Conference by Dr. Rodrigue Tremblay

at the Renaissance Academy

(Florida Gulf Coast University - FGCU)

Friday, March 19, 2010.




Economic Bubbles and Financial Crises, Past and Present:

The Collapse of Subprime Mortgage-Backed Derivatives, in 2007-09, and How the U.S. Government Became the de facto Private Government of Large Banks and Bailed them out of their Huge Gambling Debts




Dr. Rodrigue TREMBLAY, Ph.D.

Emeritus professor

University of Montreal



"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."

Henry Ford (1863-1947), American industrialist


When plunder becomes a way of life for a group of men living together in society, they create for themselves in the course of time a legal system that authorizes it and a moral code that glorifies it.”

Frédéric Bastiat (1801-1850), French economist


"The normal functioning of our economy leads to financial trauma and crises, inflation, currency depreciations, unemployment and poverty in the middle of what could be virtually universal affluence-in short ... financially complex capitalism is inherently flawed."

Hyman Minsky, American economist


“If the American people ever allow private banks to control the issue of their money, first by inflation and then by deflation, the banks and corporations that will grow up around them, will deprive the people of their property until their children will wake up homeless on the continent their fathers conquered.”

Thomas Jefferson (1743-1826), 3rd US President


"Of all the events and all of the things we've done in the last 18 months, the single one that makes me the angriest, that gives me the most angst, is the intervention with AIG... Here was a company [AIG] that made all kinds of unconscionable bets. Then, when those bets went wrong, we had a situation where the failure of that company would have brought down the financial system."

Ben Bernanke, U.S. Fed Chairman, Sunday April 12, 2009



I- Introduction

The outbreak of a severe worldwide financial crisis two years ago was a surprise to many people. Indeed, it was widely thought that financial crises and the severe economic recessions and sometimes depressions they provoked were a thing of the past, thanks to a protecting net of financial regulations designed to prevent a repeat of the past.


But here we are again, mired in the most severe economic crisis since the 1930s. We may ask why? The main reason is that the U.S economy, but also most of the world economy, have been subjected to a financial experiment that has turned sour. In fact, it has turned into a financial fiasco.


A new type of banking finance was invented and all the risks involved had not been properly assessed. For a while, a debt pyramid was allowed to grow, but it collapsed when its shaky foundation disintegrated.


Of course, there have been similar financial collapses in the past, and the overall cause is always the same: the financial sector takes too much risk and expands too much, creating a debt load for the economy that is unsustainable.


Before getting into the nitty gritty, I would like to put the current financial crisis into its larger context. I will first present a description and an overview of the financial situation that led to the crisis. Then, I will give you an analysis of why the financial crisis happened.


It is always fascinating for those like me who study business cycles and financial crises in our democratic capitalist system how they seem to reoccur every two generations, i.e. every 50 to 75 years, with some regularity, depending if the period includes or not a world war. It seems that what one generation learns the hard way is rapidly forgotten by the next generation, and the same errors are repeated over and again. One rarely experiences, as an adult, more than one of those financial tsunami in a lifetime. I will argue today that those in control in government and in banking have not totally learned the lessons of the current financial crisis, let alone the lessons of history about previous financial crises. —And I will attempt to explain why. A New York Times journalist, Andrew Sorkin, has written a minute by minute account of the 2007-09 financial crisis, titled “Too Big to Fail”. I encourage anyone among you, interested enough, to read his book. —It reads like a novel.


Therefore, what I would like to do to-day is to present in simple terms a big picture of the immediate and remote causes and consequences of the current financial crisis and of the subsequent deep economic recession that has followed.





1. Causes and Consequences


What has taken place over the last few years will be studied and debated for years to come and is truly amazing. —Let me remind you that a financial crisis is for the economy the equivalent of  a heart attack for an individual: it stops credit from circulating in the economy and this could be deadly.


But, more precisely, why did the debt pyramid collapse? Why was the financial tail allowed to wag the economic dog?


I am first referring here to why traditional financial rules were abandoned and replaced by the rules of leverage finance.

Under the old traditional financial rules, indeed, a bank or a credit union would collect deposits or borrow in the open market, lend this money to investors, keep reserves for contingencies, and would hold onto the loans until maturity, in an ever repeating cycle. The merging of investment banking with commercial banking has caused an abandonment of the traditonal financial rules and their replacement by the rules of asset securitization. Under these new rules, a bank still amasses money through deposits or borrowing, but it does not hold on the loans it makes. It takes a bunch of heterogeneous loans made by itself or by others, repackages and slices them up, and sells them as investment vehicles to third parties.


- Second, I am referring to why the debt level of home buyers was allowed to rise so much that it resulted in a housing asset bubble, leading to a subsequent meltdown.


- Third, I am also referring to why the credit markets froze and money markets stopped functioning, the world over, in the fall of 2008 when the third largest U.S investment bank, Lehman Brothers was allowed to go into bankcruptcy.


- And, fourth, I am  referring to why the large insurer American International Group (AIG) was bailed out by the U.S. government with an injection of $180 billion of taxpayers' money to pay the gambling debts of banks and speculators alike. This government bail-out of AIG and of large banks has created a huge transfer of wealth from the general population to the management of these banks and to speculators, while millions of Americans took heavy losses due to some 8 million forced home foreclosures so far, a number that is expected to surpass ten million this year or next.


Two fundamental questions also beg to be answered here:

a- What are the true causes of the current financial crisis and the subsequent deep economic recession?

And b- Could this disaster have been avoided if a more prudent approach had been followed?


2. Past Financial Crises that Resulted in Economic Depressions: 125 years ago and 70 years ago


Without going back too far in time, let me remind you of the last two major worldwide financial crises that beset the world economy over a century and a half and translated into economic depressions. It is disconcerting to observe that each financial crisis originates from some form of overextension of the financial sector.


-The first one is the 1873 financial crisis that precipitated the 1873-1880 depression. -The second one is the 1931 financial crisis that transformed the crash of 1929 into the 1929-39 depression. There were other serious financial crises in 1884, 1890, 1893, and 1907, but they did not result in economic depressions, only in economic downturns and relative stagnation.


Before central banks were created, financial crises were usually liquidity crises. Indeed, when an economic downturn was about to take place and asset prices began to fall, there were typically banking panics or bank runs with people attempting to withdraw their deposits before a bank could fail under the weight of bad loans and illiquid assets. Nowadays, the threat of bank runs has been completely eliminated, at the depositors' level, with the creation of the FDIC-Federal Deposit Insurance Corporation and the advent of government-backed deposit insurance, in 1933. (In fact, these days, depositors do not make a run on a bank anymore; it is rather the bankers who sometimes make a run on their own banks, taking out huge bonuses at the expense of shareholders!)


Also, today, as the current crisis indicates, financial crises are more due to structural market dislocations and to solvency crises (insufficiency of capital) than to purely liquidity crises (insufficiency of ready available cash). When liquidity is required to prevent the freezing of credit markets, central banks, as a lenders of last resort, are more ready to provide emergency liquidity through discount lending, so as to limit the negative effects of such market dislocations. Solvency issues are more difficult to tackle because they involve the very functioning of a capitalist market system in which insolvent units are supposed to be allowed to dissolve or be restructured. The too-big-to-fail banks problem is an example of such a dilemma.


For example, the financial  crisis of 1873 began with the bankruptcy of the Philadelphia banking firm Jay Cooke & Company, on September 18, 1873. This bankruptcy was due to a lack of liquidity on the bank's part. Indeed, the Cooke & Co bank had its reserves invested nearly entirely in Northern Pacific Railroad bonds. When a run on the bank took place, the bank could not sell enough bonds to meet its obligations and it had to close its doors. This, is turn, brought about a stock market crash and a chain reaction of bank runs and failures. This led to a wave of financial and industrial bankruptcies that resulted in the 1873-1880 depression. The 1873 crisis was what I would called a standard vanilla-variety financial crisis. It was a liquidity-driven crisis.


In the U.S., the Federal Reserve System was created in 1913 with the express purpose of avoiding such liquidity-driven financial crises by having a lender-of-last-resort for banks in need of liquidity.


But what about the 1931 financial crisis? Why was it not avoided? Because, like the current financial crisis, it was both a liquidity crisis and a solvency crisis.

The 1931 financial crisis started in Europe, more precisely in Austria, and it spread quickly to London because of inter-bank loans. It began with the failure, in September 1931, of the big Austrian CreditAnstalt bank, owned by the Rothschild family. This failure created a domino effect of financial collapses that spread quickly throughout the German, the British and the global financial system. Central banks at that time were slow to respond to the crisis and they let it develop to the point that the conflagration could no longer be stopped. In the U.S., the Fed did not act quickly enough to prevent a contraction in the money supply. Instead, it applied the wrong policy of raising interest rates at the wrong time, a move that made matters worse.


Why did it act that way? It was because the Gold Standard monetary system of the time required that the amount of credit the Federal Reserve could issue was partially backed by gold in its possession. The Fed raised interest rates and tightened credit in order to conserve its gold reserves, which had been depleted when its demand notes had been redeemed in gold. In order words, the Fed failed in the early 1930s to alleviate the liquidity crisis, which in turn, exacerbated the solvency crisis. This time, the Fed went the other way, trying to solve the liquidity crisis and the solvency crisis at the same time by creating loans against bad debts. More on that later.


3. General Causes of financial crises: Corruption, Greed (unrestrained egoism), and Debt; Accessory causes: Incompetence and Naivety


Total Debt in the economy


By 2005, the table was set for what could turn out to be the biggest financial mismanagement in history. It was the product of two interrelated bubbles:  a housing bubble and a financial debt bubble.


The housing boom was fed by extraordinairily low interest rates and by lowered lending standards for mortgages. Indeed, from 2002 to 2005, under chairman Alan Greenspan, the Fed maintained excessive monetary liquidity in the financial system and short-term interest rates fell to 1 percent, with real interest rates negative.


Indeed, after the tech-bubble burst in 2001, and the March- November 2001 recession, the Greenspan Fed aggressively lowered the Federal Funds rate from 6.5 percent to 1 percent in 2004, the lowest it had been since 1958. It is widely accepted today that this aggressive monetary policy lasted too long and has played an important role in fueling the housing bubble.


But the housing bubble would have only been an above normal top within the 18-year Kuznets cycle ( from a 1987 top to the 2005 top) if it had not been reinforced by an extraordinary debt bubble.


Indeed, before dealing with more specific causes of the current financial crisis that followed the housing and mortgage bubble that burst in 2006-07, let me elaborate on the issue of total debt in the economy, the dangerous process of debt deflation and the dangerous credit crunch that usually follows. I will stress the fact here that the new financial products and practices invented from thin air over the last ten years or so—especially the insurance against the debt default of derivative products, with dubious value, in order to artificially maintain a borrower's high credit rating—have encouraged the present high and dangerous debt level in the economy.


Indeed, the ratio of total debt to the U.S. Gross Domestic Product (GDP) is now higher than it was in 1933, when it reached the lofty and unsustainable level of 299.8 percent. It took nearly twenty years to bring down the debt/GDP ratio to below 140 in 1952. In the second quarter of 2008, all debt records were broken when the total debt ratio in the U.S. registered at 356,7 percent of GDP. If the same process of unwinding of excessive debt level plays itself out this time, this could translate into a debt deflation process lasting possibly until 2027!


Today, the U.S. ratio of total debt ($57 trillion) to the economy (GDP: $14.5 trillion in 2009) is even higher today at 3.9, than it was before the onset of the crisis in 2007-08. To say it differently, let's say that it takes today nearly $4.00 of debt to create one dollar of GDP activity while it took only $1.40 of debt in the early 1950s to create one dollar of GDP activity. This is a reflection of how complex the financial system has become. Some of this financial complexity is good for a better managment of risk in the economy; but also, part of this debt level relative to the economy is excessive and reflects too much a casino like activity  that makes the economy vulnerable to financial collapses.


What this means, in reality, is that it takes today about $4.00 of debt to create one dollar of economic activity while it took only $1.40 of debt in the early 1950s to create one dollar of GDP activity. This shows how devastating it is for the real economy when financial flows are disrupted and when credit becomes unavailable. This is our situation today. Investors and producers have a lot of problems financing their projects. This is a big monkey on the back of the economy, and it is a source of economic stagnation.


That is why I would argue here that the problems of U.S. financial dysfunction in the U.S. economy and in other countries have not been solved. On the contrary, they have been swept under the large rug of even easier money and of even larger debts, which is only postponing a day of reckoning. And no meaningful financial reform seems to be coming from the gridlocked Washington D.C. political establishment.


For sure, the large Wall Street banks' bad gambling debts in the form of toxic securities have been transferred to the public sector (the Treasury and the Fed) and to the quasi public sector (Fannie Mae and Freddie Mac), but the overall debt load of the U.S. economy and excessive risk-taking by the banking sector has not been reduced; it has been increased. That is why I think the U.S. economy will remain vulnerable to the process of debt deflation in the coming years, and I would add, accompanied by possible inflation shocks and fiscal shocks in the form of higher taxes to service the debt load, both foreign and domestic.


Moral Dimension:

Greed (unrestrained egoism), and Debt; Accessory causes: Incompetence and Naivety


Among the general causes of financial crises, I mention at the top of the list the moral dimension. This is an issue that I explain more fully in my new book The Code for Global Ethics, (ISBN: 978-1616 14 17 21).


Indeed, I have come to believe that the fundamental causes of recurring financial crises and economic decline, every 50 to 75 years, are not primarily technical in nature, but are rather moral and ethical.

This takes two kinds of corruption or fraud.


First, consider the fraudulent practices of the U.S. mortgage industry and the U.S. banking industry when they engaged in subprime lending, selling adjustable-rate (ARMs), or interest-only or even negative-amortization subprime mortgages, with minimal or no down payments, to borrowers they knew could not pay them back if anything went wrongsuch as a situation of rising interest rates, a situation of falling house prices and/or a situation of rising unemployment. Well, these three situations did unfold after the top of the housing bubble in 2005. So far, about 8 million foreclosures have already occurred. And it is expected that in 2010-11, the number of foreclosure filings could rise to another 3.5 to 4 million.


In the past, lenders of traditional mortgages would have been more prudent because they were the ultimate holders the mortgages. But with the new practice of financial securitization, primary mortgage lenders were not worried by the possible insolvency of borrowers, because they knew they could sell those risky subprime mortgages to other banks which ultimately sold them down-stream as some commercial-like paper to unaware investors. It was a form of “pass-the-buck” lending.


But for this to occur, some basic political corruption had to take place. Indeed, when the level of political corruption in government becomes very high, as it is the case in the United States presently, it becomes nearly unavoidable that political corruption and corporate greed will reinforce each other in a vicious cycle that is most destructive to a society and to an economy. Over the last twenty-years, and especially over the last ten years, this is what has happened in the United States and elsewhere. This was an era dominated by the ideology of “greed is good”. —[Greed was glorified in the 1987 movie Wall St.” in which Michael Douglas, playing the character of Gordon Gekko, says: “Greed is good, Greed is right. Greed Works.”.


This was the prevailing ideology at the time. I won't deal here with the kind of intellectual corruption that supported the ideology that markets can do no wrong or that they are always “efficient”. In fact, markets are very imperfect; they are often under the control of monopolies or cartels, and sometimes, they do not function at all.


In the corporate world, greed and unrestrained egoism meant that making money at any cost and in any way, irrespective of any moral principles, became the acceptable practice. If this meant buying the influence of politicians with tons of cash to remove any barrier to speculation and fraudulous practices, so be it. In the political world, this means that the common good ceases being the compass guiding laws and policies, and private immediate interests for reelection become the paramount, if not the only objective of behavior. Money flows and money talks and those who refuse to play the game are quickly replaced with more malleable individuals.


For the last twenty-five some years, the United States has witnessed such a public moral degradation, culminating, I think, on Thursday, January 21 (2010) when the conservative John G. Roberts Jr U. S. Supreme Court's majority ruled that business corporations and labor unions can spend as much money as they like to buy political influence and clout, a throwback to the robber-barons worst days of corrupt politics of the nineteenth century. Nowadays, large corporations do not have a nationality. They operate around the world and their main goal is the pursuit of profit for their management and shareholders.


Such an historically bad decision may have definitely confirmed the implantation in the U.S. of a system of corporatocracy or of corpocracy, i.e. a form of government where large business corporations, banks, conglomerates, and government-sponsored enterprises control the electoral process, the media, the courts and the government of a country, thus depriving ordinary citizens of their democratic rights. Such a system could also be called plutocracy, which is a form of fascism.


That fateful January 2010 decision probably marks the top of a twenty-five year cycle of wholesale government deregulation in the United States and elsewhere. It can be seen, indeed, as the culmination of a whole string of deregulatory moves taken over the last twenty-five years and designed to enhance private special interests at the expense of the common good.


It will have tremendous political and social consequences, because the Roberts' Court majority decision opens even wider the floodgates of unlimited money-backed political corruption, and because by devaluating the importance of each American's vote in elections, it will feed cynicism and apathy among the population, always a sign of political decadence.


It would take a complete conference just to enumerate all the financial deregulation steps taken over the last twenty-five some years. Suffice it to mention here the most important and blatant ones.


It all began with rich individuals and corporations taking over the control of the electronic media. This was made possible by a move made by the Reagan administration in 1986 that abolished the “Fair Doctrine” requirements as a condition to obtain radio or television licenses.


That decision alone, more than any other, was instrumental in turning the public airwaves in the U. S. into an unrestrained space of money-backed propaganda and, in the process, in the demise of independent and objective journalism in the powerful electronic media.





4. The Direct Cause of the 2007-09 Financial Crisis


The current financial crisis is the result of twenty-five years of wholesale financial deregulation that has brought us back to an era of anything goes, similar to what prevailed during the era of the robber-barons in the last part of the 19th century. As a matter of fact, I see a lot of similarity between the long period of economic stagnation that prevailed in the last third of the 19th century and the situation at the beginning of the 21st century, which I see continuing for many years.


Indeed, there was a string of specific financial deregulation steps taken by the politicians that has paved the way for the current era of irresponsible Ponzi-scheme finance, of casino-like leverage banking practices and of the unhealthy concentration of wealth and income in a few hands. I will outline here five (5) of the most important financial deregulation steps taken before the outbreak of the 2007-09 crisis, and which played an important role in bringing it about.


Although there were public deregulation moves made before that date, the two most serious steps were taken in 1999-2000, at the advice of then Fed chairman Alan Greenspan, under an initiative of the Republican controlled Congress, and with the collaboration of the Democratic Clinton administration. Indeed, two fateful laws were passed to deregulate the American financial industry.


First, in 1999, the U. S. Congress passed the Gramm-Leach-Bliley Act (GLBA) that, in effect, abolished most of the 1933 Glass-Steagall Act. In the past, that law had prevented unregulated investment banking from merging with the regulated and government-insured commercial banking sector.


With the new law, the large unregulated Wall Street investment banks that underwrite corporate securities and the regulated commercial banks that take government-insured deposits, and some insurance companies as well, could tremendously enlarge the range of their financial and speculative activities.


There seems to exist a revolving door between Washington regulatory agencies and corporate America. For example, Wendy Gramm, wife of Texas Senator Phil Gramm, headed the Commodity Futures Exchange Commission. At Enron's request Enron became exempt from Commodity Futures Exchange Commission regulations in January 1993. Wendy Gramm resigned her position and six weeks later was appointed to the Enron board of directors.


Then, in a one-two punch, the lame-duck 2000 U. S. Congress went further and reintroduced legalized gambling into the financial sector, a prohibition that had been in place since after the 1907 financial crisis, when President Theodore Roosevelt (1858 –1919) was in office. Indeed, by adopting the Commodity Futures Modernization Act of 2000, Congress, and President Bill Clinton who signed it, exempted outright financial gambling from state gaming laws. With the new law, the entire American financial system could be turned into a large unregulated casino where everything goes (legally).


This move paved the way for transforming a financial instrument, the credit default swap (CDS) into a casino chip that speculators could play with to their advantage. More about that later.


- Another step toward a near complete public deregulation of previously regulated financial activities was taken in 2004, this time by the regulatory agency of the Securities and Exchange Commission (SEC). Indeed, on March 28, 2004, the Securities and Exchange Commission (SEC), led by former congressman and Bush-appointee Christopher Cox, removed the ceiling on the level of risk that the largest American investment banks (Goldman Sachs, Morgan Stanley, Lehman Brothers, Merrill Lynch, Bear Stearns) could take on so-called securitized loans and on their hedge fund operations.


- A fourth legislative step was taken in April 2005 when a bill to limit access to bankruptcy protection (S 256) was sponsored by and passed with the support of the Republicans, but also of many conservative Democrats. With this bill, formally called the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, [] federal bankruptcy judges were in effect prevented from accepting court-approved plans to restructure mortgages before resorting to foreclosures, under Chapter 7 of the U.S. bankruptcy code. As a consequence, bill S 256 made the foreclosure of 2007-09 worse than it would have been if the old bankruptcy law had been in effect, i.e. allowing people to file under Chapter 13 of the bankruptcy code that permitted a reduction of some debts. [N.B.: According to the Center for Responsive Politics, the banking industry spent over $100 million in lobbying efforts to have bill S 56 passed].


- Finally, the Securities and Exchange Commission took the last step toward deregulating financial markets when in the month of July 2007, only weeks before the subprime financial crisis went into full gear, it removed  the “uptick” rule [] for short selling any security, including for so-called asset-backed securitized securities.—The stage was set for the disaster to unfold. And it did. The end-result of all these deregulation policies was the de facto collapse of the American financial system in the fall of 2008.


Not that all that could not have been foreseen. A lot of other people saw the crisis coming. Ten years ago, in 2000, I myself wrote an article stating that some unregulated financial derivatives were a time bomb waiting to explode (Les Affaires, Les produits dérivés, 11 novembre 2000). Well, it took eight years, but it finally exploded on September 15, 2008, when the financial crisis reached its climatic stage. That is when the pyramid of unregulated credit derivatives, heavily concentrated on U.S. subprime mortgages, went crashing down under a wave of mortgage defaults and housing price declines that had not been anticipated, like a house of financial cards. There was no market for those artificial credit derivatives and investors worldwide ran in panic to the exit.


All these public deregulation steps were wrapped into an excessive easy monetary policy of the Greenspan-Bernanke Fed during the 2001-2004 period. Indeed, artificially low interest rates were a powerful encouragement for borrowers to take adjustable rate mortgages (ARMs), at low rates for one or two years to be reset later at much higher rates. This was at a time when primary mortgage lenders were encouraged to lend to just about anybody, no matter the borrower's creditworthiness. In 2006, for example, about 25 percent of American mortgages were subprime loans and close to 20 percent were adjustable rate loans (the U.S. mortgage market is worth $14 trillion). Therefore, with nearly half of the mortgages issued being risky mortgages, it can be said that the economy was borrowing from the future to artificially boost the present economic conditions of the time. There are indications that this was done for political reasons.


In the end, many of the primary and secondary mortgage lenders such as Countrywide Financial, Washington Mutual, IndyMac, and ultimately Bear Stearns, collapsed. And Fannie Mae and Freddie Mac, the two largest players in the U. S. mortgage market as insurers and secondary mortgage lenders, came very near to total collapse before the U.S government came to their rescue and invested $400 billion in them.


Many large Wall Street banks which had bundled and recycled primary mortgages bought from primary lenders into risky collateralized financial obligations, suffered tremendous losses on the credit derivative products they had underewriten and still had in stock. The largest U.S. insurance company, American American International Group (AIG) which had insured many of the banks' credit derivative products through its Financial Products division, without adequate reserves or collateral, but with the blessing of credit rating agencies, also was on the brink of bankruptcy. This was a total financial mess.


5. The credit derivatives: The New Alchemy of “Structured” Finance.


Credit derivatives are the conduit through which the subprime mortgage crisis was allowed to build up. Indeed, the main reason for the lending recklessness that took place was the facility with which subprime lenders could sell their risky mortgages upstream to bigger players, investments banks for example, which undertook to buy them, pool them into mortgage bonds and re-channel them into new financial instruments through a process of aggressive securitization.


Credit derivatives come in acronyms like alphabet soup, but the most basic ones are: 

-The synthetic subprime collateralized debt obligations (CDOs), (or slices or tranches of amalgamated pools of subprime loans based on mostly interest-only second-handed mortgages, but also on other types of debts, such as credit card debts). CDOs are basically illiquid financial products because they usually can be bought or sold only through the entity that created them.

-And, the Credit Default Swaps, (CDSs). CDSs are insurance credit protection contracts offering protection against default on the interest or principal payments of a loan.


These credit derivatives belong to the class of  "structured investment vehicles" (SIVs), which themselves belong to the larger class of derivative products. [For reference, let us keep in mind that total derivative products around the world amount to more than $600 trillion, or more than 10 times the output of the global economy. This is a staggering overhang on the world economy when something goes wrong.]


The Collateralized Debt Obligations" (CDOs), for example, had the characteristics of short-term asset-based security that were backed by the underlying income-producing mortgage assets downstream and were graded according to a certain risk of default. —But, in order to have protection against default on interest or principal payments, and in order to justify high credit ratings, another financial instrument had to be invented. —The Credit Default Swap was born. There was a worldwide market for those CDS-insured CDOs. In fact, more than one trillion and a half dollars ($1,500.000,000,000) of these asset-backed financial products were sold, not only in the U.S., but all over the world. However, the market for such an artificial or somewhat fictitious financial instrument began to tighten significantly when the housing bubble burst in 2005 and 2006, as a wave of foreclosures and mortgage defaults hit the industry. It got worst after the August 2007 subprime crisis, and it became de facto frozen in the spring of 2008, after the demise of the investment bank Bear Stearns, on March 15, 2008.


The CDS (credit default swap) market is an opaque and thinly traded over-the-counter market that is easily open to manipulation. At any moment in time, nobody really knows who owns or owes what to everybody else. Speculators buy those CDSs as if they were put options on the underlying bonds. When their prices go up, the price of the underlying bonds goes down, and a financial crisis ensues for the bond-issuing company or government. Together, CDOs and CDSs can make for a very toxic cocktail. —This is a clear case where the speculative financial tail moves everything else. Speculators are in control.


At the outset of the 2007-09 financial crisis, things went into a downward spiral, when the credit rating agencies (Moody's, Standard & Poor's and Fitch) decided that they had no choice but to lower their artificially high ratings on asset-based securities (ABS), and the prices of ABS plummeted. These credit rating agencies had competed between each other to give artificially high ratings to the new structured financial instruments, thus raking in large fees (as much as $25 million for each new deal).


Creating CDOs (i.e. packaging different debts together) was very profitable for banks, for some insurance companies that insured them while holding very little reserves, and for the credit agencies that rated them.


There was tremendous pressure and profitability to create those CDOs. This, in turn, encouraged the lowering of mortgage-lending standards all over the board with just interest loans, negative amortization loans and adjustable rate mortgages, which in turn led to the mortgage-default crisis, which in turn led to the credit derivative crisis.


The political side of the equation cannot be neglected either. Indeed, for many years, the Department of Housing and Urban Development exerted pressure on banks and on mortgage lenders generally to lend to unqualified borrowers in order to raise home ownership. Consider, for example, the Community Reinvestment Act, passed in 1977, by which the Federal Housing Administration loosened down-payment standards for marginal borrowers. In 2003, President George W. Bush also signed “The American Dream Downpayment Act into law” (U.S. HUD 2003) that aimed at providing subprime mortgages to needy borrowers incapable of making down payments. Therefore, it can be said that while financial institutions profited tremendously from the subprime-led housing bubble, they were encouraged by politicians to make subprime loans for political or social reasons. For instance, by 2006, up to 40 percent of all mortgages were subprime or low-quality (Alt-A) mortgages. The banks' financial innovation was to transfer the increased risk to unsuspecting investors.


Who were these investors? They were mostly private companies, municipalities and universities, for example, who wished to obtain higher returns on their working balances. They bought the sliced CDOs as they would have common short-term commercial paper, not fully realizing that the banks which sold them were not guaranteeing them.


And it is because CDOs were sold by banks, many thought that these new financial products would be kept liquid (and somewhat implicitly guaranteed) by the underwriting banks. Their big advantage was that they carried a higher interest rate; the risk, of course, came from the fact that they were backed by longer term mortgages and the banks were not guaranteeing them. All this took place, one has to remember, during a period when the Greenspan Fed kept interest rates very low from June 2000 to September 2003 and everybody was in search of higher returns.


Where was the alchemy in all that? Essentially, it was in the transformation of risky subprime long-term mortgages into high yield liquid short-term paper. That is where the vulnerability of the financial sector rested.


When the credit derivative market collapsed in the fall of 2008, credit markets around the world froze because nobody wanted to lend money against the toxic CDO products. Nobody could trust anybody. Interest rates rose and stockmarkets crashed. This was a major financial shock.


When the creditworthiness of risky CDOs fell, the price of the insurance CDSs rose, an indication that problems were brewing. The CDOs and the CDSs are the two related, but unregulated and uncontrolled, beasts that nearly brought the world economy to its knees in 2008.


A few more words about the CDSs products, because they really were the corner stone of the financial pyramid that collapsed.


As I said, CDSs are insurance contracts that protect an insured party against the default of interest or principal payments on a loan. Corporations, municipalities and governments typically purchased this type of protection in order to lower their borrowing costs.


There are lot of structural problems with CDSs.


-First, although they are really insurance contracts, they are not typically written by insurance companies but by financial firms or subsidiaries. This means that they are not regulated under insurance laws, state or federal, especially as to the level of reserves required or as to offsetting insurance coverage necessary.


-Second, and as a consequence of the first weakness mentioned here, one does not need to have an insurable interest to purchase CDS insurance. (For example, it is not allowed to buy life insurance on a person with whom the buyer is not closely related. The same for a fire insurance policy on a home; one must be an owner to qualify).


But with CDSs, one may be an outsider, i.e. a speculator or a hedger, who has nothing to insure but is only interested in holding the CDS contract for financial gain. As a consequence, the total amount of CDS contracts issued can be much larger than the value of the insured security, four or five times larger. Then, CDSs become casino chips whose ultimate value is backed only by the issuer.—And this has consequences. In fact, the invention of CDSs has made the debt default crisis much worse by artificially maintaining the value of debts at a high level, thus creating bankruptcies all around. It is as if a system of fire insurance had resulted in increasing the incidence of fire. This is an example of a very bad financial innovation.


In fact, let me say that this is what drove General Motors to bankruptcy. Banks had transformed normal GM bonds into collateralized debt obligations (CDOs) by merging them with other debts, and these bonds had been insured against default with CDSs issued mainly by the Financial Products unit of the large insurance company American International Group (AIG). Speculators bought these CDSs in the hope that the underlying CDOs that incorporated GM bonds would fall if GM were to fail. In essence, the speculators were betting that GM would fail, and they were helping it to fail at the same time by selling short the very CDOs that incorporated GM debt while buying on leverage the CDSs on those CDOs.


When GM ran into financial troubles due to the recession and a drop in car sales, the value of GM bonds should have declined, allowing GM to buy them back at a lowered discount and enabling it to reduce its debt load and survive. But this time, thanks to the new securitization finance, more appropriately called “Ponzi-scheme finance”an imprudent and possibly criminal type of finance in my opinion things did not work out that way. GM's debts had been placed in packaged CDOs that were impossible to untangle, just as individual housing mortgages had been merged and packaged in sausage-like mortgage CDOs that could not be untangled if something were to go wrong.


CDS holders against CDO-GM bonds, both legitimate and gambling speculators, were insured against losses by AIG. And, as I will explain later, the Bush-Paulson administration guaranteed the value of all CDSs issued by AIG against CDO bonds, so the value of those bonds could not decline as they should have, and as they have in the past during an economic downturn. Besides, there are no open market for those CDOs, so nobody could know their real value.


—This is what forced General Motors to file for bankruptcy. It is the same cause that provoked eight million plus home foreclosures in the U.S. while there are much fewer foreclosures in Canada. For example, in the first quarter of 2008, 1.6 per cent of mortgages issued by Canada's top three sub-prime lenders were behind by at least three months. The equivalent rate was about 16 per cent in the U.S. As a consequence, house prices in Canada have been stable or rising. —In this light, the GM bankruptcy was less a normal bankruptcy than a financial assassination.


—Please note that by salvaging General Motors, the U.S. government paid twice: It paid in full the banks and the speculators who held CDSs on CDO-GM bonds; and it later paid to keep GM operating.


Mind you, the same thing that the new securitization finance did to U.S. homeowners and to GM is being done these days to Greece. Greece's government debt has been transformed into derivative products, insured with CDSs. Speculators are buying those Greek CDSs in the hope that the government of Greece will default on its debt.—This is the main reason behind the drop in the euro and of the pound sterling in the last few weeks. There is a fear of a domino effect, with many European countries defaulting if speculators begin attacking one country after another. This could even bring down the euro monetary union.


—This is a crazy and immoral system. The plot thickens even more with the rumor that AIG has been a major issuer of Greek CDSs. If this were true, it would mean that the U.S. taxpayers are paying for AIG's losses on Greek CDSs with U.S. bail-out funds, thus financing the possible collapse of the euro monetary zone! —This cannot be allowed to go on. There should be an international conference to stop the madness.


-This is the reason I wrote on my international blog ( that the international financial system has been transformed nowadays into a gigantic unregulated Casino that allows all types of Ponzi schemes to go on.





6. How Large Speculating Banks and Insurance Companies were Bailed Out with Public Money


What followed was as astonishing as the series of events that led to the crisis. Some of the large Wall Street banks, which had been the main underwriters of the toxic financial products, came out of their collapse nearly unscathed. Indeed, what we have witnessed over the last few years has been the wholesale bailout of some large Wall Street banks, at the expense of others, with public money under hardly any meaningful conditions.


Some have concluded that the practically unconditional bailouts of some of the “too-big-to-fail” banks can be seen as some form of state socialism for the rich, coupled with harsh and unregulated market capitalism for the poor, saddled as they are with unlimited home foreclosures and personal bankruptcies under a newly enacted and stricter bankruptcy law.


The epicenter of the unprecedented banking salvage operation is the Federal Reserve System, sort of a parallel government for the banks, with the power to impose hidden costs and hidden taxes on the economy. Even more than the Department of Treasury's generous Troubled Asset Relief Program (TARP) of purchasing preferred equity in troubled banks, and other similar Treasury plans, that I will talk about later on, the bulk of the banking bailouts came from the Federal Reserve system, especially the bank-controlled New York Fed, in the form of many trillion dollars of guarantees, investments and loans at close to zero percent.


The list of the numerous Fed's bailout programs is very long and very complicated and remains mostly off screen, because it is mostly camouflaged within a super-easy monetary policy.


Without a doubt, the single bank that profited the most from the overall public rescue program was the large Wall Street investment bank Goldman Sachs, which became a commercial bank holding in the fall of 2008, in order to qualify. Goldman Sachs is also the bank that Secretary Henry (Hank) Paulson led until he became Treasury Secretary in 2006.


This is a bank that was deeply involved in the underwriting of subprime credit derivatives like CDOs and in the purchase of CDSs. It had a net worth of $42 billion on August 27, 2008, but was saddled with a CDO portfolio of $22 billion. Worse, it had invited some European banks to invest in CDOs with the understanding that such products were guaranteed and secured. Worse still, Goldman Sachs profited even more when, after realizing the fragility of the CDOs it was peddling to unsuspecting clients, began selling bundles of CDOs short (against the interest of its own clients) and speculated on the rising value of the CDSs by purchasing them. Thus, Goldman was making money as the entire subprime credit derivative market it had been instrumental in creating was folding! —One would hope that someone in Washington D.C. understands that.


One question must be answered. When did Goldman Sachs become directly involved in supervising, within the government, the very financial problem they had been deeply involved in creating? The fateful day was Tuesday, May 29, 2006, when President George W. Bush named Henry (Hank) Paulson, then Chief Executive Officer (CEO) of Goldman Sachs, to be Secretary of the Treasury. He assumed his post on July 3, 2006, after confirmation by the Senate. Paulson's compensation package at Goldman Sachs was $38 million the preceding year, 2005. This was a reflection of the fact that Paulson had been a major architect in building the very profitable subprime mortgage-backed derivative business at Goldman Sachs.


More importantly, maybe, Paulson had also successfully lobbied the Bush administration and the U.S. Securities and Exchange Commission, two years earlier, in 2004, to release the major investment houses from the net capital rule, i.e. the requirement that their brokerages hold reserve capital that limited their leverage and risk exposure. This made the subprime derivative business that much more profitable because investment banks like Goldman Sachs could rake in fees in selling various types of collateralized debt obligations (CDOs) while holding very little reserves or collateral as counterparts. In 2004, also, Paulson was instrumental in having the SEC surpervision of big banks replaced by a program of voluntary regulation by the big banks themselves.


Moreover, having been named as head of the U.S. Treasury just when the number of home foreclosures was on the rise and the housing market was beginning to disintegrate after its peak in the spring of 2005, Paulson brought many key Goldman Sachs people with him. For a while, at least, the U.S. Treasury became a de facto Goldman Sachs officine. This proved to be very convenient when the financial crisis reached its climax in September 2008.


- A Mammoth Financial Conflict of Interest


With Goldman Sachs' Paulson in control of the U.S. Treasury, in 2006, it was as if the fox had been placed in charge of the financial chicken coop. Indeed, as Secretary of Treasury, Paulson was well placed to make sure that the large banks' bad loans could be nationalized (not the banks, only the bad loans!) and paid in full with taxpayers' money. And, that's precisely what happened.


As I have already said, the core of the crisis centered on the large insurance company AIG, which had insured large amounts of toxic subprime derivative CDO products against default, with the help of the credit rating agencies (Standard & Poor’s, Moodys, Fitch) which gave high credit ratings to these products. With the collapse of these products, AIG did not have enough funds to pay the holders of its CDS insurance contracts. The holders of CDSs, mainly banks and speculators, risked losing tremendously. At the time, as Fed chairman Ben Bernanke observed, “AIG Financial Products was basically an undercapitalized hedge fund that was attached to a large and stable insurance company.”


AIG's insurance proper subsidiaries were solvent; only the Financial Products unit was insolvent. AIG Financial Products was unregulated because federal law allowed AIG to choose its own regulator for its overextended unit. It had chosen the federal Office of Thrift Supervision (OTS) which was not equiped to supervise AIG Financial's sophisticated products.


In normal circumstances, indeed, the fact that AIG didn't have the funds necessary to pay the large banks the insurance money (CDSs) on their depreciated and illiquid toxic securities (CDOs) meant that the banks were to lose tens of billion dollars, if not hundreds of billion dollars. And Goldman Sachs was to lose the most in money and in reputation because it was AIG's biggest client and because the European banks involved had often been brought into the fold at Goldman Sachs' request. But Goldman Sachs and its allied foreign banks did not lose one penny with the collapse of AIG, the cornerstone of the shaky U.S. financial system at the time. It is the government (the U.S. Treasury and the Fed) that supplied AIG's casino-like division, AIG  Financial Products, the money necessary to pay up the holders of CDSs.


Indeed, history will record that, in September 2008, the U.S. government and Secretary Henry Paulson decided to step in and provided the necessary funds and guarantees to AIG Financial Products, so that the big insurer could pay banks such as Goldman Sachs and Société Générale of France others—at 100 cents on the dollar—for the credit-default swaps they had purchased on their underwritten CDOs. In fact, the Goldman Sachs bank was one of the biggest recipients of the AIG money, receiving a check in the amount of $12.9 billion from AIG for its otherwise near worthless CDS paper.


Altogether, the insurance giant American International Group (AIG) which had sold billions of dollars of insurance guarantees on the Wall Street banks' risky mortgage-backed credit derivatives, and all the while keeping insufficient reserves, received a whopping $182.5 billion public bailout from the U.S. Treasury and the Fed to avoid bankruptcy. More than half of that amount, more than $90 billion, was used to pay the foreign and domestic banks for the CDS insurance contracts they had bought from AIG. Without the government intervention, payments on the CDSs would have been suspended sine die and the banks holding them would have received close to nothing.


Meanwhile, and because of this bailout money, the largest American banks are getting larger. For example, in 2006, the combined assets of the U.S. six biggest banks (Citigroup, Morgan Chase, Bank of America, Wells Fargo, Goldman Sachs, JP Morgan) totaled 55 percent of U.S. GDP. In 2010, this ratio stands at 63 percent (it was only 17 percent of GDP in 1995).

Consider also another measure: In 2007, the four largest U.S. banks —(Citigroup, Morgan Chase, Bank of America, and Wells Fargo) —held 32 percent of all deposits in FDIC-insured institutions. As of June 30, 2009, it was 39 percent.


Therefore, since the structural banking problems have not been solved but rather made worse, the crisis could flare up again anytime, either here, as a lot of commercial loans (office buildings, malls, hotels...etc) are on the brink of default and will likely default in the coming years, or elsewhere, with many European governments having their own subprime crisis and being attacked by CDS gamblers.


Let me make myself clear. —It would have been better if the problem had been avoided with more prudent government policies and banking practices. However, in the fall of 2008, the U.S. government had a responsibility, especially after the failure of Lehman Brothers on September 15th, to stabilize the financial system and to avoid a deeper and wider financial crisis. After all, it was a series of government policies and deregulation steps that paved the way to the housing bubble and to the meltdown, to the emergence of risky financial products and to the resulting financial crisis. It is how this was done that borders on the scandalous, not the goal itself of averting the financial crisis from spiraling out of control. For example, there was no need to pay billions of dollars to banks and speculators at 100 cents on the dollar for toxic and illiquid securities that were worth much, much less.


As an alternative way to obtain the same result, AIG could have been placed into receivership under the Federal Deposit Insurance Corporation (FDIC) and its old subidiary, the Resolution Trust, used in the 1990s to wind down the Savings & Loans bad loans. In such circumtances, banks and speculators alike would have been forced to accept much reduced amounts on their CDSs. Also, receivership could have allowed AIG to change its management, and this would have erased the value of AIG's common shares. It would have also most likely prevented AIG and the benefiting large banks from going ahead and paying hundreds of millions in bonuses, after they had just been rescued from bankruptcy by the government.


Instead, some of the operators which were the most involved in creating and inderwriting the subprime credit derivatives, far from being penalized, were rather rewarded with hundreds of billion dollars in unconditional government largess. That's where and how the unwarranted transfer of wealth between the government (i.e. the taxpayers) and AIG and the large Wall Street banks took place. Nothing like that has ever existed in the entire history of finance.


In exchange for this unparalleled generosity, the U.S. government took (partial) control of AIG and now owns 79.9 percent of AIG equity. Why not 100 percent of equity, one may ask, since all the rescue money came from the government? It seems that, in 2008, the Bush administration wanted to preserve the appearance of private enterprise at AIG by letting its shareholders keep ownership of 20 percent of the company.


Fannie Mae and Freddie Mac placed under conservatorship


One week earlier, on September 7, 2008, Secretary Paulson and the Bush administration had gone one step further in the case of the large so-called government-sponsored enterprises (GSEs), Fannie Mae (Federal National Mortgage Association: FNM) and Freddie Mac. (Federal Home Loan Mortgage Corporation: FRE) These two giants were also in financial trouble and close to insolvency. They received $200 billion each from the government against new preferred shares and warrants to buy common shares. This was done to prevent bankruptcy and to solidify their mortgage lending operations and their $5.3 trillion joint debt. But in exchange, they were placed into conservatorship, i.e. nearly nationalized, with the U.S government taking a 79.9 percent stake in the two mortgage giants. Thus the political fiction that the two firms were still “private” companies was again kept alive, even though all the money to sustain them came from the government. (N. B.: Conservatorship is a legal procedure wherewith an entity or organization is subjected to the legal control of an external entity or organization, known as a conservator. When banks and financial institutions are in financial trouble, they can be placed under the stricter legal procedure of receivership by the Office of the Comptroller of the Currency for banks, by the Office of Thrift Supervision, or by the FDIC-Federal Deposit Insurance Corporation).





