Why the U.S. credit crisis should never have happened

By Robert Borosage on October 16, 2008

How did it come to this? The banksters issue a threat: hand over $700 billion in taxpayers’ money–on top of the $600 billion already forked over–or we’ll take down the global economy.

There will be a lot of obfuscation—fingers pointing every which way—but the story is very clear.

The immediate cause is the inflating and busting of the housing bubble. Federal Reserve chairman Alan Greenspan will be remembered for stoking a bubble economy. Coming out of bursting of the dot.com bubble, Greenspan lowered interest rates and kept them there. With his war and tax cuts, President Bush racked up record deficits. Struggling with stagnant incomes, Americans took on record debts. Foreign creditors, like Chinese central bankers happy to loan us money to buy their goods, flooded the U.S. with dough. With mortgage rates low, housing prices rose. An unregulated shadow banking system began marketing exotic mortgage-backed securities across the globe. As the housing bubble grew, brokers hawked shakier and shakier Alt-A and subprime mortgages. Ninja loans—no income, no jobs, no assets—became the rage.

Since the brokers sold off the mortgages immediately, they had a stake in making the loan, not whether the loan would be repaid. The banks and investment houses sliced and diced the loans into ever more exotic securities, which got prime ratings, although no one really knew what was in them. European banks and others bought more and more of the stuff. To escape capital limits, they invented credit default swaps in which companies like AIG guaranteed the loans in case of default. That totally unregulated over-the-counter market soared to $60 trillion. Banks set up off-balance-sheet entities to evade capital limits. Investment houses like Bear Sterns and Lehman Brothers borrowed at 30 times their capital to speculate in these markets. Wall Street’s executives were pocketing tens of millions from the take.

The regulators turned their heads. Greenspan not only fueled the cheap money; he cheered on the exotic mortgages, even while refusing to acknowledge, much less limit, the housing bubble. The Securities and Exchange Commission exempted five major investment houses from their normal capital requirements. Fannie Mae and Freddie Mac’s executives profited personally as their enterprises started buying Alt-A mortgages.

Everything was great so long as housing prices went up. When they topped out, the bottom fell out. Defaults and foreclosures soared. Suddenly, no one knew what the value of the securities they held was, much less what was in the balance sheets of other banks. Much of the exotic paper turned toxic; no one wanted to buy it. As the banks slowly were forced to write down its value, they had to raise capital. With everyone trying to sell at the same time, the values went through the floor. Bear Sterns, Lehman Brothers, and Merrill Lynch collapsed into bankruptcy or fire-sale mergers. The insurance giant AIG and Fannie and Freddie were taken over by the federal government.

And now, Washington is gearing up for the largest bailout in history, throwing an estimated $700 billion (for now) more to buy up the toxic paper from the banks to keep the entire financial system from collapsing.

This catastrophe was the direct result of conservative misrule. In the Great Depression, our grandfathers learned a simple lesson: Finance is too important to be left to bankers. So President Franklin D. Roosevelt saved the banks, but in exchange put them in a regulatory straitjacket. Currencies, interest rates, capital requirements, limits on leverage and on financial instruments—all were regulated to create a banking system that could provide financing needed by businesses and homeowners without debilitating speculative excesses.

In the 1970s, with the country experiencing stagflation, oil shocks and the Vietnam War, and with President Nixon moving to floating currencies, banks started pushing hard for deregulation. Wall Street money in Washington paved the way. With the election of Ronald Reagan, true believers—those whom George Soros calls “market fundamentalists”—took over Washington. Government was the problem, not the solution. Deregulation was the order of the day.

Conservatives argue now that the problem was poor regulation, not unbridled markets. But conservatives trumpeted that markets were self-correcting, and so systematically set out to weaken the regulatory agencies—not simply repealing laws, but appointing regulators who scorned the very responsibilities they were given.

Republicans led this charge, naturally, but Democrats also imbibed the conservative Kool-Aid. Deregulation became a bipartisan enterprise; Democrats began trumpeting their dedication to markets, and pocketing contributions from Wall Street. The deregulation of the savings and loans in the first months of the Reagan administration was a bipartisan effort. That disaster, which allowed S&Ls essentially to gamble with government guarantees, ending up costing taxpayers about $150 billion. We didn’t learn the lesson.

Led by such zealots as Republican Phil Gramm, Congress freed the banking system from its New Deal restraints. With the support of Bill Clinton and his Treasury Secretary Robert Rubin, the Glass-Steagall Act was repealed, ending the divide between commercial and investment banks. Commodity exchanges were exempted from regulation, leading to the over-the-counter credit swap trading that Warren Buffett warns is a financial weapon of mass destruction. The SEC exempted five investment houses—Goldman Sachs, Bear Sterns, Merrill Lynch, JPMorgan and Lehman Brothers—from capital requirements. Three of them are now gone. Questions about the survival of the other two triggered the current frenzied bailout. With the cop on the financial beat disarmed, the casino opened for business.

