Friday, December 19, 2008

The Economic Meltdown

Here's yet another research paper I recently wrote. This one is on the current economic crisis. Pretty depressing stuff--you may want to skip it or save it for after the holidays...

The Next Great Depression

The National Debt Clock in Times Square had to be taken down in September. The clock, which has been informing the public about the United States' soaring debt for nearly two decades, needed to be reconfigured to add space for new numbers. According to the Treasury, the national debt has grown more than $500 billion each fiscal year since 2003. And then, beginning on September 30, 2008, it grew another $500 billion in a single month. Never before in U.S. history has the national debt increased so rapidly. The $700 billion government bailout recently passed by congress could send the total debt to more than $11 trillion and the current global cost of the financial crisis is $2.8 Trillion and counting. As the nation speeds toward what could be the next great depression we are left to wonder, “what happened?” To find the answer, it helps to understand Wall Street jargon—mortgage backed securities, collateralized debt obligations, credit default swaps. It also requires us to revisit former economic sage Alan Greenspan, deregulation, and the role of U.S. homebuyers. The answer to the question, however, can be summed up in a single word: Greed.

The current financial tragedy began with one sentence uttered by former Federal Reserve Chairman Greenspan right after the internet bubble burst in 2000. He said, “The [Federal Open Market Committee] stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance.” What this basically meant was that the U.S. Treasury was going to lower interest rates to an absurdly low one percent. This was a problem because there is a lot of money out in the world that needs to be invested. This global pool of money—which is, essentially, all the money the world is saving at any given time—is all of the pension funds that pay for people's retirements, the money insurance companies hold back in case of catastrophes, and the savings of all of the world's central banks. It is, in short, the subset of global savings called fixed-income securities. It is also huge; around $70 trillion, which is more than all of the money spent and earned by every country on the planet in a year. This global pool of money had also recently ballooned (doubling in size between 2000 and 2006) largely because some formerly poor countries like India and China had gotten rich selling seemingly insatiable U.S. consumers everything from electronic goods to dog food. The investment managers who oversee this money are continually looking for low-risk investments that pay some return and, suddenly, thanks to Greenspan's decision, they weren't going to find it in historically safe United States Treasury Bonds.

The low interest rates at the Fed were, however, helping a different class of investor—U.S. homebuyers. The nation's real estate market was booming and banks were earning anywhere from five to nine percent or more on mortgages. It was only a matter of time before the global pool of money figured out a way to get in on the action. Brokers sold mortgages to small banks who, in turn, sold them up the food chain to Wall Street where they were bundled as “mortgage backed securities” and peddled to investors. Wall Street couldn't get enough of these things. And that was the problem. Suddenly, banks, in order to feed the growing beast on Wall Street, started making riskier and riskier loans. No Income, No Asset loans (NINAs), which require no verification of a person's salary or net worth (and are usually reserved for only the most credit worthy borrowers), began being offered to anyone, regardless of their employment status or credit history. Ivy Zelman, a former housing-market analyst for Credit Suisse says “there is a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1.” “All these people were saying it was nearly as high in some other countries,” Zelman continues, “but the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.” Investors were happy, homebuilders were happy, and homebuyers-turned-speculators were happy. But, as the housing bubble grew, at least a few Wall Street insiders realized (as far back as 2004) that Greenspan's fateful decision was going to “lead to some terrible day of reckoning.” That day has come.

Vincent Daniel, a research analyst who looked at companies that made subprime loans, says, “I saw how the sausage was made in the economy, and it was really freaky.” The “sausage” Daniel is talking about includes something called a Collateralized Debt Obligation (CDO). CDOs are Wall Street derivatives made by taking good mortgages, slicing them up with riskier mortgages, and running the resulting concoction through credit rating agencies like Standard and Poor's or Moody's. Big Wall Street investment banks were taking “huge piles of loans that in and of themselves might be rated BBB, [throwing] them into a trust, [carving] the trust into tranches (different classes of related securities offered as part of the same transaction), and [winding] up with 60 percent of the new total being rated AAA.” Marketplace's Paddy Hirsch, explains it this way:

Basically, the CDO manager has a champagne bottle filled with mortgages. Every month when the debtors pay their mortgages, it fills the bottle with payments. The cork pops off and he pours the bubbly over a tray of glasses, each one representing a tranche of increasing risk. The glasses at the top, rated AAA, get paid first and the least amount, and the bubbly flows down to AA, BBB, BB and equity, the tray at the bottom.

“The party,” says Hirsch, “gets bad when people stop paying their mortgages.” Unfortunately, that's exactly what happened and pretty quickly the glasses on the bottom weren't getting filled at all while the securities representing these mortgages dried up completely. BBB loans transformed into AAA-rated bonds? Sausage was turned into caviar and, eventually, champagne became sewage. A reasonable person might ask how all of this was legal. The answer lies in something called deregulation.

