As the United States braces itself for the onset of a recession, much of the blame for the current downturn is being attributed to the recent subprime mortgage crisis. While boom and bust cycles in real estate markets are nothing new, what distinguishes the current crisis is that the massive run-up in home prices was driven by the proliferation of new forms of securitized finance that permitted massive sums of loan capital to be pumped into the property markets. Only a few years prior these exotic financial products were being touted for their ability to hedge risk and achieve a more efficient allocation of credit. Buoyed by an exuberant sense that the wizards of Wall Street had so thoroughly transformed the nature of risk that the rules of the game had been fundamentally altered, investor demand for these securities exploded, and the underwriting and trading of these new forms of engineered debt underwent an extraordinary period of growth.
This system of securitized finance is now being put to a test. As the housing bubble turns to bust, serious concerns have emerged about the financial condition of the U.S. household sector that has been the main driver of economic growth for over a decade. The sheer extent of the built-up debt within the household and financial sectors and the degree to which credit creation has become “decoupled” from the financing of productive accumulation raises a series of troubling yet pertinent questions. How did this crisis come about, and what are its longer-term implications? Are limits being reached in the ability of speculative credit creation to boost asset prices and sustain a debt-ridden and debt-dependent form of accumulation? Or is this a mere bump in the road prior to the resumption of a new wave of credit-fueled growth?
Role of the Banks in the Current Crisis
To understand the nature of the current crisis, it is necessary first to consider how recent financial innovations have transformed the process through which banks supply credit. Money—universally accepted means of payment for the settlement of financial obligations—is created when banks issue loans and is destroyed when borrowers repay their debts. In issuing a new loan, a bank simultaneously creates a yield-bearing asset—a loan held in its own portfolio—and a liability on its own account in the form of a demand deposit that obligates the bank to honor borrowers’ demand for funds.
The borrower, which may be a household applying for a mortgage loan or a hedge fund seeking a line of credit, issues an IOU that commits the borrower to repay the principal with interest. In deciding whether to issue this credit, banks typically perform some assessment of the borrower’s creditworthiness based on criteria such as the value of the borrower’s collateral, net worth, existing debt-to-equity ratio, cash flow available to pay off the debt, past credit history, and the bank’s expectations regarding future market conditions that impact the borrower’s ability to earn sufficient income to make all contracted debt payments. If the entity issuing the IOU is a large corporation or another major financial institution, banks will meet borrowers’ requests for funds more or less on demand in the form of overdraft accounts or open-ended lines of credit.
In the “old” system of bank-based financial intermediation, banks issued credits that created both a liability on their own accounts—a demand deposit drawn on by the borrower—and an illiquid interest-bearing asset held in the bank’s own portfolio. Profits came from the spread between the interest rate charged on loans and the rate banks paid on deposits through which banks “purchased” funds from households—for example, checking accounts, savings accounts, and other checkable deposits. In the “new” world of twenty-first century finance, banks issue loans and then typically sell these assets into the secondary loan market where they are aggregated into large pools and used to create new classes of yield-bearing financial assets. “Securitization” refers to this process of transforming formerly illiquid loans held in the banks’ own portfolios into marketable (negotiable) assets traded on secondary bond markets.
The process begins when a mortgage originator issues a new loan to a household used to finance the acquisition of the home. Rather than holding the loan in its own portfolio, the originator—either a private mortgage company or a major bank or thrift—typically sells the loan to either a government-sponsored entity (GSE) such as Fannie Mae, Freddie Mac, or the government-insured Ginnie Mae (if the loans conform to Federal Housing Administration and Department of Veterans Affairs underwriting standards), or to Wall Street investment banks (Goldman Sachs, Citibank, Merrill Lynch, etc.).
Buyers of these loans aggregate them into large pools and then issue a type of bond known as a mortgage-backed security (MBS) whose yield is supported by the pass-through of payments of interest and principal from the underlying pool of mortgage debt.
Banks realize profits on the fees they charge for services provided in underwriting this type of debt—e.g., the purchase and aggregation of loans, creation and sale of securities on the secondary market, and the management of the pass-through of the underlying mortgage payments to final purchasers, typically wealthy households, and large institutional concerns such as pension funds, insurance companies, and hedge funds. MBSs are highly liquid instruments traded on deep secondary markets, and are one of the largest financial asset classes by outstanding volume currently bought and sold on U.S. capital markets. These instruments are today the major conduits of funding new mortgage loans, the vast majority of which are issued under the expectation that they will be sold into the secondary mortgage market.1
Securitization has spanned the creation of a plethora of exotic and increasingly complex financial instruments “engineered” from the payment streams thrown off by MBSs. The most prevalent of these new classes of engineered financial assets are known as collateralized debt obligations (CDOs), whose rapid growth between 2000 and 2006 lies at the root of the current subprime crisis.
