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The Great Recession: The Origins of the Worse Economic Crisis Since the Great Depression

The roots of the most recent financial crisis, like most crises of this sort, can be traced back to a bubble, in this case the housing bubble. Between 2000 and 2005 the median sales price of a home in the United States rose from $143,600 to $219,600, a 53% price bump (Sowell, 2009). The housing bubble was even more pronounced on the west coast where land is at a premium: In Los Angeles and San Diego, the median home price rose 110% and 127% respectively.

The financial instrument at the heart of this growing housing market is called a mortgage, a conditional conveyance of property as security for the repayment of a loan, often a loan for the property itself. The banks that make these loans evaluate the credit worthiness of the borrower, and based on the degree of credit worthiness, decide whether to make the loan and what rate of interest to charge (it is through interest on a loan that banks make the lion’s share of their profit). Typically, the better the credit, the lower the interest rate. This is the mechanism of home ownership that has been used in America for decades.

So how did home mortgages bring the global economy to its knees? One scapegoat that has emerged among conservative punditry particularly is low and moderate income families on whose behalf liberal politicians advocated for more affordable housing. Conservative economist Thomas Sowell (2009), for example, traces this economic crisis to as far back as 1977 and the Community Reinvestment Act. The CRA is meant to address perceived racial bias in bank lending policy[1] by incentivizing loans to low and moderate income borrowers (The Federal Reserve Board, 2008), to which minorities make up a disproportionate part. These new federal incentives spawned a whole new market of potential home loans called subprime mortgages. It was this government intrusion in the home market, the argument goes (Sowell, 2009), that led banks to make riskier loans than they would have made otherwise.

This argument, however, does not account for all of the lending that occurred over the last decade or so. For one thing, the CRA had been around for twenty-five years when the housing bubble first began to inflate. Surely if the risk in subprime lending incentivized by the CRA was so great as to cause the kind of damage that has occurred, the bubble and bust would have occurred sooner. More importantly, however, nothing in the CRA accounts for the predatory lending that fed the bubble in the first place and significantly contributed to the market’s spectacular bust.

So the question becomes, what happened prior to the housing bubble that might account for the economic carnage the housing bust has left in its wake? And for that answer we don’t have to go back any further than a decade.

In 1998, Texas Senator Phil Gramm co-sponsored a bill that repealed many of the Depression-era banking protections, giving rise to “too-big-to-fail” behemoths like Citigroup and American International Group (The big takeover, 2009). Since the Great Depression commercial banks have been prevented from issuing and selling securities, but Gramm’s sweeping Commodity Futures Modernization Act relaxed many of the regulations of securities. In 2000, on Congress’ last day in session, the act was inserted into an 11,000-page spending bill at the last minute and passed (The great American bubble machine). This deregulation of the banking industry gave rise to collateralized-debt obligations (CDOs) and credit default swaps.

CDOs are debt-backed assets (like home mortgages) that are split into many pieces and bundled together. As various debtors, including these home mortgage holders, pay their bill, part of that money flows to any number of these CDOs. Because CDOs managed risk by spreading it across any number of assets, ratings agencies like Moody’s and S&P scrambled to give the CDOs their highest AAA rating, attesting to its lack of risk (The big takeover). To get AAA ratings, the CDOs relied not on their actual underlying assets but on mathematical models that theoretically quantified the default frequency of various combinations of debtors.

These CDOs fueled a massive explosion of predatory lending, in part because it became hard to find enough subprime mortgages to chop up. Further, as banks and investors all over the globe gobbled up these new “risk-free” securities, they wanted some kind of insurance policy to shield them in the unlikely case the housing bubble ever burst and all that debt went south at the same time. This is where credit default swaps come in.

A credit default swap is simply a bet on an outcome and had been around for many years prior to the advent of CDOs. Say, Bank A underwrites a $500,000 mortgage. They can buy default protection from Bank B, which agrees to pay the full amount of the mortgage if it is defaulted on. In essence, Bank A has paid Bank B to assume the risk of Bank A’s loan. Bank A is covered if the new homeowner does default and Bank B makes out like a bandit if he doesn’t.

With CDOs though, these swaps reached a fever pitch. It didn’t simply stop as a bet between two banks on whether a certain mortgage would end in default. In what was known as a “naked” swap (continuing the above example), Bank B would turn around and buy the same default insurance  on the same mortgage from Bank C, and Bank C from Bank D, and so forth and so on. Only, in the case of CDOs it wasn’t a single asset that banks were betting on, it was bits and pieces of a whole bunch various debt-backed securities like home mortgages all bundled together in a single obligation.

American International Group’s Financial Products division (AIGFP) was the father of naked swaps, selling some $500 billion worth of credit default swaps[2] in a span of just seven years. But in truth, AIG didn’t have the cash on hand to cover these bets despite stellar returns: from $737 million in 1999 to $3.2 billion in 2005. As long as the risk of default on the underlying securities remained unlikely, AIG could simply collect huge and steadily climbing premiums by selling insurance against a disaster few in the industry thought would ever actually occur.

