The Financial Crisis- A Year in Review

This is a paper I wrote at the end of 2008, but I think a lot of the points are still salient.



As we enter what will be the second year of the U.S. recession, a lot has been done in an attempt to ensure that the current environment does not turn into a depression. Governments and central banks both in the U.S. and around the globe have pumped massive amounts of funds into the financial system in response to commercial banks’ and investment houses’ near refusal to lend to anybody, including each other. In the U.S. alone, some estimate that the cost of the current bailout has already reached over eight trillion dollars (Casey Research 2008). While the sheer dollar size of the government intervention has been large, it is worth taking a step back and looking at the efforts so far to assess them at what is likely the midpoint of the economic downturn/recovery. It is very clear that there are weaknesses not yet addressed as well as many lessons to learn for future generations to avert this disaster.

One of the key points of the Emergency Economic Stabilization Act of 2008 was the allowance for a suspension of “mark-to-market” accounting, specifically FAS 157 (HR 1424 2008). This is a point that has gone completely overlooked on the priority list of almost everyone involved in major policy decisions. Mark-to-market accounting and any derivations thereof need to be suspended temporarily for all asset classes until normal market conditions become prevalent and are sustained. While there might be some unsettling effects in the short term on stock markets, banks would no longer have to sock away larger and larger portions of their capital in order to make accounting charges to their reserves and continue write downs on their illiquid assets. These assets, in the vast majority of cases, are performing. They might not be performing exactly as expected, but they are certainly performing. The huge deleveraging of the financial markets caused many securitizers and other intermediaries to lack proper funding to ensure the normal flow of these assets to their final ware houses. This created a need to fire sale them, which is being used as the “mark” on the assets. Those who still have them are not likely to sell them until markets return to normal, so why should they be forced to write down their value? Were normal market conditions present, these reserves and write downs would not be necessary. This was the initial reason for buying troubled assets- to give everyone a sense of where the bottom would be. Since the government has elected not to buy the assets, it should return to its original intent to suspend mark-to-market.

The problem is not just a big bank problem. While these larger institutions have huge exposures to complex financial instruments for which there are no liquid markets, community and regional banks have large exposures to real estate and other similar assets that are similarly not being accurately priced in the current market. This was all caused by the problems at larger banks, despite these smaller institutions lack of direct exposure to the complex instruments that initially caused the market to crash. One of the extensions of FAS 157 is in reserve analysis methodologies and specifically those related to FAS 114 (FASB 1993). This extension has caused a great number of banks, particularly at the community bank level, to revalue their real-estate assets to an “as-is” or “mark-to-market” value when there is no intention by those bankers to sell these assets until a more viable market returns. Because of illiquidity in these markets and ongoing efforts by regulators to enforce “mark-to-market,” “as-is,” and “fire sale” valuations, the community banking industry is seeing its capital base erode just as quickly as its larger counterparts while seeing very little of the government help that was promised. Without spending a single dollar, governments and regulatory bodies around the world could at least provide a temporary relief to the huge amounts of pressure on capital levels at all financial institutions. Not doing so has been a major issue.

Another problem that will need to be addressed before the banking industry can be made truly safe and sound again is addressing the massive problems with the current regulatory structure. Secretary Paulsen has offered a large number of suggestions on this subject, but so far those efforts have been a waste. Just prior to the massive meltdown in the global economy the Treasury Department published the following:

The U.S. regulatory structure does not serve American as well as it could, and modernization is inevitable. It has been largely knit together over the last 75 years, put into place for particular reasons at different times and in response to circumstances that may no longer exist. The current U.S. regulatory framework for financial services providers includes:

Five federal depository institution regulators in addition to state-based supervision.
One federal securities regulator, additional state based supervision of securities firms, and self-regulatory organizations with broad regulatory powers.
One federal futures regulator
Insurance regulation that is almost wholly state-based, with 50+ regulators. This structure also has an international dimension that can be inefficient, costly and harmful to U.S. competitiveness. (Paulsen 2008)

Clearly, this is a highly ineffective regulatory structure, particularly given the evolution of the financial world over the last sixty to seventy-five years. Now, many are crying out for more regulation because of the obvious fraud and intense leveraging that went on for the last eight years. However, prominent bankers like Ken Lewis of Bank of America argue that any new regulation shouldn’t “impose heavy new burdens that harm the competitiveness of American companies” (Fitzpatrick 2008).

