Oversight is Essential

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After devoting over 20 years to financial planning, I am convinced that government oversight is required in the banking, investment, and insurance industries.

I understand that many people think our government should be less involved in our lives (i.e., they want a smaller government), but it just doesn’t work in the world of finance. Greed is the driver when money is involved, and we have plenty of examples to learn from in recent history.

2022

In mid-November, we watched FTX — one of the world’s largest crypto exchange platforms — implode and file for bankruptcy. Initial reports suggested the collapse was caused by Sam Bankman-Fried (CEO of FTX) transferring billions of dollars from customer assets at FTX to his crypto hedge fund, Alameda Research. Additional factors were later identified. In late November, crypto lender BlockFi filed for bankruptcy, and it is too soon to predict how widespread the economic damage will be.

I never recommended Bitcoin or cryptocurrencies to any of my clients, and I would never invest in them myself. The risk is too high for my conservative investment philosophy. However, I know several people (even financial advisers) who have invested. Cryptocurrencies are digital assets, and many early investors reveled in the fact that there was limited oversight by U.S. or global authorities.

The FTX collapse is being compared to the 2008 bankruptcy of investment bank Lehman Brothers, which was a major factor in the 2008 financial crisis. Let’s review the factors that almost brought down the U.S. and global economies. A lack of oversight was definitely involved.

In mid-November, FTX — one of the world’s largest crypto exchange platforms — filed for bankruptcy.

2008

In approximately 2005, the mortgage industry began encouraging people to buy larger houses than they could afford — with hefty mortgages. The old rule of thumb to not spend over 30% of a person’s gross income on housing was discarded, and “low-doc” or “no-doc” paperwork became common. Often, no deposit was required to buy a house. The mortgage industry argued that housing prices would continue increasing, thereby justifying the excessive mortgages they were selling to vulnerable homebuyers.

Everyone seemed to forget that real estate values are cyclical. According to a white paper by the U.S. Federal Reserve (containing data from CoreLogic), housing prices in the U.S. declined by about 33% from 2007 to 2009 as compared to their peak in 2006. This led to many mortgage holders being “underwater” and owing more than their home was worth. Many people walked away from their mortgages and lost their homes.

The U.S. economy may have tolerated the housing correction, but the banking and investment industries exacerbated the problem by bundling “subprime” mortgages into “collateralized debt obligations” (CDOs). The CDOs were bundles (or “pools”) of risky mortgages that the mortgage industry had sold to unsuspecting home buyers, knowing they required excessive monthly payments when compared to the buyer’s income. (Clearly, the bundles should have been categorized as high-risk or subprime). The next unethical step was that rating agencies gave the CDOs (absurdly) double A and triple A ratings. Fraud was widespread, and the CDOs were marketed to investors in the U.S. and abroad as safe, low-risk investments.

I’ll never forget the phone calls I received in 2008 from large investment firms and banks, trying to convince me to recommend that my clients buy their CDOs. Although I ran a very small financial planning firm, the banks and investment firms were desperate to “unload” (i.e., sell) the low-quality CDOs to investors, and I was seen as a gatekeeper. Thankfully, my rule of waiting three years to see if a new investment proved to be worthy, prevented me from ever recommending CDOs to my clients.

Greed was in full swing, and a cascading set of events were about to occur.

In 2007 and 2008 investment firms decided to use excessive leverage to buy and sell more CDOs. Selling CDOs was very profitable, and the investment firms chose to ignore the enormous risk they would face if housing prices declined and the underlying mortgages defaulted. Lehman Brothers was reportedly leveraged 35-to-1 in 2008, meaning its debt was 35 times the amount of its capital.

This was incredibly risky, because as it became obvious that the mortgages in the CDOs were poor quality — and housing prices were declining significantly — the CDOs (which they owned and had not yet sold to investors) declined in value. A reduction in value of only 3% was all that was needed for Lehman Brothers to become insolvent. Other firms were leveraged at over 30-to-1.

In March 2008, U.S. investment bank Bear Stearns failed and was purchased at a bargain price by J.P. Morgan Chase. This was the first “shoe to drop.”

On Sept. 7, 2008, mortgage giants Fannie Mae and Freddie Mac were placed under government control because of the turmoil in the mortgage industry.

During the weekend of Sept. 13–14 there was a frenzy of activity (behind the scenes) as CEOs and government officials huddled to decide what to do about the impending downfall of financial firms and the U.S. economy.

On Monday morning, Sept. 15, 2008, we learned that Bank of America purchased Merrill Lynch over the prior weekend. This was a rushed transaction due to enormous losses caused by excessive leverage and the declining value of the CDOs. That same day, investment firm Lehman Brothers filed for bankruptcy, after reportedly rebuffing buyout offers.

In late September 2008, insurance giant AIG failed, and the U.S. government bailed it out with a $180 billion loan. Within a few weeks Washington Mutual bank was purchased by J.P. Morgan Chase and Wachovia bank was purchased by Wells Fargo.

On Oct. 3, 2008, the U.S. Congress approved $700 billion for a bailout program called TARP (Troubled Asset Relief Program). Wall Street investment firms and many of the nation’s banks benefited from TARP, along with large firms such as General Motors and Chrysler.

What is not reflected in the above transactions is how the 2008 financial crisis impacted average Americans.

Many people watched their retirement accounts and their home values plummet. In addition to losing their homes, many lost their jobs and companies suffered. Between October 2007 and the low point of March 9, 2009, the U.S. stock market (S&P 500) declined 54%. It then turned the corner and started to recover.

The moral of the story

To be fair, much of the financial industry currently has government oversight. Or at least, Congress attempts to provide oversight. The issue is that if executives in these industries decide to get creative with new products (such as CDOs that are deceptively rated and marketed as safe investments), they are often ahead of the regulators and greed fuels their actions. Efforts at more oversight are repeatedly challenged by lobbyists representing financial, banking, and insurance firms that spend millions of dollars to persuade Congress to not make changes that may limit their freedom.

What’s the moral of the story? Perhaps it is Buyer Beware. If an investment, like crypto, implies a get-rich-quick result, recognize that the risk is very high. Or, maybe the moral is to learn from our past. We will have future financial crises, and we need to protect ourselves and our futures. And recognize that oversight of these industries is essential.

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This article originally appeared in the Albuquerque Journal on December 3, 2022. Donna Skeels Cygan, CFP®, MBA, is the author of The Joy of Financial Security. She owned a fee-only financial planning firm for over 20 years and she is now writing a new book, Sage Choices After 50: A Guide for Women Who Want More Freedom, Financial Security, and Joy, that will be published in 2023.