Financial Crisis II

This post is based on an article, ‘Too Little, Too Late: Why?’, by Jeff Madrick in the New York Review of Books. See Subscription for information on subscribing. You will never use your money more usefully than when buying a subscription to the NY Review of Books.

He examines three books,

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead
by Alan S. Blinder
Penguin, 476 pp., $29.95

Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself
by Sheila Bair
Free Press, 415 pp., $26.99

Bailout: An Inside Account of How Washington Abandoned Main Street While Rescuing Wall Street
by Neil Barofsky
Free Press, 270 pp., $26.00

looking for reasons that both the Bush and Obama administrations employed measures altogether too weak to pull the U.S. economy out the recession caused by the collapse of the financial markets starting in 2007.

“By 2008, major firms — AIG, Lehman Brothers, and Bear Stearns among them — were beginning to teeter as the mortgage securities they had issued fell in value and losses jeopardized their ability to meet their financial commitments,” writes Madrick.

Mortgage-backed securities are based on mortgages, obviously. A mortgage arises when a bank loans a potential homeowner a sum of money which said person uses to buy a house. The mortgage owner repays the bank in regular amounts along with another sum of money which is the interest on the mortgage. The interest payment is where the bank makes its money.

A mortgage-backed security is a bundle of mortgages which when sold will secure the buyer of the security interest rate payments from all the securities in the bundle.

A bank can either bundle many of its own mortgages into a security or buy mortgages from many banks and bundle them into a security.

Banks also earn money on assorted fees charged for providing the services required for bundling and selling these things.

This explanation of securities and other financial devils is LSW’s shortened and possibly amateurish version of Simon Johnson/James Kwak’s concise and easily understood explanation of the financial instruments that were involved in the financial crisis of 2008. Financial Crisis for Begynners is easily understood and a fairly quick read.

So far, everyone is happy. The person buying the mortgage gets a dwelling, the bank has acquired a stream of debt and interest payments and more bankers earn more money if and when individual mortgages are bundled together and sold as a security.

The only dark cloud in this rosy picture revolves around possible defaults on the mortgages making up the security. If enough people default on the mortgages making up the security, the bank owning the security will have lost money as the cost of the security will be more than the income streams the security is bringing in.

The banks not only used mortgages as the basis for their securities, they used subprime mortgages, which were sold at interest rates that initially were low and affordable but, which as specified buried in the small print, were designed to increase. In addition, the owners of these mortgages were often not vetted for their financial ability to pay off the mortgage which would pretty much guarantee that the mortgage would not be paid off.

There was money made by the initial bank that sold a mortgage in terms of fees and there were more fees paid in the sale of the mortgages to the bundlers of the securities and still more money was ‘made’ by the bank issuing the security.

Everyone made money and got rich. Except the owner of the mortgage who would eventually not be able to pay off the mortgage and lose his/her house. The banks employed risk models which assured them that these securities were stable in the sense that the number of possible defaults would never pose a danger to the owner of the security. Hot shot statisticians judged the risk of ‘all’ the mortgages going belly up as unlikely. These risk models, however, were based on data from the past and did not take into account data from present nor the riskiness involved in subprime mortgages.

In addition, banks discovered another way to make/swindle money: insuring securities (CDS, credit default swaps). For a relatively small sum the owner of a security could insure the value of that security or, amazingly enough, any security. These things began to be sold in the gadzillions as financiers took to betting on the fall of securities. Real smooth, the very issuers of securities made money betting against them.

When home prices began to fall and subprime mortgages began to be defaulted on, the banks and other owners of mortgage-backed securities began to lose ever increasing amounts of money. Compounding the damage, CDSs began to be called in, to such a degree that the issuers of the CDSs could not pay them off. Due to the extent of the use of CDSs and mortgage-backed securities found themselves on the edge of, or already in, bankruptcy with lending for other loans frozen as the financial stability of lending and lender institutions was not verifiable.

Without lending, the economy was faced with paralysis.

Back to Madrick. As giant banks wobbled and lending was frozen, the Treasury, the Fed and its New York branch hastily created TARP (Trouble Asset Recovery Program or some such, otherwise known as The Bailout) which provided the big banks with hundreds of billions of dollars.

Timothy Geithner, the Treasury man, while president of the New York Fed,along with Henry Paulson, George Bush’s Treasury secretary, and, to a lesser degree, with Ben Bernanke, Bush’s appointee as chairman of the Federal Reserve, codesigned TARP. Options for the design of the thing included nationalization of the banks in question (an option supported by many economists), buying up bad mortgages or simply injecting money into the banks, in the form of purchases of bank shares which would later be bought back.

