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Finance — A Dysfunctional System

Stock-Markets / Financial Markets 2010 Nov 05, 2010 - 08:10 AM GMT

By: Barry_Elias

Stock-Markets

Best Financial Markets Analysis ArticleIn 1993, I commented to a colleague that the market seemed to be appreciating more rapidly than the underlying dynamics would suggest.

Was something afoot?


The St. Louis Federal Reserve reports that since January 1994, hundreds of banks and depository institutions reduced the amount of required reserves by classifying demand deposits as savings deposits (known as a “sweep” transaction). Unlike demand deposits, savings do not have capital reserve requirements.

In his July 1995 Humphrey-Hawkins Act testimony to Congress, Alan Greenspan, former chairman of the Federal Reserve Bank, indicated retail sweep programs have substantially distorted the growth of M1, total reserves, and the monetary base.

Anderson and Rasch (2001) estimated that sweep programs from 1994-1999 reduced required reserves by $34.1 billion.

During this time, Christopher Whalen, a former Federal Reserve Bank of New York analyst and co-founder of Institutional Risk Analytics, notes risk-adjusted return on capital (RAROC) for the top 100 banks fell precipitously from roughly 170 percent to 20 percent, when innovative securitization began to grow. As of 2009, the RAROC hovered near zero.

In 1994, George Akerlof (Nobel Laureate in Economics, 2001) and Paul Romer co-authored a paper entitled “Looting: The Economic Underworld of Bankruptcy for Profit" which delineated the potential for moral hazard and excess risk taking by the financial industry.

Simon Johnson, professor at MIT recently said, “The nonfinancial private sector completely gets and understands this point; if you sold boxed cereal in the same way that financial services have been sold (by some people), you would be kicked out of the boxed cereal business — by your industry colleagues. The financial sector, unfortunately, has lost its moral compass and ability to police itself."

In 1995, MERS (Mortgage Electronic Registration System) was created to improve the servicing of the extraordinary volume of mortgage assignments. Bloomberg reports, “MERS is owned by the largest lenders in the country including Bank of America, Citigroup Inc., JPMorgan Chase & Co. and Wells Fargo & Co., in addition to Fannie Mae and Freddie Mac, which own or guarantee more than half of the $11 trillion U.S. mortgage market.”

Apparently, once the mortgages were within the jurisdiction of MERS, the true owner was not preserved within the documentation. The rating agencies provided their services based on a commitment to declare the securitizing party “bankruptcy remote,” which suggests a complete removal of potential liability in the transaction.

In assessing market behavior in 1996, Greenspan observed an “irrational exuberance.” Despite misgivings in 1997 by Brooksley E. Born, chairwoman of the Commodity Futures and Trade Commission, the Presidential Working Group of 1999 recommended proceeding with deregulation of derivatives.

This group included Greenspan, Securities and Exchange Commission Chairman Arthur Levitt, and Treasury Secretary Lawrence Summers. At that time, Summers stated that, "As we worked to clarify the legal framework for OTC derivatives, we were guided by time-tested principles of competition, efficiency and transparency. If enacted, these changes will strengthen the financial system by improving a segment of the market which helps American businesses to hedge and manage risk more effectively and reduces borrowing costs for both individuals and corporations."

Subsequently, President Clinton signed the Gramm- Leach-Bliley Act of 1999, which repealed a provision of the Glass-Steagall Act that prevented bank holding companies from owning other financial institutions.

The following year, President Clinton signed The Commodity Futures Modernization Act of 2000, which effectively deregulated the derivative market. In 2000, the notional value of the credit default swap market was $900 billion. By 2007, it had increased to $60 trillion, and the entire derivative market had a notional value of nearly $600 trillion.

In a recent statement before the Risk Management Association (RMA) in Baltimore, FDIC Chairman Sheila C. Bair said:

"The loss of confidence we saw in the global financial system two years ago was the direct result of both a failure of risk management at an institutional level and a failure of regulators to limit the buildup of system-wide risk.

"Innovation in financial practices and structures has proven to be another prime source of systemic risk. High among the lessons learned in the recent crisis is that financial innovation and complex securitization structures allowed leverage and risk to build in an opaque way that was not well understood until it was too late. While the financial industry is highly sophisticated in its ability to innovate, all too often the profit motive has proven to be more powerful than its commitment to managing risks.

She added that, "Market discipline fails to rein in the excesses at these institutions because equity and debt holders — who should rightly be at risk if things go wrong — enjoy an implicit government backstop. This skewing of financial incentives inevitably leads to a misallocation of capital and credit flows."

During a recent hearing on subprime lending, securitization, and government-sponsored enterprises by the Financial Crisis Inquiry Commission, Richard Bowen, former senior vice-president and business chief underwriter with CitiMortgage Inc., stated:

“In mid-2006 I discovered that over 60% of these mortgages purchased and sold were defective. I started issuing warnings in June of 2006 and attempted to get management to address these critical risk issues. These warnings continued through 2007 and went to all levels of the Consumer Lending Group.

"We continued to purchase and sell to investors even larger volumes of mortgages through 2007. And defective mortgages increased during 2007 to over 80% of production.

He continued to state that, “On Nov. 3, 2007, I sent an e-mail to Mr. Robert Rubin and three other members of Corporate Management . . . In this e-mail I outlined the business practices that I had witnessed and attempted to address. I specifically warned about the extreme risks that existed within the Consumer Lending Group. And I warned that there were 'resulting significant but possibly unrecognized financial losses existing within Citigroup.”

According to Christopher Whalen, “That five- or six-year period during the boom, that was just purchase activity created by credit . . . When you’ve withdrawn all of this credit from the economy, you’re also taking a component of revenue out . . . We’ll be lucky if revenue growth for U.S. banks is flat this decade.”

Deleveraging (debt reduction as a percentage of equity) has reduced aggregate loan demand. The manifestations include reduced revenue, compensation, and employment.

Robert Shiller, Yale University economics professor and co-creator of the S&P Case-Shiller Index, which monitors the nation's housing market, suggests, "This high unemployment equilibrium could last for years."

These issues have developed over several decades: it may take a decade or more to rebuild and set a more sustainable trajectory. By Barry Elias

Website: http://www.moneynews.com/blogs/Elias/id-114

eliasbarry@aol.com

Barry Elias provides economic analysis to Dick Morris, a former political adviser to President Clinton.

He was cited and acknowledged in two recent best-sellers co-authored by Mr. Morris: “Catastrophe” and “2010: Take Back America - a Battle Plan.” Mr. Elias graduated Phi Beta Kappa from Binghamton University with a degree in economics.

He has consulted with various high-profile financial institutions in New York City.

© 2010 Copyright Barry Elias - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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