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To regulate or not, that is the question! September 23, 2008

Posted by shaferfinancial in Uncategorized.
Tags: , , , , ,

Many commentators including myself trace the genesis of the current financial trouble to the repeal of the Glass Steagall Act and the passing in 1999 of the Gramm-Leach-Bliley Act.  A quick background.  The Glass Steagall Act of 1933 was passed as a result of commercial bank failures when they took on too much risk causing them to fail (sound familiar?) and take with them their deposits.  It kept commercial banks from investing in high risk activities that investment banks take part in.  Part of the ACT was the forming of FDIC government backing for deposits in exchange for not being able to get involved in high risk activities that had led to massive bank failures.  The thought was that the deposits of average folks would be protected, giving commercial banks an advantage in obtaining funds which could be redeployed in conservative ways as a foundation for the economy.  During the 1990’s through much lobbying the investment banks, insurance companies and commercial banks were able to convince the government to repeal this, signed into law by Clinton in 1999 after a bipartisan vote in congress that was veto proof.

Now in 1999 there was a full on economic change happening to Wall Street as investors were demanding high returns for their capital and were not reticent to move their money if they were disappointed.  Hence the investment banks taking on more leverage and trading in mortgage backed securities backed by sub-prime loans.  Now, commercial banks seeing the amount of money being paid for these MBS’s and having pressure to increase the return they give to investors startedto be tempted.  Some started to originate mortgages with questionable underwriting because they could sell these out and make huge profits.  Other banks and mortgage companies were formed just to originate sub-prime mortgages.  Still other small regional banks were able to grow exponentially by originating questionable loans. Insurance companies  (AIG) started to get in the business too by either trading in these MBS or insuring them.  In short, since there was no longer any fire wall between commercial banks, insurance companies and the more risky investments and there was intense pressure to increase returns to investors many companies felt compelled to take on the added risk in order to stay competitive to investors eyes.

As this easy credit pushed real estate pricing up well past what average people could afford you had a classic bubble that when popped, started a chain reaction that has taken down investment banks, commercial banks and 1 insurance company.

Readers who have a different understanding of this are encouraged to reply to this post.  This is only my thinking on the subject and I hope others can add or disagree with these ideas.  Somewhere in this is a very important point about regulation!

Additionally, I have read a really good book called “Supercapitalism” by economist Robert Reich.  It really puts together much of the economic history into a easily understood framework.  I think readers will be surprised by some of the suggestions coming from this former member of Clinton’s cabinet!



1. Joshua - September 23, 2008

Great post! You have given the best overall summary of today’s market crisis and did so with only a few short paragraphs!

I’m a Libertarian and believe that the government should be involved as little as possible in invididual and commercial affairs. I would like to hear your opinion on what would happen if the government never stepped in.

How does it hurt me if some large bank fails? I keep paying my mortgage to my local credit union each month like I’ve always been doing. Failure of those banks only makes an opportunity for someone else to take advantage of. Why can’t a more smartly run company go in and buy all those properties (not the debts) from the banks and make a healthy profit?

Example, Jimmy buys a house for $100,000. His ARM adjusts upwards and now he can’t afford his payments. The bank forcloses on him and Jimmy loses his house. The bank now has a house, lets even say its worth only $80k now and that Jimmy still owed a principle balance of say $92k since he started payments. The bank is now upside down $12k on the house itself and there is nothing it can do about it. The bank was the one who ultimately made the mistake by loaning to Jimmy and now has to write off the loss.

Bob comes along and says, “Hey bank, I’ll buy that property from you for $75k. Do we have a deal?” Bob buys the property holds onto it for a few years and then sells at a nice profit when the market has recovered.

Maybe I just don’t understand it all, but isn’t this how it’s supposed to work?

2. shaferfinancial - September 23, 2008

Except that the loan has been bundled with others and sold up line. Some companies have bet their entire investor capital on the leveraged value of the now bundled loan. Others have insured the losses. Meanwhile in order for the bank to sell the loans they originated they have to agree to buy back a certain percentage of the loans, which they don’t have enough capital to accomplish. Therefore, the bank goes out of business, taking along with it all the deposits from average folks, the companies that bought the bundled loans go out of business taking with it investor capital, the one’s that insured the loans go out of business again taking investor capital. Meanwhile, banks that write loans take a look at all this and tighten credit so only a few individuals can get credit, so the real estate industry is destroyed, businesses can’t get credit so many of them are destroyed and the whole house of cards goes down in a wave of deflationary assets!

Problem with the libertatarian view in my opinion is a failure to understand how important the government has been to mediate the failure of capital markets. If all this creative destruction is OK with you; and remember if you own a home its value will depreciate along with your mutual funds and any stocks in companies that depend upon the real estate/construction/financial sectors in order to operate or who depend upon the people in these sectors (perhaps up to 25% of all folks work in some part of these sectors) to have money to spend on their products, then you can call for “pure capitalism” without government regulation.

Of course make sure you work in a business that won’t be affected and fail!

3. Joshua - September 24, 2008

Thank you for the further explanation.

At the risk of sounding like some anti-government hack, I would like to say that the government had some sort of hand at the beginning and some of the acts they passed within the last decade may have been huge factors to this ultimate ending.

All I know is that it’s a great time to buy stocks and I’m in like Flin.

4. shaferfinancial - September 24, 2008

All things being equal I would hope to see no bailout of failing companies. However, the “creative destruction” that would occur would lead to more rules and regulations.

