FacebookTwitterRedditEmail

What Really Triggered the Financial Crisis?

Most people still don’t know what caused the financial crisis. They know it had something to do with subprime mortgages and Lehman Bros, but beyond that, it gets rather hazy. Unfortunately, Congress appears to be in the dark too, which is why their attempt to regulate the system is bound to fail and pave the way for another crisis in the next few years. [Financial crises occur on average every seven years. Eds.]

The real source of the the last crisis is a design-flaw in the architecture of the modern banking system. This sounds more complicated than it really is.

You see, credit, which used to be strictly regulated–since it allows banks to create money out of thin air–has become a franchise which is shunted off to hedge funds, insurance companies, pension funds and other so-called shadow banks which are able to take advantage of loopholes in the system and create gigantic amounts leverage without any regulatory supervision.

At one time, when a bank made a loan, they made sure that the applicant had a job, steady income, collateral, and a good credit history. That’s because the banks knew they would be holding the loans to maturity and any loss on the loan would impact their profitability. That’s the only way that it’s safe to allow private industry (aka–the bank) to create credit. The financial crisis proves that unregulated credit-generation is every bit as lethal as a neutron bomb, which kills everyone in the vicinity, but leaves the buildings still standing. The credit-mechanism cannot be handed over to unregulated speculators without putting the entire economy at risk.

The new system works differently. Now the banks are largely middle-men who originate the mortgages, (or other loans) chop them up into bits and pieces in their off-balance sheet operations, and sell them to investors in the secondary market. The process is called securitization and it magically transforms one man’s liability (the loan) into another man’s asset.(the security) But don’t be fooled. The debt is the same as if it was still sitting on the bank’s balance sheet instead of some oddball structured-debt instrument, like a mortgage backed security (MBS) or a collateral debt obligation (CDO). What’s really changed is the ability to generate credit has shifted from highly-regulated depository institutions to fly-by-night speculators whose only interest is to maximize leverage, create another bubble, and cash in before the mighty zeppelin crashes to earth.

Keep in mind, that a bank is any institution that takes deposits and agrees to provide ready access to cash for people who want to withdraw funds. A bank makes its money by “borrowing short” (deposits or repo) to “go long”. (putting money in long-term illiquid assets) That means that a bank is required to hold liquid reserves and enough capital to meet its needs even in a crisis.

The banks have abdicated their role as credit producers, because the shadow banks can do the job cheaper. And the reason they can do it cheaper is because they are undercapitalized. Take AIG for example. They were selling insurance policies (CDS) but they didn’t have the capital reserves to pay off the claims. Think of how easy it would be to make gobs of money if you could sell property that you didn’t really own. The only problem, of course, is that if you engaged in such activity, you’d be dragged off to the hoosegow in chains.

So how do the shadow banks make so much money by increasing leverage?

Here’s how it works: There are three houses on the block; all of them are identical and all of them are the same price, $100,000 each.

Harry buys the first house and pays cash, $100,000 on the barrelhead.

Joe buys the second house and puts 10 per cent down, in other words, he pays $10,000.

Frank, who works for a big chiseling hedge fund on Wall Street, buys the third home and puts 0.0 per cent  down; so he has zero equity.

12 months later the value of all three homes has gone up 10 per cent; so now they are all worth $110,000. That means:

Harry has made a measly 10 per cent on his investment.

Joe has made 100 per cent on his investment.

And chiseling Frank has made $10,000 pure profit.

This simple breakdown is intended to help people grasp the real purpose behind securitization and derivatives trading, which is not to make markets operate more efficiently or to “disaggregate” (spread) risk (as the proponents of “innovation” say). It is simply to peddle garbage assets which are balanced on minuscule slices of capital. It’s a shyster’s dream-come-true; capitalism without capital.

All Wall Street’s profit’s derive from some variation of this low-capital, high-risk schema.

ZERO-HOUR FOR LEHMAN
The day the shadow system blew up

Before to the meltdown, the depository “regulated” banks were mainly funded through repurchase agreements (repo) with institutional investors. (aka—“shadow banks”; investment banks, hedge funds, insurers) The banks would post collateral, in the form of bundled “securitized”  bonds, and use the short-term loans to maintain operations.  When the bank’s collateral became suspect — because no one knew which  bundles held the subprime mortgages — then intermediaries (primary dealers) demanded more collateral for the loans. Suddenly the banks were losing money hand-over-fist as the value of their assets tumbled. Lehman got trapped in this revolving door and couldn’t roll-over its debt using its shabby collateral, which, by now, everyone knew was garbage. There was a bank-run on the shadow system; the secondary market collapsed.

In other words, the banks were going to the primary dealers the same way that I would go to a pawn shop, and borrow money by posting my lavish, fully-landscaped 4,000 ft colonial home and custom Maserati sports car for a $200,000 loan. That scam might work for a while, but eventually the owner of the pawn shop will wise up and realize that I don’t really own a lavish, fully-landscaped 4,000 ft colonial home and custom Maserati sports car. Rather, I live in a makeshift clapboard-shack with a corrugated tin roof by the railroad tracks and drive a rusty Schwinn bicycle to my job collecting aluminum cans for the recycling center. That’s what happened to Lehman.

