Financial Russian Roulette
Paul Krugman (Courtesy The Newyork Times)
Will the U.S. financial system collapse today, or maybe over the next few days? I don’t think so — but I’m nowhere near certain. You see, Lehman Brothers, a major investment bank, is apparently about to go under. And nobody knows what will happen next.
To understand the problem, you need to know that the old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the “shadow banking system.” Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by “nondepository” institutions, institutions like the late lamented Bear Stearns — and Lehman.
The new system was supposed to do a better job of spreading and reducing risk. But in the aftermath of the housing bust and the resulting mortgage crisis, it seems apparent that risk wasn’t so much reduced as hidden: all too many investors had no idea how exposed they were.
And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs. These don’t look like the old-fashioned version: with few exceptions, we’re not talking about mobs of distraught depositors pounding on closed bank doors. Instead, we’re talking about frantic phone calls and mouse clicks, as financial players pull credit lines and try to unwind counterparty risk. But the economic effects — a freezing up of credit, a downward spiral in asset values — are the same as those of the great bank runs of the 1930s.
And here’s the thing: The defenses set up to prevent a return of those bank runs, mainly deposit insurance and access to credit lines with the Federal Reserve, only protect the guys in the marble buildings, who aren’t at the heart of the current crisis. That creates the real possibility that 2008 could be 1931 revisited.
Now, policy makers are aware of the risks — before he was given responsibility for saving the world, Ben Bernanke was one of our leading experts on the economics of the Great Depression. So over the past year the Fed and the Treasury have orchestrated a series of ad hoc rescue plans. Special credit lines with unpronounceable acronyms were made available to nondepository institutions. The Fed and the Treasury brokered a deal that protected Bear’s counterparties — those on the other side of its deals — though not its stockholders. And just last week the Treasury seized control of Fannie Mae and Freddie Mac, the giant government-sponsored mortgage lenders.
But the consequences of those rescues are making officials nervous. For one thing, they’re taking big risks with taxpayer money. For example, today much of the Fed’s portfolio is tied up in loans backed by dubious collateral. Also, officials are worried that their rescue efforts will encourage even more risky behavior in the future. After all, it’s starting to look as if the rule is heads you win, tails the taxpayers lose.
Which brings us to Lehman, which has suffered large real-estate-related losses, and faces a crisis of confidence. Like many financial institutions, Lehman has a huge balance sheet — it owes vast sums, and is owed vast sums in return. Trying to liquidate that balance sheet quickly could lead to panic across the financial system. That’s why government officials and private bankers have spent the weekend huddled at the New York Fed, trying to put together a deal that would save Lehman, or at least let it fail more slowly.
But Henry Paulson, the Treasury secretary, was adamant that he wouldn’t sweeten the deal by putting more public funds on the line. Many people thought he was bluffing. I was all ready to start today’s column, “When life hands you Lehman, make Lehman aid.” But there was no aid, and apparently no deal. Mr. Paulson seems to be betting that the financial system — bolstered, it must be said, by those special credit lines — can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish.
The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system — if institutions need to be rescued like banks, they should be regulated like banks — why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for “orderly liquidation” of failing investment banks. Well, that was six months ago. Where’s the mechanism?
And so here we are, with Mr. Paulson apparently feeling that playing Russian roulette with the U.S. financial system was his best option. Yikes.
The fruit of hypocrisy
Joseph Stiglitz Source: The Guardian dated September 16th 2008
Dishonesty in the finance sector dragged us here, and Washington looks ill-equipped to guide us out
Houses of cards, chickens coming home to roost - pick your cliche. The new low in the financial crisis, which has prompted comparisons with the 1929 Wall Street crash, is the fruit of a pattern of dishonesty on the part of financial institutions, and incompetence on the part of policymakers.
We had become accustomed to the hypocrisy. The banks reject any suggestion they should face regulation, rebuff any move towards anti-trust measures - yet when trouble strikes, all of a sudden they demand state intervention: they must be bailed out; they are too big, too important to be allowed to fail.
