2008 Black September, 15 – 2010 Gray September, 15
No consensus at all about the causes of the Great Recession and regarding a radical reform of the financialization regime to be done. Three analysts in a virtual round table around the globe, from Boston, to Dublin, to Singapore.
A conversation with Economics Editor Marc Coleman, from Dublin, Financial Consultant and author Peter Cohan, from Boston, and David Caploe, Chief Economy Editor from EconomyWatch in Singapore.
© Jorge Nascimento Rodrigues, September 15, 2010
Q: Can we say there’s a consensus about the causes of this Great Recession?
MARC COLEMAN: No, unfortunately. There is too much attention, relatively speaking, on the role of the banks and too little attention on the role of policy makers (central banks maintaining interest rates that were too low, regulators failing and governments building up an overreliance on tax revenues which – due to overly loose monetary policy – were excessively vulnerable to a downturn). Without the encumberance of big government, the leading economies of the world would have been in a position to respond to the crisis with the tax cuts needed to stimulate growth. So although we cannot say the public sector initiated the crisis, its approach to monetary governance made it possible and its approach to fiscal governance hindered the necessary response.
PETER COHAN: Not formally. For example, there’s still a commission [in the US] trying to figure out the causes. But if you ask me, I think there are six: 1) Securitization. Up until about 30 years ago, people took out mortgages from an S&L and paid their loan officer every month until they owned their house. In the 1980s, Wall Street invented securitization — the process of buying up, say, 1,000 mortgages from mortgage companies, creating a security based on those mortgages, paying for a AAA rating, and selling the securities to investors worldwide. Securitization is a problem for reasons I’ll describe below. 2) Too much borrowing. Over the last several years, Financial Institutions (FI) have made some $2 trillion in fees from securitization, according to DealBreaker. One reason for this is that they have been able to buy these securities — of which there are $13 trillion on the market between Mortgage-Backed Securities (MBSs) and Collateralized Debt Obligations (CDOs) — with a sliver of capital, roughly $340 billion. The typical FI had a ratio of assets to capital of 30:1. This meant that a mere 3% decline in the value of these securities would wipe out all the capital. 3) Skewed incentives. Bankers, ratings agencies, and consumers made decisions based on a bad system of incentives. Bankers got paid as a percentage of the size of the deals they brought in — if they brought in a big deal and it later lost money, the bankers got to keep their multi-million bonuses. Ratings agencies competed with each other to win million dollar fees from investment banks depending on whether they would give the junkiest securities their highest, AAA, rating. And consumers — struggling with declining incomes and rising costs — could not resist the lure of borrowing money they could not repay — in the case of the $1.3 trillion in subprime mortgages. 4) Lack of transparency. The MBSs and CDOs were priced by extrapolating historical patterns of mortgage repayments, delinquency rates, and home price changes into the future. When those historical patterns proved to be poor predictors of current behavior as three million borrowers foreclosed and housing prices declined 15%, there was no way to put an accurate value on the securities. In simple terms, pricing those securities would require examining each of the say, 1,000, mortgages in an MBS and identifying which mortgages are current and likely to remain so and which are not. Such basic information is simply not available to investors. 5) Letting managers write their own report cards. Examples abound of the dangers of letting CEOs direct how they report their results to investors. Lehman Brothers used an accounting trick, Repo 105, to deceive investors into thinking it had less debt than it really did. Madoff put together a subservient and largely untrained staff to “generate false and fraudulent documents,” and Madoff “told lies and supplied false records to regulators, and shuffled hundreds of millions of dollars from bank to bank to create the illusion of active trading.” In other words, he wrote his own report card every day. Letting managers write their own report cards was a key source of the financial collapse. 6) Global interconnection of markets. If global financial markets were not so closely intertwined, the collapse of one institution would not have such a terrible impact on the rest of the world. For example, earlier in the week a bank in Hong Kong experienced a run on the bank because of rumors that it was weakened by the collapse of Lehman Brothers. One reason the government bought AIG was that the counter-parties to its Credit Default Swaps (CDSs) were so inter-dependent that AIG’s failure could have placed severe strains on many big players.
DAVID CAPLOE: Absolutely NOT. My basic argument is that the US — and now I would have to include the Eurozone — is in the midst of a structural crisis with SIX different, albeit interrelated aspects: financial / economic / ideological / political / intellectual – academic / media … If you look at the latter two especially, I think it’s clear that MOST conventional economists have learned absolutely NOTHING about the real world, a failure which comes from a general lack of DESIRE to know anything about the real world. So I would say, in fact, that the current crisis has, if anything, EXACERBATED the fault lines among those — supposedly — in the know.