The latter option was used, however the amount paid in dividends on the stock purchased from the banks by the government, the taxpayers, was 5% as opposed to the 10%, for example, received by Warren Buffett on billions he invested in Goldman Sachs. Madrick, ““No private investors would have offered the terms the government did,” says Phil Angelides, the former head of the Financial Crisis Inquiry Commission.”

Neither was there any requirement that the banks inform the government on how the money was being used.

“Astonishingly, there were no demands by Paulson or Geithner that the banks lend any portion of their funds to businesses. Barofsky was in charge of preventing fraud. How could he do that if he did not know where the money was going?”

Not only that, the government did not stipulate that the money should be made available for loans to get the economy moving again.

“This is one of many examples of how Geithner bent over backward to protect the banks. The New York Times published an article in early 2009 about Barofsky’s concerns, in which it reported that lending to business was not the highest priority of the rescued banks. They were using the money to pay down debt, make acquisitions, or build up their savings.”

In addition, the institutions which were bailed out, were bailed out in whole and not forced to take any losses on their acts of grotesque greed and incompetency. And to top it off, the large bonuses and compensation to the incompetents in the banks were not limited or curtailed.

Why was TARP so friendly to Wall Street? Because Wall Street basically created TARP. Madrick:

“Geithner himself was not from Wall Street, but many of those running the programs in the Treasury were, including the powerful Neel Kashkari, formerly from Goldman Sachs. Geithner’s patron was Robert Rubin, Clinton’s Treasury secretary and former head of both Goldman Sachs and later Citigroup. Blinder says the Treasury’s policymakers were probably “too pro-Wall Street.” Bair is harsher. She writes that Geithner “had been elevated to the role for all of the wrong reasons, boosted by Bob Rubin, who no doubt had had every expectation that Tim would continue his Citigroup-friendly policies.””

According to Madrick the “most egregious failure of TARP, however, was that both the Bush and Obama administrations never adequately used the funds to reduce mortgage debt for Americans, even though help for homeowners was a principal part of the TARP legislation” High levels of mortgage debt have restricted economic activity and inhibited recovery.

The anger aroused by TARP created resistance to government financial actions. Obama thought he had to include tax reductions as part of his stimulus program. While tax cuts have never assisted economic growth, they formed a substantial portion of the so-called stimulus because Obama felt tax cuts had to be included in order to appease Republicans. Public attitudes also prevented Obama from adding more stimulus programs which were sorely needed. And, indeed, it could be argued that TARP furnished gasoline to the fire pumping up the wrath of what would become, with the assistance of billionaires, the Tea Party. Especially in lieu of Democratic resistance to TARP.

As of today,

“most egregious failure of TARP, however, was that both the Bush and Obama administrations never adequately used the funds to reduce mortgage debt for Americans, even though help for homeowners was a principal part of the TARP legislation. “

2012 status:

“The nation is still undeniably living with TARP’s flaws. Bank lending even as late as the fall of 2012 had still not reached the levels of late 2008. Thirteen or fourteen million home owners are still underwater. Four million have already lost their homes. Many people remain angry about the failure to hold bankers responsible—no major banker has been criminally prosecuted for the financial fiasco. It will be hard to bail out the system again should a new crisis occur five or ten years from now.

Moreover, the financial community has not been reorganized and regulated in ways that give confidence that it will be a productive contributor to the American economy, rather than a danger zone, for decades to come. The crisis could have led to sweeping reform, but that opportunity was wasted.”

A to-do list:

  • change compensation schemes, make these ‘folks’ in the financial industry liable for their losses
  • make derivatives more transparent than does Dodd-Frank, registering them on open exchanges
  • reduce permitted leverage meaning limit the loan amount in relation to money up front.
  • operations involved in financing of derivatives and securities should be walled off from units making business loans and engaged in traditional business activities
  • capital requirements on banks are still not in effect and Volker Rule regulations on proprietary trading by commercial as well as derivative regulations are watered down under the influence of lobbyists.
  • Investors still rely on ratings agencies who are paid by the issuers of the things being rated.

It should also be noted that

“The public’s angry reaction to the bailout of bankers seemed to extend to government intrusiveness of any kind, even the financial reregulation act known as Dodd-Frank, named for its sponsors, Senator Chris Dodd and Representative Barney Frank. Ironically, the TARP reaction may have made it harder to implement tough new regulations on the banks. The TARP bill left to the regulators themselves many difficult decisions that still haven’t been made. Higher capital requirements for financial firms are not yet set, for example. We still don’t have open exchanges for trade in the derivatives that were at the heart of the crisis. The regulation of those highly leveraged investment vehicles based on other securities has been watered down by intense Wall Street lobbying, as has the famed Volcker Rule, which would restrict trading by financial firms for their own profit. Speculative bubbles are already growing in some financial assets, such as low-rated corporate bonds and overseas debt, which stronger regulatory measures would have restrained.”