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Entries in "Economics"
October 06, 2008
Government of the Dow, by the Dow, for the Dow
The recent financial crisis and the frantic (and finally successful) attempt by the government and Wall Street to strong-arm the public to provide immediate relief to the very institutions that caused the crisis is striking evidence, if anyone needed it, of exactly for whose benefit the government is run: Wall Street. You can ignore all the blather about how this bailout was needed to prevent ordinary people from financial ruin. That may or may not be true. What is indubitable is that if Wall Street interests were not at stake, nothing would have been done.
As was clearly evident in the past week, while the government can drag its feet for decades, say it is too expensive, and take no action to solve urgent problems like health care, when it comes to giving away nearly a trillion dollars to the financial industry, it can act with lightning speed. And you can be sure that when this money runs out (as it surely will as Wall Street institutions get their greedy hands on it) and next financial 'crisis' appears, we will be asked to cough up even more, and told that otherwise the sacrifices we have already made will be 'wasted'. This is the same argument given for continuing the war in Iraq.
Although I have written quite a bit in recent days about the crisis and the economy and think I have at least some understanding of how things work, one thing I don't understand is how the stock market works. I understand the mechanics of it, of course, but have long given up trying to understand what makes it go up or down on any given day.
It seems to me that stock prices are only loosely based on the actual health and performance of companies and the general economy, and more on expectations of what will happen in the future. It is not based on current data but on predictions of future data. It is closer to astrology or soothsaying than science.
I can pinpoint the very event that made me give up on the whole business as being hopelessly irrational.
Emperor Hirohito of Japan (1901-1989) was the symbolic head of Japan from 1926 until his death. He was revered by his people and considered by many to be a god-king. He was quite ill during the last decade of his life and close to death on many occasions.
I was intrigued and amused by the fact that the Japanese stock market would go up and down quite dramatically based on rumors about his health, and the news organizations would solemnly report with a straight face things like, "The Japanese stock market dropped sharply today on news that Emperor Hirohito's health had taken a turn for the worse."
This was, of course, absurd. The emperor was very old, had been ill for a long time, and was a purely symbolic head of state and had no say whatsoever on how the government or the economy was run. It would be like the British stock indices fluctuating on rumors about the Queen of England. The reaction of the stock market seemed to me then, and still seems now, to be hopelessly irrational.
Although I do not invest directly in the stock market (although my retirement funds are presumably invested in it), I do an experiment on days when there is some fairly big news event, either political or financial. After I listen to the news, I try to predict what that news will do to the stock market that day. I find that there is little or no correlation. If anything, I am more often wrong than right, that what I see as bad news for the economy sends the stock market up, and vice versa. It is clear that I will never get rich speculating as a day trader.
A couple of years ago, Bob Garfield on the show On the Media had a droll report on how the media and financial analysts try to come up with simple explanations to explain the day-to-day gyrations of the stock market, usually based on nothing more than sheer guesswork or story-telling.
This is why I never take seriously those people who urge policies based on the stock market fluctuations. They are usually self-serving rationalizations for what they want to do.
For example, on Monday, September 29, the House of Representatives surprisingly defeated the Paulson bailout plan on a close vote. As you can see from the graph, the Dow Jones index immediately headed down, plunging 777 points, and that drop was blamed directly on the vote.
People were issuing dire warnings that it would continue that deep decline and we would all have our retirement funds disappear if Congress did not reverse itself and pass the Paulson plan immediately.
The next day the House was not in session due to a religious holiday and the Dow went up nearly 500 points. Did people conclude that sending Congress on vacation was good for the market? Of course not. They found some other fatuous reason.
Then the Senate passed a revised plan late on Wednesday evening and the market should have been happy on Thursday but it wasn't. (It feels so absurd to ascribe human emotions to the stock market, an institution that deals impersonally with billions of transactions daily but we now take such absurdities for granted.) The stock market declined steeply all through the day, losing about 350 points, for no reason that I could see.
Tension then mounted as the House came back in session on Friday to vote on this new package. The market started the day up and kept rising, gaining about 300 points by 1:00 pm, reaching a peak of 10,766. The House voted at that time and passed the measure quite easily.
Since we were told that the House failing to pass a bailout plan on Monday was the cause of the steep decline that day, you would expect that passing it now would be an occasion for joy. What actually happened was that right after the vote, the market immediately went into a steep decline, losing 450 points to end the day with a net loss.
To me this makes no sense at all. Maybe, to use the phrase coined by MIT professor of business Dan Ariely and which is the title of his book, the market is 'predictably irrational', meaning that there is some method in its seeming madness and I am not expert enough to see it.
As long as the stock market was tethered to the underlying real economy, that may have been true. But I think that the present out-of-control virtual economy, generated by financial institutions that have been allowed to speculate wildly using debt-based securities that were free from regulations and oversight, has resulted in the stock market being connected to the real economy by the slenderest of threads, making rational decision-making impossible.
Maybe it is truly rational and there are people who actually understand it. I know I don't.
POST SCRIPT: Paulson's history
This article points out the little publicized fact that Treasury Secretary Paulson, while head of Goldman Sachs, advocated the very policies that led to the current crisis. And now he has been given a huge check from the taxpayers to 'solve' the very problem he helped create. Nice work if you can get away with it.
Paulson, according to a celebratory 2006 BusinessWeek article entitled "Mr. Risk Goes to Washington," was "one of the key architects of a more daring Wall Street, where securities firms are taking greater and greater chances in their pursuit of profits." Under Paulson's watch, that meant "taking on more debt: $100 billion in long-term debt in 2005, compared with about $20 billion in 1999. It means placing big bets on all sorts of exotic derivatives and other securities."
According to the International Herald Tribune, Paulson "was one of the first Wall Street leaders to recognize how drastically investment banks could enhance their profitability by betting with their own capital instead of acting as mere intermediaries." Paulson "stubbornly assert[ed] Goldman's right to invest in, advise on and finance deals, regardless of potential conflicts."
In testimony in 2000 before the Securities and Exchanges Commission, Paulson as head of Goldman Sachs, argued that Wall Street should be allowed to regulate itself.
Meanwhile, Rep. Brad Sherman of California describes the horror scenarios painted for lawmakers in private sessions before the Monday vote to try and scare them into voting for the bill.
October 03, 2008
Crisis? What crisis? Which crisis? Whose crisis?
In the midst of all this panic about a financial meltdown, it is hard to get a sense of how to actually measure if there is a crisis or not. Clearly there are various measures that can be used: the number of houses foreclosed, the number of personal bankruptcies, the number of banks going under, the amount of credit available, the state of the stock market, and so on. While they are all connected in some way, which ones should we be paying most attention to?
Deciding which measures are being used to say there is a crisis is important because that will drive the efforts to resolve it. Clearly what is concerning the political leadership is the state of the financial market, and the current bailout efforts seemed to be aimed at reassuring the banking, insurance, and other financial sectors and propping up the stock market. People are being scared and told that if the stock market declines their retirement savings will go down the tubes.
It is true that there have been fluctuations in the stock market and some recent declines. But whether this is a problem or not depends on whether we know what the "true" level of the stock market should be. If it is declining from an artificially high value to a more realistic one, then there is no crisis, just a return to normalcy.
To get a rough idea of how to see this, you can look at this graph that shows the Gross Domestic Product (GDP), the Consumer Price Index (CPI), and the S&P 500 stock market index since 1970. The GDP is a rough measure of the size of the 'real' economy, while the CPI is a rough measure of the rate of inflation.
We see that from around 1970 onwards until now, both the GDP and CPI growth rates have fluctuated around an average annual value of roughly 3.5%. But beginning around 1980, the S&P index started taking off like a rocket, meaning that the size of the 'virtual' economy that is measured purely by stock market prices was outstripping the growth of the 'real' economy.
This raises the interesting question of what happened after 1980. That was the year that began the great deregulation era, where the corporations and financial institutions markets were steadily freed of the constraints and regulations imposed on them following the Great Depression of 1929. The drive for deregulation started towards the end of the Carter administration, kicked into high gear with Ronald Reagan, and has been on full throttle ever since.
Government regulation was portrayed as this bureaucratic burden that was stifling innovation, so those regulations were removed. The banking and financial sector was delighted because now they could do more things, borrow and lend more money, and take much greater risks than ever before. This was the beginning of the creation of exotic new financial instruments like derivatives, credit default swaps, collateral debt obligations, and securitized mortgages that led to huge debt-based transactions that enabled trillions of dollars to swirl around in an opaque and unregulated manner. All this freely flowing capital drove up stock prices.