MARC COLEMAN:“I think the real trigger was the collapse of Bear Stearns in March 2008. Given the momentum of the crisis over ensuing months, I believe the collapse of Lehman was inevitable and desirable.”
Q: Lehman was the trigger of the financial panic and the accelerator of the Great Recession? At the time, could secretary Paulson and FED chairman Bernanke acted differently?
MARC: I don’t believe so. I think the real trigger was the collapse of Bear Stearns in March 2008. Given the momentum of the crisis over ensuing months, I believe the collapse of Lehman was inevitable and desirable. The institution’s behavior over the preceding summer – contemplating further real estate based investments in Korea! – clearly marked it out as badly led. The subsequent contraction in world output has been harsh. But it had to happen. And it is better that it happened sooner rather than later. Bernanke was also correct to raise interest rates steeply upon becoming Fed Chairperson. I believe his performance has been exemplary.
PETER: Lehman’s bankruptcy was the peak of terror in the financial markets. Short-term money markets froze up. Two measures of that were the TED spread, which counts the difference between three-month (London Interbank Offered Rate) Libor and the three-month Treasury rate, and the Libor-Overnight Indexed Swap (OIS) spread. As I posted, on September 30, 2008 the TED spread was near a record 3.38% (it was 1.1% in August 2008). And the Libor-OIS spread was a record 2.46% (it was 0.08% in September 2007). Paulson and Bernanke could have arranged a bailout as they did for Bear Stearns and the rest of Wall Street after they saw how bad their decision was to let Lehman collapse. It’s quite possible that Bush did not like the criticism he was getting for not letting the free market work so he decided not to bail out Lehman. Then Paulson and Bernanke – who may well have counseled a bailout – are forever forced to claim that they had no legal authority to do the bailout.
DAVID: I could write a book on this alone — and several people already have ;-), but they could and should have done something at the time of Bear Stearns in March, which they were content to shrug off as “just one of those things” instead of a CLEAR harbinger of structural problems. Both at the time, and in retrospect, it is shocking that they were so relaxed about the potential systemic implications of an investment bank failure, and were consciously un-willing to acknowledge in March how close the global system came to collapse, in precisely the way it ALMOST did, in fact, in September, with Lehman Brothers. There are about a million things they could EASILY have done differently — had they not been so much a part of the Cheney / Bush propaganda effort about the soundness of the financial system — but I would say the main one was not taking Bear Stearns more seriously at the time. In this context, Fuld’s testimony before the so-called Commission — which clearly will NEVER be mentioned in the same breath as the Pecora Commission [in the 1930s] — is intriguing, because he just about said Paulson, as former head of Goldman Sachs, was willing to let Lehman Bros go in order to simplify the playing field for his former company. Of course, Fuld didn’t have any answers for Repo 105, which made clear how structurally weak Lehman was for a long time, so I guess that part of it is, as for so much of this situation, not a victory for ANY of the participants involved.
PETER COHAN: “Banks are taking the nearly free money the government is providing them and investing it in risk-free assets like Treasury bills.”
Q: The brutal deleverage of the banking system particularly of the shadow financial system was an inevitability?
MARC: Yes. Unfortunately it should have started much earlier and this would have happened had interest rates been increased as they should have earlier in the policy cycle. Had this happened the deleveraging would have been less procyclical and far less damaging. Again this underscores the procyclical and dysfunctional nature of global policy cycles.