Here is a simple way of looking at regulation.
The government (citizens through their legislatures) set the rules of the game. That is their role in the process. Industry has the job of satisfying investors (and consumers) as best they can or see their capital dissapear. As long as they play within the rules set up by citizens all is well. Industry has no moral imperative to operate for the good of the country, good of community or any other good you can think of. There only directive is to satisfy investors and consumers. Government has the duty to act in the best interests of the people and country; that is there reason for being!

Now let me ask you a question, do you think the citizens will demand more rules if they watch their jobs, investments, homes, etc. taken from them because of the behavior of these companies?

If your answer is yes, then as a libertarian you should support these bailouts as a way to avoid more regulation of capital markets!

5. Break Up The Banks | BloodhoundBlog: National real estate marketing and technology blog | Realtors and real estate, mortgages, lending, investments - September 24, 2008

[…] industry.  Through mergers and acquisitions, the banking cartel grew to become infallible.  Dave Shafer pins the tipping point of this crisis to the repeal of The Glass-Stegall Act of 1933.  I’m not so certain he’s […]

6. Joshua - September 24, 2008

Honestly, I think citizens will demand more control because they don’t know any better and that once you give government something its very hard to get it back from them.

I do however believe that if the government has to step in to save our financial system as a whole then they are doing what is necessary. However, once things are stable the government should be returning control to entreprenuers and the market.

You are right in that these corporations, and all corporations by definition, are in it for the bottom dollar they can return to their shareholders (private or public). Companies fail every day and they do so for a reason. I say reduce taxes overall, destroy the capital gains taxes, and let those companies fail outright.

It will hurt at first but in the long run things will get much better.

7. shaferfinancial - September 25, 2008

I am not sure that this latest bailout is needed or that things are as dire as this administration and the Fed is making them out to be. However, I understand it is the governments job to make decisions for the betterment of the country as a whole, so I will sit back and watch this happen with a curious mind. Bottom line is my concern that I and my clients can still find ways to build wealth. I think that all this financial shenanigans only points out that Wall Street can’t be trusted with my money, something I came to a conclusion on around 2000. Since then I have seperated my money from them and have seen my wealth soar!

As to the capital gains tax, at 15% it is already manageable and I have found ways to legally get around even paying that for many of my investments. For the smart, taxes aren’t really a burden.

All this points to what I have been talking about, which is folks need to become an active investor, finding ways to make good rates of returns and hedge against taxation!

8. Joshua - September 25, 2008

Great points! I just now received an excellent letter from Ron Paul that I would like to duplicate here for your viewing pleasure. Everything he states in it I wholeheartedly believe is true.


Wednesday, September 24, 2008

Dear Friends,

Whenever a Great Bipartisan Consensus is announced, and a compliant media assures everyone that the wondrous actions of our wise leaders are being taken for our own good, you can know with absolute certainty that disaster is about to strike.

The events of the past week are no exception.

The bailout package that is about to be rammed down Congress’ throat is not just economically foolish. It is downright sinister. It makes a mockery of our Constitution, which our leaders should never again bother pretending is still in effect. It promises the American people a never-ending nightmare of ever-greater debt liabilities they will have to shoulder. Two weeks ago, financial analyst Jim Rogers said the bailout of Fannie Mae and Freddie Mac made America more communist than China! “This is welfare for the rich,” he said. “This is socialism for the rich. It’s bailing out the financiers, the banks, the Wall Streeters.”

That describes the current bailout package to a T. And we’re being told it’s unavoidable.

The claim that the market caused all this is so staggeringly foolish that only politicians and the media could pretend to believe it. But that has become the conventional wisdom, with the desired result that those responsible for the credit bubble and its predictable consequences – predictable, that is, to those who understand sound, Austrian economics – are being let off the hook. The Federal Reserve System is actually positioning itself as the savior, rather than the culprit, in this mess!

• The Treasury Secretary is authorized to purchase up to $700 billion in mortgage-related assets at any one time. That means $700 billion is only the very beginning of what will hit us.

• Financial institutions are “designated as financial agents of the Government.” This is the New Deal to end all New Deals.

• Then there’s this: “Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” Translation: the Secretary can buy up whatever junk debt he wants to, burden the American people with it, and be subject to no one in the process.

There goes your country.

Even some so-called free-market economists are calling all this “sadly necessary.” Sad, yes. Necessary? Don’t make me laugh.

Our one-party system is complicit in yet another crime against the American people. The two major party candidates for president themselves initially indicated their strong support for bailouts of this kind – another example of the big choice we’re supposedly presented with this November: yes or yes. Now, with a backlash brewing, they’re not quite sure what their views are. A sad display, really.

Although the present bailout package is almost certainly not the end of the political atrocities we’ll witness in connection with the crisis, time is short. Congress may vote as soon as tomorrow. With a Rasmussen poll finding support for the bailout at an anemic seven percent, some members of Congress are afraid to vote for it. Call them! Let them hear from you! Tell them you will never vote for anyone who supports this atrocity.

The issue boils down to this: do we care about freedom? Do we care about responsibility and accountability? Do we care that our government and media have been bought and paid for? Do we care that average Americans are about to be looted in order to subsidize the fattest of cats on Wall Street and in government? Do we care?

When the chips are down, will we stand up and fight, even if it means standing up against every stripe of fashionable opinion in politics and the media?

Times like these have a way of telling us what kind of a people we are, and what kind of country we shall be.

In liberty,

Ron Paul


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