Eventually, however, we were always going to learn how big the safety net was. And a sign of the limits of the US Federal Reserve and treasury's willingness to rescue comes with the collapse of the investment bank Lehman Brothers, one of the most famous Wall Street names.
The big question always centres on systemic risk: to what extent does the collapse of an institution imperil the financial system as a whole? Wall Street has always been quick to overstate systemic risk - take, for example, the 1994 Mexican financial crisis - but loth to allow examination of their own dealings. Last week the US treasury secretary, Henry Paulson, judged there was sufficient systemic risk to warrant a government rescue of mortgage giants Fannie Mae and Freddie Mac; but there was not sufficient systemic risk seen in Lehman.
The present financial crisis springs from a catastrophic collapse in confidence. The banks were laying huge bets with each other over loans and assets. Complex transactions were designed to move risk and disguise the sliding value of assets. In this game there are winners and losers. And it's not a zero-sum game, it's a negative-sum game: as people wake up to the smoke and mirrors in the financial system, as people grow averse to risk, losses occur; the market as a whole plummets and everyone loses.
Financial markets hinge on trust, and that trust has eroded. Lehman's collapse marks at the very least a powerful symbol of a new low in confidence, and the reverberations will continue.
The crisis in trust extends beyond banks. In the global context, there is dwindling confidence in US policymakers. At July's G8 meeting in Hokkaido the US delivered assurances that things were turning around at last. The weeks since have done nothing but confirm any global mistrust of government experts.
How seriously, then, should we take comparisons with the crash of 1929? Most economists believe we have the monetary and fiscal instruments and understanding to avoid collapse on that scale. And yet the IMF and the US treasury, together with central banks and finance ministers from many other countries, are capable of supporting the sort of "rescue" policies that led Indonesia to economic disaster in 1998. Moreover, it is difficult to have faith in the policy wherewithal of a government that oversaw the utter mismanagement of the war in Iraq and the response to Hurricane Katrina. If any administration can turn this crisis into another depression, it is the Bush administration.
America's financial system failed in its two crucial responsibilities: managing risk and allocating capital. The industry as a whole has not been doing what it should be doing - for instance creating products that help Americans manage critical risks, such as staying in their homes when interest rates rise or house prices fall - and it must now face change in its regulatory structures. Regrettably, many of the worst elements of the US financial system - toxic mortgages and the practices that led to them - were exported to the rest of the world.
It was all done in the name of innovation, and any regulatory initiative was fought away with claims that it would suppress that innovation. They were innovating, all right, but not in ways that made the economy stronger. Some of America's best and brightest were devoting their talents to getting around standards and regulations designed to ensure the efficiency of the economy and the safety of the banking system. Unfortunately, they were far too successful, and we are all - homeowners, workers, investors, taxpayers - paying the price.
· Joseph E Stiglitz is university professor at Columbia University and recipient of the 2001 Nobel prize in economics josephstiglitz.com
The Current Situation of the United States Economy
by William K. Tabb Source: MRZine Magazine
A Briefing to the Vietnamese Central Committee Delegation, September 11, 2008
The economic situation of the United States today is widely understood to be the most serious since the Great Depression of the 1930s, and not only for this country. So far the actions by the government have been inadequate, late, and do not address fundamental causes which will eventually have to be addressed. I expect policy solutions will continue to lag and be too little, too late and biased in favor of helping the powerful interests and not the masses of Americans who are suffering. It has originated in the financial sector, specifically the mortgage market, but is spreading: unemployment is rising, investment is falling, and government is taking on more bad debt at taxpayer expense to bail out the financial sector in an effort to restore some level of trust and renew lending needed by the economy.
