from US Socialist Worker
24 September 2008
The worst financial crisis since the Great Depression has struck the U.S., and political leaders in Washington are scrambling to respond. Lee Sustar answers questions about the economic earthquake that is shaking U.S. capitalism to its core.
The U.S. government is scrambling to keep the worst financial crisis since the 1930s from turning into an economic catastrophe.
To solve the problem, the conservative Bush administration has thrown its free-market ideology overboard to carry out the greatest government intervention in the economy since the Great Depression. The aim is to stop the world financial system from collapsing completely – something it came dangerously close to doing during "Black September."
Already, the U.S. has carried out the biggest nationalization of financial institutions in history. The five independent Wall Street investment banks that existed at the start of 2008 are gone, owing to mergers, bankruptcies and regulatory changes.
And that's just the beginning. If Treasury Secretary Henry Paulson has his way, the U.S. will commit $700 billion in taxpayer money to buy up the bad debts of the banks and other financial institutions. In reality, the cost could run to hundreds of billions dollars more.
If enacted, Paulson's proposal, when added to the costs of earlier interventions, means that the government is so far on the hook for $1 trillion--equivalent to the cost of the Iraq war, now the longest U.S. military involvement in any war other than Vietnam.
For Corporate America, the crisis isn't only economic, but political and ideological as well. After more than 30 years of preaching that the free market solves all problems and telling workers that they had to sink or swim on their own, big business is running to the government for a massive bailout.
Whatever package is finally approved, it will be done at workers' expense – and the political impact of this crisis will shape U.S. politics and society for many years to come. Here, SocialistWorker.org answers your questions about the crisis.
TREASURY SECRETARY Henry Paulson is pushing for a bailout for the banks worth $700 billion. How is this supposed to work, and who's going to pay for it?
PAULSON'S PLAN is, as Nation writer William Greider put it, a "historic swindle." But even that description doesn't fully convey the scale of this attempt to foist the costs of this crisis onto the backs of working people.
Leave aside for a moment all the financial jargon from Corporate America, their spin doctors and the media. The basics of the crisis are straightforward: Workers' wage increases in the 2000s haven't kept pace with the rate of inflation. That's because virtually the entire increase in national income since the recession of 2001 went to capital instead of labor.
So to maintain their standard of living, many workers borrowed money against their houses with mortgage refinancing or got adjustable-rate mortgage with teaser low interest rates. In turn, Wall Street bought up these mortgages and packaged them into securities, to be sold off to big investors.
When workers could no longer pay, their mortgage foreclosure rates increased, and the value of these mortgage-backed securities started to fall. This set off a chain reaction among big banks, which forced them to admit the scale of bad mortgage-related debt that they had kept hidden.
Now, the banks are running to the government for help in offloading all this toxic debt. Paulson, the former CEO of the investment bank Goldman Sachs, is all too willing to oblige. Essentially, he wants dictatorial authority to spend $700 billion any way he wants in buying up bad assets from U.S. financial institutions, as well as foreign-owned banks with substantial U.S. operations. His plan would allow him to operate without any oversight from Congress, and with immunity from any lawsuits related over his decisions.
The utterly undemocratic nature of this scheme is outrageous enough. But the rest of Paulson's proposal is even worse. Rather than create a government agency that would come under public review, Paulson would hire Wall Street companies to buy and manage these assets.
In other words, the same people who caused this catastrophe would rake in many millions of dollars in fees in exchange for their services.
Then there's the question of how much the Treasury Department will pay for these assets. Merrill Lynch recently was forced to sell off mortgage-backed securities initially valued at $30.6 billion for just 22 cents on the dollar. Will the government pay more for similar assets? And what happens when Treasury turns around and tries to sell those same assets? Will it sell them for less than it paid for them, and stick taxpayers with the loss?
Basically, the answer is yes.
To see how it works, look back at the history of the Resolution Trust Corporation (RTC), created by Congress in 1989 to bail out bankrupt savings and loans.
The RTC bought up savings and loan banks as well as their real-estate assets, then sold them off on the cheap to banks and other investors, who picked up institutions and property for a fraction of their worth. The losses were borne by the taxpayers to the tune of $124 billion, plus interest.
The proposed rip-off in Paulson's plan is vastly greater, not only due to the sums involved, but the nature of the assets to be bought up. At least the RTC was purchasing functioning banks and bricks-and-mortar real estate. Paulson's plan, however, calls for buying up mortgage-backed securities and other investments of dubious value.
