"End of Wall Street Boom" - Must-read history

[seemslikeadream]

Paul Craig Roberts

[coffin_dodger]

She seems to get it.

[seemslikeadream]

Wall St. Fears Go Beyond Shutdown
Jason Reed/Reuters

Chief executives headed to the White House on Wednesday for a meeting with President Obama.
By NELSON D. SCHWARTZ and CHARLIE SAVAGE
Published: October 2, 2013

With Washington preoccupied by the government shutdown, Wall Street is shifting its attention to an even more worrisome situation: the possibility that the government could run out of money within the next few weeks, forcing an unprecedented default on its debt.

The Treasury said last week that Congress had until Oct. 17 to raise the limit on how much the federal government could borrow or risk leaving the country on the precipice of default. If the debt ceiling is not raised by then, the Treasury estimates it will be left with about only $30 billion in cash, which would be used up in a matter of days.

As a result, economists and investors have quietly begun to explore the options the White House might have in the event Congress fails to act.

The most widely discussed strategy would be for President Obama to invoke authority under the 14th Amendment and essentially order the federal government to keep borrowing, an option that was endorsed by former President Bill Clinton during an earlier debt standoff in 2011.

And in recent days, prominent Democrats like Senator Max Baucus, chairman of the Senate Finance Committee, and Representative Nancy Pelosi, the House minority leader, have urged the White House to seriously consider such a route, even if it might provoke a threat of impeachment from House Republicans and ultimately require the Supreme Court to rule on its legitimacy.

Other potential October surprises range from the logistically forbidding, like prioritizing payments, issuing i.o.u.’s or selling off gold and other assets, to more fanciful ideas, like minting a trillion-dollar platinum coin.

So far, administration officials have continued to insist that there is no plausible alternative to Congressional action on the debt limit.

In December 2012, Jay Carney, the White House spokesman, flatly renounced the 14th Amendment option, saying: “I can say that this administration does not believe that the 14th Amendment gives the president the power to ignore the debt ceiling — period.” And on Wednesday, a senior administration lawyer said that remained the administration’s view.

Still, some observers outside government in Washington and on Wall Street, citing a game theorylike approach, suggest that the president’s position is more tactical than fundamental, since raising the possibility of a way out for the White House like the constitutional gambit would take the heat off Republicans in Congress to act on its own before the Oct. 17 deadline.

“If a default is imminent, the option of raising the debt limit by executive fiat has to be on the table,” said Greg Valliere, chief political strategist at Potomac Research. “Desperate times require desperate measures.”

Some professional investors echoed his view, which is a reason Wall Street remains hopeful that the economic and financial disaster a government default could usher in will be avoided.

“At the end of the day if there is no action and the United States has a default looming, I think President Obama can issue an executive order authorizing the Treasury secretary to make payments,” said David Kotok, chief investment officer of Cumberland Advisors in Sarasota, Fla., which has just over $2 billion under management. “There’s always been more flexibility in the hands of Treasury than they’ve acknowledged.”

According to some legal theorists, the president could essentially ignore the debt limit imposed by Congress, because the 14th Amendment states that the “validity of the public debt of the United States, authorized by law,” including for debts like pensions and bounties to suppress insurrections, “shall not be questioned.”

Absent Congressional approval for raising the debt limit, the constitutional route or some creative financing plan, the only alternative to default would be to cut spending by as much as a third, financing debt payments and other government obligations out of money coming in from tax receipts and other sources. If continued for more than a few days, that would deliver a shock to the economy that would almost certainly send the nation, and perhaps the global economy, back into a severe recession.
Before that could happen, analysts say, the stock market would inevitably plummet. “Investors will hit the panic button on Oct. 18 if the debt ceiling has not been raised by then,” said Ajay Rajadhyaksha, head of fixed-income research at Barclays. “The market will force Congress’s hand.”

There are precedents for such a denouement. After the House rejected initial legislation authorizing the bank bailout known as the Troubled Asset Relief Program during the financial crisis in late September 2008, the Dow Jones industrial average plunged more than 700 points in one trading session, prompting legislators to reverse course and approve a similar bill within days.

Market turbulence also helped set the stage for a deal in summer 2011 when Congressional Republicans and Mr. Obama squared off over the debt ceiling but ultimately compromised.

After largely staying on the sidelines as the budget battle approached in recent months, business leaders are also increasing warnings about the danger of a default. On Wednesday, Jacob J. Lew, the Treasury secretary, and other White House officials held a conference call with leaders of the Business Roundtable, which represents major American companies. Afterward, both Mr. Obama and Vice President Joseph R. Biden Jr. sat down to discuss the issue with Wall Street chieftains, including Lloyd C. Blankfein, the chief executive of Goldman Sachs.

Another option, at least in the short term, would be to issue i.o.u.’s to cover some of what is owed and buy more time. The California State government employed this tactic in summer 2009 during a fiscal showdown in Sacramento, issuing 450,000 i.o.u.’s valued at approximately $2.6 billion.

Mark A. Patterson, who served as the Treasury’s chief of staff from 2009 until May 2013 said that he and other top administration officials studied various strategies before the 2011 standoff, including the constitutional path, selling gold and a trillion-dollar coin. “We would have been thrilled if we had an easy option to take default off the table,” he said Wednesday. “We examined every idea and concluded that none of them would work.”

The idea of invoking the 14th Amendment has been attacked on both constitutional and pragmatic grounds. Some legal scholars said that the amendment did not confer any legal authority on the president, pointing to the words “authorized by law.” Pragmatically, specialists on Wall Street said questions about the legality of such bonds might cause potential buyers to eschew them.

“If there is no borrowing authority, any Treasury debt issued after Oct. 17 could become susceptible to legal challenges,” Mr. Rajadhyaksha of Barclays said.

While the Oct. 17 Treasury deadline will increasingly become the focus in the days ahead, both for politicians in Washington and investors around the world, there may still be a bit of wiggle room after that, said Michelle Girard, chief United States economist at RBS. But not much.

The government’s obligations are relatively light in mid-to-late October. That all changes on Nov. 1, when nearly $70 billion has to be paid for Social Security, Medicare, military paychecks and other obligations.

Without additional Treasury borrowing, “it’s impossible to get beyond Nov. 1,” Ms. Girard said. “And in our view, even Oct. 31 is too close to be able to sleep comfortably.”

[seemslikeadream]

MONDAY, OCT 14, 2013 06:43 AM CDT
Greed destroyed us all: George W. Bush and the real story of the Great Recession
Faulty monetary policy and insufficient regulation helped — but old-fashioned avarice really tanked the economy
BY RICHARD S. GROSSMAN


George W. Bush (Credit: AP/Lm Otero)
Excerpted from “WRONG: Nine Economic Policy Disasters and What We Can Learn From Them”
If financial crises came with their own nicknames, the subprime meltdown surely would have earned the sobriquet “worst financial crisis since the Great Depression.” That mantra has been chanted over and over again, not only by leading academics and media pundits, but at the highest levels of policy making. When President Barack Obama selected Christina Romer, an economic historian from the University of California, Berkeley, as chair of his Council of Economic Advisors, some carped that the president should have selected an economist with a deeper background in policy rather than in economic history. When Romer herself later asked President Obama’s chief of staff Rahm Emanuel why she got the job, Emmanuel answered: “You’re an expert on the Great Depression, and we really thought we might need one.” Given how close the subprime crisis came to economic Armageddon, it is important to understand the series of policy mistakes behind it.

For the most part, previous chapters in this book have focused on particular policies that have had disastrous results, rather than on economic disasters and the policies that led to them. The three policy failures of the interwar period—German reparations after World War I, the interwar gold standard, and the increasing trade protectionism of the 1930s—each merited its own chapter instead of being discussed in a single chapter on the Great Depression. The approach adopted here is different. Rather than starting with a failed economic policy, this chapter starts with a disaster—the subprime crisis—and examines the policies that contributed to it.

There are good reasons for proceeding in this way. The interwar policies discussed earlier had their origins in different countries and occurred under widely differing circumstances. World War I reparations resulted from fears that an isolationist United States would not be able to counter future German aggression, the heavy burdens of inter-Allied debts, and a French desire to punish Germany. The worldwide return to the gold standard was galvanized by the British precedent, which was based on a desire to return to the monetary “normalcy” of the nineteenth century. And the rise of trade protectionism, spurred by the United States’s Smoot-Hawley tariff, was a response to the beginnings of a global economic downturn and domestic political factors. By contrast, the subprime crisis originated almost entirely in the United States, although it subsequently spread far and wide. The main culprits behind the crisis were ill-conceived and ideologically motivated fiscal and monetary policies, which were aided and abetted by inadequate regulation and a variety of other policy mistakes.

