Leadup to the Crisis: The Undoing of the Old System

Roosevelt's highly successful financial reforms first began to come under pressure in the 1970's, as inflation began to accelerate. Slowly and inconspicuously at first, several things began to chip away at the old financial order.

In 1968, when Fannie Mae was privatized, it was split. FNMA (Federal National Mortgage Association) was privatized and bought up private mortgages. The Government National Mortgage Association (Ginnie Mae) remained a governmental entity and bought up mortgages issued by governmental entities such as the FHA or the VA. It was Ginnie Mae that first got the idea of pooling mortgage payments and selling a portion of the income to investors in 1970. Fannie and Freddie soon followed. In 1977, a banker named Lew Ranieri introduced the privately securitized mortgage.

Another financial innovation of the 1970's was the first breach of the wall between commercial and investment banks, from the investment side -- the money market mutual fund. Investment firms began offering money market mutual funds as an alternative to bank accounts. These funds kept their shares constantly at $1 so that investors could withdraw whatever they put in at any time, just like a bank account. They made short-term, low-risk loans, known as commercial paper, to blue chip companies and, although not insured, were considered just as safe as a bank account. But they had better returns than a bank account, even a certificate of deposit. With inflation running high and rapidly eroding savings in bank accounts, banks found themselves more and more strapped for funds, including funds to finance home mortgages. (Money mutual funds did not finance home mortgages).

In the 1980's, these two innovations began to merge. Savings and Loans, the primary fianciers for home mortgages, were trapped between fleeing depositors, fixed rate loans, and rising interest rates. One response was the invention of the adjustable rate mortgage (ARM), a mortgage with interest that fluctuates with general interest rates. These began to be used in the early 1980's to cope with extremely high interest rates. Another was that S&L's began selling mortgages to Fannie, Freddie and the private securitizers and buying mortgage backed securities. Inexperienced in the world of high finance, S&L's did poorly. The ultimate failure of so many thrifts left a gaping hole in the finance of home mortgages.

As interest rates dropped after 1982, mortgage-backed securities began running into another problem. Defaults were still rare, but home owners were refinancing at lower rates or paying of their loans early. The made mortgage backed securities a less reliable source of income than anticipated. Securitizers responded by carving up securities into tranches (slices) setting priority in payment. Senior tranches got paid first, but at the lowest rate. As priority dropped, risk and return rose. By the mid-80's, other finance companies began to recognize that the principles of securitization did not have to be limited to home mortgages. They began expanding the practice to equipment leases, auto loans, credit cards, student loans, or anything else that required frequent payments.

A new finacial institution called a "special purpose vehicle," generally backed by an investment bank, arose to buy and securitize loans. High finance increasingly began establishing loan originators, not backed by any deposits, to make loans to be sold and securitized. It increasingly encroached on areas traditionally occupied by commercial banking, filling in the gap left by the failure of Savings and Loans, and funding car loans, credit cards, and other consumer loans. And how was all this financed, without deposits? Apparently by commercial paper, that is, by short-term loans from money market mutual funds, using the loans to be securitized as collateral.

Naturally with all these encroachments by high finance on commercial banking, commercial banks wanted to return the favor. Throughout the 1980's and '90's, the Federal Reserve increasingly allowed commercial banks to trade in stocks and issue commercial paper. Slowly, the wall became so eroded that repeal was little more than a formality. After repeal, "bank holding companies" were formed that could hold commercial banks, investment banks and insurance companies as separate subsidiaries. Commercial banks also began moving into the securitization business, establishing Structured Investment Vehicles (SIV's) to securitize their loans. SIV's were, in effect, a clever accounting gimmick that allowed banks to evade regulations requiring them to hold capital against their loans by "selling" these loans to SIV's that were actually owned by the bank. And what did banks do with the income from selling their loans? They invested it, often in securitized loans.

The risks of securitization are obvious, at least in hindsight. A company making loans to sell has strong incentives to think purely in terms of quantity, not quality. The buyer should have an incentive to impose strict quality control except that it, too, just intends to pass the loans along to someone else. And buyers of the securitized products assumed that even if there were some bad loans in there, tranching (prioritizing) payments should take the risk away. In short, quality control was Somebody Else's Problem. Worse, regulators also believed that securitized loans were safer than direct loans. Applying the eminently reasonable rule that banks should hold more capital the riskier a loan, they rated mortgages as riskier than mortgage backed security and therefore required more capital for direct loans than securitized loans. Banks understandably responded by securitizing more.

The dangers of such a system should have become apparent during the mid 1990's with a sort of a dress rehearsal crisis. Securitization of credit card loans made credit cards easier and easier to get. Once the privilege of people with an established income and credit rating, by the mid-'90's credit cards were being handed out like candy. Predictably enough, many new users ended up in over their heads and went bankrupt. Zandi regards unsupportable credit card debt as one of the causes of the 1998 LTCM financial crisis. The asset-backed securities market briefly froze during that crisis, but the larger economy was not harmed and, for the most part, did not even notice that it had happened.

