The relentless revolution: a history of capitalism (64 page)

Wanting to keep the good times going, financial institutions began issuing mortgages to people with risky credit records or insufficient income to make their payments. Banks and savings and loan companies lured customers with low down or no down payment offers. A whole new market for leveraging was tapped. The Federal Reserve Bank’s downward pressure on interest rates also made home mortgages more appealing. Both Democratic and Republican administrations promoted homeownership as sound public policy. These additional buyers drove house prices up even higher. As more and more people with subprime credit records took out subprime mortgages, the risk grew exponentially. During the heyday of the housing market, many homeowners used the rising value of their property as a bank. Sharing in the financial sector’s optimism, they took out home equity loans on the enhanced value of their houses. With these, they could pay for a child’s college tuition, start a business, buy an SUV, or landscape the new home.

The unintended consequences of perfectly rational, individual decisions can help explain how the world’s financial centers skidded into a trough in 2008. When Asian families decided to build nest eggs after their 1997 financial crisis, they didn’t intend to stimulate American consumption with the cheap credit their savings created. When Republican and Democratic administrations endorsed homeownership as sound social policy, they didn’t intend to set off a race among bankers to issue subprime mortgages so they could securitize them for eager investors. When CEOs at investment banks and hedge funds paid their star traders handsome year-end bonuses, they intended to reward and encourage superior performance. Totally unintended was the creation of a testosterone-driven competition so intense it kept at bay second thoughts, looking at the larger picture, or listening to naysayers. The notion of unintended consequences doesn’t lend itself to the mathematical models favored by economists, but the freer the market system, the more widespread are individual initiatives that pull along in their train the unintended consequences of their actions. And when they converge, as they did in 2008, they can create unexpected consequences.

Risk taking is integral to capitalism, but it plays differently in the financial sector than it does in technology. Banks, like utilities, contribute most when they are dependable and efficient. Instead bankers became as ingratiating as used car salesmen. The cold shoulder they used to give to incautious borrowers turned into a warm welcome for all comers. Of course, if they never lent to risk-taking entrepreneurs, capitalism would suffer. Balancing stability with innovation eluded banks in the first decade of the twenty-first century. Investment banks even started buying the asset-based securities that they were selling to others, with disastrous results. Some say strategies of risk taking changed for bankers when their institutions went public, allowing them to bet on other people’s money instead of their own. Year-end bonuses on performance furnished a further incentive to expand operations and became a major bone of contention in the public realm after the financial institutions came begging for government help to stay afloat. Those who didn’t work on Wall Street considered bonuses running in the millions obscene. Nor were they impressed with the financial wizards’ logic that they should profit handsomely from what they were able to sell for their company—or “eat what they killed,” in insider lingo. They remained mute about what should be done when the kill roared back into life and brought their firms near bankruptcy.

We might dub this the world of virtual investment whose material reality was a stream of electronic messages issuing from some sixty thousand terminals around the world. Technological advances made possible the increasing volume of financial transactions. There was also some double duping, when mortgage salesmen encouraged people to assume mortgages they couldn’t afford and financial firms talked pension fund managers and municipalities into buying their asset-backed securities without sharing information about the risk.

During the last ten years, financial services grew from 11 percent of our gross national product to 20 percent. Some otherwise sober men and women were able to leverage at a ratio of 1:30 for money invested, spreading risk without tracking it. The really daring investor would nest several forms of leveraging into a single investment vehicle. More damaging to the nation in the long run, physicists, mathematicians, and computer experts were drawn away from their original work to join the high-earning financial wizards. At least 40 percent of Ivy League graduates went into finance in the early years of the twenty-first century. With million-dollar annual incomes commonplace, Wall Street formed a tight little winners’ circle where all the incentives were thrown on the take-more-risk side and positive disincentives discouraged caution or even candor.