A CDO is created when a government-sponsored entity or Wall Street investment bank buys up a large pool of subprime mortgages. Payment streams are then carved up and distributed to various “tranches” distinguished according to their level of exposure to losses from defaults occurring in the underlying mortgage pool.
The lowest (unrated) tranche (the equity tranche) is the first to absorb losses. Once this tranche is exhausted, any further losses are applied to the next tranche until this principal is exhausted, and so on, up the ascending ladder—or “mezzanine”—of tranches. This will—in theory—provide protection to the senior tranche that receives the AAA grade credit rating. The lower tranches, being more exposed to credit risk and carrying lower credit ratings, pay a higher rate of return to investors. Each tranche thus represents a different sub-class of debt distinguished according to the rate of return and risk. CDOs have been promoted by their sponsors as vehicles that provide investors with a greater range of investment options by allowing fund managers to more readily recalibrate the relative balance of risk and return in their portfolios.2
For its proponents—the major financial interests and their supporting chorus of sycophantic academics—securitization has increased the ability of financial markets efficiently to allocate credit where it is most needed. In fact, the recent subprime debacle demonstrates the degree to which financial innovation has provided fertile ground for rampant speculation.
Securitization has intensified, not dampened, the tendency inherent in a bank-based system of credit intermediation to engender periodic cycles of excessive credit creation that swell financial claims at a rate that far outstrips the rate of growth and accumulation. This leaves the financial system vulnerable to a crisis due to any one of a number of factors that slow economic growth and leave highly indebted entities unable to pay down their financial obligations—e.g., higher interest rates, a downturn in investment, or a drop in consumer spending.
This is not the result of bad policy decisions or well-intended but ultimately misguided public interventions, although the actions of the Fed certainly play a significant role in underwriting the overissue of credit and steering the system toward speculative excess. On the contrary, the tendency excessively to expand financial claims is inherent in a system where credit creation, fueled by financial innovation, has become progressively decoupled from real accumulation—i.e., tangible capital investments. Episodic crises are endemic in such a system of decoupled financial speculation. What has happened before will happen again, potentially on an even greater scale. The only question is when.
Anatomy of the Recent Boom and Bubble
The subprime debacle has its immediate origins in the decisions of the Federal Reserve to lower interest rates following the bursting of the dot-com bubble. As equity prices declined, concerns emerged that the massive write-down of the (nominal) value of the portfolios of financial speculators threatened to pull the entire economy into a downward spiral. To avert such a scenario, between late 2000 and June 2003, the Federal Reserve cut the federal fund rate—the rate banks charge one another for overnight loans—by 550 basis points, or from 6.5 to 1.0 percent. While the reduction in the interbank loan rate failed to halt the stock market decline, it did reduce the cost of consumer and mortgage credit.
Lower interest rates increased the amount that households could pay for homes. As prices rose, this increased lenders’ confidence in the security of these newly issued mortgage loans, as appreciation meant the full value of the loan could be recovered in the (then seemingly unlikely) event of default and eventual foreclosure. This reduced assessments of asset-specific risk throughout all stages of the funding process, as even very high loan-to-home value ratios were expected to decline with the further rise in home prices. As confidence grew, lenders became more willing to issue larger mortgages despite the rise this entailed in household’s debt-to-income ratio and the loan-to-value ratio of many newly acquired homes.
Investors flush with surplus cash and buoyed by access to cheap credit that could be used to finance highly leveraged investment acquisitions began to demand ever-greater quantities of the structured financial products (MBS and CDOs) engineered from income flows emitted by these underlying mortgage pools. In this manner, the rise in home prices transmitted a sense of confidence throughout all stages of the securitization conduit that underpinned investors growing appetite for collateralized debt.
In understanding how the boom unfolded, it would be a mistake to see the major banks as passive suppliers of credit accommodating a given level of market demand. On the contrary, banks are subject to the same type of profit imperatives as other capitalist enterprises. To expand markets and profits, the major lending institutions began aggressively to market a host of mortgage and consumer credit products. Beginning in 2004, the securitization conduits set up by Wall Street underwent rapid expansion and began to take up a growing portion of the secondary market. Investment banks also set up a new type of off-balance sheet operation known as structured investment vehicles (SIVs) that provided an additional apparatus for buying up mortgage loans that were restructured into CDOs and then placed into off-balance sheet accounts.
