How Government Caused the "Great Recession" and Why It Is not Solving It
by Richard "Chip" Peterson, PhD, March 20. 2010
The U.S. Economy is the weakest it has been since the Great Depression of the 1930s. It is called the "Great Recession" but it could get worse. Bad policies of the US. Government, its Politicians, and the Federal Reserve System contributed greatly to the development of the Great Recession. Unfortunately, the political forces that created the bad precursor conditions for the recession are also preventing the government from taking appropriate corrective actions. In fact, some politicians and interest groups are gaining or hope to gain from the prolonging of the ordinary citizens' agonies.
Primary causes of the great recession are several. One was the inordinately easy monetary policy pursued by Alan Greenspan and the Federal Reserve system for many years starting in 1997 during the Asian financial crisis. The Fed's easy policies continued in 1998 (when a large hedge fund failed); in 1999 when Greenspan feared "Y2K" accounting problems (caused by computers that could not properly calculate dates starting with 2000 rather than 1999) would cause financial confusion; in 2001 after the "9/11" attacks; and in the 2002 recession and in subsequent post-recession years. As a result, interest rates fell to inordinately low levels due to the continuing floods of easy money and much "malinvestment" (bad investment) occurred as many projects were funded that would not have qualified for funding if interest rates had not been artificially depressed. Furthermore, because of the low Fed-induced interest rates, pension funds, insurance companies, and other investors who had promised to earn guaranteed rates of return for their customers had to take more risk in order to try to earn satisfactory returns. Unfortunately, as they did so, they made too many investments that did not earn a high enough rate of return to cover their risks, and risk-premia on investments declined to ridiculously low levels--thereby exposing those investors to potentially great future losses should the risk become more apparent at some time in the future.
A second cause was the Democratic Party led Congressional support and encouragement for the two major "Government Sponsored Enterprises" or "GSEs"--Fannie Mae and Freddie Mac--to extend easy credit in the mortgage markets to encourage home ownership by people who otherwise wouldn't qualify for mortgage loans. The pressure became most apparent in the early 2000s after the Democratic-appointed leaders (particularly Franklin Raines and cohorts at Fannie Mae) of those institutions had engaged in some questionable accounting in order to earn larger bonuses. In order to retain Congressional support, the institutions gladly adopted the easy mortgage origination policies pushed by Democratically controlled Congressional Committees. Those institutions and their easy credit policies came to dominate the mortgage markets because the GSEs could borrow at low interest rates since they had implicit (now explicit) government support, and therefore could outcompete private lenders to force mortgage interest rates and credit standards down. In fairness, it should be said that Republican legislators also encouraged Fannie Mae and Freddie Mac to adopt easy credit policies, because they had constituents who hoped to benefit from booming housing markets fueled by easy mortgage credit. Thus, while much of the pressure for the GSEs to make irresponsibly easy mortgage loans came from Democrats in Congress who wanted to make sure every one of their constituents (regardless of qualifications) could qualify for a mortgage loan, both Democratic and Republican legislators were quick to push easy mortgage money policies by the GSEs to please other constituents in their districts as well.
Third, the process of extending easy mortgage credit was encouraged by financial institution regulators who aggressively enforced the "Community Reinvestment Act--"CRA"-- from the time of Bill Clinton's administration onward. The CRA made financial institutions support lending to people and community groups in their trade area even if those institutions and individuals would have not otherwise qualified for funding on relatively easy terms.
