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Friday, October 31, 2008 How
U. S. Politicians and Bankers Built a Financial Debt House of Cards (whose Collapse Threatens to Destroy
the World Economy). “People of the
same trade seldom meet together, even for merriment and diversion, but the
conversation ends in a conspiracy against the public, or in some contrivance
to raise prices.” "All
for ourselves, and nothing for other people, seems, in every age of the
world, to have been the vile maxim of the masters of mankind." Adam Smith
(1723-1790), (The Wealth Of Nations, 1776) "This
economy of ours is on a solid foundation." President
George W. Bush (January 4, 2008) "While
the crash only took place six months ago, I am convinced we have now passed
the worst and with continued unity of effort we shall rapidly recover." President
Herbert Hoover (1874-1964), (May 1, 1930} Why does the world economy seem to be
caught every 60 some years
in a financial and banking turmoil that threatens to collapse the real
economy? The answer has to be sought in human greed and
political corruption that seem to collaborate in pushing to
the extreme all types of speculative and parasitic practices. Between 2002 and
2007, we have witnessed the culmination of such an example of greed and
corruption on a very high scale, as an unstable pyramid of artificial financial
debt instruments was built to higher and higher unsustainable levels, to the
benefit of unregulated financial operators who raked in hundreds of billions
in excessive profits, juicy fees and obscenely high year-end bonuses.
Similarly, parasitic
speculators took advantage of the situation that regulators
had allowed to develop, and they made billions (not millions) speculating
against the shaky house of cards of mortgage-backed securities. —These
are the winners: bankers and speculators. —The losers in that charade
are about everybody else: homeowners, investors, taxpayers, retirees, and
workers who are poised to lose their jobs and incomes, as a consequence of
the failure of government to prevent
these financial excesses. Indeed, the
problem is both political and financial and this has to be understood in
order to disentangle the web of causes that produces a financial and economic
collapse. It is that combination of political corruption and racketeering
financial and banking practices that creates the right environment for a
major crisis to develop. Why each 60-some years? Essentially because the
lessons learned the hard way by a grandparents' generation, sixty some years
ago, are forgotten by a succeeding spoiled brats current generation, and the
same past mistakes and fresh ones are made anew. On that score,
the big financial crises of 1873-1880 and 1929-1939 had pretty much the same
type of causes as the one we are entering into today: the collapse of public
and private basic morality
among a very small elite that pushes its exploitation of public institutions
to the breaking limit. For such a small elite, there comes a time when all
means justify the supreme goal of enriching itself at the expense of the rest
of society. All combines, tricks and schemes become acceptable and justified
by pious ideological slogans such as “the market always knows
best“, the new “wealth (no matter how acquired) will trickle
down”, or, for the more delusional ones among them, “God is
placing all that money in my hands, therefore, I must be doing good”! The immediate
technical question that must be answered is how a casino-like
financial capitalism was allowed
to develop? Why were banking practices twisted in such a way as to turn
capital into the equivalent of casino chips? Indeed, banking's primary function is to allow
capital to be used in the most productive ways. It is the primary function of
financial intermediaries
(banks, savings & loans associations, stock exchanges, etc.)
to convert savings into productive capital (plants, roads, etc.). Investments
are kept tradeable and liquid by secondary capital markets. Properly
regulated to avoid combines and scams, capital markets usually function
smoothly. It is when
politicians, or regulators themselves, throw out such regulations that things
can get ugly. In the U.S., a few disastrous steps were taken in 1999, 2000,
2004 and 2007, which can explain the current financial crisis. A Decade of Planned
Deregulation
Indeed, under
the advice of then Fed chairman Alan Greenspan, a libertarian at heart, the
Republican controlled Congress and the Democratic Clinton administration
passed two laws designed to deregulate the American financial industry.
