The Crooked Deals That Made This Financial Meltdown Inevitable

Posted by Stirling Newberry, Firedoglake at 3:25 AM on September 24, 2008.

Almost every weekend for the last month, there has been an extra-ordinary announcement from the financial world and the White House. The financial system is rattling apart, and while the poor card player may blame his cards, the expert knows when there has been a crooked deal.


From nationalizing the mortgage market by taking over Freddie Mac and Fannie Mae, to the bankruptcy of Lehman brothers, to the demand that Congress write a bottomless blank check to Secretary of the Treasury Hank Paulson to bail out the investment bank he once ran, and others like it. But in this whirlwind there has been almost no explanation of why there is a sudden rush to do something.


Here's an overview of how this happened.


Lack of Investment Supply

Last October certain mortgage lenders with very risky strategies began having problems collecting on the mortgages they made. Many of them were sold to people who had hoped to buy a house with nothing down, use sweat equity to improve it, and sell it at a huge profit quickly. When the houses sat, they dumped or even walked away. Normally this would be a tiny sliver of the market, but the only difference between the most aggressive of flippers, and the rest of the housing market, is that the flippers were late to the party. The major home builders had been putting up houses at a fantastic rate. However, the American boom was not much different than the global housing boom. Prices for homes shot up in Europe and China, and by similar amounts when adjusted for currency. Very little is good or evil in itself, but more as we make of it. The global housing bubble turned to global housing slump rapidly because the world had been building too many houses. Even before 2007 was over home prices decline for the first time in the post-WWII era. However, the market had, in fact, peaked in mid 2005.



The as yet undeclared recession of late 2007 early 2008 made this spiral: For the first time since the end of the Second World War, Americans owed more on houses than they had equity. As a whole Americans are "upside down."



But it was not merely a home bust which created this great and growing wave of crisis, but the fundamentals of the economy itself. Fundamentals that reach down into the decision to go to war in Iraq. In 2002, by not shaving down Bush's majorities in two houses of Congress, Americans decided they wanted an economy based on building houses here, blowing them up in Iraq, and creating a vast web of paper tied to the bet that Iraq would be a resounding success, oil would plunge, and we could sprawl out farther and farther for ever.


Even as the world hated George W. Bush, it bet heavily that he would work out.


The underlying problem then, is not the housing bust, since that could be dealt with by a relatively modest FDIC bail out of banks and changes to Freddie and Fannie, nor even the wall of paper that was created, since that could be dealt with by cleaning up a few toxic funds. It is that the very basic bet of the economy was wrong.


The very bet was that war and debt were all that was needed to grow for ever. Because every cent was being poured either into the war, or houses, or into gambling double and triple that these would expand forever, there was no money for anything else. The root evil was that, on one hand, Greenspan ran interest rates at unsustainably low levels, and on the other hand, the free market fundamentalism of the age allowed these to be turned into a riot of consumption. We had a war, with war time spending, and without wartime austerity. It is mistakes like this that brought down the French Monarchy, among other regimes with delusions of grandeur.


Because of this, the wall of paper was created: there was a lack of investment supply. Investment demand is money looking for returns. Every time someone buys a stock, or bond, the are creating investment demand. Investment supply are businesses that can pay the cost of money. It was a vicious circle: the more money flooded into home building and buying, the less there was for anything else. And homes in the US had a magical property, behind the mortgages and the banks, stood an implied bail out by the US government, which meant the citizens and residents of the US.


What made this wall of paper dangerous was that it was backed by the housing stock of the US, which, in turn, is the basis for banks to be able to issue new loans. Very directly, the amount of money that can be created by the United States, is tied to the assets on the books of banks, and several trillion dollars of that, is home equity. With more loaned out on homes, than could be gotten from homes, even at inflated prices, the financial system was tap dancing on a land mine.



Too Big to Fail.


'Too Big to Fail' will be the new order of the day. And guess who gets left holding the bag when they're too big to fail? One of these monsters goes down, and it will cost as much as the whole S&L debacle.


Molly Ivins October 26, 1999


(Hat tip to Karina Newton for finding this one.)