Fourth, in 1999, the Gramm-Leach-Bliley Act was passed with bipartisan support in a Republican dominated Congress and signed by the Democratic President, Bill Clinton. That Act allowed took away many of the safeguards that the Glass-Steagall Act of 1933 had erected during the Great Depression. That act had prevented commercial banks (who accepted deposits and made loans to business) and investment banks (who sold and underwrote securities like stocks and bonds) from entering many of the same lines of business. The Gramm-Leach-Bliley Act (GLB Act) was passed because the major Wall Street Investment Banks and Commercial Banks provided substantial funding to Washington politicians and the President and provided for many well-funded lobbyists who argued that commercial banks and investment banks needed to pursue combined operations in order to compete better with Europe's Universal Banking entities and to better serve their customers. The lobbyists forgot to mention that the Glass-Steagall Act had initially been passed because legislators in the 1930's thought that excessive risk taking by combined commercial and investment banks had contributed to the severity of the great depression. One consequence of the GLB act was that the large commercial bank holding company sector could hold less capital (their own money) to back their risky assets since investment banking operations were not required to hold as much capital as deposit taking banks. The process of holding less capital was aggravated by the fact that large banks could now "securitize" their loans and sell interests in their loans to others, retaining only a small or zero portion of the initial loan on their balance sheets. They could earn fees on the loans they originated and sold while not having to retain their own funds (capital) to support large loan holdings. against the risk of loss. Unfortunately, often the income streams they expected to earn from securitizing loans and the residual pieces of the loan pools they held exposed them to far greater risks than they had anticipated. Thus, their earnings and balance sheet risk was far greater as the result of reckless securitization, and the small amount of their own money (capital) that they held subsequently proved inadequate to cover their potential losses. That is why in 2008, several major investment banks (Bear Sterns and Lehmann) failed and many large commercial and investment banks (think, in particular, Citicorp and Merrill Lynch, among others) either failed or needed to be bailed out with Federal Funds (i.e. taxpayer provided TARP money) on the assumption that they were "too big to fail." In addition, the large insurance firm, AIG, also basically failed and became a ward of the U.S. government, at great expense, so other major banks or investment banks--think Goldman Sachs--which is politically well connected to both major political parties, particularly the Democratic Party, in the U.S.--and European banks would not fail in the event AIG defaulted upon its credit default swaps.(CDSs).
The excessive leverage (ratio of borrowed money to their own money --capital) used by U.S. investment banks became even more excessive during the early 2000s after the U.S. Securities and Exchange Commission allowed them to lower their capital ratios (increase their leverage) so they could compete better with European banking entities. By holding only $1 of their own money for every $30 to $40 of assets they held, the largest U.S. investment banks faced the prospect of being wiped out if they lost only 2 1/2 to 3% of their asset values--which is easy to do almost overnight if an institution holds risky assets.
Fifth, the process of excessive risk-taking by banks and U.S. investment banks was aggravated by the use of Credit Default Swaps (CDSs) and the sloppy bookkeeping and inadequate collateral requirements involved for institutions who traded in those instruments. Credit Default Swaps are basically "bets" as to whether an institution or a security will default upon its debts. The buyer of a credit default swap pays a large fee (the premium) to the seller in the form of a premium interest rate for the underlying security). If the security defaults, the buyer of the credit default swap will receive a large payment from the seller of the swap, dependent upon its value after default. . In order to guarantee that the payment will be made if necessary, the seller of the swap must post collateral, with the amount varying with the seller's credit rating and the riskiness of the underlying security being guaranteed. If the seller was AAA rated by a rating agency, often it did not have to post explicit collateral. If the underlying security was highly rated (AAA) the collateral requirement would be slight in any case. Large banks and investment banks with AAA ratings liked to write credit default swaps since they did not have to post much if any collateral--thereby earning fees without posting their own capital. Compliant rating agencies, such as Moody's and Standard and Poors who had to be sanctioned by the U.S. Government and , therefore, had oligopoly powers, were often quick to hand out good ratings to large institutions and the debts they wished to swap in order to earn repeat business from those institutions. In retrospect, they were too willing to give high ratings to many large financial institutions and many large pools of risky mortgage derivative securities.
