Innovation, Capital, Jobs and Taxes

We have high unemployment in part because our financial system misallocates capital.  This post starts to explore why and what to change.

I’ll use terminology from Clay Christensen’s forthcoming book, “The Capitalist’s Dilemma” because his “The Innovator’s Dilemma” is among the most illuminating I’ve ever encountered.  Why, he wondered, was the industry leader in 14 inch computer disk drives not the leader in 8 inch, and why did leadership change again in the next generation?  Why did the same thing happen in all fast-developing industries?  It’s because, he realized, industry leaders innovate only at the high end of their market.  Innovation below their market that results first in products for new markets continues to develop until it replaces products for existing markets.

Christensen terms these revolutionary innovations that transform complex, costly products into simple, cheap ones “empowering”.  Examples include the Ford Model T, the Sony transistor radio, and the IBM PC.  These innovations require long-term capital and, when successful, they create many new manufacturing, sales and service jobs.

“Sustaining” innovations that replace existing products with new versions create few if any new jobs because those who worked on the replaced products now work on the new ones.  Sustaining innovation is attractive because it offers a faster, and in the short-term less risky, return on capital than empowering innovations.  It is insufficient in the longer term because its products will be replaced by later products of empowering innovation.

“Efficiency” innovations cut the cost of making and distributing existing products and services. They cut jobs because they streamline processes.  They also free up capital.  Toyota’s just-in-time production system, for example, enables them to operate with much less capital invested in inventory.

What we want our financial system to do is encourage capital freed up by efficiency innovation to be redeployed as investment in new empowering innovations.  We want empowering innovations because they create new consumption.  We want enough of them so they create more jobs than efficiency innovations cut.  That way, we’ll have enough jobs for our increasing population.

What is happening in the US today is too much capital liberated by efficiency innovations is being invested in more efficiency innovations.

Part of the remedy is to change how we tax capital gains.  Gains from investments held less than a year are now taxed like personal income while gains on investments held more than one year are taxed at a much lower rate, 15%.  We should change that because gains from empowering innovations come, if at all, only after considerably more than one year while efficiency innovations pay off sooner.

We should tax capital gains at a set of decreasing rates depending on how long the capital remains invested.  Rates should start at the personal income rate, drop slowly in years two and three, then faster, maybe even to zero after five or eight years.  This would have little impact on the Federal budget in the short term because capital gains generate only a small part of Federal tax revenue.  In the longer term, by encouraging more investment in empowering innovation that creates new jobs, income tax revenue should grow and Federal spending on unemployment should drop.

Unfortunately, I’ve realized I should resume exploring tax policy.  Ben Franklin famously wrote: “Our new Constitution is now established, and has an appearance that promises permanency; but in this world nothing can be said to be certain, except death and taxes.”  I’ll start with corporate tax because Ben did not foresee the rise of corporations, which are by nature exempt from the inevitability of death and by trickery can also escape taxation.

Essential Financial Reforms

Congress asked the Government Accountability Office (GAO) to assess the cost of the 2007 financial crisis and if the 2010 Dodd-Frank legislation will prevent future crises.  GAO just released their findings:  “the present value of cumulative output losses could exceed $13 trillion” and “[there is] no clear consensus on the extent to which, if at all, the Dodd-Frank Act will help reduce the probability or severity of a future crisis”.  $13 trillion?  If at all?  That’s alarming.

GAO studied not just the bailout cost, which looks to be $1.5T to $3T, but the overall cost.  “While the structural imbalance between spending and revenue paths in the federal budget predated the financial crisis … From the end of 2007 to the end of 2010, federal debt held by the public increased from roughly 36 percent of GDP to roughly 62 percent.  Key factors … included (1) reduced tax revenues … (2) increased spending on unemployment insurance … (3) fiscal stimulus programs … (4) increased government assistance to stabilize financial institutions and markets.”  36% to 62% is one big jump.

