Last year we witnessed the emergence of the most serious financial crisis to hit the U.S. and the greater global economy since the 1930s—a crisis that has already begun to precipitate a major recession in the U.S. in 2008 and, in turn, raising the odds for a wider global downturn in 2009.
History will show a remarkable congruence between the conditions, events, and policies of the decade of the 1920s, on the one hand, and the events and policies of the past decade.
The 1920s were characterized by:
- an over-extended housing and construction boom in mid-decade that imploded
- a slowdown in investment in the productive economy as speculative investment steadily crowded out real investment
- a Federal Reserve System that pumped up the money supply without concern for its eventual speculative impact
- an increasing imbalance in world trade and currency instability
- the near destruction of labor unions—to name the more notable
The progressive destruction of unions over the course of the 1920s, when combined with the radical restructuring of the tax system that provided massive tax cuts for the wealthy and corporations, resulted in a dramatic shift in income distribution toward wealthy investors and corporations from the rest of the working population. By 1928 the wealthiest households had doubled their share to 22 percent of all incomes in the country, according to IRS data. Perhaps more than any single contributory factor, the rapid and extreme growth of income inequality during the decade was eventually responsible for the ultimate financial implosion of 1929 and the consequent depression. The massive shift in incomes that fed the speculation in turn resulted in a further income shift, as super-profits were realized by the wealthy from the speculative investment frenzy. More concentration of income in turn provoked a dizzy spiral of asset price inflation, speculative profits, and a euphoric expectation the process would continue without limit.
The speculative excesses of the 1920s were assisted by a host of shady business practices—in the banking industry in particular—that were condoned by business, media, and the government. Some of the more notable practices included the explosion of buying stocks and securities on margin—or what is sometimes called leveraging. It included practices that ensured the speculation remained near invisible to average investors; practices by which private businesses, responsible for rating investments for the general public, lied to the public as a consequence of conflicts of interest. The government refusal to monitor or check the speculative excesses also contributed.
The foregoing process culminated in a stock market crash, once the cracks in the real economy began to appear and the speculative boom quickly turned to the bust of October 1929. As in all such similar speculative booms and busts, the financial crisis of 1929 in turn exacerbated and accelerated the already declining real economy by freezing up credit for investment, ensuring further corporate defaults, massive job losses, and subsequent decline. Thus, while the increasingly speculative activity was not the sole cause of the crisis, it was a critical and central development provoking the crash and the depression that followed.
As in the 1920s, in the last decade the U.S. has been lurching from one speculative bubble to the next. These include:
- the Long Term Capital Management (LTCM) hedge fund bailout of 1998
- the Asian debt crisis of 1998 (at the center of which were U.S. money center banks)
- the dot-com technology asset bubble of 1999-2000
- the recent subprime mortgage bust (the foundations for which were laid in 2003-04)
- the recent rapid spread of the subprime crisis in 2007-2008 to other capital markets in the U.S.
The series of speculative bubbles from 1998-2008 in each case were temporarily contained by an unprecedented expansionary monetary policy engineered by the U.S. Federal Reserve under Alan Greenspan. The Greenspan Fed thus contributed to the series of bubbles with money injections designed to stave off the spread of liquidity crises and credit crunches. The temporary fixes did not solve the problem, but postponed the crisis for the short term. The result has been a containment each time that has bottled up pressures, which then emerged once again with subsequent greater effect.
While Federal Reserve policies have thus enabled the speculative flames, the rapid growth of income inequality since 2000 provided the kindling. A major, historic shift in incomes in the U.S. clearly began under President Reagan and continued unabated under Clinton. In recent years, under George W. Bush, that inequality has accelerated. Starting with a share of only 9 percent of total national income, for example, by 2006 the wealthiest 1 percent of households had again raised their total share to the 22 percent they enjoyed in 1928.
As in the 1920s, the rapid rise of income inequality has been driven largely by the restructuring of taxation, as more than $4 trillion of tax cuts were passed in Bush’s first term alone, 80 percent of which is projected to accrue to the wealthiest households and large corporations. Further corporate tax cuts of more than a $1 trillion were passed in his second term. Meanwhile, the rest of the population has experienced income stagnation and reduction as the decline of unions has continued, the post-World War II pension and health-care benefit systems have accelerated their collapse, the shift to part-time and temp jobs from full-time and permanent employment has continued, and millions of high paid jobs have disappeared due to neoliberal trade and offshoring.
