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How to avoid another financial crisis, from a man who made a fortune off the last one

January 14, 2010 |  5:30 am

The big bank chiefs got most of the press on the first day of the Financial Crisis Inquiry Commission's inaugural hearings on Wednesday.

Too bad. If you want to quickly understand why we had to have a crisis in the first place -- and how best to avoid a repeat -- read the succinct testimony of J. Kyle Bass, a Dallas hedge fund manager who made a fortune betting against subprime mortgage bonds in 2007.

Bass testified on the panel that followed the bankers. His focus was on the ridiculous amount of leverage that major financial institutions were allowed to employ in the credit-bubble years.

Leverage, of course, is what makes the modern banking system possible. With a capital base of just $4 you can make $100 worth of loans. But as Bass noted, leverage went far beyond 25-to-1 at many financial giants in the boom years. When it all blew up, it wasn't hard to wipe out some players' capital almost overnight.

And the most leveraged of all, as Bass documents, were the government's own creations, mortgage titans Fannie Mae and Freddie Mac. "At one point in 2007, Fannie was over 95 (times) levered to its statutory minimum capital," he told the commission.

He also pointed out some of the other Fannie and Freddie absurdities that many Americans only learned about after the Treasury declared the companies insolvent and seized them in September 2008:

These organizations have been some of the single-largest political contributors in the world over the past decade, with $200 million being given to 354 lawmakers in the last 10 years or so. Yes, the United States needs low cost mortgages, but why should organizations created by Congress have to lobby Congress?

Even now, with Fannie and Freddie as wards of Uncle Sam, the absurdities continue, Bass said:

 At this point, the U.S. taxpayer is on the hook for whatever losses occur to either of these institutions. The most obvious question is: Why are the shareholders and other unsecured creditors continuing to receive a free ride on the taxpayers' nickel? Among the largest unsecured creditors are the very banks that are testifying here with me today.

One of the premises of putting these institutions into conservatorship was that over time these entities would shrink their balance sheets. Yet by year-end 2009 their balance sheets will be collectively larger today than they were at almost any time during the prior five years. Congress should consider stopping this ridiculousness and winding these institutions down at the shared expense of their creditors rather than the U.S. taxpayer.

In the same vein, much of Bass' testimony was devoted to his recommendations for saving  taxpayers from future banking crises. His solutions are straightforward, but whether they'll be embraced in the financial-reform legislation now wending its way through Congress remains to be seen.

Bass advises:

--- Separate deposit-taking institutions from entities that are allowed to take extraordinary risks in capital markets, including in derivative securities. Like former Federal Reserve Chairman Paul Volcker, Bass favors restoring some version of the Glass-Steagall Act, which largely separated banking from high-risk securities businesses until it was repealed in 1999.

--- If, given the realities of the current U.S. banking system some institutions have become too big to fail, they should be held to "ironclad, universal and completely transparent" new leverage ratios that rein-in risk.

--- For non-bank financial giants, at some gross balance sheet size a firm would be deemed too big to fail and would be subject to government-imposed limits on risk-taking and asset concentration.

-- Tom Petruno