To create an SIV, the sponsoring bank buys a large pool of mortgage-backed securities used to create collateralized mortgage obligations. An SIV is then set up and a type of debt known as “asset-backed commercial paper” is issued to raise funds to purchase these collateralized obligations from the sponsoring bank. Commercial paper is a short-term debt of one to ninety days duration. To insure commercial paper will be accepted the SIV is required to secure a back-up line of credit from the sponsoring bank as insurance in the event that the SIV does not have sufficient cash on hand to settle these obligations at the time they come due. So long as purchasers of this paper (the money market funds) are confident that borrowers are solvent, debts are typically rolled over at maturity at the prevailing interest rate. For this reason, the commercial paper issued by the SIVs did not initially create any additional liabilities for the sponsoring bank.3
The issue of asset-backed commercial paper exploded in 2004 after undergoing a four-year decline. The boom in the use of asset-backed commercial paper since 1995 is evidence of both the rise of this type of securitized financing and the burgeoning mass of debt currently held in off-balance sheet operations and in other highly specialized, often opaque, funding conduits, many of which are never reported. The catch, of course, was what would happen if the money markets began to refuse to roll over the SIVs’ maturing paper, as this would require SIVs to tap back-up lines of credit to settle their outstanding obligations. At the height of the credit frenzy, no one paid much heed to the lurking danger, as everyone on Wall Street was in on the game and underwriters were making record profits.
In this manner, the banks established a new investment vehicle that underpinned an explosive demand for mortgage debt. Wall Street bought up massive quantities of MBSs to create complex CDOs that were sold to pension funds or placed into their own off-balance sheet operations. These instruments returned funds back to mortgage originators who used this inflow to underwrite the issue of more mortgage credits. The turnover of money capital through this complex and highly layered “revolving fund” provided the financial fuel that drove the boom and bubble. Housing prices soared nationally, while in many regional markets the rate of increase was greater still. Much of the explosive growth in mortgage credit after 2005 reflected the entry of SIVs as a major new supplier of housing finance, although precise data on the growth of SIVs is difficult to obtain given that many of these vehicles were never reported.
Subprime Debt and the Mortgage Debacle
As Wall Street’s lust for these new forms of engineered finance exploded, lenders began to target loan products to working-class households with low to moderate income and a prior history of credit problems—the so-called subprime mortgage market. Subprime loans have interest rates that are several points higher than standard prime mortgage debt to compensate investors for the greater risk associated with holding this type of debt. To entice low-income households to take out subprime loans, lenders attached a host of sweeteners that lowered interest payments over the first several years of the loan. Interest-only mortgages, which only required borrowers to pay interest charges and were often set at seductively low introductory “teaser” rates, began to proliferate.
Negative amortization loans that capitalized unpaid principal into the base value of the loan became common. More and more loans took the form of adjustable rate mortgages. To lend to households with limited savings, mortgage brokers began to issue no-down-payment loans, lending up to the full value of the home. Borrowers were allowed to state their income on loan applications without lenders requiring any supporting documentation.4 To encourage working-class households to take on higher levels of debt, subprime borrowers were told not to worry about higher payments as their mortgages reset, given that they could always refinance into a more standard fixed rate loan at a later date.
As prices rose, lenders increased their issue of subprime debt that was sucked up by the funding conduits, reengineered, and resold as CDOs. Underwriting and monitoring standards deteriorated at all stages of the funding circuit. Given the enormous short-term profits being made, the Wall Street banks appeared blissfully unconcerned about the fact that the growing volume of CDOs was being built upon an enormous mass of highly questionable and ultimately nonredeemable debt. The major credit agencies, Moody’s, Fitch, and Standard and Poor’s, shared in the vast profits of the boom at the cost of abandoning their supposed role of providing prudent monitoring and oversight of the quality of the underlying pools of mortgage debt. In went subprime mortgage loans, and out came AAA-rated debt.
Working-class households got swept up in the mania for a complex set of reasons. First, every financial bubble generates a “contagion effect.” As the boom unfolded, stories circulated about homeowners taking out large mortgage loans to buy homes whose value increased by leaps and bounds in a period of just a few short years. Eventually this gave rise to the belief that no end to the price appreciation was in sight. Under such circumstances, households became convinced that it was time to take the plunge and load up on debt to get into a market that just seemed to keep on rising.5
Second, a period of rapidly rising prices can invert the normal relationship between housing prices and buyer demand. Metropolitan areas were rife with stories about new homes going on the market and receiving more than thirty offers in the first few hours, many of them well above the listed asking price. As prices rose, some buyers, particularly first-time purchasers or existing homeowners seeking to trade up into a more expensive market segment, grew anxious over the prospect of being permanently priced out of the market. After numerous experiences of having their offers rejected, panic can set in. Once this happened, higher prices triggered a rise in demand.6 Buyers, frustrated over a string of rejected offers, began to raise their offer prices to the ceiling of their preapproved credit limits and increased the number of homes on which they were willing to submit bids.
Given the ease with which mortgage loans could be sold into the secondary market, originators were more than willing to accommodate buyers’ demands for higher levels of debt by increasing loan-to-value ratios and raising borrowers’ preapproved credit limits despite the precipitous rise this induced in households’ debt-to-income ratio.