There was increased innovation all right, but not all in a good way. The downside of all the dismantling of oversight was not long coming. The massive federal bailout of the savings and loan industry in the late 1980s and the growth and collapse of companies like Enron and WorldCom can be traced to the removal of those regulations that required at least minimally prudent and honest and transparent business practices.
While all those debacles should have been warning signs of underlying problems, the continued rise in the stock market allowed people to ignore the storm clouds. After all, wasn't the rise in the stock market telling us that we were all getting wealthier, except for those poor saps who lost their jobs in the wake of the collapse of those giant companies?
Below is a graph of the Dow Jones index since its beginning.
Its value on January 2, 1980 was just 786. Like the S&P index, it too started rising rapidly after 1980, reaching a peak of 11,497 on October 1, 1999. It then dropped to 7,592 on July 1, 2002, rose to an even higher peak of 13,896 on July 2, 2007, and ended at 10,831 on October 1 of this year.
The alarmists are pointing to the 3,000 point drop in the last year as a sign of the financial collapse. But if we think the stock market should reflect the value of the 'real' economy as measured by the GDP, then it is possible to do a very rough calculation and see what the stock index values should be today based on the growth of the GDP.
If we take the average annual GDP growth rate of 3.5% and add to that the average inflation rate of 3.5% as measured by the CPI, then we can calculate what a 7% growth rate in the Dow, starting with its value in 1980, should give us today. That turns out to be about 5,500, about half today's value.
If I am more generous and assign a total growth rate of 8%, I still only get a current index value of about 7,200. I need to postulate an astounding rate of 9.5% over the last three decades to get the current value of the Dow index, and would have to ramp it up to 10.5% to get the July 2007 peak value. Such huge growth rates in the real economy over such a long time are, of course, unrealistic.
So is it the case than rather than us currently having "lost" a lot of money, we never should have taken seriously the idea that we had so much money to begin with? Were we living in a dream world of imaginary wealth and living high on borrowed money? Is this financial crisis just telling us that by pumping another trillion dollars we don't really have into the stock market we are simply postponing the day of reckoning since we are striving to maintain an artificial level of virtual wealth?
Michael Lewitt of Hegemony Capital Management (a hedge fund) gives his perspective. Given his position as a market insider, trading in the very kinds of things that are at the heart of the current mess, his critiques carry particular weight. He concludes that:
There is a point when free enterprise tips over into a degree of economic and social inequality that is politically unacceptable, and the United States has reached that point. HCM is well aware that its views on this topic genuinely anger many of its readers, but this is an issue that must be addressed as an essential component of any program that will return confidence to the financial system. Free market economic policies, in particular tax policies, have led to the creation of an American oligarchy whose wealth and power is excessive. While not as pernicious as the oligarchy that rose from the ruins of the Soviet Union and now lords over Russia and spends its money garishly over the world, an American oligarchy has unduly benefitted from ill-advised tax and economic policies and must be reigned in as a sign to Main Street that the game will no longer be rigged against it. (my italics)
His analysis of the causes of the current situation is similar to what I have been saying:
Financial busts are preceded by financial bubbles. The current bust was preceded by a debt bubble whose unique manifestations were debt securitization and credit derivatives. Underlying these novel debt structures were the human emotions of greed and fear that led to abuses by even the most sophisticated individuals and most highly respected institutions in the market. While these human attributes are the most difficult to legislate, their ability to wreak havoc is clear evidence that they must be regulated in a thoughtful way.
. . .
The profits that Wall Street generated over the past few years were not the result of some new-found genius in the executive suites, but were merely the product of adding unprecedented amounts of leverage to balance sheets.
He points out that all the current panic talk is being driven by short-term thinking.
It is a certainty that America, and then the rest of the world behind it, is going to experience a severe recession the likes of which it hasn't seen for decades. . . One of the problems plaguing America is that we have become so frightened of short-term pain that we are willing to risk incalculable long-term suffering. Any plan that treats the symptom (the loss of confidence) and not the disease (the underlying problems that caused the loss of confidence) will not solve the real problem.
. . .
Despite the cries of pain from the credit markets, HCM has never believed that the world would spin off its axis if a deal is not rushed to completion in the next few days. A bad deal would be worse than no deal at all. (my italics)
. . .
In order to be successful, the Paulson Plan needs to be followed up by comprehensive regulatory reform that accomplishes the goals of convincing the public that the financial system will be fairer in the future than it has been in the past (i.e. that the gains will be spread more equitably and that failure will not be rewarded) and that strong steps will be taken to prevent the oversights that led to the current instability from being repeated.
He also points out that the heads of these financial institutions, while asking for the taxpayers to bail them out, are brazen in their demands, acting like they are doing us a favor by taking our money! And Paulson and Bernanke go along with that.
While trying to help rebuild confidence in American capitalism, Mssrs. Paulson and Bernanke tried to convince Congress that bank executives would prevent their institutions from participating in the bailout if it meant that their compensation would be capped. One would think, as the financial system teeters on the brink of collapse, that the Secretary of the Treasury and the Chairman of the Federal Reserve could make a more persuasive argument than one that poses the likelihood that corporate executives would knowingly violate their fiduciary duty and refuse to participate in a plan to rescue the financial system because it might limit their compensation.
Meanwhile, Pam Martens, who worked on Wall Street for 21 years, reads the fine print in the bailout plan and discovers what Wall Street hopes to win from it. It is an inside job in which the Treasury, the Fed, and Wall Street are using their agents in Congress to pick our pockets.
The more I think about it, the more this bailout plan looks like a swindle. I hope the members of the House of Representatives defeat it in its current form and instead demand a full and careful examination of the problem and what is needed to solve it.
POST SCRIPT: The Vice-Presidential debate
Well, the debate went pretty much as I expected. Sarah Palin was fairly coherent in her answers most of the time though I thought she overdid the folksy, down-home manner. By the way, did you know that she and John McCain are mavericks? And that Palin likes to talk about energy issues whatever the question?
Those who are not political junkies may have been surprised by the solid performance by Joe Biden, who has been pretty much ignored so far in the media coverage, overshadowed by the other three candidates. This may explain why early polls suggest that he 'won' the debate, though declaring winners and losers for such events is a largely meaningless exercise.
What was really surprising was the way Palin was flirting with me.
Sarah, give me a call and let's get together for coffee sometime.
September 30, 2008
Why the Wall Street bail out plan is bad-6: The credit ratings agencies scandal
In voting down the bailout proposal 228-205 yesterday, the House of Representatives struck a small blow for democracy. They refused to be steamrolled by Wall Street and its agents in Congress and the administration.
As usual, in the run up to the vote, the administration met in secret with the Congressional leadership, worked out some vague plan, gave the House members just a few hours to see the bill, and then ordered the House members to vote for it or else, saying "Trust us, we know what is best. If you immediately don't do what we say, the world will come to an end."
Why exactly is this so urgent? Why cannot a solution wait for weeks or even months? This crisis was not created in a day, why must it be 'solved' in a day? On the rare occasions when the question is posed of why this urgency is necessary, the response is incoherent, vaguely referring to the need for 'confidence' and 'calming the markets'.
This attempt by an elite to ram through a policy with major consequences without extended debate is an insult to the democratic process and is symptomatic of an oligarchic system, not a representative democracy.
There should be public hearings when such a major issue is involved. There should be open testimony from all relevant parties as to what exactly the problem is and the pros and cons of the various options. Everything should be out in the open and completely transparent.
To their credit, enough members resisted the president, Treasury Secretary, Fed Chair, and the leadership of both parties (such as that blustering bully Barney Frank) and said resoundingly "No!" Of course they will now come under intense pressure and blamed for losses on Wall Street. But the goal of the government should be the general welfare of people and the broader economy, not to protect stock prices in the short term.
The members of Congress who voted no should resist pressure and not capitulate until they get a deal that is genuinely in the interests of ordinary people and not Wall Street. The only way we are going to get any serious and meaningful reform of the deeply flawed financial system is in exchange for the bailout money. Once you give Paulson the ransom he is demanding, it's all over. You can forget about getting any long-term solutions.
And now we return to the regularly scheduled post . . .
In my post on the current financial mess, I pointed out the key, and scandalous, role played by the credit ratings agencies like Moody's and Standard and Poor which gave the highest ratings of AAA to these mortgage-based securities although they did not deserve them. This was important since major public funds (like pensions) that deal with the savings of many lower and middle-income people are required to only invest in the safest securities. So getting the AAA rating was essential if this vast pool of money was to be tapped.
An article in Bloomberg News reveals how the top executive at these ratings companies pressured their analysts to give these highest ratings without the normal scrutiny they should receive, because "Without those AAA ratings, the gold standard for debt, banks, insurance companies and pension funds wouldn't have bought the products."
Flawed AAA ratings on mortgage-backed securities that turned to junk now lie at the root of the world financial system's biggest crisis since the Great Depression, according to Raiter and more than 50 former ratings professionals, investment bankers, academics and consultants.
"I view the ratings agencies as one of the key culprits," says Joseph Stiglitz, 65, the Nobel laureate economist at Columbia University in New York. "They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies."
What these ratings agencies did was to take short cuts and depend on computer-driven mathematical models and their competitors' analyses rather than do their own field research. In fact, people were not interested in even seeing the properties on which their ratings were based.
In late 2005, First Pacific's Mann says, he invited East Coast investors to take a subprime mortgage tour up California's main interstate artery, to see the problem for themselves. The I-5 runs from San Diego to Sacramento, passing through Orange County, Bakersfield and Stockton.
"Nobody wanted to do it," he says. "Unfortunately, most of the models were constructed by people who hadn't seen most of America and certainly weren't familiar with the areas they were rating."
The article describes how the analysts were pressured.
"We must produce a credit estimate," Gugliada, a member of the structured-finance rating group's executive committee, wrote to Raiter in a March 2001 e-mail. "It is your responsibility to provide those credit estimates, and your responsibility to devise a method for doing so. Please provide the credit estimates requested!" he wrote, signing off with his nickname "Guido."
"He was asking me to just guess, put anything down," says Raiter, interviewed at his home in rural Virginia, 69 miles (111 kilometers) west of Washington. "I'm surprised that somebody didn't say, 'Richard, don't ever put this crap in writing.'"
Gugliada, like Raiter, now says that he views as flawed many of the ratings S&P and Moody's assigned.
"There was the self-delusion, which hit not just rating agencies but everybody, in the fact that the mortgage market had never, ever, had any problems, and nobody thought it ever would," Gugliada says.
But then came the reckoning.
Driven by competition for fees and market share, the New York-based companies stamped out top ratings on debt pools that included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes between 2002 and 2007. As subprime borrowers defaulted, the companies have downgraded more than three-quarters of the structured investment pools known as collateralized debt obligations issued in the last two years and rated AAA.
. . .
Bank writedowns and losses on the investments totaling $523.3 billion led to the collapse or disappearance of Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. and compelled the Bush administration to propose buying $700 billion of bad debt from distressed financial institutions.
At bottom, the problem was the incestuous relationship between the companies seeking the ratings and the ratings agencies that bestowed them.
Through it all, the rating companies had a basic conflict: They were paid by the businesses whose products they rated. Moody's told the Paris-based Committee of European Securities Regulators in November 2007 -- in the 49th footnote of a 35-page response to its questionnaire on structured-finance -- that it allowed managers who supervised analysts to "provide expert input" on fees "in a limited range of circumstances."
SEC Chief Cox said in June that the rating companies engaged in the "lucrative business of consulting with issuers on exactly how to go about getting" top ratings.
This what happens when you take away oversight and mindlessly extol the virtues of the 'free market' and blandly assume that 'the market will correct itself.' Greed runs rampant.
POST SCRIPT: McCain and the Keating Five scandal
Given the strong similarity of the current Wall Street bailout scandal to the earlier savings and loan scandal of the 1980s, you would have thought that the media would have paid more attention to that story, especially since John McCain was one of the five US senators fingered as being influenced by the notorious Charles Keating, who went to jail for his role. Keating was a benefactor of McCain and a close friend of Cindy McCain.
For those not familiar with that earlier episode here is the story of McCain and Keating told in less than two minutes.
September 29, 2008
Why the Wall Street bail out plan is bad-5: Rewarding greed
In this next-to-last post in this series (but probably not on this topic), I want to look at how senior Wall Street executives saw their profession as some sort of game in which the goal was to extract more personal benefit than the next executive, leading to a leap-frogging of various forms of compensation packages that would leave ordinary people gasping.
These executives were taking risks with other people's money that left many ordinary people ruined while they themselves were benefiting:
The chairman of Lehman Brothers, Richard Fuld, still has his mansion in Greenwich, CT, his oceanfront estate on Jupiter Island in FL, and his Park Avenue co-op in Manhattan.
Many at Lehman blame Fuld for dallying while his investment bank went bust, taking risks with other people's money while he cleared over $40 million in salary and stock in the last year alone.
. . .
Fuld isn't the only top executive who remains well-off despite his firm's collapse. Former Bear Stearns CEO Alan Schwartz collected more than $38 million in salary and bonuses in the last three years for which figures are available.
These people live in a different world from you and me. The report describes the 'hardships' being undergone by the Wall Street executives as a result of the current financial situation.
"A lot of those people will have to sell their homes, they're going to cut back on the private jets and the vacations. They may even have to take their kids out of private school," said Frank. "It's a total reworking of their lifestyle."
He added that it's going to be no easy task.
"It's going to be very hard psychologically for these people," Frank said. "I talked to one guy who had to give up his private jet recently. And he said of all the trials in his life, giving that up was the hardest thing he's ever done."
And now we are supposed to bail out such people when their actions have resulted in other people losing their jobs or their only (modest) homes?
Some lawmakers are furious at what they are being asked to approve by the Bush administration, the Federal Reserve, and their own leadership. One anonymous Congressperson sent an email in which, in addition to demanding major reforms in the financial sector in return for the bailout, he/she also wants them to be publicly humiliated for what they have done to the country, and demanding that Congress should not be bought off with some trivial considerations.
I don't want to trade a $700 billion dollar giveaway to the most unsympathetic human beings on the planet for a few [expletive] bridges. I want reforms of the industry, and I want it to be as punitive as possible.
. . .
I also find myself drawn to provisions that would serve no useful purpose except to insult the industry, like requiring the CEOs, CFOs and the chair of the board of any entity that sells mortgage related securities to the Treasury Department to certify that they have completed an approved course in credit counseling. That is now required of consumers filing bankruptcy to make sure they feel properly humiliated for being head over heels in debt, although most lost control of their finances because of a serious illness in the family. That would just be petty and childish, and completely in character for me.
I think this congressperson is merely channeling the deep reservoir of anger in the general public at what they rightly see as little more than a fraud perpetrated on them.
When poor people get into trouble because they make stupid or greedy decisions, they are lectured to by the rich on the need to be prudent and live within their means and to suffer the consequences of their actions. When the very rich do the same thing, the government rides to their rescue. 'Throwing money at the problem' (a favorite phrase used by the rich to denigrate any attempt to fund initiatives that help ordinary people, like education or health care) becomes the desirable mode of action when the recipients are Wall Street or the defense industries.
Meanwhile on the House floor Rep. Marcy Kaptur of Ohio tells it like it is:
As I have said repeatedly, the leadership of both parties are already bought and sold by Wall Street like any of the other commodities they trade in. They are simply looking for a face-saving way to capitulate and give away the store and a grand 'bipartisan compromise' is what they seek, so that one party cannot take advantage of public anger by accusing the other of selling out to Wall Street. It is only the 'minor' members of Congress who are not beholden to these interests that can stage a revolt.
I think that most people, even if they are not sure exactly what is going on, are suspicious that this is a sweet deal for insiders by insiders. Apparently opposition to the bailout is running at between 10-to-1 to 100-to-1, if measured by the calls and emails received by members of Congress. But just like in the run up to the Iraq war, regular Congresspeople can be frightened into thinking that they will be blamed if they oppose their party leaders and the group of 'wise experts' who solemnly tell them that they know what the best of action is.
As former Labor Secretary Robert Reich says:
Put yourself in the shoes of a member of Congress, including our two presidential candidates. The Treasury Secretary and Fed Chair have told you this is necessary to save the economy. If you don't agree, you risk a meltdown of the entire global financial system. Your own constituents' savings could go down with it. An election is six weeks away. Besides, in the last two days of trading, since rumors spread that the Treasury and the Fed were planning something of this sort, stock prices revived.
Now - quick -- what do you do? You have no choice but to say yes.
But you might also set some conditions on Wall Street.
The public doesn't like a blank check. They think this whole bailout idea is nuts. They see fat cats on Wall Street who have raked in zillions for years, now extorting in effect $2,000 to $5,000 from every American family to make up for their own nonfeasance, malfeasance, greed, and just plain stupidity.
Reich lists five conditions, the first of which is that "The government (i.e. taxpayers) gets an equity stake in every Wall Street financial company proportional to the amount of bad debt that company shoves onto the public. So when and if Wall Street shares rise, taxpayers are rewarded for accepting so much risk."
There are alternatives. It has been pointed out that Sweden faced a similar crisis in 1992 but took a very different attitude and solved it with almost no cost to the taxpayers. (Thanks to Norm for the link.)
Sweden did not just bail out its financial institutions by having the government take over the bad debts. It extracted pounds of flesh from bank shareholders before writing checks. Banks had to write down losses and issue warrants to the government.
That strategy held banks responsible and turned the government into an owner. When distressed assets were sold, the profits flowed to taxpayers, and the government was able to recoup more money later by selling its shares in the companies as well.
Why should we not get what, say, Warren Buffett or JP Morgan Chase got when they invested in troubled firms like Lehmans or Washington Mutual? Why should the taxpayers not be treated as investors and have the same risk/reward expectations as any other investor? Why should we pay for something for which there is no clearly discernible public good?
It is time for people to get really angry. We should not take the word of sober-voiced people in suits who soothingly tell us that although they were the ones who created this mess and did not even see it coming, we should now unquestioningly trust them to solve the mess by giving them virtually everything they want.
We are being told that it is imperative that we 'calm the markets', as if the trillion-dollar financial sector is a colicky baby in a restaurant. We are being told that we must restore 'confidence in the markets' as if the market is a shy teenager about to go on a first date. Why should we care about confidence? And whose confidence are we talking about?
They are taking us for suckers and we will have only ourselves to blame if we allow them to do so. We, the people, technically own the government but it has been co-opted by the financiers. It is time to take it back from these usurpers.
POST SCRIPT: Imminent threat, anyone?
Jon Stewart reminds how Bush is using the same scare tactics to push the $700 billion giveaway plan that he used to push the Iraq war.
September 26, 2008
Why the Wall Street bail out plan is bad-4
A large number of economists were quick to express their dislike of the Paulson plan and have been vociferous in urging Congress to not be stampeded by the administration but to use this opportunity to put back into place some of the regulations that were dismantled over the last three decades.
Meanwhile on NPR this morning, Allan Meltzer, a former Fed economist and a professor at Carnegie Mellon University says that he does not see that this 'crisis' hurts anyone other than a few major players on Wall Street and that all the scaremongering about a global financial catastrophe if nothing is done are nor warranted.
Meanwhile a group of 150 economists have also weighed in, saying that there is no need for this mad rush and we should think things through carefully before committing ourselves to the Paulson plan or some minor variation of it.
As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:
1) Its fairness. . . .
2) Its ambiguity. . . .3) Its long-term effects. . . .
For these reasons we ask Congress not to rush, to hold appropriate hearings, and to carefully consider the right course of action, and to wisely determine the future of the financial industry and the U.S. economy for years to come.
I am not optimistic that these cautions will be heeded. The administration and Congressional leadership is deep in the pockets of Wall Street and will find some face-saving way to give them everything they want.
Alexander Cockburn walks us through some of the highlights of the bipartisan deregulation that resulted in Wall Street firms playing fast and loose with other people's money for their own benefit. One key person who appears repeatedly in this sordid story is Phil Gramm, the former Senator from Texas who is now economics advisor to John McCain and reportedly his preferred choice to be Treasury Secretary. As US senator from Texas, he pushed through some of the key legislation that resulted in this mess.
In 1999 John McCain’s friend and now his closest economic counselor, then a senator from Texas, was the prime Republican force pushing through the Gramm-Leach-Bliley Act. It repealed the old Glass-Steagall Act, passed in the Great Depression, which prohibited a commercial bank from being in the investment and insurance business. President Bill Clinton cheerfully signed it into law.
A year later Gramm, chairman of the Senate Banking Committee, attached a 262-page amendment to an omnibus appropriations bill, voted on by Congress right before a recess. The amendment received no scrutiny and duly became the Commodity Futures Modernization Act which okayed deregulation of investment banks, exempting most over the counter derivatives, credit derivatives, credit defaults, and swaps from regulatory scrutiny. Thus were born the scams that produced the debacle of Enron, a company on whose board sat Gramm’s wife Wendy. She had served on the Commodity Futures Trading Commission from 1983 to 1993 and devised many of the rules coded into law by her husband in 2000.
Somewhat stained by the Enron debacle Gramm quit the senate in 2002 and began to enjoy the fruits of his own deregulatory efforts. He became a vice chairman of the giant Swiss bank UBS’ new investment arm in the US, lobbying Congress, the Federal Reserve and the Treasury Department about banking and mortgage issues in 2005 and 2006, urging Congress to roll back strong state rules trying to crimp the predatory tactics of the subprime mortgage industry.
Cockburn points out that the enabling of Wall Street shenanigans has always been a bipartisan affair.
But is [Gramm} Exhibit A? No. That honor should surely go to Robert Rubin and to the economic course he set for his boss, the eagerly complicit Bill Clinton. Gramm has been the hireling of the banking industry. Rubin is at the beating heart of Wall Street finance, and he and Lawrence Summers at Clinton’s Treasury, were the guiding forces for financial deregulation.
Obviously the Republicans hoped that the roof wouldn’t fall in on their watch, and the crisis could be deferred to 2008 and then blamed on the Democrats. But their insurance policy was that if the roof did cave, as it has now, the rescue policy would be identical in both cases. That’s why Obama has collected more money than McCain from the big Wall Street houses.
The gang that successfully got out of Dodge in time was the Clinton-Rubin-Summers gang, just before the last bubble -–the stock market bubble -- burst in March of 2001. They knew what was coming.
Rubin is one of Obama's advisors, Gramm is McCain's so whoever becomes president, as usual Wall Street has its friends in high places. They make money from public investments when the going is good and make money directly from the taxpayers when the going is bad. The only way their hands can be taken out of the till is if the public angrily tell their representatives that there should be no bailout until massive reforms and regulations are put into place so that people's money is safeguarded from these rapacious predators.
This episode illustrates better than any civics class exactly who runs the country and for whose benefit.
POST SCRIPT: Jon Stewart on the Paulson plan
September 25, 2008
Why the Wall Street bail out plan is bad-3: More doubts
I have described before how the subprime mortgage debacle lies at the root of this mess. But how did it come about that mortgage lending, once the most conservative and transparent and regulated of banking practices, became the basis of a massive shadow economy in which trillions of dollars flowed around, free from any oversight? And what is the government bailout meant to do?
The foundations of the mess lies with the neoliberal deregulation policies that began under the Carter administration and was enthusiastically followed by every subsequent administration of both parties. The driving idea behind all this loosening was that the banking and investment sector was being shackled by too many regulations and too much oversight. The protective firewalls that had been put up between banks and investment houses following the excesses that led to the Great Depression were targeted. It was argued that if the banks were freed from these onerous restrictions, capitalism would bloom.
Since Wall Street executives have always formed the core advisory group around any government (and currently are deeply enmeshed in the Obama and McCain campaigns) and also have strong ties with the congressional leadership of both parties, it was not hard to persuade the government to loosen the restrictions that had been put into place following the last debacle of the financial sector during the Great Depression of 1929.
The same Wall Street types who put into place the conditions that caused the current mess are now the ones who claim they are the ones who can solve it. They are trying to panic everyone into accepting a plan that will rescue themselves from their own actions by passing the cost on to us.
Since the main problem now is that all these banks and investment firms are being dragged down by having on their books all these mortgage-based securitized investments whose value is doubtful (to the extent that they can even figure out its value), what the rescue plan seeks to do is to use taxpayer money to buy these possibly worthless investments at values far more than they are worth, essentially taking these liabilities off the hands of the banks and putting them in the hands of taxpayers. It is like going to a garage sale and paying original list price for the junk that is being sold.
While this is clearly a good deal for the banks and Wall Street, rescuing them from the consequences of their bad decisions by letting them unload their bad debts and giving them a huge infusion of cash, what is in it for the taxpayer? As far as I can see, very little. We greatly increase the national debt and the interest on that debt (which will eventually have to be paid in the form of higher taxes) while getting ownership of assets whose value is unknown. The only possible bright spot is that these doubtful assets may, over time, rise in value. But that is a big gamble, and I would not be surprised if there are also conditions in the agreement that will take such profits (if they ever materialize) and give it back to the banks. After all, what these people seek is to entirely privatize all profits while having the taxpayers pay for all losses.
Economist Paul Krugman, comparing this plan with the savings and loan bailout of the 1980s, explains clearly why he thinks this is a bad plan and should be rejected. (Incidentally, John McCain was implicated in that earlier influence-peddling scandal, as one of the infamous 'Keating Five'.)
The Treasury plan, by contrast, looks like an attempt to restore confidence in the financial system — that is, convince creditors of troubled institutions that everything’s OK — simply by buying assets off these institutions. This will only work if the prices Treasury pays are much higher than current market prices; that, in turn, can only be true either if this is mainly a liquidity problem — which seems doubtful — or if Treasury is going to be paying a huge premium, in effect throwing taxpayers’ money at the financial world.
And there’s no quid pro quo here — nothing that gives taxpayers a stake in the upside, nothing that ensures that the money is used to stabilize the system rather than reward the undeserving.
. . .
Treasury needs to explain why this is supposed to work — not try to panic Congress into giving it a blank check. Otherwise, no deal.
In fact, as Atrios points out, the plan seeks to give the Treasury extraordinary freedom from any oversight. They have added wording that says: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."
In other words, Paulson is telling Congress to just give him the money to do what he wants. The Treasury Secretary, like many of his predecessors, is from Wall Street (he spent three decades at Goldman Sachs) and thus is sympathetic to the plight of this particular group. They are his base.
William Greider, in a must-read article, writes that we are currently witnessing an attempt to pull off one of the biggest swindles of modern times:
It would relieve the major banks and investment firms of their mountainous rotten assets and make the public swallow their losses--many hundreds of billions, maybe much more. What's not to like if you are a financial titan threatened with extinction?
If Wall Street gets away with this, it will represent an historic swindle of the American public--all sugar for the villains, lasting pain and damage for the victims. My advice to Washington politicians: Stop, take a deep breath and examine what you are being told to do by so-called "responsible opinion." If this deal succeeds, I predict it will become a transforming event in American politics--exposing the deep deformities in our democracy and launching a tidal wave of righteous anger and popular rebellion.
He quotes others in support of his thesis that what is being proposed is an insider deal:
Christopher Whalen of Institutional Risk Analytics, a brave conservative critic, put it plainly: "The joyous reception from Congressional Democrats to Paulson's latest massive bailout proposal smells an awful lot like yet another corporatist lovefest between Washington's one-party government and the Sell Side investment banks."
A kindred critic, Josh Rosner of Graham Fisher in New York, defined the sponsors of this stampede to action: "Let us be clear, it is not citizen groups, private investors, equity investors or institutional investors broadly who are calling for this government purchase fund. It is almost exclusively being lobbied for by precisely those institutions that believed they were 'smarter than the rest of us,' institutions who need to get those assets off their balance sheet at an inflated value lest they be at risk of large losses or worse."
Greider points out that the government, if it were truly acting in the interests of the people, has a lot of power to use the crisis to reform the system:
A serious intervention in which Washington takes charge would, first, require a new central authority to supervise the financial institutions and compel them to support the government's actions to stabilize the system. Government can apply killer leverage to the financial players: accept our objectives and follow our instructions or you are left on your own--cut off from government lending spigots and ineligible for any direct assistance. If they decline to cooperate, the money guys are stuck with their own mess. If they resist the government's orders to keep lending to the real economy of producers and consumers, banks and brokers will be effectively isolated, therefore doomed.
Only with these conditions, and some others, should the federal government be willing to take ownership--temporarily--of the rotten financial assets that are dragging down funds, banks and brokerages.
Right now it looks like the Congress is getting ready to cave in to this deal in exchange for only some purely symbolic concessions like limits on executive compensation. The fix seems to be in. Only strong public opposition will prevent this giveaway of public funds to the very people who caused this crisis.
POST SCRIPT: Intelligent Design trial talk
Judge John E. Jones, who presided over the Dover intelligent design trial in 2005, will speak today from 5:00-6:00 pm in Strosacker Auditorium, followed by half and hour for questions.
September 24, 2008
Why the Wall Street bail out plan is bad-2: Manufactured crisis?
I have been getting increasingly suspicious that this so-called financial crisis may be a bogus one to enrich this administration's base of Wall Street cronies before Bush leaves office. While I am not an economist and do not have the inside knowledge that Henry Paulson (Treasury Secretary) and Ben Bernanke (head of the Federal Reserve) have, there is something about this mad rush to pass major legislation that strikes me as very suspicious. It reminds me too much of the way the administration flat-out lied about the danger that Iraq posed in order to get Congressional authorization for the invasion.
People like Paulson and Bernanke lied when they said they had the situation under control earlier when they bailed out Bear Stearns, Fannie Mae, Freddie Mac, and AIG. How do we know that they are not lying again now in order to push a covert agenda? While I accept that the financial sector is in trouble, what I want to know is what evidence has been produced that we need to act immediately. The stock market might go down if no immediate action is taken but that is not sufficient reason because they are betting on a bailout and their potential disappointment is not a reason for throwing more money into their trough.
When one of the senators at yesterday's hearings asked Paulson why he needed $700 billion all at once and why he could not initially accept a 'smaller' amount like $150 billion now and the rest staggered over time, he replied that the markets needed the larger amount to show 'confidence'. What kind of answer is that? Why should we care if the market has 'confidence'? What he really means is that he wants stock prices to go up by giving away taxpayer money. We need to go back to basics where stock prices reflect the real value of companies.
How do we know there is really a crisis except for the fact that we are being told so repeatedly in screaming headlines? What evidence do we have that the credit markets are really freezing up? Are industries not functioning because they can't get credit? Are ordinary people not being able to buy a car because they cannot get a car loan? Paulson and Bernanke keep saying that if they don't get all the money right now, this minute with absolutely no conditions, there will be a financial Armageddon and ordinary people will suffer. But the evidence produced so far is that only some banks and Wall Street financial firms will suffer.
I am not the only one who is deeply skeptical. Pulitzer Prize winning reporter on tax policy David Cay Johnson (author of the book Perfectly Legal that described how tax policies have been systematically used to siphon money away from the poor and middle class to the rich) sounds similar cautions about being pressured by a phony crisis:
In covering the proposed $700 billion bailout of Wall Street don't repeat the failed lapdog practices that so damaged our reputations in the rush to war in Iraq and the adoption of the Patriot Act. Don't assume that Congress must act instantly, as so many news stories state as if it was an immutable fact. Don't assume there is a case just because officials say there is.
The coverage of the Paulson plan focuses on the edges, on the details. The focus should be on the premise. And be skeptical of what gullible Congressional leaders, most of them up before the voters in a few weeks, say after being given a closed-door meeting on supposed horrors.
The Administration has scared the markets and some key legislative leaders, but it has not laid out a coherent, specific and compelling need for this enormous proposal, which is the equivalent of a one-time 55 percent income tax surcharge. (Instead the money will be borrowed, so ask from whom and how this much can be raised so quickly if the credit markets are nearly seized up with fear.)
Ask this question -- are the credit markets really about to seize up?
If they are then lots of business owners should be eager to tell how their bank is calling their 90-day revolving loans, rejecting new loans and demanding more cash on deposit. I called businessmen I know yesterday and not one of them reported such problems. Indeed, Citibank offered yesterday to lend me tens of thousands of dollars on my signature at 2.99 percent, well below the nearly 5 percent inflation rate. That offer came after I said no last week to a 4.99 percent loan.
If the problem is toxic mortgages then how come they are still being offered all over the Internet? On the main page AOL generates for me there is an ad for a 1.9% loan (which means you pay that interest rate and the rest of the interest is added to your balance due.) Why oh why or why would taxpayers be bailing out banks that are continuing to sell these toxic loans?
Financial reporter and New York Times columnist Gretchen Morgenson in an interview on Fresh Air tells host Terry Gross that she too does not trust these people to tell the truth now given that they have lied to us before. In a column, she argues that the fix is in to benefit Wall Street, because we, the people, have no lobbyists working on our behalf. In theory our congresspeople should be our lobbyists but given the corrupt, money-driven political system we have, even the suggestion that Congress will look out for us is laughable.
Morgenson provided some information that was new to me. She said that AIG had written $441 billion in credit insurance on mortgage-related securities that had gone sour, three –quarters of it to European banks. Furthermore, the total value of the credit default swap market (the quasi-insurance that propped up the value of the subprime mortgages) is $62 trillion. And all this was unregulated. And now we are supposed to trust Paulson, Benanke, Robert Rubin and all the other people in suits who created this unregulated monster to take us out of this mess.
When reporters for mainstream media like Morgenson say flat out that they suspect the government is lying to the people in order to reward the financial giants and their lobbyists who pour vast amounts of money into the system, it indicates that a sea change is occurring.
Chris Bowers manages to flesh out my vague fears into some very pertinent and concrete questions.
The more I think about this deal, the more it starts to look like a fraud on the American taxpayer. It is time to put the brakes on the Paulson-Bernanke-Bush juggernaut and start looking very, very carefully at how to take the gamblers out of the financial markets.
What we should watch out for is when Paulson and Bernanke meet with congressional leaders in a secret session and then they all come out and say that due to facts they cannot reveal to us, they have to do what Paulson wants (with some window dressing added) to avoid a terrible outcome. That is exactly what happened with the Iraq war and is a sure sign that the fix is in and that the reasons for taking the action will not stand scrutiny.
We should not accept this under any circumstances and should demand total transparency. This whole mess was caused by opaque trillion dollar financial transactions hidden from the world. It is not going to be solved by more secrecy.
POST SCRIPT: Silver lining?
The only silver lining to be found in this mess is that it may make it less likely that Bush will launch an attack on Iran before he leaves office. I had been fearful that the neoconservative cabal that have such influence over the Bush-Cheney regime might persuade them that carrying out such an insane plan was a good idea. Given the preoccupation with the financial crisis and its cost, such an action now seems unlikely.
Meanwhile, you can listen to (and read the transcript of) the interview NPR had with Iranian President Ahmadinejad. He repeatedly challenged the bland assumption that the US spoke for the entire world, that the things that bothered the US also bothered the world. His questioning of the assumptions so rattled the interviewer (US journalists rarely examine the assumptions of the government-corporate elite in the US that frames the discussions) that the latter started an idiotic line of questioning as to whether the Iranian leader watched western TV and whether he listened to the Beatles and Led Zeppelin.
The interviewer seemed to assume that Ahmedinejad is some kind of ignorant isolationist. The fact that he is a university academic who is well aware of what is going on in the world and capable of matching wits with western journalists seemed to have taken the interviewer by surprise.
September 23, 2008
Why the Wall Street bail out plan is bad-1
I wrote last Friday of the reasons behind the current financial mess. Over the weekend, as everyone is aware by now, the US government issued a plan to put up a huge amount of money (initially about $700 billion but likely to grow to well over a trillion) to bail Wall Street out of the financial difficulties caused by its own greed and recklessness.
The public and the Congress are being stampeded with 'the sky is falling' rhetoric into giving the Treasury Secretary Henry Paulson a blank check, with no oversight and almost no reforms, to dole out money to his cronies in the financial sector so that they can continue the reckless practices that have led to the present situation. We should not forget that Paulson spent almost his entire career (over three decades) at Goldman Sachs, one of the investment banks at the center of the current mess.
Paulson says he wants a 'quick and clean' plan approved by the Congress. To translate, 'quick' means he wants Congress to approve the plan immediately without looking too closely at it, and 'clean' means he does not want them to demand accountability and reforms in return for shelling out taxpayer money to the very firms and executives who caused this crisis.
The bankers themselves want taxpayer money with no restrictions at all and even want to prevent the courts from having any jurisdiction in the matter, which strikes me as an open invitation to swindle.
Paulson, Ben Bernanke (head of the Federal Reserve Board), and George W. Bush are acting as if there are only two alternatives: giving Paulson this blank check or a collapse of the global financial markets. This is false. Even within this short time, economists have been able to come up with possible alternatives, as has senator Christopher Dodd. I am not endorsing these alternative proposals by any means. I don't think they go far enough in providing regulatory oversight. But the point is that alternatives exist, more proposals can be created, and all should be discussed when such a large amount of money is involved.
The Paulson plan is a bad plan and should be opposed. Paulson, Bernanke, and Bush are saying that the necessary reforms and oversight can be added later after the crisis has passed, but only a sucker would accept that deal. Once the administration and the Wall Street firms get their hands on the money, you can be sure that they will fight any reforms tooth and nail. It is only now, when they are over a barrel and desperately seeking relief, that Congress has any leverage at all to get the needed reforms enacted.
We need to be wary of false compromises. After all, the leadership of both parties and the Bush administration are almost all bought and sold by Wall Street interests and they have every intention of capitulating to the demands of those interests. They will look for a way to do so while seeming to represent the interests of ordinary people. So we will hear loud grandstanding talk of needing to cap executive salaries (which those executives can easily circumvent) and some crumbs thrown to those whose homes have been foreclosed, while ignoring the fact that the real need is re-regulation of the financial markets, to put back in place those features that prevent executives at these banks and other financial institutions from acting like high rolling gamblers using other people's money. All this talk of a possible financial apocalypse is meant to steamroll those few people who oppose what is likely to be a blatant rip-off of taxpayers.
Major legislation that is rushed under panic conditions (whether real or simulated) almost always leads to bad results because the authors of the legislation use the rush to stealthily advance their covert agendas. For an example, we need go no further than the abominable USA PATRIOT Act that was rushed through in the wake of the events of September 11, 2001 under conditions of fake panic and which has resulted in the massive violations of citizen rights and protections that were once taken for granted. Or the Iraq war authorization act that was stampeded through Congress because of fake panic created that Iraq was building a nuclear bomb. We know how well those turned out. The plan for the federal bailout of Wall Street has all the signs of being a repetition of those two events.
To get a scale of the amounts currently involved, see this exchange between the hosts of the PRI program Marketplace. The 'credit default swap' market referred to is a rough measure of the amount of money that was swirling around in the subprime mortgage dealings.
BOB MOON: OK, I'm about to unload some numbers on you here, so I'll speak slowly so you can follow this.
The value of the entire U.S. Treasuries market: $4.5 trillion.
The value of the entire mortgage market: $7 trillion.
The size of the U.S. stock market: $22 trillion.
OK, you ready?
The size of the credit default swap market last year: $45 trillion.
KAI RYSSDAL: That's a lot of money, Bob.
Yes, sirree, Bob, that is a lot of money. And all of it in a shadow economy, without any supervision by the government.
If there was any doubt as to who runs the country and for whose benefit, this episode should remove them, because both the Democratic and Republican parties colluded to create the conditions which gave rise to the current crisis and now both are colluding to save their rich supporters from the consequences of their actions.
What we clearly have now is government of the rich, by the rich, and for the rich.
POST SCRIPT: Religious nuts
Recently John McCain and Barack Obama were interviewed separately by Rick Warren, pastor of the Saddleback evangelical megachurch. Jackie Broyles and Dunlap from Red State Update engaged outside the forum with protestors from the Westboro Baptist Church, a group that is so viciously and irrationally antigay that I sometimes wonder if they are actually a bunch of performance artists, cleverly playing a prank on all of us.
I have written before that humor and ridicule is the best way to deal with such people, and Jackie and Dunlap seem to share that view.
September 19, 2008
The current financial mess
In a past series of posts, I looked at the financial crisis created by the collapse of the subprime housing crisis.
In the wake this week of the massive federal bailouts of Fannie Mae and Freddie Mac and AIG (American International Group), the collapse of the venerable Lehman Brothers investment bank, and the sale of another giant Merrill Lynch to Bank of America that staved off its own bankruptcy, it may be good to see how all these are linked.
This crisis is the inevitable result that follows 'bubble' economics', the runaway (and unrealistic) growth in the price of a commodity due to the belief of investors that the price of that commodity will either always increase or that they can sell out before it drops. In this case, the commodity is real estate. At every stage of the process, the firm belief that the value of homes would increase, coupled with little or no oversight to ensure that minimum caution was exercised in lending money, resulted in this runaway train that is now crashing and causing massive damage.
The foundations of this bubble lies with the providing of mortgages to large numbers of people who simply could not afford the homes they sought to buy. How was this done? One culprit was the creation of mortgages that had very low introductory rates that enabled people to pay the mortgage premiums, at least initially. Of course, such an artificially low rate could not be sustained so the premiums would suddenly rise after a few years, to a level the buyer could not afford. This seems like an unbelievably stupid plan for both the home buyer and the people providing the mortgage. And it is, unless you believe that the price of the home would increase in value, because then the homebuyer could sell the home before the mortgage went up, repay the money to the mortgage lender, and still make a profit. Everyone wins. There seemed to be a free lunch, just for the taking.
As a result, all kinds of shady practices arose. Mortgage brokers working on commission actively sought out even ineligible buyers for properties, inflated their income to meet the minimal requirements for eligibility, and sold them properties. The banks providing the money did not bother to really check on the credit worthiness of the buyers because they immediately sold off most of their mortgages to investment banks. These investment banks then 'securitized' their collections of mortgages, bundling them into huge packages of thousands of mortgages, then dividing them up into smaller pieces, and selling the pieces like other securities such as bonds.
Since investors believed that home prices would always go up, there seemed to be little or no risk. But as a result of this bundling and slicing and dicing and no strict accounting or transparency requirements, no one knows exactly which mortgage is in which bundle, even now. But who cares? The idea was that by this bundling, even if a mortgage here or there went into default, it would be a small part of the whole package, hardly noticeable. Wholesale defaults would not happen since home prices always go up, don't they?