A large percentage of the assets he wants to buy are so-called derivatives – that is, securities tied to the value of another underlying bond or other security. Much of this paper – perhaps hundreds of billions of dollars worth – is essentially worthless. That's why some critics are calling Paulson's plan "cash for trash."
And like the RTC, Paulson's Treasury and its Wall Street hirelings would sell off as many of the assets as they could. This would allow the banks to buy back the same assets that they sold to Treasury, but at a lower price. The taxpayers would have to eat the losses, and would remain stuck with the worst of the toxic debt.
It boils down to this: Workers whose productivity gains went straight into profits during the economic expansion are now being forced to cough up $700 billion to the same banks that are foreclosing on their houses, denying them student loans and driving up unemployment by tightening credit to business.
CONGRESSIONAL DEMOCRATS say they will improve Paulson's plan. What can we expect?
THE DEMOCRATS will try to add some measures to make the plan easier to sell. The details were still being hashed out as this was written, but they will probably push for some kind of token oversight of Treasury's decision, plus a few measures to provide relief for homeowners in trouble with bad mortgages.
This might include allowing bankruptcy court judges to alter the terms of mortgages--as if depending on a conservative judge to have mercy is all that's needed. The Democrats may also try to insert some mechanism for homeowners to more easily renegotiate their mortgages, and a limit on CEO compensation for financial institutions that participate in the Treasury program.
But none of the Democrats are opposing the essence of the Paulson plan: funneling $700 billion in taxpayer money to the very people who drove the economy into the crisis in the first place.
It's a vivid illustration of how, while Wall Street bankers congenitally prefer Republicans, they always hedge their bets with big donations to key Democrats as well – especially those with responsibility in Congress for finance and banking, like Sens. Chris Dodd and Charles Schumer.
WILL PAULSON'S plan even work?
PAULSON hopes to restore confidence to the world financial system, which has come close to paralysis several times in recent weeks as banks refuse to trade with one another. Every bank lies about the bad debts on their own balance sheets, and reasonably assumes the other party has done the same.
To counter this trend, the Fed made $180 billion available for loans to foreign central banks on September 18, which in turn made tens of billions more available for loans to private banks and financial institutions. But as a Morgan Stanley researcher noted, "the intervention does not directly address the key problem...banks' desire to hoard cash and their reluctance to lend to each other."
In the Wall Street jargon, the financial system is in the midst of "deleveraging" –liquidating debt and building up its reserves of money. The danger for the economy is that this process will spiral out of control and jam the gears of the financial system worldwide.
There's no guarantee that Paulson's program, which will take some time to implement, will avert the immediate crisis. It's telling that Paulson and Federal Reserve Chair Ben Bernanke felt it necessary to grant government insurance beyond bank deposits to $3.4 trillion in money-market mutual funds up until September 19 for this year.
The Securities and Exchange Commission also stepped in with a 10-day ban on "short-selling" stock in 799 financial institutions – a tactic used by speculators to bet on a decline in stock prices. It was short-sellers who helped drive the investment bank Lehman Brothers into bankruptcy and force another, Merrill Lynch, to sell itself to Bank of America.
But the short-sellers were only responding to the reality of the situation – hundreds of billions of dollars in assets held by financial institutions worldwide that are worth only a fraction of their stated value.
No matter the exact shape of Paulson's bailout deal, huge questions remain. For example, even in the likely event that the Fed grossly overpays for bad mortgage-backed securities from the banks, those assets will have to be marked down. To cover for those losses, the banks will be forced, again, to raise their capital reserves to compensate for the losses. That, in turn, will make them reluctant to lend, cutting off the lifeblood of an economy that is already mired in recession.
If Paulson's plan succeeds, the economy could avoid the fire of a collapse of the financial system, but remain in the frying pan of a miserable slump with rising jobless rates.
Then there are the possible side effects of Paulson's program, including the devaluation of the dollar and rising inflation, as the Fed and Treasury Department pump hundreds of billions of dollars into the economy.
We've already had a taste of this. Earlier this year, when the Fed flooded the U.S. banking system with money via special loan programs, prices for food and fuel jumped at least partially as a direct result, and investors dumped the dollar in favor of the euro or the yen.
The worldwide slowdown in the economy is holding some of these tendencies in check right now. Eventually, though, the unprecedented injection of dollars into the economy could lead to rising inflation, which would further cut workers' living standards.
WHY DIDN'T the earlier government interventions stop the crisis?
AS WE'VE seen, the federal government has extraordinary powers to carry out far-reaching emergency interventions in the economy. The only question is whose class interests will be served.
