The Great Switch: Banks Rob People

Published on September 27, 2008

The US government is on the verge of making an unprecedented financial commitment, likely to cost $700 billion, to buy the bad securities held by large US and foreign financial institutions. Having driven our economy to the edge of financial destruction, the Lords of Finance now want the public to put up the money needed to save them and their firms from collapse. Maybe men don’t bite dogs, but banks do rob people.

BY JIM CROTTY
T r u t h o u t | Perspective
Posted by Bulatlat

In response to the collapse of unregulated financial markets in the early 1930s, the American people decided to tightly regulate the financial system so that it could never again threaten the US economy. The Depression-era regulations worked effectively until the late 1970s, helping to create the best economic performance in US history. When our financial system was buffeted by high inflation in the late 1970s, it became necessary to reform the regulatory process so it would be effective in the new economic era. But instead of reform, the rise to power of anti-government, right wing forces – reflected in the election of President Reagan in 1980s – led to a radical deregulation process. By the end of the Clinton presidency, radical deregulation was completed.
Deregulation – in concert with rapid financial innovation that made complex financial products such as derivatives and mortgage-backed securities possible – created a volatile pattern of financial booms and crises. Each crash led to bailouts by affected governments, which only increased incentives to financial firms to expand further and take greater risks, since there were massive profits to be made in the upturn while the public paid to limit their losses in the downturn. The new era thus saw an explosion in the size and profits of financial firms. Financial assets were less than five times the size of the US gross domestic product (GDP) in 1980, but over ten times as large in 2007. In the US, the share of total corporate profits generated in the financial sector grew from 10 percent in the early 1980s to 40 percent in 2006. As financial markets grew larger and thus more dangerous, the pressure on governments to bail them out increased proportionately.

The recent boom was driven by the rapid rise in home prices in the decade ending in 2006. The fact that home buyers and mortgage lenders assumed housing prices would never decline sustained the boom, and the fact that banks and mortgage brokers were paid large fees to originate mortgages and large fees to service them generated momentum. Since most of these mortgages were not held by their originators, but rather sold to others, it made sense for banks and brokers to maximize the flow of mortgages, even if that meant selling mortgages that were likely to default if home prices stopped rising or interest rates rose substantially. Investment banks received similar fees to package the mortgages into mortgage-backed securities that were then sold to banks, hedge funds, pension funds and insurance companies around the world. These securities were essentially highly leveraged risky bets that housing prices would keep rising. They were so complicated that no one knew what their price should be. Thus, they could only be sold because credit ratings agencies such as Fitch and Moody’s gave them AAA ratings. The agencies provided overly optimistic ratings only because they were paid by investment banks to do so.

Why did so many large financial institutions borrow so much money to invest in such risky securities? The answer lies in the way their top people are paid. Financial firm “rainmakers” get most of their compensation in the form of bonuses tied to the profits of their enterprise. When markets are booming, profits and bonuses are maximized by borrowing lots of money – investment banks borrowed $32 for every $33 of assets they owned in 2007 – and taking high risks with it. For example, in 2006, Goldman Sachs had a banner profit year and the average bonus for its 25,000 employees was $650,000. But most of this money was paid to those at the top, with key traders taking home $50 million. Everyone knew that such risk-taking would eventually lead to disaster when markets turned down, but they would not have to give back the big bonuses from the boom.
When housing prices began to fall in 2006, the game was up, though it took another year before the crisis broke out. Once it did, the gravitational pull of reverse leverage accelerated the downfall. Firms that borrowed heavily to buy assets used the value of the assets as collateral for their loans. When asset prices started to fall, so did their collateral value. Their creditors demanded that they put up additional cash, which forced them to sell assets. Of course, this made asset prices fall faster. Soon, financial firms across the globe found the value of their assets and the value of their capital plunging along with the price of their stock. As usual, they rushed to government regulators to save them.

In the US, the Fed responded to the crisis by extending massive loans to commercial banks, and, for the first time since the Great Depression, to investment banks as well. The Fed exchanged US Treasuries for shaky mortgage-related securities in such large quantities that the proportion of its $800 billion in assets invested in government bonds fell from 91 percent in August 2007 to 52 percent one year later. It later offered to lend money in exchange for any security, even corporate stocks. In addition, the Federal Home Loan Bank increased its loans to banks by almost $300 billion between June 2007 and June 2008, a rise of 43 percent.

Pages: 1 2