Volume 21, Number 11
Battle of St Paul
“FREE GAZA MOVEMENT”
Breaking Gaza's Seige
The Infamous Three G's
Outrageous Gift Offer
Goodbye to Bush Offer
GAY & LESBIAN COMMUNITY NOTES
Quo Vadis Culture Wars?
US Nuke Threat
Bush Seeks Legacy
Globalization v. Democracy
Jeffrey M. Smith
Eleanor J. Bader
Abortion & Life
Eleanor J. Bader
The American War in Pakistan
Bailout & Election
Bush Economic Legacy
NOTE: Z Magazine subscribers and sustainers have access to all Z Magazine articles here and in the archive. The latest Z Magazine articles available to everyone are listed in the Free Articles box at the top of the table of contents, and are starred in the list below. Questions? e-mail Z Magazine Online.
How Wall Street Killed the Economy
From 1982 to 2000, the U.S. stock market went on the longest "bull run" ever, as share prices rose to dizzying heights. In the late 1990s, a combination of factors, which included the Federal Reserve lowering interest rates, created a huge price bubble in Internet stocks. A speculative bubble occurs when price far outstrips the fundamental worth of the asset. Historically, bubbles have occurred in everything from real estate, stocks, and railroads to tulips, beanie babies, and comic books. As with all bubbles, it took more and more money to make a return. For instance, if you purchased 100 shares of Apple at $10 a share and it rose to $20, it cost $1,000 to make $1,000 profit (a 100 percent return), but if the shares were $100 each and rose to $110, it would cost $10,000 to make $1,000 profit (a 10 percent return)—so the percentage profit is far less and the potential loss would be much greater, too. This led to the Internet bubble popping in March 2000.
When the stock market bubble erupted, turbulence rippled through the larger economy, causing investment and corporate spending to sink and unemployment to rise. Burned by the stock market, many people shifted to home purchases as a more secure way to build wealth. Then came the September 11, 2001 attacks, generating a shockwave of fear and a drop in consumer spending.
By 2002, with the economy already limping along, former Federal Reserve Chair Alan Greenspan and the Fed slashed interest rates to historic lows of near one percent to avoid a severe economic downturn. Low interest rates make borrowed money cheap for everyone from homebuyers to banks. This ocean of credit was one factor that led to a major shift in the home-lending industry—from "originate to own" to "originate to distribute." Low interest rates also meant that homebuyers could take on larger mortgages, which supported rising prices.
In the originate-to-own model, the mortgage lender—which can be a private mortgage company, bank, thrift, or credit union—holds the mortgage for its term, usually 30 years. Every month the bank—shorthand for any mortgage originator—"originating" the mortgage receives a payment made of principal and interest from the homeowner. If the buyer defaults on the mortgage, that is, stops making monthly payments, then the bank can seize and sell a valuable asset: the house. Given strict borrowing standards and the loan's longevity, it's like the homebuyer is getting married to the bank.
In the originate-to-distribute model, the banks sell the mortgage to third parties, turning the loans into a commodity like widgets on a conveyor belt. By selling the loan, the bank frees up its capital so it can turn around and finance a new mortgage. Thus, the banks have an incentive to sell (or "distribute") mortgages fast, so they can recoup the funds to sell more mortgages. By selling the loan, the bank also "distributes the risk" of default to others.
The banks made money off mortgage fees, perhaps only a few thousand dollars per loan. Because they sold the loan, sometimes in just a few days, they had no concern that the homebuyer might default. Banks began using call centers and high-pressure tactics to "mass-produce" mortgages because the profit was in volume—how many loans could be approved how fast. This was complemented by fraud throughout the real estate industry, in which appraisers over-valued homes and mortgage brokers approved anyone with a pulse, not verifying assets, job status, or income. And the mushrooming housing industry distorted the whole economy. Of all net job growth from 2002 to 2007, up to 40 percent was housing-sector related: mortgage brokers, appraisers, real-estate agents, call-center employees, loan officers, construction and home-improvement store workers, etc.