Consumer spending (70% of our economy) fell, GAO notes, because: “median household net worth fell by $49,100 per family, or by nearly 39 percent, between 2007 and 2010”.  They also show the high human cost of long-term unemployment from the financial sector’s collapse.

Unemployment Rate GAOMaybe later I’ll explore why Congress passed legislation GAO found may or may not “reduce the probability or severity of a future crisis“, legislation that is both enormously too complex and not what we normally think of as regulation.  The Glass-Steagall Act that transformed finance after the 1929 Wall Street Crash has 37 pages.   Dodd-Frank has 848 and does not specify rules people must follow but new regulations bureaucrats must create along with enforcement agencies.  That’s not how we do things where I’d like to come from.

The immediate, urgent question is, what must we make Congress do instead?  Now I understand the problem (see previous pasts), the solution looks pretty straightforward:

  1. Eliminate too-big-to-fail.  The collapse of the big banks and AIG threatened to paralyze our entire economy.  They were bailed out because they were considered too big to be allowed to fail.  Businesses that go wrong should fail.  And they should fail without damaging the economy.  This means banks must be limited to a maximum of, say, 5% of total US deposits and any that become insolvent must be forced into receivership under the FDIC.
  2. Regulate derivatives.  The collapse of any one financial institution could trigger the collapse of the whole system because inter-dependencies via derivatives were gigantic and invisible to regulators.   To make them visible, derivatives must be traded on exchanges like stocks and futures, and ones that could require a future payout must be treated like insurance with their underwriters required to carry reserves.
  3. Restore 12:1 leverage.  The big banks failed so fast because their capital reserves were too low.  Our economy depends on lending and they had to stop when they became insolvent.  The SEC waiver of the 1975 net capitalization rule must be reversed and SEC discretion over the rule must be eliminated.
  4. Restore Glass-Steagall.  Tax-payers have to foot the cost of the mega-banks’ mismanagement because speculation and underwriting is no longer separate from taxpayer-backed depository banks.  The separation must be restored.
  5. Regulate non-bank lenders.  Many of the loans most likely to default were originated by non-banks who securitized and sold them.  Any institution that originates a loan must be required to keep, say, 10% of its securitized loans and absorb the first 10% of default losses incurred by investors in the securitized loans.

Among other things, the Dodd-Frank Act mandates the SEC to require US public companies to repossess executives’ short-term profits that result in long-term liabilities that require an accounting restatement.  There is also discussion of ways to make senior management personally liable in the event of a taxpayer bailout.  I have little confidence in either approach.  Compensation committees will indemnify executives from such provisions.  Shareholders and taxpayers will continue to pay.

The Justice Department recently sued S&P for up to $5B for defrauding investors with inflated credit ratings.  I assume Moody’s will also be sued because they, too,were paid for ratings by investment banks that issued  mortgage securities.   We might hope S&P and Moody’s will change the way they do business to eliminate the conflict of interest.  More proactive would be to open the ratings business to competition.

Hmm, my Buddhist practice must be helping – I got through exploring all this Washington/Wall Street malarkey without feeling angry.  I feel wrathful determination to do whatever I can to get it fixed, but wrath can be positive.

Fixing the negatives will discourage allocation of capital where it will have little or no value.  Next I’ll turn to the positive and explore what could guide good allocation.

It Takes a Pillage

Our finance system stopped allocating capital where it will have most value and efficiently reallocating risk.   Previous posts showed how deregulation and bailouts introduced moral hazard, how leaders of big financial institutions responded, and how in 2007 it all blew up.  But why did Washington allow the moral hazard to develop and respond as they did to the result?  Was there a cabal of corrupt Mr. Moolas?

Fat Cat

Probably not.  The protagonists seem genuinely to have believed markets would regulate the behavior of their participants.  When it went wrong, they did not consider it self-interested to preserve the big financial institutions they understood to be the financial system.

