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Monthly Archives: November 2011
By OlafurArnarson, Michael Hudson and Gunnar Tomasson*
Theproblem of bank loans gone bad, especially those with government-guaranteessuch as U.S. student loans and Fannie Mae mortgages, has thrown into questionjust what should be a “fair value” for these debt obligations. Should “fairvalue” reflect what debtors can pay – that is, pay without going bankrupt? Oris it fair for banks and even vulture funds to get whatever they can squeezeout of debtors?
Theanswer will depend largely on the degree to which governments back the claimsof creditors. The legal definition of how much can be squeezed out is becominga political issue pulling national governments, the IMF, ECB and otherfinancial agencies into a conflict pitting banks, vulture funds anddebt-strapped populations against each other.
Thispolarizing issue has now broken out especially in Iceland. The country is nowsuffering a second round of economic and financial distress stemming from thecollapse of its banking system in October 2008. That crisis caused a huge lossof savings not only for domestic citizens but also for international creditorssuch as Deutsche Bank, Barclay’s and their institutional clients.
Stuckwith bad loans and bonds from bankrupt issuers, foreign investors in the old bankssold their bonds and other claims for pennies on the dollar to buyers whose websites described themselves as “specializing in distressed assets,” commonlyknown as vulture funds. (Persistent rumors suggest that some of these areworking with the previous owners of thefailed Icelandic banks, operating out of offshore banking and tax havens and currentlyunder investigation by a Special Prosecutor.)
Atthe time when those bonds were sold in the market, Iceland’s government owned100% of all three new banks. Representing the national interest, it intendedfor the banks to pass on to the debtorsthe write-downs at which they discounted the assets they bought from the oldbanks. This was supposed to be what “fair value” meant: the low marketvaluation at that time. It was supposed to take account of the reasonableability of households and businesses to pay back loans that had becomeunpayable as the currency had collapsed and import prices had risenaccordingly.
TheIMF entered the picture in November 2008, advising the government toreconstruct the banking system in a way that “includes measures to ensure fairvaluation of assets [and] maximize asset recovery.” The government createdthree “good” new banks from the ruins of its failed banks, transferring loansfrom the old to the new banks at a discount of up to 70 percent to reflecttheir fair value, based on independent third party valuation.
Thevultures became owners of two out of three new Icelandic banks. On IMF advicethe government negotiated an agreement so loose as to give them a huntinglicense on Icelandic households and businesses. The new banks acted much asU.S. collection agencies do when they buy bad credit-card debts, bank loans orunpaid bills from retailers at 30% offace value and then hound the debtors to squeeze out as much as they can, byhook or by crook.
These scavengers of the financial system arethe bane of many states. But there is now a danger of their rising to the topof the international legal pyramid, to a point where they are in a position tooppress entire national economies.
Iceland’s case has a special twist. By lawIcelandic mortgages and many other consumer loans are linked to the country’ssoaring consumer price index. Owners of these loans not only can demand 100% offace value, but also can add on the increase in debt principal from theindexing. Thousands of households face poverty and loss of propertybecause of loans that, in some cases, have more than doubled as a result of thecurrency crash and subsequent price inflation. But the IMF and Iceland’sGovernment and Supreme Court have affirmed the price-indexation of loan principaland usurious interest rates, lest the restructured banking system come togrief.
Thisis not what was expected. In 2009 the incoming “leftist” government negotiatedan agreement with creditors to relate loan payments to the discounted transfervalue. On IMF advice, the government handedover controlling interest in the new banks to creditors of the old banks. Theaim was to minimize the cost of refinancing the banking system – but not todestroy the economy. Loans that were transferred from the old banks to the newafter the 2008 crash at a discount of up to 70% to reflect their depreciatedmarket value. This discount was to be passed on to borrowers (households and smallbusinesses) faced with ballooning principal and payments due to CPI indexing ofloans.
Butthe economy’s survival is not of paramount interest to the aggressive hedgefunds that have replaced the established banks that originally lent to theIcelandic banks. Instead of passing on the debt write-downs to households andother debtors, the new banks are revaluing these loan principals upward. Theirdemands are keeping the economy in a straight jacket. Instead of debtrestructuring taking place as originally hoped for, the scene is being set fora new banking crisis.
Somethinghas to give. But so far it is Iceland’s economy, not the vulture funds. With theIMF insisting that the government abstain from intervention, the government’sapproval rating has plunged to just 10% of Icelanders for floundering so badlywhile the new owners call the shots.
TheNew Banks have written off claims on major corporate debtors, whose continuedoperations have ensured their role as cash cows for the banks’ new vultureowners. But household debts acquired at 30 to 50 percent of face value havebeen re-valued at up to 100 percent. The value of owners’ share equity hassoared. The Government has not intervened, accepting the banks’ assertion that theylack the resources to grant meaningful debt relief to households. So unpayablyhigh debts are kept on the books, at transfer prices that afford a windfall tofinancial predators, dooming debtors to a decade or more of negative equity.
Withthe preparatory work done, the time has come for the Vultures to cash inthrough re-sale of New Bank equity shares by yearend. The New Banks have kepttheir corporate cash cows afloat while window-dressing owners’ equity withunrealistic valuations of consumer debts that cannot be paid, except at thecost of bankrupting the economy.
Thereis a feeling that Iceland’s government has been disabled from acting as anhonest broker, as bank lobbyists have worked with Althing insiders – now backedby the IMF – to provide a windfall for creditors.
Theproblem becoming a global one. Many European countries and the United States facecollapsed banks and derailed banking systems. How are the IMF and ECB torespond? Will they prescribe the Icelandic-type model of collaboration betweenGovernment and hedge funds? Or should the government be given power to resist driveby vulture funds to profiteer on an international scale, backed byinternational sanctions against their prey?
The policy danger now facing Europe
Aneconomic crisis is the financial equivalent of military conquest. It is anopportunity for financial elites to make their property grab as ForeclosureTime arrives. It also becomes a political grab to make real the financialclaims that had become uncollectible and hence largely fictitious“mark-to-model” accounting. Populist rhetoric is crafted to mobilize thewidespread financial distress and general discontent as an opportunity to turnlosers against each other rather than at the creditors.
This is the point at which all the years offinancial propaganda pay off. Neoliberals have persuaded the public to believethat banks are needed to “oil the wheels of commerce” – that is, provide the creditbloodstream that brings nourishment to the economy’s moving parts. Only undersuch crisis conditions can banks collect what has become a fictitious buildupof debt claims. The overgrowth of mortgage debt, corporate debt, student loans,credit-card debt and other debts are fictitious because under normalcircumstances there is no way for them to be paid.
ForeclosureTime is not sufficient, because much property has fallen into negative equity –about a quarter of U.S. real estate. And for Ireland, market value of realestate covers only about 30% of the face value of mortgages. So Bailout Timebecomes necessary. The banks turn over their bad loans to the government inexchange for government debt. The Federal Reserve has arranged over $2 trillionof such bank-friendly swaps. Banks receive government bonds or central bankdeposits in exchange for their bad debts, accepted at face value rather than at“mark-to-market” prices.
Atleast in the United States and Britain, the central bank can print as much domesticcurrency as is necessary to pay interest and keep these government bondsliquid. Public agencies then take on the position of creditor vis-à-vis debtorsthat can’t pay.
Thesepublic agencies then have a choice. They may seek to collect the full amount(or at least, as much as they can get), as in the case of Fannie Mae andFreddie Mac in the United States. Or, the government may sell the bad debts tovulture funds, for a fraction of their face value.
After the September 2008 crash, Iceland’s governmenttook over the old, collapsed, banks and created new ones in their place.Original bondholders of the old banks off-loaded the Icelandic bank bonds inthe market for pennies on the dollar. The buyers were vulture funds. Thesebondholders became the owners of the old banks, as all shareholders were wipedout. In October, the government’s monetary authority appointed new boards tocontrol the banks. Three new banks were set up, and all the deposits, mortgagesand other bank loans were transferred to these new, healthier banks – at asteep discount. These new banks received 80 percent of the assets, the oldbanks 20 percent.
Then,owners of the old banks were given control over two of the new banks (87% and95% respectively). The owners of these new banks were called vultures not onlybecause of the steep discount at which the financial assets and claims of theold banks were transferred, but mainly because they already had bought controlof the old banks at pennies on the dollar.
Theresult is that instead of the government keeping the banks and simply wipingthem out in bankruptcy, the government kept aside and let vulture investorsreap a giant windfall – that now threatens to plunge Iceland’s economy intochronic financial austerity. In retrospect, none of this was necessary. Thequestion is, what can the government do to clean up the mess that it hascreated by so gullibly taking bad IMF advice?