Another often cited reason for the near collapse of our economy is the failure of regulatory enforcement. AIG, for example, was regulated by the Office of Thrift Supervision (OTS), established in 1989 to regulate savings institutions (About the OTS). Thanks to yet another law passed in the late 90′s, certain kinds of holding companies were allowed to choose OTS as their regulator so long as they owned a savings-and-loan (known as a thrift). Companies like AIG rushed to purchase a thrift so they could be regulated by the understaffed and underfunded OTS. As the subprime crisis exploded, the Government Accountability Office noted in a report that the primary regulator (OTS) of the world’s largest insurer (AIG) had only one insurance specialist on staff (The big takeover).

In 2004 the looming crisis was exacerbated when the Securities and Exchange Commission agreed to release these behemoth banks from many of the lending restrictions. As a result, Bear Stearns, for example, saw their debt-to-equity ratio balloon from 12-1 to a frightening 33-1. Other large financial institutions saw a similar increase in their ratio of debt to equity. Essentially, this allowed banks to loan out even more money increasing to a still higher level the risk these financial institutions were assuming.

Almost as stunning as Wall Street’s financial hubris was the Federal Reserve’s response to the crisis. Initially one could track the injection of taxpayer money by the Fed into the nation’s banks through their oft overlooked weekly public disclosures. One of the ways the Fed managed the nation’s money supply was by buying and selling securities on the open market through so-called Repurchase Agreements, or Repos. Typically, the Fed dumped  around $25 billion in cash onto the market every week, buying up various securities, including the mortgage-backed varieties, from institutions like Goldman Sachs (AIGFP’s biggest customer) and J.P. Morgan, who would then repurchase them shortly, usually within a week or so (The big takeover). In this way, the Fed controlled interest rates: Buying up banks’ securities gave them more money to lend, pushing interest rates down; selling them back to the banks reduces their cash available for lending, pushing interest rates back up.

Beginning around the summer of 2007, at the start of the credit crunch, the Fed’s weekly reports signaled an ominous turn of events. It was clear the Fed was buying more Repos than usual, upwards of $33 billion (Federal Reserve Board), as a means of injecting capital into struggling banks whose balance sheets were mired in toxic CDOs. By November, as credit markets seized further, the Fed began injecting even more cash: $48 billion. By the end of 2007 the number had risen to $58 billion, and by March $77 billion. On May 1, 2008, the number was $115 billion. Before the end of the year the number rose to as high as $125 billion. Then at the beginning of this year the number dropped to nothing: $0.

Why did the Fed suddenly stop buying up Repos? Most critics believe it’s because the Fed wanted a less transparent mechanism for continuing to inject massive volumes of cash into the system (The big takeover). By early 2009, a series of new operations had been invented to inject cash into the economy, most all of them completely secretive. Most of these operations you’ve never heard of, with names like the Term Securities Lending Facility and the Commercial Paper Funding Facility. By March 2009, the Fed had injected almost $3 trillion into the economy through “loans,” with at least another $2.7 trillion more in guarantees. As time has gone on and the Fed has grown more secretive about their dealings with the nation’s banks, it has become increasingly difficult to find accurate information about just how much money the Fed is flooding these financial institutions with.

At the heart of the government’s strategy was the notion of “systemic risk,” a phrase used to describe the potential domino effect of one business’ failure on the rest of the economy (Sorkin, 2009). Because of perceived systemic risk, some of the worst offenders in this crisis were deemed by government fiat to be “too big to fail.” In addition to the trillions of dollars the Fed was printing and injecting into the banking system, the government has spent billions more bailing out the very corporations that nearly unraveled the global economy. A prime example is AIG.

Between the Bush and the Obama administrations’ efforts to prop up this insurance behemoth, we have spent $200 billion dollars and have acquired an 80% stake in the company (CNBC.com). In a document prepared by AIG for federal regulators (AIG: Is the risk systemic?), AIG spells out the potential economic calamity that would follow their collapse. AIG’s business model consists of a sprawling $1 trillion of insurance and financial services in more than 130 countries. Their AAA credit rating was used to backstop a $2 trillion CDO trading business that they are still winding down. AIG alone is the largest U.S. underwriter of commercial and industrial insurance and the largest U.S.-based insurer in Europe. It is also the second largest investor in corporate bonds in the U.S. But the real nightmare scenario was that if AIG went under it could drag the whole life insurance industry down with it. In the U.S. alone, the insurance industry employs over two million people. There are 375 million life insurance policies with a face value of a staggering $19 trillion.

