The Mechanics of the Meltdown

Guest Commentary for all the Faithful Federalists out there...

By Marilyn Barnewall

To whom should we listen about banking, the stock market, the economy? There are so many differing analyses right now, it is difficult to know.
One opinion is that Wall Street is sitting on $50 plus trillion in leveraged assets and the United States government has a $5 to $6 trillion gross domestic product (GDP). There is, this opinion says, no way to avoid a total meltdown.
Today I read an analysis by Stratfor, whose opinion I respect tremendously. Stratfor says we must focus on the political realities, not the economy. Using this strategy, Stratfor had been correct in predicting many things Wall Street, the Treasury, the Fed, and economists around the world have missed. Stratfor says we will have an ugly, painful recession, but the “fall of the housing markets will be trumped by the size of the American economy.” They see the core problem as the fall of the housing markets and approach problem resolution from that perspective.

Like Stratfor, I believe it is right to look at things from the geopolitical perspective when defining our economic problems. Governments around the world are acting in tandem – that in and of itself is a rare occurrence – to “solve the financial crisis and prevent a meltdown.”
Unlike Stratfor, I do not believe the core of the geopolitical problem is the value of housing. I believe the core problem is a worldwide government bid to establish a global government. They have been trying to accomplish this since the early 1900s. The people of the world do not want it and so they must face crisis after crisis so potentially devastating to modern life they can be frightened into accepting what the world’s central banks want.
Now, in some quarters, making that kind of statement gets one labeled a “conspiracy nut.” Maybe I am a conspiracy nut. Maybe I’m not. Maybe those who prefer to look at the world through rose-colored glasses and see governments as solving problems rather than causing them are the conspiracy nuts. They conspire to trust governments around the world… until necks are safely held under the black boot of totalitarians.
What is the conspiracy that makes them, rather than me, “conspiracists” by definition?
They believe governments are good, not self-surviving totalitarian organizations that crave more and more power, more and more wealth. They believe the Federal Reserve is looking out for the American people… they even think the Fed is part of the government.
All I can say is, when one “nut” has more evidence on his or her side than another “nut", then the one with the least evidence must concede defeat and accept the title “conspiracy nut". It is obvious that I believe I have more evidence on my side of this argument than do those who think governments around the world are driven to do good for the people rather than oppressing them more and more.
Let’s go back in time.
How was our financial services industry structured? This is an important question because the regulations in place from the 1930s until the 1970s were put in place to protect America from another Great Depression.
Savings and loans were established as the primary underwriters of American mortgages. When granting a mortgage, it is a 20 to 30 years financial commitment by a lender. Because the world of business and consumer banking moves quickly, and because the cost of funds are volatile, S&Ls were established for the specific purpose of making long-term mortgage loans. Commercial banks did not make them. And, there was no problem with bank liquidity because bank loan commitments are relatively short-term by comparison to mortgages. A commercial bank must know from day-to-day that it has sufficient funds on hand to deal with business and consumer borrowing needs… difficult to do when your deposits are tied up for 30-year mortgages.
We had Regulation Q. It said that savings and loans could offer one-quarter of a percent more in savings interest than commercial banks. S&Ls were required to pay 5.50 for long-term savings and 5.25 percent for short-term deposits. Commercial banks were required to pay 5.0 percent on short-term savings and 5.25 percent on “time” savings – like a certificate of deposit or a “time” savings account.
We also had commercial banks. Their primary business was to take in deposits for checking and savings deposits and loan that money out within the community at a profitable rate. By doing so, they stimulated business and, thus, job growth. They were not allowed to branch across state lines. In many states (like Colorado, Illinois and Texas), they were not allowed to branch within the state where a bank’s corporate headquarters was located. When did that change and why?
In the mid-1970s, the Comptroller of the Currency (who has no authority to change the laws passed by Congress… its job is to oversee regulatory control, not change it) issued an opinion that banks could become bank holding companies. A bank holding company in non-branch banking states (called unit banking states) could, in the Comptroller’s opinion, open other banks under the same bank name provided that each new bank opened had its own Board of Directors, its own letterhead. It had to be independent from the large bank that funded it.
The creation of branch banks in non-branching states was a necessary piece of the plan to implement interstate branching which would come later.
In Colorado, Governor Roy Romer all but promised the independent bankers in the state that he would not support in-state branch banking. The Colorado House passed House Bill 1111 banning interstate branch banking on February 7, 1995. On February 21, 1995, the Senate approved its version of the same legislation... banning interstate branch banking in Colorado.