The root cause of the problem was not, then the deregulation or wall of paper, it was the fundamental corruption of the American economic system. Deregulation and mortgage backed securities, were merely the murder weapon. In the 1990's it had been setting up fake markets and using financial theory to exploit leverage between government bonds and corporate bonds. In the 1980's it was profits from an oil boom coupled with high interest rates through unregulated Saving's and Loans, which had been, you guessed it deregulated by a partial repeal of Glass-Steagall provisions.. Obvious the S&L crisis taught Wall Street that if you want to rob a bank, the best way is to get Congress to deregulate the bank.


Whenever people want a casino, they find someplace, preferably someplace considered stodgy, to set it up. Until Enron, utility stocks were considered best for little old ladies. Until Silverado, a Savings and Loan was the place were ordinary people borrowed enough money to build a small house. Until this wave of paper, consumer home mortgages were not the exciting place to be in banking. Regulations are taken off the books, and ones that are on the books are ignored. During the Reagan Era the thrift regulators were starved of staff and funds, and by the time they got them, the chain reaction which would blow up into the crisis, had already started. In this decade, capital cushions were routinely over stated.


We not only had bad laws, we enforced the ones we had badly. But this is because we badly wanted the money.



The truck that all of this was driven through was the repeal of the provisions of the same Depression Era law, namely the Second Glass-Steagall Act. Even at the time it was regarded as a mistake. It might even be a general principle that whenever someone decides to repeal a banking provision from the Great Depression, they may end up causing one.


The too big to fail principle coupled with the no rules, just riches attitude of the time, a loaded gun. But for a crime you need to prove means, motive, and opportunity. If deregulation was the means, and the Iraq War was the opportunity, what is the motive for pulling the trigger now on a plan to create a Federal program that is larger than the Department of Defense?


The sad story of the Savings and Loans, where a Democratic President and Congress start a chain of deregulation which, under a Republican President, becomes a license to open a casino with the public's money, has been repeated now on a vastly larger scale.


Even 60 years later, the specter of the Great Crash still looms over us. Like the 1980s, the 1920s were a time of impressive economic performance in many ways, marred by unstable financial markets. And in spite of the many unresolved debates over what really caused the Great Depression, it still seems clear that in the end financial instability undermined the real economy. Certainly anyone today who dismisses financial events with the assertion that the economy is “fundamentally sound’ is aware of the slightly hollow echo of that remark, no matter how reasonable it may be.


Paul Krugman, Financial Crises in the International Economy , 1989


There is a remarkable amount of parallel between the savings and loan crisis and the present one. Deregulation by an outgoing Democratic president seized on by a Republican president to throw open the gates to speculation, regulators hamstrung or under funded, and then a bust followed by a bail out. Even many of the actors are the same: Steny Hoyer and Chuck Schumer both co-sponsored one of the deregulation bills, and Alan Greenspan, who set rates a generation lows in this crisis, assumed the Fed chairmanship.


A great many words were written, and many laws were passed, to avoid the same thing from happening again. Obviously, whatever was done, was not enough. The same pattern: of complex financial instruments built on top of the safe haven of housing, has led to the same place. In recent years we have remade cheap television shows as screen blockbusters at 10 times the price. This, has happened here.



E. Gerald Corrigan's words printed in a 1989 NBER report seem oracular: he argued then that with complex instruments, even sophisticated investors would not be able to price them, let alone ordinary investors. It is interesting to look at the contributors to that report: Krugman, Summers, Feldstein, and Volcker are front and center today as well. The conclusion? That the risks of financial crisis are real, and that they can unravel even seemingly placid economies if met with the wrong policies.


This then is the general background: the objective of the whole Crooked Deal, was to turn ultra-low and safe interest rates, into highly speculative instruments, which could be traded with the belief that while they paid as if they were high risk, the risk would only come true of everything came crashing down, and at that point there would be a bail out. This is "lack of moral hazard" as Kenneth Arrow called it. But what turned the Crooked Deal into a house of cards on fire, was a series of triggers and missteps.


What set the stage, then, was an economy that did not have a really high powered sector of growth, but, instead, was suspended waiting for the flood of cheap oil promised in Iraq. The great financial houses shuffed a deck of crooked cards, and used the very low interest rates to fund building them high up into the stratosphere. Even such laws as were on the books, were ignored. Instead of cutting this off when it had peaked in 2005, a deliberate decision was made to let the economy run hot. Into this dangerous situation came Ben Bernanke as Fed Chairman, and Hank Paulson as Treasury Secretary, and a new Congressional majority that had little memory of how to deal with a lame duck opposition President effectively.

Tagged as: economy, financial crisis, economic meltdown