To make the loans easier to sell, the banks go to Fannie Mae or Freddie Mac and get "assurance" for "conforming" (or prime, which refers to the credit score of the borrower) mortgages. Assurance means one of the agencies certifies that the loans are creditworthy; they also insure part of the loan in case the homeowner defaults. Before their recent nationalization, Fannie and Freddie were "government-sponsored entities" (GSEs). While anyone could buy shares in the two companies, they were also subject to federal regulation and congressional oversight. This federal role was seen as an implicit guarantee because all parties believed loans backed by Fannie and Freddie were absolutely safe. This allowed them to borrow huge sums of money at extremely low rates.
Banks then sold their newly acquired assured prime mortgage loans to "bundlers," ranging from Fannie and Freddie to "private labels," such as investment banks, hedge funds, and "money banks" (ones that hold deposits like savings and checking accounts). Bundlers pooled many mortgages with the intention of selling the payment rights to others—that is, someone else pays to receive your monthly mortgage payments.
The next step was to "securitize" the bundle (a security is a tradable asset). Much of the financial wizardry of Wall Street involves turning debts into assets. Say you're Bank of America and you sell 200 mortgages in a day. Lehman Brothers buys the loans after they are assured and "bundles" them by depositing the mortgages in a bank account—that's where the monthly payments from the 200 homeowners go. Then, a "mortgage-backed security" (MBS) is created from this bundle. An MBS is a financial product that pays a yield to the purchaser, such as a hedge fund, pension fund, investment bank, money bank, central bank, and especially Fannie and Freddie. The yield, essentially an interest payment, comes from the mortgage payments.
How does it work? The homeowner keeps making monthly mortgage payments to Bank of America, which makes money from the fees from the original mortgage and gets a cut for servicing the mortgage payments, passing them on to Lehman Brothers. Lehman makes money as a bundler of the mortgages and "underwriter" of the mortgage-backed security. The purchaser of the mortgage-backed security, say, Fannie Mae, then gets paid from the bank account holding the mortgage payments.
At first, this process covered only prime mortgages because Fannie and Freddie could not assure subprime loans. To address low rates of home ownership among low-income populations and communities of color, around 2004 Congress began encouraging Fannie and Freddie to start assuring subprime mortgages on a wide scale. And easy credit fed investors' appetite for more and more mortgage-backed securities, which provided funding for new mortgages.
One definition of subprime loans is any loan at an interest rate that is at least 3 percentage points more than a prime loan. Many of these loans were "adjustable-rate mortgages" (ARMs) with "teaser rates." The rate was low for the first few years, but then it would "reset," causing monthly payments to leap dramatically, sometimes to two or three times the original amount. Subprime borrowers are considered riskier because of low credit scores and are concentrated among people of color and immigrant and low-income communities who are much more likely to miss payments, driving down credit scores. With mortgage brokers and lenders pushing loans on anyone and everyone, those with less financial acumen often found themselves with mortgages that became unaffordable.
With the surge in mortgage loans, around 2004, banks started extensively using financial products called collateralized debt obligations (CDOs). The banks would either combine mortgage-backed securities they already owned or bundle large pools of high-interest subprime mortgages. CDOs were "sliced" into "tranches"—think of them as cuts of meat—that paid a yield according to risk of default. The best cuts, the filet mignon, had the lowest risk and hence paid the lowest yield. The riskiest tranches, the mystery-meat hot dogs that paid the highest yield, would default first if homebuyers stopped making payments. This was seen as a way to distribute risk across the markets. The notion of "distributing risk" means all the market players take a little risk, so if something goes bad, everyone suffers but no one dies.
Tranches were given "ratings" by services like Standard & Poor's, Moody's, and Fitch. The highest rating, AAA, meant there was virtually no risk of default. The perceived safety of AAA meant a broad variety of financial institutions could buy them. Because tranches were marketed as a tool to fine-tune risk and return, this spurred a big demand. The rating services had a conflict of interest, however, because they earned huge fees from the investment banks, giving the services an incentive to rate dodgy securities highly. Moody's earned nearly $850 million from such structured finance products in 2006 alone. The investment bank also bundled lower-rated mortgage backed securities, like BBB-rated ones, and then sliced them to create new tranches rated from AAA to junk. This was like turning the hot dogs into steaks.