However, after receiving a telephone call from President Bill Clinton (and, it is rumored, from NationsBank -- now Bank of America), Governor Romer decided he wanted branch banking. Clinton told Romer that all sorts of calamities would befall Colorado banks if the branching legislation at the state level did not get passed. Romer passed that information on to Tim Foster. Foster was the Colorado House Speaker and pushed the legislature, having been told Colorado would be in violation of the law if the legislation did not pass. I called Foster right after the legislation passed and asked him what in the world he thought he was doing, violating the laws of the State of Colorado. He is the one who told me why he, a Republican, became so supportive of getting legislation passed for a Democrat governor. The above story is a direct quote from Foster.
Shortly after the above transpired, Roy Romer was made the head of the Democrat National Committee where he served for several years. Later he accepted a highly-placed position with the Department of Education in California. Foster has been the President of Mesa State College for a number of years.
Why did Bill Clinton make that phone call to Governor Roy Romer? Because. The interstate banking plan could not be implemented unless all 50 states accepted branch banking and it was part of an overall plan to implement the credit crisis we have today.
Once all 50 states allowed branch banking, the Comptroller decided it was okay for banks to use bank holding companies to establish banks in other states… a direct violation of the McFadden Act. Suddenly, we saw First Interstate Banks all over the western United States. We saw NationsBank of North Carolina owning banks in Florida and Citibank moved into California and Arizona. Until this time, the McFadden Act prevented interstate branch banking – intrastate branch banking laws were controlled by each state.To my knowledge, the McFadden Act has never been over-turned… just ignored by the Congress.
The Honorable Louis T. McFadden, Congressman from Pennsylvania, leveled charges at the Federal Reserve Board on the floor of Congress that would have made the most aggressive conspiracy theorist blush.
McFadden accused the Federal Reserve of swindling the U.S. Treasury, of conspiring with their foreign principals (central banks in other nations) and others to defraud the American government. Thus, the charges I would make against the Federal Reserve in 2008 were first made in 1932 by a U.S. Congressman.
As if that were not enough, McFadden further told his compatriots on the House floor that the Fed had “…robbed the U.S. government and the people of the United States by their theft and sale of the gold reserves of the U.S.”
On June 10, 1932, Congressman McFadden launched a twenty-five minute tirade against the Fed. Some of his remarks:
"Mr. Chairman, we have, in this country, one of the most corrupt institutions the world has ever known. I refer to the Federal Reserve Board and the Federal Reserve banks. The Federal Reserve Board, a government board, has cheated the government of the United States out of enough money to pay the national debt.”
McFadden continued: “The depredations and the iniquities of the Federal Reserve Board and the Federal reserve banks acting together have cost this country enough money to pay the national debt several times over.
“This evil institution has impoverished and ruined the people of the United States; has bankrupted itself, and has practically bankrupted our Government. It has done this through defects of the law under which it operates, through the maladministration of that law by the Federal Reserve Board, and through the corrupt practices of the moneyed vultures who control it.”
I would make those same charges today.
On May 23, 1933 - less than a year after his 1932 tirade - Congressman McFadden brought formal charges against the Board of Governors of the Federal Reserve Bank system, the Comptroller of the Currency and the United States Treasury. He charged them with "numerous criminal acts, including but not limited to, “conspiracy, fraud, unlawful conversion, and treason."
The petition for Articles of Impeachment was referred to the House Judiciary Committee, but no action was ever taken by the Congress. It was never rejected or acted upon. Looking at Congressional records, it appears McFadden’s charges are still pending against the Fed.
McFadden saw the Federal Reserve and the nationalization of our banks as a great threat to the freedom and the individual wealth of the American people. In 1927, he authored the McFadden Act and fought hard to get it passed by the House and the Senate.
It’s purpose: To prevent interstate branch banking.
McFadden felt he could hold what he perceived as a power-hungry Federal Reserve in check. He thought he could keep them from becoming too powerful. The way he did it was to limit the banking industry’s ability to establish branch banks over state lines.
For almost 70-years, this Act pre-vented interstate branch banking.
The waters are very murky, indeed, as to whether interstate branch banking legislation is legal. It may violate federal law... the McFadden Act of 1927, and the National Bank Act of 1863. I can’t say I have the greatest understanding of how federal law works, but I always thought that you could not write a new federal law that contradicts an old federal law without repealing the old law.
Back to what we used to have and why it’s important:
We had the Glass Steagall Act. Actually, there were two Glass Steagall Acts, but the one with the most bang for bank bucks was Glass Steagall II and it is to that I refer herein. It was passed in 1933 and the official title is the Banking Act of 1933.
During the Great Depression, Congress undertook to examine how conflicts of interest existed in some commercial banks because of their involvement in securities. Even fraud was discovered. Glass Steagall II built a brick wall between the activities of commercial banks and investment banks.
