Lessons learned

Almost a decade ago, a decision was made that rocked the financial markets and moved western economies to the brink of collapse.

On Friday September 12 2008, the Federal Reserve decided not to bailout Lehman Brothers. Without a private sector solution, the investment firm could not obtain the liquidity needed to stabilise and three days later became the biggest bankruptcy in US history – $613 billion – nearly six times the previous record set by telecommunications company Worldcom six years earlier. This was particularly shocking, given that the rescue of Bear Sterns only a few months previously set the expectation that the government would bailout a big financial institution at whatever cost.

The impact was devastating. The aftermath caused more than 860,000 families in the US to lose their homes, unemployment hit a 26-year-high and the US household debt-to-GDP ratio reached 99%. Beyond these morbid figures, the consequences of the crash could have been even starker.

Treasury Secretary Hank Paulson met with the Bush administration and Congress to discuss the possibility of martial law and UK Prime Minister Gordon Brown even discussed troops on the streets in the event of food shortages.

A decade has passed and the impact is still being felt. Yet for the top of the tree, statistics show that the US has largely recovered from the toughest recession of our time. The US stock market, with the exception of a bearish period in August, has confounded all expectations and continues to grow, private equity is flying and the housing market is booming, all reminiscent of 2007. What is also evocative of the pre-crisis period is the large-scale deregulatory drive of the past 18 months. All of this has culminated in many believing another crisis is imminent.

According to Lasse Sinikallas, director of macroeconomics at RISI, the increasing interest rates have led to a slowing down in the credit market. Yet the Dodd-Frank reform could grow the credit market and stimulate the economy in the short-term by easing the rules on borrowing for community banks.

"During the anticipated growth phase, the economy runs into the risk of inflation with the growing demand in the consumption side," he says.

The risk in the long-term though is the inflationary pressure could result in bubbles forming, particularly given that inflation is already on the rise.

Following the inauguration of President Donald Trump in January 2017, large scale regulatory reform began, most notably the recent rollback of the Dodd-Frank Act, a piece of legislation initially introduced in the wake of the financial crisis. In a typically ceremonial display, Trump even went to the extent of literally cutting red tape in front of the cameras last December, underlying regulatory reform as a big part of his presidential priorities and a policy that is unlikely to stop anytime soon.

Paul Kupiec, resident scholar at the American Enterprise Institute explains there are many trade-offs in the reforms, but they certainly place more responsibility on the Federal Reserve.

"Large institution monitoring now depends more than ever on government regulators and in particular on the Federal Reserve rather than market discipline," he says. "The Federal Reserve has a truly horrible record of recognising and fixing banking system problems before the markets find out about them and react."

Many have assumed a Lehman situation could never happen again, and the Trump administration's insistence on keeping the Orderly Liquidation Authority increases the chances of the state stepping in to avoid the collapse of a huge financial firm.

It's unclear whether some holding company creditors will take some of the losses, but the government currently claims that it will force them to do so.

There is a risk to easing reporting requirements for lenders, and it’s inflating the already growing bubble Abdulla Zaid, RISI

President George Bush was widely criticised for his role in the crisis, for deregulating financial markets in the early part of his presidency and not sufficiently protecting investors in the mortgage-backed securities market. But while he was a great proponent of deregulation, he merely continued what had been a long regulatory rollback drive in the years before his presidency and long before the crisis began.

Former President Bill Clinton repealed the Glass-Steagall Act two years earlier, which forced commercial and investment banking activity to be separated, and made affordable home ownership a key policy objective. This caused banks to drop their borrowing standards and led to 'Ninja' (for no income, no job or assets) loans during the crisis. The repeal also caused the supervision of banks to decline.

Even before this point, Bush could point his finger reluctantly at his father. Bush Senior passed the Garn–St. Germain Depository Institutions Act, which deregulated the savings and loans market and increased Federal Deposit Insurance Corporation insurance for these associations. This led to the infamous savings and loans crisis in 1989, as depositors put money into riskier institutions and cost an estimated $160 billion to fix.

