2 – TROUBLE, WE GOT TROUBLE
It is impossible for those who profess to understand economics and government to escape the charge of knowing nothing whatever of these subjects so long as poverty and unemployment exist in an age of brilliant scientific achievement.– Frederick Soddy [1]
I once read that no one is actually responsible for the Wall Street meltdown of 2007-2008. Some Wall Streeters may have been especially greedy but most of those in banking and finance were just doing their jobs, trying to get ahead, looking for the best deal and trying to make a living in difficult times. How could you blame them?
Homebuyers were offered terrific financing deals and jumped at the chance. Now they could own instead of rent and stop pouring money down a rat hole. Brokers who sold the adjustable-rate mortgages made their quotas, commissions, and bonuses for the month. Bankers couldn’t get enough of those liar-loan mortgages. They sold them for good profits to New York, who was always screaming for more of them. The big money-center banks took thousands of little mortgages, good and bad, sliced them up, and packed them into mortgage-backed bonds. These were sold at a markup to other big banks, investors, pension funds and foreign governments wanting sizeable returns with low risk, safe as houses. All of this was to everyone’s advantage. They were getting what they wanted. It was win-win, up and down the line. It was a textbook case of the free market at work. The self-interest of each participant was focused on concluding the sale. Once done, it was “I’ve got mine, Jack,” and the hot potato was passed onward. What could possibly go wrong?
The story of capitalism is not just one of climbing up a mountain in triumph. Remember those little blips on the ever rising curve? They were not so little to those that lived through them. There were really big headaches every generation or so. The depressions of the 1870s and early 1900s in America are now beyond living memory but the 1930s are not, not quite yet. In 2008 we were again fortunate to be living in interesting times. The tremors started in August of 2007 and the bottom fell out in September, 2008. On Wall Street, the Lehman Brothers and Bear Stearns brokerages collapsed and some banks went under. Washington Mutual bank in Seattle, Wachovia bank in South Carolina and Colonial bank in Alabama all disappeared, gone bust because they held so-called toxic assets: unsaleable mortgage-backed securities. Solomon Brothers and Goldman Sachs on Wall Street reorganized themselves into bank holding companies in order to draw on the Federal Reserve’s emergency lending powers.
The crash in 2008 was not as big as that of October, 1929, but bank lending essentially stopped. There were no new mortgages issued, no commercial paper, and finally no overnight inter-bank lending. Corporations were squeezed to meet payrolls. Everyone held their breath. Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke met with Congressional leaders and demanded an overnight $900 billion emergency funding bill or else the banking system of the nation, and likely the rest of the world, would collapse. They proposed to buy toxic assets from the banks to free them of the paralyzing fear of lending to other banks which might be going broke; fear of getting any loans repaid. Congress labored and brought forth a $790 billion Troubled Asset Relief Program, or TARP, but it was not carried out because the toxic assets couldn’t be valued. The banks wanted full book prices for them but their real prices were unknown since there was no longer a market for them. Besides, the bad mortgage securities were only a part of the problem. Credit-default swaps had been sold against them which added up to far more than the securities’ values. So Paulson & Bernanke went to Plan B – they gave cash to the banks, adding to their reserves to keep them from going broke. They forced all banks to take money from TARP so that none of them would be singled out as being troubled.
There was tremendous public outrage. The banks that had caused the mess were now being rewarded for their bad behavior. Some that didn’t need money to stay afloat confirmed the public’s worst perceptions by paying huge year-end bonuses to their management or by buying up smaller banks with TARP funds. That doomed any chance for more public funds no matter how desperate the need.
The credit-default swap problem was bottled up by nationalizing the AIG insurance company which held many of them. The Fed put another $180 billion into it. But the toxic mortgage-backed securities and credit-default swaps were still out there, held by banks and investors around the world. There was no central registration of who held what. They were hidden like land mines. Banks everywhere were reluctant to make any substantial loans, not knowing who was about to fail or be taken over by their governments. This loan strangulation was much improved when Congress relaxed the accounting requirements for problem loans by allowing U.S. banks to carry them at book value rather than market value. This was immediately dubbed “mark to model” instead of “mark to market.” There was no such relief for homeowners who desperately needed their mortgages marked to model too.
The story is incredible, unbelievable, but true.
Some new home mortgages started to become available in 2010. Perhaps lending remained slow because there were more shoes to drop. Maybe the banks knew something we didn’t know. What could it be? Some said another flood of foreclosures was coming. Maybe there were more asset-backed securities based on commercial properties or credit cards. Auto loans might start to default and force another cascade of bank failures. But there was no sign of such things. Bank lending was anemic because demand was poor. Businesses held onto cash, layoffs continued, and consumer sentiment was in the dump. Investors knew it was better to buy something at the bottom rather the top, but perhaps it wasn’t yet the bottom.
An article in The Economist magazine pointed out that this behavior by both banks and consumers was an example of extreme Liquidity Preference, as Keynes would have put it. I could understand why consumers were scared; many had lost their jobs and more were afraid of losing them. So why were banks still acting terrified? I could only make some guesses. First, many of them were nearer to failure than we realized. A misstep might finish them off. Rumors told them that other banks could be close to the edge too. Would you lend to someone who might be about to go belly-up?