Furthermore, the banks would "hedge" the tranches, another way of distributing risk, by purchasing credit default swaps (CDSs) sold by companies like AIG and MBIA. The swaps were a form of insurance. This was seen as a way to make tranches more secure and hence higher rated. For instance, say you're Goldman Sachs and you have $10 million in AAA tranches. You go to AIG to insure it, and the company determines that the risk of default is extremely low so the premium is 1 percent. So you pay AIG $100,000 a year and if the tranche defaults, the company pays you $10 million. But CDSs started getting bought and sold all over the world based on perceived risk. The market grew so large that the underlying debt being insured was $45 trillion—nearly the same size as the annual global economy.
Also around 2004, things began to get even trickier when investment banks set up entities known as structured investment vehicles (SIVs). The SIVs would purchase subprime MBSs from their sponsoring banks. But to purchase these MBSs, the structured investment vehicles needed funds of their own. So the SIVs created products called asset-backed commercial paper (short-term debt of 1 to 90 days). "Asset-backed" means it is backed by credit from the sponsoring bank. The SIVs then sold the paper, mainly to money market funds. In this way, the SIVs generated money to purchase the mortgage-backed securities from their bank. The SIVs made money by getting high yields from the subprime MBSs they bought, while paying out low yields to the money markets that purchased the commercial paper (profiting from a spread like this is known as "arbitrage").
Wall Street's goal was to conjure up ways to make money while not encountering any liability. It was moving everything "off-book" to the SIVs to get around rules about "leveraging." Banks, hedge funds, and others leverage by taking their "capital reserves"—actual cash or assets that can be easily turned into cash—and borrowing many times against it. For instance, Merrill Lynch had a leverage ratio of 45.8 on September 26. That means that if Merrill had $10 billion in the bank, it was playing around with $458 billion. The Federal Reserve is supposed to regulate reserves to limit the growth of credit, but the SIVs were one method to get around this rule. More leverage also meant more risk for the bank, however, because funds could disappear quickly if a few bets went bad. This is all part of what's called the "shadow banking system," meaning it gets around existing regulations. The shadow banking system is seen as the main culprit in the demise of the Wall Street firms and global economic crisis.
The whole process worked as long as everyone believed housing prices would go up endlessly. This is a form of "perceptual economics," one principle of which is that any widely held belief in the market tends to become a self-fulfilling prophecy. In the case of housing, homeowners took on ever-larger mortgages in the belief that prices would keep rising rapidly. Mortgage lenders believed the loans were safe because even if the homeowner defaulted, the mortgage holder would be left with a house that was increasing in price. Confidence in rising prices led the creators and purchasers of mortgage-backed securities to think these investments were virtually risk-free. This also applied to over-leveraging—as long as there was easy credit and quick returns to be made, investors clamored for more mortgage-backed securities. This applied to the money market funds that brought the paper from structured investment vehicles. As long as the money market funds had confidence in the system, they didn't cash out the commercial paper when it came due, but "rolled it over" at the same interest rates. This allowed the SIVs to mint money without posing any liabilities for their sponsoring banks.
This system kept the U.S. economy chugging along for years. For some 35 years, real wages have been stagnant for most Americans, but as house values skyrocketed over the last decade, many homeowners refinanced and cashed out the equity—turning their homes into ATMs. For example, if you owed $200,000 on a mortgage but the house value rose to $300,000, you could potentially turn the $100,000 difference into cash by refinancing. By 2004, Americans were using home equity to finance as much $310 billion a year in personal consumption. This debt-driven consumption was the engine of growth.
U.S. over-consumption was balanced by over-production in many Asian countries. Countries like China, India, Taiwan, and South Korea run large trade surpluses with the United States, which sped their economic development. They invested excess cash in U.S. credit instruments ranging from corporate debt and MBSs to government bonds and bills. It's what economists call a virtuous cycle: we buy their goods, helping them develop, while they use the profits to buy our credit, allowing us to purchase more of their goods. But it's also unsustainable. A country cannot over-consume forever.