Obama changed course from his predecessors. A series of regulatory reforms under the Dodd-Frank Act aimed to provide more investor protection, including the Volcker Rule to deter speculative activity in view of the financial crisis, which forbids banks from trading on their own account.

Much of the regulatory tightening post-crisis focused on the banking system. According to US-based economist Benedict Guttman-Kenney, since the crisis there has been a particularly rapid growth of non-bank lenders in the US mortgage market. These lenders are not always subject to the same regulations or scrutiny as banks.

"While non-bank lenders may prosper in the good times, they may not be as robust to a downturn, and given their larger market share pre-crisis there's a worry this could lead to an abrupt restriction in credit availability harming the economy," he says.

While this may illustrate that the banking sector is now under sufficient regulation, moving the risk away from the banking sector, the main cuts in financial regulation of most concern are not to do with the risks of the financial crisis but consumers continuing to be left without protections.

The US consumer regulator, the Consumer Financial Protection Bureau (CFPB) established under Dodd-Frank, stopped its investigation into payday lending, which has a huge impact on household debt and may lead to a brain drain at the regulator. Fears were that the regulator would be disbanded entirely but it has escaped that fate for now, despite CFPB head Mick Mulvaney pledging to cut the annual budget by 20%.

The Bureau was created after Congress concluded that existing federal regulators were not doing a good enough job. It has returned nearly $12 billion to 20 million people wronged by financial institutions.

After Richard Cordray's departure as head of the CFPB in November, enforcement has reduced and his successor Mulvaney notably requested absolutely zero funding from the Federal Reserve in the first quarter of his reign. Mulvaney, a tea-party Republican and an outspoken opponent of Obama-era regulation, said the organisation needs to move away from the politics of Elizabeth Warren, a vocal supporter of post-crisis regulation and the driving force behind the Bureau.

In August, CFPB student loan ombudsman Seth Frotman resigned and wrote a letter to the Trump administration saying that it was abandoning consumers.

In the same month, Warren accused Mulvaney of 'hurting people to score cheap political points'. However, while the CFPB has scaled back its activity, its investigation into CitiBank shows it still acts to protect consumers. It found that the bank failed to re-evaluate and reduce the annual percentage rates for consumer credit card accounts and forced it to pay $335 million to consumers affected.

Yet a Bill passed through the Senate in July proposed implementing a $485 million funding cap from 2019, the ability for the president to remove the director at any time and the need for any major rule change to receive congressional approval. If Kathy Kraninger is confirmed as the next permanent director as expected, it's anticipated that funding cuts will intensify.

A similar pattern is said to be emerging at the Office of Financial Research, also set up under the Dodd-Frank Act to provide better information to regulators. A particular problem during the crisis was the inability of regulators to track defaults or leverages during the subprime mortgage boom and reacted late to the fallout as a result. The organisation can even issue subpoenas to get the information it desires if a company refuses to cooperate.

The consensus is that the organisation has not performed as well as it should by not enforcing its subpoena power. The Trump administration, rather than seeking to support the organisation, has decided to cut its staff by a third and budget by a quarter.

An economist at the Federal Reserve System echoes the view that this is the most damaging aspect of the reforms, saying the concern is currently less about lowering the so-called too big to fail (TBTF) threshold for stress testing, and more about the aggressive steps the Trump administration has taken with respect to consumer protection from predatory financial institutions.

The administration is said to have been actively undermining the CFPB, and has rolled back laws that would restrict many practices such as the predatory targeting of underprivileged minorities.

"This is an area where the current administration and Congress has very clearly sided with banks and financial institutions and against American families," the Federal Reserve economist says.

The Fed has a truly horrible record of recognising and fixing banking system problems before the markets find out about them Paul Kupiec, American Enterprise Institute

Most pivotal in light of the financial crisis was the regulation on security-based swaps, increasing expectations for record-keeping and duties for traders in light of the scandal involving collateralised debt obligations, fundamental to the collapse of the credit market.

