Thomas Schoenbaum on the Causes of Global Financial Crisis – Part 1

Professor Thomas Schoenbaum from George Washington University has written a paper discussing the worldwide financial crisis.  His paper entitled “Saving the Global Financial System: International Financial Reforms and United States Financial Reform, Will They Do the Job?”, identifies 12 factors as triggering the financial crisis.

The first six are as follows (the second six are discussed in part 2).

1. The diminished authority of the United States Securities Exchange Commission.  This constituted a regulatory failure.  States Prof. Schoenbaum,  “beginning in the 1980’s, the once-feared SEC became largely toothless due to rule-revisions, exceptions, and leaders that discouraged fraud investigations and enforcement actions.”

Such failure continued for two decades, but not without warning.  “One of the most egregious of SEC failure occurred on April 28, 2004, when the SEC voted to exempt investment companies from the SCC’s net capital rule . . . During this meeting, Harvey Goldschmid, one of the Commissioners, remarked, ‘If anything goes wrong, its going to be awfully big mess.’”

2. Failure to Regulate the Derivatives Market.  Another regulatory failure.  The derivative market is enormous, yet it operated for years without effective oversight.   Again, there were warnings.  The Commodities Futures Modernization Act of 2000 specify exempted derivatives and swaps from supervisory oversight by the Commodity Futures Trading Commission, “despite warning from its chairman that unregulated derivatives “could threaten our regulated markets or, indeed, our economy without any Federal agency knowing about it.”

3. Lax Regulation of Financial Institutions.  Here, the author cites the Federal Reserve and the Comptroller of the Currency as failing to exercise proper oversight of the U.S. banking industry.  Thus, “the persons in charge of bank regulations were totally obvious to the dangers of the extensive use of derivatives such as MBS’s.  Accordingly, the use of MBS’s allowed financial institutions to profit from transactions that involved unreasonably low capital requirements.”

This point could be stated in slightly different terms.  The players in the financial markets, especially in derivatives, were permitted to gamble with other people’s money.  The oversight in the banking industry was absent in the derivatives market.  Such easy access to such excessive leveraging encouraged Wall Street to take unreasonable and dangerous – desperately dangerous – risks.

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4. Financial Institutions That Took on Too Much Leverage.  The authors cites this factor as a private sector abuse,  stating “a key cause of the Crisis was the fact that key financial institutions, especially the investment banks, took on far too much leverage, risking vast qualifies of borrowed capital so that they were unable to withstand a down turn in asset prices.”

What kind of leveraging was going on?   “After the SCC exempted investment banks from the ‘net capital’ rule in April 2004, leverage increased dramatically to levels in excess of 40 to 1.”  This meant the investment banks could make a $40 bet with only $1 in actual assets.  Is this a recipe for disaster?  You bet it is.

5. Mismanagement by Bond and Securities Ratings Agencies.  As explained by Prof. Schoenbaum, “hearings in the Congress and the European Union have established a sloppy and misleading ratings practices that causes most of the now ‘toxic’ derivatives to be given triple A ratings.  Only after the Crisis began did the ratings agencies downgrade these securities.  The credit ratings agencies were among the enablers of the Crisis.“

See, the vast tradings in the investment banking world were really a shadow financial system, running parallel to the banking industry.  The banks were heavily regulated and were backed by the FDIC.  The investment banking world had no such official guarantees, so they invested the insurance provided by companies such as AIG.  At present, “AIG has benefitted for governmental largesse amounting to a total of $182.5 billion.  None of this funding has been repaid.”

That means that the U.S. taxpayers bailed out the bets that were made by Goldman Sachs and other investment banks to the tune of $182 billion that has never been repaid.  It’s one thing to take risks with your own money; it’s entirely different when the government steps in to save private industry in the amount of $182 billion.  Oversight and accountability must be established, otherwise the taxpayers just gave away $182 billion to the bankers.

6. Low Saving Rates and High Borrowing by American Consumers.  This is a social factor.  Explains the author, “as of 2007, the U.S. savings rate touched zero, which means that as a group Americans were spending every penny of income.  Moreover, many Americans were deeply in debt, now only for home mortgages but on credit cards and other consumer loans.  The American economy was overheated and riding for a fall.”

Part 2 follows next week.

Uniform Commercial Code Law Journal, Vol. 43, No.1 (October 2010) page 479.