In addition to billions of dollars in bailout money, congress passed a $700 billion stimulus bill in February 2009. In the first quarter of 2009, the economy shrank by more than 6%. A decline in business investing (capital stock) accounts for 4.7 percentage points of the contraction (Cooper, 2009). Similarly, the rate of savings in the country went from 1% in the first quarter of 2008 to upwards of 4% one year later (it has continued to climb, topping almost 5% this quarter), souring consumer consumption (BEA). With both business investment and consumer spending plummeting and a U.S. trade deficit that was only worsened by the global economic downturn, only government spending remained to stimulate the economy[3], a process known as priming the pump. While controversial, many economists agree that it is the only way to avoid sending the economy into a negative feedback loop (Krasny): the less consumers spend, the less money businesses have to invest in making more goods and the fewer employees needed to make them, which forces layoffs; unemployed consumers spend even less, which forces business to lay off even more, and the economy spirals into total collapse.

The biggest risk with the stimulus bill is the potential for its failure to actually stimulate, which many economists argue could happen because of too much pork and too little actual stimulus. Others argue that our deficit is dangerously high and that the federal government can’t spend its way out of a recession. But President Obama inherited both a deficit and an economic crisis and deficit spending of the sort advocated by his administration is pretty standard economic fare during periods of contraction.

While the stimulus bill is controversial and politically costly to a young administration, the greatest threat from the government’s actions to date comes not from Congress or the White House, but from the Fed. With financial institutions’ balance sheets padded with trillions of newly printed dollars, these institutions are now sitting on what could be an inflation time bomb. So far at least the banks have continued to sit on the new capital, but the fed is holding interest rates to nominal levels to encourage additional lending. If the banks increase their lending too quickly, inflationary pressures could jeopardize the economy’s budding recovery.

As grave as the threat of inflation is right now, the whole system could unravel further and more completely if bankers, businesses, regulators, politicians and economists don’t become better custodians of our economy. The notion of “too big to fail” stands in stark contrast to free-market principles. Allowing AIG and others to continue being “too big to fail” will discourage competition and encourage greater risk-taking. Something must be done to reduce if not outright eliminate systemic risk.

Stronger regulations of the financial industry must also occur. Banks should again be legislated out of the securities business. But more than regulation, what happened to cause this crisis was nothing short of economic treason and laws criminalizing its reoccurrence should be passed immediately. America’s standing in the world has been weakened and our position as the leading industrialized economy jeopardized. Who needs terrorists when American corporations are destroying the country from the inside?

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References

American International Group (2009). AIG: Is the risk systemic? Retrieved September 27, 2009. Website: http://wallstreetwatch.org/AIGSystemicRisk2_tcm385-152209.pdf.

Bureau of Economic Analysis. (2009). Personal saving rate. Retrieved October 7, 2009. Website: http://www.bea.gov/BRIEFRM/SAVING.HTM/

CNBC.com By the Numbers (September 16, 2009). AIG: 1 Year After its Bailout. Retrieved October 4, 2009. Website: http://www.cnbc.com/id/32865451.

Cooper, James C. (May 18, 2009). Real recovery will hinge on capital spending. Business Week. p. 8.

The Federal Reserve Board (2008). Community Reinvestment Act. Retrieved September 29, 2009. Website: http://www.federalreserve.gov/dcca/cra/.

The Federal Reserve Board (2009). Federal Reserve Statistical Release. Retrieved October 1, 2009. Website: http://www.federalreserve.gov/releases/h41/.

Krasny, Ros (April 11, 2008). Negative feedback loop in full swing in U.S. economy. Reuters. Retrieved October 4, 2009. Website: http://www.reuters.com/article/ousiv/ idUSN1152328820080411.

Office of Thrift Supervision. About the OTS. Retrieved October 4, 2009. Website: http://www.ots.treas.gov/?p=AboutOTS.

Sorkin, Andrew Ross (March 2, 2009). The Case for Saving A.I.G., by A.I.G. New York Times. Retrieved September 22, 2009. Website: http://www.nytimes.com/2009/03/03/business/ worldbusiness/03iht-03sorkin.20548486.html.

Sowell, T. (2009). The housing boom and bust. New York: Basic Books.

Taibbi, Matt (March 19, 2009). The big takeover. Rolling Stone. Retrieved September 19, 2009. Website: http://www.rollingstone.com/politics/story/26793903/the_big_takeover/print.

Taibbi, Matt (July 13, 2009). The great American bubble machine. Rolling Stone. Retrieved October 1, 2009. Website: http://www.rollingstone.com/politics/story/29127316/ the_great_american_bubble_machine/print.

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[1] Thomas Sowell’s counter argument to the notion of racist lending policies is that banks are in business to make money and that they “would be cutting their own throats financially if they arbitrarily denied loans to people with good prospects of paying them back with interest” (p. 38). I find this argument historically specious: There is a well-documented history of any number and type of business establishments refusing service to minorities despite their having money to spend.

[2] Of the $500 billion in AIGFP CDS protection, less than $100 billion of that (20%) was tied to the subprime mortgage market, further undercutting the argument that the subprime market was feeding the housing boom.

[3] This analysis is based on the fundamental equation of economics, which is Y = C + I + G + N, where Y is national output (GDP), C is consumer consumption, I is business investment, G is government expenditures and N is net exports (exports minus imports).

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