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Deregulation of Financial & Electricity Markets: Two Failed Experiments, Same Discredited Ideology _____________________________________________________ Iowa Association of Municipal Utilities Annual Conference Holiday Inn Des Moines, IA October 7, 2010 Presentation by John M. Kelly John M. Kelly & Associates, LLC Bethesda, Maryland 20814 Telephone: 301.503.0042 Fax: 301.986.5199 E-mail: [email protected] 1 Financial Crisis: Jumble of Events, Outcomes, Facts, and Players Bankruptcies, Acquisitions & Bailouts Washington Mutual Acquisition Bears Stern Acquit ion Lehman Bankruptcy Fannie and Freddie Mae Bailouts AIG Bailout Major Bank Bailouts (Citigroup; Wells Fargo, JP Morgan Chase; Goldman Sachs; Bank of America; Morgan Stanley) Etc. … Financial Products Credit default swaps Interest rate swaps Currency swaps Collateralized debt obligations Derivatives Mortgaged backed securities Securitization Special Purpose Vehicles (SPVs) Structured Finance Special Investment Vehicles (SIVs) Etc. … Other TARP, Bank Compensation, Rating Agency Complicity Accounting Firms Complicity, GDP, Unemployment. Etc. … I 2 Organizing Proposition The financial industry regulation did not keep pace with financial innovation, such as: shadow banking; derivatives; and off-balance sheet financing. 3 Outline What? (Crash) How? (Vehicles) Why? Parallels in Electric Utility Industry Deregulation 4 The Great Recession: What – How -Why … in Brief “Main Street’s economic murder at the hands of financial behemoths who gambled recklessly with taxpayer chips’ while paying Washington to look the other way.” Laurence Kotlikoff, Boston University 5 The Great Recession: What – How -Why … in Brief “…A dozen or so banks that dominate the financial system placed bets on complex derivatives and exotic mortgages, that eventually poisoned the economy and threaten the stability of the entire financial system.” Simon Johnson, MIT 6 What: Chronology of Major Events 2006 -- U.S. Home Construction Index drops 40% 2007 Drop in home sales largest in 25 years; Bankruptcy Filings: New Century Financial, largest U.S. subprime lender; Mortgage Lenders Network USA, 15th largest subprime lender ($3.3 billion in loans); American Home Mortgage Investment Corp. 7 What: Chronology of Major Events 2007 Merrill Lynch announces $5.5 billion loss due to loss as a consequence of the subprime crisis; Countrywide Financial, largest mortgage lender in the United States, stock drops 13% in August. 8 What: Chronology of Major Events 2007 Consortium of U.S. banks announce super fund of $100 million to purchase mortgage-backed securities; Alan Greenspan acknowledges “a bubble in housing;” Federal Reserve: Cuts the discount rate by half a percentage point in attempt to stabilize financial markets; Injects $41billion into the money supply for banks to borrow at a low rate. 9 What: Chronology of Major Events 2008 March: Bear Stearns shares plummet & obtains Fed funding; Bear Stearns acquired for $2/share by JPMorgan Chase, avoiding bankruptcy; June: Senate Banking Committee Chairman Christopher Dodd proposes a housing bailout. 10 What: Chronology of Major Events 2008 September- November: Moody's and Standard and Poor's downgrades AIG's credit rating; Federal lends $180 billion to AIG to avoid bankruptcy – while AIG paying $165 million in bonuses to executives and traders that caused the collapse; Federal takeover of Fannie Mae and Freddie Mac (owned or guaranteed half of the U.S.'s $12 trillion mortgage market). 11 What: Chronology of Major Events 2008 September- November: Merrill Lynch sold to Bank of America amidst fears of a liquidity crisis; Lehman Brothers files bankruptcy. 