Start with the first big intervention of this year--the move by the federal government in March to put up $29 billion to finance the forced takeover of the investment bank Bear Stearns by JPMorgan Chase. The deal was structured so that the Fed would take any losses associated with the toxic mortgage-backed securities on Bear Stearns' books. It was only that guarantee that enticed JPMorgan to do the buyout.
The deal did shut out the shareholders in Bear Stearns – their stock became worthless. This reportedly was Paulson's idea. He wanted to inflict a loss on a limited group of investors to have political cover for his broader agenda – avoiding a meltdown in world financial markets by keeping the healthiest U.S. financial institutions operating, with taxpayer money, as needed.
Paulson used a similar approach in the nationalization of Fannie Mae and Freddie Mac, the companies that own or guarantee nearly half of the $12 trillion in U.S. mortgage loans. (Actually, it was a re-nationalization in the case of Fannie Mae, which began as a 1930s New Deal initiative to resuscitate the housing market in the Great Depression.)
As government-sponsored enterprises, Fannie and Freddie were the twin engines of the housing boom. Lenders were willing to underwrite mortgages as long as Fannie and Freddie were there to buy or guarantee them.
Because of their central role in the housing market, government policymakers thought Fannie and Freddie could help the economy weather the housing crisis. But over the summer, as losses mounted on the mortgage-backed securities that they held, Fannie and Freddie saw the value of their mortgage portfolio – and hence their stock price plummet. This made it hard for them to raise capital needed to cover their losses.
Foreign investors in Fannie and Freddie bonds began to get nervous. While it was long assumed that the Treasury Department would make good on Fannie and Freddie's debts, Paulson finally had to make that explicit. He did so through outright nationalization of the companies--though it was called a "conservatorship" in deference to Republican sensibilities. Under the terms of the deal, the Treasury Department will inject up to $200 billion into the two companies and directly buy $5 billion of mortgage-backed securities.
As in the case of Bear Stearns, the shareholders of Fannie and Freddie got shut out by Paulson's deal. This may seem radical – imagine how Washington would react if Venezuelan President Hugo Chávez carried out his nationalizations without compensating shareholders.
But Paulson had bigger fish to fry – appeasing the bondholders of Fannie and Freddie, in particular, the central banks of China, Japan and other countries that also buy the U.S. Treasury bills, which finance the U.S. government's budget deficit, estimated to be about $410 billion this year. A collapse of Fannie and Freddie could have triggered a worldwide sell-off of U.S. government bonds.
Paulson did try to draw the line by refusing to use taxpayer dollars to finance the investment bank Lehman Brothers, which was allowed to go bankrupt. Almost simultaneously, another investment bank, Merrill Lynch, sold itself off to Bank of America at a bargain price.
But just two days after Paulson let Lehman go bust, the government stepped in to effectively nationalize AIG, the world's biggest insurance company.
HOW DID an insurance company like AIG get in the middle of the crisis? Why did the U.S. government seize control of the company?
AIG IS still profitable in its core business as the largest commercial and industrial insurer in the U.S., plus other areas like car insurance and fixed annuities from life insurance, a popular method for retirement savings.
The company got into trouble almost entirely from one obscure division called AIG Financial Products, which was formed nearly 20 years ago as the Wall Street boom in complex financial speculation really took off. AIG hired some specialists in derivatives trading and went after a piece of this action.
Over the past decade especially, the company became one of the big buyers of mortgage-backed securities. The returns on these investments weren't huge, but because AIG was such a big player and bought in such large quantities, the low yields added up – and all for making investments that were considered very safe, as unlikely to default, or not be paid back, as Treasury bills, the safest of all bonds, issued by the U.S. government.
But AIG blazed a trail with a further innovation of the new financial marketplace – so-called "credit default swaps," which amount to an insurance policy on big investments like bonds. Basically, at the same time as it was buying debt-backed securities itself, AIG was selling financial protection to investors and companies that made the same investments – in essence, AIG promised to cover the losses if the bonds defaulted.
The big banks loved credit-default swaps, because it allowed them to buy dubious mortgage-backed securities without having to raise extra capital to cover potential losses, as required by regulations. European banks in particular used AIG's credit-default swaps to reassure their regulators. They could say, "don't worry, it's all insured."
For its part, AIG was doubly committed to this obscure area of high finance – both as a buyer of bonds, and an insurer of the other buyers of similar bonds.
As the housing boom gathered momentum, the market for credit default swaps exploded. A market that barely existed a decade ago today accounts for an estimated $62 trillion worth of debt – greater, that is, than the total annual production of goods and services of every country of the world.
In general terms, the insurance business is based on a gamble. Companies calculate that they will be able take in more money selling policies than they will pay back in claims.
