Wednesday, 25 July 2012

The Second Global Financial Crisis, Part I

Defalcation on a Unimaginable Scale 

We are nearly four years on from the Global Financial Crisis.  It has achieved the status of its own acronym (GFC)--a sure sign in modern parlance that it "means something".  Its effects are still with us and some assert they will ripple out for a further decade. Has the problem been solved?  Far from it.

In short the regulatory changes made, particularly in the United States, have been both inadequate and even those passed, ineffectually policed.  The causes of the original crisis were manifold; the solutions, however, appear straightforward.  They have largely been ignored.
  One reason for this is that the foxes in the hen house--the dominant US investment banks--were allowed undue influence upon the hen house rules.  The sad fact is that the United States is gradually morphing into a plutocracy where the very wealthy pull a lot of politician's strings.  Politicians, after all, need money for campaigning and running their electoral affairs.  They also "need" money if they are to depart national office much richer.  Many have become multi-millionaires whilst in office--with a net-worth way beyond their pay grade.  Much of their wealth has come from insider trading and from the relationships they have forged with the financial masters of the universe.  Big money has never talked more loudly.

There are fundamental issues--moral issues--which have not been addressed at all.  There are also technical matters which have largely been ignored.  Hapless, helpless governance has also been a major causal factor.  The law of unintended consequences has been another.

Let's take the last first.  One of the problems identified early on in the GFC was that investment banking was far too concentrated into seven or eight key institutions.  These were huge US owned, multi-national conglomerates.  They spent most of their time doing business with one another.  When the crisis hit the domino effect showed up.  One fell; its fall threatened to bring down the other six.  Overnight the appearance of diversification became a vapour.  John Lanchester  refreshes our memories.
. . . the really serious wave of bailouts and collapses began with Bear Stearns in March 2008 and then went to the next level with the "conservatorship" of Fannie Mae and Freddie Mac on September 7, the largest nationalization in the history of the world.  It was followed eight days later by the largest bankruptcy in the history of the world, when the investment bank Lehman Brothers went into Chapter 11, the American form of receivership.

The next day saw the biggest bailout of a private company in history, with the US government taking a 79.9 percent share in the insurer AIG.  Merrill Lynch, the bank whose symbol is the Wall Street "roaring bull," was taken over by the Bank of America on September 14, 2008.  [John Lanchester, I.O.U.: Why Everyone Owes Everyone and No One Can Pay (New York: Simon & Schuster, 2010),  p.39.]

The end result of this series of disasters has been that global financial risk has become more concentrated still in the hands of fewer (but bigger-than-ever) investment banks.  Systemic risk has therefore markedly increased from 2008 as a result of the actions taken.  Instead of the institutions which failed being broken up into several smaller entities they were "shoved" into their competitors, so that greater concentration has resulted.

Consider the following, written by Neil M. Barofsky, the special inspector general of the Troubled Asset Relief Program:
It is clear that the criminal-justice system has proved ill-equipped to address the financial crisis. For that, we needed effective regulatory reform. Instead, we got the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.

My fear about the inadequacy of Dodd-Frank has only gotten worse over the past year. The top banks are 23 percent larger than they were before the crisis. They now hold more than $8.5 trillion in assets, the equivalent of 56 percent of gross domestic product, up from 43 percent just five years ago. The risk in our banking system is remarkably concentrated in these banks, which now control 52 percent of all industry assets, up from 17 percent four decades ago. There is broad recognition that Dodd-Frank hasn’t solved the problem it was meant to address -- the power and influence of banks deemed too big to fail.

More important, the financial markets continue to bet that the government will once again come to the big banks’ rescue. Creditors still give the largest banks more favorable terms than their smaller counterparts -- a direct subsidy to those that are already deemed too big to fail, and an incentive for others to try to join the club. Similarly, the major banks are given better credit ratings based on the assumption that they will be bailed out.

As a result, the market distortions that flow from the presumption of bailout may have gotten worse. By failing to alter this presumption, Dodd-Frank may have inadvertently sowed the seeds for the next financial crisis.
One of the structural weaknesses of the financial system that led to its global collapse was the relatively small number of globally dominant investment banks that largely did business with each other, and which collectively controlled the global financial asset market.  This represented an enormous concentration of risk.  Now the risk is more concentrated than ever before and the number of global investment banks has shrunk.  Worse, collectively they control over half the entire assets of the banking industry. 

Of the five biggest investment banks when the GFC hit, three no longer exist or have been subsumed into other banks.  Only J P Morgan and Goldman Sachs have survived as "stand alone" investment banks.  Others have been purchased by non-investment banks (Citigroup, Merrill Lynch).   If one of these institutions were to falter, the others would fall.  Once again the government would be forced to bail out the "too big to fail" institutions.

In a previous world, when telephone company ATT was considered market dominant the US Justice Department forced it to split up into the Baby Bells (in 1984).  The Federal Government has unfortunately done the reverse in the case of the US global investment banks.  It has forced them together, reducing their number, thereby concentrating their market power and great exacerbating the risk of the US and global financial system.

Keith Fitz-Gerald, writing in October last year, noted:
In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller.  The four banks in question: JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS).
More concentrated than ever!

J P Morgan recently made a "bet" that interest rates in Europe would eventually rise.  Using its London subsidiary, (whilst borrowing virtually limitless funds from the ever obliging Federal Reserve under its "quantitative easing" programme), it borrowed at margin, and placed an enormous derivatives position into the market.  If interest rates in Europe had risen, it would have gained billions of dollars of profit.  As it turned out interest rates did not rise and J P Morgan owed some other institutions an awful lot of money (between five to nine million dollars, depending on who is counting).  That loss hit J P Morgan shareholders.

No problem, said senior management.  We are so big it is just a small blip.  Until it isn't--and then the GFC will come back seven times worse, requiring and demanding a taxpayer bailout.

This is a regulatory failure--a breach of duty by government.  Federal regulators and politicians have defalcated upon a fundamental duty of the state: to ensure the integrity of property via maintaining the law of contract.  If the electorate does not act quickly to hold government to account in the end we will all pay for it, whether we like it or not.

We will take this up in our next piece. 

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