One key part of what drove all of this was the need to make the banking sector a way that oil profits could be repackaged for Arab investors. Essentially, they sold us oil, and took paper that gave them control over our companies and economy. The "Red Queen’s Race" was to make it so that control was just out of reach. Thus, consolidation. Another incentive was "development arbitrage." Development arbitrage is buying up the assets of an undeveloped or developing country, and then holding them as they appreciate. Much of the neo-liberal trade order was, effectively, about forcing open capital markets in countries without enough liquidity. Which is how we got the story of John Perkins being an economic hit man. Globalization was not about free trade, or any economic theory, but about the raw ability to buy low, and sell high.
However, all games come to an end, and the house of cards that was the paper for oil economy under George W. Bush started to come to an unraveled almost as soon as he was reelected.
Greenspan’s Last Bubble
That there will be a recession that ends an economic expansion is a metaphysical certainty. The question is always, when? When is the growth that an expansion is giving not worth the pressure on limited resources that it is causing. There is no settled answer. For some the answer is always at the last possible moment, that recessions are bad, and growth is good, so always growth. However, enough expansions have collapsed into deep recessions, or blown up into severe inflation, that it is hard to sustain this line of argument. Another pragmatic argument is to get the recession out of the way early in a government’s mandate, giving it as much time as possible to turn things around. Another view is that central banks should announce their target rate of inflation, and stick to it, economic consequences to growth be damned.
2005 was the year that this question came to the fore. Clearly the underlying inflationary pressures from oil were there, and the economy was running on war time spending. An examination of GDP and employment showed, clearly, that housing, health care, and Iraq were the areas of growth, and the rest of the economy was virtually idling. Had Greenspan been of Volcker’s mettle, he might well have started a recession that would have hit in 2005-2006, the last year of the bubble of housing would not have happened, and, as importantly, the attempts to turn dross into gold would not have happened. It would have, however, wrecked any delusions of grandeur in Iraq. Greenspan did not, or could not, take a strong stance.
In August of that year, a storm whose name is legend, Katrina, swept through the gulf, and we tasted just how close to disaster the economy was. Instead, Greenspan left floating on accolades, and leaving the economy in a position where real inflation was running far too high, and an untested hack, Ben Bernanke, was put in charge. Even then it was clear that Greenspan left behind a bubble in the housing market that when coupled with other fundamental facts presented a grave danger to the economy. Let it not be said that "no one saw this coming." Instead, there was a virtual cottage industry devoted to critiquing it.
The Adventures of Captain Carnage, former Helicopter Pilot
Despite all of the praise heaped on Ben Bernanke from left and right as an economist expert in monetary policy ideas, he had gotten to his place by being personally affable, and compliant to George W. Bush in the matter of the massive revenue reductions, and in not imposing austerity economically to rein in the deficit during the war. It should have been a warning to those who praised him that he had, at least, been complicit in a very questionable economic program, and had signed off on it. Whether this was out of lack of integrity, as it was with Mankiw, or lack of grounding in reality, as it was with Powell, should not have made much difference.
My own view in 2001 once he was appointed as economic advisor to the President was that he would be the Federal Reserve Chief after Greenspan. His theories on the Great Depression made it very clear that his role was to prevent a bail out from creating a moment where financial elites would have to go hat in hand to the public, and accept regulation, or worse, from a liberal government.
In early 2006 Greenspan left the Chairmanship of the Federal Reserve, and in his place is the man who may well be known to history as Captain Carnage. Once ascending to the pinnacle of central banking power, Ben Bernanke’s fed behaved, as the old joke runs, like a group of highly motivated snails. There was talk of transperancy, targets, changes in communication. And four tiny quarter point rate increases, rounding out the incrementalist program that started June 30th of 2004. The sorry story is here.
This program of slow rate increases was the worst possible idea. It neither cut off the speculative excess, nor buffered the budget. It allowed continued bombardment of consumers with wave after wave of enticement to buy now with "rates at historical lows." The mortage industrial complex, as I heard one banker call it, stopped at little to nothing to push people into homes that were over-priced, with mortgages that were half baked. The paper from these mortgages was then, as Nouriel Roubini acidly commented, packaged for Arabic consumption.
