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Financialization and the Economic Crisis

by Betsy Bowman, Ph.D., Research Associate, Global Justice Center
February 2009

Since last fall, I’ve been trying to figure out how did so much debt pile up?  We don ‘t have a liquidity crisis but rather a debt crisis.  There is so much more debt than underlying value, the situation is unsustainable.

After all, debt has some connection to the real economy.  Debt is used for financing investment; consequently, there is some correlation between the amount of debt and productive accumulation, the building  or development of something – a factory, farm, service -- that will make something that can be sold.   Financing production-driven accumulation – when value is added by something being made by human beings – this is a healthy use of debt.  But when accumulation is driven by debt rather than production, ultimately there is a crisis.   Debt does not create new value; only human labor does.  It is important to keep in mind that all of these debt instruments have created nothing – not a single pencil, paperclip, or pair of socks. 

NEW WALL STREET SYSTEM

Over the last quarter century, since the mid 1980s (since Ronald Reagan), the structure and dynamics of Wall Street banking have changed.

Investment banks used to have stock brokers who bought and sold stocks and bonds -- – pieces of paper showing ownership --for their clients.  But for the last 20 or so years, brokers in investment banks have been buying and selling financial instruments for the benefit of the investment bank itself. This is called the “lender-trader” model. Peter Gowan, in an article entitled “Crisis in the Heartland” in New Left Review, 55, Jan/Feb ’09, explains what he calls the New Wall Street System. That’s how Henry Paulson, the former CEO of Goldman Sachs and formerly the Treasury Secretary made $500 million in his years at Goldman Sachs.  That’s how another guy named Paulson  that David Schweickart tells us about  made $3.7 billion in 2007 alone.

FINANCIAL INNOVATION AND SECURITIZATION

New financial instruments were invented.  They have nothing to do with creating more value, thet are simply more ways of shuffling pieces of paper that indicate ownership that is attached to an income stream of interest payments.   We’ve heard these names before – mortgage backed security, collateralized debt obligation, derivatives. 

These new forms of engineered debt – touted as financial innovation – have transformed the process through which banks supply credit.   In the old days, “banks issued credits that created both a liability on their own accounts and an illiquid interest-bearing asset held in the bank’s own portfolio.”  Under the New Wall Streeet System, “banks issue loans and then sell these assets into the secondary loan market or capital markets where they are aggregated into large pools and are used to create new classes of yield-bearing financial assets.”  (Gowan, 2009)  “Securitization” refers to this process of transforming formerly illiquid loans held in the banks own portfolios into marketable/negotiable assets traded on secondary bond markets. 

Retail banks – there are five main banks which hold primary responsibility for pushing millions of mortgages and subprime mortgages on consumers – HSBC, JPMorgan Chase, Citigroup, Wachovia and Bank of America.  These banks were actively involved in advertising home equity loans,  mortgages and second mortgages.  Citigroup in the 1990s had a billion dollar advertising campaign promoting “Live Richly” trying to seduce people into borrowing money. 

When a retail bank makes a loan, instead of holding it in its own portfolio, the bank sells the loan to Freddie Mac, Fannie Mae or Wall Street investment banks.  Buyers of these loans then put them together into large pools and “issue a type of bond known as a mortgage-back security (MBS) whose yield is suported by the pass-through of payments of interest and principal from the underlying pool of mortgage debt.”  (Gowan, 2009)

To you or me this might seem like alchemy, but as Karl Beitel in Monthly Review, (60:1, 27-44) explains it:  “Only a few years prior these exotic financial products were being touted for their ability to hedge risk and achieve a more efficient allocation of credit.  Buoyed by an exuberant sense that the wizards of Wall Street had so thoroughly transformed the nature of risk that the rules of the game had been fundamentally altered, investor demand for these securities exploded, and the underwriting and trading of these new forms of engineered debt underwent an extraordinary period of growth.”  Managers of money-market funds, pension funds insurance companies, hedge funds and other financial entities buy these mortgage-back securities in the secondary capital markets.

“Banks make profits in the fees they charge for services provided in underwriting this type of debt – e.g. the purchase and aggregation of loans, creation and sale of securities on the secondary market, and the management of the pass-through of the underlying mortgage payments to final purchasers.  MBSs -- mortgage backed securities -- are highy liquid instruments traded on deep secondary markets, and are one of the largest financial asset classes by outstanding volume currently bought and sold on US capital markets.  These instruments are today the major condits of funding new mortgage loans, the vast majority of which are issued under the expectation that they will be sold into the secondary mortgage market.”  (Beitel, 2008)

“Securitization has spanned the creation of a plethora of exotic and increasingly complex financial instruments’engineered’ from he payment streams thrown offby MBSs.  The most prevalent of these new classes of engineered financial assets are known as collateralized debt obligations (CDOs) whose rapid growth between 2000 and 2006 lies at the root of the current subprime crisis.”  (Beitel, 2008).   

And banks in  Europe bought them.  And  then huge corporations bought them as a place to stash cash.  For example, Commercial Mexicana bought so many derivatives on the US market that they are now about bankrupt. 

