Milestones in a Declining Economy
by Alfred Lagan - April 7, 2010
Reprinted with permission.
It helps now and then to revisit past events, especially in the financial industry. Some news items are ascribed momentous importance and considered milestones in our financial history, but beyond the immediate emotional response they evoke, they have no real lasting import. Others, however, hold lessons for the future and should be remembered. Here are some events that have had a seminal influence on the financial markets over the past 25 years.
The Rise and Fall of Portfolio Insurance
What has come to be called Black Monday – October 17, 1987 – is seared into the memory of every investor who lived on that eventful day. All stock indices plunged in what is still a record one-day decline. The deluge of selling was a worldwide phenomenon; exchanges from Hong Kong to London plunged. Of 20 industrial countries, 19 declined more than 20 percent. There was no obvious trigger that caused the severe drop: The violent and sudden onslaught came as a complete shock.
The action of October 17 was unique for another reason: It was over in a single day. The explanation for the event was revealed in hindsight: In October 1987, the stock market was in its fifth year of a record bull run, which saw the Dow Jones Industrial Average rise from 776 points in August 1982 to 2,722 in August 1987. Over that five-year period, a new hedging technique became popular and was embraced by many consultants and institutional investors. Created by three University of California, Berkeley, finance professors and cleverly named Portfolio Insurance, the program involved adjusting hedges or cash in discrete steps as market values changed.
In practice, the approach necessitated selling more stock index futures as prices fell, theoretically immunizing a portfolio against a whopping decline. The program was based on a sophisticated mathematical model that assumed a steady-state trading pattern in which there would always be buyers at a price. The model had no solution for a market environment in which liquidity – in other words, buyers – ceased to participate. Execution of the "insurance" policy on October 17 sharply and very suddenly increased the amount of stock for sale, scaring away the buyers. It was tantamount to pouring gasoline on a raging fire.
The fallout from the crash turned out to be surprisingly modest. Confidence in the soundness of the financial system was quickly restored by swift actions of the Federal Reserve Bank and New York Stock Exchange, and the market recovered the following day.
But the real lesson has perhaps yet to be learned. Mathematical models, no matter how esoteric or brilliantly conceived, are only as good as the assumptions on which they are based. Not for the last time, the use of hedging techniques and other risk-dampening schemes result in increased, not reduced, volatility. Ten years later, Long Term Capital collapsed after assumptions made to support an enormously leveraged fixed-income gamble, developed by several Nobel Prize Laureates, suddenly acted irregularly. It became the first trillion-dollar loss. In recent years, a host of complex, mathematically based fixed-income products using mortgages as the main ingredient imploded, bringing the world financial system to its knees.
The Rise and Fall of Glass-Steagall
What is known today as Glass-Steagall was enacted in 1933 in the wake of the 1929 stock market crash and nationwide commercial bank closures. The act was a reaction to one of the worst financial crises in our country's history. As the Depression wore on, commercial banks came to be seen as the prime culprits of the tragedy. In the pre-Depression era, there were no distinctions between commercial and investment banking. Large financial institutions routinely underwrote new issuances of common stock, often participating in the new offerings of other banks for resale to the public. They regularly made loans to these companies regardless of credit worthiness, and the lines between investment banking and commercial banking became increasingly blurred. As a result, industry standards declined as the more lucrative activity of investment banking became the major focus.
Glass-Steagall set up a regulatory firewall between commercial and investment bank activities: Only 10 percent of a commercial bank's total income could come from securities. An exception allowed commercial banks to underwrite government-issued bonds. Despite strong negative reactions to the bill, it was actually broadened in 1956 by the passage of the Bank Holding Company Act. This act further separated financial activities by creating a wall between underwriting insurance products and banking. It was believed that the underwriting of insurance products, like underwriting of securities, placed depositor's money at excessive risk. The 1956 Bank Holding Company Act would in time play a supporting role in the eventual repeal of Glass-Steagall.
Neither Glass-Steagall nor the 1956 expansion was well received by the commercial banking industry. During the 1980s, the pressure to repeal Glass-Steagall intensified, on the grounds that many individuals put their money in investment products when the economy was doing well and in savings when the economy faltered. Thus, it was argued, allowing individuals to accomplish both savings and investments at the same financial institutions was good for everyone. The concept of a financial supermarket was born.
