While Federal Reserve policies have thus enabled the speculative
flames, the rapid growth of income inequality since 2000 provided
the kindling. A major, historic shift in incomes in the U.S.
clearly began under President Reagan and continued unabated
under Clinton. In recent years, under George W. Bush, that
inequality has accelerated. Starting with a share of only 9
percent of total national income, for example, by 2006 the
wealthiest 1 percent of households had again raised their total
share to the 22 percent they enjoyed in 1928.
As in the 1920s, the rapid rise of income inequality has been
driven largely by the restructuring of taxation, as more than
$4 trillion of tax cuts were passed in Bush's first term alone,
80 percent of which is projected to accrue to the wealthiest
households and large corporations. Further corporate tax cuts
of more than a $1 trillion were passed in his second term.
Meanwhile, the rest of the population has experienced income
stagnation and reduction as the decline of unions has continued,
the post-World War II pension and health-care benefit systems
have accelerated their collapse, the shift to part-time and
temp jobs from full-time and permanent employment has continued,
and millions of high paid jobs have disappeared due to neoliberal
trade and offshoring.
The
growth of incomes by the wealthy provided the huge pool of
income
and wealth with which to engage in speculative investment
activity. As short term speculative activity resulted in significantly
greater returns than real investment activity, more and more
investment was shifted into speculative activity or from real
investment in the U.S. home market to investment offshore in
the so-called emerging markets—in particular, in China
and Asia. In addition to the growing income imbalance and the
easy money policies of the Greenspan Fed, a third critical
element has been the elimination of any semblance of financial
regulation and oversight, which was given a coup-de-grace in
1999 with the repeal of the 1930s-era Glass- Steagall Act.
Glass-Steagall was supposed to prevent speculative and other
abuses.
As Glass-Steagall was being progressively undermined under
Reagan, Bush I, and Clinton, the so-called financial revolution
was taking off. With that revolution in finance came a corresponding
proliferation of new financial structures and relations.
When combined with new technologies of computer processing
power, soft technologies (e.g. quantitative modeling), networking,
and the Internet, the financial system has become the first
sector of economy that has been truly globalized. In turn,
with globalization has come the further inability to regulate
finance capital and, indeed, even to monitor its activity
accurately. Thus, deregulation plus technology and globalization
has meant further de facto deregulation.
In the past decade U.S. finance capital has been unleashed,
as it once was in the 1920s, to do whatever it wishes and to
push the speculative investing envelop as far and in whatever
direction it pleases. It is therefore no coincidence that since
the late 1990s the U.S. economy has veered headlong from one
financial crisis to another with virtually no breathing space
in between. We are now beginning to see the consequences of
this concurrence of total financial deregulation, unchecked
financial restructuring, accelerating income inequality, and
accommodative government monetary policy which is now yielding
even greater financial crisis, U.S. recession, and a threat
of global instability.
Derivatives and the Securitization Revolution
If Structured Investment Vehicles (SIVs) and hedge funds are
the vehicles of the new speculative and financial crisis, their
products amount to a vast array of acronyms like CDOs, ABCP,
CBO, CMBS, CLO, CDS, CDPO, and so on. To understand the current
financial crisis it is first necessary to understand the so-called
securitization revolution that the new institutional structures
and financial devices represent. And the securitization revolution
is based upon the granddaddy of over-leveraging called derivatives.
Derivatives involve the fictitious development of financial
asset products offered for sale to investors, private and corporate.
They have no intrinsic value. They derive their value from
other real assets or other financial products. They have virtually
no cost of production. Their costs of distribution and sale
are essentially non-existent. Their market price is largely
the outcome of speculative demand and, to a lesser extent,
how fast financial institutions can create the original financial
assets (e.g., mortgage loans) on which the derivatives are
then developed. Moreover, derivatives can be created on top
of derivatives in an unlimited pyramid of speculative financial
offerings. Like a house of cards, the offerings may be stacked
upon each other, until such time as one of the cards slips
out of place and brings the rest down with it.
In
today's global economy there are more than $500 trillion
in derivatives outstanding. That compares to
a global annual gross domestic product for all the
nations of the world of
less than $50 trillion, and to the U.S. annual
GDP of approximately $13 trillion. In other words,
there are now more than ten
times in derivative contracts than all the
real goods and services produced by all economies in
the world annually.
The world's wealthiest investor, Warren Buffet,
has called derivatives "time bombs both for the
parties that deal in them and the economic system." They
represent, according to Buffet, "financial weapons
of mass destruction, carrying dangers that, while now
latent, are potentially lethal."