It isn’t that there hadn’t been a barrage of criticism, but some how, it did not get through to policy makers in Congress, or the public, that the Federal Reserve was behaving more like an arm of the Republican National Committee than an independent agency. This was made worse by the horribly butchery of the yield curve by the Treasury Secretary John Snow. Snow was in turn replaced by Henry "Hank" Paulson, who had a reputation for being far more open minded on issues which, ordinarily, the Republican Party was closed minded on. This, in retrospect, looks a great deal like being the best hockey player in Bangladesh.
But Ben Bernanke, while his feeble lurches at openness, and his interest rate policies were poor, was a disaster at precisely the thing that had made Greenspan "the maestro," namely in handling the operation of the Federal Reserve and getting others to adhere to his policy targets. One useful exercise is to look at the spread between LIBOR, that is the rate banks actually lend to each other, and the Fed’s target rate. By this and other measures, the Bernanke led Fed has often been behind the curve and out of control of interest rate policy. Leaving aside matters of theory, political preference, business cycle analysis, and communication, this is, quote LaGuardia, an issue of there being "no Republican or Democratic way to pick up the garbage."
However, the other major responsibility of the Federal Reserve is to regulate a large number of institutions and transactions. Here Greenspan’s record had not been good, and Bernanke’s was even worse. The problem isn’t just that banking had been deregulated, it had been de-regulatored. And if that was not enough, more and more money was pushed into the world of "shadow banking."
Shadow banking is really very simple, it is based on the theory that if you want to break the law, find legal ways to do it. Instead of having money in regulated in financial institutions, with the insurance that comes with, it involves doing business in instruments backed by mortgages, sovereign debt, and assorted other "too good to fail" assets, and then leveraging them up to stratospheric levels, while making inflated claims about their stability.
We can call this process "leverage laundering." The idea is to take risky and arcane financial instruments, which should exist to serve relatively specific markets, and launder them back into the ordinary banking and investment system as investment grade paper that can be widely purchased. It was to prevent exactly such behavior that the Securites and Exchange Commission was created. Indeed one can point to the South Sea Bubble mania and every one that came after it for examples of how in times of both easy credit and lax enforcement, there have been people who have sold paper pyramids as if they were made of gold.
Thus with each month, each day, that Bernanke both let rates alone, and did not constrict the flood of leverage laundering, something that could have been done with a wave of the regulatory pen, the conditions for an economic collapse grew more likely. Many of the instruments were based on sound math, but applied so thickly that the entire point was to confuse even sophisticated buyers, as has happened before. There was outright fraud ever step along the chain.
Home buyers were quoted and sold inflated prices of homes, based on the price of homes that had not yet even sold. Mortgage qualifications were falsified. Once mortgages were fed into the system of being sliced up, their characteristics were altered. For example, a mortgage with a low risk of default might have been labeled a high default risk, if the borrower had a great deal of equity, even though, in reality, if that borrow were actually to default, it would have meant a general economic collapse. Conversely, mortgages with high rates of failure were presented as being bullet proof.
This was then tied together by an instrument known as the "Credit Default Swap." The CDS looks, on the surface, like an insurance policy for a loan. The buyer of a CDS holds some debt to a third party. The seller takes payments from them, and agrees to pay the difference between the value of the debt if there is a "credit event," such as a default or a debt downgrade, and a market price. So for example, let’s say a bank buys some bonds in Argentina, and then buys a CDS that agrees to pay if Argentina goes into default. The seller of the CDS gets paid periodically, and agrees to take the bonds if Argentina defaults, and pay the bank the difference between the market value of those bonds when default happens, and some agreed on price.
In itself, a CDS is a hedge, and looks like any other hedge. However, because CDS instruments are not regulated, they can be used as ways of getting around margin requirements, as ways of simply speculating, or, in many cases, as a way of engaging in "information arbitrage." For example, let’s say a private equity firm sells a CDS in the "event of a default." But they know that the security they are selling the CDS on will be dissolved if it is downgraded, because it is highly leveraged. They then turn around and buy a CDS "in the event of a downgrade." Since a downgrade looks less risky than a default, the difference between the risk they appeared to take on, and the risk they appeared to sell, is a pure profit.