Second, the economy might not have completed its crash. Unemployment was still high. The official unemployment figure (U3) was at 9.4 percent but the more inclusive index (U6), which included discouraged workers, was at 16 to 18 percent. Jobs were being lost at a rate of about 500,000 per month during the first quarter of 2009, slowing to about 230,000 per month in July. That was better, but far from a 150,000 monthly job gain needed to keep up with population growth and to keep unemployment from getting worse. Businesses would start to hire again only when demand returned and inventories were depleted. People were scared into saving, not spending, and certainly not splurging with credit. Demand was slow to return and employment was slow to recover. Inventories were a problem until 2012. We could have been in for a “lost decade” as happened in Japan, when its banks carried bad real estate loans and could not write them off without going out of business.
Wall Street fought Washington over regulation reform. Fed Chairman Bernanke publicly stated he would push for “no more of too-big-to-fail.” He wanted a Federal agency empowered to take over financial companies, not just banks, that were about to fail; pay off their creditors, sell their assets and clean up the mess with taxpayer money if needed. It would be paid for by fees on all financial transactions and modeled on the way the FDIC handled failed banks. The idea was to prevent the failure of a large financial firm from bringing down others like dominoes. Bernanke’s difficulties were immense because of the vested interests opposing him and of international complications. He did not get what he wanted; he got the Dodd-Frank Financial Reform Act of 2010, a complicated stitch-up that only a Congressional committee could love.
By 2014 the signals were still mixed. Indicators showed that we were past the bottom and a recovery was happening. It was to be expected that lagging indicators like unemployment and consumer sentiment should still be bad, and they were. The recovery was more slow and dragged out than predicted. But lagging indices rule the roost in politics because they show how badly people are hurting.
This Great Recession, according to the economists and pundits, amounted to “only” a 3.6 percent contraction, not much deeper than those in the 1970s (3.1%) and the early 1980s (2.9%). We reached the bottom, turned the corner as they say, and were well into recovery by 2010. The leading indicators were present: the stock market was rising, industrial orders and home purchases were up. Green shoots were everywhere. No sir, this was not your granddaddy’s depression at all, but a bad recession and a good recovery. Yet there was more to think about. There were losses in stock portfolios, but previous downturns didn’t force General Motors and Chrysler into bankruptcy. Those earlier recessions did not cause house prices to fall by 25 percent or more and cause losses of 40 percent in some retirement accounts. Those were not just ‘losses,’ they were body blows. The effects on ordinary people were terrible. When people lost their jobs they often lost their pensions and medical coverage, if any, and sometimes lost their homes with the equity they had built up. They could also expect to pay rent for years to come because banks wouldn’t lend to those who had defaulted on a mortgage. Prospects of getting new jobs at similar wages were poor. And, employers did not provide defined-benefit pensions any more. Even if they had, new employees would take years to become vested. How about medical insurance? It could be bought on the open market if one had no pre-existing conditions or age limitations. It would cost an arm and a leg because one would no longer be a group member. In a bad recession you only lose money. Without money, a job, and your house being foreclosed, you really get behind the eight-ball.
Many were badly hurt by the crash but a few hit the jackpot, in the weirdest way. Michael Lewis tells in his book The Big Short [2] about how some saw the crash coming, shorted the market, and made lots of money while everyone else lost. A few individuals realized that the sub-prime mortgage market was headed for a disaster. The loans being issued could be repaid only if house prices continued to rise. Mortgage lenders were beginning to issue interest-only and Ninja loans, (no income, no job, no assets), scraping the bottom of the barrel. So, the market had to be reaching a top. These individuals bet against the sub-prime market by using credit default swaps, which were hard to get because insurers and brokers thought they were crazy. Their business associates thought they’d totally lost it.
Lewis described the thoughts of one of them. “Finance people are not dummies, they must see this. It’s really obvious. Everyone is buying and selling these mortgages, repackaging and reselling them, but when it all stops anyone holding them is going to lose their shirts! Are all these people deluded or are they crooks?” Afterward it was seen that they were mostly deluded. They had either followed the trend or had simply not thought about it at all. Some banks had kept those poisonous mortgage securities in their own portfolios for their high yield and were now insolvent. Goldman Sachs had held the stuff only to sell to others. Even Goldman was teetering on the edge.
Lewis said these few people were the sane among the insane. They were right but it was very hard on them. They had doubts. They developed health problems. Some were shunned by their co-workers. Literally everyone was against them. Authority figures like Fed Chairman Alan Greenspan had said everything was fine. The CEOs of monster banks regularly soothed us. It seemed to be a nationwide case of groupthink. During a mania, the pressure is to partake: “How can you afford not to get in on this; don’t be dumb!” Instead they were ostracized. They were bank robbers! So many people had lost so much money.
Capitalism, which had miraculously done so much good and lifted living standards for so many people in so short a time, had also brought spells of devastation. They were like plagues of locusts that ate the crops. Why was this? No one knew. They just had to be endured like hurricanes and earthquakes.
A side note: [3] L. Frank Baum’s 1900 novel The Wizard of Oz was written in a period of panic and labor strife – twenty people were killed in the Pullman Car Company strike. In Baum’s novel, the yellow brick road and Dorothy’s silver slippers were metaphors for the gold standard and the free coinage of silver. The munchkins represented the poor working class, the wicked witch stood for the business interests, and the wizard was that great deceiver, the President of the U.S.