PETER: It would have been much more extreme if the government had not put $23.7 trillion in cash and guarantees at the industry’s disposal. Banks are taking the nearly free money the government is providing them and investing it in risk-free assets like Treasury bills. According to the Federal Deposit Insurance Corporation (FDIC), in Q1 2010, all FDIC-insured institutions had a total of $9.2 trillion in deposits, up 2.7% from the first quarter of 2009. During that period, banks’ holdings of securities — 61% of which are U.S. government securities — rose 14.7% to $2.5 trillion
DAVID: Here I would say two things: 1) We now clearly have a two-tiered banking system in the US, with the TBTFs knowing they have NO moral hazard, but the rest of the banking system being allowed to collapse like a house of cards — making them all the easier for the TBTFs to pick up for a song, as indicated by the on-going near bankruptcy itself of the FDIC, with which Betsy Bair is trying to do a great job, but, in typical fashion, is not getting a huge amount of help from the Obama regime. 2) I think we have a LOOONG way to go in terms of the deleveraging of the SYSTEM as a whole because the derivatives issue was more or less avoided by the so-called financial reform. While I’m not the St Warren of Buffett worshiper many people are, I do think his description of derivatives as “weapons of financial mass destruction” remains the most accurate — while raising questions about his esteem for / relationship with GS, which clearly has played the derivatives game brilliantly — and, like their correlatives in the physical world, there are going to be both immediate “blast effects” and long-term “fallout” when they finally DO start crashing, an eventuality I think is unavoidable. Given this, I think we are LOOONG way from the “final” deleveraging of the global financial system — don’t forget how involved many big Euro banks got with derivatives as well — so the brutality we’ve seen is only the beginning, I’m afraid, …
DAVID CAPLOE: “If these trends continue, it’s going to be a Chinese-centered world political economy MUCH sooner than even I thought would be the case.”
Q: Two years after, how you evaluate the evolution of this recession?
MARC: It is not just a recession, although there is a clearly cyclical element to it, but also to a large extent the unwinding of a level of excessive economic output that should never have occurred in the first place but which did due to two factors. The first was the illusory belief and denial on stock markets (up until 2007) over the unsustainable trajectory of growth in terms of the growing limitation of fossil fuels availability. The second was a monetary policy regime which, since the late 1990s, was far too loose. Just when the world’s real interest rate should have been rising to counter the limited resources of fossil fuels (and consequent need for a higher hurdle for investment decisions) it actually fell, and for political reasons.
PETER: Things in the money market world have recovered nicely since then. On September 3, 2010, the TED spread was 0.17% and the LIBOR-OIS spread was 0.11%. But fear has not left the building. Instead it has taken the form of investors buying gold on the assumption of massive inflation around the corner. As I wrote on August 17, strangely, investors are also piling into corporate bonds — a bet that will only pay off if deflation is the rule and will decline in value if the gold bugs are right. Meanwhile, the US economy is at a crossroads. The good news is that job losses are way down from the nearly 800,000 lost in January 2009 at the peak of the recession. Corporate profits are high and cash balances at $1.84 trillion are at near record levels. Moreover, the economy has been growing since the summer of 2009. Unfortunately, if left to its own devices the economy appears poised for stagnation. While consumers are borrowing as much as they can from credit cards; business demand for credit appears to be down as their balance sheets strengthen and banks cut lending to them. With 70% of economic growth coming from consumer spending, it is hard to see how that spending will rise enough to get the economy moving again until businesses start to hire enough workers to take up the slack from the 8.4 million who have lost their jobs since the recession began in December 2007.
DAVID: I think all the structural problems in the US / Icelandic / UK / Irish housing markets remain, and have barely been addressed, let alone solved. So I see no relief coming from an improvement in those housing sectors at all. At the financial level, of course, the US and EU are following almost step by step the deeply mistaken Japanese mistake of NOT forcing the banks — ALL the banks, including the TBTF ones like — to write down their bad loans and losses, for fear of hurting the stock price of those banks. Meanwhile, the non-TBTF banks, at least in the US, are collapsing, and the TBTF banks are just sitting on the zero-interest money the Fed has BEGGED them to take, and NOT lending it out, but either letting it sit there, as I said, or using it to profit by buying short-term bonds with higher interest rates. The result of this is the collapse of most of the “real economy”, which is not just damaging on a human scale, but is also disastrous from a long-term “advancing sector” point of view. I am definitely a Schumpeterian, insofar as I think sustainable long-term growth MUST come from innovation of some fundamental sort, whether technological or not — because it means that the financial sector is sucking up WAAAY too much of the society’s resources, and there is little left for the type of long-term / costly, especially at the start / slow to develop invention, and then innovation that will eventually solve the problems. The only society that is NOT losing out on long-term research into the sectors like clean energy — is China, which is very intelligently using its huge hoard of cash to get top-flight researchers from all over the globe to come there and DO that kind of vital R & D. If these trends continue, it’s going to be a Chinese-centered world political economy MUCH sooner than even I thought would be the case, a prospect that has both good and bad potentialities. India is growing well in most areas, but high levels of domestically-held debt, corruption and, even worse, increasing income inequality are potential traps for them, so they’ve got to be careful, as do the Chinese, who DO seem to have come in for the “soft landing” we have long predicted, in terms of lower but more sustainable growth rates, but have a brewing crisis in their non-public-bank “private trust company” sector and, related to that, the finances of many municipalities & provinces, which have borrowed heavily in the last two years, and may not be able to pay back. Fortunately, the Chinese have a lot of cash, so they can avoid some of the otherwise predictable problems of an active “shadow banking system,” but they do have to be careful that everything doesn’t suddenly colapse.
