On August 15, 2007, I wrote a essay that indicated that unless the Federal Reserve and the Treasury took major remedial steps to make major regulatory changes that they would someday be unable to overcome the growing threat to the world economy because of three ominous trends: 1) The proliferation of incredible magnitudes of leverage using short-term borrowing 2) The widespread global investment in derivative products whose values fluctuate greatly, that lack independent valuation verification, and whose creditworthiness is not fully appreciated by its participants 3) The dramatic bonus incentives for financiers to take enormous risks in order to capture spectacular bonuses irrespective of the risk profile for their parent organizations.
Moreover, neither the Federal Reserve nor the Treasury has the appropriate tools to monitor and regulate the utilization of securities by institutions. That is, mutual funds, hedge funds, off balance sheet corporate entities, off shore investment funds, and globalization of the financial markets has so broadened the risk parameters to the financial system that the Treasury and the Federal Reserve lack both the sophistication and regulatory scope to track properly the escalating risk parameters. This weekend there was an article highlighting the ignorance of chief executives about their organizations. That is, the article pointed out that the widespread disparate nature of today’s business behemoths leads to operation ignorance because the operations have become to disparate and the senior executives are surrounded by “Yes” men.
Since my August 15th essay, several major events have occurred that support my concerns. First of all, commercial and investment banks have written off billions of dollars of over valued securities. Secondly, major mortgage banks such as Countrywide and American Mortgage Corporation has either failed or has been bailed out. Thirdly, the Federal Reserve has taken the unprecedented step of allowing commercial banks to borrow at the discount window using mortgages as collateral. Fourth, the Federal Reserve has encouraged the commercial banks to borrow at the discount window; therefore, they have abandoned their policy since 1913 that borrowing from the Federal Reserve was a privilege not a right. Fifth, the Treasury is using a combination of arm twisting and financial incentives to create a $75 Billion to $100 Billion back up fund that would be used to buy risky mortgage securities and other assets. This latest step is strictly a bail-out for Citicorp that had some $80 billion in its bank-affiliated investment vehicles. The deteriorating value of these investments created a massive problem for Citicorp. That is, Citicorp either had to sell off these investments at enormous losses or Citicorp has to guarantee these off-the- book entities. Either one of these solutions would have seriously impaired Citicorp’s financial stability.
The participation by J.P. Morgan and Bank of America and Citicorp is frankly a cover up for Citicorp. That is, J.P. Morgan nor Bank of America do not have this problem. Thus, their participation is 1) to generate fees from trading in these questionable securities and 2) provide financial cover for Citicorp. In essence, “the too big to fail” hypothesis is being seriously tested. Stated differently, the bigger they are, the harder they fall might be more appropriate. For years, despite the Japanese horrendous bank failures, the Federal Reserve has allowed commercial banks to swallow up competitors under the erroneous theory that “bigger was better” and we needed larger institutions to compete globally.
I would argue that the events of the last two months demonstrate that we need a dramatic overhaul in the regulatory process including significantly higher margin requirements on a variety of securities that have been engineered over the past generation. For example, the investment banks hold significantly higher Level 3 inventory securities than their net worth. Level 3 securities cannot be accurately evaluated and have very thin secondary markets. Given that investment banks are leveraged at more than twenty to one, forced liquidation of these Level 3 securities would be the same pressure on investment banks as Citicorp is facing currently. Moreover, the major write downs by Bear Stearns, Merrill Lynch, Morgan Stanley, and Goldman Sachs shows that these firms employ in high places unqualified “risk takers” whose multi-million dollar bonuses lure them to take unwarranted risks. Moreover, the pressure to obtain disproportionate trading profits to augment service income has added immensely to the risk profile.
On the investment banking side, the investment banks and commercial banks have billions of dollars of unsold bridge loans. The loans originally intended to be syndicated were created to finance highly risky acquisitions by private-equity firms.
In summary, unless appropriate actions are taken to reign in risk, central banks throughout the world will someday be unable to stop the inevitable financial panic. Moreover, the failure of foreign institutions that unwisely purchase syndicated securities created in the United States points out that financial excesses have no national borders.
Originally published in the Sarasota Herald-Tribune
