Tuesday, May 04, 2010

The Subprime Conspiracy

Was There a Plan to Blow Up the Economy?

Many people now believe that the financial crisis was not an accident.
They think that the Bush administration and the Fed knew what Wall Street
was up to and provided their support. This isn't as far fetched as it
sounds. As we will show, it's clear that Bush, Greenspan and many other
high-ranking officials understood the problem with subprime mortgages and
knew that a huge asset bubble was emerging that threatened the economy.
But while the housing bubble was more than just an innocent mistake, it
doesn't rise to the level of "conspiracy" which Webster defines as "a
secret agreement between two or more people to perform an unlawful act."
It's actually worse than that, because bubblemaking is the dominant
policy, and it's used to overcome structural problems in capitalism
itself, mainly stagnation.

The whole idea of a conspiracy diverts attention from what really
happened. It conjures up a comical vision of top-hat business tycoons
gathered in a smoke-filled room stealthily mapping out the country's
future. It ignores the fact, that the main stakeholders don't need to
convene a meeting to know what they want. They already know what they
want; they want a process that helps them to maintain profitability even
while the "real" economy remains stuck in the mud. Historian Robert
Brenner has written extensively on this topic and dispels the mistaken
view that the economy is "fundamentally strong". (in the words of former
 Treasury secretary Henry Paulson) Here's Brenner :

"The current crisis is more serious than the worst previous recession of
the postwar period, between 1979 and 1982, and could conceivably come to
rival the Great Depression, though there is no way of really knowing.
Economic forecasters have underestimated how bad it is because they have
over-estimated the strength of the real economy and failed to take into
account the extent of its dependence upon a buildup of debt that relied on
asset price bubbles.
"In the U.S., during the recent business cycle of the years 2001-2007, GDP
growth was by far the slowest of the postwar epoch. There was no increase
in private sector employment. The increase in plants and equipment was
about a third of the previous, a postwar low. Real wages were basically
flat. There was no increase in median family income for the first time
since World War II. Economic growth was driven entirely by personal
consumption and residential investment, made possible by easy credit and
rising house prices. Economic performance was weak, even despite the
enormous stimulus from the housing bubble and the Bush administration's
huge federal deficits. Housing by itself accounted for almost one-third of
the growth of GDP and close to half of the increase in employment in the
years 2001-2005. It was, therefore, to be expected that when the housing
bubble burst, consumption and residential investment would fall, and the
economy would plunge. " ("Overproduction not Financial Collapse is the
Heart of the Crisis", Robert P. Brenner speaks with Jeong Seong-jin, Asia
Pacific Journal)

What Brenner describes is an economy \that--despite unfunded tax cuts,
massive military spending and gigantic asset bubbles--can barely produce
positive growth. The pervasive lethargy of mature capitalist economies
poses huge challenges for industry bosses who are judged solely on their
ability to boost quarterly profits. Goldman's Lloyd Blankfein and JPM's
Jamie Dimon could care less about economic theory, what they're interested
in is making money; how to deploy their capital in a way that maximizes
return on investment. "Profits", that's it. And that's much more
difficult in a world that's beset by overcapacity and flagging demand.

The world doesn't need more widgets or widget-makers. The only way to
ensure profitability is to invent an alternate system altogether, a new
universe of financial exotica (CDOs, MBSs, CDSs) that operates independent
of the sluggish real economy. Financialization provides that opportunity.
It allows the main players to pump-up the leverage, minimize
capital-outlay, inflate asset prices, and skim off record profits even
while the real economy endures severe stagnation.

Financialization provides a path to wealth creation, which is why the
sector's portion of total corporate profits is now nearly 40 per cent.
It's a way to bypass the pervasive inertia of the production-oriented
economy. The Fed's role in this new paradigm is to create a hospitable
environment (low interest rates) for bubble-making so the upward transfer
of wealth can continue without interruption. Bubblemaking is policy.
As we've pointed out in earlier articles, scores of people knew what was
going on during the subprime fiasco. But it's worth a quick review,
because Robert Rubin, Alan Greenspan, Timothy Geithner, and others have
been defending themselves saying, "Who could have known?".

