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Monday, March 17, 2008

Howto: Financial Meltdown!

posted by on March 17 at 14:18 PM

Kenneth Rogoff, the former chief economist at the IMF and now a professor at Harvard University, said the greenback may drop another 12 percent on a trade-weighted basis.“This recession will be long and deep and when we get out of it, we’ll have inflation,”

How did this happen? This stick-figure cartoons sorts it out for you. The short of it? “Really smart guys” at financial services companies figured out a legal (but ethically dubious) means of recycling crappy mortgages into something resembling actual investments. How did they get it past the audits, the financial controls, the rating agencies? Well, it’s easier when they’re all the same few companies, each profiting from the bigger lie.

Why is this legal? It didn’t use to be. In the aftermath of the Great Depression, regulations were written into law specifically to prevent this sort of Ponzi scheme from occurring again, like the Glass-Steagall Act of 1933. It worked, until the laws were written out of existence in the late 90’s. In a great triumph of conservative economic theory, the laws, protections and regulations were evaporated, leading to an orgy of mergers resulting in the flailing financial service monsters of today.

Not every economist was happy about this turn of events.

Twenty-five years ago, when most economists were extolling the virtues of financial deregulation and innovation, a maverick named Hyman P. Minsky maintained a more negative view of Wall Street; in fact, he noted that bankers, traders, and other financiers periodically played the role of arsonists, setting the entire economy ablaze. Wall Street encouraged businesses and individuals to take on too much risk, he believed, generating ruinous boom-and-bust cycles. The only way to break this pattern was for the government to step in and regulate the moneymen.

You might think that the best solution is to prevent manias from developing at all, but that requires vigilance. Since the nineteen-eighties, Congress and the executive branch have been conspiring to weaken federal supervision of Wall Street. Perhaps the most fateful step came when, during the Clinton Administration, Greenspan and Robert Rubin, then the Treasury Secretary, championed the abolition of the Glass-Steagall Act of 1933, which was meant to prevent a recurrence of the rampant speculation that preceded the Depression.

As pleasant as it would be to lay the current financial crisis entirely at Bush’s feet, a significant amount of the blame should go to Rubin and Clinton. Signing the (now clearly disastrous) Gramm-Leach-Bliley Act in November of 1999—dismantling most of the Depression-era protections—was a classic bit of Clintonian triangularization, a gigantic sop to Wall street firms at the expense of Bill’s base of liberal and working class supporters. What could they do? Who could the people hurt by this act vote for? Nader? Let the checks from the financial services industry roll in!

Some might call this experience that matters.

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And you, and me, and every other John Q. Taxpayer gets to clean up the mess. The financiers are all for deregulation while the money's flowing but suddenly embrace socialism when the losses mount.

BTW: where are the indictments, the perp walks? This is Enron times 1000, where are the disgorgements? Who's going to prison for this one?

Posted by Westside forever | March 17, 2008 2:37 PM

Fuck prison, I want my pound of flesh. And I'll take whatever blood comes with it.

Posted by Greg | March 17, 2008 2:42 PM

The government that cedes away supervision at the whims of the republic deserves every bit of pain that it has coming to it.

I was against the repeal of glass-steagall for the provisions regarding the bank holding companies owning many different financial companies. There is no good reason that a commercial bank that conducts integral operations to the government or market should be allowed to gain the kind of exposure that would endanger the function of those operations.

Posted by Bellevue Ave | March 17, 2008 2:48 PM

I think that two disastrously expensive and unnecessary wars financed by both credit and printing way too much money helped augment the mess quite a bit, don't you think?

Posted by Catalina Vel-DuRay | March 17, 2008 2:55 PM

Catalina, Bush was how responsible for credit expansion and approving the spending on two wars?

Give some credit where credit is due; the republic and the voters who elect people to it.

Posted by Bellevue Ave | March 17, 2008 2:58 PM

Bellevue Ave, again, wins my heart. This guy gets it. *swoon*!

Posted by swoony mcloverson | March 17, 2008 3:13 PM

Actually, the repeal of Glass-Steagall had virtually nothing to do with our current mess. There is still a fair amount of separation between commercial lending and underwriting. (After all, Bear Stearns wasn't in the commercial banking business, and none of the slides in this admirably accurate explanation includes "Hey, investment banker, let's shove these worthless securities down the throats of our unwitting commercial banking depositary customers.")

That's not to say that the markets couldn't use some additional regulatory oversight, just as the accountants had to be cracked down on when they turned a blind eye to Enron-style practices.

The more likely cause was lenders who weren't used to subprime customers extending credit to them. Once high-risk mortgages were permitted into the low-risk mortgage finance system, no one knew how to put a value on any mortgage-backed securities. When no one can value them, no one wants to buy them, which means that even though they have some intrinsic value (because the great majority of mortgages are being paid on in a timely manner), their effective market value is zero, which really wreaks havoc on a financial institution's balance sheet.