Those working for the Securities and Exchange Commission feared offending the leaders of the major firms they hoped would hire them later. Credit-rating agencies like Standard & Poor’s and Moody’s were similarly disinclined to lower the ratings of bank customers that took on too much risk. In retrospect, people who were making decisions affecting the economies of dozens of countries were sealed into a cozy club of high-fiving camaraderie where there was no tomorrow.
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The wild card in this scenario was psychological and endemic: the feeling of confidence that encouraged people—in this case institutional investors and hedge fund managers—to purchase the new asset-backed securities. In retrospect, their misperception of the risk seems bizarre. Pretty mindless during an upswing, optimism is contagious. Working the other way around, rumors and foolish public statements can cause a precipitous fall in confidence just about as easily as reports of disappointing earnings or turbulence in foreign markets. Whether upbeat or downbeat, these responses from traders and investors introduced a degree of risk that impinged on the whole global economy because of the easy access the world’s investors had to these “good deals.” One could add that the United States benefits from this selective blindness because of the world’s indifference to the country’s annual seven-hundred-billion-dollar trade deficit.

A Nobel Prize–winning chemist named Frederick Soddy had some ingenious observations to make about debt when he turned from chemistry to economics during the great bubble of the 1920s. People buy debt (i.e., lend money) because they want to realize more wealth in the future. The rub is that no one knows what will happen in the future. If I lend a farmer $100 in the expectation of getting back $110 when the harvest comes in, I am banking on good weather and no visit from locusts. If there are in fact more claims upon future wealth than can be redeemed, then some of those with claims on future earnings are going to lose out. The market in futures not only is volatile but must always cope with this uncertainty.
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And in the case of the securitized mortgages, the number of claimants grew exponentially.

The American Dialect Society voted “subprime” the word of 2007.
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During the euphoria over rising housing prices, the lexicon of global finance migrated out of Wall Street into daily newspapers, where you could find references to option adjustable interest rate mortgages, collateralized debt obligations, interest rate swaps, swaptions, and special purpose vehicles! Hedge funds grew fivefold in the first decade of the twenty-first century, attracting managers of pension money, university endowments, and municipal investments, all now suffering with the retraction. Those people who ran hedge funds, established derivatives, and created option adjustable rate mortgages had built a house of cards with mortgage paper. Their initial success with rising house prices bred the “irrational exuberance” noted in an earlier bubble by the former Federal Reserve Bank president Alan Greenspan, himself a somewhat repentant opponent of regulation. Ignoring their conflicts of interest, credit rating agencies gave artificially high ratings to mortgage securities. Thus even those created to assess risk failed the system.

When house prices started to fall in late 2007, the securities they backed fell too. Like a boa constrictor, deleveraging—i.e., paying for securities bought on the margin—squeezed all along the financial line from bankers to insurers, hedge fund investors, and their institutional and private customers. Liquidity dried up; money became tight. Even legitimate business borrowers couldn’t get loans. So bad were things that Goldman Sachs and Morgan Stanley sailed into the safe harbor of greater regulation and scrutiny by becoming commercial banks and leaving the shark-infested waters of investment banking. Of course they also gained access to government aid and lending sources.

Financiers who wanted a free hand are not alone responsible for the 2008 crisis. It also took public officials, from city councillors to members of Congress, mayors to presidents, to dismantle the regulatory system that had monitored financial firms. The U.S. government went from being a more or less neutral umpire of economic relations to an advocate of business interests. Changes in political campaigning promoted the collusion between economic and political leaders. With the emergence of television as the principal medium for election campaigns forty years ago, money—never negligible—took on a new importance. The expense of TV spots threw officeholders and their challengers into the arms of business interests. As slick Willie Sutton once explained, he robbed banks because that’s where the money was. And that’s why candidates of both parties went to the wealthy to seek contributions.

