2 June 2008William Tabb
Mainstream finance theory of the sort taught to millions of undergraduates each year features the fairy tale of rational expectations, efficient capital markets, and smooth movement from one equilibrium position to another. But even the most compliant, careerist economics student is now faced with the horror of media accounts of the rising number of people losing their homes, of a major investment bank crashing—Bear Sterns went from being worth $70 a share one week to $2 the next and having to be saved by a Federal Reserve-arranged bailout granting ownership to JP Morgan Chase—or of the largest mortgage issuer in the country collapsing and having to be bought at salvage prices by Bank of America. Regulators who did little regulating—given their faith in the market—are now aghast and are throwing taxpayer money at the problem while still fearing it will not be enough.
The economists' usual soothing reassurances when trouble develops—that the problem is government interference, exogenous events, a few bad apples—don't really cut it anymore. The crisis is too big and the uncertainties too great. Endogenous crises caused by greed pushed to the point of unsustainability are the workings of the system itself, of overoptimism collapsing in the face of overextension. Those who are charged with regulating finance come from a financial industry background and retire to even more lucrative positions in finance. They tend to do their job in a way that gives this "class of parasites," as Marx calls them in Capital, the widest latitude possible, constrained only by fear of doing damage to system survival. Politicians depend on this sector for necessary monies to run for office and generally allow their leading lights to run the Treasury Department—think Clinton and Robert Rubin, Bush and Hank Paulson.
There have, of course, always been such crises as long as there has been capitalism. But while many elements of past crises remain, each new crisis is unique. At the structural level, today's financial- ization bubble and collapse was made possible by the vast increase in low cost computer computational power. This allowed all manner of new financial products to be priced not by markets, but by models that investors did not understand. They were, in part, a response to the crisis of growth and profitability that came with the decline of the industrial economy in the 1970s.
As the U.S. auto, steel, rubber, textile, and other industries that dominated the 20th century economy declined in the face of global competition (often from U.S.-based transnationals), financiers figured out ways to withdraw capital in corporate reorganizations at the expense of workers who had produced this surplus. In the new centers of accumulation, above all China, but also in other so-called emerging markets, huge current account surpluses produced savings available for investment elsewhere. This has kept global interest rates low and allowed the huge borrowing of some 70-80 percent of global current account surpluses by the United States. These are important factors in the vast increase in liquidity in financial markets and in stimulating global growth.
Along with major redistribution from labor income to capital throughout the world economy, surplus funds available on generous terms led to reductions in loan standards. New borrowing was possible for even those with poor credit without much of a risk premium. Because rates of return are so low in the real economy, the smart money in finance has looked for ways to make better returns. The new financial instruments and new players in the financial sector thus became more prominent in restructuring contemporary capitalism and inventing and selling new financial products.
We were told not to worry about the loss of manufacturing jobs. There would be dramatic growth in the "new economy"—high tech jobs, Internet companies with better pay, and the promise of rapid growth and endless prosperity. This turned out to be a serious exaggeration. By 2000 the stock market bubble based on such expectations collapsed. The Federal Reserve cut interest rates dramatically and kept them low to save, among others, the bankers who had lent to companies that never turned a profit. By holding interest rates low for a number of years to stimulate the economy, the Fed unleashed a housing boom. As housing prices rose year after year, mortgage brokers increasingly used low interest teaser rates and no down payment arrangements to sell mortgages and collect fees up front. The mortgages were then packaged and sold off to other investors. Such securitization in the form of collateralized debt obligations (CDOs) spread, and all manner of risk was sold off, often with guarantees by the banks that if they were defaulted, the bank would take them back. Because it was widely thought housing prices could only go up, the risks were thought to be minimal. Anyone who could not pay their mortgage could, it was thought, sell their house for more than they paid (and for more than the money owed on the mortgage) and pay their debts.
In a climate of low default rates and easy money the subprime market grew dramatically. Finance service companies (often subsidiaries of major banks) would originate such mortgages and then package and sell them off in groups presumably based on their riskiness. Moody's and Standard and Poor's were paid by issuers to rate the securities, which were then sold to not only hedge funds, but to pension funds. These AA and AAA ratings on 90 percent of CDOs made them easy to sell at good prices and were a major source of income for the rating agencies who did not verify or investigate the information they were given. These ratings proved wildly inaccurate.
From 2000 to 2005 housing starts went up by a third and sales of new and existing homes increased by close to 40 percent. While employment in U.S. manufacturing fell in these years by 17 percent, membership in the National Association of Realtors grew by 58 percent. Housing prices grew faster than the consumer cost of living index overall and $5 trillion was added to the home-owning population's wealth, who increased their consumption by an estimated $150 billion. This resulted in producing a million and a half jobs.
