The Financial Crisis: Who's to Blame?

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The Federal Reserve plans to spend $700 billion (adding to our current $10.6 trillion deficit) to buy up mortgage-related debt from our ailing banks so the banks will be able to lend again. Credit is, after all, what America runs on. As Fed Chairman Ben Bernanke put it, this plan is "the last wrench in the toolbox" to fix our financial crisis. But how did we get here? Here's where the blame game leads us"¦

Alan Greenspan
He had interest rates too low for too long, which resulted in the housing bubble. But what is too low too long? I don't blame Greenspan, though he did push subprime lending, lauding the "innovation and structural change in the financial services industry "¦ critical in providing expanded access to credit for the vast majority of consumers, including those of limited means."

Consolidated Supervised Entities Program
In 2004 the SEC changed the rules under which banks with at least $5 billion of capital calculate their gross leverage ratios. It basically raised the leverage ratio to 30, from about half that. A leverage ratio measures the amount of debt a company has compared to its total capital. A leverage ratio of 30 means that 30% of a bank's total capital is debt. The banks could take on more debt, which was good when times were good because it allowed them to make more transactions. However, high levels of debt means it takes only a small decline in the value of the firm for the bank to go bankrupt.
Five investment banks fell under the program: Goldman, Merrill, Lehman, Bear, and Morgan Stanley. It is noted that at the time of decline, Merrill had a leverage ratio of about 40, Lehman of 36.

Goodbye, Uptick Rule
In 2007, the SEC eliminated the "uptick rule," which prohibited sellers from shorting a share when the stock was selling for lower than the previous trade. This rule was instituted after the Crash of 1929, as shorting was alleged to be the culprit of the crash. After research and assessment of the rule, the SEC suggested the uptick didn't matter and lifted the ban. Now, shorting has been blamed for today's crisis and has been put on a temporary ban.

Hedge Funds
Hedge funds aren't as highly levered as investment banks, but they do a lot of shorting. Perhaps their ubiquity spurred the financial decline. They'll pay whether or not that is the case. About 90% of hedge funds are currently losing money and that's sure to increase with the advent of the short selling ban.

Ratings Agencies
It's not the Fed's job to allocate or assess risk, so we can't truly blame Greenspan. But the job is someone's responsibility. Whose? The ratings agencies, these government sanction oligopolies like Moody's, S&P, and Fitch. See, the ratings agencies slapped high ratings on all of the Mortgage Backed Securities. An MBS is a bundle of a bunch of loans, some dodgy, some not, that are all rolled into one tradable security, like a stock. The Ratings Agencies rate all securities based on their level of risk. Again, the ratings are a lot like school grades: A good, B okay/bad, C junk. The Ratings Agencies aren't regulated by the SEC, and so were not really watched throughout this whole game. So they were able to slap high ratings on risky MBS' last year, and then downgrade AIG last week, putting the onus of bailing them out on you and me.

sec.jpgThe SEC
The SEC was created in 1933 to protect small investors against securities fraud. It doesn't have robust oversight over all financial entities, ratings agencies included, and is not really equipped for our financial world.

The Deregulatory Financial Modernization Act of 1999
In 1933, Congress established a set of banking regulations under the Glass Steagall Act. Thinking commercial banks (ones that take deposits from everyday citizens) caused the Crash of 1929, the act separated the commercial banks and the investment banks. This way investment banks would take on risky investments, and commercial banks could protect its members by not doing that. Before 1933, there were few investment banks and the Glass Steagall Act spurred Wall Street as we know (ahem, I mean knew) it.

The Glass Steagall Act was repealed, however, in 1999 under the Deregulatory Financial Modernization (Gramm-Leach-Bliley Act) Act. This allowed the commercial banks to take on the same risky bets that investment banks did. A commercial bank (one that sells to you and me, like Citigroup or WaMU) could trade Mortgage Backed Securities, Collateralized Debt Obligations, and other Structured Investment Vehicles. So basically, it allowed the guys that are usually safe and who hold my life savings to take on risky investments and get all mixed up in the mess too.

The Glass Steagall Act of 1933
Or you could blame the Glass Steagall Act of 1933 (mentioned above) itself, for really creating the stand alone investment bank in the US.

Be sure to read more of what Diana learned today here.

September 25, 2008 - 7:02am
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