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Testimony of Robert Kuttner Before the Committee on Financial Services U.S. House of Representatives Washington, D.C.

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more from72.14.205.104

My name is Robert Kuttner. I am an economics and

financial journalist, author of several books about the economy, a magazine editor, and

former investigator for the Senate Banking Committee.
I devoted a lot of effort to reviewing the abuses of the 1920s, the

effort in the 1930s to create a financial system that would prevent repetition of those

abuses, and the steady dismantling of the safeguards over the last three decades in the

name of free markets and financial innovation
The Senate Banking Committee, in the celebrated Pecora Hearings of 1933 and 1934,

laid the groundwork for the modern edifice of financial regulation.
The most basic and alarming parallel is the creation of asset bubbles, in which the

purveyors of securities use very high leverage; the securities are sold to the public or to

specialized funds with underlying collateral of uncertain value; and financial middlemen

extract exorbitant returns at the expense of the real economy. This was the essence of the

abuse of public utilities stock pyramids in the 1920s, where multi-layered holding

companies allowed securities to be watered down, to the point where the real collateral

was worth just a few cents on the dollar, and returns were diverted from operating

companies and ratepayers. This only became exposed when the bubble burst. As Warren

Buffett famously put it, you never know who is swimming naked until the tide goes out.
A second parallel is what today we would call securitization of credit. Some people think

this is a recent innovation, but in fact it was the core technique that made possible the

dangerous practices of the 1920. Banks would originate and repackage highly speculative

loans, market them as securities through their retail networks, using the prestigious brand

name of the bank – e.g. Morgan or Chase -- as a proxy for the soundness of the security.
It was this practice, and the ensuing collapse when so much of the paper went bad, that

led Congress to enact the Glass-Steagall Act, requiring bankers to decide either to be

commercial banks—part of the monetary system, closely supervised and subject to

reserve requirements, given deposit insurance, and access to the Fed’s discount window;

or investment banks that were not government guaranteed, but that were soon subjected

to an extensive disclosure regime under the SEC.
repeal of Glass Steagall in 1999
A third parallel is the excessive use of leverage.
If you thought the

market was just going up forever, you could borrow most of the cost of your investment,

via loans conveniently provided by your stockbroker. It worked well on the upside. When

it didn’t work so well on the downside, Congress subsequently imposed margin limits
The fourth parallel is the corruption of the gatekeepers
Yet another parallel is the failure of regulation to keep up with financial innovation that is

either far too risky to justify the benefit to the real economy, or just plain corrupt, or both
A last parallel is ideological -- the nearly universal conviction, 80 years ago and today,

that markets are so perfectly self-regulating that government’s main job is to protect

property rights, and otherwise just get out of the way.
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- And may be this is the key point. Achieving an optimal stae cannot be realized without some sort of feedback on past performance. if the past performance is not aligned with accountability then there in lies the problem.
  posted by whertha on 2007-12-19
Financial regulation was pro-efficiency.
Fed races to the rescue
it bails out the

speculative system, so that the next round of excess can proceed.
So when things are booming, the financial engineers can advise government not to spoil

the party. But when things go bust, they can count on the Fed to rescue them with

emergency infusions of cash and cheaper interest rates.
So the point is not that the Fed should let the whole economy collapse in order to teach

speculators a lesson. The point is that the Fed needs to remember its other role – as

regulator.
So we need a careful examination of better ways of holding managers accountable
“The economic fundamentals are

sound.” Those same words were used by President Hoover and the captains of finance, in

the deepening chill of the winter of 1929-1930.