When Lehman Bros collapsed, there was NOT a panic. That’s another myth. Lehman merely triggered a radical repricing event, which means that the assets that had been trading for artificially high prices, suddenly fell to reflect what reasonable people thought was there “true” market value. This (collective) judgment was not made out of fear, but rather with the knowledge that the underlying collateral (shabby mortgages) was gravely impaired. Prices in the repo market for some MBS and CDOs fell more than 50 per cent.

Of course, Bernanke still clings to the idea that these are just “unloved” assets that will eventually bounce back. But what else can he say?  “We’re going to mark these turkeys down to their real value and shove the banking system off a cliff?” That’s not going to happen.

So, it’s up to congress to grasp the thistle and demand that the shadow banks be strictly regulated from here-on-out so we don’t end up in the same pickle two years from now.

The state has a compelling interest to make sure that credit-generating financial institutions are strictly regulated. Credit expansion is vital to economic growth and to raising standards of living. But, in the wrong hands, it will increase inequality, divert money away from productive activity, and inflate asset bubbles that end in disaster.

The reforms which are now being debated in the congress, (Too big to fail, off-balance sheet operations, derivatives trading, securitization) miss the larger point. Regulators must have the authority to intervene WHEREVER they think it is necessary to ensure that institutions are adequately capitalized, that lending standards are strictly upheld and that credit production is carefully monitored by trained government supervisors.

MIKE WHITNEY lives in Washington state and can be reached at fergiewhitney@msn.com.

 

WORDS THAT STICK

More articles by:

MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at fergiewhitney@msn.com.

bernie-the-sandernistas-cover-344x550
Weekend Edition
July 19, 2019
Friday - Sunday
Rob Urie
The Blob Fought the Squad, and the Squad Won
Miguel A. Cruz-Díaz
It Was Never Just About the Chat: Ruminations on a Puerto Rican Revolution.
Anthony DiMaggio
System Capture 2020: The Role of the Upper-Class in Shaping Democratic Primary Politics
Andrew Levine
South Carolina Speaks for Whom?
Jeffrey St. Clair
Roaming Charges: Big Man, Pig Man
Bruce E. Levine
The Groundbreaking Public Health Study That Should Change U.S. Society—But Won’t
Evaggelos Vallianatos
How the Trump Administration is Eviscerating the Federal Government
Pete Dolack
All Seemed Possible When the Sandinistas Took Power 40 years Ago
Ramzy Baroud
Who Killed Oscar and Valeria: The Inconvenient History of the Refugee Crisis
Ron Jacobs
Dancing with Dr. Benway
Joseph Natoli
Gaming the Climate
Marshall Auerback
The Numbers are In, and Trump’s Tax Cuts are a Bust
Louisa Willcox
Wild Thoughts About the Wild Gallatin
Kenn Orphan
Stranger Things, Stranger Times
Mike Garrity
Environmentalists and Wilderness are Not the Timber Industry’s Big Problem
Helen Yaffe
Cuban Workers Celebrate Salary Rise From New Economic Measures
Brian Cloughley
What You Don’t Want to be in Trump’s America
David Underhill
The Inequality of Equal Pay
David Macaray
Adventures in Script-Writing
David Rosen
Say Goodbye to MAD, But Remember the Fight for Free Expression
Nick Pemberton
This Is Heaven!: A Journey to the Pearly Gates with Chuck Mertz
Dan Bacher
Chevron’s Oil Spill Endangers Kern County
J.P. Linstroth
A Racist President and Racial Trauma
Binoy Kampmark
Spying on Julian Assange
Rose Ramirez – Dedrick Asante-Mohammad
A Trump Plan to Throw 50,000 Kids Out of Their Schools
David Bravo
Precinct or Neighborhood? How Barcelona Keeps Rolling Out the Red Carpet for Global Capital
Ralph Nader
Will Any Disgusted Republicans Challenge Trump in the Primaries?
Dave Lindorff
The BS about Medicare-for-All Has to Stop!
Arnold August
Why the Canadian Government is Bullying Venezuela
Tom Clifford
China and the Swine Flu Outbreak
Missy Comley Beattie
Highest Anxiety
Jill Richardson
Weapons of the Weak
Peter Certo
Washington vs. The Squad
Peter Bolton
Trump’s Own Background Reveals the True Motivation Behind Racist Tweets: Pure White Supremacy
Colin Todhunter
From Mad Cow Disease to Agrochemicals: Time to Put Public Need Ahead of Private Greed
Nozomi Hayase
In Crisis of Democracy, We All Must Become Julian Assange
Wim Laven
The Immoral Silence to the Destructive Xenophobia of “Just Leave”
Cecily Myart-Cruz
McDonald’s: Stop Exploiting Our Schools
Kollibri terre Sonnenblume
Our Veggie Gardens Won’t Feed us in a Real Crisis
CounterPunch News Service
A Homeless Rebellion – Mission Statement/Press Release
Louis Proyect
Parallel Lives: Cheney and Ailes
David Yearsley
Big in the Bungalow of Believers
Ellen Taylor
The Northern Spotted Owls’ Tree-Sit
July 18, 2019
Timothy M. Gill
Bernie Sanders, Anti-Imperialism and Venezuela
W. T. Whitney
Cuba and a New Generation of Leaders Respond to U.S. Anti-People War
FacebookTwitterRedditEmail