Petrino DiLeo looks at how politicians of both parties allowed an
unregulated shadow banking system to take shape.
IT’S UNTHINKABLE. The United States–the paragon of the “free market”
and loudest proponent of neoliberal policies such as free trade,
deregulation and privatization–has just carried out the three largest
nationalizations in world history in taking over the twin mortgage
behemoths Fannie Mae and Freddie Mac, and now the insurance giant AIG.
The U.S. government is now the largest guarantor of mortgages in the
world–and the largest insurance company as well.
The events that have caused the worst financial crisis since the Great
Depression are the logical conclusion of policies and legislation
implemented during the past 30 years. Lax standards and weakening of
regulation led to a free-for-all in the financial world and the
creation of a multitrillion-dollar “shadow banking system.”
Along the way, Wall Street institutions invented arcane investment
instruments called derivatives, swaps, structured financial products
and securitized debt–and investors dove headfirst into the resulting
alphabet soup of mortgage-backed securities, collateralized debt
obligations, credit default swaps, structured investment vehicles,
etc.
These investment products were sloppily hashed together, barely
monitored and never stress-tested. Rating agencies rubber-stamped
everything that Wall Street concocted. And the result is the unfolding
financial bloodbath.
“What we are witnessing is essentially the breakdown of our modern-day
banking system, a complex of leveraged lending [that is] so hard to
understand,” Bill Gross, head of the Pimco asset management group
wrote, in December of last year. “Colleagues call it the ‘shadow
banking system’ because it has lain hidden for years, untouched by
regulation, yet free to magically and mystically create and then
package sub-prime loans in [ways] that only Wall Street wizards could
explain.”
Of course, the real tragedy isn’t that Wall Street is falling. The
banks and other financial institutions like AIG gorged themselves for
years. Whatever happens, the titans of finance will remain
millionaires many times over. Few, if any, will face jail time.
The real issue is that the collapse on Wall Street is wreaking havoc
on lives around the country and around the world.
People who had no idea that their mortgages were part of Wall Street’s
slice-and-dice game are paying the price. Workers whose pensions ended
up invested in toxic bonds may not be able to retire. Cities and
states face a drying up of revenue and are cutting back on jobs and
services. And the federal government–using taxpayer money–is
swallowing Wall Street’s losses, while leaving the same people in a
position to profit when the crisis is defused.
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After the financial crisis that contributed to the Great Depression of
the 1930s, Congress enacted laws such as the Glass-Steagall Act of
1933 to separate commercial banks from investment banks.
The objective of this reform was to insulate risky deal-making by
investment banks from individuals’ deposits in commercial banks. The
Federal Reserve Bank, the Office of the Comptroller of the Currency
and state regulators all were charged with monitoring commercial
banks. The Securities and Exchange Commission was given purview over
monitoring the large investment banks and brokerage houses.
The traditional commercial banking model was of deposit-taking
institutions, which lent money back out as mortgage loans or other
forms of credit. Such banks were monitored and regulated, and had to
have a certain amount of capital on hand at all times.
Furthermore, deposits up to a certain dollar value were guaranteed by
the Federal Deposit Insurance Corporation (FDIC). Commercial banks
were allowed to borrow directly from the Federal Reserve Bank to
ensure their continued operation–a privilege that was only extended
to investment banks during the current crisis.
This banking model held for many years. The long economic boom after
the Second World War kept financiers pretty happy. Furthermore, the
prosperity helped keep in place an overall approach to economics that
tolerated government intervention into the economy. This approach was
known as Keynesianism, after the liberal British economist John
Maynard Keynes.
Crises in the 1970s, however, led to a revival of calls for
unregulated free markets. By the 1980s and 1990s, as part of
neoliberal restructuring, financial regulation came under attack. This
culminated in the Gramm-Leach-Bliley Act, signed into law by Bill
Clinton in 1999, which essentially repealed Glass-Steagall.
The Gramm in the law’s title is former Republican Sen. Phil Gramm, now
an executive at the UBS bank and John McCain’s top economic advisor.
But a key lobbyist for the law was Robert Rubin, the Citigroup
executive and former Treasury Secretary under Democratic President
Bill Clinton.
The Gramm-Leach-Bliley Act allowed banks, brokerage firms and insurers
to merge once again. It also dissolved the wall between commercial
banks and investment banks.
In 2000, Congress passed legislation (again, supported by Gramm)
called the Commodity Futures Modernization Act, which effectively
helped keep the commodities market hidden and unregulated. This law is
one reason why, during the run-up in food and oil futures prices
earlier this year, no one was quite sure how big a role speculators
played in pumping up prices.
