Since September 2008 an awful lot of Americans have lost 40 to 50 percent of their net worth. According to Bloomberg News, the federal government, during the same period, has committed $11.3 trillion in loans, guarantees, and investments to bail out the financial system. The Obama administration believes this effort will help the overall economy and save jobs. The problem, however, is that it is impossible to show that this vast effort will actually help the economy. The downside is clear, but the upside is not. MIT economics professor Simon Johnson believes what we are facing could “be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big.” Almost all countries are showing “a weakening of confidence among individuals and firms, and major problems for government finances.”
The public, meanwhile, believes the federal bailout is primarily helping the bankers and others whose poor behavior caused the trouble. The Obama administration, as a consequence, has felt obliged to proceed without going to Congress to give its effort democratic legitimacy. Instead, it has used the Federal Reserve and FDIC to create ten trillion dollars of its support.
Both the Bush and Obama administrations decided they would not let the bankrupt go bankrupt. Natural forces, if allowed to work, would quickly put the weak to sleep, leaving stronger firms to pick up the business. The problem with the decision to intervene is that, once made, there is no reasonable way of stopping.
Then why intervene? The bankers say you can pay us now or later; we are all tied together like climbers on Mount Everest; we are all too big to fail. You are doomed if you let us go. British Prime Minister Gordon Brown, in his March 4 address to Congress, stated:
We tend to think of the sweep of destiny as stretching across many months and years before culminating in decisive moments we call history. But sometimes the reality is that defining moments of history come suddenly and without warning. And the task of leadership then is to define them, shape them and move forward into the new world they demand. An economic hurricane has swept the world, creating a crisis of credit and of confidence. . . .
And we need to understand what went wrong in this crisis. That the very financial instruments that were designed to diversify risk across the banking system instead spread contagion across the globe. And today’s financial institutions are so interwoven that a bad bank anywhere is a threat to good banks everywhere.
The “contagion,” in large part, is something called credit default swaps (CDS), which were unknown to ordinary human beings before September 2008. In 2001, there were $900 billion of them; in 2008 there were $46 trillion.
There are two types of credit default swaps. In the first, the buyer owns a security and purchases insurance to protect against default. This sounds strange: If you thought a security might default, wouldn’t you just sell it rather than bet against yourself? The explanation is that the banks used the credit default swaps to evade capital requirements—banks are required to hold some capital against their loans and investments—but the regulators accepted the swaps to show that there was no risk of default and, therefore, no need for capital.
In the second type of credit default swap the buyer of insurance does not own the underlying security; instead, the seller and buyer pretend that he does. These so-called synthetic or naked credit default swaps are pure gambling. In the 19th century many American cities had what were known as bucket shops. A bucket shop had a New York Stock Exchange ticker and would post quotations as they came in. Rather than buy the stock, the customer bet on the tape—e.g., 20 shares of sugar at $100. The shop took a commission: If the stock went to $105, the shop paid; if it went down, the customer lost. Customers could also short a stock. Edwin Lefèvre’s 1923 classic Reminiscences of a Stock Operator vividly describes the turn-of-the century bucket shop. The shops were partially blamed for the Panic of 1907, and the states outlawed them shortly after that. Of course the New York Stock Exchange, where customers bought the underlying assets, continued to be legal.
The “synthetic” credit default swap is a revival, 100 years later, of the bucket shop. Could anyone defend the return of gambling shops? Well, yes, President Obama’s principal economic advisor Larry Summers could. In July 1998, as deputy treasury secretary, he explained to Congress that the derivative market “in just a few short years” had become “highly lucrative” and a “magnet for derivative business from around the world.” The market, Summers continued, is developed “on the basis of complex and fragile legal and legislative understandings.” It was true, he added, that “questions have been raised as to whether the derivatives market could exacerbate a large, sudden market decline.” Summers didn’t think so, noting that the derivatives supported “higher investment and growth in living standards in the United States and around the world.” Moreover, there was no reason for concern, since
the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws.
Summers explained that the market was based on an “implicit consensus that the OTC derivatives market should be allowed to grow and evolve without deciding” the legal issues—i.e., whether derivatives violated laws prohibiting bucket shops, gambling, and trading in unregistered securities, not to mention doing so outside the regulated options exchange. “At the heart of that consensus has been a recognition that ‘swap’ transactions should not be regulated . . . whether or not a plausible legal argument could be made” that the contracts are “illegal and unenforceable.”
The huge derivatives market, according to Summers, was based not on law but on “understandings” and an “implied consensus.” Summers never explained how the exotic devices would be of any help to the real economy or why the market needed secrecy to operate. When the market broke, the secrecy turned out to be malignant.
