Three years plus after the financial meltdown there is still little public understanding about its underlying causes.   If you want to learn in some detail the real dynamics involved you should read Yves Smith’s book Econned and former New York Times journalist Jeff Madrick’s Age of Greed.

Both books chronicle the same swirl of change that began more than 40 years ago.    In Econned, which offers more detail about the inner workings of these dynamics,  Smith goes back even further in order to explain the evolution (or devolution) in economic thought which she is convinced enabled and magnified the unintended ill effects of changes in finance.  She makes a very good case.

In any case a summation.  The Great Depression laws; FDIC insurance, stricter SEC regulation, the Glass Steagall separation of investment and commercial banking being the most notable worked pretty well.    For almost 80 years there was no run on a bank.  Recessions were relatively mild and short lived.  America grew smartly and there was almost always more than sufficient capital and liquidity to support that growth.

But as America grew, and as international growth began to accelerate, demand for financial services grew as well and this growth put pressure on the structure of American banking, particularly investment banking.   Investment banks historically were private companies where the principals had their own money at stake.   Income came from acting as middlemen in any merger or acquisition, underwriting new stock or bond issues to raise investment capital for corporate clients, or proprietary trading of financial instruments with the firm’s money.  Much of this business was fairly routine and often  awarded based on who you knew rather than what you knew.   Proprietary trading and merger and acquisition were the two most lucrative areas.

The pressure came basically because America’s largest corporations expanded dramatically around the world, opening offices and operations literally in every country.  Their banks needed to follow them, offering services everywhere their clients went.   This tremendously expanded the need for capital by investment banks.  In rapid fashion this explosion in the need for capital outstripped the private, principal owned model of investment banking.   So they all went public and became shareholder owned in order to raise the additional capital.  Goldman Sachs was the last holdout and went public in 1999.   The new capital was good, except that it was ‘other peoples’ money’ now.  That cut the risk tether imposed under the private model where the firm’s money was at stake.

The next dynamic was the one which ended up tearing down the Glass Steagall firewall between investment banking and commercial banking.  That occurred primarily due to commercial banks wanting entry into the higher margin businesses of merger and acquisition and proprietary trading.   Under Glass Steagall commercial banking was a utility.  Regulations virtually guaranteed a bank moderate profits, but those same regulations kept commercial banks out of the riskier investment bank businesses where FDIC insured deposits could end up being lost.   Investment bankers were also eager to gain access to the immense capital Glass Steagall guaranteed for the commercial side.

A third dynamic was involved.  This was the one of financial ‘innovation.’   Derivative securities in particular offered large profits.  But they are complicated and risky.

Taken together these changes produced a nightmare for management.   Decision making often got pushed down below managerial level, particularly in the derivative areas, because each required specific skills and expertise.   Because these areas were often among the most lucrative ones, traders could and often did, take out-sized bets without manager approval.  Unlike most other large businesses, profit opportunities come and go swiftly in investment banking, particularly in the numerous and often unique derivative markets.    This is not something for the faint of heart and it opened up many avenues for abuse, not least one where trader specialists could manipulate the profit margins and the timing of trades in order to boost their bonuses.  Many times these profit boosting trades were booked at inflated prices which would be paid for by customers.   And with a little bookkeeping manipulation profits could be ‘shown’ when a trade was entered into–before anyone including the trader knew whether the trade was even profitable.

Given the inability of banks to manage risk within their own ranks, it should come as no surprise that government regulators had no clue.  And even when they did make a complaint to their administrators, regulators were often told to look the other way–called ‘forbearance.’  This was not only because of the cold hard political cash forthcoming to campaigns from banks rewarding regulatory ‘forbearance,’ but also because the dominant economic/political views were that government regulation was unnecessary.   Unfettered private markets and industry would naturally smoke out the cheaters better than a government bureaucrat could.  That was the theory, anyway.

As Yogi Berra pointed out, sometimes theory and practice are different.  Unlike the experience when Great Depression regulations were in full force, this new business model has produced a long series of blowups spanning more than 40 years, each more severe than the prior.   The 2007-08 financial meltdown was the first systemic banking collapse since the one that threw America into the Great Depression in the 1930s.   It was the first ‘bank run’ since the Great Depression.

Additionally, without the Great Depression rules in force, taxpayers ended up bailing out financiers.   For the first time since the imposition of FDIC insurance, there was a devastating run on the entire banking system.  And that run ended up, for all practical purposes, forcing taxpayers to insure all types of deposits and investments–hundreds of billions of which were not even in American banks.  It was a Great Depression lesson forgotten by this generation at unimaginable cost.

The big banks are bigger now than when the 2007-08 collapse happened.  The murky, complicated derivatives are still primarily traded Over the Counter (OTC) outside of regulatory view.  Most importantly, Congress and the administration still depend upon bank campaign cash for their survival, so efforts to re-regulate finance, to restrain risk taking, are weak to non-existent.

Beezer here.  Will the next blowup be another one created by financial risk and irresponsibility?  Who knows.  There doesn’t appear to be the political will to restrain bank speculation.  Even after the last meltdown.  Apparently it takes something even worse for the public majority to do something to protect themselves.