In the final stage of the housing bubble, fewer first-time buyers could afford traditional mortgages. Rising house prices required ever-larger down payments so subprime mortgages multiplied, as they often required little or no money down. From 2004 to 2006, nearly 20 percent of all mortgage loans were subprime loans. As the vast majority were adjustable rate mortgages, this created a time bomb. The minute interest rates went up, the rates reset, and homeowners with ARMs were saddled with larger monthly payments.
Various factors combined to slow real-estate prices and deflate the bubble. Rising prices led to a building boom and oversupply of houses, ever-accelerating prices meant more money brought smaller returns, and, once again, the Fed played a role by raising interest rates. It was trying to stave off inflation, but given the proliferation of adjustable rate mortgages, it led to higher mortgage payments, pushing hundreds of thousands of homeowners into foreclosure.
Once the bubble started to leak, the process accelerated, turning the mania into a panic. First, the default spread to the structured debt instruments like collateralized debt obligations and mortgage-backed securities. The system of distributing risk failed. Securitization had spread across the entire financial system—investment and money banks, pension funds, central banks, insurance companies—putting everyone at risk. Because the finance sector had lobbied aggressively for decades to slash regulation, the lack of oversight amplified risk. There had been so much slicing and trading of mortgages and related securities no one knew exactly where the losses lay. As mortgage holders defaulted, mortgage-backed securities also began to default. The subprime funding conduit from Wall Street froze up, leading big mortgage lenders like Countrywide, New Century Financial, and American Home Mortgage to go belly-up.
As panic set in, money market funds began to stop rolling over the commercial paper—they wanted to cash it out. So SIVs now had to either call on their credit line from their sponsoring banks or sell assets such as the mortgage-backed securities to raise money. Mortgage defaults and forced sales of the MBSs began to push prices down even further. This forced banks to book losses, requiring some to sell more assets to cover the losses, further lowering prices, forcing them to book more losses, creating a vicious cycle. This is known as a "liquidation trap." Since no one was sure about the size of the losses, banks began to hoard funds, which caused the credit markets to dry up.
Over the last year, the Federal Reserve and Treasury Department have taken increasingly drastic measures—lowering interest rates, pumping cash into the banking sector, allowing investment banks to borrow funds while putting up low-valued securities as collateral. This proceeded to financing takeovers, such as the Fed providing a $29 billion credit line for JP Morgan to take over Bear Stearns in March. Then it nationalized Fannie Mae and Freddie Mac; this was followed by the federal takeover of AIG, which was done in by its gambling with credit default swaps. In the end, legendary Wall Street banks disappeared in a fortnight—bankrupt, acquired, or converted into bank holding companies like Citigroup.
But the contagion has not been contained. Whether the bailout plan can succeed is highly questionable. Many are skeptical as to whether the bailout will even restore confidence—and credit—to the banking system. As Reuters stated recently, "Doubts remain as to how it [the bailout plan] could immediately thaw the frozen money and credit market." Even if the bailout revives the banking sector, few economists think it will jumpstart the consumer credit machine. For one, over-leveraged, money-strapped banks will eagerly dump near-worthless securities on taxpayers in exchange for cash to bulk up their reserves. Plus, with working hours and wages declining and unemployment, home foreclosures, and inflation surging, banks are in no mood to give consumers more credit, so consumption—and hence the economy—will continue to contract.
There are many other, better options that were proposed: avoiding the poisonous mortgage-backed securities and buying equity stakes directly in troubled banks, re-regulating the industry, sending in teams of government auditors to decide the real worth of financial companies and which should live and die, creating a Home Owners' Loan Corporation to allow the government to buy troubled mortgages directly, allowing local governments to seize foreclosed homes and turn them into subsidized housing to minimize abandonment (which creates ghost neighborhoods, driving down the price of still-occupied homes), a public works program, alternative energy investments, and a "Green New Deal." But these are political questions that depend on organizing and political power to propose, legislate, fund, and enforce. That's what will determine if there is a 21st-century New Deal or the biggest financial crime in world history.