To AIG, the particular form of insurance on mortgage-backed securities (even though it wasn't called insurance) looked like easy money – sell the promise to pay off in the event of defaults, which never seemed to happen while the housing market was booming. Like everyone else on Wall Street, AIG could ignore the fact that the mortgage-backed securities contained risky sub-prime loans, pushed on homebuyers by aggressive mortgage companies, as long as the housing boom kept the whole market afloat.
Not only was AIG itself delighted with this lucrative business, but its role in insuring mortgage-backed securities was critical to everyone else. The credit-default swap scheme "allowed banking and finance to expand their [debt] explosively, borrowing and lending far beyond the traditional limits defined as prudent risk-taking," wrote William Greider. "Critics repeatedly warned that these derivatives were a time bomb – trillions of dollars in risk insurance that would be exposed as meaningless if financial markets ever experienced a sharp fall in asset values."
The critics were ignored as long as the housing and financial bubble kept inflating. On the contrary, the managers at AIG and other companies were hailed as financial geniuses for their daring innovations.
But then the bubble burst – and AIG's bluff was called. Over the past few months, the company had to write off $41 billion in losses, with more to come.
AIG's huge investments in mortgage-backed securities – especially its credit default swap insurance scheme – tied the company's fate to banks and financial firms all over Wall Street and around the world. So when AIG looked like it would also go bankrupt, alarm bells went off in financial institutions internationally. Because the credit default swap business was unregulated, no one could say how extensive the damage would be if AIG went down.
The nightmare scenario was that the collapse of AIG would lead banks around the world to stop lending altogether, even to each other, out of fear that their money would disappear in other bankruptcies. In short, the credit machinery of capitalism could seize up entirely.
That's why the Federal Reserve made an emergency loan of $85 billion to keep AIG afloat, in return for effective control over the company. The insurance company was saved, whereas Lehman Brothers and Merrill Lynch weren't, precisely because AIG had been more reckless and foolhardy in its blind pursuit of profit.
But the government takeover of AIG won't resolve the threats from a collapse of the credit default swaps market. The failure of another bank or financial institution will trigger payouts on this form of insurance – and the sellers of these credit default swaps may not have the money to do so. For that reason, 10 big banks, including JPMorgan, Goldman Sachs and Citigroup, created a pool of $70 billion to settle Lehman's trades when they carved up the remains of that company with the British bank Barclays.
The market has absorbed Lehman's disappearance – but that's no guarantee that another big bankruptcy wouldn't wreck the system. That's because the shadow banking system, erected beyond the reach of regulators and governments, has many more potential threats that still haven't been uncovered.
THERE ARE many commercial banks in danger of going under, too. Is my money safe?
EIGHT BANKS have failed since the collapse of the West Coast-based mortgage lender and bank IndyMac in mid-July, and analysts expect more in the coming weeks and months, including some very large banks.
As long as capitalism is around, banking will continue. Businesses must borrow to compete and expand, so banks are needed to loan them deposited funds, along with helping people buy houses and cars. It's tolerable if some banks fail, but banking must continue and be seen as trustworthy and reliable.
The question today is the price that working people will have to pay as the government struggles to clean up the current crisis.
At the end of June, the Federal Deposit Insurance Corp. (FDIC) had 117 banks, worth approximately $78 billion in total, on its "troubled banks" list – and that list didn't include IndyMac before its failure. The list excludes the holding companies that own most large and medium-sized banks. Rumors of mergers, takeovers or failure today surround Washington Mutual, the largest savings and loan in the U.S., and Wachovia, the fourth-largest commercial bank.
This crisis arose with deregulation in the 1990s. Many banks sought ever-higher profits by making nontraditional, riskier loans to people with weak credit histories or unverified income and assets. This helped expand the housing bubble.
But as housing prices went into freefall last year, banks were left with risky mortgages and foreclosed homes, and had to revalue these assets according to what they could sell them for. This is how a bank ends up bankrupt – owing its depositors more than the value of its assets.
Washington Mutual is seen as a good candidate for takeover since it has $239 billion in outstanding loans, including $52.9 billion in risky mortgages. Wachovia has $122 billion in risky mortgages.
Meanwhile, supposedly more healthy banks like Citigroup and JPMorgan Chase are making overly optimistic assumptions about a housing market recovery, according to David Reilly of the Wall Street Journal. If they're wrong, they'll be further hurt.
