What Caused This Crisis in the Economy?

by Tex Norman⁽⁷⁸⁾

My mama use to say, “Too many cooks spoil the broth.” What she meant was when too many people are involved in doing any activity the activity gets complicated, and when they go wrong, and the will, well, it becomes difficult to figure out whom is to blame because there were too dang many people involved.

This current economic crisis is an example of too many cooks spoiling our economic broth. There is a way to begin understanding the causes, but it requires a historic look back.

Economic Legislation

The Great Depression has been linked to the 1929 stock market crash, and while that is too simplistic an explanation, it is just easy to use that Wall Street disaster as the starting point. Some believe that had the government taken a more aggressive hand in controlling the economy the Great Depression would have ended quicker, and may not have been as devastating to the US and the World.

Eventually, under Roosevelt, there was legislation aimed at addressing the problems of the Great Depression and most feel that these legislative interventions helped heal the economy.

The Glass-Steagall Act (or the Banking Act of 1933)

Reasons for the Act - Commercial Speculation

When the economy went belly up and the condition was named the Great Depression, people looked around to see who was at fault. What happened? If you knew what went wrong you could fix it, or so many thought. When smart people looked over the causes for the Great Depression they learned that it was caused, in part, by commercial banks that took deposits (other people’s money) and made speculative investments. The word speculative, in this context, can be defined as wild, crazy risks. The Glass-Steagall Act eliminated conflicts of interest that were involved in the granting of credit and lending. The conflict of interest that had existed lead to investing that was more akin to high stakes gambling by Financial Hot Shots. If you know anything about risky bets it is that eventually you lose. You can run one red light and you might do OK, once, maybe even twice, but if you run all of the red lights you are going to crash. Before the Glass-Steagall Act the financial world was running red lights, making wild, crazy, high risk bets with other people’s money, and when they lost everybody lost.

The banking industry itself became sloppy and its purpose, goals, and objectives became blurred. The banks were in bed with stock sellers. Commercial Banks no longer felt that their purpose for existing was to protect the money people put into them by making prudent sound loans. Stocks were the way to get big profits fast. Why take the slow safe route of growing money through safe, solid loans for homes and businesses when you could get these huge jumps in money by betting on the stock market. What followed was banks making unsound loans (crazy, risky loans) to companies in which the bank had invested, and then their clients would be encouraged to invest in those same stocks.

Regulatory Barriers

The Glass-Steagall Act became a legislative reaction to one of the worst financial crises at the time, and the teeth of this Act was in setting up regulatory barriers between commercial and investment bank activities. The natural next question is: What is the difference between a commercial bank and an investment bank?

Commercial Banks

A commercial bank is allowed to legally take checking and savings account money deposited by regular people and small businesses and to use that money to make loans for cars, second mortgages, small business loans, etc. Of course some of these loans may fail, so what happens to the money that belongs to the regular people who just deposited their pay checks, or day’s receipts? Well, the federal government provides insurance guaranteeing these deposits from regular working folks. This insurance is called FDIC (Federal Deposit Insurance Corporation). But, and this is a big but, if the banks want these FDIC guarantees, these commercial banks must follow a myriad of regulations.

Investment Banks

Investment banks operate differently. The biggest difference is that an investment bank has no vault, no inventory of cash deposits that they can then use to lend out. No, the investment bank is more a wing man, a sort of financial dating service, a third party, an intermediary, and the function of the investment bank is to matches sellers of stocks and bonds with buyers of stocks and bonds.

Let’s say a company needs money to expand. Well, a company could go and get a loan from a regular ole commercial bank, or it could go to an investment bank and through the investment bank the company could sell some tiny part of the business, and use the money from that sell to finance the expansion. It is sort of like debt, but in this case it is stock, or bonds, and it becomes a debt to the business, and an investment to the stock holder. The stock is sort of a loan to the company, but it also makes the stock holder a tiny fractional partner in the business. If the business gets richer, the value of the stock gets more valuable. Stock holders, (people who have bought stock) are distant partners in the business. If the business is doing well, the stock is worth more, and the stock holders can sell the stock and put money back in their pocket, or they can hold on to the stock and hope it goes up even more in value.

Of course, if the stock goes down then something worth $50 per stock share, may become something worth 5¢. While the FDIC insures the money of depositors, there is no government insurance for the stock investor’s money.

The big difference then is that commercial banks already have funds available because they are allowed to use money parked in their facility by depositors, and the depositors don’t mind this use of their money, because they know they can always get it out, any time they want to, even if the bank gets into trouble, because the depositors are covered by FDIC. The investment bank does not have any depositor money on hand. This is the dating service part of the business. The investment bank is finding some plain guys and gals with money and linking them up to some sexy stock, hoping this match will result in a little “magic” and create a profitable relationship.

With the Glass-Steagall Act a bank could not be both a commercial bank AND an investment bank. The banks had to choose. The goal of the Glass-Steagall Act was to create this firewall between regular commercial banks, and investment banks. The Glass-Steagall Act was designed to prevent the investment banks from using people’s regular money for risky investments.

This may sound smart, but the Glass-Steagall Act was considered too confining, too harsh, too restrictive by the financial community. The Glass-Steagall Act was considered an overreaction to the crisis of the Great Depression.

