January 18, 2021
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The Wall Street Blues -II

Continuing with our effort to de-mystify the US financial crisis -- all that you wanted to know but were afraid to ask

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The Wall Street Blues -II

I am hearing the phrase "privatization of profits and socialization of loss" these days. What is that?
Banks and other financial institutions made loans to home-owners, and then sold those mortgages in repackaged forms over and over again, making money hand-over-fist. When the scheme eventually – and inevitably – ran aground, they walked away leaving the Treasury and tax-payers with a bill. Even Freddie Mac and Fannie Mae... 

Wait a minute. I am not sure I understand what the FMs are.
In order to encourage home ownership, the government set up these organizations whose purpose was to guarantee mortgages. Institutions that bought these guarantees paid a fee and in return the FMs took on the credit risk of the mortgages (promising to pay the lending institution the principal and interest on the loan if the buyer defaulted). This freed up lending institutions to make further loans, thus increasing the amount of money available for mortgages, thus raising home-ownership levels. 

Mae ‘n Mac are government run businesses?
No, they are government sponsored enterprises (GSEs) chartered by the Congress. Their relationship with government is ambiguous. They are privately corporations but with a line of credit from the Treasury and an implicit – though not legal – guarantee that their securities are protected by the U.S. government. 

What was the purpose of this special relationship?
The idea was that the government support Frannie & Freddie received – through subsidized financing, for example – would allow them to reduce the cost of mortgages for American homeowners. But in reality, they used this competitive advantage to make huge profits for their private shareholders. Check this out for a detailed analysis

So the executives in the financial industry, various investors, hedge funds etc. profited by lending money to home buyers and selling these mortgages to others?
Kind of. They took these mortgages and securitized them. Securitization is a fancy word for the creation of fictitious products called "securities" (which are themselves based on actual assets that are expected to generate income). This is how the game was played: the get-rich-quick Wall Street crowd peddled these subprime loans that they knew very well were predatory, created a bunch of abstract securities by using the mortgage as collateral, packaged them with fancy labels called MBSs-CDOs-CMOs, persuaded credit rating agencies to attach AAA labels to some of the securities, sold these to investors, exploited accounting loopholes to create shell companies called Special Purpose Vehicles (SPVs) in the Cayman Islands and other tax havens, and transferred the junk securities to the balance sheet of the SPVs. So by the time they were done, they had taken crappy mortgages and converted them partly into AAA securities, partly into lower rated ones, and partly into trash that was no longer on their own books (these are the various "tranches" we keep hearing about). And then they did it again and again. They also gave themselves fat salaries and huge bonuses (try the $490 million Dick Fuld made during his tenure as the CEO of Lehman), and engineered their own payoff in a way that allowed them to have it taxed at the 15% capital gains rate as opposed to the 35% federal income tax rate. 

Why were the subprime loans "predatory"?
Subprime lending – a fancy term for giving high-interest loans to the poor – was turned from a tiny niche in 1990 into a huge 20% slice of the market by 2006. It would take too long to list the ways in which these loans were predatory, but here are some of them. Seventy percent of these loans came with a pre-payment penalty; in other words, you were stuck with them even when you realized that you’d been duped. You couldn’t pay them off, refinance the loan, or pay on an accelerated basis. The loans were sold with teaser rates that were designed to "balloon" after 2 or 3 years and written in ways that made them appear cheaper than they turned out to be (by hiding taxes, insurance, and delaying interest payments). Worst of all, there was a deliberate effort to target buyers in poor communities through hard-selling and false advertising. Though they are being depicted as irresponsible and reckless, the subprime borrowers were – for the most part – victims of an elaborate scam. 

Was there a racial element to this targeting?
It certainly appears so, at least when one looks at the impact. Consider the following. In a population that is 66.4% white and 13.4% black, 54.7% of high-cost loans were given to blacks and 17.2% to whites. These numbers partly reflect the fact that black communities tend to be poorer than white communities. But there is also plenty of evidence to show that black families that could have qualified for a prime loan were steered towards and bamboozled into taking loans at subprime rates. See the report State of the Dream put out by United for a Fair Economy for more details. 

The financial institutions made money when the time was good. Why not let them pay the price when there is a downturn? If this is a system that believes in free markets, why not allow market discipline to work? If that means that several firms collapse, let them.
I don't know what the consequence of laissez-faire would be – where are its passionate proponents now? – and I suspect no one else does either. But it will not be pretty. If the financial system goes into disarray, it will result in crisis of liquidity, which means that businesses will find it difficult to borrow money and a crisis of solvency, which means that many businesses will go bankrupt. The economy will consequently shrink considerably. Among other things unemployment will rise. In other words, we will quite likely have a serious and significant recession. 

Will the government’s plan work?
That is the $700 billion question. It will certainly have an effect, but in all likelihood, this infusion will not be enough to stabilize the credit markets.  House prices will continue to decline, capital will be in short supply, consumer spending will be down, and unemployment will rise. Experts will finally concede what many working class families have known for a while: that we are already in a recession that will get worse over time. It’s unlikely to be a deep recession, but there are tough times ahead. 

Does the government really have an option?
Given the dominant ideologies in place, and the marginal difference between the two major parties on economic issues, the options available to lawmakers are limited. The political reality is that there will be a bailout. The political reality will also require that any bill has some populist measures including limits on compensation for the top executives, and perhaps the demand for an equity stake in the companies that are helped out. Regulations and mechanisms for oversight will follow. But the intricacies and interconnectedness of the global financial system, the entrenched power elite, and the incredible pressure that a falling stock market can exert on the will of the Congress, shall ensure that the changes will be marginal.  

What would a more just and equitable system look like?
That is too big a question to address briefly and requires serious debate and discussion. But here’s a starting point. One of the biggest problems in America is its growing inequality. Most of the gains of increased productivity in the economy have gone to the richest 5% or so. In the meantime, the median hourly wage of the American worker hasn’t changed in nearly four decades. Middle- and working-class American families are becoming poorer despite the fact that over 60% of women (16 years or older) are now in the workforce, and that more and more Americans are working longer days. As the credit markets tighten, and as ordinary Americans become all borrowed out, their ability to spend will diminish. This trend will probably be exacerbated by the expected growth in unemployment. I know that this is a very Fordist suggestion, but the one way to rescue the system would involve figuring out ways of increasing the income of the bottom 4 quintiles of the American population. Higher minimum wage, universal health care, and an empowered union movement along with a process that sets undocumented workers on the path to legalization would all go a long way towards providing some respite to those who have paid the highest price during this era of unregulated profiteering. It would also put money in the hands of those who will actually spend it – on food, shelter, and other basic needs – thus giving the economy the boost it needs.

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