How we conceptualize the world is shaped by our experience.  It’s instructive to explore the experience of those whose beliefs got us so far off course but future Fed Chairpersons and Treasury Secretaries will also have conceptual blinders.  To avert repeating the catastrophe we must make structural changes.

In this post we considered Alan Greenspan’s expansion of the Fed’s mission to include managing asset prices.  His successor, Ben Bernanke, holds the same belief.  Central banks do influence asset prices while raising and lowering interest rates to help manage inflation and unemployment but they overestimate monetary policy hoping it can compensate for poorly managed fiscal policy, i.e., government revenue and spending.

What set the beliefs of Treasury Secretaries?  Robert Rubin, 1995-1999, had worked at Goldman Sachs for 26 years and was co-chairman from 1990 to 1992.  He later became a director of Citigroup and was its chairman at the height of the 2007 crisis.  Larry Summers, 1999-2001, formerly Rubin’s deputy, followed his lead against regulating derivatives and for deregulating big banks.   Paul O’Neill, 2001-2002, formerly CEO of Alcoa, deplored Bush’s tax cuts, investigated al-Qaeda funding by American allies, objected to the invasion of Iraq, and was fired.  John Snow, 2003-2006, formerly CEO of CSX, had to resign when it was revealed he failed to pay income taxes on $24M at CSX .  Henry Paulson, 2006-2009, was formerly chairman and CEO of Goldman Sachs.  Tim Geithner, 2009-2013, was at Treasury from 1998–2001 under Rubin and Summers, then President of the NY Fed.

With the exception of O’Neill and Snow who had little impact, the beliefs of all these men were shaped by Goldman Sachs.  Did they act always in what they believed to be the best interests of all the people?  Let’s assume they did.  What they believed would have led them to the actions they took.   Of course they believed big financial institutions must be saved, and of course they believed it essential to bail them out.

They may well have been right.  Deregulation probably had made the big financial institutions too big to fail and bailouts had become Washington’s Pavlovian response to confidence-threatening failure of big enterprises.

But what about after the bailouts?   We already considered moral hazard created by bailouts that protect fools from the disasters they create.  What about moral hazard created after the bailouts by weak punishment of those who committed fraud?  This is where more folks think they see Mr. Moola.

Financial institutions have agreed to settlements that sound large.  Global banks agreed to pay almost $11B in the US last year.   This January, Bank of America reached a $10.3B settlement with Fannie Mae.  The Fed and Treasury reached a separate $8.5B settlement with 10 banks, including BofA.   But no institution or executives have been brought to trial.  And while $11 + 10.3 + 8.5 = $30B of settlements is a big number, financial sector stocks in the S&P 500 earned $168B in profits last year, up 21% from 2011.  The cost of the settlements was inconsequential, $30B of what would have been $200B.

The settlements make even less difference to those responsible.  Angelo Mozilo, for example, was paid almost $470M as CEO of Countrywide Financial but paid none of BoA’s settlement for what Countrywide did under his leadership.   He did settle with the SEC on unrelated insider trading charges but even there he paid only $47M of the $67M settlement because he had a $20 million indemnification in his employment contract.  Criminal convictions have discouraged insider trading.  Mortgage and other financial frauds should also have been vigorously prosecuted.

But far more important than punishment for crimes past are major changes we must make (1) to minimize moral hazard and the likelihood of another financial crisis, and (2) so the financial system will allocate capital where it has the highest value.  The first, which I will itemize in the next post, are easy to see now that I understand the problem.  The second requires more exploration.

The Dukes of Moral Hazzard

In the world of finance, moral hazard exists when someone can profit from successful bets and suffer little or nothing from bad ones.  In the 1980s Dukes of Hazzard show the Duke boys, their beefed-up Dodge Charger and their short-shorted cousin Daisy keep foiling corrupt county commissioner “Boss” Hogg’s scams but because the well-meaning boys often bail him out, he’s always coming up with new scams.  So it has been in the world of finance for the last three decades.