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frontline: the wall street fix: mr. weill goes to washington: the long demise of glass-steagall | PBS

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more fromwww.pbs.org

Following the Great Crash of 1929, one of every five banks in America fails
seeking to limit the conflicts of interest created when commercial banks are permitted to underwrite stocks or bonds
In 1956, the Bank Holding Company Act is passed, extending the restrictions on banks, including that bank holding companies owning two or more banks cannot engage in non-banking activity and cannot buy banks in another state.
n December 1986, the Federal Reserve Board, which has regulatory jurisdiction over banking, reinterprets Section 20 of the Glass-Steagall Act, which bars commercial banks from being "engaged principally" in securities business, deciding that banks can have up to 5 percent of gross revenues from investment banking business.
In the spring of 1987, the Federal Reserve Board votes 3-2 in favor of easing regulations under Glass-Steagall Act, overriding the opposition of Chairman Paul Volcker. The vote comes after the Fed Board hears proposals from Citicorp, J.P. Morgan and Bankers Trust advocating the loosening of Glass-Steagall restrictions to allow banks to handle several underwriting businesses, including commercial paper, municipal revenue bonds, and mortgage-backed securities.
Thomas Theobald, then vice chairman of Citicorp, argues that three "outside checks" on corporate misbehavior had emerged since 1933: "a very effective" SEC; knowledgeable investors, and "very sophisticated" rating agencies.
The Fed also indicates that it will raise the limit from 5 percent to 10 percent of gross revenues at some point in the future.
In December 1996, with the support of Chairman Alan Greenspan, the Federal Reserve Board issues a precedent-shattering decision permitting bank holding companies to own investment bank affiliates with up to 25 percent of their business in securities underwriting (up from 10 percent).
This expansion of the loophole created by the Fed's 1987 reinterpretation of Section 20 of Glass-Steagall effectively renders Glass-Steagall obsolete. Virtually any bank holding company wanting to engage in securities business would be able to stay under the 25 percent limit on revenue
The transaction would have to work around regulations in the Glass-Steagall and Bank Holding Company acts governing the industry, which were implemented precisely to prevent this type of company: a combination of insurance underwriting, securities underwriting, and commecial banking. The merger effectively gives regulators and lawmakers three options: end these restrictions, scuttle the deal, or force the merged company to cut back on its consumer offerings by divesting any business that fails to comply with the law.
After 12 attempts in 25 years, Congress finally repeals Glass-Steagall, rewarding financial companies for more than 20 years and $300 million worth of lobbying efforts. Supporters hail the change as the long-overdue demise of a Depression-era relic.
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- Oct-Nov 1999
  posted by whertha on 2007-12-19

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BBC NEWS | Business | The US sub-prime crisis in graphics

Tags: sub-prime on 2007-12-18 and saved by7 people -All Annotations (0) -About

more fromnews.bbc.co.uk

THE NEW MODEL OF MORTGAGE LENDING
<form>How it went wrong

</form>
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- Certainly shows a few (three) flaws in the process. And why did this happen?
  posted by whertha on 2007-12-18
In recent years, banks have moved to a new model where they sell on the mortgages to the bond markets.
But it has also led to abuses as banks no longer have the incentive to check carefully the mortgages they issue.
sub-prime lending to borrowers with poor credit histories and weak documentation of income, who were shunned by the "prime" lenders like Freddie Mac.
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- Weak documentation of income?
  posted by whertha on 2007-12-18
They also included "jumbo" mortgages for properties over Freddie Mac's $417,000 (£202,000) mortgage limit
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- Sub prime lending areas
  posted by whertha on 2007-12-18
They told them that they could get cash by refinancing their homes, but often neglected to properly explain that the new sub-prime mortgages would "reset" after 2 years at double the interest rate.
By late 2007, one in ten homes in Cleveland had been repossessed and Deutsche Bank Trust, acting on behalf of bondholders, was the largest property owner in the city
And it is likely that as many as two million families will be evicted from their homes as their cases make their way through the courts.
glut of four million unsold homes
banks have announced $60bn worth of losses
Also suffering huge losses are the bondholders, such as pension funds, who bought sub-prime mortgage bonds.
It is estimated that ultimately losses suffered by financial institutions could be between $220bn and $450bn, as the $1 trillion in sub-prime mortgage bonds is revalued.