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The Subprime Conspiracy

Many people now believe that the financial crisis was not an accident. They think that the Bush administration and the Fed knew what Wall Street was up to and provided their support. This isn’t as far fetched as it sounds. As we will show, it’s clear that Bush, Greenspan and many other high-ranking officials understood the problem with subprime mortgages and knew that a huge asset bubble was emerging that threatened the economy. But while the housing bubble was more than just an innocent mistake, it doesn’t rise to the level of “conspiracy” which Webster defines as  “a secret agreement between two or more people to perform an unlawful act.”  It’s actually worse than that, because bubblemaking is the dominant policy, and it’s used to overcome structural problems in capitalism itself, mainly stagnation.

The whole idea of a conspiracy diverts attention from what really happened. It conjures up a comical vision of  top-hat business tycoons gathered in a smoke-filled room stealthily mapping out the country’s future. It ignores the fact, that the main stakeholders don’t need to convene a meeting to know what they want. They already know what they want; they want a process that helps them to maintain profitability even while the “real” economy remains stuck in the mud.  Historian Robert Brenner has written extensively on this topic and dispels the mistaken view that the economy is “fundamentally strong”. (in the words of former Treasury secretary Henry Paulson)  Here’s Brenner :

“The current crisis is more serious than the worst previous recession of the postwar period, between 1979 and 1982, and could conceivably come to rival the Great Depression, though there is no way of really knowing. Economic forecasters have underestimated how bad it is because they have over-estimated the strength of the real economy and failed to take into account the extent of its dependence upon a buildup of debt that relied on asset price bubbles.

“In the U.S., during the recent business cycle of the years 2001-2007, GDP growth was by far the slowest of the postwar epoch. There was no increase in private sector employment. The increase in plants and equipment was about a third of the previous, a postwar low. Real wages were basically flat. There was no increase in median family income for the first time since World War II. Economic growth was driven entirely by personal consumption and residential investment, made possible by easy credit and rising house prices. Economic performance was weak, even despite the enormous stimulus from the housing bubble and the Bush administration’s huge federal deficits. Housing by itself accounted for almost one-third of the growth of GDP and close to half of the increase in employment in the years 2001-2005. It was, therefore, to be expected that when the housing bubble burst, consumption and residential investment would fall, and the economy would plunge. ” (“Overproduction not Financial Collapse is the Heart of the Crisis”, Robert P. Brenner speaks with Jeong Seong-jin, Asia Pacific Journal)

What Brenner describes is an economy \that–despite unfunded tax cuts, massive military spending and gigantic asset bubbles–can barely produce positive growth.  The pervasive lethargy of mature capitalist economies poses huge challenges for industry bosses who are judged solely on their ability to boost quarterly profits. Goldman’s Lloyd Blankfein and JPM’s Jamie Dimon could care less about economic theory, what they’re interested in is making money; how to deploy their capital in a way that maximizes return on investment. “Profits”, that’s it.  And that’s much more difficult in a world that’s beset by overcapacity and flagging demand.  The world doesn’t need more widgets or widget-makers. The only way to ensure profitability is to invent an alternate system altogether, a new universe of financial exotica (CDOs, MBSs, CDSs) that operates independent of the sluggish real economy. Financialization provides that opportunity. It allows the main players to pump-up the leverage, minimize capital-outlay, inflate asset prices, and skim off record profits even while the real  economy endures severe stagnation.

Financialization provides a  path to wealth creation, which is why the sector’s portion of total corporate profits is now nearly 40 per cent. It’s a way to bypass the pervasive inertia of the production-oriented economy. The Fed’s role in this new paradigm is to create a hospitable environment (low interest rates) for bubble-making so the upward transfer of wealth can continue without interruption. Bubblemaking is policy.

As we’ve pointed out in earlier articles, scores of people knew what was going on during the subprime fiasco. But it’s worth a quick review, because Robert Rubin, Alan Greenspan, Timothy Geithner, and others have been defending themselves saying, “Who could have known?”.

The FBI knew (“In September 2004, the FBI began publicly warning that there was an “epidemic” of mortgage fraud, and it predicted that it would produce an economic crisis, if it were not dealt with.”) The FDIC knew. ( In testimony before the Financial Crisis Inquiry Commission, FDIC chairman Sheila Bair confirmed that she not only warned the Fed of what was going on in 2001, but cited particular regulations (HOEPA) under which the Fed could stop the “unfair, abusive and deceptive practices” by the banks.) Also Fitch ratings knew, and even Alan Greenspan’s good friend and former Fed governor Ed Gramlich knew. (Gramlich personally warned Greenspan of the surge in predatory lending that was apparent as early as 2000. Here’s a bit of what Gramlich said in the Wall Street Journal:

“I would have liked the Fed to be a leader” in cracking down on predatory lending, Mr. Gramlich, now a scholar at the Urban Institute, said in an interview this past week. Knowing it would be controversial with Mr. Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich broached it to him personally rather than take it to the full board. “He was opposed to it, so I didn’t really pursue it,” says Mr. Gramlich. (Wall Street Journal)

So, Greenspan knew, too. And, according to Elizabeth MacDonald  in an article titled “Housing Red flags Ignored”:

“One of the nation’s biggest mortgage industry players repeatedly warned the Federal Reserve, the Federal Deposit Insurance Corp. and other bank regulators during the housing bubble that the U.S. faced an imminent housing crash….But bank regulators not only ignored the group’s warnings, top Fed officials also went on the airwaves to say the economy was “building on a sturdy foundation” and a housing crash was “unlikely.”