Bank                               $ billion


Soc. Générale                   16.5

Goldman Sachs                 14.0

Deutsche Bank                    8.5

Merrill Lynch (B of A)         6.2

Calyon                               3.8

Ten other banks                 8.8

Total                               62.1


Source: Office of the Special Inspector General for the Troubled Asset Relief Program (TARP), “Factors Affecting Efforts to Limit Payments to AIG Counterparties”, November 17, 2009, P. 20.


- The failure of Lehman Brothers on September 15, 2008.


One week later, however, things turned out differently. Indeed, probably the most damaging error made by the Bush-Paulson administration may have been letting the global investment bank Lehman Brothers fail ($691 billion of assets at the end of 2007 and a large issuer of CDSs), on Monday September 15, 2008, instead of placing it under government receivership. In fact, I happen to believe that the correct policy at the time should have been to place the most seriously crippled large money center banks which were de facto on the brink of bankruptcy into temporary administrative receivership, rather than bail them out with trillions of dollars of public money that had to be borrowed by the U.S Treasury or printed outright by the Fed.


This fateful date of September 15, 2008, will likely be remembered in the future as the day when the financial crisis reached its climax. This was the largest failure of an investment bank since the collapse of Drexel Burnham Lambert in 1990. In contrast, the Fed and the U.S. Treasury moved quickly in mid-March (2008) to save a similar global investment bank in distress (but half the size of Lehman), Bear Stearns, by quickly lending and guaranteeing $29 billion to the large universal J. P. Morgan Chase bank in order to absorb it. —(N.B.: Let us keep in mind that it was the collapse, in June 2007, of two internal Bear Stearns hedge funds that had been heavily invested in mortgage securities that kicked off the severe market panic that unfolded in August 2007, and which later turned into a full-fledged international financial crisis).


Why was the same treatment not offered to Lehman? Possibly because of a personal lack of empathy between Treasury Secretary Henry M. Paulson Jr. (a former chief executive of rival investment bank Goldman Sachs) and Lehman's CEO Mr. Richard S. Fuld Jr., or possibly because the Bush administration wanted to make an example that not all investment banks, no matter how large, could count on being rescued by the government. The Bush administration did not even bother to appoint a trustee to supervise Lehman’s liquidation in order to make it orderly.


Such a liquidation of a large international bank, known for its worldwide interconnections and unsound banking practices, was nearly a repeat of the mistake made in letting the large Vienna-based CreditAnstalt bank fail, on May 13, 1931. This was a bank that had borrowed large amounts of money in London and in New York to finance its activities. Its failure created a domino effect among other international banks that had lent to each other in the international credit chain. So much so that the failure of the CreditAnstalt forced them to severely tighten their lending to absorb their sudden losses.


Seventy-seven years later, in 2008, the Bush administration's decision to let the Lehman Brothers bank fail without taking it over produced a similar ripple effect throughout the international financial system. And, perhaps more important politically, it signaled to the markets that the Bush administration was willing to let a dangerous debt deflation and an ominous credit crunch proceed. This may turn out to have been a most tragic mistake. These ripple effects have not ended, because many European countries are still in the throes of managing their derivative and sovereign debts. Countries such as Ireland, Greece, Spain, and Portugal may have years of financial troubles ahead.





7. No Financial Reform in view: How the Banks can Control, or if need be, Succeed in Paralizing the U. S. Government


On paper, the Democrats control the White House, the House of Representatives with 256 members (out of 435 voting members) and the Senate with 57 seats (out of 100). But does the Democratic Party control the political agenda in Washington D.C.? The answer is no. In reality, it is rather a coalition that we can name “The Unified Corporate Party” (UCP) that controls the American political agenda. And that is true whoever occupies the White House, whether that person is a democrat or a neoconservative.


Why is this so? Essentially because the neoconservative Republican Party is ideologically unified along a pro-corporate and pro-Israel ideology, while the Democratic Party is really two parties in one. It has two wings with diverging ideological interests, one progressive and liberal, the other very conservative and nearly undistinguishable from the Republicans. For example, the Democratic Party includes a 68-member strong block of conservative so-called New Democrats. 


Some of the New Democrats, for example, have strong links with the Wall Street lobbies and other special interest lobbies, with whom rests their basic loyalty. Some of the New Democrat representatives are even former Goldman Sachs investment bankers, such as first-term congressman Jim Himes from Connecticut. Moreover, Obama's own Chief of staff, Rahm Emanuel, was a member of the New Democrat group during his time in the House.


The members of this group, led by New York Representative Joseph Crowley and supported by President Barack Obama's Chief of staff, Rahm Emanuel, are socially progressives, but on many economic and fiscal issues, they are really Republican-Democrats, primarily financed by Wall Street firms and other corporations. They frequently align themselves with other conservative democrats, such as the socially and economically conservative-leaning 54-strong so-called "Blue Dog" Democrats, who are financed primarily by the health care industry and other special interests, and with the Republicans proper, thus creating a formidable de facto governing do-nothing Corporate Party. Therefore, we can say that presently, except for war, the United States has no functional government. It has instead a one-party system caught in institutional gridlock.


With nearly half of the Democrats in the House of Representatives being disguised Republicans, one can understand the idological disarray of the majority Democratic Party when time comes to govern and pass legislation. This is a party which is sabotaged from within by the New Democrats and the Blue Dog Democrats. The internal Democratic division, coupled with the U.S. Senate's 60 percent rule to stop a filibuster and to enact any meaningful legislation, means, in practice, that the Republicans are nearly always in charge of the political agenda in Washington D.C.


The most recent task of the New Democrats and the Blue Dog Democrats has been to block any meaningful reform of the broken U.S. financial system. They have torpedoed, with the help of their conservative Republican allies, most of the financial reform plans proposed so far, both in the House of Representatives and in the Senate. Business Week magazine has explained recently why this so, stating in so many words that the U.S. Congress is In Wall Street's Pocket”. Therefore, we can say that everything seems to boil down to political corruption and ideological intransigeance.






8. In the eye of the Hurricane: Five Additional Threats for the Future


We are presently at the tail-end of the long 60-year inflation-disinflation-deflation Kondratieff cycle that began in 1949, when war-frozen prices were liberalized. That powerful long politico-financial cycle is winding down now. But it takes time to purge the economy of all the excesses accumulated over the last twenty-five years.


Besides what I have already mentioned, I see five major threats to our economic and financial prosperity in the near and not so near future:


• A major sovereign debt crisis in many parts of the world, especially in southern Europe;


 A major commercial debt crisis and small bank crisis in the United States;


 The historical high level of income inequality in the United States and elsewhere;


 The aging of the population in the United States and elsewhere and a concomittent slowdown in private consumption.


• The over-heating Chinese economy, its undervalued currency, and a possible financial crisis in that country.


Indeed, let me begin with the demographic threat to economic growth in the next twenty years or so. We are presently entering, in most Western countries, a period during which the largest demographic cohort in the history of mankind, the post Word War II baby-boomer generation, has passed its spending peak. As a consequence, consumers will be less of a driving force behind economic growth in the coming years and other spending sources will have to be found, lest we enter into a period of relative economic stagnation and persistent high unemployment.


One such source in the past has been government spending on wars. I do hope that we will not go that route again, but it is surely possible. Some sectors of the economy bent on profiting from wars will undoubtedly push for that solution. A better way would be to reinvest domestically in public capital projects, as was done in the 1950s.


To prepare for the future, for example, we need tremendous investments in internet infrastructures, just as we needed inter-state highways in the 1950s. We need more investments in education and in health care infrastructures for the coming wave of aging individuals. Internationally, many countries are in dire need of productive investments. Advanced and maturing economies can provide this capital and the exports of goods, services, and technology that go with it. These could be the rational sources of economic growth of the future to create jobs and to improve standards of living. But, I repeat, wars should be avoided because they are a source of death, debt, and destruction, and the prosperity they create is factice and short-term.


Another medium-term threat is related to the current high income inequality in the United States and elsewhere. This is a barometer of future serious social unrest as the rich get richer and the poor get poorer.


Indeed, one consequence of bad economic policies in the United States has been a rapid rise in income inequality between the very rich and other Americans. Over the last thirty years, there has been a dramatic increase in economic concentration of income and wealth in the U. S. From a peak just before the 1929 stock market crash, income inequality fell for thirty years until the 1950s, and was flat for twenty years thereafter until the late 1970s. Since the 1970s, however, inequality has skyrocketed, climbing back in thirty years to levels last seen in the late 1920s, when the top 1 percent of income earners reaped 20 percent of all incomes.


By 1979, for example, the top one percent of all U.S. taxpayers received about 8 percent of national income. But by 2007, the top one percent received over 18 percent, more than doubling its share. (If we include income from capital gains in the calculation, the increase in inequality is even sharper, with the top one percent capturing 10 percent of all income in 1979, but over 23 percent in 2007, as compare to 24 percent in 1929.)


Table-2: Share of Total Income, Top 1% (incomes above $398,900 in 2007) of U.S. Income Earners


1920: 20%


1979: 8%


2007: 18%


Source: “Striking it Richer: The Evolution of Top Incomes in the United States”, by Thomas Piketty and Emmanuel Saez, 2009.


Today, we say that as far as income concentration is concerned, the U. S. is close to being back to where it was in the 1920s, before the Great Depression of 1929-1939, i.e. the top 1 percent receiving close to 25 percent of total U.S. income. (The top one tenth of one percent of Americans rake in 6 percent of total U.S. income.) As a consequence, the American middle class is being squeezed and is contracting fast at the expense of that 1 percent of the population. If history is a guide, the pendulum is about to swing back. How this is going to be done is the only thing which is not known.


A few words about two other crises that could unfold under our very eyes in the not-too-distant future, i.e. a sovereign debt crisis in Southern Europe and elsewhere and a commercial debt crisis and small bank crisis in the United States.


Historically, a serious structural worldwide financial crisis sooner or later results in debt defaults by some countries. This happened in 1833-37, 1870-90, 1932-1945, and it is to be expected that the number of countries that will renege on their foreign debt will increase in the coming years. A global debt bomb is hanging over Europe and other parts of the world. The euro zone itself may not survive the coming crisis.


And, I would not exclude some U. S. states from this default scenario, not even the U. S. federal government, with its trillion + dollar fiscal deficits for as long as we can see, even though it has the power to print dollars which are still accepted around the world. That is the reason why I expect the other financial shoe to drop in 2011-13. A major financial crisis, a major U.S dollar crisis (and the concommittent rise in the price of gold) and major bond and stock market crashes have a good chance to unfold in that time period.


More immediately, I mean this year and next (2010-11), there is a fair chance of a repeat on a relatively smaller scale of the private home foreclosure crisis of 2007-09, but this time in the commercial real estate (CRE) loan market. A lot of small and medium-sized American banks hold commercial debts for properties that are presently “underwater”, i.e. whose market value is inferior to the supporting debt.


Indeed, it is estimated that over the next five years, about $1.4 trillion in U.S. commercial real estate loans (land and construction loans of three to ten years) will reach the end of their terms and require new financing. But commercial property values have fallen more than 40 percent nationally since their 2007 peak, and nearly half of these commercial loans are presently "underwater” and are held by smaller regional and community banks all over the United States. Banks do not have to “mark to market” those loans, so the losses are spread over time. Come the time to renew those commercial loans, however, loan losses are unavoidable and will have to be realized. This will be a financial shock to as many as more than one third (3,000 banks ) of the some 8,400 FDIC-insured American commercial banks, with losses estimated to be on the order of $200 to $300 billion. The possible insolvency of so many small banks, as a result of their lack of capital, is bound to be a drag on many local economies.


VI- Conclusions


It seems to me that the U.S. financial system, and even the world financial system, have to be profoundly reformed, if they are to serve the real economy, rather than the contrary. If such a reform does not come about, however, I am afraid that we have entered a period of economic difficulties that may last many, many years. In fact, I think that the world economy stands today at the edge of a large precipice.


What type of reform? First of all, the packaging of different debts in impossible to untangle CDOs should be outlawed. These products are financial time-bombs waiting to explode in the real economy, not only in the United States, but around the world. Second, CDS insurance products should be issued only against insurable securities and not issued as casino chips in values much larger than the value of the insured securities (i.e. no so-called naked CDSs). In other words, the entire innovation of securitization finance has to be reviewed and reigned in before it does further damage.


However, if the U.S. Congress feels that this is too big a problem to tackle on its own, for different reasons, my third recommendation would be for the Obama administration and the EU to call for an international finance conference, preferably a G-20 conference, to adopt coordinated actions and propose legislation implemented to that effect.


So far, the steps taken to study the problem and to reform the system have been slow in coming and very timid. For example, House Speaker Nancy Pelosi intends to create a congressional panel (rather than an outside commission of inquiry) to investigate the causes of the US 2007-09 financial crisis. This would seem to me to be an inadequate and insufficient response to a crisis of this magnitude and severity.


Fourth, for the longer run, and regarding the toxic financial products that precipitated the crisis, one wonders why new medication pills or drugs have to be approved by the U.S. Food and Drug Administration (FDA) in order to make sure that they do not hurt the human body, while no similar requirements of the sort exist for new financial products to make sure that they are not going to be very harmful to the real economy.


There seems to be two different standards applied here. I personally think that there is a  need for a Financial Products Administration (FPA) in order to make sure that possibly toxic financial products are not made available to the public before having been fully tested for their absence of toxicity. It should be mandatory that risky financial products be tested and approved before being sold to the public.


Fifth, as for deposit-taking banks and investment banks, I happen to believe that the Glass-Steagal law should be brought back in full. It was a wise and prudent law that stabilized financial markets for three quarters of a century. Its near complete elimination in 1999 opened the floodgates of irresponsible financial gambling that nearly brought down the demise of the entire U.S. economy. I do not think the contemplated “Volcker rule” to prevent banks from operating their own hedge funds goes far enough, considering the magnitude of the problem.


—I was amazed when the Glass-Steagal act was de facto repealed in 1999, and I am still amazed that the very economist who was most instrumental in that repeal is currently President Obama's principal economic adviser (Larry Summers).


—As a general principle, it should be reaffirmed that finance is there to serve the needs of the real economy, and not the reverse.


—Finally, I would say that in economics, as in medicine, it is never too late to do the right thing. But if you don't, the disease may become progressively worse and it may become irreversible. I think that is where we stand today regarding the necessity to reform the financial system.


* Conference by Dr. Rodrigue Tremblay at the Renaissance Academy, Florida Gulf Coast University- FGCU, Florida, Friday, March 19, 2010.


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