Inthe United States, banks receiving TARP bailout money were supposed tonegotiate with mortgage debtors to write down the debts to market prices and/orthe ability to pay. This was not done. Likewise in Iceland, the vulture fundsthat bought the bad “old bank” loans were supposed to pass on the debtwrite-downs to the debtors. This was not done either. In fact, the loanprincipals continued to be revalued upward in keeping with Iceland’s uniqueindexing designed to save banks from taking a loss – that is, to make sure thatthe economy as a whole suffers, even suffering a fatal austerity attack, sothat bankers will be “made whole.” This means making a windfall fortune for thevultures who buy bad loans on the cheap.
Isthis the future of Europe as well? If so, the present financial crisis willbecome the great windfall for vulture banks, and for banks in general. Whereasthe past few centuries have seen financial crashes wipe out the savings andcreditor claims (bonds, bank loans, etc.) that are the counterpart to baddebts, today we are seeing the bad debts kept on the books, but the banks andbondholders that provided the bad loans being made whole at taxpayer expense.
Thisis not how economic democracy was expected to work during the 19th-centurydrive for Parliamentary reform. And by the early 20th century,social democratic and labor parties were supposed to take the lead in movingbanking and credit along with other basic infrastructure into the publicdomain. But today, from Greece to Iceland, governments are acting as enforcersor even as collection agents on behalf of the financial sector – as the OccupyWall Street movement expresses it, the top “1%,” not the bottom 99%.
Icelandstands as a dress rehearsal for this power grab. The IMF and Iceland’sgovernment held a conference in Reykjavik on October 27 to celebrate theostensible success in their reconstruction of Iceland’s economy and bankingsystem.
Inthe United States, the crisis that Obama Chief of Staff Rahm Emanuel celebratedas “too good to let go to waste” will be capped by scaling back Social Securityand Medicare as soon as the autumn Doomsday Clock runs down and theCongressional Super-Committee of 12 (with President Obama holding the 13thvote in case of a tie) gets to agree to make the working population pay WallStreet for its bad loans. The Greek austerity plan thus serves as a dressrehearsal for the U.S. – with the Democratic Party playing the role ascounterparts to Greece’s Socialist Party that is sponsoring austerity, andexpelling labor union leaders from its ranks if they object to the granddouble-cross.
*Olafur Arnarson is an author and columnist atPressan.is. Michael Hudson is Prof. of Economics at UMKC. Gunnar Tomasson is aretired IMF advisor.
Previously, we have shown that government deficits lead to an equivalent amount of nongovernment savings. The nongovernment savings created will be held in claims on government. Normally, the nongovernment sector prefers to hold some of that savings in government IOUs that promise interest, rather than in nonearning IOUs like cash. Further, we have shown that budget deficits create an equivalent amount of reserves. And banks prefer to hold higher-earning assets than reserves that pay almost nothing (until recently, they paid zero in the USA). Hence, both savers as well as banks would rather have government bonds. We, thus, find that in normal times government will offer interest earning bonds in an amount almost equal to its deficits (the difference is made up by bank accumulation of reserves and private sector accumulation of currency).
However, when government deficit spends, some of the claims on government will end up in the hands of foreigners. Does this matter? Yes, according to many. At one extreme we have many commentators worrying that the US government might run deficits, but will find that the Chinese desire to “lend to” the US government is insufficient to absorb bond issues. Others argue that while Japan can run up government debt to GDP ratios equal to 200% of GDP this is only because more than 90% of all that debt is held domestically. The US, it is said, cannot run up debts that great because so much of its “borrowing” is from foreigners—who might “go on strike.” Others worry about ability of the US government (for example) to pay interest to foreigners. And what if foreigners demand more interest? And what about effects on exchange rates? This week, we begin to look at such issues.
Foreign holdings of government debt. Government deficit spending creates equivalent nongovernment savings (dollar for dollar). However, some of the savings created will accumulate in the hands of foreigners, since they can also accumulate the government’s domestic currency-denominated debt.
In addition to actually holding the currency including both cash and reserves (indeed, it is possible that foreigners hold most US dollar-denominated paper currency), they can also hold government bonds. These usually just take the form of an electronic entry on the books of the central bank of the issuing government.Interest is paid on these “bonds” in the same manner, whether they are held by foreigners or by domestic residents—simply through a “keystroke” electronic entry that adds to the nominal value of the “bond” (itself an electronic entry). The foreign holder portfolio preferences will determine whether they hold bonds or reserves—with higher interest on the bonds. As discussed in previous weeks, shifting from reserves to bonds is done electronically, and is much like a transfer from a “checking account” (reserves) to a “savings account” (bonds).
There is a common belief that it makes a great deal of difference whether these electronic entries on the books of the central bank are owned by domestic residents versus foreigners. The reasoning is that domestic residents are far less likely to desire to shift to assets denominated in other currencies.
Let us presume that for some reason, foreign holders of a government’s debt decide to shift to debt denominated in some other currency. In that case, they either let the bond mature (refusing to roll over into another instrument) or they sell it. The fear is that this could have interest rate and exchange rate effects—as debt matures government might have to issue new debt at a higher interest rate,and selling pressure could cause the exchange rate to depreciate. Let us look at these two possibilities separately.
a) Interest rate pressure. Let us presume that sizable amounts of a government’s bonds are held externally, by foreigners. Assume foreigners decide they would rather hold reserves than bonds—perhaps because they are not happy with the low interest rate paid on bonds. Can they pressure the government to raise the interest rate it pays on bonds?
A shift of portfolio preferences by foreigners against this government’s bonds reduces foreign purchases. It would appear that only higher interest rates promised by the government could restore foreign demand.
However,recall from previous discussions that bonds are sold to offer an interest-earning alternative to reserves that pay little or no interest. Foreigners and domestic residents buy government bonds when they are more attractive than reserves. Refusing to “roll over” maturing bonds simply means that banks taken globally will have more reserves (credits at the issuing government’s central bank) and less bonds. Selling bonds that have not yet matured simply shifts reserves about—from the buyer to the seller.
Neither of these activities will force the hand of the issuing government—there is no pressure on it to offer higher interest rates to try to find buyers of its bonds.
From the perspective of government, it is perfectly sensible to let banks hold more reserves while issuing fewer bonds. Or it could offer higher interest rates to sell more bonds (even though there is no need to do so); but this just means that keystrokes are used to credit more interest to the bond holders.
Government can always “afford” larger keystrokes, but markets cannot force the government’s hand because it can simply stop selling bonds and, thereby, let markets accumulate reserves instead.
b) Exchange rate pressure. The more important issue concerns the case where foreigners decide they do not want to hold either reserves or bonds denominated in some currency.
When foreign holders decide to sell off the government’s bonds, they must find willing buyers. Assume they wish to switch currencies, so they must find holders of other currency-denominated reserve credits willing to exchange these for the bonds offered for sale. It is possible that the potential buyers will purchase bonds only at a lower exchange rate (measured as the value of the currency of the government bonds that are offered for sale relative to the currency desired by the sellers).
For this reason, it is true that foreign sales of a government’s debt can affect the exchange rate. However, so long as a government is willing to let its exchange rate “float” it need not react to prevent a depreciation.
We conclude that shifting portfolio preferences of foreign holders can indeed lead to a currency depreciation. But so long as the currency is floating, the government does not have to take further action if this happens.
Current accounts and foreign accumulation of claims. Just how do foreigners get hold of reserves and bonds denominated in a government’s domestic currency?
As we have shown in previous weeks, our macroeconomic sectoral balance ensures that if the domestic private sector balance is zero, then a government budget deficit equals a current account deficit. That current account deficit will lead to foreign net accumulation of financial assets in the form of the government’s debt. This is why, for example, the US government is running deficits and issuing government debt that is accumulated in China and elsewhere.
Of course,in the case of the US, for many years (during the Clinton and Bush, jr. presidencies) the domestic private sector was also running budget deficits—so foreigners also accumulated net claims on American households and firms. The US current account deficit guarantees—by accounting identity—that dollar claims will be accumulated by foreigners.
After the crisis, the US domestic sector balanced its budget and actually started to run a surplus. However, the current account deficit remained. The US government budget deficit grew—by identity it was equal to the current account deficit plus the private sector surplus. Given that the US government became the only net source of new dollar-denominated financial assets (the US private sector was running a surplus), foreigners must—by accounting identity—have accumulated US government debt.
Some fear—as discussed earlier—that suddenly the Chinese might decide to stop accumulating US government debt. But it must be recognized that we cannot simply change one piece of the accounting identity, and we cannot ignore the stock-flow consistency that follows from it.
For the rest of the world to stop accumulating dollar-denominated assets, it must also stop running current account surpluses against the US. Hence, the other side of a Chinese decision to stop accumulating dollars must be a decision to stop net exporting to the US. It could happen—but the chances are remote.
Further,trying to run a current account surplus against the US while avoiding the accumulation of dollar-denominated assets would require that the Chinese off-load the dollars they earn by exporting to the US—trading them for other currencies. That, of course, requires that they find buyers willing to take the dollars.
This could—as feared by many commentators—lead to a depreciation of the value of the dollar. That, in turn would expose the Chinese to a possible devaluation of the value of their US dollar holdings—reserves plus Treasuries that total over $2trillion.