The chairman of the Federal Reserve and the secretary of the Treasury campaigned aggressively for change. Then, in 1998, Citibank acquired Travelers, a clear violation of both earlier acts (a temporary waiver was granted to Citi by the Federal Reserve Board). New legislation in 1999, called the Gramm-Leach-Bliley Act, sanctioned this acquisition and repealed both Glass-Steagall and the 1956 act. At the time of the acquisition, Citi Corp became the largest and most profitable company in the world. Shortly after passage of Gramm-Leach-Bliley, the Treasury secretary, Robert Rubin, joined Citi as vice chairman.
With the elimination of Glass-Steagall, banks quickly took advantage of their newfound freedom to acquire other financial institutions. They built large investment banking units and, within a very few years, were competing head-to-head with the largest investment firms. They had a distinct advantage – access to low-cost deposits, the same issue that caused the inappropriate banking activities during the 1920s. The seeds of the financial collapse of 2007 were sewn by their actions.
The Rise of the Euro
Despite the current difficulties of several heavily indebted countries, the development of the euro was hugely significant to the European financial system. The euro came into being in 1999 and has fulfilled the benefits its proponents predicted for it. Its singular achievement of establishing a common currency created a single market from eleven different ones. Cross-border competition became an instant reality, lowering transaction costs and reducing price differentials. Financial institutions benefited by making it easier to conduct banking and insurance with a single currency. Exchange-rate uncertainty, which in the past had caused extremely volatile swings in individual currencies, was eliminated.
The benefits were not lost on other European nations: The euro zone now consists of 27 member nations, 16 of which use the euro. The market is huge and is estimated at about 500 million people. Countries outside of Europe have also benefitted: Since the establishment of the euro and the elimination of trade barriers, world trade has expanded rapidly, and worldwide economic growth has risen strongly, creating millions of new jobs. While other factors were at work in the expanse of globalization, monetary union in Europe certainly helped.
Because of the size and depth of its financial markets, the euro is becoming a world-class currency second only to the dollar. It is a logical alternative to the dollar as a reserve currency, a movement that is in its infancy. Monetary union has opened all of Europe to investment, creating massive expansion of the financial markets and making them accessible to investors all over the world. It is arguably one of the greatest financial advances of the 20th century.
The End of 'Too Big to Fail'
The causes of the recent, astounding near-collapse of the financial system of the industrial world will remain red meat for generations of college finance professors and financial authors. It has already spawned several memoirs by participants hoping to absolve themselves from culpability, as well as pious protestations by regulators and legislative leaders. In reality, for the financial market to unravel as quickly as it did in September 2007, many parties had to pull on many threads.
Mortgage bankers gave loans to Americans for homes they could not afford, often based on inflated house appraisals and no documentation of income or assets. Mortgage bankers immediately transferred their mortgage loans to Fannie Mae or Freddie Mac, who packaged them into debt securities for sale to institutions, netting huge fees in the process. Investment banks also gathered mortgage loans and, through the miracle of technology and mathematical modeling, reformulated them into complex debt instruments whose risk they did not understand. These firms fed a market hungry for yield and ever-higher returns. Rating agencies gave their seal of approval, and investors, many of whom were hedge funds, borrowed heavily to buy them. Regulators – including the Federal Reserve – ignored the warning signs, and efforts to rein in Fannie and Freddie by the administration met with stiff resistance from powerful legislators.
In short, what is often referred to as a bubble was in fact a mania for ever-higher profits and returns on investments. The pyramid collapsed from within.
The list of firms rescued by government action and not allowed to fail represents a compendium of former icons of American industry and finance. The enormous sum of public money committed to the effort is in excess of a trillion dollars. The passage of time and exposure to the light has revealed not only the extent of the greed that drove the excesses, but also the legislative and regulatory failures that sanctioned the activities.
The backlash is just beginning, in the form of new oversight regimes and expanded regulations. While the final form is still being debated, they will undoubtedly alter the freewheeling framework that contributed to the catastrophe. The coming changes will likely put an end to the "too big to fail" philosophy, a central theme of government policy since at least the 1970s.
Another milestone has been passed.
Alfred A. Lagan is founder and chairman of the Congress Asset Management Company.
