Know This: Not All Money is Good Money:
A Review of Bad Money by Kevin Phillips
May 6, 2009
THE AMERICAN DREAM has been ransacked, and people want to know how and why and who’s to blame. A veteran political and economic critic and author of more than a dozen books, Kevin Phillips explains it all in Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism (2007). (After the Fall: The Inexcusable Failure of American Finance by Kevin Phillips, an update to Bad Money, was published as an electronic book in 2008. Its content is included in the current electronic version of Bad Money.)
A crisis is what follows, Phillips asserts, when a leading world economic power “entrusts its markets to hedge funds, bad quantitative mathematics, and [controversial commercial] banks.” Throughout Bad Money, Phillips documents the rise in power of the U.S. financial sector and the resulting “orgy of debt and credit” that led to the financial crisis of 2008 and will continue to impact the American economy for many years to come. He also provides more than a few helpful definitions:
“Credit swaps allow an investor—or a gambler—to take out a contract for an agreed-upon period on the credit worthiness of a borrower or lender, whether bank, brokerage firm, insurance company, or even sovereign government.”
“Because these swaps represented insurance of a sort, the American International Group (AIG), the giant U.S. insurance company, emerged as the leading issuer or writer. Other firms were also drawn into what was an unregulated, but initially lucrative field. The issuer—AIG or some other enterprise—didn’t have to put up any collateral on its swaps so long as it could maintain its triple-A credit rating. On top of which, the writer could book a profit… as soon as the contract was sold. Taking out credit swap ‘insurance’ appealed to institutions anxious to hold a lower-rated but high-yielding asset.” Most credit derivatives are credit swaps.
“Derivatives are contracts whose value is derived from assets including stocks, bonds, commodities, and currencies or from events like changes in interest rates.”
“The process of securitization involves the bundling of consumer loans and home mortgages into packages of securities that are then resold.” As a business, securitization encompasses two main products: asset-backed and mortgage-backed securities. While mortgage-backed securities are obviously tied to housing, two asset-backed securities products are generally tied to housing as well: collateralized debt obligations and home equity loans.
By 2003, “the annual volume of securitization issuance had jumped from $400 billion in 1995 to an astounding $4 trillion.” “Lenders applauded the opportunity to sell loans quickly and get them off their books, to spread the institutional risk of the weaker [a.k.a., subprime or liar or even NINJA (because No Income, No Job, no Assets were needed to get one)] loans, and to collect most of their payment up front, obtaining the wherewithal to make even more loans.” Meanwhile customers purchasing these bundled loans—whether at home or abroad—“eagerly sought the high interest carried by these products, most reassuringly rated AAA or AA.” But at the same time “half of the financial services sector food chain had been in on the act”…including the three biggest—and most trusted—rating agencies, Fitch Rating, Standard & Poor’s, and Moody’s.
The ratings offered by these agencies are supposed to reflect the actual relative credit risk of a financial product or “obligation.” A financial obligation with the highest rating of AAA is supposed to carry only a very small level of risk. Those rated AA are still supposed to carry only minimal risk, but may not stand up over the long term. Since these trusted rating agencies are paid by the same companies whose products they are rating, however, conflict of interest has resulted and the overall ratings system has suffered. Phillips describes “[t]he ratings given to structured securities” by these rating agencies as “shoddy and opportunistic.” But everyone in the financial industries depends on these ratings; even a minor rating change can have a tremendously positive or catastrophic impact on a company—and its investors.
How did all this apparently deliberate deception become possible? From the mid-1980s through the mid-2000s, Phillips argues, speculative finance rose to such “counterproductive economic and political dominance in the United States” as to undermine the credibility of the entire U.S. financial industry. Trouble is, during that same time those in power in the U.S. guided the nation away from its role as a leader in manufacturing and exporting goods toward a much more lucrative (for those in the upper echelons of politics and business) role as a top world economic power. By 2006, Phillips had noted the “extraordinary rise of the U.S. financial sector from 11-12 percent of the gross national product back in the 1980s to a stunning 20-21 percent of the U.S. gross domestic product by 2004-2005,” while manufacturing slipped from 25 percent to 12 percent of GDP. This reversal stands at the core of what Phillips calls the “hijacking” of the U.S. economy. “In 2006 and 2007,” he writes, “confident Wall Streeters predicted that derivatives, securitization, and structured finance were becoming this country’s biggest and most profitable export, replacing yesteryear’s manufactures. For several years, the market [had] seemed promising, but foreign sales tanked in late 2007 and 2008.”
“The problem lay in all (the) toxic securities the Wall Street geniuses had dreamed up, gorged on, and sold around the globe in huge quantities between 2003 and 2007.” By the fall of 2008, such toxic assets could not be sold. Their worth was simply unknown.