As a result of manipulations like this, CDS’s exploded into trillions of dollars. Now many of these will expire without anything happening, and many are offsetting bets, like at a race track the winners pay off the losers, plus a cut for the track. However, that is only if the whole system stays in balance. If, however, there are events that throw this out of balance, such as the discovery of fraud where there should not have been any, the system becomes unstable. That’s the problem with almost any unregulated system of finance: it seems to work extremely well, as long as everything is going extremely well.
This then was the combination of events: an economy without underlying truly profitable activity that was dependent on debt and development arbitrage for much of its profits. A tax system which forced vast volumes of money upwards, and consolidated, in order to keep assets in US hands. A period of unsustainably low interest rates, without corresponding rationing or other mechanisms to prevent abuse of this credit, a central banker who was more ideological hack than cool headed analyst, a system of deregulated, and unregulated, pyramiding of leverage, outright fraud in both the underlying assets and in their repackaging, and, essentially, an implicit assurance from the highest levels that all of this would be cleaned up in the event of a collapse.
This, combined with a set of mathematical models which priced instruments in that never never land of perfect information, allowed entities to hide real difference in basis, that is the difference between what the price is in theory, and what it could actually be sold for. With each level of leverage, these small, but real, differences pile up, until they are larger than the value of the underlying mortgages.
Take together, these elements: too much money at the top to be sustained by too little economic activity at the bottom, ideological blindness, and pervasive criminality in the very fabric of the shadow markets, constitute "The Crooked Deal" that Bush offered America in his second term.
The chain reaction that was in place was tax advantaged overpriced homes, bought with excessively cheap money, packaged into fraudulent mortgages, sold on the secondary market away from all ability to track them, sliced into leveraged instruments, and then "insured" with speculative CDS’s, and bundled together with an unwritten insurance policy backed by the First National Bank of Bernanke, was the powder keg. That this whole system funded consumption which became oil inflation, and hence undercut the value of the houses, because houses in suburbia cannot be going up in price, at the same time that jobs are hard to find, wages are stagnant, and gasoline is going up, was the spark. In 2004 I called this "The Bush Bomb," where the consumption driven inflation would undercut the very paper being sold to buy the oil.
The Collapse of the Crooked Deal
With these elements in place: ideological devotion to a "mandate from God," as activist Sara Robinson accused Bush of believing in, a pyramid of debt fueled leverage, an ineffectual central banker, and a carnival of corruption that had infected the investment grade credit markets, the question was when, not if, there would be an implosion.
That explosion began even as the bubble seemed like it was still near its peak. While the nominal peak of the bubble in houses was in June of 2005, in fact there had been several flat months. The Crooked Deal, like all pyramid schemes, requires a constant input of fresh meat. People bought homes as if there would be a limited supply, even as builders stamped them out like cookie cutters.
With this, the tremors began to ripple through the system, and then Katrina hit, exposing how fragile the global balance of energy supply and demand was. Realize that the US had bet a trillion dollars on the proposition that an invaded and occupied Iraq would produce 2 million barrels a day more than Saddam’s Iraq could be allowed to produce. Since that oil was not on line, when Katrina, and then Rita and Wilma , ripped through the gulf, it sent a shock of price increases. The Fed was in a bind, it could neither drop rates quickly to aid reconstruction, nor raise them sharply to contain inflation. Instead the situation was allowed to twist in the wind, with people throwing good money after bad.
In early 2007 the dominoes began falling, wherever economic activity was sparse, particularly in far flung areas with high unemployment that had attracted speculation, from the outer reaches of main, to the central valley of California and it’s desert kingdom, default rates spiked. The right wing may spew racist garbage through Rush Limbaugh’s microphone, but many of the worst hit counties have racial compositions in excess of 98% white. The unifying factor were parts of the economy parched for real economic activity, not the race of the borrowers.
In August of 2007 a nervous banking industry spiked interbank lending rates. The Fed cut rates, and in early September said that the credit crisis is contained. This was not the prevailing view among those who had been critical of the policies to this point in time, and instead predictions came forward that this was going to continue to snowball. Congress did not act. The Fed acted feebly, and the White House seethed with idle gestures.
