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How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism
By Yves Smith
Palgrave Macmillan Copyright © 2010 Aurora Advisors Incorporated
All rights reserved.
THE SORCERER'S APPRENTICES
History is the long and tragic story of the fact that privileged groups seldom give up their privileges voluntarily.
—Martin Luther King
It was January 2007, and the Great Moderation was in full swing. Economic policy makers and central bankers were congratulating themselves for creating an over two-decade period of long economic expansions and relatively mild downturns. Crises, severe recessions, nay, anything other than largely steady growth, were a thing of the past, with any hiccups due to events like the September 11, 2001 attacks, which were clearly outside economists' control.
As this paean illustrates, the economics profession looked upon its handiwork with great satisfaction:
... we are living through one of the great transformations of modern history. Almost unnoticed, most of the industrialised world, especially the Anglo-Saxon part of it, has enjoyed a period of unprecedented economic stability.... The wild fluctuations of employment, output, inflation and interest rates have been firmly damped....
Economists are debating the causes of the Great Moderation enthusiastically and, unusually, they are in broad agreement. Good policy has played a part: central banks have got much better at timing interest rate moves to smooth out the curves of economic progress. But the really important reason ... is the liberation of markets and the opening-up of choice that lie at the root of the transformation. The deregulation of financial markets over the Anglo-Saxon world in the 1980s had a damping effect on the fluctuations of the business cycle. These changes gave consumers a vast range of financial instruments (credit cards, home equity loans) that enabled them to match their spending with changes in their incomes over long periods.... The economies that took the most aggressive measures to free their markets reaped the biggest rewards.
Yet the Great Moderation was, as bodybuilders describe steroid-abusers, a Cadillac body with a Chevy underneath. Its rate of expansion was lower than previous postwar growth phases. Inflation-adjusted worker wages had been stagnant. Dampened swings in the real economy were accompanied by more frequent and severe financial crises. The supposed better timing of central bank intervention merely led financial market participants to believe they could count on the authorities to watch their backs, encouraging more risk-taking. But perhaps the biggest danger was that blind faith in the virtues of markets converted regulators from watchdogs into enablers.
The very few economists who recognized that the vital signs were moving into danger zones and tried to alert officials were rebuffed. For instance, Yale's Robert Shiller (of Irrational Exuberance and S&P/Case-Shiller Index fame), recounted how, as a member of the economic advisory panel to the Federal Reserve Bank of New York, he had to soft-pedal his concerns about the developing real estate bubble:
In my position on the panel, I felt the need to use restraint. While I warned about the bubbles I believed were developing in the stock and housing markets, I did so very gently, and felt vulnerable expressing such quirky views. Deviating too far from consensus leaves one feeling potentially ostracized from the group, with the risk that one may be terminated.
Shiller gave more pointed warnings in 2005 to the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, both bank regulators, urging them to impose tougher mortgage lending standards. He was brushed off.
The Yale economist believed his views were rejected because they were based on the theories of behavioral economics, a new branch within economics that looks at how people behave when presented with various economic choices, a real-world perspective notably absent in orthodox theory. In his words, "Behavioral economists are still regarded as a fringe group by many mainstream economists."
But Shiller's views conflicted with conventional thinking in a more profound way. Remember, the profession had succeeded, since the 1970s, in transforming policies to conform with the view that unfettered markets were the royal road to prosperity. The touted Great Moderation was taken as a triumphal confirmation of the mainstream's collective wisdom. If this supposed success proved to be mere Potemkin prosperity, a facade masking an underlying deterioration, then it would call the credibility of much of the work in the discipline into question.
Shiller sounded alarms before the most toxic phase of mortgage lending started, in the second half of 2005, early enough to have contained the damage. Another warning was dismissed in August 2005, at the Federal Reserve's annual Jackson Hole conference, an end-of-summer gathering at the resort area in Wyoming for Fed officials and elite economists. It was the last of these forums chaired by Alan Greenspan. The participants were throwing verbal bouquets at the retiring Fed chief, with one notable exception.
The former chief economist at the International Monetary Fund (IMF) Raghuram Rajan presented a paper, "Has Financial Development Made the World Riskier?" His conclusion was "yes." Rajan had set out to establish that the financial innovations during Greenspan's tenure had increased safety. But the further he dug, the more troubling evidence Rajan found of bad incentives encouraging undue risk taking. One was the burgeoning market in credit default swaps, a relatively new product that allowed investors to buy or sell insurance against the possibility that a borrower would go bust. The sellers were massively undercapitalized, which meant that the insurance might be worthless. The result was a financial system in danger of a meltdown due to widespread holdings of high-octane, high-risk product.
