banks and the voluntary regulation regime

In 1975, the Securities and Exchange Commission (SEC) promulgated a rule requiring investment banks to maintain a debt to-net capital ratio of less than 15 to 1. In simpler terms, this limited the amount of borrowed money the investment banks could use. In 2004, however, the SEC succumbed to a push from the big investment banks -- led by Goldman Sachs, and its then-chair, Henry Paulson -- and authorized investment banks to develop net capital requirements based on their own risk assessment models. With this new freedom, investment banks pushed ratios to as high as 40 to 1. This super-leverage not only made the investment banks more vulnerable when the housing bubble popped, it enabled the banks to create a more tangled mess of derivative investments -- so that their individual failures, or the potential of failure, became systemic crises.

6. Basel II weakening of capital reserve requirements for banks
Rules adopted by global bank regulators -- known as Basel II, and heavily influenced by the banks themselves -- would let commercial banks rely on their own internal risk-assessment models (exactly the same approach as the SEC took for investment banks). Luckily, technical challenges and intra-industry disputes about Basel II have delayed implementation -- hopefully permanently -- of the regulatory scheme.

7. No predatory lending enforcement
Even in a deregulated environment, the banking regulators retained authority to crack down on predatory lending abuses. Such enforcement activity would have protected homeowners, and lessened though not prevented the current financial crisis. But the regulators sat on their hands. The Federal Reserve took three formal actions against subprime lenders from 2002 to 2007. The Office of Comptroller of the Currency, which has authority over almost 1,800 banks, took three consumer-protection enforcement actions from 2004 to 2006.

8. Federal preemption of state enforcement against predatory lending
When the states sought to fill the vacuum created by federal non-enforcement of consumer protection laws against predatory lenders, the Feds -- responding to commercial bank petitions -- jumped to attention to stop them. The Office of the Comptroller of the Currency and the Office of Thrift Supervision each prohibited states from enforcing consumer protection rules against nationally chartered banks.

9. Blocking the courthouse doors: Assignee Liability Escape
Under the doctrine of “assignee liability,” anyone profiting from predatory lending practices should be held financially accountable, including Wall Street investors who bought bundles of mortgages (even if the investors had no role in abuses committed by mortgage originators). With some limited exceptions, however, assignee liability does not apply to mortgage loans, however. Representative Bob Ney -- a great friend of financial interests, and who subsequently went to prison in connection with the Abramoff scandal -- worked hard, and successfully, to ensure this effective immunity was maintained.

10. Fannie and Freddie enter subprimeAt the peak of the housing boom, Fannie Mae and Freddie Mac were dominant purchasers in the subprime secondary market. The Government-Sponsored Enterprises were followers, not leaders, but they did end up taking on substantial subprime assets -- at least $57 billion. The purchase of subprime assets was a break from prior practice, justified by theories of expanded access to homeownership for low-income families and rationalized by mathematical models allegedly able to identify and assess risk to newer levels of precision. In fact, the motivation was the for-profit nature of the institutions and their particular executive incentive schemes. Massive lobbying -- including especially but not only of Democratic friends of the institutions -- enabled them to divert from their traditional exclusive focus on prime loans.

Fannie and Freddie are not responsible for the financial crisis. They are responsible for their own demise, and the resultant massive taxpayer liability.

11. Merger mania
The effective abandonment of antitrust and related regulatory principles over the last two decades has enabled a remarkable concentration in the banking sector, even in advance of recent moves to combine firms as a means to preserve the functioning of the financial system. The megabanks achieved too-big-to-fail status. While this should have meant they be treated as public utilities requiring heightened regulation and risk control, other deregulatory maneuvers (including repeal of Glass-Steagall) enabled them to combine size, explicit and implicit federal guarantees, and reckless high-risk investments.

12. Credit rating agency failure
With Wall Street packaging mortgage loans into pools of securitized assets and then slicing them into tranches, the resultant financial instruments were attractive to many buyers because they promised high returns. But pension funds and other investors could only enter the game if the securities were highly rated.

The credit rating agencies enabled these investors to enter the game, by attaching high ratings to securities that actually were high risk -- as subsequent events have revealed. The credit rating agencies have a bias to offering favorable ratings to new instruments because of their complex relationships with issuers, and their desire to maintain and obtain other business dealings with issuers.

This institutional failure and conflict of interest might and should have been forestalled by the SEC, but the Credit Rating Agencies Reform Act of 2006 gave the SEC insufficient oversight authority. In fact, the SEC must give an approval rating to credit ratings agencies if they are adhering to their own standards -- even if the SEC knows those standards to be flawed.