Daisy Duke

Moral hazard inflated the bubble whose collapse in 2007 left us wallowing in the Great Recession.  Wall Street executives made bets that profited them immensely expecting, correctly, they would not suffer when the bubble blew.  Their firm might suffer, perhaps even cease to exist, but they would keep their profits.  Their firm might pay penalties for law-breaking, but they would not.  Moral hazard defeats what finance should do, allocate capital where it will have most value and efficiently reallocate risk.  This post examined finance’s mechanisms – securities, credit and insurance – and the following one highlighted regulatory changes enabling the mechanisms to be used in ways that led to the 2007 financial crisis.  This post explores how Washington became Wall Street’s savior.

Bailouts of individual enterprises started in 1971 when defense contractor Lockheed  was rescued from financial mismanagement with $250M of loan guarantees.  Then in 1973, the Penn Central Railroad, which declared bankruptcy in 1970 but was considered “too big to fail”, was merged by Congress into Conrail, whose operating costs Congress spent $7B subsidizing.  Next, in 1980, Chrysler was bailed out with $1.5B in loan guarantees.  So, with these bailouts starting in 1971, Washington began thwarting capitalism’s creative destruction.

Lockheed was mismanaged financially, its defense and civilian mega-projects had big cost overruns and were late, and it was bribing foreign government officials.  Penn Central’s executives utterly failed to gain operational control after it was formed in a 1968 merger.  Chrysler’s executives produced its uncompetitive cost structure and low quality products.  If, to take just one example, Chrysler had declared bankruptcy, its management would have been replaced and its contracts renegotiated.  Because it was not restructured, it inevitably failed again and leaders of GM, Ford and the unions learned they, too, might expect to be bailed out.

The Chrysler bailout, the first whose rationale was to save jobs and the economy, set an especially bad precedent.  In 1987, the Fed took the next step along that path of unintended consequences which led to the 2007 financial collapse.  The Fed’s traditional mission had been to manage inflation and promote sustained output growth by supervising credit.  Now it began trying to manage asset prices.

When the Dow plunged 23% on October 19, 1987 following drops of 4% and 5% the previous week, the Fed promised before the market opened the next day to “serve as a source of liquidity to support the financial and economic system”.  No economic event had triggered the crash.  Stock prices had simply risen too far too fast, 40% in the first eight months of the year, and there was panic at the first sign of the bubble deflating.

Why, then, did the Fed do anything?  Because Fed Chairman Greenspan saw market prices not as an indicator of the economy’s health but as something he should manage.

Market prices kept heading up through the 1990s following each downward blip, e.g., the LTCM hedge fund collapse and bailout in 1998, until in 2000 the dotcom bubble collapsed.  Greenspan then began cutting interest rates almost month to month from 6% in January 2001 to 1.75% by year-end, and he kept on down to 1% in 2003.  Consumer spending, around 70% of the entire US economy, had barely dropped; only the stock market had plunged.  Greenspan’s unprecedented rate-cutting was not required to stimulate economic growth but stock prices, which it did until the next collapse.

Interest from investment was now so low that it became essential to speculate for income – trust funds and foundations must disperse 5% of assets each year.   And speculation seemed safe because a new pattern had emerged; when bubbles collapsed, the Fed would save the day.  So houses, traditionally a safe investment, became a vehicle for speculation.  Until that bubble collapsed in 2007.

The Fed was not the only creator of moral hazard.  Congress, in the 1995 Securities Litigation Reform Act to control nuisance class action lawsuits, exempted accountants from liability for fraud by their clients.  Accounting scandals soon followed.  Enron was the most dramatic and its 2001 fall also took down its auditor, Arthur Andersen, one of the “Big Five” accounting firms.

