The Party Isn’t Over – Why We’re on the Brink of Another Financial Crisis

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In the last scene of a movie depicting a group of men who were able to predict the 2008 financial crisis and make money from it, The Big Short, one of the protagonists, Vinny Daniel (Jeremy Strong), is speaking to his associate, Mark Baum (Steve Carrell). They talk about the bankers who led to the crash.

“Paulson and Bernanke just left the White House; there’s gonna be a bailout,” Baum says to Daniel.

Daniel responds with, “I mean, they had to, right? I mean, paper markets would’ve collapsed, money would’ve stopped coming out of ATM’s, they had to back stop this.”

“They knew,” replies Baum. “They knew the taxpayers would bail them out. They weren’t being stupid; they just didn’t care.”

“Well, yeah, ‘cause they’re f**king crooks. But, at least we’ll get to see some of them go to jail. I mean, they’re gonna have to break up the banks. The party’s over,” says Daniel.

The party’s over. Daniel, an investing associate working at arm’s length of Morgan Stanley, assumed after the total collapse of the housing market due to the fraudulent handling of risky loans, mortgages, and, most importantly, collateralized debt obligations (CDO’s) by the major investment banks, that the heads of those banks were going to be punished. He assumed that the federal government was going to have to intervene and separate investment banks from commercial banks. He assumed there would be reasonable reform and regulation to prevent the market from such reckless handling of derivatives, commodities, securities, and the like.

Sadly, for the fate of the economy, the party isn’t over. It appears that banks are starting to repeat behavior that led to crash in the first place.

To start, it is important to define what caused the financial crisis nearly a decade ago.

The 2008 Crash

Many factors led to the 2008 financial crisis. The crash itself came at the peak of major Wall Street deregulation. The Glass-Steagall Act, which separated commercial banks from investment banks, was repealed in 1998. That was the beginning.

In 2000, the Federal Reserve under Alan Greenspan lowered interest rates to one percent. This turned out to be a disaster for the stability of the market. Low interest rates meant low yields for municipal bonds or treasury bonds. This discouraged investment in those more stable bonds and led to asset or fund managers investing in higher yield mortgage-backed bonds. These bonds, however, were risky. We’ll get back to these bonds soon.

Former Fed Chairman, Alan Greenspan, speaks during the SIFMA annual meeting in New York, October 23, 2012.

Deregulation continued in 2004 and set the stage for an epic collapse of investment funds. In 2004, the Office of the Comptroller of Currency preempted state laws. These laws were anti-predatory lending laws designed to regulate mortgage credit.

Also in 2004, the Securities and Exchange Commission (SEC) changed leverage laws that were designed to limit banks from holding any more than a 12-1 asset-to-capital leverage ratio. The five main Wall Street banks pushed their leverage as high as 40-1.

Now, let’s get back to those “risky” bonds. Credit Rating Agencies, lobbied heavily by investment banks, rated these very risky bonds with AAA ratings. This classified them as stable as government bonds – which they simply weren’t. Many of these poorly rated AAA securities were grouped together to create CDO’s. These are, essentially, a structured pool of assets—such as bonds, loans, and mortgages. The debt obligations act as the collateral—and these things are absolute ticking time bombs. As Baum described them in the movie, they are “dog shit wrapped in cat shit.”

They are bundles of invisible currency (in this case mainly sub-prime mortgages) that are unlikely to be paid and as a result are beyond volatile. The market for CDO’s was “infinite” with these derivatives accounting for three times the global economy at the height of the eventual crash.

Derivatives as a whole are uniquely unregulated. They require no oversight, no counter-party disclosure, no exchange-listing, no state insurance supervision, and no reserve requirements. This makes it harder to monitor or regulate big spending by banks and keeps their activity in the dark.

And with the 2004 laws that allowed for the banks to hold so much leverage in derivatives, there was no limit to how much the banks could gamble with these CDO’s. With these CDO’s being backed by sub-prime mortgages that aren’t likely to be paid, a bubble began to form in the housing market.