Here is an additional link. It has other links which will take you to the full report.

http://wallstreetwatch.org/soldoutreport.htm" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank" target="_blank

The ideological battles should take place somewhere else.

Solictr,

I’ll stress that all other issues changed the timing of the crash – not whether the crash would happen or not. Side issues. With that in mind, I’ll answer your queries, and hope that the answers are inclusive to most posters.

solicitr wrote:

Isn't it the case that the 1994 and 1996 revisions to the CRA encouraged (and in some cases via litigation forced) banks to issue ever more subprimes?

The original Community Reinvestment Act (CRA) attempted to stop discrimination in loans made to individuals and businesses from low and moderate-income neighborhoods. There was a caveat though – that the loans were still consistent with safe and sound operation. It did not require institutions to make high-risk loans that may bring losses to the institution. The Act was purely one of those ‘don’t discriminate and be seen not to discriminate’ acts.

That is still the case today.

solicitr wrote:

Didn't Fannie and Freddie's loosened underwriting requirements provide a ready-made secondary-market sump into which lenders could dump dubious subprimes?

Fannie Mae and Freddie Mac expanded their subprime business in the late 90s, partially in response to the higher affordable housing goals established by the government.

In fact their larger subprime role helped to reduce the level of predatory lending, since both FMs set clear guidelines about the types of loans that they will not purchase. They were limiting themselves to ratings of A- or above (about 8/10). So no, there was no dumping so long as the credit risk was not being deliberately underplayed by unscrupulous banks. But that’s a different issue.

What it did though was to increase the money available for subprime mortgages – at least for the relatively good ones. The money available was further increased between then and now as the government set higher and higher targets for minority home owners. The more money around, the higher the housing prices, and this magnified the crash.

solicitr wrote:

What are you thoughts on Basel II and the mark-to-market rule? It strikes me that MtM created a dangerous positive-feedback loop which both inflated the bubble and accelerated its crash, since it tended to first over- and then understate nominal asset value.

Basel II
Basel II is an international agreement that tries to ensure that banks have sufficient capital to back what they are doing just (as mentioned in an earlier post) as casinos need sufficient cash on the premises to cover every chip on the floor. It also provides a level playing field across the world so investors and lenders can compare like for like. The earlier version did not cover many important risks and was unsophisticated in its calculations.

Under Basel II the calculations involved can be highly complex. Basically, you look at the assets and then make discounts for different types of risk, and the bank needs sufficient capital to cover the total.

For example:
- liquidity risk (a building on the books worth USD 10m gets a discount, cash of USD 10m does not since it’s already cash)
- credit risk (a loan to a Zimbabwean bank gets a huge discount compared to, well, almost anyone else)
- concentration risk (a wide portfolio gets a small discount, but if you have 90% of your loans to farmers for example, there will be a large discount)
…and many more. There is even a discount applied to how good the banking internal systems are. The better the system, the lower the discount made.

It is interesting to note that for the credit risk calculation, the US is pretty much the only major country not yet to have implemented Basel II. It’s due out in the next few months. Most countries had implemented even the advanced version by January 2008.

I like Basel II immensely, but would a fully implemented version have prevented the crash? No, but it might have softened it to a small degree - the reasons for the crash were beyond the scope of a capital adequacy framework. The series of events that have led to the current situation were sparked by a search for return and growth in an environment of historically low interest rates and fueled by poor underwriting standards, opaque and complex financial products, lax investor due diligence, short-term incentive distortions, inadequate risk management, and weak valuation and disclosure. Most of that came as a consequence of the repeal of the GSA.

And this is what pisses me off. I’ve worked for the head office of group companies that included banks from 1994 and decided to get out of the finance sector in Sep 2007. Within those groups there was monthly reporting – my speciality. For companies / divisions that were not banks, the focus was entirely on the profit, with a cursory glance at the balance sheet to make sure creditors were not being overstretched and debtors were paying on time. For banks, the focus was concentrated on the balance sheet (mainly various risks and yield by asset type, liquidity and capital adequacy,). The profit was not so much an afterthought but a lowly second. This was industry standard.

Bankers took their eyes off the ball post GSA.

The crash also highlighted the importance of thorough assessments of the quality of underlying assets, because without such assessments any regulatory regime would quickly become ineffective. As I said, everyone thought they were selling the risk. They hadn’t realised, naively, they were buying it as well.

In a Basel II environment
- the closer alignment of risk with capital would require more capital to be held against the riskier credits arising from weak underwriting practices
- banks are encouraged to improve their risk monitoring and managing techniques
- there is greater disclosure of the adequacy of individual banks' risk exposures, risk-assessment processes, and capital.