The growth of incomes by the wealthy provided the huge pool of income and wealth with which to engage in speculative investment activity. As short term speculative activity resulted in significantly greater returns than real investment activity, more and more investment was shifted into speculative activity or from real investment in the U.S. home market to investment offshore in the so-called emerging markets—in particular, in China and Asia. In addition to the growing income imbalance and the easy money policies of the Greenspan Fed, a third critical element has been the elimination of any semblance of financial regulation and oversight, which was given a coup-de-grace in 1999 with the repeal of the 1930s-era Glass- Steagall Act. Glass-Steagall was supposed to prevent speculative and other abuses.
As Glass-Steagall was being progressively undermined under Reagan, Bush I, and Clinton, the so-called financial revolution was taking off. With that revolution in finance came a corresponding proliferation of new financial structures and relations. When combined with new technologies of computer processing power, soft technologies (e.g. quantitative modeling), networking, and the Internet, the financial system has become the first sector of economy that has been truly globalized. In turn, with globalization has come the further inability to regulate finance capital and, indeed, even to monitor its activity accurately. Thus, deregulation plus technology and globalization has meant further de facto deregulation.
In the past decade U.S. finance capital has been unleashed, as it once was in the 1920s, to do whatever it wishes and to push the speculative investing envelop as far and in whatever direction it pleases. It is therefore no coincidence that since the late 1990s the U.S. economy has veered headlong from one financial crisis to another with virtually no breathing space in between. We are now beginning to see the consequences of this concurrence of total financial deregulation, unchecked financial restructuring, accelerating income inequality, and accommodative government monetary policy which is now yielding even greater financial crisis, U.S. recession, and a threat of global instability.
Derivatives and the Securitization Revolution
If Structured Investment Vehicles (SIVs) and hedge funds are the vehicles of the new speculative and financial crisis, their products amount to a vast array of acronyms like CDOs, ABCP, CBO, CMBS, CLO, CDS, CDPO, and so on. To understand the current financial crisis it is first necessary to understand the so-called securitization revolution that the new institutional structures and financial devices represent. And the securitization revolution is based upon the granddaddy of over-leveraging called derivatives.
Derivatives involve the fictitious development of financial asset products offered for sale to investors, private and corporate. They have no intrinsic value. They derive their value from other real assets or other financial products. They have virtually no cost of production. Their costs of distribution and sale are essentially non-existent. Their market price is largely the outcome of speculative demand and, to a lesser extent, how fast financial institutions can create the original financial assets (e.g., mortgage loans) on which the derivatives are then developed. Moreover, derivatives can be created on top of derivatives in an unlimited pyramid of speculative financial offerings. Like a house of cards, the offerings may be stacked upon each other, until such time as one of the cards slips out of place and brings the rest down with it.
In today’s global economy there are more than $500 trillion in derivatives outstanding. That compares to a global annual gross domestic product for all the nations of the world of less than $50 trillion, and to the U.S. annual GDP of approximately $13 trillion. In other words, there are now more than ten times in derivative contracts than all the real goods and services produced by all economies in the world annually. The world’s wealthiest investor, Warren Buffet, has called derivatives “time bombs both for the parties that deal in them and the economic system.” They represent, according to Buffet, “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Subprime mortgages represent one relatively small land mine in the panoply of “financial weapons of mass destruction” described by Buffet. Subprimes are an essential element of just one example of super speculative investment built on one form of derivative called a CDO, a Collateralized Debt Obligation. Subprime mortgages lay at the foundation of the CDO’s derivative pyramid. The mortgages themselves represent the value of a real asset—i.e., the housing product on which the mortgage is based. The mortgages are then packaged into the fictitious financial asset package called the CDO, which is then marked up by the financial institution which sells the CDO to wealthy investors, hedge funds, other funds, or corporations. The mortgages themselves are not packaged in original form in the CDO, but instead are broken up, i.e., divided into slices that may be distributed across various CDOs. Only parts of any given subprime mortgage may thus reside in any given CDO offering: parts of other assets are typically sausaged into the same CDO alongside the subprime slice as well. These other assets may themselves be fictitious in character (i.e., not based on any real physical asset) or may be based on some real asset—for example commercial paper issued by some real company to raise funds to carry on or expand its real business; or a loan issued by a bank backed by real collateral (e.g., CLO). Other forms of bundled assets may include fictitious securities issued based on expectations of future ticket sales for sports events, a rock star’s future concert royalties, or even more absurd examples of so-called bonds.