The investment banks then bought and sold these securities, their huge commissions adding to the price. They were aided in this by the credit ratings agencies (like Moody's) that gave these securities the highest ratings of AAA, which made them seem to be very safe investments. Why would the credit rating agencies give high ratings to securities whose origins were so murky and about which they seemed to know so little? Because it is a little known fact that these rating agencies are paid by the very companies they rate and so have a vested interest in pleasing their clients. Of course, they also felt there was little risk in giving these high ratings because, as we all know, home prices always go up, don't they?
What about those cautious investors who were still a little nervous about buying these securities despite their high ratings? No problem. Along comes AIG, a huge insurance conglomerate. They created a new division that sold things called Credit Default Swaps (CDS). These things act like insurance in that they guarantee to reimburse the investor if their securities should lose value, thus reassuring them that these mortgage-based securitized investments were a safe bet. Although the CDS were sold like insurance, they are not actually called insurance because insurance is a regulated industry monitored by the states and as soon as something is called insurance it comes under that regulatory umbrella. But no one really paid much attention to such petty details since home prices are sure to go up, aren't they? Thus no one was likely to lose money. So AIG was raking in huge amounts as 'insurance' premiums, while feeling it ran little or no risk of having to pay out any money.
And as long as home prices went up, they were all making money and no one was paying close attention, except for a few worrywarts who didn't like to see trillions of dollars moving around in an unregulated and opaque manner. And for awhile home prices did go up, as was inevitable as more and more people were being encouraged and enabled to buy homes they really could not afford on the expectation that prices would go up yet higher. Thus were created the classic bubble conditions.
But all bubbles are inherently unstable and eventually collapse. And when it does, who gets hurt the most depends on who ends up holding the worthless investments. In this case, it is the US taxpayer.
Home prices started to drop. As homebuyers realized they could not pay the suddenly increased mortgage payments and could not sell the houses for a price that covered the amount they owed, they defaulted. As those defaults spread rapidly and became well known, investors started getting nervous about the value of the mortgage-based securities they were holding and started to sell them, rapidly lowering their value. This meant that banks and other investment houses that had these things as assets suddenly found their value drop precipitously and had to announce huge write-offs. Furthermore, those companies could no longer use those worthless securities as collateral to raise money and thus could not pay their own debts, making them risks for default and bankruptcy. This decreased investor confidence in those institutions and their share prices dropped dramatically.
This is what happened to Bear Stearns, Lehman Brothers, and Merrill Lynch. But they are just the most highly visible institutions. Huge numbers of banks are owners of similar mortgage-based assets and are nervously trying to figure out how much (or little) they are worth and what impact the revelations of their true value will do to their viability to survive. Eyes are now looking nervously at other banks like Washington Mutual and Wachovia and the two remaining large investment banks Goldman Sachs and Morgan Stanley.
British comedians John Bird and John Fortune back in August 2007 explained how subprime mortgage crisis came about. I have shown this before but it remains one of the clearest explanations.
Fannie Mae and Freddie Mac got hammered because they were the ultimate purchaser, the backstop if you will, of these mortgage-based securities. By buying them from the investment banks, they pumped money back into the mortgage system, enabling further cycles of dubious homes sales. As a result, these two giants ended up holding trillions of dollars of such worthless assets. They were able to buy these securities because they were easily able to borrow money since, although they were private companies, their incorporation charter gave them a quasi-government status, encouraging investors (especially foreign governments like China and oil-rich states with a lot of money to invest) to loan them money, since it was widely believed that the US government would not let these two institutions collapse. This is what the government did last weekend, essentially nationalizing those companies.
The US government desperately needs these foreign governments to invest in the US because that is the chief way they finance the deficits caused by the tax cuts for the rich and the two wars that are currently being fought. So essentially the US cannot do anything that will discourage future investments by these foreign governments. By taking over Fannie Mae and Freddie Mac, the US government is reassuring the foreign governments that they will get their money back since now the US government is directly responsible for paying back the money.
Meanwhile AIG, which had been eager to 'insure' these securities because of their safety (since home prices always go up, don't they?) had to pay out huge amounts of money when the value of the securities collapsed and was on the verge of financial collapse itself. Although their regular insurance business was sound, the action of its little known CDS division was threatening to bring down the entire company. Since many other large institutions (mutual funds, pensions funds etc.) had large investments in AIG, the collapse of AIG was believed to be potentially disastrous over the entire financial sector. So on Wednesday the government essentially nationalized that too.
But as a result, the taxpayers are now suddenly the owners of these three shaky companies with all their dubious assets. Furthermore, the trillions of dollars in debt owned by these companies now become part of the national debt, effectively doubling it. So while these companies made a lot of money for their executives and investors while the going was good, the taxpayers are now stuck with the bill for their recklessness. This is what capitalism has become, privatizing profits while socializing losses. Capitalism in the US has become socialism for the rich.
John Bird and John Fortune discuss how the belief in markets always going up usually end up as government bailouts.
How will the US government (i.e., us) pay back all the money it now suddenly owes as a result of the unregulated greed that ran rampant over the last decade and that enriched a few at the expense of the many? How much bad debt still lurks in the financial sector and how many firms are still hiding the true extent of their liabilities?
I would hope that all those people who were gung-ho for privatizing social security, like George Bush and John McCain, would now realize what a bad idea that is.
The next president is going to have a lot to deal with.
POST SCRIPT: Explaining the current crisis
On April 3, 2008, Michael Greenberger, in an interview with Terry Gross on Fresh Air provided a very lucid explanation of what was roiling the financial markets.
He paid a return visit two days ago (September 17, 2008) to explain what was behind the most recent developments.
Both interviews are well worth listening to.
March 18, 2008
Yet another federal bailout for the rich
Last Tuesday, the Federal Reserve Board said that it would guarantee up to $300 billion worth of the highly devalued assets held by those banks that had been speculating in the subprime real estate market, thus enabling those banks to borrow money because of the federal guarantee. Nobody else would accept the subprime mortgage portfolios as collateral for loans. So in effect the taxpayers were being put on the hook if the loans could not be repaid. The stock market that day reacted with glee, skyrocketing upwards. (I explained what was going on here.)
That party ended on Friday. The big investment bank Bear Stearns said that it could not meet its obligations and requested a loan from another big investment bank JPMorgan Chase. The latter, unlike the general public, was aware of the nature of the assets held by Bear Stearns and said nothing doing, unless the Federal Reserve was willing to guarantee that loan too. The Fed, always eager to please the big financial interests on Wall Street, readily agreed and in a single day the whole transaction was approved. This is pretty amazing speed when you consider that $30 billion of taxpayer money was involved.
But the news of Bear Stearns' troubles, which came just two days after a cheery message of confidence by its head just two days earlier that everything was just fine and dandy, sent jitters down the spine of investors who wondered how bad the situation really was and what dark secrets existed in the vaults of other big financial institutions.
They found out on Sunday when it was announced that JPMorgan Chase was actually buying Bear Stearns for the astoundingly low price of $2 per share, with the Fed once again guaranteeing the transaction. Just last year that stock had been trading at $172 per share. In just one year, the bank had lost almost 99% of its value, a collapse of Enron-sized proportions, but this time affecting one of the oldest and largest investment banks in the country. The total cost to JPMorgan Chase to buy this former financial powerhouse was only $236 million. Given that the Bear Stearns' fancy headquarters building alone was estimated to be worth about a billion dollars, this fire sale price indicates that Bear Stearns was in even more terrible shape than previously thought.
To understand what is going on here, we need to know that banks invest the money deposited in them to make money for themselves and their depositors. They do this by buying and selling securities of various types. But they are expected to keep a certain percentage of that money in cash to meet the routine demands of depositors who need to withdraw money for whatever reason. As long as not too many people want too much money at once, the banks are said to have sufficient 'liquidity' and the system works well. Even if the banks run out of cash, they can get short-term loans from the Fed or other banks using their securities as collateral. The interest on these loans is what is called the 'discount rate' and it is much less than the interest that we pay on loans. These kinds of loans are routinely done and are meant to ease any short-term liquidity problems.
But if there are suspicions that a bank is in trouble, that can lead to a stampede of depositors all demanding their money at the same time and we have a 'run' on the bank. If the banks cannot convert enough of their securities to cash or raise large enough loans, it can go bankrupt. This can happen even if a bank is perfectly sound. All it requires is a rumor of trouble to cause a run.