Because credit default swaps were lucrative and traded over the counter in opaque markets, large financial institutions found they could make a great deal of money from originating and trading credit default swaps. Outside participants were not well informed about buying and selling prices for various swaps, so institutions who sold the swaps could often make substantial profits by originating and trading CDSs. Furthermore, since many people traded the swaps, once they had originated the swap, they could often lay off their risk by taking the opposite position with another swap market participant at a slightly better price--thereby locking in a quick profit (and large potential bonus) with essentially no capital requirement (i.e., no money of their own at risk). Because of the rapid trading of CDSs, the market grew rapidly as daisy chains of swaps developed as one bank or dealer might originally sell a CDS contract, then turn around and buy a similar swap at a better price from another dealer, who, in turn, might buy a similar swap from another dealer or institution, etc.--all the while creating a chain of obligations that linked all the highly rated dealers together in a daisy chain of obligations, while the traders collected commissions or future bonus benefits from the book value of the profits they made while trading.
Unfortunately, the incentive for traders and institutions was to engage in numerous transactions in credit default swaps and the nominal value of the swap market soon grew to equal many times the value of the underlying securities. Furthermore, since trades took place at a rapid pace, bookkeeping was often inadequate, and any collateral requirements that may have existed tended to be poorly documented or enforced. Since the swap dealing largely took place among New York commercial and investment banks and other highly rated institutions with New York offices, the Federal Reserve Bank of New York became aware of the sloppy bookkeeping and daisy chain nature of the swap market. Gerald Corrigan, the President of the New York Federal Reserve Bank tried to get the firms involved to increase their back room functions and the transparency of the CDS market in the mid 2000s. He also tried to get Alan Greenspan to get the entire Federal Reserve System involved in trying to regulate the burgeoning market. However, Greenspan demurred. Subsequently, Corrigan was hired away at a high salary by the most politically influential major investment bank, Goldman Sachs, and, the New York Federal Reserve Bank (headed by Tim Geitner, our present Secretary of the Treasury after Corrigan left) apparently diminished its enforcement efforts, as the CDS market continued to grow dramatically.
While a valid case may be made for the existence of CDSs for debts that otherwise would be hard to insure against loss, such as various sovereign debts, it is less reasonable to argue that one should have swaps available to guarantee every possible security against default. However, the originators of swaps can profit if swaps are issued against more securities because appropriate risk information is harder to calculate for individual securities with varying default probabilities and debt covenants. Therefore, since market information is less perfect for individual securities, writers of credit default swaps can often make greater profits by writing swaps on such securities. Consequently. participants in the swap market have vociferously defended their right to originate credit default swaps on any security they wish and , further, to issue such swaps as "over-the counter" contracts between individual entities, where those contracts do not trade on exchanges where appropriate bid and ask prices are readily available to all participants. The argument that credit default swaps should not be limited to either the number or type of securities covered or to exchange-related trades is still being made by the lobbyists for large banks and financial institutions who arrive in Congress carrying loads of money to support politicians who are opposed to imposing serious restrictions on the CDS market.
Credit default swaps conyributed to our present great recession in various ways. In particular, they could be written on pools of mortgage backed securities. Even though a pool of securities might contain risky loans, on the assumption that not all loans would default, at least part, if not most, of each pool of mortgages could obtain a AAA rating from compliant rating agencies who assumed that real estate prices would always increase and most mortgages would not default. Thus, those securities would be eligible for credit default swaps and the worst part of the pool could either be held by the originating institution or sold to another institution who would combine them into a new pool of securities that, once again, was not assumed to suffer simultaneous defaults of all its components. Thus, most of the new risky mortgages being originated became eligible for credit guarantees in the credit default swap market, This gave a great incentive to originators of mortgage securities and the commercial and investment banks that pooled them up to create mortgage backed securities--often exploiting guarantees from Fannie Mae or Freddie Mac in the process-- to originate all the mortgages they could, form them into mortgage-backed securities, and sell them to others, who could insure them, if necessary, in the CDS market. All the time, at each step in these transactions, the brokers and investment banks, and commercial banks and traders, created fee income for themselves, commissions, and potentially large bonuses, which they recorded as profits and/ or extracted from the market. At the same time, because of high rating s and low capital requirements, they were able to report high returns on invested capital since they had to post very little or no money to underwrite (i.e. guarantee) their transactions.