The SEC’s contribution to the 2007 crisis was facilitation of stupidity.  From 1975, the SEC limited investment bank borrowing to no more than $12 on each $1 of their capital.  In 2004 they gave the five biggest ones a special exemption that allowed them to lever as much as 40:1.  Three years later, all five of them were insolvent.  First, Bear Stearns went belly-up in a bank run when clients fearing it was over-leveraged pulled out 90% of its liquidity in two days.  Almost immediately after that Lehman Brothers became the largest bankruptcy ever in the USA.

Bear was eased into the arms of JP Morgan with $29B of guarantees from Washington.  Lehman was allowed to fail.  Its clean assets were bought by Barclays and others.  But then Washington stepped in full force.  Merrill Lynch was helped to sell itself to Bank of America.  Morgan Stanley and Goldman Sachs borrowed massively from Washington and changed their status to commercial banks so Washington would lend them more.  The Fed bailed out AIG whose massive exposure to derivatives made it “too big to fail” and Secretary of the Treasury Paulson, ex-CEO of Goldman Sachs, nationalized Fannie Mae and Freddie Mac for the same reason.

Why were these economy-threatening institutions allowed to grow so big?  Deregulation of the barriers was strongly advocated throughout the 1990s by Treasury Secretary Rubin, formerly co-chairman of Goldman Sachs.

And why were economy-threatening derivatives not regulated?  Rubin’s advice was instrumental in that decision, too.  He later became a director and temporary chairman of Citigroup.

When asset prices tumbled as the real estate bubble collapsed, banks had to stop lending, not that there was much demand for new borrowing.  It was said to be a liquidity crisis because the big banks were, or were close to being, insolvent.  The confusion led to a Wall Street crash.  In that panic, Treasury Secretary Paulson proposed a $700B program to inject capital into the big banks and buy the junk off their books while the Fed began far more massive capital injections via all the big banks.

Pretty soon Washington (the Fed, FDIC, Treasury and FHA) had a $15T commitment of monies spent, lent, and guaranteed, around the size of the entire US economy. Much of what was lent has since been repaid because the big banks were saved and many of the guaranteed loans were sound.  Nonetheless, the cost looks likely to end up in the range of $1.5T to $3T.  Those numbers are too large to imagine.  For comparison purposes, the inflation adjusted cost of WW2 was around $3.5T.

And saving the banks but did not avert global economic recession.  Furthermore, the saved big banks are still too large to fail and their executives are still profiting as they did before when, for example, the CEO of Citibank was paid $130M from 2003 until late 2007 when Citi’s stock collapsed from 55 to 2.

I’ll explore in the next post why the people who wreaked such destruction on their employers got to keep their enormous rewards and why although their employers later had to pay big penalties for fraudulent actions on their watch, none of the executives has been indicted.

The Tent of Sherlock Holmes

Sherlock Holmes and Watson pitch their tent and go to sleep.  Hours later, Holmes jogs Watson awake and commands: “Look up and tell me what you see.”  Dutifully, Watson gathers his thoughts.  “I see countless stars,” he begins, “in the immeasurable vastness of the heavens.”  He ponders how tiny he and his friend are in comparison and can say no more.  “What is it you see, Holmes?” he asks.  “I see some scoundrel stole our tent.”

Watson sees the concept he always sees, Holmes sees what changed.   This post examined finance’s mechanisms – securities, credit and insurance.  Now we can focus on what changed to make the 2007 economic collapse possible.  Because human nature did not change, we will defer to a future post how what did change was exploited.

The combination of several changes led to the 2007 perfect financial storm.

The root cause was the Basel I agreement in 1988 which, following the messy liquidation of a German-based bank, set minimum capital reserve requirements for all G-10 banks based on the relative risk of five classes of assets.  Domestic sovereign debt required zero reserves, corporate debt 8%, intermediate types 0.8%, 1.6% and 4%.  Residential mortgages required 4%.  That got bankers thinking.  How could they keep making more loans without increasing their capital reserves?

