How a Perfect Economic Storm Became Possible

By Robin Hahnel, for the workshop on the financial crisis at the Fifty First Annual Conference of the Fellowship of Reconciliation at Seabeck, Washington, July 2-5 2009

The economic crisis today is not simply the result of some mortgages that should never have been made. Less than 20% of mortgages were in arrears when the crisis hit last fall, which means that 80% of mortgagees were current with their payments. Only because unsustainable macroeconomic imbalances were permitted to evolve, only because prudent regulation of the banking industry dating back to the Great Depression was systematically dismantled under pressure from the financial industry, only because people like Larry Summers and Timothy Geithner actively intervened to prevent regulation of highly speculative Wall Street investment banks and Hedge Funds, was it possible for the worst financial crisis in eighty years to unravel when a housing bubble — which had to come to an end at some point –finally did.

Here are seven steps that led to what I call the perfect economic storm that also contained a surprise ending for banks and those who tried to rescue them.

Traditionally, people applied to local banks for mortgage loans, and the bank approving the loan held the loan for 30 years. Under these conditions banks insisted on collateral – 20% down was the standard for decades – and banks checked carefully to be sure applicants had a secure job, income sufficient to make their mortgage payments, and a good credit rating — because if a mortgagee defaulted the bank who authorized the loan would suffer the adverse consequences. This worked well enough for all involved, except the big Wall Street banks were not involved in a major way and therefore weren’t making much money off the business.

Step 1: The banks reviewing mortgage applications no longer keep the loans themselves. Instead, by the late 1990s most mortgages were sold within a few days of being approved to someone else, and often re-sold, and re-sold again many times within a few months, thereby creating what economists call a perverse incentive for the banks evaluating loan applications to no longer do their work carefully.

But why would large brokerage houses and investors buy these mortgages if many of them were now of dubious quality?

Step 2: Large Wall Street banks buy up huge numbers of mortgage loans from every region of the country and do something very creative with them. They chop these loans up into tiny little pieces, and package together thousands of pieces of different loans into securitized debt instruments which they usually sell off to institutional investors, but sometimes keep on their own books as well.

But why would institutional investors buy these fancy mortgage based securities if at least some of them contained poor quality loans?

Step 3: There are rating agencies who rate the riskiness of different securities. But the agencies do not provide this service for free, nor do the buyers of the securities pay for the evaluation. Instead, the agencies rating the securities are paid by the Wall Street banks who package them together! Enter a second perverse incentive: The Wall Street banks have little trouble getting almost all of their mortgage based securities rated Triple A – the highest rating, supposedly meaning the lowest risk for a buyer – by agencies that don’t get hired and paid unless Wall Street banks are happy with their ratings.

At this point we have transformed a simple, straightforward and largely local home mortgage industry that worked well for decades into an incredibly lucrative international business riddled with two, serious perverse incentives, with the Wall Street banks at the center raking in handsome fees for their securitization work which they proudly describe as minimizing systemic risk by spreading risk more broadly.

Step 4: Fearful that the housing bubble in the US cannot go on forever, in 2006 institutional investors, particularly in Europe, start to get cold feet and become more reluctant to buy the mortgage based securities that have become the life blood of a global financial bubble. Good old Yankee ingenuity comes to the rescue once again. A medium sized insurance company few had ever heard of named American International Group offers to sell insurance policies against the event that a securitized debt instrument proves to be of little value. Worried that the mortgage backed securities you bought might be worthless due to defaults? Buy an insurance policy from AIG.

Step 5: Almost overnight AIG becomes the largest insurance company in the world selling insurance to buyers of mortgage backed securities, but what come to be known as credit default swaps are not classified as insurance and thereby fall outside the purview of government agencies regulating the insurance industry. As a result AIG is not required to set aside any significant amount of the premiums they collect for the credit default swaps they sell. Moreover, what quickly becomes a multi-trillion dollar market in credit default swaps not only falls outside all regulation, there is not even an information clearing house where one can determine the size of the market and who owns credit default swaps against what.