Not all CDOs have subprime mortgages bundled within their packaged market offering. Some may have slices of higher grade mortgages or what are called Alt-A mortgages. Or they may have both. Many CDOs also include what are called Asset Backed Commercial Paper (ABCP). Many companies with doubtful performance and future prospects unable to raise capital more economically from other sources have entered the ABCP market in recent years to raise cash and stave off default. Their commercial paper is then bundled with a CDO and offered to market. Thus shaky subprime mortgages may be packaged with equally shaky corporate commercial paper.
But the banks and other institutions that eventually sell the CDOs were, at least until the recent crisis began to appear in late summer 2007, not all that concerned about the quality of such derivative-CDOs. Their relative unconcern flowed from their ability to buy insurance for the CDO in the form of yet another derivative called a Credit Debt Swap or CDS. Yet another means by which banks attempted to insulate themselves from the shaky quality of speculative investments has been their creation of Secured Investment Vehicles. SIVs are in essence electronic shadow banks set up by investment and commercial banks like Morgan Stanley, Bear Stearns, Citigroup, Bank of America (and virtually every known national or regional major bank in the U.S.) to offload potentially risky CDOs from the banks’ balance sheets, where bank record keeping is subject by law to review by the U.S. Securities and Exchange Commission. With SIVs typically quickly turning over, or selling, to hedge funds and other wealthy investors and corporations, a third safety valve presumably existed.
Subprime mortgages, bundled within CDOs, issued by SIVs, and held off balance sheet by the big banks represent a highly profitable enterprise for the banks. First, the banks make money from fees issuing the CDO. Second, they are able to offload assets from their bank balance sheets thereby both reducing capital carrying costs as well as making available more bank reserves for loaning out at interest. Third, their SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profit growth of more than 20 percent per year collectively for each year from 2004 through 2006—i.e., roughly the period of the most explosive growth of subprime mortgages bundled with CDOs.
The above scenario is sometimes referred to as an example of the so-called securitization revolution in finance. Securitization is the process of assembling assets on which new securities are issued and then sold to investors who are (in theory) paid from the income flow created by the assets. The more risky the assets contained within the CDOs, the lower the credit ratings but the higher the potential return. The justification for the highly speculative and high risk character of the offerings is that by slicing the CDOs into tranches, based on the degree of risk in the assets in the given CDO, the risk would be dispersed among a large population of investors. In reality, however, the result was the dispersion of contagion not dispersion of risk from the risky investments.
In 1998 the total international volume of securitized offerings amounted to less than $100 billion. By 2003 it had risen only to $200 billion, more than $500 billion in 2005, and exceeded $1 trillion in 2006.
Bursting the Subprime-CDO Bubble
Business press pundits repeatedly query about why so many subprime mortgages were issued to home buyers who clearly could not qualify for mortgage loans on any reasonable criteria or would be unable to make payments once interest rates inevitably rose to normal levels. What the pundits don’t understand is that, given the increasing trend over time toward a greater relative mix of speculative to total investment arrangements in the capitalist economy, it is quantity, not quality, of investment opportunity that takes precedence. Since 2003 the practice of banks had been to encourage mortgage loan companies to produce more loans regardless of the quality. Mortgage loan companies in turn encouraged real estate brokers to deliver more loans without consideration of quality. And real estate brokers did whatever was necessary to close the deal with home buyers.
No matter if the total volume of mortgage loans by 2005-06 were more subprime than not. The quantity of loans, not their quality now mattered most. And quantity was only part of the new profit model. Finance profitability was becoming less and less dependent on the issuance of loans per se, but increasingly on derivatives and their supporting institutions. By 2005 more than $635 billion of subprime loans were issued. In 2006 the amount was another $600 billion and the cumulative total by 2007 was more than $1 trillion.
