EXPLAINING THE 2008 FINANCIAL MELTDOWN

It was not just the housing collapse!

By Ed Lette, CPA, CEOBusiness Bank of Texas, N.A.

The History

1907 - Bucket Shops cause Panic and Stock Market Crash1913 resulted in the formation of the Federal Reserve Bank 1920 States began campaigns to ban them, and they were

finally made illegal. - No more wagering on the stock market http://www.cbsnews.com/video/watch/?id=4546583n

1933 – Glass-Stegall Act- Separated Banking, Insurance, and Brokerage

1998 – Citi Corp violates Glass-Stegall Act- By purchasing Travelers Insurance

Beginning of the End?

• 1998 Citicorp and Travelers agree to combine two companies. Financial times labeled “a merger that redefines world finance

• Merger required repeal of Glass-Steagall Act – Citi spent millions in lobbying for change– Growing support in Academia and most

importantly with Fed chief Alan Greenspan – 1999 Congress passed the Gramm-Leach-

Bliley• Which repealed the Glass-Steagall Act of 1933

The History continued

1999 – Commodity Futures Modernization Act- Credit Default Swaps

- Bucket Shops allowed AGAIN ! Cause of AIG collapse

1999 - Glass-Stegall Act repealed- Banks, Insurance, and Brokerage no long segregated by

law.

Bucket Shop of the early 1900’s

More of the Beginning of the End ?

• Bear Stearns, Merrill Lynch, Lehman Brothers, Morgan Stanley and Goldman Sach ask and receive increase in leverage above 12x capital– Decision not made in a vacuum– Granted US international banks right to leverage

up to compete with dominating European international banks

– Hedge funds add to problem

Mortgage Loan and S&L History

***Savings & Loans Banks (S&L) “infected” by financing long term mortgages with short term deposits***– 1960’s Regulation Q

• Govt. set Savings and Certificate of Deposit rates

– 1970 Rule change - S&L’s to become Real Estate Developers

– 1980 S & L s went broke – took 20 years

Freddie Mac & Fannie Mae systems

are the answer to the S&L interest mismatch problem

Good idea –– Relief of interest rate mismatch in S&L industry

(buying and selling of MBS in the open market)– Should be government regulated not government

operated!

Freddie Mac and Fannie Mae unforeseen consequences

• Effect of Common and Preferred Stock Purchase by Federal Savings Banks

• Allowed to purchase w/o limitations• Political (govt.) agenda – homes for everyone!

Market Engineeringthe real collapse

• Credit Default Swaps– Bucket shops/gambling on the stock market

• Subprime– Loans to individuals that couldn’t afford them

• MSB (mortgage back securities)– Pooled security – secured by individual mortgages

• CMOS (Collateralized Mortgage obligation)– Pooled security – secured by commercial mortgages

• ARS (Auction Rate Securities)– debt instrument (corporate/municipal bonds) with a long-term

nominal maturity – interest rate regularly reset via a Dutch auction

The contributing Factors

• Excessive Leverage– Leveraged investors can not survive a sharp drop in

asset prices• Volatility • Widespread Product confusion

– ARS (Auction Rate Securities)– MSB/CMOS (Mortgage Backed Securities)– Subprime (loans/mortgages)– No regulator controls – CDS (Credit Default Swaps)

Accounting

Fair Value Accounting – allows banks to manipulate balance sheet through continued acquisitions – not holistic growth.

Goodwill Accounting Wachovia 50% + of equity attributed to good will Regions Bank 59% of equity attributed to goodwill

Accounting should be reality (cost and cash flow) not theory

Wachovia Corp.’s Fall

Pick a pay-ment

ex-penses

23%

Legal, Secu-rity, SILO's & RE

losses 15%Market disruption related

charges19%

Merger, Restructure & other provisions expense

19%

Goodwill im-

pair-ment

charge24%

Multiple Cracks

From inflation to deflationDeleveraging means less credit available

• Deflation seed sowed when external credit markets dried up

Inflation comes from to much credit available• Inflation caused by excessive credit creation outside

commercial banking• Fed gave up control of the banking system

• No opposition to repeal of 1907 and 1933 acts• Explosive growth in non-banking lending

– UPS (united Parcel Service) making SBA loans

Issues for the New Congress

TARP limited oversight of first round of funding Implementation of oversight

Financial Restructuring System regulator Dual banking Thrift charters Office of Thrift Supervision/Office of the Comptroller of

the Currency Merger source: Texas Bankers Assoc.

Issues for the New Congress

• Future of Mortgage Finance Federal Home Loan Bank’s Freddie Mac/Fannie Mae Regulation of the mortgage lending process

• Accounting/Mark to Market

source: Texas Bankers Assoc.