The current regulatory framework has become overly burdensome and highly redundant. Many banks, specifically, have at least three primary regulators: the FDIC, Federal Reserve Bank, and either their State Banking regulator or the Office of the Comptroller of the Currency. All of these currently serve very similar functions and perform very similar audits. This is absolutely unnecessary. Beyond the redundancy, this framework creates a highly combative environment between the regulators. On numerous occasions, and particularly recently, the agencies appear to have different opinions on methodology, procedures, and policy. This has caused undo stress, confusion, and has exacerbated an already strained relationship between banks and those regulating them. Governments must be sure to regulate properly and avoid the “witch hunt” mentality that they normally display during knee-jerk reactions to crisis. After all, their last knee jerk was Sarbanes-Oxley, which is widely believed to be incredibly ineffective as evidenced by the constant pushing back of compliance timelines.

In order to ensure that smaller institutions are not the fodder of those larger institutions being propped up by TARP, there needs to be a requirement of some of the funds from the TARP capital injection to the larger and regional banks to be used to extend lines of credit to smaller banks and bank holding companies (BHC’s). These lines would be senior debt and, in the case of BHC’s, secured by the stock in the bank. This would allow capital markets to get flowing again for smaller institutions, which would in turn allow for a more a fundamentally sound economy both on a very broad and localized scale.

The capital injections into financial institutions have failed to get lending going again because these banks are not only shoring up their own balance sheets, but also simply waiting for mounting liquidity and capital pressures at smaller institutions to finally force those banks to shut down and be placed into receivership at the FDIC. In a recent letter to Secretary Paulsen, Lynn Westmoreland charges that unless these banks are effectively forced grant lines of credit to smaller institutions, they will simply lay in wait for smaller banks, who are the obvious intended losers in this bailout, to fail (Westmoreland 2008). They’ll then buy deposits and assets at severely depressed prices, wiping out shareholder interest, and allowing them to rapidly expand their businesses without effectively stimulating local economies and small businesses. This will only add to the mounting pressure on the FDIC fund, to continue the ongoing, systemic flight of depositors from small to large banks, and to lead to a destruction of the community bank model. It seems as though the government allows that shareholders of the largest institutions who engaged in the most risky behavior (Citigroup, Freddie, Fannie, AIG, Wachovia, Washington Mutual, National City, etc) are going to be propped up by government funding, while those of community banks and small businesses, in large part, are left as fodder for those in the Treasury Department’s inner circle.

Further complicating problems at small bank is the fact that cheap funding sources and credit lines at government enterprises such as the Federal Home Loan Bank and the Federal Reserve Discount Window are drying up. Banks are either being cut off from anymore borrowings or forced to put up greater amounts of collateral, which heavily impacts liquidity positions in a negative manner. The question has to be raised whether or not this is part of a larger effort by the government to effectively leave the banking industry in the hands of a few major players. The Federal Reserve pumps trillions of dollars into markets that money center banks access, but does very little for smaller institutions without paying a heavy penalty. Larger banks and former investment houses routinely borrow huge sums of money to fund their daily operations, but when smaller institutions attempt to do the same, they are penalized heavily. There seems to be an obvious line in the sand drawn between these “too-big-to-fail” institutions and their smaller counterparts. This line is being turned into a giant crevice thanks to an inability of smaller institutions to receive funding when they need it most.

While it is true that the government programs, both in the U.S. and abroad, have had some impact in at least temporarily stabilizing markets, it is unclear how effective the response has been. There are seemingly obvious fixes that were never addressed, such as the suspension of mark-to-market. The government has chosen to start from the top and work its way down in addressing the needs of financial institutions. Whether or not this approach is in the financial system’s best interest remains to be seen. It seems to go against everything that capitalism stands for when companies are simply too big to fail, yet our government is, intentionally or not, encouraging this type of size. Funding sources for the vast majority of business and financial institutions are still dry, and the TARP program has failed to address this key issue thus far. Capital injections so far have appeared to only allow institutions to shore up their own balance sheets or snap up liquidity from failed competitors. This, too, seems to lack a sort of fairness. Finally, and perhaps most importantly after the world economy gets back on its feet, the regulatory framework has become an afterthought. Each day, however, the Federal Reserve, FDIC, State Regulators, etc all are vying for who will come out on top when the battle is over. They are all doing very nearly the same thing, but are increasingly having to be less willing to work with institutions in an effort not to be seen as the regulator that failed to regulate properly. The government appears to have done a decent job in avoiding a depression, but it is clear that they have not done everything possible.