A toxic combination of greed and need—greed on the part of the high-flying engineers of finance and need from politicians to pay for their ever more expensive campaigns—made officeholders beholden to business executives who wanted government off their backs. The free market ideology dominating public discussions gave cover to those in government. Even so, after the passage of the Gramm-Leach-Bliley Act, some legislators still tried to limit the trade in derivatives. They accurately predicted the cascading effect of any downturn. Representatives proposed measures to combat predatory lending, like those the Ohio cities had passed, but the leave-enterprise-alone advocates blocked their efforts. When regulation has been discredited as it was in the 1980s, even those regulatory agencies left intact become faint of heart and inattentive.

Complacent administrative officials and legislators defended the relaxing of regulation on the ground that American bankers would have taken their money out of the country and built their securitized mortgage empires elsewhere. Competition, the elixir of capitalism, worked inexorably to promote risk taking. When more cautious bankers saw their rivals riding high, they wanted to do the same thing. Raining on a parade has never won popularity. Shorn of oversight, the banks’ trade in credit default swaps ballooned from $900 billion in 2001 to $62 trillion in 2007.
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Hedge funds grew in one decade from $375,000 to $2 trillion in 2008, plunging losses into the trillion-dollar column. The figures are hard to grasp, but not the dimension of the problem. Nor should consumers be let off the hook, if blame is to be assigned, for many Americans demanded easy credit and cheap mortgages.

As befits a litigious people, homeowners began sueing their banks, mortgage lenders, Wall Street banks, little banks, big banks, and those same banks’ loan specialists. Even municipal governments got sucked into buying high-yielding shares of securities backed by mortgages, subprime and prime. Some as far away as Australia took investment banks to court for hiding the risks of the securities that they were selling. Such a respectable firm as General Electric, expanding into financial services, got hit with a suit from an insurance company for following fraudulent standards. Recent Supreme Court rulings have favored Wall Street, but that won’t stop the march of people into lawyers’ offices to seek retribution, if not full compensation.
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Housing prices did not need to decline very much before many homeowners owed more on their mortgages than their houses were worth. By 2009 more than one-quarter of all homes with mortgages—about thirteen million properties—were “underwater” foreclosures averaged five thousand a day! Investors lost upward of four hundred billion dollars. Mindful that the Japanese government had not acted swiftly enough to stem the losses in its 1990 depression, the U.S. government struggled to get a handle on the recovery process and to speed the return of confidence. The Federal Reserve Bank and the Treasury Department at first offered seven hundred billion dollars for “troubled assets.” “Bailout,” with its strong suggestion of a sinking boat, lost favor as a term. Soon people were talking about stimulus, followed by promises of recovery. The new administration of President Barack Obama put in place the largest public works program since the Great Depression. All official efforts aimed at convincing ordinary market participants that the worst was over, or, as Franklin Roosevelt’s 1932 campaign song had it, “Happy Days Are Here Again.”

Meanwhile the long-brewing decline of the American automobile industry led to calls for infusions of taxpayers’ funds. General Motors and Chrysler had run out of money, and Ford was barely limping along. The carmakers’ intractable problems challenge one of economists’ strongest convictions: that we can rely on the rationality of market participants. Enlightened self-interest should have whispered into the ears of Detroit leaders back in the 1970s that something was amiss when Hondas, Nissans, and Toyotas made their American debuts. Of course most people in Michigan “buy American,” so they didn’t see those natty new cars on the freeways of California and New York. Being large enough to control a whole region, the automakers’ CEOs could indulge themselves in pipe dreams, responding to short-run tastes for gas-guzzling SUVs while exporting their innovative designs to showrooms abroad. In 1989 Michael Moore’s popular film
Roger and Me,
mocked the studied myopia of GM’s CEO Roger Smith after the layoff of fifty thousand auto workers in Moore’s hometown of Flint. And there must have been regular reports on their dwindling market share. Such willful ignorance can’t last forever. When all the sick chickens finally came home to roost in 2009, when both General Motors and Chrysler went into bankruptcy.