Rajan met withering criticism and was dismissed as a financial Luddite. Yet two years later, when the crisis he predicted began to unfold, Fed presidents began citing that very paper in their speeches.
* * *
Not everyone was a true believer. Some could see the signs of the coming storm. For instance, Gillian Tett of the Financial Times was so alarmed by a flurry of e-mails from readers that she did something unorthodox. She wrote them up.
The troubling messages arrived in January 2007, the same month as the self-congratulatory assessment of the state of the global economy quoted at the start of the chapter. By contrast, Tett, a seasoned capital markets editor, had just published a story on a question that nagged at her: was growth in the murky, mushrooming world of structured finance distorting lending?
Structured finance was the latest flavor of "securitization," a technique of using loans as the foundation for investments (see "A Primer on Structured Finance," pages 12–13). This process, which started in the 1970s, meant that banks no longer held most loans to maturity. After it made loans, a bank often sold them to a packager, usually an investment bank, which performed its financial wizardry and offered the resulting particular pieces of the deal to eager buyers. This process is sometimes called the "originate and distribute" model.
A newly popular, complex structured finance product, collateralized debt obligations (CDOs), had grown explosively since 2004. The concern was that CDOs allowed borrowers to continue to get cheap funding even when central banks like the U.S. Federal Reserve were trying to choke it off.
What caught Tett's attention was the tone of the e-mails she received in response to her structured credit musings. For instance:
I have been working in the leveraged credit and distressed debt sector for 20 years ... and I have never seen anything quite like what is currently going on. Market participants have lost all memory of what risk is and are behaving as if the so-called wall of liquidity will last indefinitely and that volatility is a thing of the past.
I don't think there has ever been a time in history when such a large proportion of the riskiest credit assets have been owned by such financially weak institutions ... with very limited capacity to withstand adverse credit events and market downturns....
The degree of leverage at work ... is quite frankly frightening.... Very few hedge funds I talk to have got a prayer in the next downturn. Even more worryingly, most of them don't even expect one.
And the leverage, which is the degree to which an investor or business uses borrowed money, was stunning. A hedge fund might borrow a dollar for every dollar invested, not terribly aggressive in that world.
But a fair portion of that hedge fund's money did not come directly from wealthy individuals and institutions like insurance companies, but via funds of funds, entities that invested in multiple hedge funds. The theory was that the fund of funds manager would make an expert assessment and select a good mix. But many of those fund of funds borrowed money, often three dollars for every one invested, to make their returns look better and compensate for the additional layer of fees.
Now suppose the underlying hedge fund invested in the riskiest layers of a structured credit deal, say a collateralized debt obligation that could be effectively geared nine times, meaning it behaved as if it had nine dollars of debt for every dollar of equity. As one of Tett's sources explained:
Thus every 1m of CDO bonds [acquired] is effectively supported by less than 20,000 of end investors' capital—a 2% price decline in the CDO paper wipes out the capital supporting it.
Borrowing magnifies the impact of profit and loss: If you buy a house for $300,000, put up only 5% of the price and borrow the other 95% (20:1 leverage), then if the value of the house falls by more than just 5%, you lose your entire investment. But the seduction is that if the price increases a mere 5%, you double your money.
The razor-thin cushion against losses wasn't a risk just to the hedge funds, but also had wider ramifications for the credit markets. If the decay in CDO prices is big enough, the hedge and the fund of fund middlemen don't just deliver losses to their investors in their funds but can also partially default on the money borrowed, usually from one of the big investment banks active in that business, such as Goldman Sachs, Morgan Stanley, or the now defunct Bear Stearns. If the hedge funds were losing money on their CDOs due to a general worsening of conditions in that market, the investment banks would probably be taking losses directly on CDOs they held as trading inventory and speculative positions. And investment banks similarly funded those positions to a significant degree with borrowed funds.
It was a house of cards, a train wreck waiting to happen. The savvy players knew it was likely to end badly, yet with eager buyers and sellers, it seemed foolish to turn down the opportunity for profit.
And that was the right bet in January 2007. There was one last fat bonus year before the wheels really came off the financial system.
* * *
Tett had been early to recognize the dangers of structured finance, particularly its hottest offering in the new century, collateralized debt obligations, and had sounded warnings two years before.
In 2005, Michael Gibson, the head of trading risk analysis for the Federal Reserve, remarked that perhaps as many as 10% of CDO investors did not understand the risks of the product. Other comments at that time suggested that some of the most sophisticated investors in this product were out of their depth. For instance, Cynthia McNulty of Integrated Systems stated: "There is such a buzz about credit derivative products now that there are hedge funds getting into it without the requisite abilities."