Despite the severity of both the Great Depression and the subprime crisis, neither was completely unprecedented. Banking crises were common during the nineteenth and early twentieth centuries: there were more than 60 such crises in the industrialized world during 1805–1927. Many of these crises shared a common “boom-bust” pattern. Boom-bust crises occur when business cycles—the regular, normally moderate upward and downward movements in economic activity—become exaggerated, leading to a spectacular economic expansion followed by a dramatic collapse. Boom-bust crises play a central role in formal models of financial crises dating back at least as far as Yale economist Irving Fisher, who wrote about them in the 1930s. In Fisher’s telling, economic expansion leads to a growth in the number and size of bank loans—and even the number of banks themselves—and a corresponding increase in borrowing by non-bank firms. As the expansion persists, bankers continue to seek profitable investments, even though as the boom progresses and more investment projects are funded, fewer worthwhile projects remain. The relative scarcity of sound projects does not dissuade eager lenders, however, who continue to dole out funds. Fisher laments this excessive buildup of debt during cyclical upswings: “If only the (upward) movement would stop at equilibrium!” But, of course, it doesn’t.

When the economic expansion ends, the weakest firms—typically those that received loans later in the expansion—have difficulty repaying and default. Loan defaults lead to distress among the banks that made the now-impaired loans, panic among the depositors who entrusted their savings to these banks, and a decline in the wealth of bank shareholders. Even if no depositor panic ensues, banks under pressure will become more defensive by reducing their loan portfolio, both by making fewer new loans and by refraining from renewing outstanding loans that have reached maturity. Banks and individuals will sell securities in an attempt to raise cash, leading to declines in stock and bond markets. The contraction in the availability of loans will hurt firms and further exacerbate the business cycle downturn. The deepening contraction will lead to more loan defaults and bank failures, which will further depress security prices and worsen the business cycle downturn that is already underway.

Two other distinctive features characterize boom-bust crises. First, the economic expansion is typically fueled by cheap and abundant credit. That is, bankers have a lot of money to lend, which they are willing to lend at low interest rates. This often occurs when the central bank follows a low interest rate policy. In earlier times, when gold constituted a substantial portion of the money stock, credit expansion could be the result of gold discoveries or gold imports, which made loanable funds plentiful and cheap. It could also be a consequence of an increased willingness on the part of banks to lend the funds that they already have on hand, or from the emergence of new ways of lending money, including the creation of new types of securities. Second, boom-bust cycles are often accompanied by increased speculation in a particular asset or class of assets, the price of which, fed by cheap and abundant credit, rises dramatically during the course of the boom—and then collapses catastrophically during the bust.

The scenario described above aptly describes many nineteenth and twentieth century crises. For example, England suffered crises in 1825, 1836–39, 1847, 1857, 1866, and 1890. Each of these was preceded by several years of rapid economic growth, frequently fueled by gold imports and accompanied by increased speculation. The object of speculation varied from crisis to crisis and included at different times grain, railroads, stocks, and Latin American investments. Similar stories can be told about US crises of 1837, 1857, 1873, 1893, and 1907, and many others in Australia, Canada, and Japan, and across Western Europe.

As the world economy became more interconnected during the course of the nineteenth century, increasing numbers of these crises took on an international character. During the weeks following the outbreak of a panic in London in August 1847, business failures spread outward from London to the rest of Britain, to British colonies, and to continental and American destinations. Similarly, the 1857 crisis, which started in the United States, soon spread to Austria, Denmark, and Germany. The even more severe crises of the mid-1870s, early 1890s, 1907, and early 1920s, not to mention the Great Depression of the 1930s, also traveled extensively.

It is impossible to identify precisely when the run-up to the sub-prime crisis began. According to the National Bureau of Economic Research, the private academic organization that is the arbiter of when business cycle expansions and contractions begin and end, the longest-ever US business cycle expansion began in March 1991 and lasted until March 2001. Following an eight-month downturn—among the shortest in US history—the business cycle turned upward again in November 2001. That expansion ended late in 2007, about the same time that the subprime meltdown began. The boom, like countless others before, was fed by expansionary fiscal and monetary policies.

The business cycle expansion that began in 2001 was given a substantial boost by a series of three tax cuts during the first three years of the administration of President George W. Bush. President Bush was ideologically committed to lower taxes and had pledged, if elected, to cut taxes. In his acceptance speech to the Republican National Convention in Philadelphia on August 3, 2000, Bush said:

Today, our high taxes fund a surplus. Some say that growing federal surplus means Washington has more money to spend. But they’ve got it backwards. The surplus is not the government’s money. The surplus is the people’s money. I will use this moment of opportunity to bring common sense and fairness to the tax code. And I will act on principle. On principle…every family, every farmer and small businessperson, should be free to pass on their life’s work to those they love. So we will abolish the death tax. On principle…no one in America should have to pay more than a third of their income to the federal government. So we will reduce tax rates for everyone, in every bracket.

Supported by a Republican majority in the House of Representatives and a nearly evenly divided Senate, Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Job Creation and Worker Assistance Act of 2002, and the Jobs Growth and Tax Relief Reconciliation Act of 2003. These laws lowered tax rates in all brackets, reduced taxes on capital gains and some dividends, and increased a variety of exemptions, credits, and deductions. Some of the tax cuts, which were to be phased in under EGTRRA, were accelerated under the 2003 legislation.

Further fiscal stimulus was provided by the invasion of Afghanistan the month following the terrorist attacks on September 11, 2001 and the war in Iraq, which began in March 2003. The war led to the deployment of 5,200 US troops in Afghanistan during the fiscal year 2002; by 2008, the combined in-country forces in Afghanistan and Iraq had reached nearly 188,000. Thanks in large part to the collapse of the Soviet Union, US military spending had been relatively flat in the 1990s, never exceeding $290 billion in any year. By 2008, annual military spending had more than doubled, to $595 billion.

President Bush was faithful to his pledge to eliminate the federal government’s budget surplus. The net effect of the tax cuts, combined with the additional expenditure related to the overseas conflicts, turned the federal government’s $236 billion surplus in 2000 to a $458 billion deficit by 2008. This fiscal stimulus encouraged more spending by households and firms and contributed to the economic boom that lasted from 2001 to 2007.

The boom was also fueled by expansionary monetary policy, as the Federal Reserve kept interests rates low for a prolonged period. At the end of 2000, the federal funds rate, a key indicator of Federal Reserve monetary policy, stood at 6.5 percent. Following a sharp decline in stock prices in March 2001, primarily the result of the collapse of internet stocks (the “dot-com bubble”), the Federal Reserve lowered interest rates swiftly and dramatically in an effort to cushion the effects of the fall on the wider economy. By the end of March 2001, the federal funds rate had been reduced to 5 percent, and by June it was 4 percent. In August it stood at 3.5 percent, and was further reduced following the terrorist attacks of September 11. By the end of 2001, the federal funds rate was below 2 percent—its lowest level in more than 40 years. The rate remained at or below 1 percent for nearly a year during 2003–04, and below 2 percent until the middle of November 2004. The low interest rate policy, especially during 2003–04, helped to ignite a speculative boom.

The Fed kept interest rates low for two reasons. First, employment had recovered more slowly than expected from the 2001 recession, the so-called jobless recovery, indicating that a more prolonged period of lower interest rates was needed to stimulate the economy. Second, Fed policy makers were concerned that the country might fall into a Japanese-style “lost decade” if they did not make a clear and convincing case through bold actions that low interest rates would persist as long as required to boost the economy. A less charitable view holds that Fed chairman Alan Greenspan’s motives were less economic and more ideological and self-serving—supporting easy monetary policy to increase the re-election prospects of fellow Republican George W. Bush, who was locked in a tight re-election race, or to curry favor with the administration so that he would be reappointed Fed chairman when his term expired after the presidential election. And, in fact, President Bush did nominate Greenspan for an unprecedented fifth term in May 2005. Whatever the reason for the prolonged monetary easing, it was crucial to the development of the boom.

As previously noted, boom-bust cycles are often accompanied by increased speculation in a particular asset or class of assets. During the subprime meltdown, the object of speculation was real estate. Housing prices, which had risen by about 25 percent during the entire decade of the 1990s, more than doubled between 2000 and 2006. The amount of debt undertaken to finance housing purchases also increased dramatically. Although expansionary fiscal and monetary policies undoubtedly fueled the explosion in house prices, the boom was enabled by a variety of legal and financial developments that eased constraints on the housing finance market, particularly the subprime mortgage market.