Depreciation of the dollar would also increase the dollar cost of their exports, imperilling their ability to continue to export to the US. For these reasons, a sudden run by China out of the dollar is quite unlikely. A slow transition into other currencies is a possibility—and more likely if China can find alternative markets for its exports.
Next week, we will look to the frequent claim that the US is “special”—while it might be able to run persistent government deficits and trade deficits, other countries cannot.
By Marshall Auerback
It is said that the EuropeanUnion is a remarkably inefficient organization in terms of organizing economicrescue packages, but when it comes to subverting democracy, they are asruthless and efficient as a well-oiled crime syndicate.
Considerthe following: in the space of less than2 weeks, the eurocrats have managed to eliminate two troublesome electedleaders, whose actions dared to interfere with their broader objectives offinalizing the “European Project” – a project which, to put it bluntly, islooking more and more like a financial coup d’etat.
First,Greece, which has in a sense provided the template: Prime Minister George Papandreou, had theaudacity toseek the consent of his own people to decisions that would shape their livesvia referendum. Well, judging from thepetulant reactions of German Chancellor Angela Merkel and French PresidentNicolas Sarkozy, this clearly wouldn’t do. Blatantly interfering with the internal affairs of a fellow democracy(and an ostensible ally), both lobbied (andthreatened) the Greek government, the end result being that Mr. Papandreou wasduly shoved aside after backtracking.
And look who’s the new PM in Greece: LucasPapademos, a former ECB official, (naturally, with the requisite Goldman Sachspedigree), in order to implement the latest set of “structural reforms”, whichwill almost certainly have the effect of deflating the Greek economy evenfurther into the ground. Of course, theprivatizations will go ahead and Greece’s rapacious tax evading oligarchs willscoop them up at distressed values (presumably with the cash they’ve alreadystashed offshore in the London property market, or Swiss banks), therebyconsolidating their control of an increasingly dysfunctional Greek economy. The vast majority of Greeks will sufferhorribly. They have no say, in a sensebeing left with the choice of shooting themselves or a firing squad. Still, it’s not a total loss: no doubt Goldman Sachs will reap substantial feesas it helps to auction off these very same state assets.
Across, the Adriatic, itappears as if the “Merkozy” tandem has also played its cards successfully forRound 2, this time successfully eliminating its troublesome nemesis, Italy PM SilvioBerlusconi. Say what you will about MrBerlusconi, but in this instance he was right to object to a crude political ploy being foisted on him by theECB, the French and Germans to accept an irrational and economicallycounterproductive program fiscal austerity program in exchange for “support”from the likes of the IMF. Ask any Argentinean what IMF “support”entails.
AllBerlusconi had to do was cast his eyes toward Athens to see the likely effectof a renewed assault on the Italian welfare state. But the markets’ euphoric reactionto his resignation was surreal: akin to turkeys voting for Thanksgiving.
InRome, this Franco-German powerplay is being overseen by a canny ex-Communist,President Giorgio Napolitano, who is in the process of engineering life-longeurocrat, Mario Monti, as the next PM in Italy. Look at Monti’sbackground: Impeccable credentials: a virtual “lifer” within the European Union’stechnocratic governing structures, mingled with some private sector“experience” as a director of entities such as Coca Cola and, of course, an “internationaladvisor” to Goldman Sachs.
What is taking place isnothing less than a financial coup d’etat by the Eurozone’s rentier class. And it is one of history’s sad ironies that,at least in the case of Italy, this is all being engineered by an ex-Communist,who likely would have been chased out of the Italian Government (a la JuanBerlinguer) by a Cold War-driven CIA hadthis taken place but 30 years earlier.
How have we come to this passwithin the EU? It is hard to point toone person. We have seen this vastproject moved along by a handful of unelected bureaucrats for several decadesor more. Jacques Delors was a truly seminal figure, but he did not actalone. The whole of the Europeanproject has been increasingly driven by these unelected tenured eurocrats, who have rotated in and out of various positions withinthe EU’s governing structures and spent a few years’ getting the requisiteprivate sector training at a place like GS or JP Morgan.
You could make the case thatthis started when then French President Francois Mitterrand came to power inthe early 1980s, and tried to implement a genuinely fresh progressive economicdirection for France. He was promptly undermined until he learned to “playball” with the powers behind the throne. Since then, the game planhas largely remained the same: EuropeanCommissioners set up multiple diktats, rules, regulations, minus, of course, anyreal kind of democratic recourse when they encounter popular resistance. You start small and build up gradually and create fait accomplis everywhere.
Whenthere is democratic backlash via a referendum, the setback is onlytemporary. Countries, such as Ireland,which dare to vote the “wrong” way in a national referendum, do not have theresults respected. EU officialdom hasgenerally responded, not by reflecting on a popular expression of democraticwill, but ignoring the results until the silly peasants realize the egregiouserrors of their ways and re-vote the right way.
Ifit takes two, or even three, referenda, so be it. Politically, theinterpretation of any aspect of the Treaties relating to European governancehave always been largely left in the hands of unelected bureaucrats, operatingout of institutions which are devoid of any kind of democraticlegitimacy. This, in turn, has led to an increasing sense of politicalalienation and a corresponding move toward extremist parties hostile to anykind of political and monetary union in other parts of Europe. Underpolitically charged circumstances, these extremist parties might become themainstream.
The one figure who emerges as a tragic figure here isGeorge Papandreaou. However ineffectually, Papandreou had been deeply committedto making the October deal work. But asHarvard economist (and Greek government advisor) Richard Parker has noted,Papandreou faced a firestorm on multiple fronts: competitors in his own partywho wanted his job; parliamentarians in his party who threatened to bolt overnew austerity measures; the wholesale intransigence of Samaras and NewDemocracy; to say nothing of economy that was deflating into the ground beforeany real help had arrived. Calling for a referendum became his onlyinstrument to put out multiple fires at once—by forcing Greek politicians andtheir powerful backers to back down and by forcing European leaders back to thetable immediately to finalize a workable rescue plan in final form.
Of course, he was bound tofail, given the powerful opposition behind him. The Greek PM was being punished on the one hand by his”allies” in the EU, who have imposed collective punishment on theGreek people because of decades of embedded corruption in the system, in spiteof the fact that this Prime Minister had come clean. Making Greece a properfunctioning democracy was Papandreou’s raison d’etre for in getting into Greekpolitics.
And, on the otherside, the parasite Greek oligarchs themselves, who saw his actions asfrontal attack on their control of the Greek economy, fought to destroy himpolitically and in effect moving Greece one step closer to a failed state.
And now Greece has provided aconvenient model. You’ve now manufactured a crisis (that EASILY could have been solved by the ECB years ago – Greece is around 2.5% ofEurope’s GDP), which is now spreading, but providing ample opportunity to getrid of troublesome politicians who don’t do what they are told (effectivelyembrace this “stability culture” that the Germans bleat on about, butwhich in reality is nothing more than consolidation of the rentiers’ control ofthe various governments).
Similarly in Italy, theEuropean Central Bank has been buying Italian bonds, but in very half-heartedfashion and certainly not enough to stem the relentless rise in rates. The ECB’s new chief, Mario Draghi (also anex-Goldman man), kicked off his term with a blunt warning that Europe’s centralbank would not act as a “lender of last resort” (hiding behind dubious legaltechnicalities) and thereby put his fellow countryman in a position where hisresignation was the only course of action to salvage the country from animmediate financial crisis.
Berlusconi was also an easy target, given his colorfuland dubious private history. And hislikely replacement, Mario Monti, is a perfect bagman for the financialoligarchs of Europe. He is, indeed, part of what one can rightly refer toas a “financial mafia” that has wrecked the world economy since 2008. Thesehatchet men of this murky and opaque financial world are now being appointed toimplement austerity on poor working households to save the financial sectorfrom a debt deflation — an artificial crisis created because of thearchitecture of the Euro system, which as we know these same financial“markets” so much celebrated when the euro was launched in 1999. Sadly, a largenumber of Italians still see the euro as their saviour from a corrupt past,which many associate with the Italian lire and high interest rates, even if thecorrupt Berlusconi has been himself intimately linked to the same Euro elite.
And Draghi himself has a dubious past: as wenoted in a recent post,historically, Italyactively exploited ambiguity in accounting rules for swap transactions in orderto mislead EU institutions, other EU national governments, and its own publicas to the true size of its budget deficit.
Itseems indeed fitting that Draghi is now the man forced to deal with theconsequences of this national accounting fraud. But it’s hardly just for the people of Europe, all of whom will continueto get crushed under the boot of yet more fiscal austerity, by an increasinglydetached and democratically unaccountable elite. No wonder the streets of Madrid, Athens, Romeand elsewhere are beginning to burn.
Thanks for comments and apologies for being late. I justreturned from Rio. And lest you think I was just tanning on the beach, I wasactually indoors at a conference—underground, no less.
Rather than repeating the questions, let me justsummarize six key issues raised.
