Wayne O’Leary

A Tale of Two Banks

The last several weeks have provided an instructive lesson in how different political systems are dealing with the rolling worldwide financial crisis brought about by the subprime-mortgage mess. Americans tend to think of this latest breakdown of global capitalism as strictly a domestic affair, but it’s not. Because we are the world’s biggest economic player, the problem is most pronounced here, but it’s not our exclusive property.

American lenders invented the subprime mortgage, the loaning of money at variable interest to home buyers not really capable of paying it back once initially low “teaser” rates were adjusted upward; Europeans (particularly the British) eagerly copied it. Simultaneously, Wall Street investment bankers developed the concept of bundling such mortgages together as marketable securities and selling them to investors, including those in foreign countries; this harebrained scheme was likewise adopted abroad, again most avidly by free-market Britons. The combination of greed and stupidity thereby went global, accompanied by diminished government oversight. Now, a decade of financial deregulation has come back to bite the world’s collective backside.

Placing shaky home mortgages in the financial market and allowing them to be bought and sold by institutional investors (called “debt securitization”) was a genuinely bad idea whose time had regrettably come by the new millennium; it freed bankers of responsibility for their loan policies. Who cared if the mortgagee couldn’t pay back? The bank no longer held the loan, which was now part of a securities package residing in New York, London, or Berlin at some private-equity fund, brokerage house, or investment bank; it was, in fact, no longer a mortgage, but an exotic credit instrument—a collateralized debt obligation, or CDO, to the cognoscenti.

Meanwhile, those taking out subprime mortgages, encouraged by Bush administration hosannas to the “ownership society,” by blind belief in the American Dream, and by the empty reassurances of business-seeking lenders, dug themselves bottomless financial holes. They assumed (and were told) that home values would keep increasing until the end of time; house prices had, after all, risen every year from 1960 to 2000. Compounded equity would not only cover payment of upwardly ratcheted adjustable-rate mortgages, but would provide ample credit for the miscellaneous borrowing upon which the American economy had become dependent.

Unfortunately for borrowers and lenders alike, the housing bubble of skyrocketing home prices, which began around 2001-02, was punctured just as record numbers of new mortgagees, many with scant resources, entered the market. Excess dwelling capacity created by speculative overbuilding and foreclosures on subprime borrowers turned positive equity into negative equity. Houses were increasingly worth less than their purchase prices, and those holding mortgage-backed securities as investments saw the value of those securitized mortgages plummet. Suddenly frightened, lending institutions retrenched, putting the international economy in a stall.

What has formed since 2006 is a financial perfect storm: foreclosed homeowners, banking institutions fearful of lending money, corporate entities verging on bankruptcy, and an unfolding recession proceeding from the credit markets to real estate, construction, and beyond. It’s the ultimate cautionary tale of unregulated capitalism. In the US, the reaction to a financial emergency that could morph into a systemwide economic collapse mirroring 1929 has been typical of what one would expect from a conservative Republican administration. The knee-jerk response, implemented by the Federal Reserve Board under the chairmanship of Ben Bernanke, has been to lower interest rates—not once, but again and again and again—in a vain attempt to stimulate investment through business borrowing and, more immediately, reduce mortgage costs.

Since the conservative era began in the 1980s, monetary policy (chiefly the manipulation of interest rates by the Federal Reserve) has been virtually the federal government’s sole answer (tax cuts aside) to problems in the economy—to the point where it’s forgotten all other remedies, such as public spending. The one-note policy hasn’t worked. Still, the Fed persists, convinced its efforts to save large banks and other megabusinesses that made bad decisions and to artificially prop up the stock market (the be-all and end-all) constitute its sole economic responsibilities. In the process, millions of people on fixed incomes, who rely on stable savings interest to survive, are being sacrificed for the greater good of the market system.

The ultimate arrow in Washington’s quiver, the one it uses as a last resort, is the bailout. This is usually preceded by the private rescue package, such as the one negotiated in December between Treasury Department officials, mortgage lenders, and holders of mortgage-backed securities seeking to stabilize the credit market and provide debt relief to homeowners by voluntarily freezing some (but not all) subprime adjustable-rate mortgages. A half-million borrowers, the most severely imperiled, were left out. Too bad.

The true bailout, the direct use of public funds to save businesses, not individual consumers, is reserved for corporate entities large enough to threaten Wall Street’s equanimity. The latest example transpired in March with the takeover of prostrate investment bank Bear Stearns by a larger competitor, J. P. Morgan Chase & Co., using federal funds. On the verge of bankruptcy because of overexposure to chancy mortgage-backed investments, Bear Stearns was saved with a $29 billion Federal Reserve guarantee of its mortgage liabilities—essentially employing taxpayer money to free purchaser J. P. Morgan from any potential financial loss.

That’s been the American way: using the public Treasury to compensate for corporate mismanagement, effectively rewarding bad behavior. Faced in February with a similar problem afflicting Britain’s fifth-largest mortgage lender, however, the Labour government of Gordon Brown took a different approach. It simply nationalized the bank in question (Northern Rock), the first such nationalization in a generation, but one strongly supported by the British public as the best available alternative to either bankruptcy or a taxpayer bailout.

Assuming that the bogeyman of public ownership remains off the table in Washington, firm government action is nevertheless needed. Paul A. Volcker, respected former Fed chairman (1979-87), has called for thoroughgoing regulation of our freewheeling investment-banking sector, given the world’s complex new financial structure. Self-regulation and desperate Federal Reserve interest-rate cuts, he correctly observes, are proven failures. It goes without saying that major bank re-regulation, including especially the outlawing of CDOs, should be high on the list of priorities for any incoming Democratic administration in 2009.

Wayne O’Leary is a writer in Orono, Maine, specializing in political economy. He holds a doctorate in American history and is the author of two prizewinning books.

From The Progressive Populist, May 15, 2008

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