By mid-2006 it had become clear that the subprime mortgage market was in freefall. Home buyers with subprime mortgages were now defaulting on payments at record rates and foreclosures were beginning to rise. By late summer 2007 it was estimated that there would be two to three million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted and with them many of those CDOs in which they were imbedded. The subprime mortgage market virtually shut down. It was not possible to accurately estimate the magnitude of the losses from the subprimes since they were sliced and distributed within different CDO offerings. And if the losses for the subprime elements in CDOs could not be accurately valued, the CDOs could not be accurately valued. Nor could the asset backed commercial paper often bundled with the CDOs. And so on.
The typical response of investors in such situations is to ask how much their investments were under water. When they cannot be accurately told, their next response is often “sell my investment and give me the cash remaining.” But with no markets for subprimes by late 2007 their remaining value was impossible to estimate. No sales meant no price meant no possible valuation estimate and in turn no cash out. Investors, like the banks and their SIVs, were locked together in many cases in a death spiral, unable to bail out and destined to ride the doomed vehicle into the ground.
By late 2007 various estimates place the value of expected losses from the subprime market collapse from Goldman Sachs’s low of $211 billion and the OECD’s estimate of $300 billion to estimated losses— based on the ABX Index, the official measure of subprime mortgage securities’ value—at approximately $400 billion. In stark contrast to these estimates the losses admitted by the major banks as of year end 2007 amounted to only a paltry $60 billion. More, indeed, much more in terms of bank losses and bank write-downs are yet to come in 2008.
But subprime losses and write-downs on bank balance sheets were only part of the bigger picture.
Spreading the Subprime-CDO Pain
The estimated total volume of all CDOs worldwide (not all of which have subprime mortgages bundled with them) is, according to the OECD, approximately $3 trillion in total value. Approximately half that total is held by hedge funds, a fourth by banks, and the remaining exposure by asset managers and insurers.
As noted, many of CDOs also bundled commercial paper—sometimes with subprimes and often without. But asset backed commercial paper appears equally at risk as subprime mortgages and the consequences of its collapsed are yet to be fully realized.
Like the subprime mortgage market, the ABCP market experienced a sharp run up between 2003-07 in conjunction with the acceleration of CDOs and other derivatives. Many companies in trouble financially and unable to raise capital to continue turned to the ABCP to issue commercial paper on their remaining real assets to raise cash for operations or investment purposes. Much of their risky commercial paper was bundled with CDOs. But like the subprime market, the ABCP market has virtually shut down as well since the advent of the financial crisis in late summer 2007. The ABCP market in the U.S. peaked at $1.2 trillion in August 2007 and had fallen to $700 billion by year end. By June 2008 an additional $300 billion is projected to come due. That’s another $300 billion banks may have to provide for on their balance sheets, in addition to the $400 billion in additional subprimes coming due. In Europe the commercial paper market is also declining rapidly, having fallen 44 percent by October 2007 to $172 billion from a May peak of $308 billion.
With the ABCP market largely shutting down, many corporations straining to stay in business in recent years by selling their commercial paper will likely begin to default. That means a sharp rise in business bankruptcies. For example, non-farm business debt rose by 30 percent in 2004 and continued thereafter at above average levels. Many CDOs helped hold off defaults and failures between 2003-07 by imbedding their commercial paper. But with the shutdown of the ABCP markets, pressures for corporate defaults will be released with the consequent result of sharp increases in corporate bankruptcies in 2008-09. The corporate ratings agency, Moody’s, predicts an increase in default fates between four and ten times in the period immediately ahead, the highest since the peak fallout from the dot-com bust in 2002.
How the current financial crisis has been spreading at an historically rapid rate from the subprime to other capital markets, and how the crisis is being transmitted in turn from those latter markets to the general economy in the U.S.—thereby guaranteeing a recession in the U.S. in 2008 and threatening to expand globally in 2009—will be addressed in Part II of this analysis.
Jack Rasmus is the author of the The War At Home: The Corporate Offensive From Ronald Reagan to George W. Bush 2006 and The Trillion Dollar Income Shift: Essays on Income Inequality in America (2008).