Mortgage securitization was the first answer.  It had been developed in small steps associated with the growth of Fannie and Ginnie Mae then heavily promoted by Washington in response to the 1980s Savings and Loan Associations (S&L) crisis.  Very high interest rates established to quell inflation had caused almost a quarter of Savings and Loan Associations to fail.  Securitization attracted big investors and helped stabilize the residential mortgage market.  Now commercial banks began using securitization to get mortgages off their balance sheets so they would need no corresponding capital reserves.  They could keep the origination fees and keep issuing more mortgages.

Capital reserves could also be avoided using Citigroup’s 1988 invention of off-balance-sheet entities, e.g., SIVs, Structured Investment Vehicles, which at their 2007 peak had over $400 billion of assets.

The new mechanism for securitizing mortgage loans, the Collateralized Debt Obligation (CDO), was invented in 1987 by now-defunct Drexel Burnham Lambert to securitize mortgage-backed loans for a savings institution that later became insolvent.  Their issuance exploded to more than $180 billion by Q1 2007.  The credit quality of CDOs declined as subprime and other non-prime debt grew from 5% in 2000 to 36% of CDO assets in 2007 but the credit ratings of CDOs did not change.

Rating agencies ignored the risk of a nationwide collapse of housing values when giving CDOs the highest grade.  They also tended to give high ratings to all CDOs because they were paid for those ratings by the CDO originators.

CDOs are complex instruments.  Investors worried about the risk of default on the underlying loans.  The answer was JP Morgan’s 1994 invention of the Credit Default Swap (CDS).  In return for a small payment, the buyer of a CDS would get the full amount of the loan if the borrower defaulted (the seller of the CDS would get possession of the loan).

A CDS is different from an insurance contract because it pays off  whether or not the CDS buyer suffers an actual loss.  Unlike life or fire insurance, you can buy a CDS on a loan made by someone else.  More dangerous, the seller of a CDS is not required to have capital reserves.  And there was no oversight because CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.

Credit Default Swaps soon came to be used for purposes very different from risk mitigation.  For a small outlay you could buy a CDS to collect the entire face value of a CDO if it collapsed.  Multiple CDSs could be stacked on the same CDO and CDOs began to be collateralized by other CDOs.   It was easy to see that betting against CDOs whose underlying loans would default could generate big profits, and if you borrowed enough money to make huge bets your winnings could be gigantic.

Speculative frenzy drove the total “value” of outstanding Credit Default Swaps over $60 trillion by the end of 2007, four times as high as GDP, almost the size of the entire global economy.

Meanwhile, the Fed was holding interest rates very low to maintain investor confidence after the dotcom bubble’s collapse in 2000-2001.  That enabled lower income buyers to enter the housing market, encouraged refinancing and led to lower and lower underwriting standards that culminated in NINJA (no income, no job, no asset) loans to people who would inevitably default, but not within the 90 days it took to securitize and resell their mortgage on which the originator would keep the origination fee.

The last regulatory change for the perfect financial storm is the Fed’s relaxing of the 1933 Glass–Steagall Banking Act which limited banks’ size and barred commercial banks from securities activities.  Looser “interpretation” of the Act that began in the early 1960s was far advanced by 1998 when Citibank merged with Salomon Smith Barney, one of the largest US securities firms.  In 1999 the Act was repealed altogether.

The financial system was soon dominated by behemoths.  In 1990, the 10 largest US banks had almost 25% of the industry’s assets.  That grew to 44% in 2000 and almost 60% in 2009.  The two biggest banks in housing finance had 44% of US mortgage originations in 2009.  Oversight, or indeed management, of these giants whose operations are global, complex and opaque became, and still is, little more than a hypothetical possibility.

When the $22T housing bubble burst in 2007, around $5T was very rapidly lost.  Financial institutions had too little capital reserved to cover such a loss and unknowable inter-dependencies.  They had traded so much with each other that failure of one would likely bring down others.  The CDS insurance sold by AIG and others to mitigate the risk was useless because they had no reserves to compensate those whose assets were suddenly worthless.