The Urge to Deregulate

With the election of Ronald Reagan an anti-regulation sentiments gained wide-spread support. Fiscal conservatives gained power in Congress and the White House. The Glass-Steagall Act became the bulls-eye toward which Republicans aimed their darts. On November 12, 1999, Congress passed something now called the Gramm-Leach-Bliley Act. The banking industry and fiscally conservative fans had been seeking the repeal of the 1933 Glass-Steagall Act since the 1980s, if not earlier and the key to deregulating the banking industry was this Gramm-Leach-Bliley Act. The Gramm-Leach-Bliley Act was justified in the minds of some because they believed individuals usually put more money into investments when the economy is doing well, but they put most of their money into savings accounts when the economy was doing poorly. It was thought that the Gramm-Leach-Bliley Act would spur both 'savings' and 'investment' within the same financial institution, and that would be good, wouldn’t it? Like Wal-Mart you could do your savings, personal savings and buy some stock. In theory, the bank would do well in both good economic times and in bad.

Commodity Futures Modernization Act

The Commodity Futures Modernization Act of 2000 added to the deregulation lovefest, and has been called the "Enron loophole.” Provisions of the Commodity Futures Modernization Act of 2000 exempted so-called "naked" credit default swaps .

A naked credit default swap (CDS) is actually a contract that allows the buyer of the CDS to makes a series of payments to the seller and, in exchange, the buyer receives a payoff if a credit instrument fails. This means that if an investor buys a CDS from CITI Bank, where the reference entity is AIG Corp and if AIG Corp defaults on its then the investor would receive a payment from CITI Bank and the CDS contract would be terminated. In other words, if the investor actually owns AIG Corp debt, then the CDS be a way of hedging the debt, or insuring the risky investment. An investor could buy CDS contracts referencing AIG Corp debt, without actually owning any AIG Corp debt. This stuff was done solely for speculative purposes, as a bet against the solvency of AIG Corp. These "naked" credit default swaps are and were nothing more than a scheme that allowed investors to gamble, to take foolish risks on deals that were likely to fail, but this credit default swap was a way to cover the likely loss. The problem of course is that is you insure too many bad deals and all the bad deals go belly up on you, where will you get the money to cover the bets?

One of two things can happen:

1. The investor would have to deliver a defaulted asset. This means they would pay off with money, also known as a physical settlement, or

2. the company would pay the investor the difference between the investment price and the market price of a specified debt obligation. What this means is that even if you lost money, you wouldn’t lose all the money. You might get say 50¢ for every $1 that had been invested, also referred to as a cash settlement.

The swap is dangerous because there are no rules that say the backers have to have enough money on hand to pay off should these deals fail. In other words, the naked credit default swap could exist because there was no one to say, “No, this is stupid, risky, and certain, eventually, to fail.” Because there were no securities, commodities or insurance regulators looking at these financial deals, there was also no one to protect the investors from reckless deal makers. The CDS market grew from about $900 billion in 2000 to an estimated $58 trillion today. The problem we have in the world economy today is linked directly to deregulations of these CDS deals.

AIG was backing the trillions of dollars in risky deals and when the economy failed, they were left holding a very empty bag. There was no rule, no regulation, no requirement for AIG to have a way to pay if the deals failed.

Now imagine that I have offered to take $100 a month to insure your $700,000 house and you accepted this deal. Now imagine that the house burns down, and you want me to pay off. Well, I assure you that I can’t pay off a $700,000 house. This puts me in a similar position to AIG.

You say, “But wait, it would be stupid to insure a house and have nothing to pay with should the house burn down.”

Right. But there was no regulation that said I couldn’t do that, so I did it. Not only that, but I insured thousands of $700,000 houses and they have all burned down and I can’t pay off on any of them. I am AIG, which stands for And It’s Gone.

“Someone should have stopped this crazy crap!” you scream.

But to stop this crazy crap you either had to care about protecting the investors, or you would have to be required to follow the regulations made by some government agency that cares about protecting the investors. Deregulation opens up opportunities for people to steal, or gamble with other people’s money, and they do, because there are no consequences.

Article submitted Saturday, March 21, 2009 & read 522 times.

Tex Norman is a social worker, currently working at the Oklahoma DHS Abuse and Neglect hotline. He interviews people reporting abuse and/or neglect of children and vulnerable adults and writes a narrative. The narratives (and demographics) are used to initiate investigations of the allegations. He says it is like writing 8 to 10 stories a day. In August 2012, he will have been married to Kathie for 40 years. He has a son Ryan who earned a PhD from Princeton and he is now a scientist doing research in molecular biology. Tex spends his free time working as an artist and writer. He has one art site, and a blog that might be of interest: http://tex-norman.artistwebsites.com/ and http://collagepoetrybytex.blogspot.com/

Please log in to leave your comments.

» left by Gary W. Halsey Sr. (2 years 324 days ago.)

Now I know the difference between what type of bank does what...that is cool, another thing learned on Kerplop....Very interesting, and most of all informative article, tons of research , and tons of knowledge roll into this one. I think you said it best, to sum it all up at the end, by saying "Deregulation opens up opportunities for people to steal, or gamble with other people’s money, and they do, because there are no consequences". There is AIG in a nutshell....Well written, well said, and well done Tex, very interesting article....Your pal, and friend in pen, and fan......Gary

» left by Anonymous (2 years 324 days ago.)

Thanks Gary. Kerplop awaits articles from you as well. I know you have your own buisness, so you have an insight into the economy that is personal and real. Peace be with you. tex

5-2-2-0-0-ADSO