So why not let the bad decision-makers at the leading Wall Street institutions fail and pay the price for such debilitating mistakes? According to Phillips, “too many institutions in the U.S. were perceived [by the U.S. government as] too big to fail.” By the fall of 2008, Washington had stooped to fear-mongering: “the notion of the nation’s credit system being at death’s door…was exaggerated in order to scare the public and Congress into passing a [bailout] program that would focus on assisting, even subsidizing, several dozen of the largest U.S. financial institutions.”
Federal refusals to reveal details regarding the 2008 and 2009 Treasury and Federal Reserve financial industry bailouts have led to a long list of questions for those trying to determine what’s really going on, and where to go from here:
“How much was given to what portions of the financial sector on what terms and with what collateral?
“What were the rules?
“How many trillions worth of exotic loans and arcane products are still to be written off?
“How much inflation is about to course through the system?”
Most Americans would also add to the list: Who’s to blame for this mess? Phillips (a former Nixon advisor) places 70% overall blame on Republican shoulders and 30% on Democrats, noting that the Bill Clinton White House and the Treasury Department of Robert Rubin followed by Lawrence Summers were squarely responsible for “blocking regulation of derivatives, promoting merger mania…, [and] encouraging Wall Street debt excesses….” He also blames Republican administrations since the 1980s for leading the charge to ambush federal regulations affecting the finance industry, and the second Bush White House following 9/11 for pressuring American citizens to help correct the travesty the U.S. economy was quickly becoming: “In a caricature of the U.S. government’s World War II advice to the public to save and buy war bonds, after 9/11 Americans were told to spend, charge away on their credit cards, or travel to help keep the private economy in growth mode.”
But the blame doesn’t stop at the White House:
“Hyping Americans into something like card-carrying indentured servants obliged to support 70 percent of the U.S. economy was unforgivable. Letting the merger and acquisitions process run wild and create mega-firms beyond effective national regulation but disposed to experiment and speculate hither and yon was disastrous. Allowing the financial sector to metastasize using $15 trillion of borrowed money over a quarter of a century was calamitous. So was permitting the derivatives and securitization business to create its $11 trillion of this and $53 trillion of that with the most incestuous and uncontrolled webs of distribution and counter-party relationships. And turning the core of the American dream, home ownership, into a trap for the rest of that dream staggers belief. For these transgressions, combined with a malfeasance that has jeopardized tens of millions of jobs, turned some suburbs into incipient ghost towns, and bushwhacked retirement plans, university endowments, and pension funds, the principal blame can fairly be placed on big finance [i.e., the ‘financial mega-firms formed after the 1999 repeal of’ the Depression-era Glass-Steagall act] and on largely ineffective federal regulators and political overseers.”
The 1999 Financial Services Modernization act repealed restraints that had been placed on financial industry mergers to protect distinctions between elements of the industry (commercial banking, securities underwriting, mortgage lending, and insurance) by the Glass-Steagall act. President Bill Clinton, Clinton’s Treasury Secretary Robert Rubin, and Congressional Republicans led the drive to create and pass the Finance Services Modernization act, an act that effectively “crippled” the ability of the U.S. government to regulate the financial industry.
A decade later, the U.S. government appears to remain just as ineffective on this front. “If any federal regulator was seen as generally benign by the financial sector, it was the Fed,” Phillips notes, because the Federal Reserve has always been so close to Wall Street, listening and responding to Wall Street requests with little apparent concern for the overall health of the economy. Nothing indicates any planned change to this approach.
Appointments of Lawrence Summers and other Rubin disciples such as New York Federal Reserve Bank President Timothy Geithner as top Obama economic advisors also “bespoke more continuity than reform and rethinking,” Phillips adds, noting that the probability of significant reform in such an environment is not high, especially as Wall Street “has shifted its chips” to the Democratic party and seems to wield a tight grip of influence on the new administration. “Most financial-sector donors to the Democrats assumed by election day (2008) the inevitability of significant re-regulation between 2009 and 2012” and expected any “change would be reasonably collaborative, implemented by Democrats acceptable to Wall Street.” Such expectations unfortunately were supported by an Obama statement that “The answer [to the financial crisis] is not heavy-handed regulations,” as well as the appointments of Summers as head of the National Economic Council and Geithner as Treasury Secretary.
U.S. leadership still must decide whether to try to bolster the financial industry back into a swollen bubble through more misguided bailouts, or to whittle the industry down to a more manageable size. Yet if policy makers and administration advisors are those who’ve benefitted most from a bloated financial industry, what’s to incent them to suggest, support, or champion reform? “As for breaking up some of the new financial mega-firms or rolling back the financial sector’s excessive size and influence,” Phillips writes, “I doubt that Obama will try. But never say never. The minority view in January 2009 had Obama surrounding himself with so many Wall Street and party establishment figures as initial cover that would enable him to undertake bolder moves in later years.”
As the American Dream continues to crumble around so many American families, we can only hope some such grand plan is in the works. Stranger things have certainly happened.
—Sherry Seiber
|