Because this whole operation was so lucrative, the mortgage markets kept expanding and the investment banks and large commercial banks kept profiting by originating more and more mortgage securities for risky borrowers on generous terms, originating pools of mortgage backed securities, getting Fannie or Freddie to guarantee the loans, and issuing and trading credit default swaps on the pools of mortgages. Since they all could record instant commissions, trading, or fee income by so doing, the frenzied dance of mortgage origination continued even though they eventually started to originate mortgages to people who didn't document their income and jobs, or didn't make any downpayment, or didn't have to pay any interest (or very little interest) for many years.
In order to continue to sell more pools of mortgages, the credit default swap market also exploded. as people sought CDSs on pools of mortgages to guarantee eventual repayment. Unfortunately, this gave some unscrupulous institutions an incentive to peddle bad pools of mortgages along with credit default swaps that they could pass on to someone else in the daisy chain of CDSs.
I'm not sure exactly what was involved here, but Goldman Sachs reportedly sold large amounts of mortgage backed pools to AIG and also entered into numerous credit default swaps with AIG. When AIG approached bankruptcyin late 2008, it was rumored that their default could cost Goldman Sachs at least $15 billion, thereby jeopardizing its existence as well. Since Hank Paulson , a former co-chairman of Goldman Sachs was Secretary of the Treasury under Bush in 2008 (and Robert Rubin, another former Chairman of Goldman Sachs had been Secretary of the Treasury under Bill Clinton, and was presently on the Board of Directors of Citicorp, another threatened institution in 2008) the powers in Washington had a powerful incentive to go to Congress to plead for nearly $800 billion TARP funds from the taxpayers so they could bail out AIG and other threatened institutions--such as Goldman Sachs and Citicorp. While it is possible that the failure of those firms could have aggravated a potential daisy chain of defaults as one institution after another found that its extensive credit default swap guarantees were no good (so its low level of capital was wiped out and it too was bankrupt), it cannot be said that the powers that be in Washington had no personal interest in saving the affected institutions.
To this point, I have explained how mortgage market greed, CDSs, mortgage pools with excessively risky loans backed by Fannie Mae and Freddie Mac, and a general climate of excessive risk taking caused by the Federal Reserve's easy money policies over the course of a decade created the conditions that preceded our Great Recession. Once mortgages and institutions started to default, people found that they had taken too much risk and had made too many malinvestments. The housing market collapsed as mortgage credit dried up. Furthermore, as shell shocked financial institutions with inadequate capital cut back on all lending, the general economy suffered. It is still suffering as excessive stocks of housing inventories and of other malinvestments and of associated bad credits are being worked off.
Unfortunately, Congress and the administration have not changed their ways to eliminate the preconditions that caused the problem. The Fed is still creating easy money. Congress is still trying to promote easy lending in the mortgage market. The administration has explicitly guaranteed all $7 trillion dollars plus of Fannie Mae's and Freddie Mac's financial obligations, and the Federal Housing Administration is guaranteeing low downpayment loans with relatively weak credit standards.
Furthermore, lobbyists from the major investment banks and commercial banks still have the ear of Congress and the Administration (large financial institutions were most of the largest supporters of Obama's Presidential campaign). Consequently, they have fought limitations on the CDS market and potential requirements that CDSs be traded on public exchanges where proper capital requirements could be imposed, monitored, and enforced, and appropriate bid and ask prices would be readily available--thereby pinching the profits of potential swap trading institutions (the largest investment banks and commercial banks). They also have supported a continuation of the past "too-big-to-fail" policies that allow the largest institutions to raise capital and borrow cheaply due to the implicit government guarantee that they have. That lets the large institutions draw funds away from probably more efficient smaller banks, who retain more of the risk in loans they originate and therefore are more cautious in attempting to not make bad loans. It also lets the large institutions pay their executive egregiously large salaries, in the tens or hundreds of millions of dollars, because they can borrow cheaply from the government. They claim that they deserve the salaries because they are the best and the brightest--but that is not true, they are merely the best connected politically, and ultimately, they are profiting from their actual or perceived ready access to taxpayer , or cheap Federal Reserve created, money and credit. Finally, Congress has made no serious attempt to try to make people responsible for the long term performance of the loans that they originate and trade. If people can continue to make bad loans and sell them to others to earn an instant fee or commission with impunity if the loans later go bad, they will continue to do so. Only when people or institutions play with their own money and have their own capital, future net worth, or income at stake will they have proper incentives to guarantee that they do not continue to make bad loans. However, Congress has not even addressed issues related to increased capital requirements, and attempts to make a portion of lenders' compensation dependent upon future performance of their loans (while prevalent in smaller banking institutions) have made little headway on Wall Street with its short-term trading orientation.
