Overview of This Week’s Report: “Financial Crisis”

Change was on the agenda this spring when the giant Swiss bank UBS – the world’s largest wealth management company – held its annual shareholder meeting.

Only a few months earlier, UBS had been poised for major expansion. But then came the global credit crunch, brought on by the spread of subprime mortgages and other bad debts through financial institutions around the world.

Addressing shareholders assembled in Basel for an April 23 meeting described as “raucous” and “stormy,” outgoing Chief Executive Marcel Rohner acknowledged UBS was shelving its grand ambition to go beyond its primary business of private banking and become a dominant global player in the lucrative field of investment banking.

“We no longer aim to offer everything to everyone in investment banking,” Rohner said. “We do not need an oversized balance sheet. We do not need an oversized inventory of trading portfolios. And we do not need an unnecessary concentration of risk.”

Along with other big banks in Europe and the United States, UBS had experienced a financial meltdown – and in UBS’s case a shareholder revolt – after it lost nearly $38 billion, more than any other lender, since the start of the subprime crisis in July 2007.

A report filed by UBS with the Swiss Federal Banking Commission blamed the losses on some $70 billion worth of risky assets accumulated in the face of supposedly elaborate risk-detection procedures by two arms of UBS’s investment bank.

The report acknowledged that UBS had made no “specific decision either to develop business in, or to increase exposure to, subprime markets” or “substantially to increase UBS’s overall risk taking.” Risk-management controls, the report added in bland corporate-speak, had not been “sufficiently robust.”

U.S. banks likewise had not consciously decided to substantially increase their risk taking in the past few years, but that is what happened – and by April 2008 they were paying for their mistakes. One by one, major U.S. banks reported billions in write-downs: $13 billion for Citigroup, the nation’s biggest commercial bank; $9.7 billion for Merrill Lynch, perhaps the best-known investment bank; $5.1 billion for JP Morgan Chase; $1.9 billion for Bank of America.

The grim reports came only a few weeks after the stunning demise of perhaps the most aggressive of the major Wall Street investment houses: Bear Stearns. With billions of dollars’ worth of dubious financial instruments known as mortgage-backed securities on its books, Bear found itself in mid-March facing the 21st-century equivalent of a run on the bank. Clients began pulling out their money after word rippled through Wall Street that other financial institutions were refusing to extend Bear credit.

Bear’s top executives went on the CNBC financial news channel on March 11 and 12 to insist that nothing was amiss, but by week’s end they had to go hat in hand to rival JP Morgan for an emergency loan. Over the weekend the Federal Reserve stepped in. With Fed Chairman Ben Bernanke personally superintending, the nation’s central bank forced Bear Stearns to accept a buyout by JP Morgan at the fire-sale price of $2 a share (later raised to $10). The Fed greased the deal by extending a $29 billion line of credit to JP Morgan and taking over management of Bear’s mortgage portfolios.

Much, but not all, of the blame for the financial dislocations at Bear and other institutions lay with the explosion of subprime mortgages: expensive, frequently high-interest loans hawked aggressively by mortgage brokers, often to speculators or home buyers with poor credit, and then packaged into mortgage securities for sale to banks or other financial institutions. Far removed from the borrowers, the financial institutions either could not or did not carefully evaluate the quality of the underlying loans.

For many home buyers and speculators, the unsustainable loans translated into delinquencies and foreclosures. But beyond the countless stories of once hopeful families losing their homes or struggling to keep them, the national and global economies were feeling pain, too.

“We had a problem that originated in the subprime sector and then spread to the entire credit market,” says Daniel Beim, a professor of finance and economics at Columbia Business School in New York City. “We now have a total gridlock in the global credit market economy.”

Wall Street’s best and brightest had clearly messed up – tripped up, according to one expert, by overconfidence in their financial wizardry and enabled by regulatory failure. “With the benefit of hindsight,” says Thomas Schlesinger, executive director of the Financial Markets Center, which monitors the Federal Reserve System and the financial sector, the crisis “came about by a combination of risk taking, innovation and hubris in the financial sector and equal amounts of deregulation, desupervision and hubris among financial regulators.”

Some of the blame is also being laid on the major credit rating agencies, private companies retained by the banks that marketed mortgage securities to provide ratings that would-be purchasers relied on in deciding whether to buy. Some experts blame the agencies for giving the securities favorable investment-grade ratings even after evidence of the mortgage meltdown began to emerge.

On Wall Street, the demise of the 85-year-old Bear Stearns is likely to mean pink slips for many of its 14,000 employees. UBS’s financial misadventures are forcing the bank to lay off 5,500 employees.

Overall, the U.S. financial sector had already lost 60,000 jobs over the past year, according to the Bureau of Labor Statistics. The trimmed payrolls and bleak earnings reports signaled an end to a quarter-century of high-flying earnings that saw the financial sector’s share of total corporate profits in the United States rise, according to the Bureau of Economic Analysis, from 15 percent in 1980 to 27 percent in 2007.

While engineering the Bear Stearns rescue, the Fed also took a broader step to ease the financial crisis by creating a new lending window – to be called the “primary dealer credit facility” – for investment banks. Wall Street and Washington both generally approved the action as a needed step to keep financial markets going, but some saw the move as long overdue. “I’m not 100 percent sure what kept the Fed from doing this earlier,” says Ross Levine, a professor of economics at Brown University in Providence, R.I.

Beefing up the Fed’s ability to protect financial markets from “systemic” risks is one of the most concrete recommendations in a “blueprint” for financial regulatory reform released by the Treasury Department in late March. The 218-page report also calls for:

• Establishment of federal standards for all mortgage lenders, not just banks.
• Fundamental restructuring of the multiple agencies currently regulating banks, thrifts (such as savings and loan associations) and credit unions;
• Consolidation of the two major agencies protecting investors: the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC).

Financial-sector trade associations call the blueprint a good starting point for a debate over “modernizing” a federal regulatory structure that has evolved piece by piece since the Civil War. Consumer groups, on the other hand, are criticizing the proposals as warmed-over deregulation. In any event, Treasury Secretary Henry Paulson – former head of Goldman Sachs, biggest of the investment banks – acknowledges the Fed set out proposals too sweeping for Congress to digest in the seven months before the presidential election.

In fact, the Democratic-controlled Congress is largely ignoring the Treasury report. Instead, House and Senate banking committees are concentrating on more immediate steps to aid financially strapped mortgage borrowers and crack down on predatory lenders.

Whatever may be done to ease the mortgage crisis, pressing questions about financial markets and their regulation will remain. The era of traditional, personal-relationship banking and investing has yielded to an impersonal system that is more complex and more opaque. In addition, the historic separation between commercial banks and investment houses has all but ended thanks to industry consolidation and a deregulatory law passed by Congress in 1999.

In one of the least understood changes, a variety of new financial instruments has emerged known as “credit derivatives.” In one of the simplest forms – a “credit default swap” – a bank or other institution holding a loan buys what amounts to insurance by paying a premium to a “counterparty” that agrees to pay off the loan in the event of a default by the original borrower.

The advocates of derivatives say they help ease credit by spreading risk. The critics say they threaten financial disaster by spreading it. One side points to the 1980s and ‘90s as evidence, the other to the current financial turmoil.

The debate underscores the importance of risk management in the financial sector, forcing lawmakers and regulators to ask whether there is a need for tighter regulation of financial institutions by Congress, the Federal Reserve or other federal agencies. Specific proposals are in short supply so far, however, and any significant changes will face hard going in a field with lots of competing financial and political interests.

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