Subprime
mortgages represent one relatively small land mine in the
panoply of "financial weapons of mass destruction" described
by Buffet. Subprimes are an essential element of just one example
of super speculative investment built on one form of derivative
called a CDO, a Collateralized Debt Obligation. Subprime mortgages
lay at the foundation of the CDO's derivative pyramid. The
mortgages themselves represent the value of a real asset—i.e.,
the housing product on which the mortgage is based. The mortgages
are then packaged into the fictitious financial asset package
called the CDO, which is then marked up by the financial institution
which sells the CDO to wealthy investors, hedge funds, other
funds, or corporations. The mortgages themselves are not packaged
in original form in the CDO, but instead are broken up, i.e.,
divided into slices that may be distributed across various
CDOs. Only parts of any given subprime mortgage may thus reside
in any given CDO offering: parts of other assets are typically
sausaged into the same CDO alongside the subprime slice as
well. These other assets may themselves be fictitious in character
(i.e., not based on any real physical asset) or may be based
on some real asset—for example commercial paper issued
by some real company to raise funds to carry on or expand its
real business; or a loan issued by a bank backed by real collateral
(e.g., CLO). Other forms of bundled assets may include fictitious
securities issued based on expectations of future ticket sales
for sports events, a rock star's future concert royalties,
or even more absurd examples of so-called bonds.
Not all CDOs have subprime mortgages bundled within their
packaged market offering. Some may have slices of higher grade
mortgages or what are called Alt-A mortgages. Or they may have
both. Many CDOs also include what are called Asset Backed Commercial
Paper (ABCP). Many companies with doubtful performance and
future prospects unable to raise capital more economically
from other sources have entered the ABCP market in recent years
to raise cash and stave off default. Their commercial paper
is then bundled with a CDO and offered to market. Thus shaky
subprime mortgages may be packaged with equally shaky corporate
commercial paper.
But the banks and other institutions that eventually sell
the CDOs were, at least until the recent crisis began to appear
in late summer 2007, not all that concerned about the quality
of such derivative-CDOs. Their relative unconcern flowed from
their ability to buy insurance for the CDO in the form of yet
another derivative called a Credit Debt Swap or CDS. Yet another
means by which banks attempted to insulate themselves from
the shaky quality of speculative investments has been their
creation of Secured Investment Vehicles. SIVs are in essence
electronic shadow banks set up by investment and commercial
banks like Morgan Stanley, Bear Stearns, Citigroup, Bank of
America (and virtually every known national or regional major
bank in the U.S.) to offload potentially risky CDOs from the
banks' balance sheets, where bank record keeping is subject
by law to review by the U.S. Securities and Exchange Commission.
With SIVs typically quickly turning over, or selling, to hedge
funds and other wealthy investors and corporations, a third
safety valve presumably existed.
Subprime
mortgages, bundled within CDOs, issued by SIVs, and held
off balance sheet by the big banks represent a highly
profitable enterprise for the banks. First, the banks make
money from fees issuing the CDO. Second, they are able to offload
assets from their bank balance sheets thereby both reducing
capital carrying costs as well as making available more bank
reserves for loaning out at interest. Third, their SIVs make
money from marking up and selling the CDOs as well as from
insuring them at an additional charge with credit debt swaps.
It is therefore not surprising that mainline investment and
commercial banks experienced compound profit growth of more
than 20 percent per year collectively for each year from 2004
through 2006—i.e., roughly the period of the most explosive
growth of subprime mortgages bundled with CDOs.
The above scenario is sometimes referred to as an example
of the so-called securitization revolution in finance. Securitization
is the process of assembling assets on which new securities
are issued and then sold to investors who are (in theory) paid
from the income flow created by the assets. The more risky
the assets contained within the CDOs, the lower the credit
ratings but the higher the potential return. The justification
for the highly speculative and high risk character of the offerings
is that by slicing the CDOs into tranches, based on the degree
of risk in the assets in the given CDO, the risk would be dispersed
among a large population of investors. In reality, however,
the result was the dispersion of contagion not dispersion of
risk from the risky investments.
In 1998 the total international volume of securitized offerings
amounted to less than $100 billion. By 2003 it had risen only
to $200 billion, more than $500 billion in 2005, and exceeded
$1 trillion in 2006.
Bursting the Subprime-CDO Bubble
Business press pundits repeatedly query about why so many
subprime mortgages were issued to home buyers who clearly could
not qualify for mortgage loans on any reasonable criteria or
would be unable to make payments once interest rates inevitably
rose to normal levels. What the pundits don't understand is
that, given the increasing trend over time toward a greater
relative mix of speculative to total investment arrangements
in the capitalist economy, it is quantity, not quality, of
investment opportunity that takes precedence. Since 2003 the
practice of banks had been to encourage mortgage loan companies
to produce more loans regardless of the quality. Mortgage loan
companies in turn encouraged real estate brokers to deliver
more loans without consideration of quality. And real estate
brokers did whatever was necessary to close the deal with home
buyers.