12 What: Chronology of Major Events 2008 September—November Treasury and Fed meet with key legislators to propose a $700 billion emergency bailout; Fed lends $1.3 trillion directly to companies outside the financial sector; Fed lends $800 billion more to financial institutions ($600 billion to buy mortgage bonds issued or guaranteed by Fannie Mae, Freddie Mac, and Federal Home Loan Bank); Average house price declined by over 20% from mid-2006 peak. 13 What: Chronology of Major Events June 2009 -- S.E.C. sues Countrywide Chief Executive claiming he publicly reassured investors about the quality of the company’s loans while at the while he issued “dire” internal warnings & sold $140 million of his own shares. September 2009 -- 14.4% of all mortgages outstanding were either delinquent or in foreclosure. 14 What: Economic Impacts Real Gross Domestic Product (billions of dollars) 2008(II) $13,415 2009(II) $12,902 Four percent drop – 1St Time GDP declined since WWII 15 What: Economic Impacts Fixed Investment: (billions of dollars) 2008(II) 2009(III) $ 775 $ 344 (-56%) Residential: Non-Residential: 1,604 1,269 (-21%) 16 What: Economic Impacts Electricity Retail Sales (2008-2009): (millions of kilowatt-hours) 2008 2009 %Change U.S. -- 3,732,962 3,575,450 minus 4.2% Iowa -- minus 6.1% 45,488 42,703 17 What: Economic Impacts Stock Market: Dow Jones Industrial Avg. fell from 14,093 (Oct 2007) to 6,627 (Mar 2009) – 53%; Corporate Profits: 2007(IV)-2008(IV) declined from $1,353 billion to $837 billion (38%). 18 What: Economic Impacts Unemployment: (Oct) Unemployed Unemployment rate 2005-7 7.2 million 4.8 % 2009 15.6 million 10.1% 19 What: Debt Burdens U.S. private debt: 123% of GDP in 1981 versus 290% in 2008; 2007 --Top five investment banks reported over $4.1 trillion debt – about 30% of GDP; 2008 -- Fannie Mae and Freddie Mac owned or guaranteed $5 trillion in mortgage obligations when placed into conservatorship by the U.S. government. 20 How: Primary Vehicles Structured Finance (MBSs and CDO’s); Credit Default Swaps; Subprime Lending. 21 How: Definitions Securitization Financial assets brought together into interest-bearing securities that are sold to investors. Derivatives* Financial products whose value are determined from an underlying reference rate (interest rates, foreign currency exchange rates); an index (that reflects the collective value of various financial products); or an asset (stocks, bonds, and commodities.) *(Warren Buffett referred to derivatives as “financial weapons of mass destruction”) 22 How: Structured Finance: Mortgage-Backed Securities (MBS) MBS – Securitization of Mortgages; MBS Volume: 1984 – $11 billion; 1994 – $200 billion; 2007 – $3 trillion 23 How: Structured Finance: Collateralized-Debt Obligations (CDOs) CDOs – Securitization of credit card, commercial, and similar non-mortgages loans; CDO Volume: 1978 Negligible 2007 $4.5 trillion 24 How: Structured Finance: Credit Default Swaps (CDS) CDS -- Financial contract that allows the transfer of credit risk from one market participant to another (more simply, insurance against default) No requirement that buyer own the debt; AIG insuring MBS against default (issuing CDS) for $20,000 for $100 million coverage. 25 How: Structured Finance: Subprime Lending 1993 2005 Mortgages: 24,000 1 million Refinancings: 80,000 1.2 million 2007 -- Value of U.S. subprime mortgages estimated at $1.3 trillion 26 How: Structured Finance: Growth of Financial Sector Financial sector and GDP: 1978- 3.5% of GDP 2007– 5.9% of GDP Profit – 1980-2007: Non-Financial sector 250%; Financial Sector grew 800%. 27 How: Structured Finance: Growth of Financial Sector Average Compensation: 1948-1979: Banking sector and private sector roughly the same; By 2007 banking sector’s average compensation twice private sector’s; Goldman Sachs – estimated average of $750,000/employee in 2009 28 Why: Proximate Causes Housing Bubble: Assumption that housing prices would continue to rise; Excessive Leverage by Homeowners and Financial Institutions. Explosion in Structured Finance & Subprime mortgage lending; Assumption that mathematical financial models accurately measure risk; Low interest rates. 