That was when the final change took effect, a non-regulatory one.   In 1998, Long-Term Capital Management, a hedge fund that used 100:1 leverage to buy over $100B of emerging market bonds and $1T of derivatives, had lost $5B when Russia defaulted on its debt.  Fearing market panic, the Fed pressured the banks that lent the $100B to buy LTCM’s assets so it could be promptly liquidated.  Wall Street executives learned from that event.  They would likely be bailed out, too, if their bad bets were big enough to shake the markets.

When the banks and shadow banks bets did go bad in 2007, Washington stepped in with $2 trillion of tax-payers’ money to halt what was fast shaping up to be a potentially economy-wide bank run.

Financial institutions had come under stress because of bad bets, which their high leverage turned into a crisis with potentially huge domino effects.  We cannot know how serious the results would have been if the crisis had been allowed to play out.  We do know the leaders of the giant financial institutions got the one critical bet for their own future right, the Federal Reserve and Treasury did bail them out.

I will next explore how that financial moral hazard developed; how Washington came to be Wall Street’s savior and made financial and economic crisis inevitable.

Mr Economy’s Paralyzing Stroke

Finance is like the circulatory system distributing oxygen and nutrients through the human body, stabilizing its temperature, and so on.  It’s prone to strokes.  What led to Mr Economy’s massive one in 2007?  Will he have more?  How severe will they be?  And will he ever recover from the paralysis that one caused?

Our economy depends on finance to flow.  Unfortunately, Washington has the wrong model.  When the flow stopped in 2007 they applied giant plungers, TARP and Quantitative Easing, to what they imagine is a blocked financial toilet.  Not surprisingly, the flow has not been restored.

To understand what led to the cerebrovascular accident and what risk factors to change, we must first know the purpose of finance, what it should do, and its basic mechanisms.   Its purpose is to help people save, manage, and raise money.  What it should do is allocate capital where it will have most value and efficiently reallocate risk.  Its mechanisms are securities, credit and insurance.

We need to know how those mechanisms work to understand how and why the circulation of finance got interrupted.

Securities can be bought and sold.  Their traditional function is for commercial enterprises to raise new capital from investors who seek income and/or capital gain.  Their traditional categories are equity and debt.  Equity securities represent fractional ownership of the issuer, debt securities a loan.  Debt securities typically require regular interest payments and the issuer must repay the loan.  Equity securities are not entitled to payment but may receive a periodic share of the issuer’s profits.  Equity owners hope the value of the issuer, and therefore their securities, will increase.

Credit has traditionally been supplied by bank loans governed by an agreement between issuer and borrower.  Those loans could not be traded.  The issuer received interest payments for the use of their capital and protected against failure to repay with a claim on the borrower’s assets, i.e., collateral.

Insurance transfers the risk of a loss from one entity to another in exchange for a payment.  The insured accepts a definite small loss in the form of their payment to the insurer in return for compensation in the uncertain event of a larger financial loss.

Several things changed in the past three decades.  There was a great increase in securitization of what was originally credit.  Security, credit and insurance transactions got combined in new and ever more complex ways.  Financial regulation was relaxed and funding of regulatory oversight was cut.

Mortgages (i.e., credit) were bought in bulk, repackaged and resold as new types of securities, CDOs, Collateralized Debt Obligations, Re-REMICs, Re-securitizations of Real Estate Mortgages, ABS, Asset-Backed Securities, MBS, Mortgage-backed Securities and etc.  Banks could now originate more  mortgages because the ones they sold were no longer on their balance sheet.  Buyers of mortgage-backed securities could pay for them with money borrowed against other securities as collateral and hope to resell them for a quick profit.  They could insure against their collateral’s possible loss of value.   And so on and so on.

