As the
American election gets near, the partisans on either side have
assembled to criticise one another and show that there are actually
serious policy differences between the Democrats and Republics and
between President Barak Obama and his challenger, Mitt Romney. Yet
increasingly, the United States has degenerated into a one party state
divided into two factions: one calling itself Democratic and the other,
Republican. The two parties keep recycling the same people who have
promoted policies that have left the US as the world’s most indebted
nation. The genius of this system is to make most Americans believe if
offers alternatives.
For example, although Democrats claim that the cause of the 2008 financial crisis was caused by George W. Bush, the deregulation of the financial sector that began under Ronald Reagan (a Republican) were carried through with passion and zeal by the Bill Clinton administration (Democrats) supported by leading Republicans in the House and Senate. Bush only carried to the logical, albeit tragic, conclusion what both parties had promoted.
For
instance, in 1998 Citicorp and Travelers Group merged to form Citi
Group. This merger violated the Glass-Steagall Act, which had been
passed in 1933 after the Great Depression to prevent commercial banks
with customer deposits from engaging in risky investment activities. The
Federal Reserve (or Fed) under Allan Greenspan should have intervened
to stop this merger. Instead, it gave them an exemption for one year.
Clinton’s
Treasury Secretary, Robert Rubin strongly supported the act. Rubin had
been the Chief Executive Officer (CEO) of Goldman Sachs. In 1999,
Congress passed the Gramm-Leach-Bliley Act, which overturned
Glass-Steagall and paved way for deregulation. Senator Phil Gramm, one
of the sponsors of this act was the Republican chairman of the Senate
banking committee. From then onwards, the combination of commercial
banking with investment finance and securities trading proceeded without
hindrance and was to become the leading cause of the 2008 financial
meltdown.
In fact,
there had been an attempt to stop this slide into financial madness by
the chairperson of the Commodities Futures Trading Commission (CFTC),
Brooksley Born. In 1998, she raised alarm bells that trade in
unregulated Over the Counter Derivatives (OCDs) was likely to lead to
chaos. Inside the Clinton Administration, a coalition of Greenspan,
Rubin, his deputy Larry Summers, then chairman of the Securities
Exchange Commission (SEC), Arthur Levitt worked tirelessly with the
Republican controlled Congress to block Born’s attempted regulation
forcing her to resign in 1999.
When he
left government, Rubin became vice chairman of Citi Group and made US$
126m in that capacity. When Gramm left the senate, he became vice
chairman of UBS, one of the leading banks trading in derivatives.
Gramm’s wife had served on the board of the energy giant, Enron, which
later collapsed amidst corruption and fraud. Summers went on to become
and earn millions of dollars as a consultant to Wall Street financial
firms. When Obama came to office, he hired Summers as his economic
advisor – which is like putting Dracula in charge of the blood bank.
First, a
background: Previously in America and Europe, like in East Africa
today, a bank lent its own money (or customers’ deposits) to a borrower –
for example, to buy a home. Because the mortgage takes long to repay
(anything between 15 to 30 years), banks are always careful to evaluate
the credit worthiness of the borrower to ensure he/she pays back. So if
you have a regular income from a job or a business and your bank
records show a specific amount of income per month, you are approved
for the loan. This means that there is a direct relationship between a
home buyer and the lending bank. If the borrower fails to pay, the
lending bank suffers.
Then came
securitisation. Here, a bank lends money to many home buyers. It then
bundles together thousands of these loans and issues a bond, otherwise
called a “mortgage backed security”. It would then sell the bond to an
investment bank. A bond is a piece of paper saying: If you buy this
paper, I promise to pay you back with an interest of X percent per
month for Y years. The investment bank would sell them to investors. So
the lending bank would collect the money from the borrower, pay itself
a commission and pass on the balance to the investment bank, which
would in turn pass it on to the final investor. This secondary
mortgage market (otherwise called a securities market) separated the
borrower from the lender. It also transferred the risk in the event of
default to the holder of the bond – the investor.
Although I
have used the home buyers, there were other forms of credit which were
also traded. Investment banks would combine car loans, student loans,
credit card debt, corporate buy-out debt, commercial mortgages etc.
into complex derivatives called Collateralised Debt Obligations (or
CDOs). Investment banks would then sell these CDOs to investors all
over the world. These investors were often pension funds. Because they
carry long term liabilities, pension funds need long term investments to
match their obligations. Since money financing such debt did not come
from the commercial bank but these investors, it meant that these
investors were the ultimate lenders. But this also meant that the lender
did not know the borrower anymore.
Thus,
when the borrower paid their mortgage, credit card debt, student loan
or car loan, the money would go through the chain: the lending bank to
investment bank (each of whom would collect their commission) and
finally to the investors. In effect, these intermediary banks became
commission agents only collecting fees. This separation of the lender
from borrower encouraged intermediaries – lending banks and investment
banks – to indulge in excesses. Lending banks had little interest in
evaluating the credit worthiness of their borrower. They earned more
money by passing on the mortgages to investment banks and hence raising
more liquidity to lend to more and more people.
Investment
banks enjoyed a similar incentive structure. The more CDOs they sold,
the more money they made – a factor that encouraged banks to give ever
more and more risky loans and investment banks to sell ever more and
more toxic derivatives. In one dramatic case, a bank in California gave a
US$ 720,000 home loan to a Mexican berry picker who was earning US$
1,100 per month. This is a classic case of subprime lending gone nuts.
And many of the CDOs issued against such subprime mortgages were rated
AAA by rating agencies.