For all these reasons, as the boom unfolded it generated a speculative psychology that encouraged homeowners to treat housing as a financial asset purchased under the expectation that it would undergo appreciation. As prices rose, it became easier to convince borrowers, and for borrowers to convince themselves, that even homes bought with little or no down payment would quickly return a handsome capital gain. A cultural transformation began to take place wherein it became increasingly common to see newspaper articles or media discussions comparing homes and stocks as alternative investments whose relative desirability derived from the rate at which they would be expected to appreciate over time.7
Once such a psychology takes root, a house is no longer just a home. On the contrary, homeowners are encouraged to treat their houses as financial assets that will provide recurrent opportunities to convert rising equity values into higher levels of current consumption through equity withdrawal and mortgage refinancing. As a result, U.S. households took on more inflation-adjusted debt between 1998 and 2006 than they did in the entire prior thirty years.8
Subprime Debts Come Home to Haunt Wall Street
By late 2005, signs were emerging that this debt-fueled housing boom was headed for trouble. For one, the rise in prices in many regional markets began to flatten out as the Federal Reserve increased interest rates in a preemptive strike against inflation. As interest rates rose and a growing number of “teaser rate” loans started to reset accordingly, borrowers began defaulting on their obligations. Alarm began to spread among the hedge and pension funds and the larger insurance companies that had been buying this structured debt. Initially, the crisis looked like it would remain confined to the subprime market. It quickly became apparent, however, that the proliferation of these new forms of securitized credit had not engineered risk out of the system of interlocking financial obligations. On the contrary, as defaults rose and losses began to spread, suddenly no one was sure where the bad debt was being held, given that securitization had distributed this subprime debt across a vast number of investment portfolios.
As investors moved to reduce their exposure to mortgage-backed financial products, mortgage originators found it harder to access the secondary markets. Wall Street banks that just one year prior were feeding the subprime expansion scrambled to reduce their exposure, and the funding conduit froze.9 On April 2, 2007, New Century Financial, the largest U.S. subprime lender, filed for Chapter 11 bankruptcy status. American Home Mortgage followed suit by filing for Chapter 11 status in early August. This was followed in rapid succession by several high-profile meltdowns in Europe, with the UK-based Northern Rock Bank and BNP Paribus, the French banking group, both taking major hits to their mortgage-backed portfolios. Countywide Financial, the largest mortgage lender in the United States, only narrowly avoided bankruptcy by arranging to take out an $11 billion bank loan. What made Countywide particularly significant is that the firm was not a specialist in subprime debt. Hence, its flirtation with Chapter 11 sent a powerful signal that even the nation’s largest private mortgage lender was having increasing difficulties off-loading its mortgage portfolio.
As defaults rose, panic began to spread. Money market funds began to refuse to roll over the SIVs’ commercial paper. This was the moment when what seemingly began as a localized problem confined to a specialty market niche threatened to erupt into a full-blown crisis. Suddenly, banks that had set up the SIVs would either have to make good on their commitments on back-up lines of credit or sell off assets to raise cash to retire these maturing obligations. Uncertain about the size and scale of their potential exposure, the banks became hesitant to extend short-term loans on the interbank capital market and began to hoard funds. Despite the officially quoted rates on overnight federal fund and LIBOR loans (the London Inter-Bank Offer Rate on short-term funds borrowed in the Euromarket), banks were engaged in rationing short-term credit, refusing to lend even to other ostensibly solvent multinational financial institutions.10 Credit, until recently so abundant, dried up, and the phase of “revulsion” was followed by “crash and panic.”11
The Federal Reserve and the European Central Bank initially sought to stem the spreading crisis by providing additional reserves to the money center banks ($30 billion in the United States, $138 billion in the case of Europe).12 On August 17, the Federal Reserve lowered interest rates by 50 basis points (one-half of a percent) in an effort to ease the interbank credit crunch and signal that it stood ready to lend should the banks face a sudden increase in the demand for funds. The Fed also encouraged banks to make use of the discount window where banks borrow directly from the central bank.13 When this failed to ease the crunch (in part due to the stigma attached to using the discount window), the Federal Reserve further lowered the federal funds rate by 75 basis points in between its regularly scheduled meetings, followed by another rate cut on January 30 of 50 basis points.
It quickly became clear, however, that interest rate reductions were failing to do the trick, as banks remained wary of lending funds on the interbank capital market given rising uncertainty over the scale and extent of their subprime exposure. This prompted the central bank to unfurl a series of unprecedented measures in an attempt to calm the nerves of rattled investors and lenders and prevent the subprime debacle from turning into a potentially catastrophic financial meltdown.
First, on December 12 the Federal Reserve announced it would expand the types of assets it would accept as collateral for short-term loans to member banks. Under the guise of the “Term Auction Facility,” the Fed began to “auction” loans to the banks by accepting MBS and other structured debt obligations as collateral. Initially introduced as a short-term emergency measure, there is little doubt that the new facility will eventually be made a permanent feature of the Fed’s regulatory arsenal.
