Rep. Keith Ellison (D-MN) is at it again. Looking out for the underdog, the underrepresented, fulfilling his promise that “everybody matters.” He has introduced a bill to close a loophole that banks exploit to maximize their profits but endanger your savings. What Keith is doing is trying to get at the heart of what allowed so many financial institutions to overleverage and teeter on the brink of collapse or actually collapse.
This is complex, but let’s start with Keith’s bill:
Congressman Keith Ellison (D-Minneapolis) introduced important legislation today in anticipation of upcoming Congressional action on financial regulatory reform. The Regulatory Capital Enhancement Act addresses a glaring loophole in existing banking rules.
Under current federal regulations, banks are required to maintain a minimum level of capital based upon the riskiness of the assets that they hold. However, a number of financial institutions have been able to avoid these requirements by creating and using off-balance-sheet vehicles, such as special purpose entities (SPEs), to warehouse risky assets. The Regulatory Capital Enhancement Act would address this problem by requiring federal banking regulators to issue rules that treat assets held in SPEs in a way that is equivalent with those held on bank’s balance sheets.
(From press release email)
Sounds pretty straightforward right? The implications are not.
Let’s start with the rest of the press release email before I jump off the deep end:
“Allowing unregulated segments of the market to build up risk unchecked is bad public policy,” Ellison stated. “This bill would close the loophole by eliminating banks’ incentives to use these vehicles as a means of evading prudent regulation.”
SPEs often used short-term debt called asset-backed commercial paper (ABCP) to finance purchases of securities (backed by mortgages, consumer loans and other assets) from the banks that sponsored them. When markets were stable and flush with liquid funds, these entities had no problems refinancing their ABCP. However, when the crisis hit, the SPEs could no longer roll over their short-term debt. This forced a number of banks to consolidate oftentimes risky, and sometimes distressed, assets on to their balance sheet at the worst possible time. While these SPEs allowed banks to appear better capitalized than they were for a while, the financial crisis ultimately exposed this as fiction.
“Giving regulators the authority to oversee and apply capital standards to these entities is a crucial element of comprehensive regulatory reform. Most importantly, this statutory authority provides regulators the flexibility to address future attempts to arbitrage regulatory requirements,” Ellison concluded.
(From press release email)
The New Yorker reviewed a few books analyzing our economic collapse. One of the authors, Gillian Tett, predicted the collapse. She starts at the beginning of what started the binge.
The new idea was based on an old one, that of the swap. Say you’re in the grocery business, and feel gloomy about your prospects. Your immediate neighbor is in the stationery business, and he feels gloomy about his prospects, less so about yours. You get to talking, and one of you hits on a brilliant idea: why not just swap revenues? You take his earnings for the year, and he takes yours. The actual business doesn’t change hands, making the swap, in banking terminology, “synthetic.”
Like a “gateway” drug (and I apologize for the pathetic drug analogy), these swaps led to more dangerous, riskier activity.
But competition was making those swap deals less profitable. The quest was for a new, and therefore newly lucrative, product to sell. What got the J. P. Morgan team rolling was this thought: instead of swapping bonds or currency or interest rates, why not swap the risk of default? In effect, it could sell the risk that a borrower won’t be able to pay back his debt. Since banking is based on making loans to customers, the risk of default by those customers is a crucial part of the business. A product that made it possible to reduce that risk-by selling it to somebody else-had the potential to create a gigantic new market.
These derivative swaps are all well and good as long as financial institutions don’t overleverage. Of course, y’all know what happened.
In late 1994, Blythe Masters, a member of the J. P. Morgan swaps team, pitched the idea of selling the credit risk to the European Bank of Reconstruction and Development. So, if Exxon defaulted, the E.B.R.D. would be on the hook for it-and, in return for taking on the risk, would receive a fee from J. P. Morgan. Exxon would get its credit line, and J. P. Morgan would get to honor its client relationship but also to keep its credit lines intact for sexier activities. The deal was so new that it didn’t even have a name: eventually, the one settled on was “credit-default swap.”
But they couldn’t make enough money out of this. They needed to make huge piles of cash — this is America after all isn’t it? So they invented a process called securitization.
Traditionally, banking involves a case-by-case assessment of the risk of every loan, and it’s hard to industrialize that process. What securitization did was bundle together a package of these loans, and then rely on safety in numbers and the law of averages: even if some loans did default, the others wouldn’t, and would keep the stream of revenue going, thereby diffusing and minimizing the risk of default.
Banks began bundling these debt risks and reselling them. You can guess where this leads.
Inevitably, J. P. Morgan’s innovation was taken up by more aggressive and less cautious banks. Mortgage-based versions of collateralized debt obligations were especially profitable. These C.D.O.s involved the techniques that the J. P. Morgan team had developed, but their underlying assets were pools of mortgages-many of them based on the most lucrative mortgages, the now notorious subprime loans, which paid higher than usual rates of interest
And here’s the killer, the summation of everything that went wrong:
The new financial instruments, as clever as they were, had an unfortunate side effect: they broke banking. At its heart, banking is a simple business. Customers deposit money at a bank, in return for interest; the bank lends that money to other people, at a higher rate of interest. This isn’t glamorous or interesting, but banking is not supposed to resemble skydiving or hip-hop; what recommends it is that it’s a good way of making steady money (and of creating credit in the economy), as long as the bank is careful about whom it lends money to. The quality of the loans is critical, because those loans are the bank’s earning assets.
This isn’t some incidental issue; it’s the very core of what banking is. But the model of packaging plus securitization spurned the principle that a bank had to individually assess and monitor every loan…
Now let’s return to Keith’s bill. If banks can’t over-leverage, they can’t start down the path toward what got us into this mess in the first place. So … long story simplified as much as possible … Keith has our back.