Yet the future of Dodd-Frank is subject to severe doubt. Aspects of the legislation have yet to be enforced, including a number for securities-based swaps, and other parts are being actively overturned. While President Trump is known to change his mind, his administration has vowed to dismantle the legislation.

The reforms so far raise the standard of TBTF from $50 million to $250 million, and as a result these banks would not need to undergo any stress testing. The changes also ease mortgage reporting requirements for the vast majority of banks.

Abdulla Zaid, economist at RISI, says this should reduce costs and encourage more lending in small community banks, spurring growth in local communities. "But there is a risk to this scenario: inflating the already growing bubble," he adds.

The reforms have received bipartisan support, signalling a pivot from the Democrats position in the aftermath of the financial crisis. Even if they make any gains in the upcoming midterm elections, President Trump is unlikely to encounter too much resistance if he intends to repeal more of Dodd-Frank moving forwards, despite criticism from Democratic leader in the House of Representatives Nancy Pelosi.

The National Association of Federal Credit Unions (Nafcu) urged Congress in September to create a modernised version of Glass-Steagall to reduce the risks of banks branded TBTF.

In a statement, Nafcu President Dan Berger said: 'As we look to the future and economists hint at another recession on the horizon, we need to make sure history does not repeat itself. Wall Street banks cannot be allowed to bring the financial system – and a nation full of consumers – to ruin again.'

As well as separating commercial and investment banking, it could also help community banks to thrive and reduce the regulatory inequalities that arise when big banks take risks on consumer deposits for profit – without putting economic stability at risk.

According to a Federal Reserve System economist, the financial landscape is much more stable than on the eve of the financial crisis, with banks more resilient in terms of capital buffers and much smaller than they once were. But this is an endogenous outcome that is likely to have been generated by tighter regulation and the greater scrutiny that Dodd-Frank introduced in the last decade.

"On the one hand, things are better and I believe the financial system is much more able to withstand the type of shocks it suffered in 2007 and 2008," they say. "But on the other, the current legislative impetus may lead to the undoing of this safe equilibrium."

The US is in the midst of a housing boom, another troubling similarity with 2008, but while the boom 10 years ago was largely generated through risky subprime mortgages, it is believed that the growth is on a stronger footing this time around.

In particular, the qualified mortgage has changed the perception of the US housing market, requiring lenders to consider whether the borrower has the ability to pay. The qualified mortgage provision under Dodd-Frank provides lenders with legal protection if the mortgage meets certain requirements. The rule however has not escaped the glare of Mulvaney, who indicated that it needs to be reworked as it considers all financial institutions the same.

Government-owned Freddie Mac and Fannie Mae, which together purchase the most mortgages in the US, can only buy qualified mortgages, which also protects the lender from legal action if a borrower defaults and says they were sold something the bank knew they couldn't repay. The maximum loan term of a qualified mortgage is up to 30 years, and points and fees are up to three percent of the loan amount. This kind of protection means the housing market is in a very different place to 2008, but a reversal could change things.

"There is no evidence of a debt fuelled boom," says Richard Barkham, chief economist at CBRE. "My impression is a change in regulation could have an impact but may only be realised in the next cycle."

As part of the Dodd-Frank reform, the Trump administration had been considering changing the ability to repay requirement, which requires lenders to document that borrowers can repay their loans so that it can be considered a qualified mortgage. The proposed changes would increase the debt-to-income ratio for qualified mortgages from 43% to 45%. Supporters say that the change would allow community banks to do more loans outside of the qualified mortgage category and put home ownership within the reach of the poorest.

This is merely part of a wider plan to ease the regulatory burden on community banks. In May, Congress made it easier for community banks to lend by repealing part of Dodd-Frank that forced them to conduct stress tests, and excluded them from capital and liquidity requirements. This means that the major provisions of the legislation will apply to only 13 banks and is likely to result in an increase in bank lending.

"Bank lending has not been as aggressive into real estate as in past cycles," says Barkham. "More is coming from institutions, but banks are likely to come back into market now that deregulation has happened."