Subprime mortgages are housing loans made to less creditworthy borrowers. They include loans to borrowers who have a history of late payments or bankruptcy, who are not able to document their income sufficiently, or who are able to make only a small down payment on the property to be purchased. Because subprime loans are considered risky, financial institutions will only make them if they can charge higher interest rates than they charge more creditworthy borrowers. Subprime mortgage lending became more common in the 1980s when federal legislation deregulated interest rates and preempted state interest rate ceilings, allowing lenders to issue higher-interest-rate mortgages. Subsequent legislation eliminated the tax deductibility of consumer credit interest, but permitted the continued deductibility of home mortgage interest on both primary and secondary residences. This encouraged consumers to engage in cash-out refinancing, that is, refinancing an existing mortgage with a new, larger loan and taking the difference in cash. The net effect was to shift what might otherwise have been credit-card debt to mortgage debt. When interest rates increased during the mid-1990s, reducing loan demand from high-quality borrowers, lenders sought out new opportunities among the less creditworthy, which contributed to a further increase in new subprime mortgage loans.

The expansion of the subprime market was aided by securitization, a process that involves bundling a group of individual loans together into a mortgage-backed security (MBS) and selling pieces of that security to investors. A benefit of securitization is that it makes it relatively easy for firms and individuals to invest in mortgages and therefore increases the overall amount of money available for mortgage lending. The average individual investor would have no interest in buying the mortgage loan on my house. Anyone who bought my loan would have to assume administrative costs such as billing, record keeping, and tax reporting. And even if I appear to be good credit risk and hence unlikely to default, the investor who bought my loan would risk a substantial loss if through some unforeseen event I was unable to make my mortgage payments. On the other hand, that average investor would be much more likely to buy a share of a pool of several thousand mortgages like mine, where the administrative costs could be divided up among many investors and the default of a few loans (out of thousands) would not jeopardize the value of the investment. In this way, securitization increased the funding available for housing finance.

Although mortgage securitization had been popularized in the 1980s, the securitized loans at that time were typically “conforming” mortgages, that is, of a standard size with a relatively credit-worthy borrower and high quality collateral. Securities backed by pools of conforming mortgages were eligible to be guaranteed by the quasi-government Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), and hence carried a low risk of default and, therefore, low interest rates. In an effort to increase home ownership by the less affluent during the 1990s, government policy encouraged Fannie Mae and Freddie Mac to increase the flow of mortgage lending to low and moderate income areas and borrowers, including relaxing lending standards. These policy actions gave a boost to the subprime market: subprime mortgage-backed securities made up 3 percent of outstanding MBSs in 2000 and 8.5 percent of all new issues; by 2006, they constituted 13 percent of outstanding MBSs and nearly 22 percent of new issues. More than 80 percent of all new subprime loans were financed by securitization during 2005 and 2006, up from about 50 percent in 2001.

The proliferation of subprime mortgage-backed securities led them to be used in a variety of even more complex securities, such as collateralized debt obligations (CDOs) and credit default swaps (CDSs). CDOs consist of a portfolio of debt securities (including subprime MBSs), which are financed by issuing even more securities. These securities are classified into higher-and lower-risk portions, called “tranches,” with higher-risk tranches providing higher returns. The tranches were assigned risk ratings by the credit ratings agencies Moody’s, Standard and Poor’s, and Fitch, which were harshly criticized in the wake of the crisis for having been overgenerous in their ratings. One of the main complaints against the ratings agencies is that since they are paid by issuers, who pay a lower interest rate if they receive a higher rating, they have an incentive to be overly generous in assigning ratings. As a managing director of Moody’s, one of the big-three ratings agencies, said anonymously in 2007: “These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”

Credit default swaps are contracts in which one party (the protection seller) agrees to pay, in return for a periodic fee, another party (the protection buyer) in the case of an “adverse credit event,” such as bankruptcy. The availability of CDSs encouraged financial firms to hold CDOs, since they believed that CDSs insured them against losses on their CDOs. However, even though a CDS sounds very much like conventional insurance, it is not. A life-insurance company issues many policies; since the likelihood of death is small for any given policy holder, claims against the insurer are typically paid off from the proceeds of premia paid by policy holders that do not die. CDSs involve no such pooling of risk, so the extent to which the protection seller is able to pay off in the case of an adverse event depends solely on the value of the assets—which might fall during a crisis—it has to back up the contract.

It is well beyond the scope of this chapter to explain the veritable alphabet soup of derivative securities—including CDO2s, synthetic CDOs, multisector CDOs, and cash flow CDOs—that emerged during this time. Even without details, it is clear that the development of these instruments, combined with elements of deregulation and misguided policy, made it easier and more profitable for less-creditworthy borrowers to obtain mortgage loans. Because of securitization and the attractive returns paid by these new securities, it was much easier for subprime-related securities to be sold in the United States and abroad. When the US housing boom collapsed, the value of many of these securities fell sharply and led to the collapse of institutions that held or had loaned money against them.

It is clear that there were misaligned incentives every step of the way toward the subprime crisis. Edmund Andrews, at the time a New York Times economics correspondent who was caught up in his own subprime nightmare, explained the chain of events.

My mortgage company hadn’t cared because it would sell my loan to Wall Street. Wall Street firms hadn’t cared, because they would bundle the loan into a mortgage-backed security and resell it to investors around the world. The investors hadn’t cared, because the rating agencies had given the securities a triple-A rating. And the rating agencies hadn’t cared, because their models showed that these loans had performed well in the past.

The collapse of the real estate market led to a sharp decline in the value of mortgage-backed securities that had supported it and widespread distress among financial institutions—in short: the type of bust that Irving Fisher had written about more than three-quarters of a century earlier.

An additional factor contributing to the growth of the speculative bubble was the absence of effective regulation and supervision of the new and complex securities and of the institutions that employed them. To explain the importance of government regulation, we must return to fear and greed. Virtually any financial decision can be framed in terms of these twin motives. Should I invest my life savings in a risky venture that will either make me a millionaire or put me in the poorhouse? Or should I restrict myself to only the bluest of blue chip stocks and the safest, if low yielding, bonds? Greed will steer me toward the former choice; fear to the latter. If there is a boom in risky ventures and their owners all seem to be making money hand over fist, my greed might get the better of my fear. Typically, the government doesn’t get involved in my decision-making process. I am free to choose to take as much risk as I see fit. The government maintains bankruptcy courts that will help my creditors carve up my assets if I do go bankrupt, but the government will not prevent me from making choices that might increase the probability that I become bankrupt.

Bankers are also subject to fear and greed. Because most of the funds that banks use are entrusted to them by depositors, governments establish rules to ensure that bankers’ greed does not overwhelm their fear. Among the most important of these rules are capital requirements. Capital requirements prevent banks from relying solely on deposits to fund their operations, forcing them also to use money that they and their shareholders put up. This money is known as capital. Capital requirements protect depositors in several ways. If a bank fails, capital can be used to pay off depositors. Additionally, holding capital encourages banks not to behave in an excessively risky way, so as not to jeopardize their own money. Capital also provides a concrete signal to depositors that the bank will not undertake excessive risk. The capacity of capital to reduce risk taking is sometimes described as putting banks in the position of having “skin in the game.” Governments have set bank capital requirements for many years, and in the Basel (1988), Basel II (2004), and Basel III (2010) Accords, an international consensus was reached on minimum capital standards. Under the Basel Accords, banks are required to hold proportionately more capital against inherently riskier assets.

In 1996, the Federal Reserve permitted banks to use CDSs as a substitute for bank capital under certain circumstances. Thus, holding CDSs for which the protection seller was a highly rated company, such as American International Group—which was bailed out by the Federal Reserve in 2008—allowed banks to hold less actual capital, making them more vulnerable to failure if the protection seller was unable to fulfill its part of the bargain. Regulators became aware of the potential problems surrounding some of these CDSs as early as 2004, but did not take any action. Further, in 2004 the Securities and Exchange Commission (SEC) ruled that the five largest investment banks (Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns, and Goldman Sachs) would be permitted to use their own internally created risk models to determine the levels of capital required rather than some government-mandated amount: in other words, these institutions became—to some extent—the judge of how much capital they needed to hold to insure their safety. Although the SEC announced its determination to hire more staff and have regular meetings with the investment banks to monitor the situation, capital ratios declined at all five investment banks following the ruling.