Eventually that bubble popped, and CDO’s collapsed. This all led to the collapse of the mortgage/housing market; millions lost their homes. The economy went into a tailspin and the banks needed a bail out from the federal government. None of the major investment banks were broken up, and, worst of all, the risky behavior didn’t stop.

And now, the party appears to be ramping up once again.

The “New” CDO’s

If CDO’s were the monsters that destroyed the market the last time, and they were, then the new monster has a new name but a very familiar face. It is called a Bespoke Tranche Opportunity (BTO), and they are every bit as risky and volatile. Banks began selling them in 2015.

What exactly are these BTO’s and how do they differ from CDO’s? Well, similar to CDO’s, BTO’s are a grouping of loans. These loans are meant to specifically meet the investor’s needs. Just like CDO’s though, they are extremely risky to purchase in that it is unclear how much they are actually worth.

Standard & Poor, a rating agency that was at the forefront of incorrectly rating derivatives for banks leading to the 2008 collapse, is back and rating BTO’s. Though having to settle with the Justice Department for $1.3 billion following the crash, it is now again at the forefront of evaluating derivatives.

There is no sure fire way to rate this form of security as they are not tied to the success of the economy in the way a corporate bond or a treasury bond might be. Though they produce, potentially, higher yields, they come with massive risk.

BTO’s lack credibility due to the fact that they are gauged using ratings from rating agencies which have incentive (due to lobbying efforts from banks) to rate them higher than they are worth. They also lack comprehensibility, as there is no real rock-solid technique that can be implemented to measure the success of a security that isn’t dependent on market success. This leads us to the question, what will happen as a result of these BTO’s being sold?

What happens next?

At this juncture, it’s extremely unclear where the market goes from here. There are some, very few, but some, regulations in place to safeguard from this abuse of the market. A regulation that is often cited as protecting the market from this risk is the Dodd-Frank Act of 2010. When you look at what the law does though, it doesn’t inspire much trust that it can stop this behavior.

The Dodd-Frank Wall-Street Reform and Consumer Protection Act (Dodd-Frank for short), designates a Financial Stability Oversight Council to monitor risky behavior by banking executives. This is in the Title I provision of the act. Title I also designates the chairman of the council to be the Secretary of the Treasury. And who might that be at this moment?

Meet Steve Mnuchin, former hedge-fund manager and Goldman Sachs executive. Making a career out of doing work for Goldman Sachs, it appears unlikely that he will do anything to regulate the selling/purchasing of BTO’s. You may be asking, why? Well, which bank was one of the first banks to get involved with the Bespoken Tranche market? Goldman Sachs.

Mnuchin at his hearing conformation — Thursday,19 Jan 2017

Under the current regulatory environment, though seemingly, at least on its face to be preventative, it doesn’t seem as though the government will be stepping in to protect any markets affected by this irresponsible handling of loans.

What people need to realize in all of this is that it is not investment that is truly the problem. Investment is a natural aspect to a free market and can lead to economic growth. This isn’t simply investing though; this is speculating. Sometimes referred to in layman’s terms as “gambling.” This is the act of investors purchasing complex products that have no credible value. Though they may be rated highly, they aren’t backed by any market factors. It is simply risky gambling for profit, and it crashed our economy in 2008.

Unlike in 2008, no individual market appears to be at risk…yet. These bundles of loans are not as specific as they were when they were backed by sub-prime housing mortgages. It is not apparent at this point which market or markets could be affected by BTO’s.

BTO’s are not yet nearly as popular among investors as CDO’s were at the height of the crash. But there will always be a market for higher yield products. As long as rating agencies work with banks to rate them fraudulently, and as long as banks are willing to sell them off for profit, people will buy them. The more they are purchased, the greater the chances of another bubble developing—and market bubbles always pop.

So, sorry Vinny — despite what is in the best interest of the economy, as opposed to Wall Street executives, the party is far from over. The party has just begun.

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