However, prudent investment advice was already laying out how the inept management of regulation, the euphoric leverage rates, and use of piled instruments created a crisis that resembled Long Term Capital Management. Money week predicted the collapse of Bear Stearns in September of 2007, and other observers believed it would be only the first. However, policy makers, did nothing.
Only a month after it promised a contained credit crisis, the Fed backpedaled: Korszner admitted on October 22nd, 2007, that the crisis was on going. In a manner typical of the blame everyone but themselves, the argued that investors should not have trusted the credit rating agencies. Sure, Randall, we are all going to go fly out to Boca Raton and see the ranch house that makes up .00001% of our CDO.
In November of that year the first of a series of ill fated bail out attempts began, this one led by Citigroup, Bank of America, and JP Morgan Chase, and run by BlackRock the Merril Lynch associated investment firm. On the 21st of November the announced a 75 Billion dollar fund to deal with CDOs that were devaluing because of the sub-prime mortgage crisis. The Treasury backed this effort, and gave promises that it would buy troubles assets. However, it was far too late, as these had been collapsing since July of 2007. So the mortgages infected the CDOs, and it was only a matter of time before this hit the Credit Default Swaps.
As the American Prospect noted at the time, the best that Bush could offer was a "voluntary" rate freeze which was not put into effect. Without the ability to compel lenders to join, what lender would want to unilaterally cut their profits?
The chain reaction of financial entities without reserves was touched off. Mortage underwriters, who did not keep the loans, and so had no assets to protect even the smallest cut in their ability to offload mortgages, failed. Their failures meant the loans were acquired, and the rates raised. The homeowners were foreclosed upon. The mortgages became non-performing. This meant that the Collateralized Debt Obligations built on top of them had to be downgraded. Once downgraded they invoked CDS clauses, the people who had written these, assuming them to be free money, defaulted on their obligations, which in turn caused other CDS agreements to be defaulted on. The banks holding the original instruments were then stuck. If they admitted that they had un-hedged instruments, and wrote them off, they would be insolvent, but if the held them at a face value which was completely fictional, they could not make new loans. Thus many of them proceeded to write new derivatives, piling up another layer of CDS on top of the old ones, hoping that a new credit event would allow them to recoup some fraction of what they held, or they agreed with other CDS holders to simply not enforce each other’s bad debts.
Thus most of them decided to not make new loans. But this credit contraction meant that more people fell into default, ARMs were adjusted upwards even more, and another round of toxic waste was created. The number of CDS’s doubled, even as the credit market was collapsing.
Finally the Fed got serious about easing liquidity and cutting rates. Overnight interbank rates dropped, and again at the beginning of the year, again, pronouncements were made that the worst was past. But as with the ARM crisis being looked at only after it had infected CDOs, the CDO crisis had only been contained once it was burning in the world of CDS instruments. But by injecting liquidity, it created investment demand, without investment supply. Money fled for commodities, driving food and oil higher. This only put more downward pressure on the underlying housing stock, and therefore deepened the loses at Freddie Mac, Fannie Mae, the investment banks that held the CDOs, and AIG which reinsured the financial glue.
Even as its demise was obvious in August of 2007, Bear Stearns was allowed to continue functioning, spewing more toxic instruments into the financial system. Since there was no tomorrow for the Bear, they had no reason to look at the worst case scenario, they were already facing the end of their world as they knew it. Finally in March of 2008 S&P downgraded them to BBB.
This downgrade made the Bear radioactive, a deal with Chinese money involved was pulled, and with the backing of Fed Chairman Bernanke, and Treasury Secretary Paulson, Bear Stearns was absorbed in a dramatic weekend of negotiations. It was the first of many long weekends. and not the first such swan dive in value.
The situation at that moment was pregnant. It was clear to many observers that that was the time to act, and restructure the credit system. It was time to fire Ben Bernanke. Instead, Bernanke went on a campaign of using his "unusual measures" to prop up a series of deals to allow failed leverage laundering to be absorbed into other banks. The result, bad banks made good banks toxic. Even as Bear Stearns fell, Lehman
However, the financial meltdown was not happening in isolation. Failure is a team effort, and the fiscal authority, that is Congress and the President, did their best to pour gasoline on the fire. What they did was pass the worst stimulus possible in the history of stimulus. On one hand they handed Bush another blank check on Iraq, without being attached to any austerity measures here at home. On the other they passed a Reaganite stimulus bill, on the theory that government is a piggy bank for "tax payers," when, in fact, government is the savings account for the commonwealth. The sum of these two bills, when added to Bernanke’s liquidity campaign, was a recipe for a roaring bout of energy inflation.