Nonetheless, despite the prosperity of the 1990's (at least within the US), the evidence was growing that the finance system was running of control. These warning signs were ignored. In fact, at the end of the '90's, two pieces of legislation were passed that further deregulated an already dangerous system. In 1999, the Gramm-Leach-Bliley Act removed the Glass-Steagel wall between commercial banking and investment banking, a wall that (see above) had largely fallen anyhow. Some people blame the removal of the wall for the crisis, while many conservatives argue exactly the opposite, that it was removal of the wall that allowed commercial banks to rescue investment banks (as when Bank of America bought out Merrill Lynch). So far as I (as an Enlightened Layperson) can tell, the conservatives are right on this one.

More important was the Commodities and Futures Modernization Act of 2000, which effectively prevented regulation of financial derivatives. As for securitization, no one even seems to have regarded it as an issue.

Leadup to the Current Crisis: The Old Financial Order

So, at last we get to the question of how we got to where we are now. This is only an Enlightened Layperson's opinion and analysis, with no claim to special expertise. My main sources are Zandi, Krugman, and Wikipedia.

Any attempt to understand how we got here has to start in the 1930's because that is where the modern system of financial regulation began, and discuss how the finance system outgrew it. Roosevelt's financial reforms, it must be emphasized, were wildly sucessful; they tamed the boom-and-bust cycle that had troubled the economy until then and largely kept it at bay for another 50 years. Best known was the FDIC, which ensured bank deposits and put an end to bank runs.

In exchange for protection, banks were subject to tighter regulation, including requirements to hold a certain amount of their deposits in cash (actually, this existed even before) and restriction from certain risky activities. Presumably, this includes (or should include) close regulatory oversight in general, but particularly it included the Glass-Steagal act, which (it has been endlessly repeated) separated commercial banks from investment banks and insurance companies. Or, translated into terms a person ignorant of finance, like me, can understand, the Glass-Steagal act forbade any financial institution that accepts deposits from investing and trading in stocks, financing mergers, or underwriting (financing) issuance of stock. Or, more simply put, anyone taking deposits had to stay the hell out of the stock market, which was considered too dangerous. It was also driven by a fear that combining the functions would lead to conflict of interest. Another financial reform was the founding of the Securities Exchange Commission (SEC) to oversee the formation and exchange of securities and prevent secrecy and fraud.

An underappreciated financial reform was the development of the fixed rate mortgage by the Federal Housing Authority (FHA). Before that, most home mortgages were short-term, for a period of three to five years, required a 40-50% down payment, and featured balloon payments, i.e., the borrower first paid off the interest and then had to pay the principle in a lump sum. The FHA developed a mortgage requiring only a 20% down payment, with fixed and unchanging payments over a period of 30 years. This proved wildly popular, both with buyers, many of whom were able to afford a home for the first time, and with banks, which found the fixed rate mortgage to be one of the safest and most reliable of all loans.

And then, of course, there is the Federal National Mortgage Association (Fannie Mae). Fannie was founded in 1938, not to issue mortgage loans directly, but to buy them from banks in order to encourage banks to keep issuing more. Originally, Fannie was allowed to buy only mortgages that were insured by the FHA. Fannie Mae was (semi) privatized in the 1960's and the Federal Home Loan Mortgage Corporation (Freddie Mac) created to compete with it.

The background of the current, crisis, then, is the story of house the finance system gradually outgrew these reforms and morphed into something new, outside the established regulatory system.

In Which I Proclaim the Obama Presidency a Failure

It's time to face facts. The Obama Presidency is a failure. Banking reforms (assuming they) pass, may be worth something, but even healthcare reform will be worthless if Republicans repeal it after they take control in 2012. And barring extraordinarily self-destructive behavior on Republicans' part (always a possibility), they will win in 2012.

The reason is simple. Presidents are ultimately judged on one criterion and one only; the performance of the economy on their watch. This is not fair. Performance of the economy is often beyond the President's control. Prompt action by the current administration (and other countries around the world) may very well have prevented a full-scale depression. And recovery from a financial crisis as severe as we suffered in 2008 may be inevitably slow.

But none of that matters. The point is, the economy is sinking down, and nothing seems able to stop it. Prognosticators explain that when an economy begins to recover from a recession (or begins to fall into one) is spits out all sorts of contradictory data. But the data is going fast from contradictory to uniformly bad. All the people whose job it is to be reassuring are reassuring us that the economy is not experiencing a double dip. But I am inclined to think we are experiencing something else -- an L-shaped recession, Japan style. Consumer spending is lagging because consumers are worried about high unemployment. Businesses are not hiring because consumer spending is so low. It's a vicious cycle with (seemingly) no way out. Although I believe we have averted the dangers of a catastrophic, depression-like drop, prolonged stagnation seems inescapable.