This raises the question. Why haven't Congress, the Administration, and the Federal Reserve done more to try to solve the underlying problems in our financial system and economy, The answer is that big institutions and their lobbyists provide too much money to support the politicians' (both Democratic and Republican) political campaigns, and therefore have too much influence in preventing both parties from addressing the basic issues. In addition, many politicians probably do not know what the basic issues are and how they have contributed to our present problems.
Also, it seems that the Administration may well want our present economic problems to continue. Rahm Emanuel, a major Obama advisor, early on in his administration said, in essence, "we should not let a good crisis go to waste." That statement refers to the fact that a scared populace is usually willing to give up more of their sovereignty and individual freedoms to a government when they feel threatened. Thus, as long as the public feels threatened, government has an excuse to grow and become more intrusive in their lives. This may be one reason why Obama's original nearly $900 billion 2009 "stimulis" bill really did very little to stimulate the economy but did a lot to ensure that Obama supporters and government employees were well taken care of. Furthermore, the costly initiatives on health care and cap and trade pushed by the Obama administration have further depressed the incentive of private businesses to invest domestically due to the avalance of increased taxes and regulations that those policies portend. As the private sector in the U.S. stagnates, the Obama administration and the Democratic Congress will have even more excuses to expand government control and spending in the economy at the expense of private business. Unless this process can be stopped and reversed the future does not look great for the U.S. private sector and the economy as a whole.
ADDENDUM: I wrote this piece when the Senate Financial Reform Bill was first being released from Senator Dodd's Senate Finance Committee. I was disturbed since the bill gave in to the influence of large institutions and their lobbyists in that it (i) did not require credit default swaps to be traded upon exchanges and cleared through exchange clearing-houses, (ii) did not demand that financial institutions employ substantially more capital in their operations, (iii) still allowed people and institutions to make loans or create securities and earn profits, commissions, and high salaries with no further consequences if the loans or securities went bad (in contrast to loan officers in smaller banks who would be fired if their bank held too many bad loans that they had authorized), and (iv) institutionalized the too-big too-fail concept by setting up a Federally financed funding authority to help liquidate large institutions that were in serious trouble--rather than requiring that institutions employ more of their own capital in their regular operations so their stock and bond holders would monitor them more intensively, or by taking other actions to prevent financial institutions from becoming convinced they were too big to fail.
Shortly after I wrote the material above, Steve Forbes wrote an editorial ("Marx Would Be Impressed," Forbes, April 12, 2010, p.15) that noted that the financial reform bill released by Chairman Dodd's Senate Committee would be "an open invitation for the government to micromanage the whole breadth of finance in America.." He also noted that the private market would do a better job than government regulators in preventing problems provided that the regulations allowed for "Sensible debt to equity ratios, including stiffer equity requirements for volatile short-term debt, and clearinghouses for almost all derivatives [which would include clearing houses for credit default swaps] would efficiently accomplish what Dodd's monstrosity purports to do and manifestly does not. " In short, Forbes, who is Editor-In-Chief of one of our nation's best financial and business magazines, stated even more strongly some of the points that I have made in this piece.
Email Chip with any questions., Chippete@aol.com
Richard Peterson Campaign, Richard Peterson treasurer