29 Why: Proximate Causes: Housing Bubble Boom and Bubble based on: Creating; Packaging; and Selling/Marketing DEBT 30 Why: Proximate Causes: Debt Burden of Homeowners Home equity extraction: $627 billion in 2001 versus $1.428 trillion in 2005 U.S. home mortgage debt relative to GDP: 46% during in 1990s versus 73% in 2008 Household debt as a percentage of annual disposable personal income: 27% in 1990 versus 77% in 2007 31 Why: Proximate Causes: Debt Burden of Financial Institutions Financial Sector Borrowing: 1978 -- Borrowed $13 for every $100 borrowed by the real economy (households and nonfinancial companies); 2007 – Borrowed $51 for every $100 borrowed by real economy; 32 Why: Proximate Causes: Housing Bubble Housing market collapse: Defaults on home mortgages reach historic highs; Housing prices plunge; Drop in new construction; 33 Why: Proximate Causes: Housing Bubble Housing market collapse: Banks highly leveraged in risky assets incur large losses; Banks lack sufficient cash flow to supply funds to commercial credit markets; AIG can’t make payments on CDS claims, etc. 34 Why: Fundamental Causes Deregulation – Light Regulation – Non-Regulation; Change in banks’ economic role and incentives; Political Influence ; Ideology 35 Why: Fundamental Causes: Forgotten/Ignored Economic History Panic of 1907; Pujo Commission (Brandeis, Other People’s Money); 1930s Reforms (Glass-Steagall separates commercial and investment banking; FDIC; SEC; etc.) 36 Why: Fundamental Causes: Forgotten/Ignored Economic History 1956 --Bank Holding Company Act; 1966 – Fed given authority to regulate rates of Thrifts; 1968 – Truth in Lending Act; 1970 – Fair Credit Reporting Act. 37 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation 1982 – Garn-St. Germain Act: S&Ls expand into commercial banking; S&Ls invest in corporate bonds; State banks to issue adjustable rate mortgages; Merger between banks and S&Ls in different states; Lifted restrictions on loan-to-value ratios. 38 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation 1984 – Secondary Mortgage Enhancement Act: Removed tax and state impediments to issuance of MBS; 1986 – Fed allows commercial banks to set up affiliated companies to deal in securities; 1994 Riegle Act – Eliminates many restrictions on interstate banking 39 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation 1993 – CFTC exempts most over-the-counter derivatives from regulation; 1999 -- Gramm-Leach-Bliley Act allowed combination of commercial and investment banking and insurance – effectively repealing major section of Glass-Steagall Act 2000 – Federal regulation of over-the-counter derivatives prohibited 40 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation Other: Accounting standard-setters allowed depository banks to move significant amounts of assets and liabilities off-balance sheet; Credit rating agencies made changes to models that allowed for greater risk; Proprietary trading 41 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation Other: SEC relaxed the net capital rule enabling investment banks to increase their levels of debt; Shadow banking system not subject to the same regulation as depository banks; 1991 – FDIC Improvement Act – Gave Fed authority to lend to investment banks in time of crisis. 42 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation Repeal of Glass-Steagall at top of bank deregulation wish list: 1998 -- Travelers and Citicorp: merger of a major insurance company that owned and investment bank with a major commercial bank; However -- Glass-Steagall required Citigroup to break itself up in two years. 43 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation 1999 – Congress obliged w/ Gramm-LeachBliley Act : Created a new category of financial holding companies authorized to engage in any activities that are financial in nature -including banking, insurance, and securities. 