By 2004, a survey of the National Association of Realtors found 23 percent of homes were being bought as investments even as real estate lending standards declined. Interest-only mortgages were popular and by 2005 adjustable rate mortgages that allowed borrowers to make very low initial payments for the first years were the norm in more than half of new home loans.
By 2006 the most popular mortgage option included paying less than the amount due each month, the difference being added to the principle and subject to dramatically higher monthly payments in the future. The agents arranging mortgages were not above falsifying income and other data on loan applications to get commissions. The people at the top of the financial institutions encouraged the go-go sales since their own bonuses depended on growth. If problems developed later, well, they had their money and were rarely asked to give back bonuses paid for what turned out to be bad choices. Some loans allowed borrowing as much as 110 percent of the house value in piggyback loans, which were, in effect, second loans given at the time of the first mortgage on the assumption of a continued rising real estate market. Such negative amortization loans might be a bargain if home prices were rising and the person were to sell. As it turned out, by 2007 default rates were increasing dramatically as the adjustable mortgages got reset at considerably higher interest costs. Moreover, many people who bought houses with no money down and found they could not carry the mortgage were forced to sell at a lower price and had to come up with the difference beyond the sale price to pay off the mortgage.
As defaults grew and the presidential primary season heated up, candidates fell over themselves to criticize the abuses of subprime lenders who had lowered standards and offered teaser rates leading to inevitable bankruptcy. They proposed new laws to protect those described as innocent homeowners (and voters). Of course, the same outrage was expressed in 2000 after the economy turned down. Then the Clinton administration detailed a tough legislative regulatory agenda to curb predatory lending. Today the Bush administration has done the same, saying it will protect homeowners who have been victimized by predatory lending.
There is the same discussion of hidden charges, excessive fees, refinancing of loans that are of no benefit to the borrower, high pressure tactics, deception, and outright fraud. Then, as now, it was discovered that subprime loans accounted for most refinancing in predominantly African American neighborhoods. Then, as now, the largest banks were found to be running some of the shoddiest subprime operations. As a May 2007 Business Week headline read: "Some major companies do a substantial business in the market for the working poor." People were often sold high cost loans and not encouraged to understand the small print. Not much has changed for the better in any of this. Then, as now, the Federal Reserve bailed out the banks and other financial interests by lowering rates and making money available, even as Fed officials talked about "punishment being meted out to those who have done misdeeds." As soon as public attention died down the banking industry stepped up pressure to prevent laws aimed at curbing unscrupulous lending as it did in the last housing bubble and will no doubt do in this one.
In the second quarter of 2007 (the latest data available as this goes to press) more than one in seven homeowners with subprime loans are not meeting their mortgage payments. More than 600,000 homeowners face repossession and the foreclosure rate will increase substantially as subprime loans are reset to considerably higher rates. The fallout may be particularly great as one feature of the current financial crisis is a president that has expressed faith in the ability of mortgage servicers to help distressed borrowers stay in their homes. His Council of Economic Advisers chair remarks, "I believe, and I think the president believes, that markets are very good at finding ways to solve problems." Faith is a wonderful thing to be sure, but this is nonsense as applied to for-profit companies that dump "losers" as a matter of course. More importantly, most subprime loans have been sold off through secondary markets in complex packages and are no longer with banks as they once were. The servicing companies are themselves declaring bankruptcy and the assets are falling into the hands of people who are called vulture investors for a reason.
The New Financial Terrain
The capacity to borrow huge amounts at low cost in a rising market allowed hedge funds and those who ran them for huge fees to do quite well, thanks to the magic of leverage. A hedge fund with $10 (excuse the ridiculous numbers, but you get the idea) can borrow $40 more, invest in an asset, and use its $50 value to borrow $200 to buy an option that might net $1,000. You could make a good deal of money with your $10 (or ten million). The problem comes when your initial investment, the money you or your investors actually put in, is no longer accepted as collateral for assets that you have purchased. When these decline in value, you are asked to put up more cash and you soon have trouble rolling over your debt. You must sell off some of your collateral to find more cash from new investors. In a down market the latter is unlikely. To raise money, investors sell positions, throwing assets of declining value on the market, further depressing prices in what can become a downward cycle as other investors flee to safety and lenders refuse to roll over loans to speculators. This is what happened when housing prices stopped going up and soon securitized student and corporate loans were in similar doubt. The change can be dramatically sudden.