Second, in March 2008 the Fed undertook another unprecedented step by pledging a $200 billion line of credit to the major Wall Street investment banks that similarly allowed loans to be secured against a wide range of structured financial instruments. Never before had the Federal Reserve granted this type of credit directly to the investment banking sector. In so doing, the Fed has significantly expanded the range and scope of its credit market operations, and appears to be abandoning its long-standing prudent practice concerning the types of assets it is willing to hold in its own portfolio (still predominantly composed of near zero-risk government securities) by accepting CDOs and other complex structured financial instruments as collateral. This marks an unprecedented increase in the Fed’s exposure, as it involves absorbing the credit risk of these complex financial products directly into its own portfolio.
More spectacular still was the aggressive intervention on March 14 by the Federal Reserve to secure JPMorgan Chase’s purchase of Bear Stearns, at that time Wall Street’s fifth largest investment bank. The crisis associated with the near collapse, bailout by the Fed, and absorption by JPMorgan Chase of Bear Stearns was triggered by mounting concern over the quality of the mortgage-backed assets Bear had been using as collateral to secure short-term loans and credits from counterparties in its securities trade.
As Bear’s trading partners began to refuse to accept these assets as collateral concern began to spread to Wall Street that Stearns would be unable to meet its outstanding short-term overnight obligations in the so-called repo market, through which banks and security firms receive and extend short-term overnight loans backed by securities. It was this that spurred the Fed to intervene, since a default on overnight obligations by one of Wall Street’s major investment banks threatened to destroy the liquidity of the $4.5 trillion repo market on which all the major financial institutions depend to finance their lending and trading operations.14 Deemed “too interconnected to fail,” the Fed pledged a $29 billion line of credit to JPMorgan to finance the acquisition of Bear’s asset portfolio. Under the terms of the deal, JPMorgan will end up acquiring Bear’s still profitable proprietary trading operations at well below market value, while the Fed will absorb the default risk of subprime-backed CDOs directly into its own portfolio.15
Despite these drastic steps, the ongoing uncertainty over the extent of banks’ exposure to subprime debt has prompted them to continue to ration credit, including imposing restrictions on short-term loans to other major financial institutions. The failure of lower interest rates and cash infusions quickly to resolve the crisis is not surprising, given that the origins of the current distress are rooted in financial innovations that underpinned the massive overissue of ultimately nonredeemable debt.
Once it becomes apparent that more and more mortgages are destined to enter into default, no amount of short-term liquidity infusion will annul the fact that overextended borrowers are unable to meet their present mortgage obligations. Infusions of funds and interest rate cuts cannot resolve the underlying contradiction of a financial system that is prone to expanding credit at a rate that far exceeds the growth in the real economy. On the contrary, to the extent these interventions are successful in averting a systemic crisis, they function to merely defer the ultimate moment of reconciliation—i.e., a massive debt deflation that will restore some parity between the value of outstanding credit obligations and the value of the underlying tangible assets.
What seems certain is that, barring major federal level intervention, losses on subprime loans will continue to mount. Foreclosure rates on subprime mortgages with adjustable interest rates rose from 1.52 percent in 2004 to 4.72 percent by the third quarter of 2007. Equally alarming is the rise in the number of subprime mortgages with adjustable rates that were in default, from 10.3 percent to 18.8 percent over the same period.16 According to estimates put out by the Joint Economic Committee, ongoing resets could eventually push as many as two million subprime mortgages into foreclosure.17
This will exacerbate negative feedback effects already at work in many regional housing markets. As prices fall, many households find they are trapped in a negative net equity position—e.g., the value of their homes is now worth less than the amount they still owe on their outstanding mortgage obligations. Under such circumstances, deciding to walk away from a subprime loan can be a rational decision, particularly for borrowers with bad credit ratings. The case for default is particularly strong for households that purchased homes with no money down, as the default option allows them to walk away without having lost any of their own equity on the transaction.
As more mortgages enter into foreclosure, lenders will try to recoup some of the principal by selling the repossessed homes. This will flood the market, place additional downward pressure on prices, and compound incentives for households to exercise the default option to rid themselves of an increasingly undesirable—and in many cases unsustainable—repayment obligation. Current estimates of the impending loss of wealth range from $300 billion to over $1.2 trillion.18 What is clear is that the scale of the losses will be huge. Once this process of debt repudiation and collapse in asset prices is under way there may be no readily available measures open to the Federal Reserve to reverse the process of deflation. Particularly in an environment characterized by the rationing of credit and closure of the secondary funding circuit, falling home prices will unleash a negative wealth effect that will depress consumer spending. Under these circumstances it is not clear where the next economic stimulus will come from short of an increase in debt-financed public sector expenditure. If this option is off the table, the United States may be posed to enter a long and nasty recession.
