Wayne M. O’Leary

Subprime Meltdown: The Players

The emerging contours of the mortgage-driven financial crisis of 2007-08 are only now becoming clear. They include: a nationwide drop in house values of 25%, property foreclosures approaching 3 million, negative home equity affecting 15 to 20 million homeowners, bank mortgage-lending losses in the multiple billions of dollars, overall investment losses to American financial firms of anywhere from $300 to $500 billion, and an associated recession that will lead to who knows where in terms of business bankruptcies and job losses.

Since none of this was brought about by Osama bin Laden or the tooth fairy, it may be useful to try tracking down the actual culprits, if only as a cautionary lesson for future times. Sadly, one causal agent was the collective American public, more particularly those members of it who hitched their dream wagons to the elusive notion of having it all. Mortgage lenders dangled the bait of cheap mortgages with no money up front to millions of unwary first-time buyers who had no business being in the housing market. Unsurprisingly, given the cultural imperative of homeownership, the selected quarry went for the lure of immediate gratification and were hooked on adjustable-rate mortgages (ARMs); they could have waited and saved, but that’s not the American way.

This first step in the downward spiral was encouraged by people in the highest reaches of government, who should have known better. They are actually more responsible because they are policymakers with presumably superior knowledge and understanding of how the economy actually works. In the case of the Bush administration, which is where the ball started rolling, expanded homeownership was a longstanding article of faith based partly on conservative ideology and partly on pure politics.

The ideological aspect (the “ownership society”) incorporated the belief that homeowners are natural conservatives with a vested interest in stable respectability and sober stakeholder values; renters, by contrast, are footloose and unreliable ne’er-do-wells lacking sufficient commitment to the socioeconomic status quo. This belief tied in with practical politics. As Margaret Thatcher established in Great Britain when she transitioned habitually Labourite public-housing residents into owners of their former rental flats, identification with the “propertied class” often produced Conservative voting behavior. Swelling US homeownership from a static 65% of householders to, say, 69%—exactly what took place after 2000, adding 12 million new mortgage holders—would, so the theory went, similarly increase the Republican vote.

The whirlwind swirling around us derives from far more than a GOP desire to change working-class voters into right-thinking members of the petty bourgeoisie, however. In any case, the president’s detached, Katrina-like response to the travails of marginal homeowners facing foreclosure shows that to be a subsidiary concern. Far more important in the larger scheme of things is the economic welfare of the financial-services industry and its big-time political contributors, which is why this administration, and the one before it, allowed American bankers to do the things that exacerbated the housing calamity, taking it from a manageable home-mortgage problem to an investment crisis having the potential to bring down the entire financial system and with it the economy as a whole.

The critical role of America’s financial institutions in this greatest internal economic threat of the postwar period arose, in the first instance, from their radically expanded share of the nation’s economy, which resulted from two pieces of federal deregulatory legislation authorized by the Clinton administration. The Riegle-Neal Act of 1994 legalized interstate banking; the Gramm- Leach-Bliley Act of 1999 removed the barriers between traditional banks, brokerage firms and insurance companies. Together, these statutes stimulated a wave of mergers and created the huge, diversified financial-services conglomerates (Citigroup, Bank of America, J.P. Morgan Chase, et al.) that, by 2007, accounted for 40% of total US corporate profits and 19% of all stock-market value.

Suddenly, everyone was dangerously engaged in everyone else’s financial business. The separation between retail banking and investment banking, established by New Deal regulators, disappeared. Erstwhile commercial banks were no longer just taking deposits and making loans; they were now buying and selling stocks, trading in securities, marketing insurance, processing credit cards, managing business assets, arranging mergers, and overseeing corporate acquisitions. And they were no longer modest intrastate operations, but among the largest corporate entities in the country—in fact, in the world. By 2006, just 10 banks controlled half of all US banking assets. One of them, Citigroup, had offices in 106 countries.

Unfortunately, size has proven no guarantee against disaster; the reverse has actually been the case. With excessive bigness in banking come diseconomies of scale. One hand doesn’t know what the other is doing, so that concealed risks are neglected and internal controls fail. When Citigroup shocked the financial world by admitting to $55 billion worth of suprime-mortgage securities exposure, leading to $11 billion in losses last year, fabled board chairman and former CEO Robert Rubin (who helped push through bank deregulation as Clinton Treasury secretary in the 1990s) could offer only the lame excuse that the problem was outside his area of designated responsibility. Meanwhile, his company (with capital equal to 1% of American GDP) had become too big to fail, or “tbtf” in the jargon of the professionals, making it the taxpayers’ ultimate responsibility.

The worst offenders were not the former commercial banks, however, but the investment banks, whose traditional role has been making business loans at interest, underwriting (or insuring) corporate debt, acting as asset managers and stock brokerages, and advising on mergers and acquisitions, mostly on a commission basis. In the new deregulatory environment, these staid institutions, such as Lehman Brothers, Merrill Lynch, and Bear Stearns, became gambling dens, setting aside their fee businesses in favor of massive trading in risk-laden securities, especially the esoteric credit derivatives and securitized loans called CDOs (collateralized debt obligations), which included packaged subprime mortgages. For some leading investment banks on Wall Street, it shortly accounted for two-thirds or more of their net revenues.

The corporate bankers were, in effect, trading in debt, usually with high-flying private-equity and hedge funds. Worse, they were doing it with borrowed money, speculating on margin by leveraging themselves at loan-to-capital-asset ratios of up to 35 to one. It had to end badly, and it did.

[This is the first of two parts. See the second part here.]

Wayne O’Leary is a writer in Orono, Maine, the author of two books.

From The Progressive Populist, June 15, 2008

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