Just before the Bipart Report was created we had a conference call with Mike Leahy who runs the TCOT report. He mentioned he liked to see some investigative journalism. For example, he speculated that the current economic crisis might have been the result of manipulations by George Soros in October 2008. That's just plain nuts. The origin of the crisis came much earlier. Also, the economic experts who were not beholden to hyper-libertarianism saw this one coming from a mile a way. In particular, there is an organization of central bankers and regulators known as the Bank for International Settlements (www.bis.org) that look at things such as derivatives. If you read their reports like I do the proposals for re-regulating the financial markets that came this Thursday would sound eerily familiar. In fact, if they had been listened to earlier the housing bubble would probably have just caused a mild recession rather than this semi-depression (and we wouldn't have been literally 3 hours away from economic apocalypse in September 2008).
Note what they said in 1998. http://www.bis.org/publ/ecsc08.pdf?noframes=1
Despite the widespread use of bilateral netting, OTC derivatives have become a significant source of credit exposures between the global financial institutions that are the largest
dealers. Consequently, if a major global financial institution were to fail, losses to other dealers on OTC derivatives would be a potential channel for the transmission of systemic disturbances. The collateralisation of inter-dealer exposures in principle could greatly reduce the likelihood of these systemic disturbances being transmitted through that channel. However, as noted above, the use of collateral entails other types of risk, including legal risk and liquidity risk, which, if not managed effectively by dealers, could also pose threats to the financial system. With respect to legal risk, there is the risk that in the event of a counterparty’s insolvency collateral agreements might prove unenforceable in one or more relevant jurisdictions. Such a development could result in widespread losses, because many counterparties might have relied upon the enforceability of the agreements and incurred exposures that they would have avoided if they had suspected the agreements were unenforceable. With respect to liquidity risks, as the usage of collateral grows, dealers may become more vulnerable to liquidity pressures; large changes in market prices could produce significant demands for collateral. Thus, it will become increasingly important for dealers to conduct stress tests to estimate potential demands for collateral and to take whatever steps are necessary, including steps to allow effective reuse of collateral, to ensure that they can meet the estimated demands. If dealers fail to do so, collateral agreements could add significantly to liquidity pressures during periods of market turbulence.
What are these OTC derivatives? These are the CDOs and CDSs that AIG and other high fliers were selling. They thought the practice of bilateral netting also known as "netting out" would protect them from systemic risk. Note the recommendation of stress tests. In fact, policy makers went in the exact opposite direction with Gramm-Leach-Bliley in 1999 and the Commodity Futures Modernization Act in 2000. Because these are sold over the counter they become opaque and cannot be effectively regulated causing a risk to the entire world economy to be created. (More on that later.) One of the major recommendations in 1998 was the creation of a clearing house under regulatory control because these unregulated OTC relationships were simply too risky. Gee, this sounds exactly like Tim Geithner's testimony last Thursday.
Here's the specifics of the 1998 recommendations:
A development that the study group believes could significantly mitigate risks in OTC derivatives transactions is the rapidly expanding use of collateral. However, to ensure that the benefits concerned are realised, counterparties must effectively manage the liquidity, legal, custody and operational risks of using collateral. The study group recommends that counterparties carefully assess these risks and that prudential supervisors consider developing supervisory guidance in this area.
In the end, neither happened. The counterparties relied on bogus ratings from the ratings agencies and the Bush Administration had zero supervisory guidance because, hey, deregulation was the way to go.
Fast forward to the 2007-2008 time frame. http://www.bis.org/publ/work251.pdf?noframes=1 The potential became the actual. Starting in mid 2007, the BIS was sending alarm bells that something seriously wrong was happening. First, the explosion of these toxic derivatives: [Note: all that follows here was written in February 2008]
At a structural level in the financial system, recent years had seen an acceleration of financial innovation. The main manifestation had been the extraordinary expansion of credit risk
transfer instruments, which permitted the transfer, hedging and active trading of credit risk as a separate asset class (Graph 4). Examples included credit default swaps (CDSs) and, in
particular, structured credit products, through which portfolios of credit exposures could be sliced and diced and repackaged to better suit the needs of individual investors. This category included, in particular, collateralised debt obligations (CDOs), backed both by cash instruments, such as primitive securities, loans or asset-backed securities, and by derivative claims, such as CDSs and CDOs themselves (Graph 4). The expansion of these products had both contributed to, and been supported by, a strengthening of the originate-and-distribute (O&D) [Note: this market was expanded greatly under Gramm-Leach-Bliley] business model of financial intermediation. Increasingly, rather than holding the credits they originated, credit institutions would sell them off, possibly after having repackaged them, into the capital markets.
Note the scale here. TRILLIONS of dollars. Then the credit shock happened in August 2007. Here's some graphical representations of how bad things were getting.



This gave the BIS much concern about the economy in the 2H of 2007. What was their going forward look as of February 2008?
At bottom, the characterisation of the dynamics of the financial turmoil is rather simple. The turmoil represented a sharp repricing of credit risk that, given the leverage built up in the system, led to, and was exacerbated by, an evaporation of liquidity in many markets, including in the interbank market. The repricing, which happened to have the US subprime mortgage market at its initial epicentre, followed a prolonged phase of broad-based and aggressive risk-taking. [Note: due to Gramm-Leach-Bliley allowing excess leverage.] It was amplified by the great opacity of new instruments [Note: due to Commodity Futures Modernization Act], such as structured credits, and of the distribution of exposures across the system. This led to a crisis of confidence in valuations, triggered by unexpected rating agency downgrades, and to a generalised distrust of counterparties, as market participants wondered about the size and character of their own exposures and of those of others. The crisis of confidence in turn triggered an evaporation of market liquidity for the instruments concerned and of funding liquidity for those institutions suspected of being vulnerable to the market disruption. As time passed, the underlying asset quality weaknesses inevitably became more evident.
In the end this mess was caused by deregulation and the BIS knew about and warned us about it. People like Phil Gramm who wrote the legislation that was behind this called our economy in June 2008 a "mental recession". What Tim Geithner presented last Thursday was in my opinion the most import leg of the recovery so that the deregulatory madness never ever happens again!