Mark-to-market
First of all, some background.

Mark-to-market (MTM) is a way of valuing an asset. Basically, you use the current price unless it’s a long term investment such as a treasury bond which you expect to keep to maturity. That’s all there is to it.

What happens when the asset’s share price is all over the place. Let’s take an extreme example. Suppose you invested in a company to the tune of USD 100m and the share price has been quite steady. However, on the last day of the reporting year there is a rumor that the company has lost its major customer and the share price drops 20%. However, the next day the company announces that the rumor is unfounded and the share price recovers and continues to stay at that level. Under the MTM accounting rules, you have to value the asset at only USD 80m, ie show a USD 20m loss that year. Next year, presuming the share price stays as was, you will show the asset back at USD 100m and show a USD 20m profit.

The same would be true the other way. Suppose those rumours were takeover rumours which increased the share price at the year end. You would show a profit that year, and a subsequent loss in the next when the rumours were scotched.

Tough. Them’s the rules. That’s the value of the asset on the day and that’s that.

You also need to apply the rule when you have a contract to supply or receive an asset in the future – not just when you have the asset. Such things are called derivatives. A simple example would be where I have an agreement with someone to give them USD 6m in exchange for GBP 3m next month. If right now the exchange rate was 2.00 (those were the days…), that contract is worth nothing to me today - I’m neutral. However, if the exchange rate is 1.50 right now, I’ll need to spend GBP 4m to source the USD 6m, and get only GBP 3m in return. So right now I’m showing a loss of GBP 1m on that future contract. Derivatives can be used for all manner of items – exchange rates, share prices, interest rates, you name it.

It is only within the last few years that these derivatives needed to be accounted for.

Now back in the days before the repeal of the GSA, these derivatives were used as a hedge, an insurance policy if you will, to minimize risk and volatility in the numbers. Instead of being highly exposed to interest rates, they would make a contract with another bank to effectively fix the rates. No loan is made, but a future contract (for a fee) similar to the example above, only using interest rates, not currency. If the interest rate increased, the bank would effectively be insured for it. If the interest rate decreased, the bank would be paying out to the other party. But its profit would be stable whatever happened.

However, once the investment arm was unleashed by the repeal of the GSA, traders at banks saw derivatives as a way of (hopefully) making profits for the investment arm without a cash outlay and soaking up the bank’s capital. They would make such deals for the future, and then sell them on (hopefully for a profit) before they would mature. Take the currency example above. Suppose my agreement is with a bank. At the exchange rate is currently 1.50, I’m showing a loss of GBP 1m on the deal and the bank is showing a profit of GBP 1m.

What the trader would then (ie should) do is to make a contract with someone to sell USD 6m for GBP 4m next month. Since that’s at the current exchange rate, there will be buyers. That way, no matter what happens next month with the exchange rate – it could double, it could halve – the bank will see USD 6m in and out, and GBP 3m out and GBP 4m in. The GBP 1m profit has been locked in and the bank did not have to spend any money to do it.

The huge explosion of the use of derivatives purely for speculation without the capital outlay has made the stock markets (and indeed all markets – commodities, bonds, currency, you name it) far, far more volatile than before. Just as Fannie and Freddie increased their own and everyone’s risk by putting more liquidity into the subprime market, the same happened elsewhere making market prices far more sensitive and volatile than ever before.

Think of the markets as spinning tops. You can knock a big, chunky spinning top and it will quickly return to its stable upright position. Do the same knock to a spinning broom handle and it will topple over. The markets had become broom handles.

What also complicated matters was, as I mentioned, banks did not fully realise what they were buying with these mortgage-backed securities. They were being overvalued by all. It was only when the crash happened did the banks properly analyse revalue them – the ones they had been caught with in the massive game of pass the parcel they were inadvertently playing when the music stopped.

OK, that’s the background, and apologies for the length of it.

You may have spotted a couple of problems with mark-to-market. What if there isn’t a market? Suppose you have a third share in a local shop. Those shares are not traded on any stock market, so how would you try and value it? In that case, you would try and find where someone had recently sold a similar shop (or a part share in one), and scale up or down the value based on that.

The other main problem is if the market is not orderly, such as during the economic crisis. The US, correctly in my opinion, is now allowing an override to using MTM in such times. Basically, the value of an asset in an orderly market may then be estimated instead. Possible abuse there of course, but it’s a better approximation to a fair value than MTM might be, and in essence that’s what it’s all about – fair value.