It was to prevent such problems that the FDIC system was set up. This said that whatever happened to a bank, the government would guarantee to reimburse depositors up $100,000 each. This was meant to reassure depositors so that they need not panic and withdraw their money suddenly. This is what possibly saved Countrywide Bank last year when it was discovered to have had huge losses by investing in subprime portfolios. I, for example, have an account at Countrywide but did not panic and ask for my money back when I heard the news of its troubles, precisely because of the guarantee.
In return for this government guarantee, the commercial banks have to submit to supervision by the government to make sure that they are not making too many risky investments, though we see in the case of Countrywide that the system is not foolproof.
But investment banks like Bear Stearns are not like the commercial banks ordinary people deal with. There are two kinds of investors in banks like Bear Stearns, those who buy shares in the bank and those who give the bank their money to manage. These banks are outside the FDIC system and the federal government has not previously assumed any responsibility for them or their depositors. Those banks are not like the ones where most ordinary people have accounts. These are meant for very wealthy investors for whom $100,000 is just pocket money. It is presumed that these wealthy depositors and investors are financially savvy people who are capable of evaluating for themselves the risks involved and do not need the government to protect their interests.
These investment banks can and do take much greater risks with their investments in return for much higher rates of return than we get on our checking and savings account. This is capitalism in theory, where there is supposed to be a correlation between risk and reward.
But the trouble was that Bear Stearns was one of the worst culprits causing the subprime mortgage debacle, underwriting many of the transactions and causing the inflation in values of those securities that had little relationship to the actual value of the properties. So when the party ended, they got stuck holding a lot of securities which they had paid high prices for and which were now worthless. When investors started suspecting that things were not going well and started trying to take out their money, Bear Stearns did not have the money and could not sell its securities to raise anywhere near enough money, and nobody would lend them money using those worthless securities as collateral.
Except the government. In an unprecedented move, the Federal Reserve decided that they would intervene to try and prop up, at least partially, Bear Stearns so that it did not go bankrupt by offering guarantees for loans given to it, essentially putting an artificial value on its securities. In essence, the government is using taxpayers' money to try and protect the wealthy financial interests associated with these investment banks. It is true that the people who held shares in Bear Stearns have lost money due to declining share prices but there is little the government can do about that. But by guaranteeing the value of the mortgage collateral, it bought those investors some time
So rather than seeing capitalism in practice what we have is capitalism in theory but a perverse socialism in practice, where the risk is borne by all taxpayers but the benefits in the form of profits accrue to just a few. All those people in government and business who preach financial discipline to the poor and say that people should be held accountable for their decisions, tend to conveniently change their tune when it is themselves or their friends who are affected.
I have shown this clip by British comedians John Bird and John Fortune before but I am showing it again because they describe precisely how we got into this mess and mention by name Bear Stearns and discuss the two funds owned by them that lie at the heart of their problems.
It is unnerving that two comedians in another country in October 2007 could finger the problem that is just now rocking the financial markets in the US.
Once again, I am not an economist so people who are more knowledgeable can chime in with corrections.
March 13, 2008
More on bubble economics
Dean Baker (co-director of the Center for Economic and Policy Research in Washington, DC) argues that the US is heading towards a recession, if not already in one, and he says that the main cause is the collapse of the housing bubble and not the spending on the Iraq war, though that is not helping either.
The villains in this story are the economists who somehow couldn't see an $8 trillion housing bubble, the banks that fueled the bubble with bad and often predatory loans, the regulatory institutions that did nothing to prevent the growth of the bubble and the spread of predatory loans, and most of all, Alan Greenspan and the Fed who blessed the whole thing.
We have to hold these folks responsible for their bubble economics. The best place to start would be to remove them from positions where they are still making economic policy.
On Tuesday, we saw the Federal Reserve decide to pump $200 billion into the financial system to try and alleviate the crisis and it sent stock prices soaring that day.
I didn't understand exactly what they did or how it was supposed to work because the news was reported in a very obscure way. Fortunately for people like me, in another article Baker explains clearly what is going on here and argues that the media is not characterizing this action for what it really is: a federal bailout of the banks that were partly responsible for this mess.
Can’t the media find any economists who don’t think that handing hundreds of billions of taxpayer dollars to the big banks and the incredibly rich people who own and manage them is a good idea? Apparently not, given the coverage so far to the Fed’s proposal to lend $200 billion to the banks using mortgage backed securities as collateral.
The workings of the Fed and the financial markets can appear complicated, so let’s simplify matters a bit to make it more clear what is going on here. Suppose that it was suddenly discovered that much of the wealth held by the country’s leading financial institutions was in fact counterfeit. Instead of having hundreds of billions of dollars of real currency in their vaults, institutions like Citigroup, Merrill Lynch, and Bears Stearns actually had hundreds of billions of dollars of counterfeit currency. Suppose further that the public did not know exactly who held what in terms of counterfeit currency, only that all of them had a lot of it. (The point here is that these banks hold mortgage backed securities, many of which are only worth a fraction of their face value, and therefore can be viewed as the equivalent of counterfeit currency.)
In such circumstances, investors would be very reluctant to accept the credit of any of the major financial institutions. They couldn’t know whether most of their assets were in fact counterfeit, and they were dealing with a bankrupt institution, or whether the counterfeit currency was only a limited share of the wealth, which would not jeopardize the institution’s ability to meet its obligations.
This is in fact the credit squeeze that we’ve have recently witnessed. The spread between the interest rates on a wide variety of assets and the interest rate on safe assets (U.S. government debt) has soared. As a result, the Fed’s effort to stimulate the economy, by lowering the federal funds rate, has been largely unsuccessful because other interest rates have remained high.
In response to this situation the Fed today announced that it would lend $200 billion to banks and other financial firms, accepting mortgage backed securities as collateral. This is effectively the same as saying that the Fed is going to lend money to banks and accept the counterfeit currency as collateral, treating it just as though it were real money.
The intended effect of this policy is to convince other investors that the counterfeit currency is in fact real currency, or at the very least that there is a really huge sucker out there (the Fed) which is prepared to treat the counterfeit currency as real currency.
So how does this story play out? Well, insofar as the Fed is successful, the counterfeit currency retains its value for a while longer. This allows Citigroup, Merrill Lynch, Bears Stearns and the rest of the big boys more time to dump their counterfeit currency on suckers who haven’t figured out how the game is played.
It is possible that they won’t be able to find enough suckers, in which case these banks will end up defaulting on their loans and the Fed (i.e. the government) has lost tens or hundreds of billions dollars paying good money for counterfeit currency. Alternatively, perhaps the big boys are successful and can offload enough of their counterfeit money to restore themselves to solvency before the music stops. Then the Fed is repaid, but the counterfeit money now sits in the hands of other, less informed, or less inside, investors.
You should really read the whole of this excellent article.
Baker shows how once again, we have the Federal Reserve colluding with the government to use taxpayer money to protect and enrich the wealthiest people in the country.
POST SCRIPT: The work of Satan
Almost everyone has had encounters with those annoying little plastic containers of milk that always seem to squirt onto your clothes when you try to open them. Stephen Fry and Hugh Laurie deal with this menace appropriately.
March 07, 2008
The phony Social Security crisis-4: What needs to be done
(For previous posts in this series, see here.)
While Social Security is not in a crisis, it does require periodic adjustments to make it work, as the economy and demographics of the population change. It can be made solvent with minor tinkering at the edges such as removing entirely the cap on payroll tax income or increasing the rate of taxation by small amounts or by lowering the annual cost-of-living increases in benefits or, in the worst case, by slightly reducing the benefits. We are not facing the catastrophe the doomsayers predict.
The major problem with Social Security is not with the retirement benefits part but with rapidly rising Medicare costs. Currently the Social Security tax (the part that goes towards retirement benefits) is 12.4% of income up to the cap, which is $102,000 for 2008. The tax rate for Medicare is 2.9% of your gross income. Your employer pays half of this 15.3% total, unless you are self-employed in which case you are responsible for the entire amount.
It is the Medicare costs that are already outstripping Medicare revenues and rising rapidly, and thus straining the government's finances. But this is largely a health care costs problem, caused by the hugely wasteful profit-making health system that currently exists in the US that has resulted in per capita costs that are at least twice as much as the costs in other developed countries and yet produces worse results. Introducing a single-payer system like that which exists in France or Canada would result in savings, greater ability to control costs, and better health care overall. (See the series of posts on health care where these arguments are presented in more detail.)
As far as Social Security is concerned, one thing that could and should be done immediately is to remove the cap on incomes that are taxed for Social Security. The existence of this cap means that people earning more than that pay no Social Security taxes at all on the extra income, and thus pay a smaller proportion of their total income into Social Security than those making less than the cap. Thus the richer you are, the smaller the fraction of your income that goes towards Soc