First, in 1999, it passed the Gramm-Leach-Bliley Act
(GLBA) that, in effect, abolished the 1933 Glass-Steagall
Act, which had regulated investment banking, and which
established tight barriers between the banking and insurance industries. With
this new law, the large unregulated Wall Street investment banks and
commercial banks, as well, could enlarge tremendously the range of their
financial activities. 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. 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). Another step
toward a near complete 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) removed the ceiling on risk that
the largest American investment banks could take on so-called securitized
loans. Such loans were based on mortgages, but also on credit
card debt, auto finance debt, student loans, etc. Finally, the
Securities and Exchange Commission took the last step toward deregulating
financial markets when in the month of July 2007, weeks before the onset of
the subprime crisis, it removed
the “uptick”
rule for
short selling any security. The Story of the Two Bubbles
The
table was then 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 extraordinaryily
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. Last February 25, 2008, I explained the extent of the
debt bubble, in the United States, in these terms: “When
one looks at a graph provided by the U.S. Bureau of Economic Analysis (BEA) and which shows the relative importance
of total outstanding debt
(corporate, financial, government, plus personal) in relation to the economy,
one is struck by the fact that this ratio stayed around 1.2 times GDP for
decades on. Then, something big happened in the early 1980s, and the ratio started
to rise, with only a slight pause in the mid-1990s, to reach the air rarefied
level of 3.1 times GDP presently, nearly 200 percent more than it used to
be.” That
“something big” was the combination of the breaking up of the
regulation apparatus we have already mentioned, and the appearance of new
risky financial instruments. Reckless
Lending On the one hand,
first came the “subprime lenders” or what some call the predatory
mortgage lenders. Spurred by an incentive system
that rewarded risk-taking (big bonuses), mortgage
banks and other lenders began to accommodate subprime borrowers with dubious
credit by extending mortgage loans to homebuyers who would not have qualified
in other times. —They lowered their lending standards. Nontraditional
home loans were advanced to borrowers who had no documented incomes. Some
loans were interest-only loans with down payments of 5 percent or less. Some were adjustable rate loans (ARMs), with low rates for one or two years to be reset
later at much higher rates. In 2006, about 25 percent of American mortgages
were subprime and close to 20 percent were adjustable rate loans. Mortgage
lenders and home buyers alike assumed that home prices were not going
to fall on a national basis or that the Fed would intervene to save the
industry by slashing interest rates. The New
Alchemy: Finance On
the other hand, the
main reason of such lending recklessness 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. These new
"structured investment vehicles" (SIVs), which fall into the large
class of derivative products, came
under various names such as "Collateralized Bond Obligations"
(CBOs) or "Collateralized Debt Obligations" (CDOs). They had the
characteristics of short-term asset-based
commercial paper that were backed by the underlying income producing mortgage assets downstream
and were graded according to a certain risk of default. —The asset-based
security (ABS) was born. [For reference, let us keep in mind
that total derivative products around the world amount to more than $500
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.] More than one
trillion and a half dollars of these asset-backed financial products were
sold, not only in the U.S., but all over the world. However, the market for
such artificial or 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. The credit
rating agencies
(Moody's, Standard & Poor's and Fitch) had no choice but to lower their artificially high
ratings on asset-based securities (ABS), and the prices of ABS plummeted. Enter
now another new financial instrument that made matters much worse and led
directly to the crisis: the Credit
Default Swaps (CDS).
Because of the lack of proper government regulation, this new financial
product really became, in financier Warren Buffett's words, a true financial
weapon of mass destruction. Essentially because it became the tool of choice
for the newly legalized activity of high level financial gambling by entities
that were unrelated to any genuine lending operation. Indeed, as we will see
below, in a panic environment, large off-shore hedge funds
with their large pools of money could literally raid imprudent and weakened
financial institutions with so-called “naked”
short sell orders that far outnumber the buy orders from any
potential buyers. In other words, they were in a position to corner the
market. Initially, in
order to protect against the risk of default on the new asset-backed
securities (ABS), some insurance companies—but also some investment
banks themselves—began to issue bilateral “insurance”
contracts against the newly created ABS. These were called Credit Default Swaps
(CDS). In theory, they were supposed to offer protection against the possible
default of an investment instrument, such as an asset-backed security. The
issuer of ABS, or an investor looking for protection, could buy such an
insurance contract and pay a premium, which was a small fraction of the asset
being protected, say 5 percent. Understandably, when housing prices were on
their way up, with little risk of mortgage default, the cost of such
“protection” was low, and conversely, in a period of price decline,
when the risk of default increases. This was a financial innovation, the
so-called “insurance against default”, that opened the floodgates
of money to be invested in the new financial instruments. Indeed, it allowed
investors such as pension funds and other institutions which have a fiduciary
obligation to buy only high-quality securities, to legally buy artificially
highly rated (but risky) ABS securities, or to invest in hedge funds which
specialized in leverage trading in derivative products. But the hic is
that the issuance and use of such financial “insurance” contracts
were not regulated by any government agency, because the word
“insurance” was not used; instead, they were considered as simply
a protection against the “default” of payment on a financial
security. And that's where the gambling part enters the picture: only 10
percent of CDS are genuine insurance contracts held by investors who really
own asset-backed securities (these are covered CDS); 90 percent of them are
rather held by speculators who trade CDS, while not owning any asset-backed
securities to be protected (these are naked CDS). To picture the situation,
we can consider such “naked” CDS as a form of high valued casino
chips that one can buy to bet on the likely future value of a financial
security, just as someone could bet on the issue of a horse race. Except that
in this kind of unregulated financial gambling, as we will see, the owner of
the chips can influence the outcome of the race by intervening in the race
itself. In other words, the game is rigged. The Financial Sector as a Vast
Casino
To repeat, and
contrary to ordinary regulated insurance contracts, Credit Default Swaps
(CDS) can be bought and sold by speculators who are not directly involved in
the mortgage business. They deal in “naked” CDS. As a comparison,
for example, it is illegal to buy ordinary life insurance on the life of
someone with whom a buyer is not related, in order to avoid evident abuses.