The Federal Reserve is technically not part of the government. Its
policies and decisions on the setting of interest rates were dictated
by financial interests, particularly under former Federal Reserve
Chair Alan Greenspan.
Meanwhile, as part of the employers’ offensive, workers’ wages and
benefits came under attack. This facilitated a transfer of wealth from
the bottom of society to the top and helped restore profitability
across Corporate America.
However, in order to maintain high levels of consumption within the
U.S. economy, something needed to replace wages. An explosion of
household debt was the result. The vast increase in debt helped
workers maintain their standard of living, despite stagnating or
declining wages. At the same time, debt became a huge profit vehicle
for Wall Street.
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As one example, investment banks offer “money market accounts,” which
in practice look and act like traditional checking and savings
accounts. But there’s one important difference–not one cent of the
deposits is guaranteed by the government through the FDIC. If these
investment banks go down, so do the accounts.
This is a major reason why, when institutions like Lehman Brothers and
Bear Stearns appeared to be failing, there have been massive runs by
any funds that had money in those banks. They sought to pull out
before the institutions failed.
Another phenomenon that emerged is called debt securitization. Banks
bought up different forms of debt–like mortgages. Yet rather than
simply hold them on their balance sheets and collect payments, they
created enormous pools of loans. They then created bonds based on
these massive pools of debt, and sold them to giant investors, at
varying levels of risk. The highest-rated and least-risky bonds paid
off at lower rates, while the riskier bonds–such as ones tied to sub-
prime loans–paid off at higher rates.
By the end of the first three months of 2007, the total value of all
outstanding securitized debt was $28 trillion–more than double the
figure of 10 years ago. None of this would have been possible without
deregulation.
The other components of the financial system that could be in trouble
include hedge funds, with $1.8 trillion in assets; the $2.5 trillion
overnight loan market, known as the repurchase, or repo, market; and
the commercial paper market–loans made to businesses without the
backing of collateral–worth $2.2 trillion.
Then there are derivatives–financial instruments based on an
underlying security such as a commodity, bond or currency, but
typically representing some kind of gamble about what direction the
value of the security would go in. The theoretical value of all
derivatives was a mind-boggling $596 trillion by the end of 2007.
On top of all this, the banks did all sorts of things to keep their
shady investment instruments hidden away, off company balance sheets.
As a result, no one knows how much damage could be done if these
trillions of dollars in paper assets have to be sold off at pennies on
the dollar–or become completely worthless. Fear of such a worldwide
financial meltdown drove the U.S. government to engineer the takeover
of Bear Stearns by JPMorgan Chase earlier this year.
The various components of the shadow banking system play off each
other. Hedge funds put their money in investment banks, or hire the
banks to place their investments. Commercial banks and investment
banks have merged. Investment banks operate their own hedge funds.
Banks use the “repo” market and commercial paper to fund day-to-day
operations. Financial institutions of all kinds have derivative
contracts. Many of these are so-called credit default swaps, a form of
insurance on bonds.
The whole system is based on the free flow of capital at all times.
But today, many parts of the shadow banking system aren’t functioning,
because the banks aren’t sure if the other banks they’re trading with
will be around tomorrow.
The credit-default swap market, worth an estimated $62 trillion, is a
particularly urgent problem. Because it’s totally unregulated, no one
knows which financial institutions will have to pay out how many
billions of dollars of insurance on mortgage-backed securities gone
bad–or whether they will have the money to do so.
It was this uncertainty that led to the government takeover of AIG,
which was a major provider of credit default swaps, and thus extremely
vulnerable to the collapse in the value of mortgage-backed securities.
This shadow banking system flourished under the non-watchful eye of
Alan Greenspan’s Federal Reserve. Today, it’s become clear that
Greenspan was warned repeatedly about many of the factors that led to
this catastrophe, but instead, cheered on the boom.
For example, Greenspan embraced the explosion of predatory sub-prime
lending. He applauded the emergence of securitization of mortgages. He
cheered on the technology stock bubble. He helped goad asset-price
bubbles with aggressive cuts in interest rates in the late 1990s and
after September 11, 2001. Greenspan also orchestrated an industry
bailout of the hedge fund Long Term Capital Management in 1998–the
godfather to today’s bailouts.
It’s impossible to predict how far the financial chaos will spread, or
just what the toll will be on the underlying economy.
But three things are clear already. The resulting credit crunch will
cause an already struggling economy to contract even further. The Wall
Street titans who presided over this disaster will remain personally
very comfortable. And workers will be asked–as always–to suffer the
consequences.
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