Friday, September 26, 2008

Trust Busted: How a Failure of Regulation Helped Lead to the Subprime Mortgage Crisis

We've discussed how the modifications to the Community Reinvestment Act (CRA) under the Clinton administration directly led to lenders being forced to make unsound loans to borrowers simply because they were minorities. Now we will exam the flip side of those modifications - the Gramm-Leach-Bliley Financial Services Modernization Act.

President Clinton was quoted as saying he, "would veto any legislation that would scale back minority-lending requirements." So the Republican sponsors of the Gramm-Leach-Bliley Act agreed to support the changes to the CRA pushed for by Clinton and the Democrats in exchange for passage and signage of their bill.

In 1933, the federal government feeling the fallout from the Great Depression passed the Glass-Steagall Act. The purpose of the act was to control speculation by limiting the ability of banks from owning both insurance companies and securities companies.

Theses regulations were removed when President Clinton signed into law the Gramm-Leach-Bliley Act, opening the door for mega mergers within the financial services industry. In the decade that followed many small town banks were gobbled up by their larger counterparts. Companies like AIG, Bank of America, Wachovia, JP Morgan Chase and Citigroup became the primary financial services companies in the United States.

When the subprime loan scandal began to implode the first companies to feel the effects were the large brokerage houses that invested millions into mortgage backed securities. With the value of these mortgages becoming near worthless overnight, companies like Bear Stearns failed. But instead of letting an over leveraged company fail, the government approved a bailout package that would allow JP Morgan to purchase the company and preserve our current financial system.

During this period companies like Bank of America and JP Morgan Chase began swallowing up mortgage companies like Countrywide and financial service companies like Washington Mutual. These companies, seeing the governments response to Bear Stearns and AIG, felt they needed to grow quickly to become "too big to fail."

So why did the federal government believe AIG was, "too big to fail"?

CNBC's Jim Cramer said, "We cannot let [AIG and Citigroup] go under, because their exposures are way too big and way too important."

"[F]or the AIG worldwide to have gone bust would have been catastrophic. They are the world’s largest insurance company and it would have brought down lots of players," stated Barrie Etchells, managing director of Belmont International.

"Too big to fail."

Since the early 90's the federal government, both under democrats and republicans, has abolished many of the rules that regulated what Teddy Roosevelt called the "trusts". We've seen an economy of many large corporations in the financial, telecommunications, and energy sectors reduced to only a small few.

These mega corporations have become so big and hold so many assets that should they make bad business decisions or be regulated into making them, as is the case with the subprime mortgage crisis, the federal government has no option but to step in and bail them out or face economic devastation that would be felt worldwide.

Had the federal government not forgotten the lessons of the great depression and prevented these mega mergers that created the oligopolies that now dominate nearly every sector of our economy, we would not be in this mess staring at a $700 billion expansion of the federal government. Had AIG not been allowed to buy up every major insurer in the country, the failure by one would not have had the kind of ripple effect the failure of the whole has or would have had.
The men of wealth who today are trying to prevent the regulation and control of their business in the interest of the public by the proper government authorities will not succeed, in my judgment, in checking the progress of the movement. But if they did succeed they would find that they had sown the wind and would surely reap the whirlwind, for they would ultimately provoke the violent excesses which accompany a reform coming by convulsion instead of by steady and natural growth.
– Theodore Roosevelt, "The Man With The Muck Rake" (April 15, 1906)

No comments: