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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 By 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." “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. PART I
PAST FINANCIAL CRISES
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 wrong—such 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. PART II
THE 2007-2009 FINANCIAL CRISIS
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 [http://www.thestockbandit.net/2007/07/03/short-selling-uptick-rule-ends/] 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 (www.TheNewAmericanEmpire.com/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. PART III
THE FINANCIAL SECTOR AS A CASINO 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). TABLE-1: AIG CDO-INSURED PORTFOLIO, NOVEMBER 10, 2008 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. PART IV POLITICAL DISFUNCTION 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. PART V POLITICAL DISFUNCTION 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. |