A. Rise of Too-Big-To-Fail U.S. Financial Institutions
Until relatively recently, federal and state laws limited federally-chartered banks from branching across state lines. |2| Instead, as late as the 1990s, U.S. banking consisted primarily of thousands of modest-sized banks tied to local communities. Since 1990, the United States has witnessed the number of regional and local banks and thrifts shrink from just over 15,000 to approximately 8,000 by 2009, |3| while at the same time nearly 13,000 regional and local credit unions have been reduced to 7,500. |4| This broad-based approach meant that when a bank suffered losses, the United States could quickly close its doors, protect its depositors, and avoid significant damage to the U.S. banking system or economy. Decentralized banking also promoted competition, diffused credit in the marketplace, and prevented undue concentrations of financial power.
In the mid 1990s, the United States initiated substantial changes to the banking industry, some of which relaxed the rules under which banks operated, while others imposed new regulations, and still others encouraged increased risk-taking. In 1994, for the first time, Congress explicitly authorized interstate banking, which allowed federally-chartered banks to open branches nationwide more easily than before. |5| In 1999, Congress repealed the Glass- Steagall Act of 1933, which had generally required banks, investment banks, securities firms, and insurance companies to operate separately, |6| and instead allowed them to openly merge operations. |7| The same law also eliminated the Glass-Steagall prohibition on banks engaging in proprietary trading |8| and exempted investment bank holding companies from direct federal regulation. |9| In 2000, Congress enacted the Commodity Futures Modernization Act which barred federal regulation of swaps and the trillion-dollar swap markets, and which allowed U.S. banks, broker-dealers, and other financial institutions to develop, market, and trade these unregulated financial products, including credit default swaps, foreign currency swaps, interest rate swaps, energy swaps, total return swaps, and more. |10|
In 2002, the Treasury Department, along with other federal bank regulatory agencies, altered the way capital reserves were calculated for banks, and encouraged the retention of securitized mortgages with investment grade credit ratings by allowing banks to hold less capital in reserve for them than if the individual mortgages were held directly on the banks' books. |11| In 2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow even larger, often with borrowed funds. |12| In 2005, when the SEC attempted to assert more control over the growing hedge fund industry, by requiring certain hedge funds to register with the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC regulation. |13|
These and other steps paved the way, over the course of little more than the last decade, for a relatively small number of U.S. banks and broker-dealers to become giant financial conglomerates involved in collecting deposits; financing loans; trading equities, swaps and commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt instruments, insurance policies, and derivatives. As these financial institutions grew in size and complexity, and began playing an increasingly important role in the U.S. economy, policymakers began to ask whether the failure of one of these financial institutions could damage not only the U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of too-big-to-fail financial institutions had become a reality in the United States. |14|
Over the last ten years, some U.S. financial institutions have not only grown larger and more complex, but have also engaged in higher risk activities. The last decade has witnessed an explosion of so-called "innovative" financial products with embedded risks that are difficult to analyze and predict, including collateralized debt obligations, credit default swaps, exchange traded funds, commodity and swap indices, and more. Financial engineering produced these financial instruments which typically had little or no performance record to use for risk management purposes. Some U.S. financial institutions became major participants in the development of these financial products, designing, selling, and trading them in U.S. and global markets.
In addition, most major U.S. financial institutions began devoting increasing resources to so-called "proprietary trading," in which the firm's personnel used the firm's capital to gain investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, brokerdealers, and investment banks had offered investment advice and services to their clients, and did well when their clients did well. Over the last ten years, however, some firms began referring to their clients, not as customers, but as counterparties. In addition, some firms at times developed and used financial products in transactions in which the firm did well only when its clients, or counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided them with billions of dollars in client and bank funds, and allowed the hedge funds to make high risk investments on the bank's behalf, seeking greater returns.
By 2005, as U.S. financial institutions reached unprecedented size and made increasing use of complex, high risk financial products, government oversight and regulation was increasingly incoherent and misguided.
2. See McFadden Act of 1927, P.L. 69-639 (prohibiting national banks from owning branches in multiple states); Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches in multiple states). See also "Going Interstate: A New Dawn for U.S. Banking," The Regional Economist, a publication of the Federal Reserve Bank of St. Louis (7/1994). [Back]
3. See U.S. Census Bureau, "Statistical Abstract of the United States 2011," at 735, http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf. [Back]
4. 1/3/2011 chart, "Insurance Fund Ten-Year Trends," supplied by the National Credit Union Administration (showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions). Data provided by the National Credit Union Administration, 1/3/11. [Back]
5. Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, P.L. 103-328 (repealing statutory prohibitions on interstate banking). [Back]
6. Glass-Steagall Act of 1933, also known as the Banking Act, P.L. 73-66. [Back]
7. Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. Some banks had already begun to engage in securities and insurance activities, with the most prominent example at the time being Citicorp's 1998 merger with the Travelers insurance group. [Back]
8. Glass-Steagall Act, Section 16. [Back]
9. Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, P.L. 106-102. See also prepared statement of SEC Chairman Christopher Cox, "Role of Federal Regulators: Lessons from the Credit Crisis for the Future of Regulation," October 23, 2008 House Committee on Oversight and Government Reform Hearing, ("It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given the statutory authority to regulate investment bank holding companies other than on a voluntary basis."). [Back]
10. The 2000 Commodity Futures Modernization Act (CFMA) was enacted as a title of the Consolidated Appropriations Act of 2001, P.L. 106-554. [Back]
11. See 66 Fed. Reg. 59614 (Nov. 29, 2011), http://www.federalregister.gov/articles/2001/11/29/01-29179/risk-basedcapital-guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of. [Back]
12. See "Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities," RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) ("amended the net capital rule under the Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain broker-dealers"). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for brokerdealers were terminated at the same time. [Back]
13. Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). [Back]
14. The financial crisis has not reversed this trend; it has accelerated it. By the end of 2008, Bank of America had purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each controlled more than 10% of all U.S. deposits. See, e.g., "Banks ‘Too Big To Fail' Have Grown Even Bigger: Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard," Washington Post (8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three credit cards. Id. [Back]
Back to Contents II. BACKGROUND B. High Risk Mortgage Lending
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