As we would expect in a class-divided society, households most negatively impacted by the crisis are those at the lower rungs of the U.S. class and occupational ladder who also happen to be disproportionately people of color. Research has shown that African Americans were 2.3 times more likely and Hispanics 2 times more likely to receive high-cost loans than white households during the subprime lending boom.19 This is hardly surprising. African Americans and Latinos are more likely to suffer from low wages, persistent poverty, higher rates of unemployment (particularly among African Americans), and the lack of intergenerational transfer of savings that has limited access to homeownership.
Many African-American and Latino households were thus left with few options other than reliance on subprime mortgage peddlers if they wanted to purchase a home. The current crisis will reinforce systemic barriers to social and economic advancement for large segments of the African-American and Latino working class by compounding wealth disparities and exacerbating problems linked to damaged credit ratings. This reveals the fallacy of relying on private capital markets subject to profit motives and destabilizing speculative dynamics to address the affordable housing crisis confronting significant sectors of U.S. working-class households.
Brave New World of Securitized Finance: Solution to Stagnation or Prelude to Crisis?
The proliferation of new forms of structured debt obligations has left the system more, not less, vulnerable to destabilizing bouts of speculative excess that require massive intervention by the public authorities to avert a potentially catastrophic financial meltdown. One of the primary effects, and for private lenders the major benefit, of recent financial innovations is that it allows them to circumvent central bank regulations ostensibly set up to impose some limits on the supply of high-risk credit.
First, securitization has further undermined the ability of the Federal Reserve to use reserve requirements to impose limits on the rate of growth of credit. Reserve ratios require banks to hold a given ratio of reserves against their total deposits (including demand accounts created through the issue of new loans). In principle (if not always in fact), this allowed the central bank to set the deposit-to-reserve ratio and then attempt to raise or lower the total supply of reserves to exercise some control over the total volume of credit the banks could create. As this account makes clear, so long as banks can acquire funds through the issue of short-term debt (e.g., certificates of deposit, commercial paper, borrowings on the offshore Eurodollar market, and short-term loans secured against banks’ holdings of government debt), banks can issue new credits and then use the securitization conduit to shift these loans out of their own asset portfolio. This has further undermined the already limited efficacy of reserve ratio requirements, and removed a policy tool from the regulatory arsenal of the Federal Reserve.
Second, securitization allows private banks to circumvent capital adequacy requirements established to insure that banks have sufficient capital reserves to cover unanticipated losses. Banks are required to maintain their capital-to-asset ratio at or above some level set by the monetary authorities. Most developed nations—the United States included—currently set their required capital adequacy requirements in line with the standards set forth in the Basel II accord that prescribes a 4 percent ratio of capital to the risk-weighted value of a bank’s asset portfolio.
Bank capital primarily consists of retained earnings and the bank’s own equity that can be liquidated as needed to cover the cost of writing off nonperforming loans from their asset portfolios. Capital reserves provide some measure of insurance that the bank has sufficient cash on hand, or assets that can be readily converted into cash, to provide protection for depositors should the bank suddenly be faced with an unanticipated rise in defaults that increases the portion of nonredeemable debts held in its loan portfolio. In setting the capital ratio, the monetary authorities can, in principle, exercise some control over the supply of high-risk credit—the higher the capital-to-asset ratio for any given stock of bank capital, the lower will be the amount of high-risk loans banks can extend through decisions to issue subprime credit.
Securitization and the creation of novel off-balance sheet operations allow banks to subvert this regulatory mechanism.20 Loans sold off into the secondary market are no longer on the books of the issuing institution. By selling these loans or placing them into unregulated accounts, banks can increase the issue of new credit, in theory without limit, provided they can continue to sell these obligations into the secondary market or place structured debt obligations into off-balance sheet operations.
The SIV exemplifies the latter dynamic, as it allows banks to move massive quantities of assets off their own balance sheets into highly opaque and largely unregulated investment instruments. More prudent minds would periodically raise concerns as to where all this was headed. Yet, as confidence spread that financial engineering had fundamentally transformed—and significantly reduced—the level of risk embedded in this highly layered system of interlocking debt obligations, the only limit on the amount of credit the banks could create was the willingness of institutional investors to continue to buy and hold these forms of securitized debt. In an environment characterized by rapidly rising prices and generous capital gains, prudence was tossed to the wind. A sense of euphoria took hold, buttressed by a belief on Wall Street that the Federal Reserve would come to the rescue if things got too far out of hand.
The profit incentives built into each stage of these funding conduits exacerbated the drive toward excess by precipitating an erosion of the monitoring and oversight functions typically performed by lending institutions. Loan originators operate on very narrow per-unit margins. The profits they earn are based on the total volume of loans they originate and sell to the secondary markets. The more mortgages they can underwrite, the greater the profits they stand to earn. Major purchasers of these mortgages and underwriters of MBS—the Wall Street banks—similarly get their profits from fees charged for underwriting services and management of the pass-through of mortgage payments. So long as buyers were willing to keep sopping up these structured debt obligations, there was little incentive for the major Wall Street banks to cut or otherwise ration the supply of credit. The greater the amount of debt that was issued, packaged, and resold, the greater the profits being made at each stage of the process. This resulted in a historically unprecedented financial expansion that has left the U.S. household sector saddled with a massive debt overhang and the U.S. economy vulnerable to a potentially protracted post-bubble recession.
