As the economic crisis grinds on, more people are exploring the relationship between the "new" programs being used by the Federal Reserve and Treasury to "restore" the economy and the "old" programs that caused the economy to explode in the first place.
I've claimed that one of the underlying problems was the lack of regulation of speculative derivatives such as credit default swaps and synthetic collateralized debt obligations, with the result that brokers and banks and hedge funds and private equity funds became big-time gamblers with our entire financial system, with little if anything holding their feet to the fire to prevent system risk and market disruption. A key piece of the lack of regulation was the late December 1999 passage of the Commodities Futures Modernization Act that ensured no regulation of credit default swaps (and many other derivative financial instruments of uncertain denomination), a thousand-page long bill pushed through by Phil Gramm in the Senate without most Senators --or their staffers--having a chance to peruse its terms and consider its consequences. Other deregulatory efforts--such as allowing companies to use their proprietary mark-to-market models for risk, valuation, and determinations of needed capital, encouraging off-balance-sheet vehicles (securitizations treated as "true sales" for financial statement purposes that were in substance financings), and disregarding the systemic risk created by the resulting system of longterm, illiquid assets supporting short-term liabilities--were mighty contributors. The unregulated "shadow banking system" that dominated the markets under the Bush administration consisted of securitization deals (backing corporate commercial paper or acting, in the form of trust preferred securities, as "junior equity" for debtors) and private equity funds and hedge fund managers (and some of their investors). See, e.g., Bill Gross, Pyramids Crumbling, Jan 2008. From 2000 to 2007, the bubble, fed by the extraordinarily hot air of speculatiove banking and buying and selling of companies, expanded and then burst. Now we are all suffering the consequences.
My cure? Break up the "too big to fail" financial institutions into "too small to do great harm" pieces. In the process, leave the shareholders and current managers holding the bag for the big losses they created. Move the depositors out into friendly commercial banks that cannot be involved in investment banking. And get the United States government out of the process of guaranteeing the speculative swaps entered into with AIG by Goldman Sachs and others. We are essentially paying them off on their risky bets shorting the economy.
So will Bernanke's Term Asset Backed Securities Loan Facility make sense? That's the newest brainchild for dealing with the toxic waste created by the speculators, that has the US and private investors buying toxic waste to clean banks' balance sheets. Even if it were to work, it would be a wrong-minded policy, since it amounts to the US saving the shareholders rather than the financial system. But it shouldn't work, for the simple reason that we shouldn't be trying to recreate the unregulated shadow banking system that securitization mothered. See Bruce Krasting, Bernanke's TALF-DOA, Mar. 12, 2009. Here's a key point: "The banks want TALF because it gets the assets off of their balance sheet and into the unregulated Shadow Banking System." As Krasting points out, the "shadow banking system" overshadowed the real banking system so much that "some bells should have gone off with [Geithner's 2007] revelation that there was "$10.5 trillion of medium to longer term assets ...being funded by short term IOU's."
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