Writing in mid-July 2007 in the Financial Times' Special Report on Hedge Funds, Tony Tassell declared, "So far, so good: 2007 has brought the hedge fund industry continued times of plenty. Financial market conditions have been benign, performance strong and investment at record levels." The top 100 hedge funds, accounting for two-thirds of all hedge fund assets, had at their disposal a trillion dollars. Goldman Sachs alone held $32.5 billion and JPMorgan and Bridgewater Associates had only slightly less. The first quarter of 2007 saw an influx of $60 billion, a 300 percent gain for the hedge fund industry over the last quarter of 2006. With so much money pouring into the industry, there were warnings in some quarters that returns must fall and new money would not find safe harbor.
In the week the optimistic evaluation just quoted appeared, two Bear Stearns mortgage security hedge funds lost approximately 100 percent of their value. This happened in spite of the fact that they had presumably been holding high grade securities, had recently told investors they had plenty of cash on hand to take advantage of "market dislocations," and had little exposure to the troubled real estate market. Bear Stearns was sued by investors who argued that they had been lied to. Investors also found that the incorporation of the funds in the Cayman Islands had more significance than merely tax avoidance. Escaping regulation might mean that their complaint would be heard in the Caymans, where judges were inclined to favor the financial firms that parked their billions there over the interests of hedge fund customers.
Within a year Bear Stearns had collapsed and the Federal Reserve, which had previously declined to regulate investment banks, hedge funds, or private equity groups, needed to bail out the whole shadow banking system out or the effects could be catastrophic. The Fed's belief that one such failure could spread across the entire financial system meant that it was ready to pump money in huge amounts to prop up the system whose problem was not illiquidity, but insolvency. Investors had bought overpriced assets and, if the market was allowed to work and prices fall to realistic levels, much of the financial industry would collapse. Because they had allowed this to happen by not regulating the industry, taxpayers would be forced to save the high rollers.
The consequences for any one sector of finance is rarely independent and protected from the consequences of trouble in other financial markets. It is a question of the degree of impact. Among the other areas (in addition to hedge funds) of rapid growth in financialization are leveraged buyout or private equity firms, which take over publicly listed companies at a premium, using small amounts of their own money and a huge amount by borrowing the assets of the target as collateral. The top quarter of buyout firms are estimated by Thompson Financial and the National Venture Capital Association to have generated net annual returns in excess of 40 percent over 20 years—through 2005. The growth of this sector has many negative impacts, including downsizing the workforce and piling on more debt to pay the new owners dividends, measures which are likely to weaken the firm in the longer run. Fees from buyout firms are an important source of earnings for investment banks. By 2005-2007, many of these loans were backed by covenant lite protection—that is, few restrictions on borrowers of the kind that traditionally protect lenders and help ensure they get their money back. Some allowed repayment in the form of new bonds, resulting in more debt.
In the summer of 2007, when trouble developed in financial markets, a number of stock buybacks (with the expectation of borrowed money that was no longer available) and corporate buyouts were called off or put on hold. Tax treatment of debt made many innovations popular. A fast food chain, for example, is able to sell itself for cash, which it pays to its stockholders. The new owners receive payment over time. The chain that has securitized itself (with the help of Citigroup, Lehman Brothers, and Bank of America) continues to operate the business. As their company grows, it can securitize more of its increased value. Just about anything—for example cell phone towers—can be securitized. What leveraged buyout firms do can be done by a host of businesses. As long as the promises can be met out of future earnings, this gambit is feasible.
In 2006 nearly a half trillion dollars in collateralized debt obligations were sold. CDOs divides different degrees of risk into different "buckets," each of which can be sold off at a different price to buyers willing to take on more or less risk at correspondingly low and high prices, instead of companies just selling corporate bonds as they did not long before. This made it easier to raise money and diversified the holders of risk globally. Until the summer of 2007, CDOs had been growing at the rate of 50 percent or more a year. The proliferation of such gambits makes it hard to understand the books of many corporations, as they are used to make things look a lot better than a fully disclosed view would show.
An important aspect of the process of financial self-levitation was that liquidity was created through speculators pyramiding debt. At each stage in the chain, those with claims on money presume their money is secure, until it's not. Rather than monetary authorities controlling an expanding and contracting money supply in counter-cyclical fashion, speculation creates liquidity in a pro-cylical fashion. In expansion, borrowing is easy and at low cost. In contraction, credit crunches deprive the system of loan capital inhibiting recovery. In the current cycle, as financialization's securitizations spread from mortgages and student loans and risk is passed on to whoever buys these securities and to those who buy them in secondary markets globally, it is not at all clear who is exposed to how much risk. Because no one knows who holds how much of the questionably valued securities, fear and uncertainty prompt widespread panic, which becomes harder for regulators to contain, given the global scope of contemporary financial markets and the growth of unregulated offshore non-bank financial firms.