The situation changes from day to day, and week to week there is a new focus, a new problem. This week it is the nationalization of Freddie Mac and Fannie Mae, the giant insurers of mortgages who together hold half of all mortgages and 70 percent of recent mortgages in the country. The government takeover is not called nationalization -- America believes in, even if it does not practice, free enterprise, so the nationalization is called a "conservatorship." I don't know how that word translates into Vietnamese. Indeed, I did not know it existed in English before the Secretary of the Treasury, Henry "Hank" Paulson, announced it. When he was head of Goldman Sachs, America's most prestigious Wall Street investment bank, Mr. Paulson had a reputation for being a strong believer in the market. In his new job he is called an aggressive, pragmatic problem solver. That is, he is committing $200 billion to bailing out these institutions in what may be the costliest ever bailout of private companies, allowing the two men together most responsible for the disaster to walk away with $24 million in Golden Parachutes.
This nationalization is the end of a long process going back to the Great Depression when banks failed and the government set up an agency to buy mortgages from banks in a move to stabilize the economy. Since then a second quasi-governmental organization was added. Their privatization put us in an odd situation: when these giant institutions earnings were high, their top executives and large stock holders made money, but when they got in trouble, the implicit guarantee was that the taxpayers would take the losses. I say this is odd, at least if one believes in capitalism, because, socializing losses, it is another example of socialism for the rich which characterizes much of our government activity. It also illustrates how private enterprise buys government: in this case, the two giants spent over $170 million dollars lobbying elected officials to obtain more and greater privileges, accommodating rules, and subsidies, and to prevent the sort of regulation which might have prevented such losses or at least kept them within some sort of bounds.
Two months ago, Mr. Paulson promised government aid to keep these companies private but he wasn't specific as to what kind of help that would be. The markets did not take his word. Mortgage rates stayed high. It remained difficult for businesses to borrow. The economy went downhill. A few months before that empty offer their regulator, a man named James B. Lockhart, announced that the government was allowing them to buy and guarantee bigger mortgages and that that would save the real estate market. He also allowed them to hold less capital against defaults so that they could lend more. That this could put them in danger and even lead to a bailout -- he dismissed that as "nonsense." In all crises the state comes to rescue capitalism from the capitalists. Ideology is put aside, and ordinary people pay to address the imbalances created by the normal workings of the system. Crises look different in terms of sectors affected first and routes of transmission of suffering, but they are all endogenous to capitalism and have been for as long as the system has existed.
With the nationalization of the mortgage giants and the making of unlimited capital available to financial institutions in trouble more generally, the idea that these companies can be counted on to solve housing problems while making responsible profit also goes by the board. After the election, Freddie and Fannie will be allowed to make still more mortgages in 2009 with the idea that by 2010 they can begin to scale down and perhaps be liquidated and the free market can once again take over. We shall see. It is unlikely to be so smooth. To explain why, let me say something about how the crisis came about and why it is likely to go on for some time.
At the end of the last growth bubble, the illusion that a new economy had been created by the Internet and information technology such that any company -- whether it had a sensible business plan or not -- could "go public," sell stock, and both the company and stockholders would get rich collapsed with the stock market in 2000-2001. To get the economy going again, the Federal Reserve lowered interest rates and kept them low, which fed the housing boom. Based on the illusion that home prices could only go up, people took out loans at low interest and bought homes. At first it worked, as in all bubbles. Prices rose and more people bought houses; some sold their homes and bought bigger, more expensive ones at low interest rates. The banks and mortgage brokers made huge profits and pushed more mortgages on people with questionable credit and prospects, the so-called sub-prime mortgages. Eventually the bubble burst and the market fell: people lost their homes, and banks which had resold the mortgages in collateralized debt obligations but also kept some of these securitized debts on their books took huge losses. Investors around the world lost tens of billions and eventually hundreds of billions.