- Weneed to tie ourselves to the masthead of budget limits to keep politicians fromspending too much. For better or worse we have a budgeting process throughwhich Congress decides how much to allocate to programs, then submits the planto the President. Once approved, this authorizes spending. That is the“democratic” process through which our elected representatives decide whichprograms are worthy of funding—and at what levels. Much of the spending is“open-ended” in the sense that it is contingent (unemployment benefits paidwill depend on economic performance, for example). I do not see how adding aconstraint beyond this is either necessary or consistent with democraticcontrol and accountability. Certainly I do not support many or even most of theprograms Congress and the President decide to fund. I can vote to throw thebums out. If I’m rich enough, I can try to buy them off with campaigncontributions. By its very nature a debt limit is arbitrary and inconsistentwith the budgeting process. In the past, it never mattered—the budget trumpedthe limit and Congress routinely raised the limit. Now the politics of aminority is trying to subvert the budgeting process. In truth, the biggerdanger is the new super-duper hand-picked for ignorance deficit committee thatis authorized to ignore Congress’s will as expressed in the budget and to slashand burn programs in a thoroughly undemocratic manner.
- Publicgoods provision is always less efficient than private goods provision; andproduction of public goods crowds-out private goods and hence must reduceoverall efficiency. This is faith-based economics of the worst sort. It hasabsolutely no evidence to support it and defies any logic. Outside of communistor socialist societies, I truthfully cannot see any legitimate use for the hazyterm “efficiency” in economics. Unlike communist societies, capitalistsocieties never operate near to full capacity (with World Wars the onlypossible exception) and hence it is never a simple matter of taking resourcesaway from private use to support public use. And in any case, one cannotimagine any private production without first having in place publicprovisioning.
- Abloated government is a drag on growth and causes inflation. Could be true.However, everywhere I look in the West (that is to say, among developednations) the problem is government that is far too small to succeed in thetasks at hand. Too much privatization, too many idle resources, inadequateprovision of essential public services.
- Whohas the authority to issue “warrants” or “platinum coins”? As discussed above,Congress and the President first work out a budget. That authorizes Treasuryspending. We can come up with all sorts of procedures to allow Treasury toaccomplish that task. A relatively primitive but effective one would be for itto simply print up Treasury notes and spend. Or it can directly keystrokeentries into the deposit accounts of recipients—but that requires that Treasurycan also keystroke reserves onto bank balance sheets. Since we divide the tasksbetween Treasury and Fed, having banks “bank at the Fed”, it must be the Fedthat keystrokes the reserves. There is no fundamental reason for this—bankscould have accounts at the Treasury used for clearing and then the Treasurywould keystroke the reserves. But we don’t do it that way. So we could have theFed act as the Treasury’s bank, accepting a Treasury IOU and keystroking bankreserves. But we don’t do that either—we say that although the Fed is theTreasury’s bank, it is prohibited from directly accepting a Treasury IOU. Andhence we created complex procedures that involve private banks, the Fed and theTreasury to accomplish the same thing.
Now I went through all that simply as an introductionto the warrant and platinum coins proposals. Treasury has the authority toissue platinum coins in any denomination, so could for example make largepayments for military weapons by stamping large denomination platinum coins. Itwould thereby skip the Fed and private banks. And since coins (and reserves andFederal Reserve notes) don’t count as government debt for purposes of the debtlimit this also allows the Treasury to avoid increasing debt as it spendsplatinum coins. Similarly we could create some new IOU we call a warrant thatis made acceptable (for example) in tax payment. It would be a Treasury IOU butwould not be counted among the bills and bonds that total to the governmentdebt. Like currency it would be “redeemed” in tax payment, hence demanded bythose with taxes due. So it is just another finesse to get around arbitrarylimits or procedures put on Treasury spending.
- TotalFed commitments (so far) to bailout Wall Street: $29 trillion. That figureresults from a close study by two UMKC PhD students who will soon be releasingtheir study.
- Whatabout Italy (etc)? Do they face market imposed debt limits (rather than simplytying their shoes together voluntarily)? Yes. Go to my GLF blog today.They are now more like US states, users not issuers of the currency.
(With apologies to Friedrich Hayek)
The markets are again infree-fall and, once again, a lazy Mediterranean profligate is to blame. This time, it’s an Italian, rather than aGreek. No, not Silvio Berlusconi, buthis fellow countryman, Mario Draghi, the new head of the increasingly spinelessEuropean Central Bank.
At least the Alice inWonderland quality of the markets has finally dissipated. It was extraordinary to observe the euphoricreaction to the formation of the European Financial Stability Forum a few weeksago, along with the “voluntary” 50% haircut on Greek debt (which has turned outto be as ‘voluntary’ as a bank teller opening up a vault and surrendering moneyto someone sticking a gun in his/her face). To anybody with a modicum of understanding of modern money, it wasobvious that the CDO like scam created via the EFSF would never end well andthat the absence of a substantive role for the European Central Bank wouldprove to be its undoing.
As far as the haircuts went,the façade of voluntarism had to be maintained in order to avoid triggering aseries of credit default swaps written on Greek debt, which again highlightsthe feckless quality of our global regulators being hoisted on their own petard,given their reluctance to eliminate these Frankenstein-like financialinnovations in the aftermath of the 2008 disaster.
What is required is a “backto the future” approach to banking: Inthe old days, a banker “hedged” his credit risk by doing (shock!) CREDITANALYSIS. If the customer was deemed tobe a poor credit risk, no loan was made.
It goes back to a point wehave made many times: creditworthinessprecedes credit. You need policiesdesigned to promote job growth, higher incomes and a corresponding ability toservice debt before you can expect a borrower take on a loan or a banker toextend one. And, as Minsky used to pointout, in the old days, banking was a fundamentally optimistic activity, becausethe success of the lender was tied up with the success of the borrower; inother words, we didn’t have the spectacle of vampire-like squids bettingagainst the success of their clients via instruments such as credit defaultswaps.
Credit default swapsthemselves are to “hedging” credit exposure what nuclear weapons are to“hedging” national defence requirements. In theory, they both sound like reasonable deterrents to mitigatedisaster, but use them and everything blows up. At least one decent by-product of the eurocrats’ incompetent handling ofthis national solvency disaster has been the likely discrediting of CDSs as ahedging instrument in the future. Notethat 5 year CDSs on Italian debt have not blown out to new highs today in spiteof bond yields rising over 7%, because the markets are slowly but surely comingto the recognition that they are ineffective hedging instruments – althoughthey have been very useful in terms of lining the pockets of the likes of JPMorgan and Goldman Sachs.
Say what you willabout Silvio Berlusconi (and there’s LOTS one can say about the man as anyreader of the NY Post can attest). But hewas right to oppose to a crude political ploy being foisted on him by the ECB,the French and Germans to accept an irrational and economically counterproductiveprogram fiscal austerity program in exchange for “support” from the likes ofthe IMF. All Berlusconi had to do wascast his eyes to the other side of the Adriatic to see the likely effect ofthat. The markets’ reaction to his resignation was surreal: akin to turkeysvoting for Thanksgiving. The overriding imperative in Euroland(indeed, in the entire global economy) should be to stimulate economic growth to ensure that there are enoughjobs for all who want them.
Private spending is very flatand so they need to replace it with public spending or GDP will declinefurther. The eurocrats seem incapable of understanding that even if the budgetdeficit rises in the short-run, it will always come down again as GDP growsbecause more people pay taxes and less people warrant government welfaresupport.
As for Italy itself, this isa sordid case of the Europe’s mandarins subverting yet another democracy,through crude economic blackmail. Already one government has been destroyed this way: In the words ofFintan O’Toole of the Irish Times:
Firstly, it was madeexplicit that the most reckless, irresponsible and ultimately impermissiblething a government could do was to seek the consent of its own people todecisions that would shape their lives. And, indeed, even if it had gone ahead,the Greek referendum would have been largely meaningless. As one Greek MP putit, the question would have been: do you want to take your own life or to bekilled? Secondly, there was open and shameless intervention by European leaders(Angela Merkel and Nicolas Sarkozy) in the internal affairs of another state.Sarkozy hailed the “courageous and responsible” stance of the main Greekopposition party – in effect a call for the replacement of the elected Greekgovernment.
The third part of thismoment of clarity was what happened in Ireland: the payment of a billiondollars to unsecured Anglo Irish Bank bondholders. Apart from its obviousobscenity, the most striking aspect of this was that, for the first time, wehad a government performing an action it openly declared to be wrong. MichaelNoonan wasn’t handing over these vast sums of cash from a bankrupt nation tovulture capitalist gamblers because he thought it was a good idea. He was doingit because there was a gun to his head. The threat came from the EuropeanCentral Bank and it was as crude as it was brutal: give the spivs yourtaxpayers’ money or we’ll bring down your banking system.