Did the CDSs violate state anti-bucket-shop laws? Without question. Then why isn’t this huge market illegal? It was, until the waning hours of the Clinton administration, when a lame-duck President and a lame-duck Congress immunized credit default swaps from state law. The Commodity Futures Modernization Act of 2000, 100 pages in length, was introduced in both houses on December 14 and passed, without debate, the next day. The President’s Working Group on Financial Markets, led by Summers and Alan Greenspan, wrote Congress that it “strongly supports” the bill, which would maintain the U.S. “competitive position in the over-the-counter derivative markets by providing legal certainty and promoting innovation, transparency and efficiency in our financial markets.” Section 17 of the 11th-hour bill states, “This Act shall supersede and preempt the application of any State or local law that prohibits or regulates gaming or the operation of bucket shops.” The immunizing law was folded into a spending bill, so no congressman had to be on record as voting for it.
Unshackled, the CDS market prospered. It was immune from federal regulation and state law. That meant it operated in total secrecy—simply bilateral contracts between parties. And the parties—banks, investment banks, hedge funds, and AIG—made bets that no gambling parlor in London or Vegas would countenance. For example, AIG took someone’s bet on the price of oil 50 years from today. Some laid bets on whether Bear Sterns, Lehman, or AIG would go bust. AIG bet that some workers’ 401(k) plans would not lose any market value. (That one cost taxpayers $40 billion.) These bets can’t be reasonably valued, and because of the secrecy of the market no one can be sure where they are. Consequently, anyone you are doing business with may be holding one. If one goes off, he will be instantly bankrupt—a fact that removes the trust necessary to conduct business. Hence, the Depression we now face.
In his Budget Message, President Obama said he would act with “unprecedented transparency and accountability.” What had caused the crack-up? His answer: an “Era of Profound Irresponsibility.” This was no doubt true but not that informative. The President’s “transparency” has been a little weak. Not until March 15, 2009, did we find out that the AIG bailout of September 2008 was really designed to funnel $12.9 billion to Goldman Sachs. And $108 billion—or over two thirds of the taxpayers’ $170 billion—went overseas to European banks. Bank of America got $4.5 billion, and Citigroup, Merrill Lynch, and Morgan Stanley received between $1 and $3 billion each.
The AIG bailout paid out—in full—the bets Goldman and others had made. What was the social purpose of that? Goldman even announced that it was not at risk; it had covered its bets elsewhere. Why had Goldman insisted on full payment from the taxpayers? They owed it, they said, to their shareholders. Now, several months later, we still do not know what the winning bets were that we paid off in full.
The last 20 years or so have witnessed the evolution of a failed financial system. Traditional commercial banks and investment partnerships, without giving any real notice to the public, changed the nature of their business. Finding revenues from lending and underwriting too small, they set sail for more adventurous seas, where they discovered a treasure trove of derivatives, including credit default swaps.
The new financial system’s incentives are all short term. Securitization rewards the origination of a loan without respect to its quality, at the expense of the ultimate holder. The incorporation of the investment partnerships meant the managers could follow the lead of our modern corporations and run the corporation for their benefit. They could take the profits—in 2006 Goldman Sachs had 50 employees who made more than $20 million—and leave the risk with the shareholders.
President Obama’s policy of trying to reinflate the bubble—see TAIF (an effort to revive securitization) and Public Private Investment Group (an effort to make taxpayers finance purchases of rotten assets from banks)—is a bad idea. Remarkably, his administration has not even proposed dealing with the cause of the problem—the “naked” credit default swaps. Today, CDSs are traded as secretly as ever. Some standard types, if the parties choose, may pass through a nonguaranteeing clearinghouse—a pitiful half-step to appease critics.
The current system has a bad design. We need to simplify and separate the banks’ utility functions from casino activities that should be carried on elsewhere. In February MIT professor of economics Simon Johnson said, “Are you going in with the bankers or are you being tough with bankers? They [the administration] don’t want to upset the banking industry and that’s the heart of it.”
Presidents get to choose—they can pick conventional or unconventional advisors. Given the current financial crisis, when it comes to economic advisors, you would not think the President would appoint the guys who wrecked the train—Summers and Geithner—to fix it. President Obama picked Larry Summers, a former Harvard president, to be the head of his White House National Economic Council. The President says he meets with Summers every day. Is Summers likely to give unconventional advice? Well, on April 3, the White House reported that in 2008 Summers earned more than $5 million from a hedge fund and $2.7 million in speaking fees from Wall Street companies. The speaking fees included Goldman Sachs ($135,000), Citigroup ($45,000), J.P. Morgan ($67,500), and the now-defunct Lehman Brothers ($67,500). White House spokesman Ben LaBolt said the compensation did not represent a conflict of interest and really was not surprising since Summers is “widely recognized as one of the country’s most distinguished economists.” Maybe, although it is not unreasonable to suspect that he would naturally want to preserve a system that has richly rewarded him. Every President gets the advice he wants. President Obama’s problem is that his choice is conventional. Summers’ policy of reinflating the bubble won’t work; the public is past it.
We need to try to correct the harm done by the infamous Section 17 of The Commodity Futures Modernization Act of 2000. Let the sun shine into this secret market. Let’s disclose all the facts so we can finally figure out who owes what to whom. That would be a beginning.