So once more we pay dearly to learn the lesson. Finance cannot be left to bankers. Banks can get too big to fail; unregulated financial systems tend to speculative frenzies because the speculators can profit greatly by taking very large bets—and now have good reason to believe that the government may cover their losses.

We need new and strict regulation on the entire financial system—no more shadow entities operating on the side. That regulation should include strict capital requirements, limits on leverage, transparency, and policing of instruments allowed and compensation schemes. We’ve got to rearm the cop on the financial beat—and elect leaders and appoint regulators who do not scorn the government they lead.

This won’t be easy. The bailout is designed to forestall a global depression. A depression would be destructive, but in the destruction the most irresponsible firms would be liquidated, the wastrels would be ruined, and the public would demand that government crack down on Wall Street.

Even with the bailout, getting Wall Street back under control won’t be easy. Wall Street is using the crisis that they’ve created to demand immediate action. Regulation, their lobbyists argue, can come later. Forget about a stimulus for the economy. Don’t complicate the bailout with requirements for renegotiating the mortgages or keeping people in their homes.

Wall Street has received the rescue without the regulation. The wastrels will have their losses covered. Wall Street money will bribe Congress to leave them alone. The public is more relieved than angry. The market fundamentalists are already blaming the crisis on government, not on the banksters on the make.

The reality, however, is clear. Finance cannot be left to bankers. Citizens have to get into this argument. We’ve got to demand conditions on any bailout And we’ve got to reject the market fundamentalism, the scorn for government and cynicism about the common good that has led us directly into this debacle.

Taxpayer money; taxpayer accountability

The Treasury now has unlimited authority to spend $700 billion in a revolving fund with no rules beyond its own discretion. We can't trust the most spectacularly corrupt administration in memory to decide how they'll cut the deals with the banks. We’d get fleeced. Instead, the law must be amended to require an independent entity, with consumers and workers having a majority of the seats on a board with authority to create rules that will prohibit gaming of the bailout. And the Congress—itself sadly compromised by Wall Street money—should be empowered to name independent monitors and to approve all board members.

Taxpayers share in the upside

Under the bill as-is, the Treasury would buy the bad paper of firms without taking any equity in the firm. That's an invitation to larceny. If a firm decides to auction off its toxic paper to the U.S agency, taxpayers should get equity in that firm, in proportion to the assets we buy. That will deter profitable firms from using the agency as a dump for their toxic paper. And it will insure that if the bailout works and the firms become profitable, taxpayers, not simply bankers, benefit from the upside.

Shut down the casino

No bailout of the predators should go forward without new regulation for the entire financial system—capital requirements, leverage limits, bans on exotic instruments, transparency, limits on compensation schemes. The shadow banking system—hedge funds, private equity firms—must be brought under the glare of regulators. Some details should be written into the law; the Treasury can be mandated to issue regulations on the rest by a date certain. Any promise to do the bailout now and the regulation later is simply a lie. If the banks are too big to fail, they are too big to play on the Street alone.

Curb excessive CEO pay

Wall Street fat cats shouldn't be pocketing millions taxpayers are forced to bail them out. Any firm that applies for relief must agree to limit the compensation of any executive—pay, bonuses and perks—to no more than the highest pay offered a senior federal official. Future compensation should be linked to profitability.

Invest in the real economy

Ending the bankers strike is not sufficient to avoid a serious recession, as consumers tighten their belts. A major public investment agenda–$250 billion or more–for launching new energy and conservation projects, rebuilding schools and infrastructure, extending unemployment and food stamps, and helping states avoid crippling cuts in police and health services, is vital to getting the real economy moving and putting people back to work. If we don’t do this, the coming recession will raise the cost of the Wall Street bailout dramatically, as credit card, auto and home loan defaults rise.

Aid the victims, not just the predators

No bailout of the banks can take place without a freeze on foreclosures and a renegotiation of bad mortgages. Bankers as well as homeowners both made foolish bets that home prices would keep rising. Many homeowners were misled by predatory lenders into taking mortgages that they didn’t understand and couldn’t afford. It would be simply obscene to help the predators and not those that they preyed on.

Curb the political corruption

Paid lobbyists of Wall Street firms should be banned from the Beltway. Any meeting with representatives of Wall Street–and many will be needed to understand what is happening–should be posted immediately by legislators in a central place on the Internet. Senators and representatives on the relevant oversight committees should forswear any contributions from Wall Street employees. All those employed over the past five years by troubled firms seeking relief should be prohibited from profiting from the bailout. Without this ban, legions of executives from Bear Sterns or Lehman Brothers will create consulting firms to profit from cleaning up the mess that they made. 


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