Of course, this is nothing new for the EU, asany Irishman or Portuguese citizen can attest. Vote the “wrong” way in a national referendum and the result is ignoredby the eurocrats until the silly peasants realize the egregious errors of theirways and re-vote the right way. If ittakes two, or even three, referenda, so be it. Politically, the interpretation of any aspect of the Treaties relatingto European governance have always been largely left in the hands of unelectedbureaucrats, operating out of institutions which are devoid of any kind ofdemocratic legitimacy. This, in turn,has led to an increasing sense of political alienation and a corresponding movetoward extremist parties hostile to any kind of political and monetary union inother parts of Europe. Under politicallycharged circumstances, these extremist parties might become the mainstream.
As for Italy itself, the country runs a primary fiscalsurplus. As George Soros has noted: “Italy is indebted, but it isn’tinsolvent.” Its fiscal deficit to GDP ratio is 60% of the OECD average. It is less than the euro area average. Its ratio of non-financial private debt toGDP is very low relative to other OECD economies.
It is not at all like Greece. It has avibrant tradeable goods sector. It sells things the rest of the worldwants. You introduce austerity at this juncture, and you will cause even slowereconomic growth, higher public debt, thereby creating the very type of Greekstyle national insolvency crisis that Europe is ostensibly seeking toavoid. And then it will move to France,and ultimately to Germany itself. Nopassenger is safe when the Titanic hits the iceberg.
The entire eurozone is already in severe recession (depression, in fact, is not too strong aword), yet the ECB, the Germans, the French and virtually every single policymaker in the core continue to advocate the economic equivalent of mediaevalblood-letting via ongoing fiscal austerity. And, surprise, surprise, the public deficits continue to grow.
Here’s anotherinteresting thing: in the 1990s, a number of countries, including Italy,engaged deliberately in transactions which had no economic justification,other than to mask their public debt levels in order to secure entry into theeuro (see an excellent paper on this by Professor Gustavo Piga, “Derivativesand Public Debt Management”, which documents this practice). Italyactively exploited ambiguity in accounting rules for swap transactions in orderto mislead EU institutions, other EU national governments, and its own publicas to the true size of its budget deficit.
And Eurostatsigned off on these transactions. And who worked at the Italian Treasuryat that time? That’s right: “SuperMario” Draghi, who was director general of the Italian Treasury from 1991-2001 whenall this was going on, and then joined Goldman Sachs (2002-2005), when theprivatisations came up. Interesting that he is now the guy who has todeal with the ultimate fall-out. Karmic justice.
Virtuallyeverybody has lied about their figures (Spain is a notable offender today), solistening to Europe’s high priests of monetary chastity is akin to listening tosomeone coming out of a brothel proclaiming his continued virginity.
Is there a solution? Ofcourse there is. But the eurozone’s chiefpolicy makers continue to avoid utilizing the one institution – the EuropeanCentral Bank – which has the capacity to create unlimited euros, and thereforeprovides the only credible backstop to markets which continue to query thesolvency of individual nation states within the euro zone. They are, as Professor Paul de Grauwesuggests, like generals who refuse to go into combat fully armed (“European Summits in Ivory Towers”):
“Thegenerals… announce that they actually hate the whole thing and that they willlimit the shooting as much as possible. Some of the generals are so upset bythe prospect of going to war that they resign from the army. The remaininggenerals then tell the enemy that the shooting will only be temporary, and thatthe army will go home as soon as possible. What is the likely outcome of thiswar? You guessed it. Utter defeat by the enemy.
TheECB has been behaving like the generals. When it announced its programme ofgovernment bond buying it made it known to the financial markets (the enemy)that it thoroughly dislikes it and that it will discontinue it as soon aspossible. Some members of the Governing Council of the ECB resigned in disgustat the prospect of having to buy bad bonds. Like the army, the ECB hasoverwhelming (in fact unlimited) firepower but it made it clear that it is notprepared to use the full strength of its money-creating capacity. What is thelikely outcome of such a programme? You guessed it. Defeat by the financialmarkets.”
The ECB should, as De Grauwesuggests, be using the ecoomic equivalent of the Powell Doctrine: when a nationis engaging in war, every resource and tool should be used to achieve decisiveforce against the enemy, minimizing casualties and ending the conflict quicklyby forcing the weaker force to capitulate.
The ECB is themonopoly supplier of currency. They can set the price on the rates,(obviously not the supply) so if they set a level (say, Italy at 5%) why shouldthere be a default? Capitulating to the markets, or entering the battlehalf-heartedly not only ensures more economic collateral damage, buteffectively emboldens the speculators by granting them a free put option onevery nation in the euro zone. They’llline them up, one by one, starting with Greece and ending with Germany.
The ECB continuesto hide behind legalisms to justify its inaction, ironic, considering theextent to which national accounting fraud has long been tolerated in the eurozone since its inception. The notionthat it cannot act as lender of last resort is disingenuous: The ECB does have the legal mandate under its”financial stability” mandate which was provided under the Treaty ofMaastricht.
True it is fairto say that the whole Treaty of Maastricht is full of ambiguity. Theinstitutional policy framework within which the euro has been introduced andoperates (Article 11 of Protocol on the Statute of the European System ofCentral Banks (ESCB) and of the European Central Bank) has severalkey elements.
One notable feature of the operation of the ESCB is the apparent absence of the lender of last resort facility, which is an issue raised by the WSJ today, and which Draghi uses to justify his inaction. But it’s not as clear-cut as suggested: The Protocols under which the ECB is established enables, but does not require, the ECB to act as a lender of last resort.
Proof that theECB exploits these ambiguities when it suits them is evident in its bond buyingprogram. The ECB articles say it cannotbuy government bonds in the primary market. And this rule was once used as anexcuse not to backstop national government bonds at all. But this changed in early 2010, when it beganto buy them in the secondary market.
The ECB also hasa mandate to maintain financial stability. It is buying government bondsin the secondary market under the financial stability mandate. And itcould continue to do so, or so one might argue that it could. True thereis now great disagreement about this within the ECB. It has been turnedover to the legal department, which itself is in disagreement, which ultimatelysuggests that this is a political judgement, and politics is what is drivingItaly (and soon France) toward the brink.
In fact, giventhe 50% “voluntary” haircut imposed on holders of Greek debt, arguably the ECBis the only entity that can buy these national government bonds today. As Warren Mosler has noted,it is hard to see how anyone with fiduciary responsibility can buyItalian debt or any other member nation debt after EU officials announcedthe plan for 50% haircuts on Greek bonds held by the private sector:
Yes,all governments have the authority, one way or another, to confiscate aninvestors funds. But they don’t, and work to establish credibility that theywon’t.
Butnow that the EU has actually announced they are going to do it, as a fiduciaryyou’d have to be a darn fool to support investing any client funds in anymember nation debt.
Thelast buyer standing is and was always to be the ECB, which will now be buyingmost all new member nation debt as there is no alternative that includessurvival of the union.
Andwhen this happens there will be a massive relief response, as the solvencyissue will be behind them, with the euro firming as well.
Of course, wewill still have to deal with the reality of a major recession in Europe so longas the faith based cult of Austerians continues to dominate policy making. Sadly, that’s unlikely to change until peopleare shot on the streets of Madrid or Rome. But at the very least, let’s get this silly national solvency problemaddressed once and for all in the only credible way possible. Mario Draghi, you have the chance to redeemyourself and your country. Don’t wastethe opportunity.
By Mitch Green
To many of the world’s most highly-regarded economists, the Eurozone’s meltdown has come as a major surprise. Committed to the belief that One Market needs One Money, most economists expected the Euro to serve as an important complement to Europe’s integration. But, as Cullen Roche at Pragmatic Capitalism has pointed out, those who recognized how the monetary systems actually work saw the writing on the wall, as the seeds of the Euro’s own destruction were unwittingly put in place right from the beginning. Wynne Godley was the first to point out that the unprecedented divorce between the Eurozone governments’ monetary and fiscal powers would place its members in a fragile position and render them powerless in the face of a crisis. It was a warning that Cullen suggested might amount to “the greatest prediction of the last 20 years.” Similar praise came just last week from John Cassidy of The New Yorker magazine, who dedicated an entire piece to Godley’s insights, calling him “The Man Who Saw Through the Euro.”
One of the most revealing thingsabout this crisis is the unwillingness to investigate whether “accountingcontrol fraud” was a major contributor to the crisis. The refusal to even consider a major role forfraud is facially bizarre. The bankingexpert James Pierce found that fraud by senior insiders was, historically, theleading cause of major bank failures in the United States. The national commission that investigated thecause of the S&L debacle found:
“Thetypical large failure [grew] at an extremely rapid rate, achieving highconcentrations of assets in risky ventures…. [E]very accounting trick availablewas used…. Evidence of fraud was invariably present as was the ability of theoperators to “milk” the organization” (NCFIRRE 1993)
Two of the nation’s topeconomists’ study of the S&L debacle led them to conclude that the S&Lregulators were correct – financial deregulation could be dangerouslycriminogenic. That understanding wouldallow us to avoid similar future crises.
