By November 2009, 120 banks had failed since the start of the year, unemployment was at 10.2%, a twenty six year high, and the government had invested billions of tax dollars in failing financial institutions that were deemed "Too Big to Fail" WHY? What made them too big to fail and why did the government bail them out? Was this a necessary evil or just plain evil? This book takes an important look back at the amazing legislative and financial events that created these "monstrosities" and lead to the financial crisis of 2008/09.

Why Too Big To Fail?

How the regulatory system failed the American peopleBy Kaye Bonnick

AuthorHouse

Copyright © 2010 Kaye Bonnick
All right reserved.
ISBN: 978-1-4490-5436-6

Contents

Foreword...........................................................................ixIntroduction.......................................................................xv1929 vs. 2009......................................................................3The Glass-Steagall Act.............................................................5Components of the Financial Services Industry......................................11The Federal Reserve System.........................................................16Post-Depression Recovery...........................................................19Disintermediation and the Savings and Loan Crisis..................................24Banks vs. the Federal Reserve......................................................32Citibank and J. P. Morgan: Their Role in the Fall of the GSA.......................35The Financial Modernization Act....................................................41Travelers-Citicorp Merger: The Final Push..........................................45The Current Crisis: 2008-2009......................................................55Fannie, Freddie, and Ginnie Mae....................................................59Securitization.....................................................................61Troubled Asset Relief Program (TARP)...............................................69Their Roles and the Results........................................................77Bear Stearns.......................................................................79Lehman Brothers....................................................................81American International Group (AIG).................................................83Citigroup..........................................................................88Merrill Lynch & Bank of America....................................................90Hedge Funds........................................................................93The Proposal.......................................................................99The Concerns.......................................................................106Conclusion.........................................................................113Notes..............................................................................119

Chapter One

The Beginning

1929 vs. 2009

On October 24, 1929, the United States stock market suffered a historic crash that has been cited as a contributing cause of the Great Depression. The economic downturn had started earlier, in the summer of 1929, and it escalated with the October stock market crash. The natural response in such a financial crisis was for consumers to stop buying. No one knew what would happen next; consumers responded by ceasing to purchase durable products. The reduction in demand led to a reduction in output-a drop in production-and, ultimately, the Great Depression. The depression did not end until around 1940.

The Depression era was a frightening period for those who lived through it. Banks failed, companies went bankrupt or downsized, unemployment was high, and people feared that they would not be able to provide for their families. Does this sound like the 2008-2009 crisis? Yes, it does. Fortunately, however, we are not experiencing failures of 40 percent of our banks and 20 percent unemployment, as was the case during the Depression era of the 1930s.

How did we climb out of the doldrums of the Great Depression? Did we put in place safeguards to prevent the possibility of widespread collapse in the future? Well, I think we did-and then we undermined our efforts!

Over the years, there have been various theories about the true cause of the Depression, but it cannot be denied that, leading up to that time, banks took serious risks with their depositors' money. Again, there are similarities today, such as the creation of, and investment in, the risky collateralized debt obligations using mortgage-backed securities. Though these particular securities did not exist in the 1930s, risky loans were made and risky investments were both offered and managed through the banks. When these loans failed, so did the banks.

The banking system has experienced many changes since that time, and yet it seems that the industry may have come back to square one. A tenet learned in basic finance courses is that the greater the risk, the higher the return. Well, that's true-but it's also true that the higher the risk, the greater the potential for significant loss. That was true in the 1930s, and it is equally true today. We are in the most severe recession since the Great Depression, and, at this crucial juncture, the way we deal with this crisis will determine our success in the future.

The Glass-Steagall Act

In an effort to fix some of the problems that caused the crisis during the Great Depression, Congress enacted the Glass-Steagall Act (GSA) of 1933. The objective of the GSA was to separate commercial and investment banking activities. Commercial banks would no longer be allowed to underwrite or trade corporate stocks or bonds. They would, however, be allowed to purchase and sell Treasury securities and general obligation municipal bonds. On the other hand, investment banks would not be allowed to perform the functions of commercial banks.

Additionally, the GSA restricted commercial banks that were members of the Federal Reserve from affiliating with companies that engaged in investment banking activities. Finally, the GSA also prohibited investment bank directors, officers, employees, or principals from serving in these respective capacities at a member commercial bank. This stipulation was put in place to guard against conflicts of interest.

The GSA also established the Federal Deposit Insurance Corporation (FDIC). The FDIC's role is to insure bank deposits in the event of bank failure. Under the GSA, all member banks of the Federal Reserve had to participate in the FDIC program. The program is similar to a regular insurance policy. The FDIC charges the banks a premium, and, in the event of failure, depositors are guaranteed the return of their money up to the sum insured. The insured value was initially set at $2,500 in 1934; by 1980, the deposit insurance coverage had risen to $100,000. The aim of deposit insurance was to reduce the likelihood of mass withdrawals by depositors, popularly referred to as "a run on the bank."