—Not so with CDS, as it is the case with "naked" CDS. And because
of the 2000 Commodity Futures Modernization Act passed by Congress, no state
has the power to regulate this new form of sophisticated gambling. The result
is astounding: it is estimated that the notional value of credit default
swaps outstanding today is about $62 trillion (4 times the size of the US
economy). This, in itself, is an indication of how popular the
"naked" CDS innovation was as a way to bet on the collapse of the
entire asset-backed securities construction. This is also a clear sign that,
in a crisis, it would be all but financially impossible for the issuers of
CDS to meet their obligations. In other words, disaster was just around the
corner. —This is an event that any regulatory agency should have seen
coming. Indeed, when
housing prices hit the expected top of their cycle, in the spring of 2005,
and began falling, especially in 2006, the price for CDSs was still
relatively low. So, some astute speculators undertook to buy CDSs and
simultaneously began selling short the ABS that had been issued by investment
banks, such as Lehman Brothers, in the correct expectation that
mortgage-backed securities were bound to lose value with the expected rise in
home foreclosures and mortgage defaults. For instance, one large speculator
is reported having
reaped, in 2007, an estimated $3 billion-plus for himself, which made it the
largest one-year gain in Wall Street history, for a single individual. Many
speculative hedge funds played the same game and raked in billions of dollars
in easy-made gambling profits. Who Pays for the Excesses?
Where did all
this money came from? It came from the loses suffered by investors in
investment banks and in some large insurance companies, and it came from
taxpayers who had to advance a lot of money to prevent these financial firms
from failing. The first losers, initially, were the very financial firms
which had initially engaged, very profitably we must say, in the new risky
finance, i.e. insurance companies, such as American
International Group (AIG),
(which was reported to have $400 billion CDS outstanding on its books when it
failed), or from highly leveraged investment banks such as Bear
Stearns, Goldman
Sachs, Morgan Stanley, Lehman
Brothers, Merrill Lynch and others which specialized in buying
primary subprime mortgages and in issuing asset-backed securities (ABS) in
their place. They have suffered huge losses on their ABS and CDS. So much so
that some of these financial firms saw their capital base nearly completely
disappear, making them de facto insolvent and creating the credit crisis that we
know. The Government at the Rescue
To prevent a
complete collapse of the financial system, the U.S. government (Fed, U.S.
Treasury and FDIC) had to step in to prevent these large financial
institutions from filing for bankruptcy, with multiple rescue and bail-out
plans, with the notable exception of Lehman Brothers, which was left to fail
on September 15, (2008). The U.S. Treasury also had to inject some $200
billion in the government sponsored Fannie
Mae and Freddie Mac in preferred shares, in order to solidify
their mortgage lending operations and their $5.3 trillion joint debt. Consequently,
large amounts of public money, in excess of $2 trillion, are now being used
to settle the risky bets that large banks took over the years and which went
bad. Public money is also being used to subsidize large banks to acquire
smaller banks, in an unprecedented restructuration of the entire American
banking sector. Such a government intervention will likely contribute to
shore up the U.S. financial sector by strengthening its consolidated balance
sheet. It remains to be seen, however, if some of the money will trickle down
to the real economy. Conclusion
The U.S.-based
financial crisis has now become worldwide and is spreading.
The root cause of this financial mess is due to the fact that the lessons of
the far away past with its financial crises, and those of a more immediate
past, have not been learned. Indeed, one would have hoped that lessons would
have been learned from the 1980s Savings & Loans crisis and from the
demise of the huge hedge fund, Long Term Capital Management, in the 1990s.
But greed and corruption seem to have overtaken wisdom and to have prevented
proper governmental oversight. In
the United States, over the last two decades, two parallel banking systems
have co-existed, sometime even within the same institution. While one, the
traditional banking system, was regulated, the other one, the investment
banks and hedge funds and the credit derivatives market, was a shadow system
that was hardly regulated at all. Not surprisingly, it is in this unregulated
sector that the worst excesses have taken place, as one ever more risky
financial innovation led to another. These excesses have resulted in creating
a shaky pyramid of fictitious financial debt that has no, or little, relation
to the underlying real economy of production of goods and services. How these
excesses are going to be unwound will dictate how the world economy is going
to fare in the coming years. At
the very least, the return to reality risks being painful and every effort
should be deployed to mitigate its consequences for the greatest number. ___________________________________________________________ Rodrigue Tremblay is professor emeritus of economics at the University
of Montreal and can be reached at: rodrigue.tremblay@ yahoo.com. He is the author of the book 'The
New American Empire'. Visit his blog site at www.thenewamericanempire.com/blog. Author's Website: www.thenewamericanempire.com/ Check Dr. Tremblay's coming book "The
Code for Global Ethics"
at: www.TheCodeForGlobalEthics.com/ _____________________________________ Posted, Friday,
October 31, 2008, at 5:30 am Email to a friend: http://www.TheNewAmericanEmpire.com/tremblay=1102 Send contact, comments or commercial reproduction
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