Investment banks like Merrill Lynch, Bear Stearns, Lehman Brothers and Goldman Sachs did not take deposits like commercial banks and savings and loans. They were not commercial banks. Their entire job in the universe was to sell stocks in America’s publicly-traded companies. Commercial banks were prevented from selling securities or making investment recommendations.
The above reflects how America’s financial industry was structured until the 1970s. Part II of this article will explain how the safety walls put in place have been eliminated, one brick at a time and, from the author’s point of view, very intentionally. Article II will explain how the changes to the safe structure that kept our economy safe for so many years were eliminated – and why. Article II will explain whose wealth has increased dramatically as a result of the change.
Part Two
In the last article, we reviewed the protective devices put into place by Congress to prevent the American people from going through another Great Depression.
We had The McFadden Act, the Glass Steagall Act, and Regulation Q. These were key pieces of legislation. They prevented interstate branch banking, commercial bank involvement in investment banking and insurance products (other than credit life), and kept long-term mortgage lending out of commercial banks and in the savings and loans. The last article told us that to gain access to deposits to fund mortgage lending, Regulation Q permitted savings and loans to pay 25 basis points more on savings and time deposits than commercial banks could pay.
As our ancestor legislators saw it in the 1920s and 30s, the lack of these protections were a primary cause of the Great Depression.
Please keep some definitions in mind as we go through the structure of the financial services industry. Until the Gramm-Leach-Bliley Act of 1999, a commercial bank made business and consumer loans and issued credit cards. Commercial banks were unable to sell investment or insurance products (thanks to Glass Steagall) and investment banks could not take deposits.
The sub-prime mortgage mess began with the Community Reinvestment Act of 1977. I wrote long ago that this law was the cause of sub-prime mortgages and it is pretty well agreed that I was right. CRA required commercial banks to stop “redlining.” What is “redlining?” It is refusing to make loans in communities where there is a high crime rate, high unemployment, poor credit history, and, generally, where real estate values are unstable and people cannot repay large home loans over thirty years because of all the problems in their community. More about CRA later…
The first big change in banking was the Depository Institutions Deregulation and Monetary Control Act. This Act passed the Congress in 1980. It gave the Federal Reserve more control over non Federal Reserve banks. Not all banks are members of the Federal Reserve. This is the law that helped cause the failure of the savings and loan industry in the mid-to-late 1980s. The primary damage was done by removing the restraints exercised by the Federal Reserve Board of Governors under Glass Steagall.
By the early 1980s, Merrill Lynch was offering Cash Management Accounts. These accounts paid high rates of deposit interest – as I recall, up to 21 percent at one time. That sounded great to consumers. Well, it sounded great to get 21 percent interest on a deposit account until so much money was taken from commercial banks and savings and loans that it caused “disintermediation.”
For an accurate definition, I suggest you use a dictionary. It means money was flowing out of one industry into another one… in this case, from commercial banks and savings and loans into investment brokers (now called “banks” – which they are not).
In other words, 21 percent interest is great – unless jobs are lost because businesses can’t borrow from banks with no money to lend (because deposits are sitting in a high interest rate account with a stock broker… who does not make loans to businesses or consumers. The 21 percent interest was great – until mortgage loan interest rates went into double digits because savings and loans had no money to loan… their deposits were also going into brokerage money market accounts. The 21 percent was great until car loans had such high interest rates on them that no one purchased new cars and jobs were lost. This occurred in the early 1980s.
At the time all of the banking deregulation was passing through Congress like castor oil through an infant, the Congress had a choice. It could give investment banks permission to offer interest-bearing deposit accounts but live with the same restrictions Regulation Q placed on banks and savings and loans. Or, it could eliminate Regulation Q and allow the investment banks to pay whatever rates of deposit interest they wanted.
Now, anyone with an IQ two points above plant life understands that if consumers can get 21 percent from a Merrill Lynch money market account or 5 percent from a commercial bank or 5 ½ percent from a savings and loan, the consumer is going to go for 21 percent. So, it should have been no surprise to any thinking person that disintermediation would occur. But, shock of shocks, when the prime borrowing rate at commercial banks reached 15 percent and more, when the home mortgage rate at savings and loans entered double digits, Congress – which had caused the problem to begin with – decided it definitely had to do something about this dastardly situation. So, it did away with Regulation Q. Banks and savings and loans quickly raised their rates of deposit interest to regain the lost deposits back into their institutions.
Why was the cost of funds so high at banks and savings and loans? Because. They had to compete with Merrill Lynch to get deposits from consumers. Everyone was putting money into brokerage money market accounts to gain the rewards of high interest deposit accounts. The cost of funds was, at the time, determined by the cost of deposits. If a bank paid zero percent for checking account money and 5 percent for savings, the average cost of funds (on which the primer rate was determined) was from 3 to 6 percent. During this time frame, the prime lending rate was close to 20 percent. The high deposit rate costs were a direct result of Congress and legislation designed, it appears, to destroy the savings and loan industry. It was designed to make Freddie Mac and Fannie Mae the primary source of mortgage money for home ownership in America.