In the aftermath of the crisis, Treasury Secretary Hank Paulson forced big banks to pass a stringent annual stress test before repaying government funding and paying dividends. He also removed government funding which forced banks to fully confront and address their balance sheets. Since then, US banks have dominated their European counterparts, with the recovery in the EU far slower and significantly impeded by the European debt crisis.

Pre-2008, few firms factored in market-wide disruption in their stress tests, but now banks need to account for this or they will fail the tests. The test has two parts: one to measure a bank's ability to hold sufficient capital in the event of a recession and the other to consider how much the bank plans to return to shareholders.

The new reforms, however, mean that many banks will not be required to conduct these stress tests, and increase the risk that they may not be sufficiently prepared if a crisis arises. And given the numerous risks to economic stability currently, it seems more of a gamble than it otherwise would be.

The US fiscal stimulus will run out by 2020, the low interest rate climate is ending and rates are likely to increase further in the coming months, trade disputes with Europe, China, Canada and Mexico could signal lower growth and increased inflation and a correction in equity and commodity markets are very possible. All of this, together with the fact that it has been a decade since the last crisis, means the economy could welcome another crisis imminently.

This exacerbates the need for strong financial regulation to safeguard against the worst risks of a crisis, yet the current administration is choosing exactly the opposite stance. After 10 years, it appears the mistakes of the great recession have been forgotten.

Obama is dressing up old, failed ideas (IFLR, July 2009)