44 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation CFTC versus Banks, Fed, Treasury, and White House (Brooksley Born (CFTC Chair) v. Greenspan, Rubin, & Summers.) Early 1998 – Born proposes “concept paper” to review whether over-the-counter derivative should be regulated 45 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation Bankers meet w/ Fed, Treasury, and White House and all oppose; May 1998 – Born releases paper; July 1998 – House Banking Committee Hearing: Greenspan, Treasury, and major banks oppose Born inquiry; Oct. 1998 -- Congress approves moratorium on derivative regulation 46 Why: Fundamental Causes: Deregulation, Light Regulation, and Non-Regulation 1999 – Born did not seek reappointment; Nov. 1999 – Presidential Working Group report on derivatives said that over-the-counter derivatives should be excluded from federal regulation; Dec. 2000 – Commodity Futures Modernization Act essentially exempted OTC derivatives from federal regulation 47 Why: Fundamental Causes: Change in Banks Economic Roles and Incentives Banks Primary Economic Roles are: Facilitate efficient transmission of credit from lenders to borrowers w/ productive investment opportunities (Intermediation); Manage the supply of credit; Assess risk Why: Fundamental Causes: Change in Banks Economic Roles and Incentives Federal government’s guarantee of the banking system – previously limited to commercial banks – effectively extended to investment banks; Bank assets could now be invested in risky assets w/ the real prospect that losses would be picked up by the FDIC/U.S. Taxpayers (e.g. Moral Hazard). 49 Why: Fundamental Causes: Change in Banks Economic Roles and Incentives Before bank investors and employers enjoyed profits and losses – now much of losses absorbed by taxpayers (e.g. Moral Hazard); Banks and other financial institutions became more interested in making loans, selling them in the form of structured securities than in economic purpose. 50 Why: Fundamental Causes: Political Influence “... The banks – hard to believe in a time when we’re facing a banking crisis that many of the banks created – are still the most powerful lobby on Capitol Hill. And they frankly own the place.” Senator Richard Durbin, April 2009 51 Why: Fundamental Causes: Political Influence Blocked: Volker Rule (separation of commercial and investment bank activities); Immediate appointment of Elizabeth Warren 52 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government Not just business avarice at work … Economic ideology made deregulation, light regulation, and non-regulation acceptable and easier for politicians to acquiesce to financial industry requests. 53 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government “… Lenders are now able to quite efficiently judge the risk posed by individual applications [subprime mortgages] and price that risk appropriately.” “… Improvements have lead to rapid growth of subprime mortgage lending … roughly 10 percent of … all outstanding mortgages … up from just 1 or 2 percent in … 1990s. Alan Greenspan, Fall 2005 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government Greenspan Doctrine: “Government regulation [of financial institutions] risks undermining private regulation and financial stability.” Donald Kohn, Fed vice chair 55 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government “... Professional counterparties to privately negotiated contracts ... have demonstrated their ability to protect themselves from losses from fraud, and counterparty insolvencies.” “... Aside from safety and soundness regulation of derivatives dealers in the banking or securities laws, regulation of derivatives transactions that are privately negotiated by professionals is unnecessary.” Alan Greenspan 56 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government IMF Economist Raguram Rajan questioned: Whether deregulation and innovation had increased risk rather than decreased risk in the financial system. Paper presented at Kansas City Federal Reserve Bank Symposium, August 2005. 