Would such an approximation be used in my opening example of the USD 100m investment? No. The rumour mill is all part and parcel of an orderly market. Shares can quite often go up or down by 20%. You would still use MTM in that case.

Do I think that mark-to-market was in part responsible for the crash? Many people, including the Former FDIC Chair William Isaac, believe this to be the case - placing much of the blame for the crash on the requirement for banks to mark-to-market their assets, particularly mortgage-backed securities.

I disagree…in the main. The huge losses that banks started to report came about when they finally realised exactly what they had been buying and the true value of it (by finally looking at the underlying assets) – much less than what they had paid. It was a correction and a necessary one at that.

Having said that though, the sudden reporting of losses by banks in the last quarter of 2007 started to destabilise the whole valuation process for these assets. Suddenly there was not an orderly market and yet the accounting rules at the time stated they had to use current market value. So instead of showing a loss of USD 4 billion when a bank realised what they had, they were now showing a loss of USD 8 billion because of the crazy market at the time. They still would have shown a hell of a loss and the crash would have happened. MTM was just a way of quantifying the effect of the banks’ screw up.

It seems some people want to shoot the messenger who got the exact number wrong, but had the scale about right.

Once the market has stabilised, MTM is the correct valuation method that should be used. No question about it. The trick though is for the bank to fully understand what the asset is in the first place!

yovargas wrote:

Free markets can only work if people know the value of what their buying. But they didn't.

Exactly my point, only you’ve expressed it in a sentence and I rambled on for more paragraphs than I care to count.

yovargas wrote:

Why??

Standard operating procedure for traders is to look at the history of the asset and analyse what it had been trading at for the last few months. How volatile is the value? Does it seem too risky for my portfolio? After all what is the value of an asset? It’s whatever someone else is prepared to pay for it. And since all they looked at with their computer programmes were the trends on the price, the price remained relatively stable and supported itself. Of course, there’s a caveat to the valuation. It’s whatever someone else is prepared to pay for it if they have full knowledge of exactly what the asset is. That’s why people have surveys before buying a house of have a mechanic go over a second-hand car that’s being sold. Some financial instruments had become so exotic and complex traders did not fully understand them and had forgotten to go back to basics.

yovargas wrote:

It seems to me that it wasn't so much the repeal of the act that made this happen - it could've been okay as long as the players involved bothered to assess the risks correctly.

The inherent risk and impending losses were still within the financial community as a whole. One bank’s seller is another bank’s buyer. It was merely a question of who got caught with what and when on the day. As I said, think of pass the parcel. Will it be Freddie Mac caught with, say, a USD 100m loss from assets bought from Countrywide, or will it be Countrywide caught with the USD 100m loss when the bubble burst because they couldn’t sell those assets, or simply hadn’t yet.

Had those assets been correctly valued and assessed for risk at the outset, they would not have been sold on in the first place, because the seller would not have taken such a low price. And when the bubble burst, it would be them taking the hit rather than someone else.

Same loss had to be shown, just a different company.

Thank you Lidless for taking the time to explain all these issues. It's really helpful to try to understand what's going on. There's a lot of moving pieces and parts to this story, but at the bottom--if I understand what you're saying--is that the environment that was created allowed home prices rising at a rate that was significantly over and above wages. Which has to end and a correction engendered at some point. Your explanation helps to illuminate how the home prices took off. Very cogently.

So what's your crystal ball say about the future? it seems that we're wringing out the mess in the banks slowly but surely, but we've added unprecedented levels of debt to the U.S. Government (and others, such as U.K.) Does this inevitably lead to high taxation and stagnation, aka Japan? Or will our demographics (growing, not declining, population) save our butts?

ellienor wrote:

There's a lot of moving pieces and parts to this story, but at the bottom--if I understand what you're saying--is that the environment that was created allowed home prices rising at a rate that was significantly over and above wages. Which has to end and a correction engendered at some point.

You've summed it up very nicely. As the gap between house prices and wages grew, banks were too scared to reduce the access to funds since that would make prices drop and endanger existing loans. The longer it went on, and the higher multiples of earnings that had to be used to get the loans out without a proper assessment of the risk, the bigger the crash.

ellienor wrote:

So what's your crystal ball say about the future? it seems that we're wringing out the mess in the banks slowly but surely, but we've added unprecedented levels of debt to the U.S. Government (and others, such as U.K.) Does this inevitably lead to high taxation and stagnation, aka Japan? Or will our demographics (growing, not declining, population) save our butts?