Indeed, regulators had been scrambling to get a handle on the market. Because CDOs were not reported to any authority and trades were arranged privately between a host of product peddlers and buyers, even the estimates of market size varied widely, with Thomson Financial pegging the total sold in 2004 at $120 billion, while J.P. Morgan put it at $366 billion. To put that in perspective, the low estimate of $120 billion exceeded the value of all the corporate bonds sold in Europe that year.
Shortly after the Gibson comment, Tett weighed in with an eerily prescient take on the promise and dangers of this rapidly growing type of investment. She acknowledged the benefits but then turned to the downside. CDOs had been so successful at pulling funds into the credit markets that they were lowering interest rates on bonds, which gave investors false comfort. As prevailing yields fall, prices of outstanding bonds rise, so investors in bonds show profits. Thus, the success of early investors encouraged others to join the party.
But a good thing could go too far. While the falling yields for existing CDOs were a vindication to those who owned them, given their complexity, they had to offer higher income than so-called plain vanilla products, such as straightforward corporate bonds that carried the same credit rating. To compensate, banks were turning to more aggressive structures, often using riskier assets, to generate the higher income that was so alluring to investors. In other words, even as far back as 2005, the market was getting a frothy feel.
And Tett also noted:
Meanwhile, the fact that CDOs disperse credit among multiple investors means that, if a nasty accident did ever occur with CDOs, it could richochet [sic ] through the financial system in unexpected ways.
As we will discuss in detail later, that is precisely what came to pass.
* * *
The signs of trouble became more and more evident as 2007 progressed. A reader of the Financial Times would have seen not just Tett's warnings, but ample evidence of superheated activity in other markets, such as takeover lending. Even the FT's measured chief economics editor, Martin Wolf, not the sort to make market calls, warned in March 2007 that equities globally were substantially overvalued by historical standards.
Yet later that March, two months after Tett replayed market participants' alarms about leverage, the then president of the Federal Reserve Bank of New York, Timothy Geithner, gave a largely comforting speech on credit market innovation.
The New York Fed is not merely the biggest of the twelve regional Federal Reserve Banks, but, more importantly, it is responsible for implementing Federal Reserve policy through the trading desks of the New York Fed. By virtue of his location and role, the head of the New York Fed is in regular contact with Wall Street and presumed to be particularly knowledgeable about market conditions. And by this point, the subprime cloud was large enough to have merited official comment. The message from Geithner: its impact did not appear to be significant.
In his remarks, Geithner set forth the concerns about the plethora of new complex financial products, but also noted that financial alchemy offered considerable advantages: more credit, better pricing, more choice for investors, and better diversification of exposures. He asserted that the past three decades of experience with financial innovation were reassuring. The growing pains had been manageable.
Yet this seemingly evenhanded description gave plenty of cause for pause. First, Geithner pointed out that banks, the credit-providers that are most closely regulated, held only 15% of the "nonfarm nonfinancial" debt outstanding (remember financial institutions lend to each other, so that is excluded when trying to measure debt that is important to the real economy). Thus, while the Fed has good information about what banks are doing, and can send in examiners when warranted, it had no idea what the biggest players in the credit markets, such as investment banks, hedge funds, sovereign wealth funds, and Tett's increasingly edgy European investors buying U.S. products, were really up to. Thus, Geithner was trying to assess the health of an elephant when he could scrutinize, at most, its leg.
So his argument boiled down to, "Our current structure and distribution of risks is outside the bounds of anything in financial history. We can conjure some arguments as to why this should be OK, and so far, it has been OK."
Second, Geithner claimed regulators were powerless:
We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.
Third, the Fed chief noted that companies weren't borrowing overmuch; in fact debt levels in the corporate sector were below recent norms. But that statement was misleading. Overall private sector borrowings had exploded, thanks to a debt-fueled consumer spending spree, and was over 180% of the Gross Domestic Product, markedly above the level at the onset of the Great Depression, 164%.
How could the authorities ignore the dramatic growth in debt? Federal Reserve officials had fallen into classic bubble-era rationalizations. The Fed chairman, Ben Bernanke (who succeeded Greenspan in 2006), had dismissed concerns about rising consumer borrowings, noting that household assets were rising too. But debt has to be serviced, which comes ultimately from income or the sale of property. With consumer savings rates approaching zero, the public was reaching the limits of how much debt it could support.
Excerpted from Econned by Yves Smith. Copyright © 2010 Aurora Advisors Incorporated. Excerpted by permission of Palgrave Macmillan.
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