57 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government Response to Rajan: Greenspan Doctrine: “Government regulation [of financial institutions] risks undermining private regulation and financial stability.” Donald Kohn, Fed vice chair “…The basic, slightly lead-eyed premise of [Rajan’s] paper [is] misguided.” Larry Summers 58 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government “These amendments are intended to reduce regulatory costs for broker-dealers by allowing very highly capitalized firms that have developed robust internal risk management practices to use those risk management practices, such as mathematical risk measurement models, for regulatory purposes.” SEC Final Rule, Aug. 2004 59 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government “Financial innovation has improved access to credit, reduced costs and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.” Ben Bernanke, April 2009 60 Why: Fundamental Causes: Ideology: Efficacy of Markets and the Role of Government (or, Ideology morphs into Theology) “The injunction of Jesus to love others as ourselves is a recognition of self interest. … We have to tolerate inequality as a way of achieving greater prosperity and opportunity for all.” Brian Griffiths, Goldman Sachs, St. Paul’s Cathedral, London, Oct. 2009 61 Electric Utility Industry Deregulation Average Revenue per KWH (All Sectors) 1990 - 2007 12 14 Selected South-Atlantic States 6 8 10 Cents 10 8 6 Cents 12 14 Selected Mid-Atlantic States 1990 1995 2000 2005 Year 2010 1990 1995 2000 2005 2010 Year MD DC NC NJ DE GA SC 62 Electric Utility Industry Deregulation (All Sectors, Prices in cents/kWh) 1996 2008 Cents Chg % Chg DE DC 6.9 7.4 12.4 13.1 5.5 5.7 79.7 77.0 MD NJ 7.0 10.5 13.0 14.4 6.0 3.9 85.7 37.1 GA NC SC 6.4 6.5 5.7 8.8 8.0 7.9 2.4 1.5 2.2 37.5 23.1 38.6 Deregulated Regulated 63 Electric Utility Industry Deregulation Summary of Stock Holding Period Returns (%) (1995-2005) 10 yrs. 5 yrs. 3 yrs. Regulated 10 9 9 S&P 500 7 5 10 Exelon Constellation SGE PPL Allegheny 22 13 19 17 7 27 22 13 18 3 30 19 20 23 60 64 Electric Utility Industry Deregulation Exelon PSGE PPL Allegheny 2007 29.4 18.3 24.1 19.9 2008 29.3 13.1 17.5 14.7 Regulated Utilities 8.1 8.8 65 Selected MISO States, All Sectors, Prices in Cents/kWh State 1998 2008 Cents Chg % Chg IL 7.5 9.3 1.8 24.0 IN 5.3 7.1 1.8 34.0 MI 7.1 8.9 1.8 25.4 MN 5.7 7.8 2.1 36.8 IA 6.0 6.9 0.9 15.0 66 Disturbing Parallels: Financial and Electric Utility Industry Deregulation Deregulation/Light Regulation: Federal & State ; Holding Company Acts; Securitizations; Effective Abdication of Regulatory Responsibility of just & reasonable prices: Indirect Regulation (SEC, FERC); Reliance on indirect measures of success/competitiveness (per se growth in derivative trading; growth in wholesale trades, etc.); 67 Disturbing Parallels: Financial and Electric Utility Industry Deregulation Mergers; Prices & Profits; Industry Influence: Political; Conventional Wisdom 68 Disturbing Parallels: Financial and Electric Utility Industry Deregulation Ideology of Competitive markets: Assumption that markets are effectively/sufficiently competitive; Forgot/Ignored: Economic History; Basic requirements for effective competition 69 Summing Up … So what? Concentration of economic and political power in industries “affected with the public interest”; Excessive profits and prices; Risky investments w/ Other People’s Money; 70 Summing Up … So what? Financial institutions “Too Big to Fail”; Prospect of future major recessions and taxpayer bailouts 71 Summing Up … “They were careless people, Tom and Daisy – they smashed up things and creatures and then retreated back into their money and their vast carelessness ... and let other people clean up the mess they made.” F. Scott Fitzgerald, The Great Gatsby 72 References: Financial Sector Krugman, Paul. The Return of Depression Economics and the Crisis of 2008. Johnson, Simon, and James Kwak, 13 Bankers: The Wall Street Takeover and the Next Financial Crisis. Shiller, Robert J, Irrational Exuberance. Stiglitz, Joseph E., Freefall: America, Free Markets, and the Sinking of the World Economy