With the onset of the economic crisis of 2008, the FDIC increased the deposit coverage on interest-bearing accounts to $250,000 and made its coverage unlimited for non-interest-bearing accounts. In the atmosphere of late 2008, amid uncertainty about which bank would collapse next, this temporary measure was intended to reassure citizens that the government would protect our bank deposits. The fears were well founded-there was a run on Wachovia when it became evident that the bank was having difficulties. Wachovia has since been purchased by Wells Fargo.

The GSA also sought to eliminate competition among banks by instituting an interest-rate ceiling for deposits, under Regulation Q. It was determined that interest rate competition among banks contributed to the bank failures of the 1930s. The premise of this regulation was the assumption that, as banks paid high interest rates to attract depositors, they would in turn acquire risky assets-which offered a high rate of return-to bolster their profits. The downside of risky investments is, of course, that the actual return could be lower than expected, which could jeopardize the viability of the commercial banks that hold them. Therefore, as part of the GSA, Congress elected to put an interest rate ceiling of zero on demand deposits (checking accounts) and limit the rates on time and savings deposits (CDs and savings accounts).

In addition to addressing concerns of competition between banks, Regulation Q was geared at encouraging smaller banks to lend their deposits to customers in their immediate communities rather than deposit them with the larger banks. Coming out of the Depression, smaller banks tended to hoard funds instead of making loans, a practice that delays economic recovery and growth. This practice is based on fear about the overall economic recovery, but it creates a vicious cycle. An economy needs active lending to stimulate growth, but financial institutions are crippled by the fear that the economy will not grow-the resulting credit freeze, in effect, causes that fear to become reality. Without lending, the economy does not grow.

Despite the apparent success of the Glass-Steagall Act, there were those who held a dissenting view. It has even been said that, two years after its enactment, one of its sponsors, Senator Carter Glass, said that he thought it had been a mistake and an overreaction and that he wanted to amend the act. However, in light of the 2008 crisis, it could be argued that the GSA may have had some redeeming qualities.

The Financial Services System

Components of the Financial Services Industry

The financial services industry includes several different types of institutions that serve different needs: depository institutions, insurance companies, investment banks, finance companies, mutual funds, and hedge funds. Our focus will be on the depository institutions and investment banks.

The diagram shows the basic flow of money between consumers and some financial intermediaries. Rather than keep their money in cookie jars, individuals want to have a safe place to save-and earn interest on-their money. These intermediaries, which can be commercial banks, savings and loan associations, credit unions, or other types of institutions, accept deposits from individuals and hold the money in various types of accounts (savings, checking, etc.). These intermediaries use their customers' deposits to provide loans to other customers. The borrowers may be depositors themselves, but oftentimes they are not.

Loans, which might be intended for personal or commercial use, are usually needed for large purchases such as cars and homes, or to start or expand a business.

The overriding expectation in this system is that loans are made at a higher interest rate than that paid to the depositors; the difference is a net gain to the institution.

Financial intermediaries take advantage of modern technology to easily conduct business globally. Electronic fund transfers, online bill payments, wire transfers, and other automated financial transactions have accelerated the pace at which business is conducted and, in some instances, have shattered barriers that made trade inconvenient.

Our banking system is at the center of the growth of the American economy, and, not surprisingly, it is at the center of our current crisis. Though the banks are the main focus of scrutiny, they are not the sole perpetrators of the current financial tsunami. The economic crisis of 2008-2009 is a complex problem with many places to lay blame.

Within the financial framework, one element of concern is the insufficient level of capital reserves held by failing institutions. To start and maintain a business, capital is required. A financial intermediary is no different from any other business; however, their capital requirements are determined by their charting agency. Typically, a financial institution is required to have a certain ratio of capital to assets.

Assets for a bank are generally the loans made to customers that are outstanding and the investments kept on its balance sheet. In the event that borrowers default on their loans or the value of an institution's investments declines sharply, the institution should have sufficient capital reserves (cash) to continue doing business despite the losses incurred.

Internationally, capital requirements are set by the Basel Committee. In early 2009, as a response to the global financial crisis, the Basel II framework was strengthened to ensure greater capital requirements. Most, if not all, large financial intermediaries and investment firms have international divisions. Following the principle that "a chain is only as strong as its weakest link," international regulatory mechanisms, such as the Basel Committee, were compelled to act to ensure that financial institutions would take steps to safeguard the interests of their depositors and investors.

Investment banks, unlike commercial banks, do not provide what is called "cash management services." That is, they do not provide traditional checking and savings accounts or any of the other services mentioned previously. Investment banks underwrite and trade securities. The term securities includes many other products besides the familiar stocks and bonds, such as swaps, options, futures, swap-options (swaptions), and asset-backed securities. These are called derivatives.

