In September 2009 we began to learn our lesson on “too big to fail”. But most of the taxpayers who bailed out the big banks haven’t a clue what happened or why it had to be done. It is important that we do understand and support President Obama in his efforts to reign in the wildcats of Wall Street so it doesn’t happen again. The problem begins with greed, an absence of regulation, and executive compensation systems that reward extreme risk taking. It ends with you, the voter, taking the issue to your congressman.
In September 2009 we began to learn our lesson on “too big to fail”. But most of the taxpayers who bailed out the big banks haven’t a clue what happened or why it had to be done. After all, it’s complicated. Without a degree in finance and economics few of us will ever be able to understand and even less will want to try and understand what went wrong. But it is important that we do understand and support President Obama in his efforts to reign in the wildcats of Wall Street so it doesn’t happen again. With an MBA and a BSBA in Economics, where do I start to explain this fiasco in terms that the every day man and woman on the street can understand? The problem begins with greed, an absence of regulation, and executive compensation systems that reward extreme risk taking. It ends with you, the voter, taking the issue to your congressman.
The US economy never recovered from the socio-economic shock of 911. The Federal Reserve Board (FRB) pumped cash into the US banking system to stimulate an economy suffering from the 911 shock. As the economy “supposedly” recovered, high tech jobs went overseas and high paying jobs were replaced with low paying jobs. President Bush launched a huge war financed with debt. The government’s ability to keep issuing debt required the FRB to keep interest rates artificially low. These low interest rates coupled with tax laws that allowed mortgage interest to be deducted from income taxes fueled aggressive refinancing and excessive home equity loans. Housing prices rose rapidly as easy money allowed people to pay extravagant prices with lower and lower mortgage payments.
A laissez-faire attitude toward regulation in Washington set the stage for deceptive lending practices and ballooning personal and corporate debt. Community banks made loans to unqualified borrowers – many without income verification. Loans were bundled together and sold to big banks, like Lehman Brothers, who aggregated them into huge portfolios. These portfolios were then resold to investors seeking interest income. Insurance companies sold policies to insure the “loan portfolios” so risky assets could still be sold to “conservative investors”. One of the biggest insurance companies, AIG decided to corner the market on loan portfolio insurance. Yes, it was risky but only a systemic failure would make it unprofitable.
AIG sold the lion’s share of policies to their big bank clients. In normal times, with reasonable oversight and regulation of the banking industry this “diversification assumption” would have been correct. However, with a corrupt banking system, the entire portfolios were at risk. AIG would never be able to cover the losses. Executives from big banks and AIG were rewarded with huge bonuses for selling these defective securities to unsuspecting investors. When the system failed, there was no remorse. The wildcats of Wall Street continued to demand tens of millions of dollars in annual bonuses for bringing the system down.
Inflation fears, a falling dollar, and rising commodity prices caused the FRB to begin reigning in the accommodative money supply. As interest rates began to rise, banks had to borrow at higher rates. Floating rate loans began to see trouble and banks were not earning enough to cover their losses on bad loans.
When Lehman Brothers failed it started a domino effect with the entire global financial services industry. One by one the biggest global banks began to fail triggering other bank failures. This string of failures began as investors panicked and began to withdraw funds; first from their money market accounts, and later from their bank deposit accounts.
How did Lehman’s failure start a run on the banks? It begins with the unspoken rule in the money market industry, “the net asset value (NAV) will never fall below a dollar”. When people invest in a money market fund, they understand it is not insured but it is considered almost as safe as an FDIC insured bank deposit. Lehman was one of the biggest players in the commercial paper market. They issued short term notes to money market fund managers and then make riskier loans to businesses. Every 30-60-90 days Lehman pays back the notes and issues new notes to fund its financing business. But Lehman got into trouble and couldn’t pay back their notes. Defaulting on their commercial paper put all their paper into question and nobody would lend to them. They had to call in lines of credit and stop issuing more credit. Perfectly viable businesses were put at risk without credit.
When Lehman failed, funds that had short term commercial paper loans to Lehman saw those loans immediately become worthless. Money market funds had to report the huge losses in their NAV for the following day; that started the panic. Banks also cut off credit lines to perfectly healthy companies who then had to downsize without cash for operations. Unemployment skyrocketed and the economic engine went into a free fall without credit and cash.
Money in the bank’s vault is called “bank reserves”. Banks make loans with depositor’s money and collect interest on the loans. Banks generally collect more interest on loans than they pay to their depositors. The FRB sets reserve requirements and allows banks to make loans in multiples of the deposits they have “in their vaults”. For every dollar that is in the bank’s vault, the FRB allows them to lend it out as much as four to ten times. Reserves are held in the vault to support the cash demands of bank customers who have deposits with the bank. When loans go bad or customer withdrawals exceed deposits the bank has to adjust their reserves by borrowing from other banks.
Lehman’s failure caused banks to borrow to cover their losses at the same time investors ran to withdraw their deposits. The banking system simply “ran out of cash”. The US government was forced to step in to stop the crash. Since capital has a “reserves multiplier” effect on bank balance sheets, the US Treasury was forced to injected cash as capital into struggling banks. By injecting capital, the US government became the largest shareholder in many big banks and the public outcry about socialism and government nationalization of banks began. Financially the banks were saved but they still didn’t have cash to lend. The banks then began to restructure their loan portfolios, systematically calling in questionable loans and foreclosing on secured assets.
It seems ironic that a little over a year after the Lehman fiasco, the US taxpayers who bailed them out are now paying these banker’s astronomical bonuses while consumers continue to struggle to repay underwater loans. President Obama is trying to bail out the US taxpayers who continue to be the insurance company of last resort.
So, when I see President Obama advocating a tax on big banks because “they still don’t get it”, I say hooray! If these banks can use taxpayer money to bail them out of poor management decisions, reap huge profits from lending out “free money” from the FRB, and manage to pay multi-million dollar bonuses while the man on Main street counts his pennies between unemployment checks, then these banks can pay windfall profits taxes to finance recovery of the real economy.
Do you think you understand what happened and what needs to be done about it? I hope so because the big banks are now hiring lobbyists to put on the same kind of disinformation show that the insurance companies did for the healthcare debate. You’re going to hear the most outrageous claims about socialism and big government you’ve ever heard. You’re going to hear about “tax and spend” Democrats. You’re going to hear how these reforms are causing massive unemployment and suffering to middle America. You’re going to hear all these lies and they’re going to sound plausible. Plausible because it’s difficult to grasp the complexity of our money and banking system and its easier to point blame with nasty sounding words like socialism, taxes, big government and liberals. Don’t be fooled by propaganda from so called grass roots not-for-profit organizations secretly funded by the biggest banks and financial service companies in the world. Don’t play ignorantly into the hands of rich and powerful Wall Street executives. Demand regulation, oversight, consumer protection, and special banking taxes to repair our floundering economic system.
We need a government that protects the little guy from the abuses of the big Wall Street Goliaths. Get on the front end of this new wave. Tell your congressman you support the President’s plan for consumer financial product protection and regulation of financial services firms. Support the Wall Street Reform and Consumer Protection Act (HR 4173). Let’s end the days of mega-million dollar bonuses for greed and corruption. Demand that bank executives accept responsibility for the economic malaise and pay fees to rebuild a thriving US economy.