What’s Next? Where Are We Headed?
A financial crisis in a capitalist system is often seen as serving to bring an ultimately unsustainable credit expansion to a halt when it has run too far in advance of the rate of accumulation. By forcing lenders to write off the value of these nonredeemable loans from their balance sheets, crisis places a periodic “check” on the inherent propensity toward the excessive creation of credit. Once nonperforming loans have been charged off and cleared from the bank’s portfolio and losses written off, the stage is set for a renewed cycle of credit-fueled reflation, provided, of course, that the distress does not erupt into a full-scale financial meltdown. The role of the central bank is to balance the need to contain euphoric bouts of speculative excess once the credit expansion threatens to push asset prices to unsustainable levels (typically by raising the interbank loan rate), while standing ready to provide liquidity and fulfill its function as the lender of last resort in the event that a looming repayment crisis threatens to cut off the supply of credit if banks panic and start hoarding funds.
If the Fed can balance these two functions, the result is an oscillating pattern of (semi)-controlled deflations and reflations of the credit structure over the course of the business cycle. While debt deflations are always full of unwelcome and nasty surprises, several factors are currently at work that will in all likelihood prevent the subprime debacle from turning into a full-scale financial meltdown. Most notably, balance sheets of nonfinancial corporations are in a generally strong condition. Because firms have used strong internal cash flows to lower their debt-to-equity ratios as opposed to increasing investments in physical capital, they are presently less directly exposed to shifting conditions in the financial markets. Given the generally strong profit position in the nonfinancial corporate sector the U.S. monetary authorities will probably find a way to muddle through the present crisis. Despite this fact, economic activity will slow, and a recession, followed by a protracted period of subpar growth, looks likely.21
As has been noted many times in these pages, in a capitalist system characterized by industrial maturity and markets dominated by large oligopolistic corporations, there are no endogenous mechanisms that insure that capitalists will collectively invest at a level required to keep the system humming along at anywhere near full capacity. This points to one of the system’s most fundamental, and ultimately irreconcilable, contradictions: mature capitalism has no endogenous means to guarantee an adequate level of private investment, yet by the same token it cannot tolerate any rise in wages that would erode the profits of the owning class. This has left the system dependent upon debt-fueled consumption. The internal contradiction shows up in the form of subpar growth and economic stagnation, or credit-driven booms and bubbles followed by crisis once the expansion of financial claims on earnings collides with the realities of wage stagnation for the majority of the U.S. working class.
While debt-fueled bubbles provide a temporary solution to problems of overaccumulation, they cannot be assumed to do so forever. The ability of households to continue to increase their debt loads at anywhere near the rate observed over the last two decades appears tapped out at present. This implies limits are being reached in the ability of debt-financed household spending to serve as a panacea for stagnation. Restoring a higher rate of accumulation will thus require the emergence of a new dynamic technology or growth sector able to absorb massive sums of capital investment and reignite the engines of long-term growth and accumulation. Absent this, the system looks poised to enter into a period of protracted stagnation.
The wild card in the current conjuncture is the fact that the subprime debacle is unfolding in an international context characterized by a deepening crisis of confidence in the dollar. Recent booms in U.S. consumer spending have driven a steady increase in the U.S. trade deficit, currently at just under 5 percent of GDP.
The United States has been able to sustain recent debt-fueled consumer spending booms despite this burgeoning trade deficit in large part because of foreigners’ willingness to use their surplus dollar reserves to purchase dollar-denominated financial assets, particularly U.S. government debt that still serves as the “gold standard” of international finance. Capital inflows from abroad have similarly provided the means through which the United States has financed its massive and growing fiscal deficits. While the dollar’s position as the world’s preeminent international reserve currency appears secure at present, the Federal Reserve’s ability to reflate the U.S. economy through periodic injections of cheap credit could at some point encounter an external financing constraint should foreigners become less willing to buy and hold U.S. government debt. Concerns are emerging in many foreign quarters over the ongoing loss of the value of their dollar-denominated financial holdings. Any longer-term move away from the dollar through a sell-off of U.S. Treasury debt would put pressure on U.S. interest rates and limit the policy options available to the Fed.
How these events will ultimately play out is impossible to predict. What is certain, however, is that other crises await, and the ability of the central bank indefinitely to defer the underlying problem of overaccumulation is far from guaranteed.