In addition, during the housing bubble, many large banks raised more money to lend by bundling mortgage-backed securities into pools that to sell to wealthy financial institutions worldwide. That's where investment banks like Lehman Brothers and Goldman Sachs came in – they combined the mortgage-backed securities into even more complex and gigantic securities known as derivatives. Because this practice was so profitable, investment banks pressured the commercial banks for even more mortgages.
The big banks also got into the game, investing in these derivatives. To hide the risks inherent in such investments, Wachovia and Citigroup kept billions of dollars off the books in what is known as the "shadow banking system."
For individuals, those with bank deposits up to $100,000 have some protection, thanks to the FDIC, which was created during the Great Depression in 1933. This has prevented most bank runs ever since.
While it is obligated to repay deposits of failing banks, the FDIC usually attempts to engineer takeovers or mergers. In either case, depositors experience only a few days of disrupted access to their money. Now, money-market funds are also insured, as the Treasury Department stemmed a run last week by providing institutions with a one-year insurance guarantee on money market mutual funds for any investments made up until September 19.
Recent bank failures reduced the FDIC's deposit insurance fund to $45.2 billion at the end of June, its lowest level since 1995 and below its legally required capitalization. In August, FDIC Chair Sheila Bair proposed raising bank fees starting in October, but this is clearly insufficient. The money for depositors will again have to come from taxpayer-provided government revenues.
At this point, the actual financial status of each bank is only a guess, and we can't predict how many will disappear. However, with FDIC insurance, most of us don't need to run to our banks and pull out our money. It's probably safer to leave what money we have in a bank than around the house.
Nevertheless, all the financial bailouts leave less government funds for basic human needs, starting with extended unemployment insurance and food assistance in the current recession.
HOW DOES this shadow banking system work?
THE SHADOW banking system is shorthand for $10 trillion in financial activities that occur outside the framework of established banking regulators.
"The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system," Timothy Geithner, president of the Federal Reserve Bank of New York, said in a speech last summer, adding that this development "made the crisis more difficult to manage."
The creation of the shadow banking system wasn't an accident. Crucial to its development was the Gramm-Leach-Bliley Act, signed into law by Bill Clinton in 1999. That law repealed the Glass-Steagall laws, which had separated risky investment banking from traditional, deposit-taking commercial banks. In 2000, Congress passed the Commodity Futures Modernization Act, which kept large parts of commodities trading beyond the reach of regulators.
These two laws, along with previous efforts at deregulation, created a Wild West atmosphere on Wall Street.
Central to this was "debt securitization," which allowed mortgage-backed securities and other forms of debt to be turned into special bonds, for sale to huge investors. By the end of the first quarter of 2007, the total amount of securitized debt was $28 trillion – twice the amount of a decade earlier.
All this activity was ramped up with the use of "leverage" – that is, borrowed money. The investment banks were allowed to spend 30 times the amount of capital they actually had on hand. This greatly magnified profits, but it also meant that the losses would be exacerbated, too.
Since the crisis broke, the Fed and the Treasury have tried to extend their regulatory powers on the fly – for example, by lending money directly to investment banks that are unregulated (now that's moot, since the crisis has wiped out the last of Wall Street's freestanding investment banks through bankruptcies, forced mergers and, now, with Morgan Stanley and Goldman Sachs, regulatory changes).
It's worth noting that while there are plenty of calls for greater regulation, it's far from clear whether all the practices that created this crisis will be banned.
WHAT COULD the government do to overcome this crisis in a way that would benefit working people?
RATHER THAN nationalize the banks' losses, the government could nationalize the banks – period.
Letting the free market run its course has created the worst financial crisis since the 1930s. Why should the same people who created this catastrophe be allowed to continue to run the financial system, and pull down hundreds of millions in executive compensation? If the government could take over AIG with a warrant to buy 80 percent of its stock, why not do the same with loss-ridden banks, and use the funds to rebuild a rational banking system?
There's also any number of things the government could do to aid those facing foreclosure or a spike in interest rates on adjustable-rate mortgages. The government could use Fannie Mae and Freddie Mac to stop foreclosures. The U.S. government now controls most mortgages in the U.S., and could end that crisis now.
What's more, the government could refinance mortgages to provide 30-year loans at reasonable rates of interest – but at the current market value of their homes, rather than the inflated prices of the boom. But the banks have been lobbying intensely against any such move. They're willing to accept a higher rate of foreclosures as long as they can keep squeeze money out of hard-pressed homeowners.
None of this is being seriously discussed in Washington. But with the credibility of the free-market ideologues destroyed by the crisis and the pressing need for relief for working people, there's an opportunity to demand the far-reaching reforms that will benefit the majority who are suffering in this recession.