PETER COHAN: “As far as consolidation, the U.S. financed even greater concentration in the financial services industry which does not bode well for the future.”
Q: Two years after, how you evaluate the “cleaning” of the financial system and its rampant consolidation?
PETER: It’s not clean because there are still huge amounts of bad mortgage debt out there and those bad loans were the cause of the collapse. Until those loans are written off, they will hang over the financial system. As far as consolidation, the U.S. financed even greater concentration in the financial services industry which does not bode well for the future. I would give financial reform a B. Bringing light to the derivatives market is a good move. Of course, unless that’s done in a very rigorous way, Wall Street will find a way to cloak it in invisibility again. Unfortunately, the plan preserves Too Big to Fail (TBTF) institutions rather than breaking them into smaller pieces. And the package doesn’t fundamentally change compensation plans that drove Wall Street to make bad bets. It fails to end the securitization process that pretty much set the world on course to the financial meltdown. It doesn’t demand outside, independent third-party accounting scrutiny of Wall Street firms’ books. And it doesn’t create sufficiently strong limits on leverage. Many aspects of the plan are OK but not great. For example, the Volcker Rule might help with some of the concerns regarding leverage and TBTF. Consumer protection could help by making it easier for people to analyze the risks of a financial product. Say-on-pay might help limit problems with pay packages, but since it lacks teeth, it’ll probably be more of a way for frustrated investors to blow off steam.
DAVID: Practically non-existent, and for the reasons cited above: the US & EU following Japan in the political “leadership”‘s un-willingness to force the banks to declare the losses. Not only is this destroying most of the banking sector, but is creating terrible effects in the real economy it is SUPPOSED to service, but is instead starving, in both the short- and, as above, long-terms. The global financial system remains a complete mess & will be so until someone on the political side shows some guts –and it certainly ISN’T Obama — unfortunately for all of us.
David Caploe: “The MAIN thing is the failure of political leadership to force the banks to clean up their books.”
Q: In your opinion what was DONE and what was NOT DONE dealing with the causes of this crisis and the prevention for the future?
MARC: What was done: 1. Bursting the bubble by raising rates in 2005 and 2006 2. Swift and effective response by central banks in September 2008 to inject liquidity into the world banking system 3. Achieving resolve at G8 & G20 to avoid destructive devaluations or trade restrictions. What was not done: 1) Accepting that long term real interest rates must rise, and that central banks must chart a course for recalibrating interest rates 2. Fundamentally re-examining the basis on which global economic growth in the last ten years has been based, i.e. a technology that is going to hit the buffers in terms of fossil fuel resources. 2) Overly loose monetary policy 3) Achieving a clear resolve to radically re-engineering monetary and fiscal governance, making the former much more independent in the US and making the latter leaner and smaller in Europe and 4) Addressing the fundamental causes of global imbalances between east and west – the US economy’s overreliance on consumption and its low savings rate and China’s failure to ease internal imbalances by allowing the renminbi to achieving a more realistic level.
PETER: Not done: 1) End Securitization. securitization is too dangerous to continue. 2) Create transparency of securities’ cash flows. If you keep MBSs and CDOs, make each cash flow completely transparent. 3) Create an indendent government agency to do financial reporting. Partially Done: 1) Put Derivatives on exchanges. Some of this is happening but not enough. 2) Limit borrowing. Bank regulators are raising capital requirements but will they remain high when lending fever resumes?
DAVID: The MAIN thing is the failure of political leadership to force the banks to clean up their books . This is the root cause of the continuing problems, and as long as it remains the case, I see little improvement on the horizon any time soon, except, again, with the possibility of China, which at least TRIES to exercise a modicum of control over its financial sector, unlike the US / EU / Japan, where the most powerful bankers basically tell the political leaders what to do –with sadly predictable results.