No
matter if the total volume of mortgage loans by 2005-06 were
more subprime than not. The quantity of loans, not their
quality now mattered most. And quantity was only part
of the new profit model. Finance profitability was becoming
less and
less dependent on the issuance of loans per se, but increasingly
on derivatives and their supporting institutions. By
2005 more than $635 billion of subprime loans were issued.
In 2006 the
amount was another $600 billion and the cumulative total
by 2007 was more than $1 trillion.
By mid-2006 it had become clear that the subprime mortgage
market was in freefall. Home buyers with subprime mortgages
were now defaulting on payments at record rates and foreclosures
were beginning to rise. By late summer 2007 it was estimated
that there would be two to three million potential foreclosures
over the next few years. The value of subprime mortgages quickly
plummeted and with them many of those CDOs in which they were
imbedded. The subprime mortgage market virtually shut down.
It was not possible to accurately estimate the magnitude of
the losses from the subprimes since they were sliced and distributed
within different CDO offerings. And if the losses for the subprime
elements in CDOs could not be accurately valued, the CDOs could
not be accurately valued. Nor could the asset backed commercial
paper often bundled with the CDOs. And so on.
The
typical response of investors in such situations is to ask
how much
their investments were under water. When they
cannot be accurately told, their next response is often "sell
my investment and give me the cash remaining." But with
no markets for subprimes by late 2007 their remaining value
was impossible to estimate. No sales meant no price meant no
possible valuation estimate and in turn no cash out. Investors,
like the banks and their SIVs, were locked together in many
cases in a death spiral, unable to bail out and destined to
ride the doomed vehicle into the ground.
By
late 2007 various estimates place the value of expected losses
from the subprime market collapse from Goldman Sachs's
low of $211 billion and the OECD's estimate of $300 billion
to estimated losses— based on the ABX Index, the official
measure of subprime mortgage securities' value—at approximately
$400 billion. In stark contrast to these estimates the losses
admitted by the major banks as of year end 2007 amounted to
only a paltry $60 billion. More, indeed, much more in terms
of bank losses and bank write-downs are yet to come in 2008.
But subprime losses and write-downs on bank balance sheets
were only part of the bigger picture.
Spreading the Subprime-CDO Pain
The estimated total volume of all CDOs worldwide (not all
of which have subprime mortgages bundled with them) is, according
to the OECD, approximately $3 trillion in total value. Approximately
half that total is held by hedge funds, a fourth by banks,
and the remaining exposure by asset managers and insurers.
As
noted, many of CDOs also bundled commercial paper—sometimes
with subprimes and often without. But asset backed commercial
paper appears equally at risk as subprime mortgages and the
consequences of its collapsed are yet to be fully realized.
Like the subprime mortgage market, the ABCP market experienced
a sharp run up between 2003-07 in conjunction with the acceleration
of CDOs and other derivatives. Many companies in trouble financially
and unable to raise capital to continue turned to the ABCP
to issue commercial paper on their remaining real assets to
raise cash for operations or investment purposes. Much of their
risky commercial paper was bundled with CDOs. But like the
subprime market, the ABCP market has virtually shut down as
well since the advent of the financial crisis in late summer
2007. The ABCP market in the U.S. peaked at $1.2 trillion in
August 2007 and had fallen to $700 billion by year end. By
June 2008 an additional $300 billion is projected to come due.
That's another $300 billion banks may have to provide for on
their balance sheets, in addition to the $400 billion in additional
subprimes coming due. In Europe the commercial paper market
is also declining rapidly, having fallen 44 percent by October
2007 to $172 billion from a May peak of $308 billion.
With the ABCP market largely shutting down, many corporations
straining to stay in business in recent years by selling their
commercial paper will likely begin to default. That means a
sharp rise in business bankruptcies. For example, non-farm
business debt rose by 30 percent in 2004 and continued thereafter
at above average levels. Many CDOs helped hold off defaults
and failures between 2003-07 by imbedding their commercial
paper. But with the shutdown of the ABCP markets, pressures
for corporate defaults will be released with the consequent
result of sharp increases in corporate bankruptcies in 2008-09.
The corporate ratings agency, Moody's, predicts an increase
in default fates between four and ten times in the period immediately
ahead, the highest since the peak fallout from the dot-com
bust in 2002.
How
the current financial crisis has been spreading at an historically
rapid rate from the subprime to other capital
markets, and how the crisis is being transmitted in turn from
those latter markets to the general economy in the U.S.—thereby
guaranteeing a recession in the U.S. in 2008 and threatening
to expand globally in 2009—will be addressed in Part
II of this analysis.
Jack
Rasmus is
the author of the The War At Home: The Corporate Offensive
From Ronald Reagan to George W. Bush 2006 and The
Trillion Dollar Income Shift: Essays on Income Inequality
in America (2008).Petroleumworld
does not necessarily share these views.