Of course as long as home prices kept rising this giant house of cards economists call a Ponzi scheme was not in jeopardy. But as soon as home prices peaked, and people whose financial plan relied on the price of their house continuing to rise because they could not afford their loan under other circumstances started to default, the whole house of cards began to unravel.

However, a 20% default rate on what came to be known as sub-prime mortgages would never have led to the financial crisis we have today had not the conditions for a perfect storm been permitted to evolve in the first place. The damage done by the inevitable burst of the housing bubble was magnified many fold because the financial sector was permitted to turn the reasonably profitable but reasonably safe home mortgage industry into a mammoth, global Ponzi scheme generating record rates of profits for its players while it lasted. In other words, what would have been a medium wave hitting only American coasts was turned into a Tsunami that swept around the globe by the sequence of perverse incentives described above. And what allowed these perverse incentives to evolve was failure to regulate key aspects of the mortgage, banking, financial, and insurance industries.

Step 6: But we are not done yet. A major surprise was still in store, first for the Wall Street banks, and then for the Bush and Obama administrations who both tried to clean up the mess that free market finance created by using taxpayer dollars to buy up the toxic assets on the books of the banks.
The real economy you and I live in is completely reliant on the functioning of the credit system. Few of us can buy a house without getting a loan. Many of us pay for most of what we buy using a credit card — whose balance we either do, or more often do not pay off at the end of the month. Even more importantly, the businesses that employ us need loans to buy the intermediate inputs we need to work with and finance shipping the goods we produce. As a result, when the credit system breaks down – as it did in the fall of 2008 – what economists call the real economy quickly begins to suffer as well.

Of course that is another way to understand the problem underlying this whole mess. Whereas the credit system should serve the real economy consisting of production and consumption, what happened over the past 30 years is that the financial sector increasingly subjected production, consumption, and investment in new machines and equipment to its own purposes, and we are now discovering how badly that can work out for most of us. In effect the tail is now wagging the dog, and the dog is increasingly uncomfortable!
In any case, the point is our real economy will not function for us when the credit system seizes up – which is what happened last fall. The credit system froze up because the big players at the top of the credit system, the Wall Street banks, were no longer willing to lend to one another because they knew what came to be called their toxic assets were of questionable value. And when the Wall Street banks could no longer get credit from one another, credit froze up for the rest of us farther down the credit chain.

Understanding why the big banks suddenly would not lend to one another last fall is not only a fascinating story in and of itself, but also the key to understanding why the government has been unable to put Humpty Dumpty back together again despite billions of dollars of transfusions of taxpayer dollars and trillions of dollars worth of commitments US taxpayers have now taken on into the distant future.

Nobody wants to discover they were the last to lend to someone who goes bankrupt the next day. Ordinarily Wall Street banks are happy to lend to one another large amounts, generally for short periods of time. Suddenly last fall they were not. The reason was simple. Wall Street banks feared that the bank they lent to might be on the front pages of the newspapers the next morning as the latest Wall Street Bank to go bankrupt. They had good reason to fear this because all of them had kept substantial amounts of mortgage backed securities on their books that were no longer really worth what they were supposed to be, and because it had become clear that the credit default swaps they had purchased from AIG were worthless because AIG had kept little in its pockets, and was itself being kept alive only by continuous transfusions of taxpayer blood.

But how toxic were these mortgage backed security assets the big banks had on their books? On average they were worth 20% less than they once were because 20% of mortgage payments were now in arrears or default. So even a full write down meant that on average the assets should have been worth 80% of what they once were – which is bad news, but not a complete disaster. But to the banks surprise they discovered that the market price for the securities was practically nothing.

While the PR departments of the Wall Street banks were busy assuring the world that they were managing risk in a smarter way by spreading it out more, what the math whizzes the big banks hired to work in their securitization departments were actually doing was a brilliant job of hiding risk. In the process of chopping and packaging the different mortgages some of the securities they created contained 95% good loans and only 5% bad loans. But some of the securities contained only 5% good loans and the remaining 95% were bad.