Another criticism of the regulators is that they did not impose more transparency on the derivatives market. That is, because these securities were so complex and were not traded on securities exchanges, it was easy for clients to misunderstand—or be misled— about the risky nature of these investments. Such allegations were made in connection with the derivatives transactions at the heart of the bankruptcy of Orange County, California, and in lawsuits brought against Bankers Trust by Gibson Greetings and Proctor and Gamble in the mid-1990s. Efforts to increase disclosure initiated by the Commodities Future Trading Commission (CFTC) met with opposition from the Federal Reserve, Treasury, and Congress; the Commodity Futures Modernization Act of 2000 exempted these derivatives from government supervision.

The subprime crisis has indeed been the longest, deepest, and broadest—in short, the worst—financial crisis since the Great Depression. Although the severity of the crisis was extraordinary, its origins were not: the boom-bust pattern of financial crises has been repeated again and again during the last 200 years.

When J. P. Morgan was asked about what the stock market would do, he famously replied, “It will fluctuate.” And, indeed, that is what most markets—be they markets for securities, currency, commodities, or real estate—do, rising and falling in an unpredictable manner. When the value of an asset, or a class of assets, continually rises for a prolonged period of time, investors often come to believe that increases will continue indefinitely: fear is banished and greed becomes the watchword. Once the belief that market prices can only go up is established, it makes good sense to borrow money to invest in that market—after all, the loan can be repaid with the proceeds from sale of the appreciated asset. The more firmly entrenched the belief that the asset will continue to rise, the greater the lengths reasonable people will go to take advantage of the seemingly free lunch.

The housing boom, fueled by ideologically driven expansionary fiscal and monetary policies, encouraged the development of new and increasingly risky ways of taking advantage of its apparently limitless profit possibilities. Mortgage lending, which previously had been confined to those most able to afford it, was made available—also for ideological reasons—to individuals of more precarious means: those with less-solid credit histories, with less money to make a down payment, and with lower incomes. There are sound public policy arguments for promoting home ownership among all sectors of society; however, encouraging the less well off to take on debt that may be beyond what they are able to service—particularly in the event of a decline in the economy and house prices—dramatically increases the risk of a severe crisis. Further, because subprime lending was profitable, financial institutions regularly devised new and increasingly risky means of raising even more money to pour into the housing market. This further inflated the bubble and made its collapse that much more painful. Finally, the supervisory and regulatory apparatuses that were specifically mandated to protect the system utterly failed.

It would be an oversimplification to place the blame for the subprime crisis solely on ill-conceived fiscal and monetary policies. Fingers have been pointed—with good reason—at a host of alternative villains, including Fannie Mae, Freddie Mac, the credit ratings agencies, and the SEC. And, of course, borrowers themselves were not blameless. According to Edmund Andrews:

Nobody duped me, hypnotized me, or lulled me with drugs. Like so many others—borrowers, lenders, and the Wall Street deal makers behind them—I thought I could beat the odds. Everybody had a reason for getting in trouble. The brokers and deal makers were scoring huge commissions. The condo flippers were aiming for quick profits. The ordinary home buyers wanted to own their first houses, or bigger houses, or vacation houses. Some were greedy, some were desperate, and some were deceived.

Nonetheless, the bulk of the blame for the crisis must be assigned to the Bush administration’s fiscal policy and the Greenspan Fed’s monetary policy. Why? Quite simply: fear and greed. The economic and speculative boom launched by the fiscal and monetary policies of the early 2000s raised the returns to greed—that is, the incentive to take on additional risk—to extraordinary levels. No matter how fear-inspiring the regulation and supervision was—and it was not—it would have been overwhelmed by dangerously high levels of greed.

[seemslikeadream]

MONDAY, OCT 14, 2013 06:43 AM CDT
Greed destroyed us all: George W. Bush and the real story of the Great Recession
Faulty monetary policy and insufficient regulation helped — but old-fashioned avarice really tanked the economy
BY RICHARD S. GROSSMAN


George W. Bush (Credit: AP/Lm Otero)
Excerpted from “WRONG: Nine Economic Policy Disasters and What We Can Learn From Them”
If financial crises came with their own nicknames, the subprime meltdown surely would have earned the sobriquet “worst financial crisis since the Great Depression.” That mantra has been chanted over and over again, not only by leading academics and media pundits, but at the highest levels of policy making. When President Barack Obama selected Christina Romer, an economic historian from the University of California, Berkeley, as chair of his Council of Economic Advisors, some carped that the president should have selected an economist with a deeper background in policy rather than in economic history. When Romer herself later asked President Obama’s chief of staff Rahm Emanuel why she got the job, Emmanuel answered: “You’re an expert on the Great Depression, and we really thought we might need one.” Given how close the subprime crisis came to economic Armageddon, it is important to understand the series of policy mistakes behind it.

For the most part, previous chapters in this book have focused on particular policies that have had disastrous results, rather than on economic disasters and the policies that led to them. The three policy failures of the interwar period—German reparations after World War I, the interwar gold standard, and the increasing trade protectionism of the 1930s—each merited its own chapter instead of being discussed in a single chapter on the Great Depression. The approach adopted here is different. Rather than starting with a failed economic policy, this chapter starts with a disaster—the subprime crisis—and examines the policies that contributed to it.

There are good reasons for proceeding in this way. The interwar policies discussed earlier had their origins in different countries and occurred under widely differing circumstances. World War I reparations resulted from fears that an isolationist United States would not be able to counter future German aggression, the heavy burdens of inter-Allied debts, and a French desire to punish Germany. The worldwide return to the gold standard was galvanized by the British precedent, which was based on a desire to return to the monetary “normalcy” of the nineteenth century. And the rise of trade protectionism, spurred by the United States’s Smoot-Hawley tariff, was a response to the beginnings of a global economic downturn and domestic political factors. By contrast, the subprime crisis originated almost entirely in the United States, although it subsequently spread far and wide. The main culprits behind the crisis were ill-conceived and ideologically motivated fiscal and monetary policies, which were aided and abetted by inadequate regulation and a variety of other policy mistakes.

Despite the severity of both the Great Depression and the subprime crisis, neither was completely unprecedented. Banking crises were common during the nineteenth and early twentieth centuries: there were more than 60 such crises in the industrialized world during 1805–1927. Many of these crises shared a common “boom-bust” pattern. Boom-bust crises occur when business cycles—the regular, normally moderate upward and downward movements in economic activity—become exaggerated, leading to a spectacular economic expansion followed by a dramatic collapse. Boom-bust crises play a central role in formal models of financial crises dating back at least as far as Yale economist Irving Fisher, who wrote about them in the 1930s. In Fisher’s telling, economic expansion leads to a growth in the number and size of bank loans—and even the number of banks themselves—and a corresponding increase in borrowing by non-bank firms. As the expansion persists, bankers continue to seek profitable investments, even though as the boom progresses and more investment projects are funded, fewer worthwhile projects remain. The relative scarcity of sound projects does not dissuade eager lenders, however, who continue to dole out funds. Fisher laments this excessive buildup of debt during cyclical upswings: “If only the (upward) movement would stop at equilibrium!” But, of course, it doesn’t.

When the economic expansion ends, the weakest firms—typically those that received loans later in the expansion—have difficulty repaying and default. Loan defaults lead to distress among the banks that made the now-impaired loans, panic among the depositors who entrusted their savings to these banks, and a decline in the wealth of bank shareholders. Even if no depositor panic ensues, banks under pressure will become more defensive by reducing their loan portfolio, both by making fewer new loans and by refraining from renewing outstanding loans that have reached maturity. Banks and individuals will sell securities in an attempt to raise cash, leading to declines in stock and bond markets. The contraction in the availability of loans will hurt firms and further exacerbate the business cycle downturn. The deepening contraction will lead to more loan defaults and bank failures, which will further depress security prices and worsen the business cycle downturn that is already underway.

Two other distinctive features characterize boom-bust crises. First, the economic expansion is typically fueled by cheap and abundant credit. That is, bankers have a lot of money to lend, which they are willing to lend at low interest rates. This often occurs when the central bank follows a low interest rate policy. In earlier times, when gold constituted a substantial portion of the money stock, credit expansion could be the result of gold discoveries or gold imports, which made loanable funds plentiful and cheap. It could also be a consequence of an increased willingness on the part of banks to lend the funds that they already have on hand, or from the emergence of new ways of lending money, including the creation of new types of securities. Second, boom-bust cycles are often accompanied by increased speculation in a particular asset or class of assets, the price of which, fed by cheap and abundant credit, rises dramatically during the course of the boom—and then collapses catastrophically during the bust.