Z Magazine Archive
CUBAN 5 - From May 30 to June 5, supporters of the Cuban 5 will gather in Washington DC to raise awareness about the case and to demand a humanitarian solution that will allow the return of these men to their homeland.
Contact: firstname.lastname@example.org; email@example.com.
BIKES - Bikes Not Bombs is holding its 24th annual Bike- A-Thon and Green Roots Festival in Boston, MA on June 3, with several bike rides, music, exhibitors, and more.
Contact: Bikes Not Bombs, 284 Amory St., Jamaica Plain, MA 02130; 617-522-0222; mailbikesnotbombs.org; www.bikesnotbombs.org.
LEFT FORUM - The 2013 Left Forum will be held June 7-9, at Pace University in NYC.
Contact: 365 Fifth Avenue, CUNY Graduate Center, Sociology Dept., New York, NY 10016; http://www.leftforum.org/.
VEGAN FEST - Mad City Vegan Fest will be held in Madison, WI, June 8. The annual event features food, speakers, and exhibitors.
Contact: 122 State Street, Suite 405 B, Madison, WI 53701; firstname.lastname@example.org; http://veganfest.org/.
ADC CONFERENCE - The American-Arab Anti-Discrimination Committee (ADC) holds its annual conference June 13-16 in Washington, DC, with panel discussions and workshops.
Contact: 1990 M Street, Suite 610, Washington, DC, 20036; 202-244-2990; convention @adc. org http://convention.adc.org/.
CUBA/SOCIALISM - A Cuban-North American Dialog on Socialist Renewal and Global Capitalist Crisis will be held in Havana, Cuba, June 16-30. There will be a 5-day Seminar at the University of Havana, plus visits to a co-op and educational and medical institutions.
Contact: email@example.com; http://www.globaljustice center.org/.
NETROOTS - The 8th Annual Netroots Nation conference will take place June 20-23 in San Jose, CA. The event features panels, trainings, networking, screenings, and keynotes.
Contact: 164 Robles Way, #276, Vallejo, CA 94591; firstname.lastname@example.org; http://www.netrootsnation.org/.
MEDIA - The 15th annual Allied Media Conference will be held June 20-23, in Detroit.
Contact: 4126 Third Street, Detroit, MI 48201; http://alliedmedia.org/.
GRASSROOTS - The United We Stand Festival will be hosted by Free & Equal, June 22 in Little Rock, Arkansas. The festival aims to reform the electoral process in the U.S.
LITERACY - The National Association for Media Literacy Education (NAMLE) will hold its conference July 12-13 in Los Angeles.
Contact: 10 Laurel Hill Drive, Cherry Hill, NJ 08003; http://namle.net/conference/.
IWW - The North American Work People’s College will take place July 12-16 at Mesaba Co-op Park in northern Minnesota. The event will bring together Wobblies from across the continent to learn skills and build one big union.
PEACESTOCK - On July 13, the 11th Annual Peacestock will take place at Windbeam Farm in Hager City, WI. The event is a mixture of music, speakers, and community for peace. Sponsored by Veterans for Peace.
Contact: Bill Habedank, 1913 Grandview Ave., Red Wing, MN 55066; 651-388-7733; email@example.com; http://www. peacestockvfp.org.
LA RAZA - The annual National Council of La Raza (NCLR) Conference is scheduled for July 18-19 in New Orleans, with workshops, presentations, and panel discussions.
Contact: NCLR Headquarters Office, Raul Yzaguirre Building, 1126 16th Street, NW, Washington, DC 20036; 202-785-1670; www.nclr.org.
ACTIVIST CAMP - Youth Empowered Action (YEA) Camp will have sessions in July and August in Ben Lomond, CA; Portland, OR; Charlton, MA. YEA Camp is designed for activists 12-17 years old who want to make a difference.
Contact: firstname.lastname@example.org; http://yeacamp.org/.