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Business, Finance

Who broke the piggy bank?

During the recent Republican primaries, I was watching two talking heads arguing about which candidate was best equipped to lead our economy out of the troubles allegedly created by the incompetence of the current administration. One stated, “This country is founded on capitalism – why do you think so many people buy lottery tickets?”</p>

<p>When I heard that, I was reminded of some recent discussions with friends. In recent articles in this paper I have been critical of financial engineering and of the trading in synthetic financial derivatives that contributed greatly to the worldwide economic crisis. Some of my friends who read the column have accused me of Marxist thinking. Perhaps this criticism comes from my friends because they were the only people who read the column, but in case there are other readers out there, I feel obliged to explain why my friends are wrong.</p>

<p>Capitalism encourages the private ownership of means of production and the creation of goods and services for profit. What does that have to do with gambling on synthetic collateralized debt obligations and credit default swaps? What production of goods and services does that activity promote? How many jobs does it create? Conversely, when major financial institutions gambled very large sums on these bets, they led to the loss of production, the loss of jobs, and the loss of almost $11 trillion of household wealth.</p>

<p>Our current financial crisis was not caused by capitalism, but by a distortion of capitalism fed by incompetent government supervision, erosion in business ethics, a deliberate lack of mortgage lending standards, the creation of complex derivative products with no real economic purpose, and dishonest credit rating agencies. The National Commission on the Causes of the Financial and Economic Crisis reviewed millions of documents, interviewed 700 witnesses, and held many public hearings. The Commission concluded that the crisis was avoidable and that the “captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand and manage evolving risks.”</p>

<p>For more than 30 years, successive administrations of both parties championed deregulation of financial institutions, with Alan Greenspan acting as cheerleader. Between 1999 and 2008, the financial sector reported $2.7 billion in federal lobbying expenses, and individuals and political action committees made campaign contributions of over $1 billion.</p>

<p>The CEO of Citigroup told the commission that he spent less than one percent of his time managing the $40 billion of mortgage securities in his portfolio – until they disappeared. Similarly, AIG’s senior management was ignorant of the terms and risks of $79 billion in credit default swap insurance they had written – until it bankrupted the company. Merrill Lynch’s top management thought their $55 billion of mortgage-backed securities were “super safe” – just before they imploded. Apparently, too big to fail meant too important to bother with trivial details.</p>

<p>In the bad old days, banks would not allow households to borrow beyond their ability to repay. In this financial crisis, people borrowed to the hilt – and so did the banks. By 2007, the five major investment banks were leveraged as high as 40 to 1. It took only a three percent drop in asset values to wipe out a firm. Bear Stearns had $11.8 billion in equity, $383.6 billion in liabilities, and was borrowing as much as $70 billion on the overnight market. Fannie Mae and Freddie Mac had a leverage ratio of 75 to 1. </p>

<p>The banks were not alone. Between 2001 and 2007, household debt rose over 60 percent, while wages were stagnant.</p>

<p>Throughout the summer of 2007, Ben Bernanke and Henry Paulson were assuring us that the turmoil in the subprime mortgage markets would be contained. Days before the collapse of Bear Stearns in March 2008, the SEC chairman said he was comfortable with the capital cushions at the big investment banks. The number of borrowers who defaulted within months of taking a loan doubled from mid 2006 to late 2007. Losses from mortgage fraud alone are estimated at $112 billion between 2005 and 2007. Nearly one quarter of all mortgages made in the first half of 2005 were interest-only loans, and 68 percent of “option ARM” loans originated by Countrywide and Washington Mutual had little or no documentation.</p>

<p>The banks were able to do this because they did not have to keep the loans on their books. Financial firms were able to package the loans in derivatives marketed as collateralized debt obligations (CDOs), or CDO squared or synthetic CDOs. Everyone believed they could off-load their risk to the next idiot down the pipeline. When borrowers stopped making their mortgage payments, the losses were amplified by the extreme leverage and the house of cards collapsed. The commission concluded that legislation enacted in 2000 to ban regulation of over-the-counter derivatives was a key step in the financial crisis.</p>

<p>The credit rating agencies were “key enablers” of the financial crisis. The CDOs could not have been sold without their endorsement. From 2000 through 2007, Moody’s rated nearly 45,000 mortgage-backed securities as AAA. Every day in 2006, Moody’s rated 30 CDOs as AAA, of which 83 percent were eventually downgraded. By contrast, only six private sector companies in real business were rated AAA in 2010, and U.S. government bonds have lost their AAA rating.</p>

<p>And so I respond to my friends and critics by saying that there is enough blame to be spread around to many people and organizations, but I do not think that raising this criticism is an endorsement of Karl Marx. He tried hard to kill capitalism without success. He might have been amused at the sophisticated way in which capitalism almost killed itself. </p>

<p>I think we have proved that when Karl Marx said, “Religion is the opiate of the masses,” he was wrong. Our current economic crisis shows that “Credit is the opiate of the masses.”</p>

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