The scenario described above aptly describes many nineteenth and twentieth century crises. For example, England suffered crises in 1825, 1836–39, 1847, 1857, 1866, and 1890. Each of these was preceded by several years of rapid economic growth, frequently fueled by gold imports and accompanied by increased speculation. The object of speculation varied from crisis to crisis and included at different times grain, railroads, stocks, and Latin American investments. Similar stories can be told about US crises of 1837, 1857, 1873, 1893, and 1907, and many others in Australia, Canada, and Japan, and across Western Europe.

As the world economy became more interconnected during the course of the nineteenth century, increasing numbers of these crises took on an international character. During the weeks following the outbreak of a panic in London in August 1847, business failures spread outward from London to the rest of Britain, to British colonies, and to continental and American destinations. Similarly, the 1857 crisis, which started in the United States, soon spread to Austria, Denmark, and Germany. The even more severe crises of the mid-1870s, early 1890s, 1907, and early 1920s, not to mention the Great Depression of the 1930s, also traveled extensively.

It is impossible to identify precisely when the run-up to the sub-prime crisis began. According to the National Bureau of Economic Research, the private academic organization that is the arbiter of when business cycle expansions and contractions begin and end, the longest-ever US business cycle expansion began in March 1991 and lasted until March 2001. Following an eight-month downturn—among the shortest in US history—the business cycle turned upward again in November 2001. That expansion ended late in 2007, about the same time that the subprime meltdown began. The boom, like countless others before, was fed by expansionary fiscal and monetary policies.

The business cycle expansion that began in 2001 was given a substantial boost by a series of three tax cuts during the first three years of the administration of President George W. Bush. President Bush was ideologically committed to lower taxes and had pledged, if elected, to cut taxes. In his acceptance speech to the Republican National Convention in Philadelphia on August 3, 2000, Bush said:

Today, our high taxes fund a surplus. Some say that growing federal surplus means Washington has more money to spend. But they’ve got it backwards. The surplus is not the government’s money. The surplus is the people’s money. I will use this moment of opportunity to bring common sense and fairness to the tax code. And I will act on principle. On principle…every family, every farmer and small businessperson, should be free to pass on their life’s work to those they love. So we will abolish the death tax. On principle…no one in America should have to pay more than a third of their income to the federal government. So we will reduce tax rates for everyone, in every bracket.

Supported by a Republican majority in the House of Representatives and a nearly evenly divided Senate, Bush signed into law the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the Job Creation and Worker Assistance Act of 2002, and the Jobs Growth and Tax Relief Reconciliation Act of 2003. These laws lowered tax rates in all brackets, reduced taxes on capital gains and some dividends, and increased a variety of exemptions, credits, and deductions. Some of the tax cuts, which were to be phased in under EGTRRA, were accelerated under the 2003 legislation.

Further fiscal stimulus was provided by the invasion of Afghanistan the month following the terrorist attacks on September 11, 2001 and the war in Iraq, which began in March 2003. The war led to the deployment of 5,200 US troops in Afghanistan during the fiscal year 2002; by 2008, the combined in-country forces in Afghanistan and Iraq had reached nearly 188,000. Thanks in large part to the collapse of the Soviet Union, US military spending had been relatively flat in the 1990s, never exceeding $290 billion in any year. By 2008, annual military spending had more than doubled, to $595 billion.

President Bush was faithful to his pledge to eliminate the federal government’s budget surplus. The net effect of the tax cuts, combined with the additional expenditure related to the overseas conflicts, turned the federal government’s $236 billion surplus in 2000 to a $458 billion deficit by 2008. This fiscal stimulus encouraged more spending by households and firms and contributed to the economic boom that lasted from 2001 to 2007.

The boom was also fueled by expansionary monetary policy, as the Federal Reserve kept interests rates low for a prolonged period. At the end of 2000, the federal funds rate, a key indicator of Federal Reserve monetary policy, stood at 6.5 percent. Following a sharp decline in stock prices in March 2001, primarily the result of the collapse of internet stocks (the “dot-com bubble”), the Federal Reserve lowered interest rates swiftly and dramatically in an effort to cushion the effects of the fall on the wider economy. By the end of March 2001, the federal funds rate had been reduced to 5 percent, and by June it was 4 percent. In August it stood at 3.5 percent, and was further reduced following the terrorist attacks of September 11. By the end of 2001, the federal funds rate was below 2 percent—its lowest level in more than 40 years. The rate remained at or below 1 percent for nearly a year during 2003–04, and below 2 percent until the middle of November 2004. The low interest rate policy, especially during 2003–04, helped to ignite a speculative boom.

The Fed kept interest rates low for two reasons. First, employment had recovered more slowly than expected from the 2001 recession, the so-called jobless recovery, indicating that a more prolonged period of lower interest rates was needed to stimulate the economy. Second, Fed policy makers were concerned that the country might fall into a Japanese-style “lost decade” if they did not make a clear and convincing case through bold actions that low interest rates would persist as long as required to boost the economy. A less charitable view holds that Fed chairman Alan Greenspan’s motives were less economic and more ideological and self-serving—supporting easy monetary policy to increase the re-election prospects of fellow Republican George W. Bush, who was locked in a tight re-election race, or to curry favor with the administration so that he would be reappointed Fed chairman when his term expired after the presidential election. And, in fact, President Bush did nominate Greenspan for an unprecedented fifth term in May 2005. Whatever the reason for the prolonged monetary easing, it was crucial to the development of the boom.

As previously noted, boom-bust cycles are often accompanied by increased speculation in a particular asset or class of assets. During the subprime meltdown, the object of speculation was real estate. Housing prices, which had risen by about 25 percent during the entire decade of the 1990s, more than doubled between 2000 and 2006. The amount of debt undertaken to finance housing purchases also increased dramatically. Although expansionary fiscal and monetary policies undoubtedly fueled the explosion in house prices, the boom was enabled by a variety of legal and financial developments that eased constraints on the housing finance market, particularly the subprime mortgage market.

Subprime mortgages are housing loans made to less creditworthy borrowers. They include loans to borrowers who have a history of late payments or bankruptcy, who are not able to document their income sufficiently, or who are able to make only a small down payment on the property to be purchased. Because subprime loans are considered risky, financial institutions will only make them if they can charge higher interest rates than they charge more creditworthy borrowers. Subprime mortgage lending became more common in the 1980s when federal legislation deregulated interest rates and preempted state interest rate ceilings, allowing lenders to issue higher-interest-rate mortgages. Subsequent legislation eliminated the tax deductibility of consumer credit interest, but permitted the continued deductibility of home mortgage interest on both primary and secondary residences. This encouraged consumers to engage in cash-out refinancing, that is, refinancing an existing mortgage with a new, larger loan and taking the difference in cash. The net effect was to shift what might otherwise have been credit-card debt to mortgage debt. When interest rates increased during the mid-1990s, reducing loan demand from high-quality borrowers, lenders sought out new opportunities among the less creditworthy, which contributed to a further increase in new subprime mortgage loans.

The expansion of the subprime market was aided by securitization, a process that involves bundling a group of individual loans together into a mortgage-backed security (MBS) and selling pieces of that security to investors. A benefit of securitization is that it makes it relatively easy for firms and individuals to invest in mortgages and therefore increases the overall amount of money available for mortgage lending. The average individual investor would have no interest in buying the mortgage loan on my house. Anyone who bought my loan would have to assume administrative costs such as billing, record keeping, and tax reporting. And even if I appear to be good credit risk and hence unlikely to default, the investor who bought my loan would risk a substantial loss if through some unforeseen event I was unable to make my mortgage payments. On the other hand, that average investor would be much more likely to buy a share of a pool of several thousand mortgages like mine, where the administrative costs could be divided up among many investors and the default of a few loans (out of thousands) would not jeopardize the value of the investment. In this way, securitization increased the funding available for housing finance.

Although mortgage securitization had been popularized in the 1980s, the securitized loans at that time were typically “conforming” mortgages, that is, of a standard size with a relatively credit-worthy borrower and high quality collateral. Securities backed by pools of conforming mortgages were eligible to be guaranteed by the quasi-government Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), and hence carried a low risk of default and, therefore, low interest rates. In an effort to increase home ownership by the less affluent during the 1990s, government policy encouraged Fannie Mae and Freddie Mac to increase the flow of mortgage lending to low and moderate income areas and borrowers, including relaxing lending standards. These policy actions gave a boost to the subprime market: subprime mortgage-backed securities made up 3 percent of outstanding MBSs in 2000 and 8.5 percent of all new issues; by 2006, they constituted 13 percent of outstanding MBSs and nearly 22 percent of new issues. More than 80 percent of all new subprime loans were financed by securitization during 2005 and 2006, up from about 50 percent in 2001.