“Neitherthe public nor economists foresaw that [S&L deregulation was] bound toproduce looting. Nor, unaware of theconcept, could they have known how serious it would be. Thus the regulators in the field whounderstood what was happening from the beginning found lukewarm support, atbest, for their cause. Now we know better. If we learn from experience, history need not repeat itself” (GeorgeAkerlof & Paul Romer. “Looting: theEconomic Underworld of Bankruptcy for Profit.” 1993: 60).
The epidemic of accounting controlfraud that drove the second phase of the S&L debacle (the first phase wascaused by interest rate risk) was followed by an epidemic of accounting controlfraud that produced the Enron era frauds.
The FBI warned in September 2004that there was an “epidemic” of mortgage fraud and predicted that it wouldcause a financial “crisis” if it were not contained. The mortgage banking industry’s ownanti-fraud experts reported in writing to nearly every mortgage lender in 2006that:
“Stated income and reduced documentation loans speedup the approval process, but they are open invitations to fraudsters.” “When the stated incomes were compared to theIRS figures: [90%] of the stated incomes were exaggerated by 5% or more.[A]lmost 60% were exaggerated by more than 50%. [T]he stated income loandeserves the nickname used by many in the industry, the ‘liar’s loan’” (MARI2006).
Weknow that accounting control fraud is itself criminogenic – fraud begetsfraud. The fraudulent CEOs deliberatelycreate the perverse incentives that that suborn inside and outside employeesand professionals. We have known forfour decades how these perverse incentives produce endemic fraud by generatinga “Gresham’s” dynamic in which bad ethics drives good ethics out of the marketplace.
“[D]ishonest dealings tend to drive honest dealingsout of the market. The cost of dishonesty, therefore, lies not only in theamount by which the purchaser is cheated; the cost also must include the lossincurred from driving legitimate business out of existence.” George Akerlof (1970).
Akerlofnoted this dynamic in his seminal article on markets for “lemons,” which led tothe award of the Nobel Prize in Economics in 2001. It is the giants of economics who haveconfirmed what the S&L regulators and criminologists observed when wesystematically “autopsied” each S&L failure to investigate its causes. Modern executive compensation has madeaccounting control fraud vastly more criminogenic than it once was asinvestigators of the current crisis have confirmed.
“Over the last several years, the subprime markethas created a race to the bottom in which unethical actors have been handsomelyrewarded for their misdeeds and ethical actors have lost market share…. Themarket incentives rewarded irresponsible lending and made it more difficult forresponsible lenders to compete.” Miller,T. J. (August 14, 2007). Iowa AG.
Liar’s loans offer what we call asuperb “natural experiment.” No honestmortgage lender would make a liar’s loan because such loans have a sharplynegative expected value. Notunderwriting creates intense “adverse selection.” We know that it was overwhelmingly thelenders and their agents that put the lies in liar’s loans and the lenderscreated the perverse compensation incentives that led their agents to lie aboutthe borrowers’ income and to inflate appraisals. We know that appraisal fraud was endemic andonly agents and their lenders can commit widespread appraisal fraud. Iowa Attorney General Miller’s investigationsfound:
“[Manyoriginators invent] non-existent occupations or income sources, or simplyinflat[e] income totals to support loan applications. Importantly, ourinvestigations have found that most stated income fraud occurs at thesuggestion and direction of the loan originator, not the consumer.”
New York Attorney General (nowGovernor) Cuomo’s investigations revealed that Washington Mutual (one of theleaders in making liar’s loans) developed a blacklist of appraisers – whorefused to inflate appraisals. No honestmortgage lender would ever inflate an appraisal or permit widespread appraisalinflation by its agents. Surveys ofappraisers confirm that there was widespread pressure by nonprime lenders andtheir agents to inflate appraisals.
We also know that the firms thatmade and purchased liar’s loans followed the respective accounting controlfraud “recipes” that maximize fictional short-term reported income, executivecompensation, and (real) losses. Thoserecipes have four ingredients:
- Growlike crazy
- Bymaking (or purchasing) poor quality loans at a premium yield
- Whileemploying extreme leverage, and
- Providingonly grossly inadequate allowances for loan and lease losses (ALLL) against thelosses inherent in making or purchasing liars loans
Firms that follow these recipesare not “gamblers” and they are not taking “risks.” Akerlof & Romer, the S&L regulators,and criminologists recognize that this recipe provides a “sure thing.” The exceptional (albeit fictional) income,real bonuses, and real losses are all sure things for accounting controlfrauds.
Liar’s loans are superb“ammunition” for accounting control frauds because they (and appraisal fraud)allow the fraudulent mortgage lenders and their agents to attain the unholyfraud trinity: (1) the lender can charge a substantial premium yield, (2) on aloan that appears to relatively lowerrisk because the lender has inflated the borrowers’ income and the appraisal,while (3) eliminating the incriminating evidence of fraud that realunderwriting of the borrowers’ income and salary would normally place in theloan files. The government did notrequire any entity to make or purchase liar’s loans (and that includes Fannieand Freddie). The states and the federalgovernment frequently criticized liar’s loans. Fannie and Freddie purchased liar’s loans for the same reasons thatMerrill, Lehman, Bear Stearns, etc. acquired liar’s loans – they wereaccounting control frauds and liar’s loans (and CDOs backed by liar’s loans)were the best available ammunition for maximizing their fictional reportedincome and real bonuses.
Liar’s loans were large enough tohyper-inflate the bubble and drive the crisis. They increased massively from 2003-2007.
“[B]etween2003 and 2006 … subprime and Alt-A [loans grew] 94 and 340 percent,respectively.
Thehigher levels of originations after 2003 were largely sustained by the growthof the nonprime (both the subprime and Alt-A) segment of the mortgage market.” “Alt-A: The Forgotten Segment of the MortgageMarket” (Federal Reserve Bank ofSt. Louis 2010).
The growth of liar’s loans wasactually far greater than the extraordinary rate that the St. Louis Fed studyindicated. Their error was assuming that“subprime” and “alt-a” (one of the many misleading euphemisms for liar’s loans)were dichotomous. Credit Suisse’s early2007 study of nonprime lending reported that roughly half of all loans called“subprime” were also “liar’s” loans and that roughly one-third of home loansmade in 2006 were liar’s loans. Thatfact has four critical implications for this subject. The growth of liar’s loans was dramaticallylarger than the already extraordinary 340% in three years reported by the St.Louis Fed because, by 2006, half of the loans the study labeled as “subprime”were also liar’s loans. Because loansthe study classified as “subprime” started out the period studied (2003) as amuch larger category than liar’s loans the actual percentage increase in liar’sloans from 2003-2006 is over 500%. Thefirst critical implication is that it was the tremendous growth in liar’s loansthat caused the bubble to hyper-inflate and delayed its collapse.
The role of accounting controlfraud epidemics in causing bubbles to hyper-inflate and persist is anotherreason that accounting control fraud is often criminogenic. When such frauds cluster they are likely todrive serious bubbles. Inflating bubblesoptimize the fraud recipes for borrowers and purchasers of the bad loans bygreatly delaying the onset of loss recognition. The saying in the trade is that “a rolling loan gathers no loss.” One can simply refinance the bad loans todelay the loss recognition and book new fee and interest “income.” When entry is easy (and entry into becoming amortgage broker was exceptionally easy), an industry becomes even morecriminogenic.
Second, liar’s loans (and CDOs“backed” by liar’s loans) were large enough to cause extreme losses. Millions of liar’s loans were made and thoseloans caused catastrophic losses because they hyper-inflated the bubble,because they were endemically fraudulent, because the borrower was typicallyinduced by the lenders’ frauds to acquire a home they could not afford topurchase, and because the appraisals were frequently inflated. Do the math: roughly one-third of home loans made in 2006 were liar’s loans and theincidence of fraud in such loans was 90%. We are talking about an annual fraud rate of over one million mortgageloans from 2005 until the market for liar’s loans collapsed in mid-2007.
Third, the industry massivelyincreased its origination and purchase of liar’s loans after the FBI warned of the developing fraud “epidemic” andpredicted it would cause a crisis and then massively increased its originationand purchase of liar’s loans after the industry’s own anti-fraud experts warnedthat such loans were endemically fraudulent and would cause severe losses. Again, this provides a natural experiment toevaluate why Fannie, Freddie, et alia, originated and purchased theseloans. It wasn’t because “thegovernment” compelled them to do so. They did so because they were accounting control frauds.
Fourth, the industry increasinglymade the worst conceivable loans that maximized fictional short-term income andreal compensation and losses. Making (orpurchasing) liar’s loans that are also subprime loans means that the originatoris making (or the purchaser is buying) a loan that is endemically fraudulent toa borrower who has known, serious credit problems. It’s actually worse than that because lendersalso increasingly added “layered” risks (no downpayments and negativeamortization) in order to optimize accounting fraud. Negative amortization reduces the borrowers’short-term interest rates, delaying delinquencies and defaults (but producingfar greater losses). Again, thisstrategy maximizes fictional income and real losses. Honest home lenders and purchasers of homeloans would not act in this fashion because the loans must cause catastrophiclosses.