As long as defaults were few, as long as the securities had a Triple A rating, and as long as people assumed that credit default swaps really did provide insurance, hiding the risk was not a problem and worked for everyone. But as soon as the housing bubble burst and 20% of the underlying mortgages were in arrears things changed dramatically. The fact that the risk had been hidden so well, and nobody except the person who had done the chopping and packaging in the first place could tell where it was, turned a big problem into a total disaster. The market price for the mortgage based securities did not fall by 20%, instead it fell by much more until nobody was willing to buy any of them except at fire sale prices because no buyer, as an outsider, could distinguish the securities that were 95% good from the ones that were 95% bad.

This meant that if their securities were evaluated according to their going market values all the Wall Street banks were insolvent – which is why the banks fought against proposals for mark to market accounting procedures. It also meant that they were no longer willing to lend to one another. The securitization departments of each bank informed their CEO that there was no way to tell if the assets of another Wall Street bank were mostly sound, or mostly without value, meaning the bank was on the verge of bankruptcy. The securitization departments knew no outsider could judge the status of another bank’s assets because they knew how successfully they had hidden risk in their own securities from outside detection.
The Wall Street banks found to their shock that they had hoisted themselves on their own petard. Only the grave diggers knew where they had buried the risk, and clearly they could not be trusted to tell outsiders where it was. In effect the Wall Street banks had rendered assets that should have been worth 80% of their former value on average almost without value at all. The more clever a securitization department had been at playing this game of liar’s poker, the more the bank found itself in check mate with nobody willing to buy its assets or extend it any loans. So what did the government due to try to unlock and fix the credit system, and why has it not worked?

Step 7: First the Bush Administration — under the leadership of his Secretary of the Treasury, Hank Paulson, Chairman of the Federal Reserve Bank, Ben Bernanke, and Chair of the New York Branch of the FED at that time, Timothy Geithner — and now the Obama Administration, under the leadership of his Chief Economic Advisor, Laurence Summers, his Secretary of the Treasury, Timothy Geithner, and Ben Bernanke who continues to be FED chair — tried to rescue the Wall Street banks from the mess they created for themselves by taking their toxic assets off their books. Since the market price for these assets is quite low the whole idea is to have a buyer pay the banks far more than their toxic assets are worth today. Whether the taxpayer bailout of the banks takes the form of direct US Treasury purchases of toxic assets through a “reverse auction” that was so hampered by perverse information asymmetries and conflicts of interest that Secretary Paulson could not achieve lift off for his plan before leaving office, or the taxpayer subsidy is more disguised in the form of “private public partnerships” where The Treasury Department, FDIC and the FED provide free insurance against downside risk to induce private party participation, as Secretary Geithner is now attempting, we have what Robert Sheer dubbed the “No Banker Left Behind” bill.

Not only is this grossly unfair – executives and stockholders in Wall Street Banks who pocketed record profits for decades are now the beneficiaries of over a trillion dollars and counting of taxpayer money – it is a poor bet to unlock the credit system. It is very possible that the toxic hole Wall Street dug itself into may prove to be so deep that taxpayer dollars cannot fill it no matter how generous our government is with our money. In other words, the approach of both the Bush and Obama administrations to the financial crisis so far is the equivalent of continuing to apply ever larger doses of electric shock treatment to patients in the emergency room who appear to be D.O.A. even though there is no sign the patients will revive, and even though the generator being used has a limited capacity and is also needed to run the rest of the hospital.

Instead it would be far cheaper to abandon the unrealistic hope that toxic assets are not really toxic after all, buy up a majority of the shares of stock in the insolvent banks, write off the toxic assets, have the FED extend new credit to what would now be our banks, and appoint new managers to preside over lending policies necessary to get credit moving again to businesses, to get mortgages re-negotiated, and to loans to businesses investing in renewable energy production and energy conservation.