Posted by Wall Street | March 17, 2008 3:16 PM

You know, if we just hunted down the CEOs and offed them, it would save a lot of taxpayer dollars ...

Posted by Will in Seattle | March 17, 2008 3:33 PM

Wall Street--

You're absolutely right about Glass-Steagall not having much to do with the unraveling of Bear Stearns.

But perhaps you can grant me that the abuse of the underwriting and rating systems--all aided by the unraveling of the regulatory apparatus since 1980--have lead to a generalized lack of confidence in the US economy and financial institutions.

I think it's also clear that this is about more than the valuation of subprime mortgage backed securities. Investors depositing into commercial paper are starting to think "dear god, perhaps my (far more conflicted bank than Bear Stearns) shoved my deposits into worthless securities. If this crap was called investment grade, what is my 'investment grade' deposit worth now?" The answer, as you've noted, is effectively zero.

Posted by Jonathan Golob | March 17, 2008 4:05 PM

Bellevue, dear - a careful re-reading of my original post would reveal no reference to President Bush. It's projection on your part.

But now that you mention it....

Posted by Catalina Vel-DuRay | March 17, 2008 4:06 PM

You'd still be blaming the wrong person or people, Catalina.

Golob, you can't say that deregulation is the reason that confidence has been lost in the U.S since the 1980s. are other economies not developing, are there not better places to put money, are there not more options now? Yes, the U.S. might not be as safe as a place to put money (but part of the reason we experienced a bubble in the late 90s was a flight to safety from asia)but there are so many more places now to put money that are relatively safe and that are growing gangbusters.

Posted by Bellevue Ave | March 17, 2008 4:12 PM

Bellevue Ave,

The crisis right now isn't over investors seeking out higher or better returns--investors willing to tolerate the risk "relatively safe" places that are growing gangbusters. Rather, it's investors seeking a safe, stable and reliable place to have money sit. Such investors want no doubt, not a little doubt--want safe, not relatively safe.

Until very recently, investment grade, dollar denominated financial products fit the bill. Just like the corrupt Chinese manufacturers stuffing "food" full of melamine and calling it protein, corrupt bankers called crappy securities investments and cast doubt over everything else (many of which are legit securities) with the same rating. Hence the current crisis.

Posted by Jonathan Golob | March 17, 2008 4:23 PM

Thank you, Bellevue. It's always good to know when you are blaming the wrong people, even when you are blaming the right people. It's also nice to know that some people never lose their faith in their ideologies. You get a gold star for keeping the faith.

Posted by Catalina Vel-DuRay | March 17, 2008 4:25 PM

Jonathan, you're right. I thought you meant overall investment level and the reasons for investing.

Ctalina, So because I wont lay the blame on a political enemy of yours I am keeping the faith? I dont like bush, never voted for bush and think that his presidency has been a disaster, but this can hardly be blamed on bush, without blaming those that enabled bush.

Posted by Bellevue Ave | March 17, 2008 4:52 PM

A political enemy of mine? Moi?

Darling, I'm just a Beacon Hill Housewife who works for the power company. I'm less than nothing. The thought of me having a political enemy list is wonderfully Nixonian, but far from the truth.

I actually get your point, but I think you're being a bit stubborn. Yes, we are - all of us - to blame, for this is a Democratic Republic. But he is our dear leader, for better or for worse. Don't you think he deserves some of the blame for the mess, particularly for the wars, and his insistence that we not raise taxes to pay for these wars?

Posted by Catalina Vel-DuRay | March 17, 2008 5:11 PM

why blame bush because it is the easy thing to do? it makes more sense to blame people who actually cause problems than tacking it on to the resume of someone who has little control over the problem.

on bushes watch?

the whole government spending issue is a minor issue in regards to cdos and mortgages. sure it affects interest rates some but not in the way that caused the problem.

Posted by Bellevue Ave | March 17, 2008 5:32 PM

Eh. The finance companies were dancing around Glass-Steagall long before it was repealed. Hell, Gramm-Leach-Bliley was passed to legitimize the most egregious of the violations, the formation of Citigroup.

Posted by Gitai | March 17, 2008 6:21 PM

I blame Hillary Clinton.

Posted by banjoboy | March 17, 2008 6:50 PM

Investing in general and any finance practice that involves the growing of money without effort, or creation and distribution of a product, naturally produces inflation.

Though, as Catalina says, the Feds printing money for the Iraq war also played a huge part. I'm not sure you can pin the forthcoming recession on just one central factor.

Posted by Gomez | March 18, 2008 9:40 AM

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