It's all about confidence and A lending to B, where B isn't just a bank but anyone. That will come about. As to the timing of that, who can say? My gut feel says we'll be 7/10s of the way there within 18 months for the economy, but don't expect significant gains in the share price of bailed out companies for a while. The interest they have to pay on the government loans are quite large.

But I've given up trying to figure out the level of stupidity, ignorance and panic of people en masse a long time ago. I must say I have a good laugh when the news channels want results now-now-now in this microwaveable-fries culture we now live in.

Quote:

The original Community Reinvestment Act (CRA) attempted to stop discrimination in loans made to individuals and businesses from low and moderate-income neighborhoods. There was a caveat though – that the loans were still consistent with safe and sound operation. It did not require institutions to make high-risk loans that may bring losses to the institution. The Act was purely one of those ‘don’t discriminate and be seen not to discriminate’ acts.

That is still the case today.

But we're not talking about the original 1977 CRA, but the revised 1990's CRA- and you yourself mention in passing government pressure to increase minority lending, quotas-in-all-but-name which were filled, largely, by subprimes. I would also reiterate the spate of litigation under the CRA which had the effect of forcing banks to toss out their lending standards in certain neighborhoods- or, in extreme cases, to settle by effectively handing over large chunks of mortgage cash in trust to "community groups" for distribution.

While I don't at all disagree that repealing GSA was a major factor in this perfect financial storm, there were other factors at least as significant, such as the Fed's full-throttle loose-money policy, credit-market pressure from exhorbitant public debt (in addition to excessive private debt); and, I believe not insignificantly, government policy which had the effect of encouraging the creation of an ocean of toxic assets. And while regulatory failures and attendant greed and criminality are certainly to the fore, government attempts at social engineering through the financial markets can't be held blameless or swept under the rug: imperatives based on political rather than market considerations are rarely a good thing (and that stricture apples to Right and Left alike).


Anyway, the credit bubble has collapsed- is it policy now in our madness to re-inflate it ?????? Through the good graces of the Chinese? The sea of red ink in my avatar (to which should be added our new off-budget IMF contribution), the advent of increased Special Drawing Rights, the Fed's decision to buy Treasuries, and officials seriously discussing 'quantitative easing' to me have all the hallmarks of Weimar Germany. I have upstairs a 1921 thousand-Reichsmark note, which was overprinted Ein Milliarde 'one billion.' Perhaps this national traum underlies Merkel's refusal to play the 'stimulus' game.

Thank you, Lidless.

The explanations so kindly provided by Lidless show us what happened, but they do not show why. There has always been an underlying assumption that self-interest would ensure sense in financial matters. No one, we believe, would act against their own self-interest. But the current mess shows that assumption to be completely wrong - it was, in fact, unbridled emotion, unfounded optimism and a herd mentality (groupthink) that brought about the crisis. Few of the men involved understood what they were doing and were lulled by their certainty that the "big guys" knew what they were doing and guess what? They didn't. They were NOT operating with reason, but out of emotion. This is something people simply do not understand. It is not "greed" only, it is "greed" in a mix of elation, optimism, folly, unrationality.

Agreed, Vison. Believe it or not.

Vison - good points. I remember the official report that some blue ribbon commission made about the 1968 police riots in Grant Park Chicago during the Democratic Convention..... they uttered a famous questions ...."who protects the public from the police?" You could adapt that and ask the same here. If we strip government of its power to regulate and control the major areas of finance as we did with Glass Steagall repeal, who then protects the little guy from the rich and powerful? The whole derivitaves disaster proved that they certainly do not control each other. And there is the great fallacy of the power of any market to regulate itslef.

Soli, as far as the CRA theory of the economic collapse, how do you account for the fact that it was Phoenix, Las Vegas, and South Florida that were the areas where prices rose the most and the fastest and now where they've fallen the most and fastest? I don't think of those areas as minority owned ghettoes. And they've been the biggest impetus of the crash (I think). I think I understand you to argue that the CRA act "began" the subprime loan spigot and once created, the subprime loan came into vogue, as you will. But is this true "causation", when some shady mortgage lenders (Countrywide, for one) took this new product and ran with it? There'd be no market for the things without the derivatives and CDOs that were created by the big investment banks.

Once you have the problem, how do you solve it? Do you let the economy auger in a la a Depression? I mean, the house prices have dropped hugely and will continue to drop, and I think the government intervention is to try to create a softer landing and prevent an "overcorrection" in prices. If credit dried up, that would create an overcorrection for sure. Where I live (Denver area), there never really was a 'bubble' but houses at the high end are dropping because of the jumbo loan problem (jumbos are a lot more expensive than 417 K and under "conforming" loans).