1. For useful accounts of the U.S housing finance system, see Michael E. Stone, “Pernicious Problems of Housing Finance,” in Chester Hartman, Rachael Bratt, and Michael Stone, eds., A Right to Housing (Philadelphia, Temple University Press, 2006), 82–104; and Michael E. Stone, Shelter Poverty (Philadelphia, Temple University Press, 1993).
2. Collateralized debt obligations, or CDOs, are investment trusts backed by mortgage pools in which investors can acquire positions in various “tranches” that differ in terms of their risk profile and rate of return. Underwriters (arrangers) of CDOs aggregate large pools of subprime mortgages against which various subclasses of securities are issued that offer varying levels of protection from losses due to default. In a typical CDO, the first tranche, referred to as the equity tranche, will absorb all losses due to default and foreclosure until its principal is exhausted. Losses will then be applied to the second tranche, typically with a BB grade credit rating, and so on, up the ascending “mezzanine” of tranches until the senior tranche is reached. The higher the credit rating of a given tranche, the lower the rate of return. The senior tranche, which carries an AAA grade credit rating, generally composes about 70–80 percent of the total principal in the trust. High-quality credit ratings given to the senior tranche were based on a credit rating agency’s estimates of the likelihood of losses based on past default rates. Purchasers of these assets—hedge funds, insurance companies, and the SIV’s set up by the banks—assumed they were protected by the lower grade, or “subordinate” tranches, that would provide a sufficient cushion against losses due to default.
3. Gillian Tett and Paul J. Davies, “Out of the Shadows,” Financial Times, December 17, 2007.
4. Saskia Scholtes, “On Wall Street,” Financial Times, March 30, 2007. See also “Cracks in the Façade,” Economist, March 24, 2007, 79–81.
5. See Robert Shiller, Irrational Exuberance, 2nd ed., (New York: Doubleday, 2006).
6. See Karl Beitel “Did Overzealous Activists Destroy Housing Affordability in San Francisco?” Urban Affairs Review 42, no. 5, 741–56.
7. For example, “Home $weet Home,” Time, June 13, 2005; “A Word of Advice During a Housing Slump: Rent,” New York Times, April 11, 2007.
8. See John Bellamy Foster, “The Household Debt Bubble,” Monthly Review 58, no.1, 1–11, on the rise in household debt.
9. “CSI: Credit Crunch,” Economist, October 19, 2007.
10. Gillian Tett, “Sense of Crisis Growing over Interbank Deals,” Financial Times, September 5, 2007.
11. The term “revulsion” (also referred to as distress) comes from the work of Kindelberger, and refers to the stage of the credit cycle after the repayments crisis has erupted and lenders are engaged in a frantic rush to hoard funds and build up liquid reserves in anticipation of further bad news. This leads to a refusal to grant new loans, even to creditworthy borrowers. “Crash and Panic” is the final stage of the credit cycle for Kindelberger and is self-explanatory. Charles P. Kindelberger, Manias, Panics, and Crashes (New York: Basic Books, 1987).
12. The two primary tools through which the Federal Reserve has historically fulfilled its function as provider of liquidity and “lender of last resort” are injections and withdrawals of reserves to and from the banking system to maintain the interbank loan rate (e.g., the rate at which banks borrow or lend short-term funds from one another on the wholesale capital market) at the target rate set by the Federal Reserve Open Market Committee, and by making short-term loans available to temporarily overextended banks through the Fed’s “discount window.”
13. Martin Wolf, “Helicopters Start Dropping Bundles of Cash,” Financial Times, December 13, 2007.
14. “The Week That Shook Wall Street,” Wall Street Journal, March 18, 2008.
15. The central bank has a balance sheet analogous to that of any other bank, with positions in assets—primarily government issued securities or loans to the private banks—matched on the liability side of its balance sheet by obligations to the private banks to honor their demand for reserves.
16. See “U.S. Housing Market Conditions, 4th Quarter, 2007,” Department of Housing and Urban Development, February 2008, http:/www.huduser.org/org/periodicals/ushmc/winter07_1/index.html.
17. “The Subprime Lending Crisis,” Report and Recommendation by the Majority Staff of the Joint Economic Committee, October, 2007.
18. Carter Dougherty, “U.S. subprime losses may hit $300 billion, OECD estimates,” International Herald Tribune, November 22, 2007, http//:www.iht.com; and Martin Wolf, “Going, Going, Gone,” Financial Times, March 12, 2008.
19. Vikas Bajaj and Ford Fessenden, “What’s Behind the Race Gap?” New York Times, November 11, 2007.
20. Marc Lavioe, “A Primer on Endogenous Credit Money,” in Studies in the Modern Theories of Money, Loius-Phillippe Rochon and Sergio Rossi, eds., (Amherst, MA: Edward Elgar, 2004).
21. This statement comes with a critical caveat, namely that if the profit rate in the nonfinancial sector begins to fall, as it appears to have done in the last year, then all bets are off.
[Courtesy 'Monthly Review', May 2008]