This
shows that the incentive for banks was to maximise the volume of
mortgages, not their quality. Investment banks preferred subprime
mortgages because they had higher interest earnings on them. In the
decade between 1996 and 2006, subprime lending grew from US$ 30 billion
to US$ 600 billion. With huge profits being made, banks were encouraged
to borrow heavily to issue more mortgages. The ratio of borrowed funds
to a bank’s own capital is called “leverage.” By 2008 when the crisis
set in, many banks were leveraged to a factor of 1:20 with some going
to 1:33. This meant that the slightest percentage drop in their value
would lead to insolvency.
There
was, of course, something like a check on this system. Investment banks
that sold these CDOs would actually give them to rating agencies to
evaluate their worth. Often, the rating agencies gave them AAA ratings –
the best in the world. It was because of such ratings that investors
bought the CDOs. There is a problem with rating agencies: First, the
higher the ratings they give, the more money they get paid. So they have
an inbuilt incentive to give high ratings. Second, investment banks
are the ones that paid rating agencies for these ratings – a clear case
of conflict of interest. This system has a fundamental flaw: if a
rating agency rated a particular CDO poorly, the investment bank can
easily take the business to its rival who is willing to give a better
rating.
Worse
still, the rating agencies suffer no risk if their evaluation of a
particular CDO turns out to be wrong. Therefore, they have incentive to
give the investment banks the ratings they want regardless of the
quality of the underlying assets; in fact, they carried no civil or
criminal liability over their evaluations. When their ratings were
questioned, they appealed to the First Amendment, which guarantees
freedom of speech saying their evaluations were simply their opinion.
Technically they were right. Morally?
One could
counter this by saying that rating agencies are big global business
and therefore have reputations to keep. But reputational costs are
illusory since they occupy an oligopolistic market. I know only three
such agencies – Standard and Poor (or S&P), Fitch and Moody’s. If
all of them are doing the same thing, there is no risk to anyone of
them. And there must be high barriers to entry that have kept this
market so narrow. Even today after their ratings have been found to have
been dubious, these three firms still dominate the market.
There was
another cushion, which seemed to solve this problem. Once investment
banks had sold CDOs, they went to insurance companies and ensured
themselves against the risk of default. These insurance policies name
to be called Credit Default Swaps (CDS) and the largest dealer in them
was the American Insurance Group (AIG). So an investor who bought a CDS
would pay AIG a monthly or quarterly premium. In return, AIG would
promise to compensate them should the CDO go bad.
A
secondary market for CDSs emerged which was unregulated and was to have
catastrophic consequences for taxpayers and profits for Wall Street. In
the regular insurance market, you can only insure only that which you
own – and you can only insure it once. But in the derivatives market,
anyone could buy CDSs from AIG – thus allowing them to bet on CDOs
against which they were issued i.e. anyone could buy an insurance policy
on assets they did not own and the same asset could be insured by 20
or 30 people. If such an insured asset failed, the amount of losses in
the insurance market would become disproportionately larger than
anything that asset represented. Since CDSs were not regulated, AIG did
not have to set aside any money to cover potential losses. That is why
when many CDOs went bad, AIG was exposed.
These
activities increased the supply of money in the home market and equally
led to many abuses. For example, a broker who sold the house and the
one who sold the CDO plus the one who sold the CDS all got paid bonuses
upon concluding the sale. This allowed brokers and banks to sell houses
even to those who would not qualify. On many homes, buyers were paying
less than one percent of the home price – meaning they had little at
risk. In a regular home market, the homeowner puts up anything between
20 to 30 percent of the price of the house and the bank finances the
balance. This means that there is a share risk between the borrower and
the lender. Without this, the borrower can easily walk out of the
mortgage at the slightest sign of reduced value.
Among
those betting on AIG’s CDOs was the world’s largest investment bank,
Goldman Sachs. It would buy CDSs from AIG and then take an insurance
policy in case AIG collapsed. At the height of trade in these
derivatives, Goldman Sachs went further – it began to sell more CDOs
specifically designed in such a way that the more money its customers
lost, the more money it made. Its biggest client was AIG. Other
investment banks did the same. When AIG was about to collapse, the US
government intervened to save it using taxpayers’ money. Government
literally took over the insurance giant.
Immediately
it took over AIG, government literally forced the insurance giant to
pay out US$ 61 billion it owed to investment banks for CDSs – Goldman
Sachs alone was paid US$ 14 billion. AIG was not even allowed to
negotiate. It had to pay 100 cents on the dollar. And who were the
government officials forcing this deal down the throat of a now
government owned AIG? Treasury Secretary, Hank Paulsen who had been
Chief Executive Officer (CEO) of Goldman Sachs only two years earlier,
Ben Bananke, the chairman of the Fed and plus Timothy Geithner, then
president of the New York Fed and board member of the US Fed. Obama was
later to appoint Geithner as new Treasury Secretary.
The
genius (and evil) of Wall Street and its control over the US government
regardless of which political party is in its power to privatise
profits and nationalise loses. When companies are doing well, their
executives and shareholders reap all the benefits – in form of high pay,
bonuses, dividends and high stock prices. However, when their excesses
push them to the brink of collapse, they use government, which they
control, to commandeer taxpayer money to bail themselves out. I know no
system, not even Marshal Mobutu Sese Seko’s in former Zaire, that is as
corrupt as the US system – only that its corruption is perfectly
legal.
Both
Obama and Romney are slight variants of drivers of a train that has
lost its brakes. That is why I wonder how people find the energy to
support either side in an American presidential election.
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