The proliferation of subprime mortgage-backed securities led them to be used in a variety of even more complex securities, such as collateralized debt obligations (CDOs) and credit default swaps (CDSs). CDOs consist of a portfolio of debt securities (including subprime MBSs), which are financed by issuing even more securities. These securities are classified into higher-and lower-risk portions, called “tranches,” with higher-risk tranches providing higher returns. The tranches were assigned risk ratings by the credit ratings agencies Moody’s, Standard and Poor’s, and Fitch, which were harshly criticized in the wake of the crisis for having been overgenerous in their ratings. One of the main complaints against the ratings agencies is that since they are paid by issuers, who pay a lower interest rate if they receive a higher rating, they have an incentive to be overly generous in assigning ratings. As a managing director of Moody’s, one of the big-three ratings agencies, said anonymously in 2007: “These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”

Credit default swaps are contracts in which one party (the protection seller) agrees to pay, in return for a periodic fee, another party (the protection buyer) in the case of an “adverse credit event,” such as bankruptcy. The availability of CDSs encouraged financial firms to hold CDOs, since they believed that CDSs insured them against losses on their CDOs. However, even though a CDS sounds very much like conventional insurance, it is not. A life-insurance company issues many policies; since the likelihood of death is small for any given policy holder, claims against the insurer are typically paid off from the proceeds of premia paid by policy holders that do not die. CDSs involve no such pooling of risk, so the extent to which the protection seller is able to pay off in the case of an adverse event depends solely on the value of the assets—which might fall during a crisis—it has to back up the contract.

It is well beyond the scope of this chapter to explain the veritable alphabet soup of derivative securities—including CDO2s, synthetic CDOs, multisector CDOs, and cash flow CDOs—that emerged during this time. Even without details, it is clear that the development of these instruments, combined with elements of deregulation and misguided policy, made it easier and more profitable for less-creditworthy borrowers to obtain mortgage loans. Because of securitization and the attractive returns paid by these new securities, it was much easier for subprime-related securities to be sold in the United States and abroad. When the US housing boom collapsed, the value of many of these securities fell sharply and led to the collapse of institutions that held or had loaned money against them.

It is clear that there were misaligned incentives every step of the way toward the subprime crisis. Edmund Andrews, at the time a New York Times economics correspondent who was caught up in his own subprime nightmare, explained the chain of events.

My mortgage company hadn’t cared because it would sell my loan to Wall Street. Wall Street firms hadn’t cared, because they would bundle the loan into a mortgage-backed security and resell it to investors around the world. The investors hadn’t cared, because the rating agencies had given the securities a triple-A rating. And the rating agencies hadn’t cared, because their models showed that these loans had performed well in the past.

The collapse of the real estate market led to a sharp decline in the value of mortgage-backed securities that had supported it and widespread distress among financial institutions—in short: the type of bust that Irving Fisher had written about more than three-quarters of a century earlier.

An additional factor contributing to the growth of the speculative bubble was the absence of effective regulation and supervision of the new and complex securities and of the institutions that employed them. To explain the importance of government regulation, we must return to fear and greed. Virtually any financial decision can be framed in terms of these twin motives. Should I invest my life savings in a risky venture that will either make me a millionaire or put me in the poorhouse? Or should I restrict myself to only the bluest of blue chip stocks and the safest, if low yielding, bonds? Greed will steer me toward the former choice; fear to the latter. If there is a boom in risky ventures and their owners all seem to be making money hand over fist, my greed might get the better of my fear. Typically, the government doesn’t get involved in my decision-making process. I am free to choose to take as much risk as I see fit. The government maintains bankruptcy courts that will help my creditors carve up my assets if I do go bankrupt, but the government will not prevent me from making choices that might increase the probability that I become bankrupt.

Bankers are also subject to fear and greed. Because most of the funds that banks use are entrusted to them by depositors, governments establish rules to ensure that bankers’ greed does not overwhelm their fear. Among the most important of these rules are capital requirements. Capital requirements prevent banks from relying solely on deposits to fund their operations, forcing them also to use money that they and their shareholders put up. This money is known as capital. Capital requirements protect depositors in several ways. If a bank fails, capital can be used to pay off depositors. Additionally, holding capital encourages banks not to behave in an excessively risky way, so as not to jeopardize their own money. Capital also provides a concrete signal to depositors that the bank will not undertake excessive risk. The capacity of capital to reduce risk taking is sometimes described as putting banks in the position of having “skin in the game.” Governments have set bank capital requirements for many years, and in the Basel (1988), Basel II (2004), and Basel III (2010) Accords, an international consensus was reached on minimum capital standards. Under the Basel Accords, banks are required to hold proportionately more capital against inherently riskier assets.

In 1996, the Federal Reserve permitted banks to use CDSs as a substitute for bank capital under certain circumstances. Thus, holding CDSs for which the protection seller was a highly rated company, such as American International Group—which was bailed out by the Federal Reserve in 2008—allowed banks to hold less actual capital, making them more vulnerable to failure if the protection seller was unable to fulfill its part of the bargain. Regulators became aware of the potential problems surrounding some of these CDSs as early as 2004, but did not take any action. Further, in 2004 the Securities and Exchange Commission (SEC) ruled that the five largest investment banks (Morgan Stanley, Merrill Lynch, Lehman Brothers, Bear Stearns, and Goldman Sachs) would be permitted to use their own internally created risk models to determine the levels of capital required rather than some government-mandated amount: in other words, these institutions became—to some extent—the judge of how much capital they needed to hold to insure their safety. Although the SEC announced its determination to hire more staff and have regular meetings with the investment banks to monitor the situation, capital ratios declined at all five investment banks following the ruling.

Another criticism of the regulators is that they did not impose more transparency on the derivatives market. That is, because these securities were so complex and were not traded on securities exchanges, it was easy for clients to misunderstand—or be misled— about the risky nature of these investments. Such allegations were made in connection with the derivatives transactions at the heart of the bankruptcy of Orange County, California, and in lawsuits brought against Bankers Trust by Gibson Greetings and Proctor and Gamble in the mid-1990s. Efforts to increase disclosure initiated by the Commodities Future Trading Commission (CFTC) met with opposition from the Federal Reserve, Treasury, and Congress; the Commodity Futures Modernization Act of 2000 exempted these derivatives from government supervision.

The subprime crisis has indeed been the longest, deepest, and broadest—in short, the worst—financial crisis since the Great Depression. Although the severity of the crisis was extraordinary, its origins were not: the boom-bust pattern of financial crises has been repeated again and again during the last 200 years.

When J. P. Morgan was asked about what the stock market would do, he famously replied, “It will fluctuate.” And, indeed, that is what most markets—be they markets for securities, currency, commodities, or real estate—do, rising and falling in an unpredictable manner. When the value of an asset, or a class of assets, continually rises for a prolonged period of time, investors often come to believe that increases will continue indefinitely: fear is banished and greed becomes the watchword. Once the belief that market prices can only go up is established, it makes good sense to borrow money to invest in that market—after all, the loan can be repaid with the proceeds from sale of the appreciated asset. The more firmly entrenched the belief that the asset will continue to rise, the greater the lengths reasonable people will go to take advantage of the seemingly free lunch.

The housing boom, fueled by ideologically driven expansionary fiscal and monetary policies, encouraged the development of new and increasingly risky ways of taking advantage of its apparently limitless profit possibilities. Mortgage lending, which previously had been confined to those most able to afford it, was made available—also for ideological reasons—to individuals of more precarious means: those with less-solid credit histories, with less money to make a down payment, and with lower incomes. There are sound public policy arguments for promoting home ownership among all sectors of society; however, encouraging the less well off to take on debt that may be beyond what they are able to service—particularly in the event of a decline in the economy and house prices—dramatically increases the risk of a severe crisis. Further, because subprime lending was profitable, financial institutions regularly devised new and increasingly risky means of raising even more money to pour into the housing market. This further inflated the bubble and made its collapse that much more painful. Finally, the supervisory and regulatory apparatuses that were specifically mandated to protect the system utterly failed.