So, the Mortgage Insurance Companies of America [MICA] also knew. And, here’s a clip from the Washington Post by former New York governor Eliot Spitzer who accused Bush of being a ‘partner in crime’ in the subprime fiasco. Spitzer says that the OCC launched “an unprecedented assault on state legislatures, as well as on state attorneys general just to make sure the looting would continue without interruption. Here’s an except from Spitzer’s article:

“In 2003, during the height of the predatory lending crisis….the OCC promulgated new rules that prevented states from enforcing any of their own consumer protection laws against national banks. The federal government’s actions were so egregious and so unprecedented that all 50 state attorneys general, and all 50 state banking superintendents, actively fought the new rules. (Washington Post)

So, the Fed knew, the Treasury knew, the FBI knew, the OCC knew, the FDIC knew, Bush knew, the Mortgage Insurance Companies of America knew, Fitch ratings knew, all the states Attorneys General knew, and thousands, of traders, lenders, ratings agency executives, bankers, hedge fund managers, private equity bosses, regulators knew. Everyone knew, except the unlucky people who were victimized in the biggest looting operation of all time.

Once again, looking for conspiracy, just diverts attention from the nature of the crime itself. Here’s a statement from former regulator and white collar criminologist William K. Black which helps to clarify the point:

“Fraudulent lenders produce exceptional short-term ‘profits’ through a four-part strategy: extreme growth (Ponzi), lending to uncreditworthy borrowers, extreme leverage, and minimal loss reserves. These exceptional ‘profits’ defeat regulatory restrictions and turn private market discipline perverse. The profits also allow the CEO to convert firm assets for personal benefit through seemingly normal compensation mechanisms. The short-term profits cause stock options to appreciate. Fraudulent CEOs following this strategy are guaranteed extraordinary income while minimizing risks of detection and prosecution.” (William K. Black, “Epidemics of’Control Fraud’ Lead to Recurrent, Intensifying Bubbles andCrises”, University of Missouri at Kansas City – School of Law)

Black’s definition of “control fraud” comes very close to describing what really took place during the subprime mortgage frenzy. The investment banks and other financial institutions bulked up on garbage loans and complex securities backed by dodgy mortgages so they could increase leverage and rake off large bonuses for themselves. Clearly, they knew the underlying collateral was junk, just as they knew that eventually the market would crash and millions of people would suffer.

But, while it’s true that Greenspan and Wall Street knew how the bubble-game was played; they had no intention of blowing up the whole system. They simply wanted to inflate the bubble, make their profits, and get out before the inevitable crash.  But, then something went wrong. When Lehman collapsed, the entire financial system suffered a major heart attack. All of the so-called “experts” models turned out to be wrong.

Here’s what happened: Before to the meltdown, the depository “regulated” banks got their funding through the repo market by exchanging collateral (mainly mortgage-backed securities) for short-term loans with the so-called “shadow banks” (investment banks, hedge funds, insurers) But after Lehman defaulted, the funding stream was severely impaired because the prices on mortgage-backed securities kept falling. When the bank-funding system went on the fritz,  stocks went into a nosedive sending panicky investors fleeing for the exits. As unbelievable as it sounds, no one saw this coming.

The reason that no one anticipated a run on the shadow banking system is because the basic architecture of the financial markets has changed dramatically in the last decade due to deregulation. The fundamental structure is different and the traditional stopgaps have been removed. That’s why no one knew what to do during the panic. The general assumption was that there would be a one-to-one relationship between defaulting subprime mortgages and defaulting mortgage-backed securities (MBS). That turned out to be a grave miscalculation. The subprimes were only failing at roughly 8 percent rate when the whole secondary market collapsed. Former Treasury Secretary Paul O’Neill explained it best using a clever analogy. He said, “It’s like you have 8 bottles of water and just one of them has arsenic in it. It becomes impossible to sell any of the other bottles because no one knows which one contains the poison.”

And that’s exactly what happened. The market for structured debt crashed, stocks began to plummet, and the Fed had to step in to save the system. Unfortunately, that same deeply-flawed system is being rebuilt brick by brick without any substantive changes.. The Fed and Treasury support this effort, because–as agents of the banks–they are willing to sacrifice their own credibility to defend the primary profit-generating instruments of the industry leaders. (Goldman, JPM, etc) That means that Bernanke and Geithner will go to the mat to oppose any additional regulation on derivatives, securitization and off-balance sheet operations, the same lethal devices that triggered the financial crisis.

So, there was no conspiracy to blow up the financial system, but there is an implicit understanding that the Fed will serve the interests of Wall Street by facilitating asset bubbles through “accommodative” monetary policy and by opposing regulation. It’s just “business as usual”, but it’s far more damaging than any conspiracy, because it ensures that the economy will continue to stagnate, that inequality will continue to grow, and that the gigantic upward transfer of wealth will continue without pause.

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

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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.

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