The underwriting role of the investment bank involves advising a company interested in issuing stocks or bonds on what price they could ask for their offering, applying to the Securities and Exchange Commission (SEC) for permission to offer the security, and preparing and distributing the prospectus, which provides all the details about the company and the intended security sale. The investment bank can handle the offer in one of two ways: a "firm commitment" or a "best-efforts" agreement.

Under a firm commitment, an investment firm would purchase the entire offering from the issuing company, and that firm would, in turn, sell the security to the public. In such a scenario, the risk is transferred to the investment company. For example, if the public does not see the issuing company in a favorable light, there would be less demand for the company's security. This would drive down the price of the security, and the investment company would lose money on that deal.

Therefore, the more popular approach is the best efforts agreement, where the investment bank helps the issuing company to sell its security, but the investment bank does not actually purchase the security. Once a security has been sold, it becomes available to be traded on an exchange. At this point, brokerage houses and online discount brokers enter the picture. On behalf of investors, these brokerage firms trade on exchanges such as the New York Stock Exchange (NYSE) or on the over-the-counter markets, such as the National Association of Securities Dealers Automated Quotation System (NASDAQ).

Many investment firms, such as Bear Stearns and Lehman Brothers, were "super companies" that did it all. They engaged in underwriting, advising, and securities trading. However, despite their size and wealth, the mortgage crisis brought these giants to their knees.

The Federal Reserve System

In 1913, the Federal Reserve was created. The "Fed," as it is commonly called, is the central banking system of the United States. One of its main roles is to ensure that the credit system remains stable and functional. To this end, the Fed regulates the banks that are members of the Federal Reserve.

Banks can have either a national or a state charter. When the Fed was established, nationally chartered banks were obligated to be members, while state-chartered banks had the option of being members. Once they joined the Federal Reserve System, banks were required to hold a reserve of funds to meet short-term demands, called the reserve requirement. The amount of required reserves was based on their level of deposits and was separate from their capital requirement.

A benefit of being a member bank is that members can borrow from the Fed and from each other. However, the Fed restricted the types of assets that member banks could hold.

The Federal Reserve System is governed by a seven-member Board of Governors. The members of the board are appointed by the president of the United States and are subject to Senate confirmation.

The Federal Reserve is responsible for setting the federal funds target rate, the discount rate, and the reserve requirements, mentioned above. We have heard many times that the Fed may change interest rates, and we often wait with great expectancy to see what the Fed will do. The rate set by the Fed is the target federal funds rate, and the financial markets react whenever a change is announced. Through interbank negotiations, as borrowing takes place, the effective federal funds rate is determined.

The federal funds rate is the rate at which banks can borrow from each other's excess reserves. Through the interbank funding process, banks lend to each other to cover their reserve requirements on a short-term basis, usually overnight. On the other hand, the discount rate is the rate at which banks can borrow from the discount window at the Federal Reserve.

If the Fed lowers interest rates, the following may happen:

1. Banks will be able to access money at a lower rate and will be more willing to give loans to consumers.

2. Mortgage rates might be lowered, and therefore more consumers might consider purchasing homes. Mortgage rates do not respond directly to changes in the discount rate, but if the discount rate is kept low for a significant period of time, this could eventually lead to lower mortgage rates.

3. Commercial interest rates may be lowered, which would encourage major capital purchases by businesses. Expansion of businesses and increased investments in more efficient processes are the anticipated outcomes of reduced commercial rates.

Therefore, lowering interest rates can stimulate credit markets and the economy. This is a monetary control tool used by the Federal Reserve Bank to guide the direction of the economy. Banks play a crucial role in the execution of this process.

Post-Depression Recovery

Over the years, more and more banking regulations were instituted to guard against widespread failures. The 1950s marked the beginning of an era when financial services institutions sought ways to expand their business and circumvent the various regulations. Banks felt that the existing regulations hindered their competitive ability and limited their growth.

As banks looked for loopholes, they began to form corporate shells called Bank Holding Companies (BHCs) to own both banking and non-banking businesses. These corporate shells would acquire multiple banks and were referred to as "multi-bank holding companies."

In response, Congress enacted the Bank Holding Act of 1956, which prohibited BHCs from acquiring banks in other states. In a subsequent amendment to this law, BHCs became subject to the state laws of the state where they wished to acquire a bank. If that state allowed for a national bank to acquire and operate a bank locally, then the BHC was free to do so. However, most states did not allow this, and, essentially, BHCs were prohibited from operating banks across state lines. The Bank Holding Act also restricted the ability of bank holding companies to engage in most non-banking activities or to acquire voting securities in companies that were not banks.

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