Oil prices shattered 100 dollars a barrel on the spot market, 110, 120. The average price per barrel climbed over 100, and then 120. And it peaked at 130 dollars a barrel. Bernanke was taken out of the chair, and Paulson was put in charge. Monetary magic was out, Wall Street wiles were in.
A swift and sudden collapse
During this time, the Treasury, the Congress, and the Fed, stood pat. While the Congress took time out to gut the constitution a bit more, the executive branch offered soothing words on inflation. It was broadly accepted in the financial world that there would be recession in the US. The housing bubble continued to erode in Europe, but while important banks failed, there was no cascading collapse. A complacency descended on the political debate, and the two candidates, as often happened, began to sound more and more alike.
All of this came to an abrupt end with the collapse of the two lending giants, wiping out their share holders, many of whom were banks or ordinary retail investors. Predictions that this would be only the next bump down the stairs were almost immediate.
The precipitating event was not the massive losses, which had been going on for some time, but the on going revelations of accounting irregularities in their portfolio of derivatives. But this too was old news, Fannie Mae’s record of funny numbers
Now banks don’t have all the money people put in them, instead they keep a reserve and loan out the rest. If they fall below the reserve levels they need, they can borrow from each other, and some can borrow directly from the Federal Reserve. This helps keep the banking system on an even keel: there is an incentive not to fall below the minimum, lest borrowing be needed, and an incentive to not go too much above it, lest too much sit around doing nothing.
If banks will not lend to each other, then central banks must step in, and they have. The US Federal Reserve offered dollar swaps, in essence buying currency without any fees, in order to make sure that banks around the world could loan. However, even with these steps panic began. Interbank lending slowed, money which would otherwise have gone to interbank lending poured into short treasuries. On the 15th, the 1 month Treasury dropped a full percentage point of yield, from 1.37% to ..36%, and the flood continued, by Wednesday the 3 month Treasury had a constant maturity yield, of just .03%. The next dayinterbank lending froze solid on 19-September-2008. Central banks began lending to stem the flood.
So if you want to know why everyone is saying "something needs to be done," it is because of this: the global banking system is not paralyzed, but it is running at a snail’s pace, and if it does not resume, the fear is that the crisis will become a catastrophe. The acute problem is that banks are not willing to lend to each other.
Panic Produces the Paulson Proposal
The root cause of the panic: last week, banks stopped lending to each other overnight, with the bench mark "LIBOR" or London Inter-Bank Offer Rate peaking at 10%, and remaining at very high levels of 3.7%. To give you an idea of what this means, the Federal Reserve target is 2% for overnight lending. Making matters worse, the LIBOR is a benchmark rate, with many other rates pegged to it. In effect, banks are pushing interest rates higher, and central banks have lost control of the banking lending rate. However, the acute spike of this has passed, and while it is unpleasant for Central Banks to provide liquidity like this, it is by no means fatal.
The problem is that the money they are flooding the system with is going directly to commodities and, especially, oil. There is an antagonistic relationship between housing in the US and oil prices: the higher oil goes, the more pressure on housing.
This see-saw has been one of the problems in solving the crisis. Central banks can make money easier to get, or harder to get. In our case, if they make money easier to get so that it is easier to bail out banks and for consumers to get loans, they make oil more expensive, and make more money disappear down the corrupt holes that riddle the body economic. If the make it harder to get to push down oil, they collapse lending and the fragile state of the economy. Catch –22. The reason the banking system is bleeding out, is that it has oil for blood, and the shrapnel of a wild west lawless boom ripping apart the integrity of the system.
However, the public is already turning against a mega-bailout approach, with costs spiraling up into the stratosphere, and no clear plan as to how this 700 billion dollar account, with virtually unlimited drawing power on the Treasury, will do anything more than be the next bucket of money dumped on a towering inferno. It is a "let them eat cake" moment.