It would be an oversimplification to place the blame for the subprime crisis solely on ill-conceived fiscal and monetary policies. Fingers have been pointed—with good reason—at a host of alternative villains, including Fannie Mae, Freddie Mac, the credit ratings agencies, and the SEC. And, of course, borrowers themselves were not blameless. According to Edmund Andrews:

Nobody duped me, hypnotized me, or lulled me with drugs. Like so many others—borrowers, lenders, and the Wall Street deal makers behind them—I thought I could beat the odds. Everybody had a reason for getting in trouble. The brokers and deal makers were scoring huge commissions. The condo flippers were aiming for quick profits. The ordinary home buyers wanted to own their first houses, or bigger houses, or vacation houses. Some were greedy, some were desperate, and some were deceived.

Nonetheless, the bulk of the blame for the crisis must be assigned to the Bush administration’s fiscal policy and the Greenspan Fed’s monetary policy. Why? Quite simply: fear and greed. The economic and speculative boom launched by the fiscal and monetary policies of the early 2000s raised the returns to greed—that is, the incentive to take on additional risk—to extraordinary levels. No matter how fear-inspiring the regulation and supervision was—and it was not—it would have been overwhelmed by dangerously high levels of greed.

[seemslikeadream]

N.Y. Fed Moves to Seal Documents in Ex-Bank Examiner’s Suit
by Jake Bernstein
ProPublica, Oct. 14, 2013, 3:02 p.m.

A federal judge in Manhattan is pondering whether to grant the request of the New York Federal Reserve to seal the case brought by former senior bank examiner Carmen Segarra.

As reported by ProPublica last week, Segarra filed a lawsuit against the New York Fed and three of its employees alleging she had been wrongfully terminated last year after she determined that Goldman Sachs had insufficient conflict-of-interest policies.

On Friday, the Fed asked for a protective order to seal documents in the case as well as parts of the complaint. In a letter to U.S. District Judge Ronnie Abrams, New York Fed counsel David Gross said the information should be removed from the public docket because it is “Confidential Supervisory Information,” including internal New York Fed emails and materials provided to the Fed by Goldman.

“These documents show that at the time (Segarra) left the employ of the New York Fed, she purloined property of the Board of Governors of the Federal Reserve System,” Gross wrote, citing Fed rules that prohibit disclosing supervisory information without prior approval of the Fed.

Gross argues that the Fed’s obligation to keep bank supervisory records secret outweigh the public’s right to know. “The incantation of a ‘public right to know’ cannot ever be a license to discharged employees that they may violate Federal law simply by filing a complaint in Federal court,” Gross wrote.

Segarra and her lawyer could not be reached for comment.

While Abrams considers her decision, Segarra’s lawsuit and appended documents have been removed from Pacer, the online records system for federal courts. The complaint and related documents are available via links in ProPublica’s story and have been published elsewhere online.

Gross states in his letter that Segarra previously made a $7 million settlement offer. The Fed rejected it.

The New York Fed has historically been one of the most opaque financial regulators and maintains that it is not subject to the Freedom of Information Act because it is not a public agency.

Under new powers granted to it by Congress, the Federal Reserve System carries responsibility for ensuring that the nation’s most complex financial institutions are not posing a systemic threat to the world economy.

Because of its location, the New York Fed supervises the majority of the so-called “Too- Big-to-Fail” banks. New York Fed officials acknowledge that the institution failed in its regulatory responsibilities in the lead-up to the financial crisis.

A hearing on the Fed’s request is scheduled for tomorrow in Abrams’ court.

[seemslikeadream]

Documents to Remain Open in Examiner’s Lawsuit Against Fed

Posted on Oct 15, 2013

By Jake Bernstein, ProPublica

This story originally ran on ProPublica.

A federal judge rejected the Federal Reserve Bank of New York’s plea to seal documents in a wrongful termination lawsuit filed by a former bank examiner who claims she was fired for doing her job.

U.S. District Judge Ronnie Abrams ruled today in the case by Carmen Segarra against the New York Fed and three employees. Much of the material the Fed hoped to keep off limits, including 67 paragraphs from Segarra’s complaint and multiple exhibits, can be found on ProPublica’s website and others.

“I am not convinced that anything will be accomplished to seal or redact a complaint that is publicly available,” said Abrams in the hearing held at the federal courthouse in lower Manhattan.

Segarra worked for the New York Fed for seven months before being fired in May of last year. She was assigned to examine Goldman Sachs and its conflict-of-interest policies, she said. Segarra said she determined that Goldman’s policies did not meet Fed requirements. Her lawsuit alleges that her bosses tried to convince her otherwise and that she was fired after refusing to change her findings.

Goldman says it has robust methods for managing conflicts of interest and has declined comment on Segarra.
At today’s hearing, New York Fed attorney David Gross accused Segarra of stealing confidential documents, including her own internal emails and meeting minutes. Were the court to allow them to remain public on its own electronic records system, called Pacer, it “would be helping this improper conduct,” Gross said.

Gross compared the New York Fed’s relationship with the financial institutions it supervises to attorney-client privilege. Should the institutions lose faith in the Fed’s ability to keep communications and documents secret, it could spell trouble, he said.

“If [the supervised banks] don’t think it will be confidential, they will be less willing to give that information, to the detriment of the financial system,” said Gross.

Although ruling against the Fed, Abrams asked Segarra and her attorney, Linda Stengle, not to reveal any more confidential supervisory information without first consulting with her. “This is not a gag order,” the judge said. “I am not telling plaintiff she cannot talk about her case.”

Linda Stengle said afterward she was pleased about the ruling but unhappy that there were constraints placed on her client. “It’s important that the public have access to the information” in support of Segarra’s case, she said.

A spokesperson for the New York Fed did not immediately respond to a request for comment.

[justdrew]

Nobel Prize Committee, Meet Your Pals in the Tea Party
By honoring a fraudulent theory with the economics prize, Stockholm only perpetuates the nonsense in Washington.
By Michael Hirsh | October 15, 2013

Who is more irrational: the tea party or the Nobel Prize committee? That's a pretty close call this week.

Tea party libertarians base much of their view of the world – and their current efforts to blow up Washington – on the simplistic idea that government is always bad and markets are always good. The more freedom, the better for all. The Nobel Prize committee effectively endorsed this concept on Monday by awarding the 2013 prize to the University of Chicago's Eugene Fama, whose "efficient markets hypothesis" was mocked even by the father of modern free-market economics, Milton Friedman, but which forms a fundamental justification of the world view that tea partiers, many of them unknowingly, live and breathe. That's the long-since debunked view that markets, especially financial markets, are always rational, so just let 'em rip. No regulation needed. No government needed.

So irrational was the Nobel decision that even the committee second-guessed itself; it simultaneously gave a piece of the 2013 award to Yale's Robert Shiller, whose life's work has sought to show that Fama's theory is "one of the most remarkable errors in the history of economic thought." (This is perhaps Stockholm's idea of what Wall Street calls a "hedge.")

Shiller has developed a field of "behavioral economics" fleshing out John Maynard Keynes's idea that irrational "animal spirits" drive markets more than policy-makers realize. If we needed any more proof of that, we got it in 2008, when we realized that virtually every Wall Street CEO and the biggest, most sophisticated banks in the world had no clue what they doing and would have destroyed themselves en masse had not the government (yes, the government) stepped in to save them at taxpayer expense.

Why does any of this matter now? Because in spite of the ample evidence before us, we in Washington still live in the free-market fantasy world that Ronald Reagan ushered in, that even President Obama has lamented he has not been able to alter, and which the work of economists such as Fama has propagated. Yes, we know that freer markets are better than "command" economies of the communist ilk. The end of the Cold War proved that as the United States essentially bankrupted the Soviet Union out of existence; even Beijing concedes this, as would the extinct dinosaurs of the Soviet era.

But it's long past time for the pendulum to swing back to the middle from the extreme conclusion that this means fully free markets always work well. They don't. The United States is, in truth, not a free-market economy but a "mixed" economy. As the great economist Paul Samuelson once wrote, the end of the Cold War meant only that "victory has been declared in favor of the market-pricing mechanism over the command mechanism of regulatory bureaucracy." The victor was plainly not pure laissez-faire capitalism but simply a more balanced economy—markets modified by government taxes and government-orchestrated transfers of wealth to limit inequality, and government monetary and fiscal policies to curb recessions and inflation.

The truth is not simple or rational, in other words, and in fact financial markets, most economists have long known, are the least rational of all,contra Fama. Even Milton Friedman didn't buy Fama's ideas, one of the late economist's students, Robert Auerbach, now a professor at the University of Texas at Austin, told me in a 2010 interview. Friedman asked his students: How could it be that all available information is instantly translated into price changes in a completely rational way, as Fama argued in his hugely influential theory, which opened the door to the kind of across-the-board deregulation that led Wall Street to almost destroy the global economy in the mid-2000s? Friedman pointed out that "traders couldn't make any money if that were true," Auerbach said.