So we have to conceptualize that  investment banks are involved in packaging and selling huge pools of debt.  They lean on the retail banks to write more and more mortgages.  They buy them, repackage them and sell them on the secondary mortgage markets.  They also
borrow money to buy securities.  We’re probably all familiar with margin trading, e.g. borrowing up to twice the value of your portfolio to buy more securities.   But investment banks can borrow (or leverage) up to ten times or twenty-five times the value of their assets.  Lehman Brothers had a leverage ratio of 25.           

Investment banks also engage in risky arbitrage; arbitrage means buying a security at a lower price in one market and selling it at a higher price in another market. 

GENERATING ASSET BUBBLES

Because the five biggest investment banks on Wall St. hold $4 trillion worth of assets, they can mobilize gigantic sums of money.  With these gigantic sums, they can actually generate price differences between markets and exploit them.  They can also generate asset-price bubbles, as they did in the 1990s.  And this can be done not just in the US, but around the world.  Thanks to the erasure of capital regulations, capital can move in and out of stock markets in countries around the world creating bubbles and bursting them.

This is how Peter Gowan describes this:  “Time and time again, Wall Street could enter a particular market, generate a price bubble within it, make big speculative profits, then withdraw, bursting the bubble.  Such activity was very easy in so-called emerging market economies with small stock or bond markets.  The Wall Street banks gained a wealth of experience in blowing such bubbles in the Polish, Czech or Russian stock markets in the 1990s and then bursting them to great profit.   The dot.com bubble in the US then showed how the same operation could be carried through here in the US without any significant loss to the Wall Street banks.”

What we have to keep in mind are two things:  first, some investment bankers made gobs of money.  Second, when an asset bubble is burst, the people pumping up the bubble don’t lose, you and I lose.  And not just you and I.  Let’s take the case of Russia.  Between the fall of the Berlin Wall in 1989 and the economic crisis in 1997-8, production in Russia fell by 50%; investment fell even more; and the life expectancy of people decreased.  People pumping up asset bubbles know that millions of average people are going to get hurt when an asset bubble bursts.  This is the crowning achievement of neoliberal globalization and its removal of banking regulations. 

CREATING THE HOUSING BUBBLE IN THE U.S.

How did this happen?  It’s what Peter Gowan calls the Greenspan-Rubin-Paulson strategy.  First, in 2001, after the dot.com bubble burst and about $7 trillion was wiped off the NYSE, the Federal Reserve lowered the interest rate by 550 basis points from 6.5% to 1.0%.  This didn’t help the stock market slide, but it did help banks lend money for mortgages, car loans, students loans, and credit card loans.  With the banks pushing mortgages, the investment banks buying them and securitizing them and selling them to huge fund managers, an expansion of the economy financed by debt seemed endless.  But that’s not all.

The banks and investment banks had yet more help, help from the government.  Banks and investment banks have certain ratios of equity to debt that is established by government regulation.  The banks of course wanted to increase the ratio so that they could borrow more, leverage their positions, make more money.  In 2004 Henry Paulson led a Wall Street campaign to get the SEC to agree to relax the so-called ‘net capital rule’  restricting leverage for large investment banks.  Henceforth, firms were effectively allowed to decide their own leverage on the basis of their own risk models.   Paulson was well rewarded for this; he was named Secretary of the Treasury.  Then he rewarded his friends in the investment banks with a $700 billion bailout from the U.S. tax payers.  (We have since learned that this bailout was actually higher than the investment banks’ market value.) 

Another part of the New Wall Street System is the expansion of  balance sheets, increasing their assets and liabilities.  So the more they borrowed and bought, the better. Citigroup’s turn to maximum balance-sheet and leverage expansion for trading activities happened after the arrival of Robert Rubin,  US Treasury Secretary under Bill Clinton.

Credit default swaps are another financial innovation; a sort of insurance on credit.  Derivatives specialists at JP Morgan Chase persuaded AIG to start writing CDSs (credit default swaps) on CDOs (collateralized debt obligations) in 1998.  Its subsequent collapse and bailout in 2008 was no doubt linked to the CDSs.

The official, “regulated” investment banks worked in tandem with the shadow banking system – hedge funds and private equity groups.  These  engaged in trading but without capital regulations nor transparency. 

If this all is starting to sound like a plan, it is.  Philip Augar, in his detailed study of the Wall Street investment banks, The Greed Merhcants,  argues that the big Wall Street investment banks have actually operated in large part as a conscious cartel. 

SOLUTIONS

But there is a solution.  The banks can be nationalized and run as a public utility.  Other corporations – those who used to scream “get government off our backs!” and are now begging for bailouts – like GM and Chrysler – they also can be nationalized and turned over to the workers to run.  GM wants $19 billion, but it’s total market value is $3 billion.    Furthermore, the government can tax the rich, after all they’re the ones with the money.  Expropriation is another possibility.

People are fighting back.  An anti-foreclosure group in Massachussetts is organizing a “Predators’ Tour” for Sat. Jan. 31, 2009.  People whose homes are in foreclosure will go to the multi-million dollar homes of the CEO’s of the big banks to discuss their foreclosure.

  SOURCES:

Beitel, Karl.  “Understanding the Subprime Debacle,” Monthly Review, 60:1, 27-44, May 08.
Gowan, Peter.  “Crisis in the Heartland,”  New Left Review, 55, Jan/Feb 2009.
Nouriel Roubini, RGE Monitor, www.rgemonitor.com
David Schweickart, “Bailout!” www.globaljusticecenter.org/articles/bailout/html

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