Behind the scenes a series of inter-connected deals were woven last week, which included Japan’s Mitsubishi Bank buying as much as 20% of Morgan Stanley., as well as the two remaining investment banks becoming regular bank holding companies.
Internationally the response was rather mixed. On one hand Finance ministers "welcomed" the plan, on the other hand, major leaders stated that they would not engage in similar bail out plans themselves. This can be translated as "we will take any free money you are handing out, thank you."
The Paulson Proposal was more than sweeping, it was, virtually a grant of unlimited power to buy or alter the financial landscape, and to dispose of assets without review or reference to any other entity. In return Senator Dodd send back a bill which modified many of the most egregious points, but left in tact the idea that a vast expenditure of money would be needed. Dodd bent, but did not break, on key provisions. But in all these were not enough to mollify a public, or even many Congress members, who were in an increasingly ugly mood at the high handed way they were treated.
The public has rapidly turned against the entire bail out concept, and in truth the problem is that Paulson is trying to "catch a falling knife," and keep prices supported at a level far above what the market for them would clear for.
However, the evidence indicates that the panic is unfounded at the scale it is being sold. While there is indeed a large systematic problem, simply put, there was a system that could print unlimited amounts of money which had claims on limited amounts of oil and houses, and there is clearly a constitutional problem in that for years this was not merely ignored but encouraged, there is no evidence macroëconomically that this bail out will either solve these problems, or buy enough time to be worth it.
What is wrong
There are a few simple problems.
• Overleveraging based on easy monetary policy. This is the simplest to explain, people were allowed to borrow money without enough assets. They did this by avoiding the regulated banking and securities sectors. The first step to almost every financial scheme, is a supply of money that is priced less than the underlying economy can support.
• Pyramiding – the second step of almost every financial crisis, is the ability to treat gains on a heavily leveraged investment as if they were real gains. This was called "pyramiding profits" in the days before the SEC, when only 10% was enough to buy stock on the margin.
• Information Arbitrage – the third step in almost every financial crisis is fraud, with holding of information, and using complexity to hide assumptions where they cannot easily be discovered.
• Contagion – This is the laundering of leverage back into the investment grade system, so that instead of gamblers at the casino playing the people who are stuck with the risk are ordinary tax payers.
• Delinkage – An uncoupling of how the financial world works from basic public policy and good. Finance exists to create the ability for people with ideas and plans to gain access to enough resources to execute them. Bad fiscal and economic policy is as instrumental to this as anything else. While it is easy to blame the bankers, the games they played were created by monetary and fiscal policy.
While regulation can address specific abuses, the reality is that it is the shadow banking system’s purpose to allow people to do things that we wanted them to do. The regular economy has not delivered real productivity. People still want to get rich, and so they create casinos when they cannot create enterprises. To solve the crisis, the linkage between liquidity and oil prices must be broken, or each attempt to "bail out" the system, will simply be another spin of the wheel for energy inflation.
The solutions? I can say clearly that the proposals in front of Congress right now do not provide a solution, and they are both bad politics and bad strategy. Why should banks negotiate or accept regulation or taxation, if they already have access to an unlimited fund? The public, hurting from a decade where they have not seen their wages rise, and where they have now seen their chance at making money from the land casino ended, is also in no mood for this. All that is left is the threat of a financial meltdown, which will probably be found right next to Saddam’s mushroom cloud, and a few doors down from the group at the Pentagon that has a secret plan to capture Osama bin Laden.
In short, the best thing the public can do, is tell Congress to shoot this turkey and start from scratch. The markets have not collapsed, nor are they in danger of taking down the economy with them. There is a recession coming anyway, one that has been predicted by almost every major source of economic analysis. And there will be plenty of time to provide monetary or fiscal stimulus in the event of a deepening down turn. However, this effort to prevent the Crash of 1929, is quixotic, ill founded, and unsupported by theory or practice. In 2002 Bush told us there were WMD in Iraq, when there was no credible evidence of anything resembling credible evidence of an advance WMD program. Tonight he will ask America for more money than funds the Department of Defense in order to engage in a project equally questionable.
Today’s crisis is the interbank lending, the solution is not a massive bailout, but to break the liquidity oil linkage, and to put a wider umbrella over the financial system.
(You can read part one of this 2 part series here.)