That increased complexity accelerated the financial system’s growth but also made it more fragile, which increased risk for the overall economy.  Issuance of these new kinds of derivative securities (chains of transactions derived from an asset) exploded from less than $100B in 2000 to more than $500B in 2007.  That’s when the uber-stimulated financial system cratered and Mr Economy had his paralyzing stroke.

US Securitization Issuance

Financing , refinancing and securitizing doubled household debt from 48% of GDP in 1980 to 99% in 2007.  Most of that increase was in residential mortgages, up from 34% to 79% of GDP.

Mortgage Origination

Financial services grew not just from credit intermediation.  Management fees grew as people switched from owning individual securities to managed funds, transferred their assets to professional managements, traded more, and as asset values increased.   Only 25%  of household equity holdings were professionally managed in 1980.  That more than doubled to 53% by 2007.

The growth in insurance was mainly in new kinds of insurance associated with securitization.

Earnings of financial services employees grew rapidly along with the financial sector’s growth.  In 1980, they typically earned about the same as their counterparts in other industries.  By 2006, they earned an average of 70% more.

Growth of Financial ServicesThe increase in household debt and associated derivative securities drove the value of total financial assets, stocks, bonds, derivatives, and etc from about five times GDP in 1980 to double by 2007.  The ratio of financial assets to tangible assets, e.g. plant and equipment, land, residential structures and etc. grew in the same rapid way.  Debt creates money because if you lend me $100 there is now $200, my $100 plus your $100 asset, i.e., my promise to repay.  Assuming I do repay.

Financial Assets vs GDP

Much of the asset growth came from securitization of loans on bank balance sheets, i.e., transforming credit into securities.  The total value of debt securities was 57% of GDP in 1980.  Securitization of loans added 58% by 2007.  The total value of debt securities more than tripled to 182% of GDP.

Much of the growth in equity securities came just from higher equity valuations, i.e., the exuberant willingness of buyers to pay more for potential future gain.  The total value of equity securities nearly tripled as a share of GDP between 1980 and 2007, from 50% to 141% of GDP.

Financial institutions traditionally earned spreads on loans on their balance sheets, i.e., they got higher rates of interest on capital they lent than they paid to depositors.  That changed with securitization.  Now they profited mainly from fee income.  By 2007, 61% of home mortgages were in loan pools of mortgage-backed securities, 72% of which were guaranteed by the Federal Housing Administration (FHA) or one of two Government Sponsored Enterprises (GSEs), Fannie Mae or Freddie Mac.

Securitization of credit was a major part of the development of the “shadow banking” system.  Many types of non-bank financial entities now perform some essential functions of traditional banking.  Like banks, they use short-term borrowing to issue or buy longer-term securities.  Their short term lenders can demand repayment at any time, and they are vulnerable to a drop in the value of longer-term securities, either of which can result in the equivalent of a bank run because deposits at shadow banks are not federally insured.

When financial transactions were primarily between a security issuer and a purchaser, or a bank and a borrower, each party’s risk could be known.  When a package of mortgages is securitized, however, third parties buy the securities, insure themselves against severe loss with a fourth party which perhaps insures itself with a fifth party, and so on and so on.  It becomes impossible to assess risk for any party.  Prudently managed entities can be brought down by others in the chain and if large enough ones fail, the economy of which they are part can collapse.  That’s what happened in 2007.

In future posts I will explore, not necessarily in this order:

  • What Washington and Wall Street did that made the collapse inevitable
  • Why Washington bailed out Wall Street’s largest enterprises instead of allowing them to fail
  • Why some Wall Street enterprises were fined for criminal behavior but no executives were jailed
  • What must be done so the financial system will fulfill its purpose

We will, I’m sorry to say, come to see that our financial system that should function as a circulatory system is instead being operated as a Washington/Wall Street mine and we are being poisoned by its toxic waste.  By exploring how that happened we’ll identify essential changes so the system will instead do what it should.  Now, where did I put my hard-hat, flashlight and canary?