The idea behind deregulation is borrowed from eighteenth century economist Adam Smith, who, back in 1776, published a book called Wealth of Nations. In it, he argued that individuals working in their own self-interest naturally benefitted society. Cornell economics professor Robert H. Frank says, “Phil Gramm, the former republican senator from Texas, and other proponents of financial industry deregulation insisted that market forces would provide ample protection against excessive risk.” In 1999, Gramm spearheaded the Gramm-Leach-Bliley Act in congress. The legislation was responsible for repealing much of the Glass-Steagall Act, which had regulated the financial services industry. Mr. Gramm’s invocation of the familiar invisible-hand theory persuaded many other lawmakers to support the act. This lack of oversight led to a culture of greed that deregulators failed to—or simply chose not to—account for. “Phil Gramm was the great spokesman and leader of the view that market forces should drive the economy without regulation,” said James D. Cox, a corporate law scholar at Duke University. “The movement he helped to lead contributed mightily to our problems.” Economic Nobel Laureate and New York Times columnist Paul Krugman describes Gramm as "the high priest of deregulation," and lists him as the number two person responsible for the economic crisis of 2008 behind Alan Greenspan. In testimony before the House Financial Services Committee, University of Michigan law professor Michael Barr stated: “My own judgment is that the worst and most widespread abuses occurred in the institutions with the least federal oversight. Conflicts of interest, lax regulation, and 'boom times' covered up the extent of the abuses—at least for a while, at least for those not directly affected by abusive practices. But no more.” Gramm, however, is unrepentant. In a recent interview he said, “Some people look at subprime lending and see evil. I look at subprime lending and I see the American dream in action.”

Steve Eisman, a financial industry analyst and one of the few people who saw the current crisis brewing early on, is one of those who saw evil. He says, “These guys lied to infinity. What I learned from [dealing with subprime lenders] was that Wall Street didn’t give a shit what it sold." Naomi Klein, author of The Shock Doctrine: The Rise of Disaster Capitalism, put it this way, “There was no morality—it was all based on the get it while you can concept." The culture of corruption on Wall Street runs so deep that, “despite plunging the global financial system into its worst crisis since the 1929 stock market crash,” financial workers at Wall Street's top banks, including bankrupt Lehman Brothers and the flailing Citibank, are set to receive pay deals worth more than $70 billion, with a substantial proportion of this money to be paid in discretionary bonuses (including a 4% increase in bonuses for Citibank executives over last year).

As awful as the subprime mortgage crisis is, it is not even the worst thing Wall Street has wrought to perpetuate the ensuing meltdown. That would be something called, innocuously enough, Credit Default Swaps. Credit default swaps were invented by Wall Street in the late 1990's as financial instruments designed to cover losses to banks and bondholders when a particular bond or security goes into default. They are, or at least were intended to function as, a form of insurance. Unlike traditional insurance, however, they are completely over the counter and unregulated and, because of this, big Wall Street banks, investment houses, and hedge funds began to use them as a form of gambling—essentially betting on the failure of big U.S. corporations and even other financial giants. The recent $150 billion government bailout of insurance giant A.I.G. was largely because of its exposure to credit default swaps, particularly related to the failure of the investment services firm, Lehman Brothers. House Agriculture Committee Chairman, Democrat Collin C. Peterson of Minnesota said in recent congressional testimony:

There is an estimated $55 trillion in credit default swaps somewhere out there, but no one knows for sure if any of these swaps offset each other, exactly who is on the hook for these swaps, who is trading with who and on what terms; and worst of all, no one has any idea who is solvent and who is upside down. The first step we need to take is to shed some light on just how the unwinding of these obligations will take place.

That amount—actually now over $60 trillion—is over twice the size of the U.S. stock market or, to put it in even sharper perspective, more than the Gross Domestic Product of the entire world. Because nobody knows who is holding them, banks are afraid to lend money which is further perpetuating the crisis. Because the banks are locked together in a daisychain of credit default swaps, the failure of one could take down many. Congress, in October, passed a $700 billion dollar “bailout” to help stave off the now nearly inevitable economic collapse.

But Wall Street's savior could also be an enabler, according to Kevin Philips, a former republican strategist and author of the book, Bad Money. Philips lays much of the blame for the current crisis at the feet of the Bush administration and, specifically, Henry Paulson, who he calls 'Mr. Risk,' based on a 2006 Business Week article about the Treasury Secretary. Says Philips:

'Mr. Risk,' calling the shots at Treasury, would focus the Bush administration's 2008 economic 'rescue' policies not on the broad national interest but on bailing-out the 'Frankenstein Fifteen' top U.S. financial institutions. the big five investment firms, the five largest commercial banks, the four mortgage biggies, and AIG, the rogue insurance giant. Along with the buccaneering hedge funds, these were the big firms that borrowed huge sums, merged grandiosely, experimented with all 'the exotic derivatives and other securities' and led the multi-trillion-dollar metastasis through which finance ballooned to take over domination of the U.S. economy by 2004 with 20-21% of the U.S. Gross Domestic product. Although in mid-2007, Paulson pretended that the emerging crisis involved no more than bad real estate lending practices, the cynical observer can assume that 'Mr Risk,' the arch-insider, knew what he was covering up, how deeply the malpractice and deception ran, and on whose behalf.

Naomi Klein, not one to mince words, calls the current $700 billion bailout plan a "stickup.”

Recently, at a congressional hearing on the financial crisis, committee chair Representative Henry Waxman of California, grilled former Fed chairman Greenspan. “You had the authority to prevent irresponsible lending practices that led to the subprime mortgage crisis. You were advised to do so by many others,” said Waxman, “Do you feel that your ideology pushed you to make decisions that you wish you had not made?” Mr. Greenspan conceded: “Yes, I’ve found a flaw. I don’t know how significant or permanent it is. But I’ve been very distressed by that fact.” “Whatever regulatory changes are made,” continued Greenspan, “they will pale in comparison to the change already evident in today’s markets. Those markets for an indefinite future will be far more restrained than would any currently contemplated new regulatory regime.” Small consolation for the millions of Americans who will be asked to do the heavy lifting to extricate the country from this debacle. Small consolation indeed.


Blossom said...

Great job of untangling a nasty snarl of information. I actually got my comb through it!

dont mess said...

This is very different from your usual writing. Well done!

Maezeppa said...

Thank you so much for this. I'm, if not innumerate, certainly noneconomic. It's grim reality indeed but I do appreciate the clarity.