More than six months before he was elected to office, US President Barack Obama stood in front of a white curtain in a black suit and red tie at the Cooper Union and called for a modern regulatory scheme. "Old institutions cannot adequately oversee new practices. Old rules may not fit the roads where our economy is leading," he told his New York audience. Since that March 2008 speech the same regulatory institutions have overseen new practices such as the Temporary Asset Relief Programme (Tarp) and the Public-Private Investment Programme under Obama's leadership. And the old rules have expanded to non-banking institutions such as American International Group and Chrysler. Obama's refusal to modernise the US regulation system culminated with July 2008's Financial Regulatory Reform Plan. Rather than build the new foundation the Plan advertises, Obama is using the same regulators and the same rules he dismissed as old in his Cooper Union speech. Obama's great council of eight Part of the Plan calls for a Financial Services Oversight Council made up of eight top regulators including the Federal Reserve, Treasury Department, Securities and Exchange Commission (SEC) and Federal Deposit Insurance Commission (FDIC). The Council will identify risky products and systemically risky institutions. It will also advise the Federal Reserve on which systemically threatening institutions that don't qualify under the Bank Holding Company Act it can monitor (called tier 1 financial holding companies or FHCs). It will also advise the Federal Reserve on which systemically threatening institutions that don't qualify under the Bank Holding Company Act it can monitor. A council of regulators to share ideas, identify risk and advise the Federal Reserve is hardly a new idea. In fact, it's the same idea and group established in 1988 under the Reagan administration. During the past 20 years the working committee didn't meet as much as it perhaps should have done. And institutions slipped by regulators that had the forum to identify the systemically risky ones. The Council combines the same working group with regulators with even greater flaws created since 1988. The emerging risks the regulators of that working group identified to Congress were either rejected, accepted too late or given up on by the regulators after short fights. After Lehman Brothers' collapse and AIG's first bailout, the working group proposed Tarp for the first time in the autumn of 2008. Facing criticism from Congress, including political pressure from future president Obama, the working group was granted a chance to save the institutions it was supposed to start monitoring 20 years ago. Merely increasing communication between the same figureheads that individually failed to catch the banking industry's risky practices is useless. Granting a Council of the same individuals the ability to identify tier 1 FHCs, when they couldn't predict the panic after Lehman Brothers' collapse, missed the right bailout amount for AIG twice and watched the two largest housing mortgage lenders fail from unsafe practices ignores the obvious blindness of regulators on systemic risk. New roles for familiar agents After the Council, led by the Treasury, lists tier 1 FHCs, the Federal Reserve will monitor those companies with the Bank Holding Company Act restraints applied to banks like Bank of America and Wells Fargo. The Plan does increase capital requirements on tier 1 FHCs in areas that regulators missed, such as mortgage-backed securities and off-balance sheet vehicles. But it doesn't fix the fundamental problem of regulatory arbitrage. "Where there were gaps in the rules, regulators lacked the authority to take action," declared Obama in a speech after releasing his Plan. "Where there were overlaps, regulators lacked accountability for their inaction." But his Plan does not eliminate the gaps in the rules or between the regulators. It still leaves banks under control of the Federal Reserve as part of the Bank Holding Company Act. The change is the repeal of the Gramm-Leach Bliley Act, which restricts the Federal Reserve from monitoring depository subsidiaries of tier 1 FHCs. Obama wants to expand the Federal Reserve's scope to cover more holding companies when that regulator didn't recognise the emerging risks in Bear Stearns or Lehman Brothers. It needed a $700 billion bailout to help the rest of the banking industry it was supposed to oversee. The Fed alone lacks the sophistication needed to monitor more of the financial industry. Yet Obama insists it can have the authority and accountability for supervision of tier 1 FHCs like AIG. "I can remember one time we went to the Fed with a proposal to split an insurance company off a bank into a separate company," says a former Federal Reserve counsel. "It was quite clear it didn't know about insurance regulation and I'm still not sure, after the split, that they had learned." What new banking supervisor? The only consolidation under the Plan involves eliminating the federal thrift charter to bring the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (OTS) under one body, the National Bank Supervisor (NBS). The NBS will monitor national and federal banks and agencies of foreign banks. The thrift-charter elimination means companies with financial entities like retailers Wal-Mart, Macy's or Target, will have to choose between selling that part of the business and exposing themselves to the Bank Holding Company Act. The change is targeted at companies like General Motors, which found itself and its lending agency GMAC bankrupt in 2008. Obama's desire to limit the seams between regulators but his inability to change the leadership has no better example than this consolidation. The NBS falls under direct supervision of the Treasury. Since their founding the OCC and OTS have remained under the Treasury's umbrella and nothing changes with this Plan. Along with keeping the same oversight, Obama's desire to consolidate rather than dissolve the OTS leaves open the regulatory door to the group that admitted failure to monitor AIG properly. The consolidation doesn't accomplish Obama's goal of eliminating regulatory seams for federally chartered institutions or change the banking industry's regulator. Obama's theory is to bring all banks up to the same level of regulation and prevent them from picking the weakest link amongst the regulators. But the FDIC, Federal Reserve and National Credit Union Administration will continue supervisory roles of state-chartered banks and credit unions outside of the NBS and Treasury scope. But worse than the consolidation that leaves the same regulators at the top is the NBS's seat at the Council. The same agency that failed to oversee AIG will be allowed to identify new tier 1 FHCs to oversee. Predictable overlap The SEC and Commodity Futures Trading Commission (CFTC) merger was one of the most widespread predictions before the Plan's release, but Obama decided not to merge the two common regulators or design a new body to look at credit default swaps. Instead he kept with SEC recommendations and promulgated central clearing parties to monitor over-the-counter swaps. The Plan standardises reporting requirements and business conduct. The problem with the Plan is its implementation. Obama is trying to keep two regulators that have been at odds over regulatory boundaries since the CFTC's inception in 1974. To his credit, Obama sets out examples of the conflicts the two will face when regulating swaps together – eg enforcement methods and the SEC's distance from non-credit related swaps. He's still trying to force together two regulators that have proved ineffective in helping each other thrice before. In 2000, when the Commodities Futures Modernisation Act was passed and excluded the two regulators from the market they could not come together and find a viable solution. Even after the credit events that brought down Lehman Brothers and threatened AIG in 2008 (two of the market's biggest participants) the two regulators could not bring a proposal to cooperate. "Streamlining that market so that regulators could look over each other's fences has been a trend for discussion at least three times before," says Smith. "And it didn't get done."