Ironically, considering that it was tea-party antipathy to Obamacare – to "the government getting involved in health care"—that has put the United States on the precipice of default and economic disaster, some of the best economics work of recent decades has shown that the health care industry is one in which free markets don't work well. The Nobel-winning economist Joseph Stiglitz, among others, has demonstrated that this is because of the lack of good information shared between insurance companies and those they insure. The companies are habitually suspicious that their clients aren't forthright about their health and therefore always look for ways to deny coverage, like "preexisting conditions." Moreover, most health care is not a tradable "good"—everyone offers a different kind of service – and people rarely make "rational" decisions in health care. That's why many economists support universal coverage supplied or guaranteed by the government, or the idea of a public option. But you haven't heard much about that in the Obamacare debate, and of course as a sop to the free-marketers the public option was replaced by health care exchanges.

Obama himself has lamented the prevalence of a zeitgeist of free-market absolutism. Facing the debt-ceiling crisis in 2010, the president complained privately to a group of liberal economists how hard it was "to change the narrative after 30 years" of a small-government zealotry dating back to the Reagan presidency, according to one of the participants. In an interview last year, Maryland Gov. Martin O'Malley called it a "fairy tale gone wild." "Since Reagan, [the Republicans] have done a very good job of setting the frame and setting the story," O'Malley, a putative challenger for the 2016 Democratic presidential nomination, said. "The enemy is government. The enemy is taxes.… Taxes are things that must be eliminated. And the only good that comes from government is the elimination of taxes."

Economics, which flatters itself that it is a science (another myth perpetuated by the Nobel committee), should be helping us out of this confusion, but it is not. Should government be reined in? Of course. But the kinds of economic ideas that would allow a rational discussion of a mix of government and markets, spending cuts and revenue increases, no longer prevail in Washington, at least on the Republican side. And so we find ourselves in this perpetual non-debate, going from shutdown to shutdown and debt ceiling to debt ceiling, an endless state of brinksmanship fueled by misbegotten ideas. And the news from Stockholm isn't helping.

[JackRiddler]

It's not a Nobel Prize! It's a prize from the Fucking Bank of Sweden. They created it in Nobel's name after his death so as to advance the myth that economics as taught by capitalism is a science.

I wish people would stop paying attention to either the peace Novel or the economics "Nobel," the two that get the most attention even though they're the least credible. The peace prize is chosen by a committee of five former members of the Norwegian parliament who are appointed by parties according to each party's weight in the Oslo parliament. And this committee plays embarrassing and opportunistic politics to pump up their own importance, as we saw with the prizes for Obama and the European Union. It's a disgusting waste and plain grandstanding any time they don't give it to a group that's actually fighting the good fight and needs the attention.

[JackRiddler]

[NeonLX]

^^^^Now that's what I call a recovery!

[JackRiddler]

Hey, it's "structural"! Meaning 7% of prior paid employment now wiped out for good. Superfluous to continued "growth," i.e. capital accumulation. Until the next crisis.

[JackRiddler]

http://www.businessinsider.com/punking- ... th-2013-12

The Insanely Complicated Volcker Rule Is A Joke

James Kunstler, Kunstler.com

Dec. 16, 2013, 12:58 PM 785 2

The so-called Volcker Rule for policing (ha!) banking practices, approved by a huddle of federal regulating agency chiefs last week, is the latest joke that America has played on itself in what is becoming the greatest national self-punking exercise in world history.

First of all (and there’s a lot of all), this rule comes in the form of nearly 1,000 pages of incomprehensible legalese embedded in what was already a morbidly obese Dodd-Frank Wall Street Reform (ha!) and Consumer Protection (ha!) Act of 2012 that clocked in at 20,00 pages, not counting the immense rafts of mandated interpretations and adumbrations, of which the new Volcker Rule is but one.

These additions were required because the Dodd-Frank Act itself did not really spell out the particulars of enforcement but rather left it to the regulatory agencies to construct the rules — which they did with “help” of lobbyist-lawyers furnished by the banks themselves. That is, the lobbyists actually wrote the rules for Dodd-Frank and everything in it, which means the banks wrote the rules.

Does this strain your credulity? Well, this is the kind of nation we have become: anything goes and nothing matters. There really is no rule of law, just pretense.

The Volcker Rule was a lame gesture toward restoring the heart of the Glass-Steagall provisions of the Banking Act of 1933, which were repealed in 1999 in a cynical effort led by Wall Street uber-grifter Robert Rubin and his sidekick Larry Summers, who served serially as US Treasury Secretaries under Bill Clinton. Glass Steagall was passed in Congress following revelations of gross misconduct among bankers leading up to the stock market crash of 1929.

The main thrust of Glass Steagall was to mandate the separation of commercial banking (deposit accounts + lending) from investment banking (underwriting and trading in securities). The idea was to prevent banks from using money in customer deposit accounts to gamble in stocks and other speculative instruments. This rule was designed to work hand-in-hand with the Federal Deposit Insurance Corporation (FDIC), also created in 1933, to backstop the accounts of ordinary citizens in commercial banks. The initial backstop limits were very modest: $2,500 at inception, and didn’t rise above $40,000 until 1980. Investment banks, on the other hand, were not backstopped at all under Glass-Steagall, since their activities were construed as a form of high-toned gambling.

The Glass Steagall Act of 1933 was about 35 pages long, written in language that was precise, clear, and succinct. It worked for 66 years. Banking during those years was a pretty boring business, commercial banking especially. It operated on the 3-6-3 principle — pay 3 percent interest on deposits, lend at 6 percent, and be out on the golf course at 3 p.m. Bankers made a nice living but nothing like the obscene racketeering profits engineered by the looting operations of today. Before 1980, the finance sector of the economy was about 5 percent of all activity. Its purpose was to allocate precious capital to new productive ventures.

As American manufacturing was surrendered to other countries, there were fewer productive ventures for capital to be directed into. What remained was real estate development (a.k.a. suburban sprawl) and finance, which was the enabler of it. Finance ballooned to 40 percent of the US economy and the American landscape got trashed. The computer revolution of the 1990s stimulated tremendous “innovation” in financial activities. Much of that innovation turned out to be new species of swindles and frauds.

Now you understand the history of the so-called “housing bubble” and the crash of 2008. The US never recovered from it, and all the rescue attempts in the form of bail-outs, quantitative easing, zero interest rates, have turned into rackets aimed at papering-over this national failure to thrive. It is all ultimately linked to the larger story of industrialism and its relationship with the unique, finite, fossil fuel resources that the human race got cheaply for a few hundred years. That story is now winding down and we refuse to pay attention to the reality of it.

The absurdity of Dodd-Frank and the Volcker Rule in the face of that is just another symptom of that tragic inattention. The baroque prolixity of these statutes must have been fun for the lawyers to construct — thousands of pages of incantatory nonsense aimed at confounding any attempt to enforce decent conduct among bankers and their supposed regulators — but it does nothing to really help us move into the next phase of history.

[slimmouse]

Jack, In all seriousness, many thanks for the information you have provided in this thread. It really is priceless.

My own immediate reaction to your latest additions was the often felt reaction of "theyre taking the piss, arent they?"

"taking the piss" is a kind of english slang for" theyre decieiving us in a pretty serious way".

[coffin_dodger]

NY Times Op-Ed Contributor
Stumbling Toward the Next Crash
GORDON BROWN
December 18, 2013

LONDON — In early October 2008, three weeks after the Lehman Brothers collapse, I met in Paris with leaders of the countries in the euro zone. Oblivious to the global dimension of the financial crisis, they took the view that if there was fallout for Europe, America would be to blame — so it would be for America to fix. I was unable to convince them that half of the bundled subprime-mortgage securities that were about to blow up had landed in Europe and that euro-area banks were, in fact, more highly leveraged than America’s.

Despite the subsequent decision of the Group of 20 in 2009 on the need for rules to supervise what is now a globally integrated financial system, world leaders have spent the last five years in retreat, resorting to unilateral actions that have made a mockery of global coordination. Already, we have forgotten the basic lesson of the crash: Global problems need global solutions. And because we failed to learn from the last crisis, the world’s bankers are carrying us toward the next one.

cont: - http://www.nytimes.com/2013/12/19/opini ... .html?_r=0

Gordon Brown, a Labour member of the British Parliament, is a former chancellor of the Exchequer and prime minister.