Wednesday, October 8, 2008

The Credit Crisis - “Understanding the problem is part of the cure"

The following is provided in the spirit of "understanding the problem is part of the cure".

As with most big problems – the credit crisis has many contributing dynamics.
At a high level – it was stupidly, greed, leverage, derivatives and securitization - these attributes were not exclusive to the US.
Villains include members of both political parties and participation from a broad spectrum of industries.

A negative saving rate in the US has not been helpful. Joseph Stiglitz (Nobel prize - Economics - 2001) is making the case that spending in Iraq has been a significant contributing factor (I am not up to speed on that thought process).

The notes below present some of the significant milestones on the way to driving the economy into the ditch.

Early 1990s:
Government Sponsored Enterprises bills expanded the power and influence of Fannie Mae and Freddie Mac. With the mantra of "fair lending", a mix of positive sentiment and greed (especially among banks and former government officials), a toxic mess was created.

November 1999:
The Gramm-Leach-Bliley Act repealed the Glass-Steagall Act which regulated the financial services industry. Gramm later became a lobbyist for UBS, collecting over $750,000 in fees and than became a Chairman of UBS. UBS issued over $18 billion in subprime mortgages. Recently, Gramm was senior economic advisor to John McCain.After 9/11, Fed Chairman Alan Greenspan started a process that led to a series of interest rate cuts meant to stabilize the economy. Over time, the US was hooked on cheap credit and Greenspan was in charge of the "punchbowl".

During 2004:
The SEC granted 5 investment banks an exemption to a 30 year old rule which limited broker debt-to-net capital ratio to 12:1 (this is the amount of leverage they could apply to investment/speculation activities). The exemption allowed them to increase their leverage to 40:1 (this could have been dramatically higher in some situations – was it high-octane, toxic or just insanity)

So, who are the FAB FIVE and where are they today: Lehman (bankrupt), Bear Stearns (bankrupt) Merrill Lynch (almost dead)- purchased by Bank of America, Goldman Sachs and Morgan Stanley – both struggling and have changed their status to commercial banks to get "back stopped" by the US government.

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