To sum it up, the known facts ofthis crisis refute the rival theories that the lenders/purchasersoriginated/bought endemically fraudulent liar’s loans because (a) “thegovernment” made them (or Fannie and Freddie) do so, or (b) because they weretrying to maximize profits by taking “extreme tail” (i.e., an exceptionallyunlikely risk). The risk that a liar’shome loan will default is exceptionally high, not exceptionally low. The known facts of the crisis are consistentwith accounting control frauds using liar’s loans (in the United States) astheir “ammunition of choice” in accordance with the conventional fraud “recipe”used that caused prior U.S. crises.
It is bizarre that in suchcircumstances the automatic assumption of the Bush and Obama administrationshas been that fraud isn’t even worth investigating or considering in connectionwith the crisis. It is as if millions ofliar’s loans purchased and resold as CDOs largely by systemically dangerous institutionsare an inconvenient distraction from campaign fundraising efforts. Instead, we have the myth of the virgincrisis unsullied by accounting control fraud. Indeed, contrary to theory, experience, and reality, the Department ofJustice has invented the faith-based fiction that looting cannot occur.
“BenjaminWagner, a U.S. Attorney who is actively prosecuting mortgage fraud cases inSacramento, Calif., points out that banks lose money when a loan turns out tobe fraudulent. “It doesn’t make any sense to me that they would be deliberatelydefrauding themselves,” Wagner said.”
Wagner’s statement isembarrassing. He conflates “they”(referring to the CEO) and “themselves” (referring to the bank). It makes perfect sense for the CEO to lootthe bank. Looting is a “sure thing” guaranteedto make the CEO wealthy. “Looting”destroys the bank (that’s the “bankruptcy” part of Akerlof & Romer’s title)but it produces the “profit” for the CEO. It is the deliberate making of masses of bad loans at premium yieldsthat allows the CEO to profit by looting the bank. When the top prosecutor in an epicenter ofaccounting control fraud defines the most destructive form of financial crimeout of existence he allows elite fraud to occur with impunity.
As embarrassing as Wagner’s statement is, however,it cannot compete on this dimension with that of his boss, Attorney GeneralHolder. I was appalled when I reviewedhis testimony before the Financial Crisis Inquiry Commission (FCIC). Chairman Angelides asked Holder to explainthe actions the Department of Justice (DOJ) took in response to the FBI’swarning in September 2004 that mortgage fraud was “epidemic” and its predictionthat if the fraud epidemic were not contained it would cause a financial“crisis.” Holder testified: “I’m not familiar myself with that [FBI]statement.” The DOJ’s (the FBI is partof DOJ) preeminent contribution with respect to this crisis was the FBI’s 2004warning to the nation (in open House testimony picked up by the national media. For none of Holder’s senior staffers whoprepped him for his testimony to know about the FBI testimony requires thatthey know nothing about the department’s most important and (potentially)useful act. That depth of ignorancecould not exist if his senior aides cared the least about the financial crisisand made it even a minor priority to understand, investigate, and prosecute thefrauds that drove the crisis. Because Holder was testifying in January 14,2010, the failure of anyone from Holder on down in his prep team to know aboutthe FBI’s warnings also requires that all of them failed to read any of therelevant criminology literature or even the media and blogosphere.
In addition to claiming that the DOJ’s response tothe developing crisis under President Bush was superb, Holder implicitly tookthe position that (without any investigation or analysis) fraud could not anddid not pose any systemic economic risk. Implicitly, he claimed that only economists had the expertise tocontribute to understanding the causes of the crisis. If you don’t investigate; you don’tfind. If you don’t understand“accounting control fraud” you cannot understand why we have recurrent,intensifying financial crises. If Holderthinks we should take our policy advice from Larry Summers and Bob Rubin,leading authors’ of the crisis, then he has abdicated his responsibilities tothe source of the problem.
“Now let mestate at the outset what role the Department plays and does not play inaddressing these challenges” [record fraud in investment banking andsecurities].
“The Department of Justice investigates andprosecutes federal crimes.…”
“As a generalmatter we do not have the expertise nor is it part of our mission to opine onthe systemic causes of the financial crisis. Rather the Justice Department’s resources are focused on investigatingand prosecuting crime. It is within thiscontext that I am pleased to offer my testimony and to contribute to your vitalreview.”
Two aspects of Holder’s testimony were preposterous,dishonest, and dangerous.
“I’m proud that we have put in place a lawenforcement response to the financial crisis that is and will continue to be isaggressive, comprehensive, and well-coordinated.”
DOJ has obtained ten convictions of senior insidersof mortgage lenders (all from one obscure mortgage bank) v. over 1000 felonyconvictions in the S&L debacle. DOJhas not conducted an investigation worthy of the name of any of the largestaccounting control frauds. DOJ isactively opposing investigating the systemically dangerous institutions (SDIs).
Holder’s most disingenuous and dangerous sentence,however, was this one:
“Our efforts to fight economic crime are a vitalcomponent of our broader strategy, a strategy that seeks to foster confidencein our financial system, integrity in our markets, and prosperity for theAmerican people.”
Yes, the “confidencefairy” ruled at DOJ. It is the rationalenow for DOJ’s disgraceful efforts to achieve immunity for the SDIs’ endemicfrauds. The confidence fairy trumped andtraduced “integrity in our markets” and “prosperity for the Americanpeople.” Prosperity is reserved for theSDIs and their senior managers – the one percent.
Bill Black is the author of The Best Way to Rob a Bank is to Own One and an associate professor of economics and law at the University of Missouri-Kansas City. He spent years working on regulatory policy and fraud prevention as Executive Director of the Institute for Fraud Prevention, Litigation Director of the Federal Home Loan Bank Board and Deputy Director of the National Commission on Financial Institution Reform, Recovery and Enforcement, among other positions.
Since the triumphal passage of the Dodd-Frank Wall Street Regulation and Consumer Protection Act on 21st of July 2010, we have been told repeatedly that the United States would “never again” be confronted with a “choice” between bailing out a large insolvent financial institution “or else.” If so, this means that one of the most pernicious and damaging features of capitalism has been forever solved. Were we convinced that the 111th Congress and the Obama Administration had actually achieved this, all right-minded persons would surely exclaim, “What a gift to the country, what a gift to humanity!” Yet, it is evident that few of us are doing that. Is the problem in ourselves? Are American voters hopeless ingrates? Or, is it that our suspicions are well-grounded?
With the emergence of Occupy Wall Street only a year before the 2012 elections, the prospects and promise of the Dodd-Frank Act is – as it should be — pivotal to our assessment of the record of this Congress and Administration. As such, let us take a moment to contemplate the specifics of the much-vaunted process that – we are told – will ensure the most important promise of Dodd-Frank – the anticipation and prevention of another fantastically costly bailout. The recent and very public troubles of Bank of America suggest that a test may be coming soon. If Dodd-Frank works as advertised, BofA’s pending failure should not cost the public a cent – and that certainly is good news, is it not?
To assess this core claim of Dodd-Frank, let us contemplate the specifics of the process that will — we have been told — successfully identify, take over, and resolve large systemically important financial institutions before they fail. To reiterate, we have been told that firms fitting this description can and will be taken over before they are insolvent, and especially before the problem becomes a charge on the public purse. As this process is best understood by an example, let us begin by supposing that one of the nation’s largest systemically important bank holding companies (BHC) is in trouble (although it could be any financial institution designated previously as systemically important). Let us further suppose that this BHC – as so many do — relies upon short-term borrowing in the markets to support a highly-leveraged portfolio of speculative, risky, and now-troubled assets. To keep it real, let us suppose that few of these assets can be traded and thereby “priced” in open or competitive markets. It is, of course, unnecessary to point out that when traders and senior managers put together these deals they greatly enriched themselves. But, they have long since cashed their bonus checks, so the problem now belongs to the bank – and potentially the public.
Today, the BHC’s stock price is falling, credit default swap premiums on its assets and the debt it issues are rising, and counter-parties are demanding ever-greater collateral to provide short-term financing. Many money-managers who have had long-standing lending relationships with this bank are refusing to provide further financing at any price, and large clients are beginning to withdraw their funds and move their accounts. Stated bluntly, the future of this firm is bleak and the situation is worsening at an accelerating pace.
What happens now? The bank’s first defense is — as always — a flat-out denial that they are in trouble. But such protests are unlikely to convince its peers, big-time money managers, or other savvy counter-parties or players. In the nineteenth century, it used to be said that if a lady had to publically defend her reputation, it was too late. Times may have changed in these matters, but for financial institutions this old adage remains true. A need to publically proclaim its solvency can — and should — be taken as prima facie evidence that a bank either is, or is about to be, insolvent. Let us, then, suppose that the situation continues to worsen for our hypothetical firm.