It is widely thought the housing market has not hit bottom. In the next two years, close to a hundred billion dollars worth of additional high risk mortgages sold with initial low flexible rates will have their rates "reset" and their interest charge increased by around 60 percent each month, making it harder for people to meet their obligations. The number of people falling behind on their mortgage payments could more than double in some categories such as "option adjustable rate mortgages." These allow for what the bankers call "negative amortization," i.e., paying less than is due and adding what is owed onto the total due. This can only be done up to a point, and then such mortgage borrowers can't borrow this way any more. At the five-year mark, the mortgages are "recast" and the monthly payment increased to insure full payment by the maturity of the loan. Many won't be able to pay the higher rates. Nor will they be able to sell their homes for what they paid for them. In some areas, Fitch Ratings tells us a quarter of such mortgages are already in default and unable to escape foreclosure. In July 2007, Ben Bernanke, the Fed chair, said he thought subprime losses would be less than $100 billion. They are already beyond $500 billion and rising.
One major Wall Street firm Bear Stearns is no more, and Lehman Brothers is in trouble, hemorrhaging billions in losses, and may not survive. The financial crisis then remains very serious and may grow more serious. But it is only part of a picture that includes: the dollar losing value (despite recent strength); dependence on imports; huge foreign debt; balance of payment problems; and a federal government budget deficit which is conservatively estimated at over $400 billion for the next years. The Bush administration, having given huge tax cuts to the corporate rich, wasted the country's wealth in the quagmire of Iraq; the Federal Reserve has mostly used up its ammunition; the recent tax cut was largely wasted because people primarily saved it or used it to pay off debt -- the Bush White House unwilling to spend the money where it would do most good, e.g., transferring it to hard-strapped state and local governments or on infrastructure projects; and now there is the possibility of a McCain administration which would make Bush's tax cuts to the rich permanent and increase the deficit by an estimated $600 billion over the next decade. But that all gets lost in the kind of presidential campaign we are seeing.
Because leverage, the proportion of borrowed money to capital, used by so many on speculative investments is so great that hedge funds and others must sell off assets to finance the debt they carry. As they -- and not just hedge funds, but banks and non-financial corporations like the auto producers and others -- push assets onto a declining market, prices fall further, forcing more liquidations. As they do this, the value of remaining assets falls, and they must raise more capital. Early on, sovereign wealth funds from surplus countries bought assets. They have lost out in doing so and have grown reluctant. Bargains do not look like such bargains in the current climate. People raise the specter of a Japan-style lost decade, their financial crisis repeating itself -- only this time it involves the world.
The United States did not have bad growth in the second quarter of this year thanks to a rise in exports (which accounted for 90 percent of the growth in the first half of 2008) and spending fueled by tax cuts (which as pointed out were not well targeted but still had important impact in raising consumer spending). But currently Europe is growing slowly and buying less from the U.S., as is Japan. Car sales in the U.S. have plunged. Unemployment is rising; incomes and profits are falling; and companies are cutting back hours, firing people, and cutting back on planned projects in cost-cutting mode. It is likely to get a lot worse.
I will conclude with a brief comment on the election and the use by the Republicans of a politics of resentment, the charge that the Democrats are elitists and that being educated or intellectual is anti-American. Obama is pictured as stuck-up, indeed uppity. The Republican base, increasingly a minority in America, fears a multicultural country which is part of the world (not a white Christian warrior nation which rules the world). Too many people don't like what America is doing, and too many Americans have been hurt by the lack of affordable health care and stagnant or falling incomes, so fear and resentment has grown in the U.S. The question is: can voter fears and resentments lead to the election of the people who have grown rich as the country's economic situation and position in the world has deteriorated? The hope for a Republican savior who will save us from terrorists is a displacement of fear of a future which will be worse than the past. The economic troubles should mean the Democrats will handily win, and they may win. But it is no sure thing as it ought to be. Insecurity and fear, instead of being targeted at the Republicans, has been effectively misdirected. I suspect that a Democratic administration would not solve the problems I have been discussing, but it would be better for the working class of America and safer for the people of the rest of the world.
William K. Tabb is Professor Emeritus, Queens College, City University of New York. He is the author of The Amoral Elephant: Globalization and the Struggle for Social Justice in the Twenty-First Century (Monthly Review Press, 2001) among other publications