I’m sure it was just an accident that Fannie and Freddie happened to be the catalyst that caused the current financial crisis in America.
Is the current financial services crisis sounding a bit like a well-crafted plan to you yet? Having been a banker for many years, it sure sounds that way to me.
The Garn-St. Germain Act was passed so savings and loans could be “saved.” They were deregulated. This is how the secure mortgage source for American home buyers was destroyed. Savings and loans could now make commercial business loans and consumer home repair and car loans heretofore only available at commercial banks.
One unfortunate part of the entire mess: Consumer and business lending is a specialized area, quite different from making mortgage loans. The computer systems in place at savings and loans could not provide reporting data required by law. They made bad loans, were unable to comply with consumer protection laws and regulatory reporting requirements, and did not properly maintain control of commercial loans (let alone evaluate their credit worthiness).
Surprise, surprise! They failed.
So, we lost our source of stable mortgage lending when the Congress passed laws that caused the savings and loan industry to fail. And, it was unnecessary. But no one really noticed because Freddie and Fannie picked up the slack.
How many people today would be delighted to receive the 5.50 percent deposit interest rate that savings and loans paid to maintain sufficient deposits to finance mortgages? Of course, the fact that today we only get one or two percent on large time deposits is a total accident. The Congress didn’t know any better… or, did they?
At the same time the savings and loans were dealing with a lose/lose financial services environment created by Congress, they were also having to fight for business profits with Fannie Mae and Freddie Mac. These two government sponsored entities (GSEs) had access (from the government, of course) to lower cost funds and they made lower cost mortgages available to people… especially people who could not afford to repay the loans. Commercial banks, you see, are audited at least once annually. Any bad loans they made were tracked. The auditing procedures at Freddie and Fannie were… criminal is a word that comes to mind.
Goodbye savings and loans.
The rest of the Glass-Steagall Act disappeared in 1999 when the Gramm-Leach-Blily Act was passed. It enabled commercial and investment banks to consolidate. Citigroup, one of the “Big 9” currently in financial hot water, merged with Travelers Group (Insurance) in 1998. They combined banking and insurance underwriting services. The Glass Steagall Act had prevented the combining of insurance and securities companies. Gramm-Leach-Blily allowed commercial banks to speculate… also heretofore prevented by Glass Steagall.
The end of the story cannot be made to sound pretty. None of it is pretty. It is not only ugly, it is evil.
The laws we had on the books from the 1930s through the 1970s kept America’s commercial banks strong. Having independently owned savings and loans that were not, in any way, "government sponsored entities" kept the mortgage market strong and real estate prices increased at reasonable rates every year. Investment banks did not offer commercial banking products and so could be intelligently regulated and monitored by the Securities and Exchange Commission… The SEC, btw, hasn’t got a clue about how to audit lending portfolios.
Combine all of the above with an increasing philosophy within the commercial banking industry to use risk elimination loan policies, and the logical result is the financial mess in which this country finds itself today.
Capitalism requires a banking system – a financial system – based on risk management. When financial risk is removed, it results in socialism. And, my friends, that is the new door through which we are about to walk.
At this point in time, the U.S. government owns 80 percent of personal real estate investments… on any home with a mortgage. It holds that ownership because it now owns Freddie Mac and Fannie Mae. Any mortgage written by Freddie and Fannie is now owned by the U.S. government. That’s called socialism, too.
Government has purchased a primary position within the insurance industry with funds “loaned” to AIG, one of the biggest insurers in the world.
In a novel I wrote recently, the female bank consultant tells two friends who are trying to figure a way out of the financial crisis they see coming (in 2006) that when the U.S. dollar fails, it was altogether possible that the government would put up as collateral all of the personally-owned real estate in America. The International Monetary Fund would require such collateral to make a loan big enough for America to buy its way out of international debt.
At the time I wrote it, I thought it was a stretch relative to believability. But, I made twelve predictions about what financial crises were coming… and so far ten of them have come true.
So… I have removed myself from the category of “conspiracy nut” and placed myself firmly into the “I’m not crazy, you are” category by comparison to those who think government can solve the problems government created. I’m not a conspiracy nut because I do not believe in the “too big to fail” theory, either. Being too big is what has caused much of the financial institution failure.
It makes no sense to think that making "too big" institutions BIGGER will solve a problem that being "too big" caused.
I rest my case.
© 2008 - Marilyn Barnewall - All Rights Reserved