The bank’s second step is to highlight its internal audit, along with the clean bill of health it has received from its highly reputable outside accountants and lawyers. Wall Street will not be convinced. Why? Because they know that these audits are readily and routinely rigged through “creative accounting.” To illustrate this point, I have my classes guess how many quarterly earnings statements showed losses at New Century Financial before its massive collapse in March 2007. The answer, dear reader, is zero. The process by which one goes from being a high-flying and highly-profitable darling of financial innovation to catastrophic bankruptcy without ever passing through an unprofitable quarter is, I will submit, “complicated.” Indeed, the SEC also thought that it was “complicated” and brought a suit. Unfortunately, this suit was settled for essentially a pittance – a “lesson” not lost on other Wall Street players and those who are obliged to interact with them. Least this case be considered a singular event, I remind them that S&P gave Lehman Brothers an “A” rating until weeks before its collapse. Similar examples abound throughout this and earlier crises.
Third, an upsurge of campaign “donations” from the troubled BHC will ensure that at a substantial portion – if not a majority — of Congresspersons will avidly assent to the firm’s own assessment of its condition and prospects (Let us note that if it is indeed insolvent, these donations and other lobbying and public relations expenses are de facto additions to the federal debt). Although the reasoning and arguments then presented to the public by these august tribunes of the people might be embarrassingly shallow, we can be sure that they will lean on the political appointees heading the regulatory agencies to take “a broad interpretation” of the situation. Simultaneously, the bank’s senior compliance and legal advisors, who in all likelihood are former senior staff at the regulatory agencies to which it answers, will contact their old colleagues to argue and reargue the bank’s version of its financial condition. They will emphasize its singularly sunny prospects for future success.
Let me digress by observing that it will not escape the attention of those who staff the government’s regulatory agencies that their former colleagues have moved into substantially higher tax brackets and much tonier neighborhoods. To that end, perhaps we should allow our regulators to indulge in a moment of wistfulness. After all, in the aftermath of such reunions it is only human to feel somewhat conscious of one’s own comparably modest socio-economic status. If our public servants are at all like most people, they might pause to consider a career move… But such ruminations are beside the point. Or are they?
Let us suppose that our regulators remain stalwart, undaunted, resolute, and unmoved by such considerations. They are good people, professionals who readily eschew fantastic opportunities to remain faithful public servants. Nevertheless, as a consequence of the bank’s previous moves, Congress is in an uproar, the White House is worried, and Wall Street has closed ranks behind the bank (the latter are sufficiently intertwined with its fortunes that they stand to take large losses). Outside of the halls of power, think-tank “experts,” television “opinion leaders,” newspaper reporters, and editorialists are running unfavorable stories about the supposed “anti-market” bias of regulators, etc. Meanwhile, the regulators, if they are doing their job properly, are not conducting interviews or discussing the story with the media. Consequently, their side of the story – and only they have access to the bank’s balance sheet – is underrepresented in the press. Moreover, those few newspapers running stories that suggest that the bank’s problems may be real will be accused of being irresponsible or anti-business. They may even have been – quietly — threatened with lawsuits claiming libel. We should recall that even spurious lawsuits can be expensive for most daily or weekly newspapers.
As the disinformation campaign moves into high gear, the regulators must get the Board of Directors of the FDIC to vote that this bank is on the brink of collapse and for that reason should be taken over quickly, before it becomes insolvent and thereby a public charge. This Board, let us recollect, is made up of three permanent members serving six year terms in addition to the head of the Office of the Comptroller of the Currency and the head of the Office of Thrift Supervision, who both serve in ex officio status. All of them are appointed by the President with Senate approval and no more than three of the five of them may be from the same political party. Stated simply, the Board may represent a variety of views, but we can be confident that the largest financial institutions have had an opportunity to carefully vet all of the participants in the discussion. After all, few administrations or senators have the stomach to fight the nation’s most powerful industry over what — to the public — may appear to be relatively obscure bureaucratic appointments. However, to give credit where it is due, over the last five years the FDIC is one of the few agencies to have shown some life in regulatory matters. One reason may be the personalities involved. Another may be that it is their funds that are used to cover depositors’ accounts and, for that reason, they are the agency left “holding the bag” in the event of a catastrophic failure.
Supposing that the FDIC has decided that this bank must be resolved, the next to vote is the Federal Stability Oversight Council (FSOC). This group is Chaired by the Secretary of the Treasury and its nine other voting members include the Chairman of the Federal Reserve Board, the Chair of the Commodity Futures Trading Corporation, the Comptroller of the Currency, the Chair of the Securities and Exchange Commission, etc. Each and every one of these individuals took their positions only after a Presidential appointment and a Senate hearing. Once again, banker views were fully present and accounted for. In short, these are people known in Wall Street/D.C. circles for their “sound views” — that is to say long-standing sympathy toward politically prominent banks, bankers, and related financial institutions. In many if not most instances, they were themselves formerly bankers or worked in law or accounting firms catering to the financial sector. This characterization also describes the bulk of their deputies. The final step is to formerly notify and advise the President of the FSOC’s decision. While lawyers and others who have examined Frank-Dodd have not agreed as to whether the President has the authority to override a vote of the FSOC, it is difficult to imagine that these several senior appointees would have allowed the process to advance this far without White House approval.
Now, let us recall that all of the above will occur as the large financial institution in question is in the throes of a rapid and accelerating downward spiral – yet it is supposed to be completed even as the firm remains – if just barely – solvent. While the Feds might try to keep their deliberations a secret, it is hard to imagine that financial markets will long remain in the dark about them. For that reason, the bank in question will find that it must post ever-greater collateral to retain the short-term financing it requires to operate. Credit Default Swaps will soar, ratings agencies might decide to (belatedly) issue a downgrade on the firm’s debt, and the bank will struggle to place its commercial paper or otherwise raise funds. Consequently, it will become increasingly dependent upon the Fed’s Discount Lending facility, which means that that latter institution stands to be even more embarrassed by the pending failure, and for that reason inclined to postpone the resolution of this bank.
Since the passage of Dodd-Frank a year ago, I have attended multiple conferences in a variety of locations in the United States and Canada. At each of them, I have informally polled a range of colleagues studying monetary and financial economics to find out if they believed that the above process has any chance of working as described. I specifically ask them if they believe that the FDIC and FSOC could (1) identify a pending failure some time before it becomes insolvent, and then (2) organize the regulatory and political will to take over a massive, interconnected, and politically powerful institution, and (3) navigate the process of arriving at a decision in a time frame sufficiently short to avoid a massive run on the institution, a run that could readily spread to similar institutions and to those firms dependent upon them. Let us recall that the prevention of just such a run is the primary task of financial regulation. To date, I have not found a single individual who believes that it will work.
For myself, I will continue to accept the view of Vermont Senator Bernie Sanders (I-VT), that “If an institution is too big to fail, it is too big to exist.” Despite what we were told, alternatives to Frank-Dodd do, and did, exist. For example, on November 6th 2009, Senator Sanders introduced legislation that would give the Secretary of the Treasury 90 days to report to the Senate with a list of commercial banks, investment banks, hedge funds, insurance companies, and other financial institutions that were “Too Big To Fail” (TBTF). The Secretary would then be granted a year from the date of that report to break them up. Sanders’ bill was not taken up.
Later, Senators Sharrod Brown (D-OH) and Ted Kaufman (D-DE) actually got a bill called the SAFE Banking Act of 2010 to the Senate floor. It would have imposed binding leverage and liability limits on bank holding companies and financial institutions, thereby effectively breaking up the largest of them. This bill was opposed by most Republicans and leading Senate Democrats (including Senators C. Dodd (CT), D. Feinstein (CA), J. Kerry, and both Senators from New York and New Jersey). The White House and the Treasury Department were also opposed. Unsurprisingly, it failed by a vote of 61-33 on June 17th, 2010 despite attracting the support of three Republicans. Senator Judd Gregg (R-NH), whose “centrist” views had once moved the Obama Administration to nominate him for Secretary of Commerce, summarized the sentiments of those voting against this act, “I don’t understand this Brown-Kaufman Amendment. Basically, what it says is if you’re successful … you’re going to break them up? I mean, where does this stop?”
Alternatives to Frank-Dodd’s cumbersome resolution authority clearly exist, and continue to exist. The key is prevention – do not allow individual banks to become so large or so leveraged as to threaten the system (while the system itself can be a source of risk, that is a separate issue). The problem was and remains a lack of political will on the part of both political parties. On the matter of Too Big To Fail, Occupy Wall Street and the broader American public are themselves asking, “Where does this stop?” Good question, maybe the Senator from New Hampshire, one of his colleagues from the Democratic Party, or someone from the Treasury or the White House will deign to let us know.
Robert E. Prasch is Professor of Economics at Middlebury College where he teaches courses on Monetary Theory and Policy, Macroeconomics, the History of Economic Thought, and American Economic History. His latest book is How Markets Work: Supply, Demand and the ‘Real World’ (Edward Elgar, 2008).