If the economy is failing, the President's popularity falls. With the fall of his popularity, he loses political capital and the ability to pass his agenda -- anything in his agenda. Furthermore, when a President lacks domestic credibility, his international political capital falls. Foreign leaders lose respect for a leader who lacks respect at home. With the failing economy, the prospects for any international diplomatic success suffer.

There is an old joke that an outgoing President gives the incoming one three boxes, one to be opened each year if the economy is going badly. The first box says, "Blame the previous administration." The second one says, "Blame the Federal Reserve." The third one says, "Prepare three more boxes." Granted, we are only in the second year. But barring some miracle, I see no reason to expect that the next two years will be any better.

Krugman, Keynes and Hoover

Reading Krugman's book, one of the most striking things to me was how much it brought up all the old issues I had learned in basic economics. In international trade, for instance, the issue of fixed versus floating exchange rates. Fixed exchange rates have the advantage of making international trade easier and more predictable. Floating rates cause wild fluctuations with great inconvenience to anyone engaged in international trade. But fixed exchange rates undermine a country's ability to set its own economic policy and require it to prioritize maintaining its exchange rate over the health of its domestic economy. A third alternative is trade and capital restrictions, but these introduce distortions and onerous regulations. So, Krugman says, if we can't have fixed exchange rates, freedom to set domestic economic policy, and international free trade, which of the three are we willing to sacrifice. In college I read books from the 1950's to the 1970's making exactly the same point.

And then there is the matter of the IMF. The Keynesian/monetarist approach to a economic downturn is to lower interest rates, run a deficit, and let the currency fall. The IMF, Krugman complains, demands exactly the opposite, that a country facing a crisis raise interest rates, balance the budget, and maintain its exchange rate whatever the domestic cost. And my response to all that is, so what's new? That is what the IMF has always done, so far back as I can remember. The IMF has always regarded domestic consumption as a waste of resources that should be reserved for important people like foreign creditors and investors. In theory, if an economy were to cut domestic consumption to zero, export its entire GDP, and hand its entire export income over to foreign creditors, the IMF would probably regard its economic management as ideal. Even the IMF realizes that this is not altogether realistic, but it does expect a country to cut domestic consumption as much as possible, export as much of what it produces as possible, and divert as much as possible of its export revenue to foreign creditors. And to be willing to sacrifice its domestic population (especially those worthless poor people who don't produce any foreign exchange and can't cause capital flight) to the wishes of international investors. Why does Krugman treat any of this in the 1990's at anything new?

And yet, although I am inclined to share Krugmans's outrage, a disturbing thought lurks at the back of my mind. What if the IMF, after all, is right? There is some evidence in their favor. As Krugman acknowledges, Mexico and Argentina followed IMF orthodoxy and experienced a short, sharp drop, followed by a rapid recovery. Japan, by contrast, followed Keynesian/monetarist orthodoxy and experienced a "lost decade." So what if retrenching and getting it over with fast is, after all, the better policy?

There are counter-arguments, of course. A small, open economy like (say) Thailand depends on foreign investment and exports for its success. A large economy like (say) Japan or the US relies mostly on domestic investment and produces mostly for domestic consumption. Sacrificing domestic consumption to please foreign investors may therefore make more sense in a country that produces most for export than one the produces mostly for itself. Krugman describes in detail how Britain and Australia were able to devalue their currency without suffering any harm, while devaluation by Thailand or Mexico set off a panic.

That debate is becoming more and more current now. Although both the US and Europe initially responded to the economic crisis with Keynesian stimulus, Europe is now embracing austerity, while the US will almost certainly run deficits into the indefinite future. So on one hand, we should have a simple test. If Europe's economy crashes and bounces back, while the US sinks into a Japanese-style lost decade, we will know that the IMF/Hoover approach is right and it is time to start balancing the budget, no matter how painful. By contrast, if the US does better than Europe, we can chalk it up as a victor to Keynes.

Or can we? The Republicans are blocking any further stimulus and calling for spending cuts, but it seems unlikely that they will make any but the tiniest token cuts in spending any time soon. Assuming they take over Congress in 2010, they may even show themselves to be good Keynesians by enacting another tax cut. All this means we can expect huge federal deficits as far as the eye can see. But states do not have the option of running deficits. Barring major federal assistance (which Republicans and Blue Dogs will almost certainly block), states will be making deep cuts next year. The US, too, will be embracing austerity, just not at the federal level.

It's a dilemma. On the one hand, I would really like Keynes to be right, not just as a matter of intellectual and ideological satisfaction, but because I really would rather not have to put an already traumatized economy through any more pain. On the other hand, since austerity is heading our way whether we like it or not, I would really like for it to work.