Financial Reform

 

Purposed legislation is a start but doesn't come near my ideals of a fair shake for the little guys who are the genius of the American economy.  Economic and social policies should not remove moral hazard for banks great and small  while mouthpieces for those banks tell consumers "Ultimately, an educated and informed consumer is the best defense against predatory practices. And which industry is most committed to helping financial literacy? The answer is New York’s and the nation’s bankers."

In his 1988 inauguration speech George W. Bush told Americans his first priority was to recapitalize the banks which as an industry were in danger of failing due to a real estate bubble which had collapsed.  He sent legislation to congress and it was passed.  During the next six years the U.S. economy grew anemically while banks were able to recapitalize themselves on the backs of tax payers with a favorable rate difference engineered by the Federal Reserve. 

'Short of investing directly in a failing bank, lowering the bank's cost of deposits is the sole method available to a central bank to sustain a bank that is "too big to fail."This blunt mechanism has two effects, both very beneficial for financial institutions. Lowering borrowing costs is slow to take effect, since if a bank pays its depositors 6.5% and charges its borrowers 9%, the bank makes 2.5% profit over a year. Not bad. But if a bank borrows money at 6.5% in the short term markets which are under central bank control, invests the proceeds in the bond market, and long term interest rates then fall creating capital gains, the effect is dramatic and immediate.

The Federal Reserve reacted in dramatic fashion, shifting its attention to the banking crisis, the most urgent problem of the day. Between the end of October and January 1991, they dropped their Federal Funds rate from 8.25% to 6.5%. For those banks without major loan problems, this flood of low cost liquidity brought fabulous profits. By the end of 1992, the share prices of JPMorgan and Chase had more than doubled from the crisis low, while shareholders of Merrill Lynch were four times wealthier. Citicorp's problems proved more intractable, and shareholders despaired as the stock price bottomed at Christmas in 1991 The Federal Reserve continued to press their funds rate down until the end of 1992, until it stabilized at 3%. Confidence in bonds escalated rapidly, and the engines of liquidity worked overtime.

In 1992 and 1993 combined, the long term bond market provided capital gains of close to 20%. The "carry trade", as this mechanism had come to be called, was so profitable that many others, particularly hedge funds, rushed to enjoy the ride, borrowing at a low cost and buying bonds. As the potential gains became obvious, unsophisticated investors joined in, pushing the bond market up dramatically in rampant speculation. By the fall of 1993, the recapitalization of the banking system was complete. Even Citicorp had by then increased to $22. At no time during this process did the Federal Reserve acknowledge the magnitude of the problems.'

Banks are necessary.  George Bush's administration tackled the capitalization problem and saved the banks.  However he lost his bid for a second term partially due to an anemic economy caused by the invisible to consumers subsidy for banks.

When the next US real estate bubble developed America again had a president named George Bush.  Commercial Banks had learned some lessons from the mid 1980's real estate bubble.  So had Investment Banks.  Bank real estate loans were sold quickly to investment banks which bundled them together for sale as highly diversified and through diversification theoretically safe bonds.  The bonds were rated by big financial firms like Moodys. While the bubble was expanding there was easy money to be made and the finance industry engaged in questionable practices which resulted in systemic risk to the world's economy.  When the bubble collapsed the government deemed some banks to large to fail.   A liquidity crises occurred but the finance industry was saved by huge temporary infusions of government capital.  The US economy is again suffering anemia from invisible cost due to risk taken by the finance industry.

Lesson's from the US financial industry over the last thirty years and two real estate bubble/bust cyclers confirm "Ultimately, an educated and informed consumer is the best defense against predatory practices. "

But the "industry" most committed to helping inform the consummer is the nation's government since the financial industry including banks of all sizes have proven untrustworthy.

Strong new regulatory structures are needed to prevent history from repeating.