There are other consequences as well. Unsophisticated home buyers, credit card users, and other borrowers are increasingly misled and harmed by fraudulent practices and find it difficult, if not impossible, to escape in a climate of deregulation and free markets. Their fears and declining financial positions reduce consumer confidence and they spend less, making matters worse.
When companies take on more and more borrowing to meet investors' demands, they put themselves, their investors, and the rest of us (who may directly hold no securities) in danger when a downturn comes. I say when, and not if, for a downturn always comes. Those who add to the fragility of the system, cut corners, and press workers and suppliers to make concessions to meet their targets earn a very nice living by tearing apart the social fabric.
The people who figure out these new products, package, and sell them make a lot of money. Gary Cohn and Jon Winkelreid were hardly household names, but as co-presidents of Goldman Sachs, they each took home $53 million in cash and stock in 2006 (just shy of the $54 million paid to Lloyd Blankfein Goldman's chief executive). Federal government policies, including regulatory forbearance, play a part in allowing these pay days. We should not forget the performance of Secretary of the Treasury Hank Paulson—who left Goldman Sachs in June 2006 to work for the Bush administration where he warns against over regulation of Wall Street. Paulson received $110 million to cover his stock options and restricted shares. Goldman paid an additional $51 million to buy back Paulson's stake in several private equity and hedge funds operated by the firm. These payments were on top of the $500 million or so in Goldman shares Paulson sold that year—to comply with government ethics rules. In 2006 the company's profits jumped 70 percent, approaching $10 billion and its shares rose 60 percent. Others at the firm also did quite well. Its chief financial officer went home with $40 million in 2006, the firm's vice chair a mere $32 million.
As to Paulson's call for more deregulation, this was part of a larger campaign by corporate America to squelch any Justice Department effort to enforce laws, some put in place after the massive fraud of the Enron years, some longstanding basic law, and some new efforts—for instance, to insist that corporations waive their attorney-client privilege in cases where the government saw the lawyers as facilitating criminal wrongdoing. How far the pendulum swings to more or less government regulation of financial sector practices, which are asserted to be illegal or unethical, depends on the level of criminality and greed with which the sector appropriates wealth from workers and consumers. The point is that this is cyclical. The state represents the interests of capital, interfering when depredations get out of hand or when the system is threatened by excesses. Politicians make fine speeches to cool off the public and create a sense that something is being done, but such reforms often are not enacted, are toothless when they are, or go unenforced, unless an aroused class conscious population is aware, angry, and active. The area where this is most likely to happen currently is in the housing sector.
How Serious?
The history of capitalism is a history of cycles. By the fall of 2007 it had become clear, as the chair of Barclay's remarked, that financial markets had suffered "a heart attack.... If we stay stuck," he went on, "the patient is going to die." By the end of that year, perhaps the establishment's most respected pundit on financial matters, Martin Wolf, was writing, "First and most important, what is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-oriented financial capitalism." He saw a mixture of crony capitalism and gross incompetence at work. He saw the credit meltdown as a turning point for the world. Currently there are predictions of a decline of 5 percent of the U.S. GDP as corporate debt will need to shrink by 11-12 percent, and a global credit loss of $1.4 trillion, causing world GDP to contract by 2.5 percent (or half the current growth rate as of March 2008), suggesting the crisis will be with us for some time.
The Fed has an unpleasant choice. If it keeps bailing out financial firms, it does so by making taxpayers bear the burden and by creating more dollars, which feeds inflation, lowers the value of the dollar (which is already falling fast), and may cause a curremcy run and raise import prices as the economy slows, resulting in stagflation. If it fails to do so, the damage to the global financial system is unknowable, but may be disastrous. The March/April issue of Foreign Policy magazine had a cover story, "The Coming Financial Pandemic: Why America's Economic Crisis Will Infect the World."
Meanwhile, the United States has a president who thinks making massive tax cuts for the rich, and small change tax refunds for everyone else, will somehow solve the problem. Where once Americans understood the cry "No taxation without representation," another American revolution might start with "No bailouts without social ownership."
FDR was elected on a platform of balancing the budget, but was pushed to more radical measures by active social movements. If Americans would act based on being sick and tired of being swindled and abused, and saw clearly what the problem was and understood the class war being waged, we might have it together to demand serious changes. After decades of defeats for the left, it will be interesting to see what popular learning goes on as this situation develops.