The FBI knew ("In September 2004, the FBI began publicly warning that
there was an "epidemic" of mortgage fraud, and it predicted that it would
produce an economic crisis, if it were not dealt with.") The FDIC knew. (
In testimony before the Financial Crisis Inquiry Commission, FDIC chairman
Sheila Bair confirmed that she not only warned the Fed of what was going
on in 2001, but cited particular regulations (HOEPA) under which the Fed
could stop the "unfair, abusive and deceptive practices" by the banks.)
Also Fitch ratings knew, and even Alan Greenspan's good friend and former
Fed governor Ed Gramlich knew. (Gramlich personally warned Greenspan of
the surge in predatory lending that was apparent as early as 2000. Here's
a bit of what Gramlich said in the Wall Street Journal:

"I would have liked the Fed to be a leader" in cracking down on predatory
lending, Mr. Gramlich, now a scholar at the Urban Institute, said in an
interview this past week. Knowing it would be controversial with Mr.
Greenspan, whose deregulatory philosophy is well known, Mr. Gramlich
broached it to him personally rather than take it to the full board. "He
was opposed to it, so I didn't really pursue it," says Mr. Gramlich. (Wall
Street Journal)

So, Greenspan knew, too. And, according to Elizabeth MacDonald in an
article titled "Housing Red flags Ignored":

"One of the nation's biggest mortgage industry players repeatedly warned
the Federal Reserve, the Federal Deposit Insurance Corp. and other bank
regulators during the housing bubble that the U.S. faced an imminent
housing crash....But bank regulators not only ignored the group's
warnings, top Fed officials also went on the airwaves to say the economy
was "building on a sturdy foundation" and a housing crash was "unlikely."

So, the Mortgage Insurance Companies of America [MICA] also knew. And,
here's a clip from the Washington Post by former New York governor Eliot
Spitzer who accused Bush of being a 'partner in crime' in the subprime
fiasco. Spitzer says that the OCC launched "an unprecedented assault on
state legislatures, as well as on state attorneys general just to make
sure the looting would continue without interruption. Here's an except
from Spitzer's article:

"In 2003, during the height of the predatory lending crisis....the OCC
promulgated new rules that prevented states from enforcing any of their
own consumer protection laws against national banks. The federal
government's actions were so egregious and so unprecedented that all 50
state attorneys general, and all 50 state banking superintendents,
actively fought the new rules. (Washington Post)

So, the Fed knew, the Treasury knew, the FBI knew, the OCC knew, the FDIC
knew, Bush knew, the Mortgage Insurance Companies of America knew, Fitch
ratings knew, all the states Attorneys General knew, and thousands, of
traders, lenders, ratings agency executives, bankers, hedge fund managers,
private equity bosses, regulators knew. Everyone knew, except the unlucky
people who were victimized in the biggest looting operation of all time.
Once again, looking for conspiracy, just diverts attention from the nature
of the crime itself. Here's a statement from former regulator and white
collar criminologist William K. Black which helps to clarify the point:

"Fraudulent lenders produce exceptional short-term 'profits' through a
four-part strategy: extreme growth (Ponzi), lending to uncreditworthy
borrowers, extreme leverage, and minimal loss reserves. These exceptional
'profits' defeat regulatory restrictions and turn private market
discipline perverse. The profits also allow the CEO to convert firm assets
for personal benefit through seemingly normal compensation mechanisms. The
short-term profits cause stock options to appreciate. Fraudulent CEOs
following this strategy are guaranteed extraordinary income while
minimizing risks of detection and prosecution." (William K. Black,
"Epidemics of'Control Fraud' Lead to Recurrent, Intensifying Bubbles
 andCrises", University of Missouri at Kansas City - School of Law).

Black's definition of "control fraud" comes very close to describing what
really took place during the subprime mortgage frenzy. The investment
banks and other financial institutions bulked up on garbage loans and
complex securities backed by dodgy mortgages so they could increase
leverage and rake off large bonuses for themselves. Clearly, they knew the
underlying collateral was junk, just as they knew that eventually the
market would crash and millions of people would suffer.

But, while it's true that Greenspan and Wall Street knew how the
bubble-game was played; they had no intention of blowing up the whole
system. They simply wanted to inflate the bubble, make their profits, and
get out before the inevitable crash. But, then something went wrong. When
Lehman collapsed, the entire financial system suffered a major heart
attack. All of the so-called "experts" models turned out to be wrong.
Here's what happened: Before to the meltdown, the depository "regulated"
banks got their funding through the repo market by exchanging collateral
(mainly mortgage-backed securities) for short-term loans with the
so-called "shadow banks" (investment banks, hedge funds, insurers) But
after Lehman defaulted, the funding stream was severely impaired because
the prices on mortgage-backed securities kept falling. When the
bank-funding system went on the fritz, stocks went into a nosedive
sending panicky investors fleeing for the exits. As unbelievable as it
sounds, no one saw this coming.

The reason that no one anticipated a run on the shadow banking system is
because the basic architecture of the financial markets has changed
dramatically in the last decade due to deregulation. The fundamental
structure is different and the traditional stopgaps have been removed.
That's why no one knew what to do during the panic. The general assumption
was that there would be a one-to-one relationship between defaulting
subprime mortgages and defaulting mortgage-backed securities (MBS). That
turned out to be a grave miscalculation. The subprimes were only failing
at roughly 8 percent rate when the whole secondary market collapsed.
Former Treasury Secretary Paul O'Neill explained it best using a clever
analogy. He said, "It's like you have 8 bottles of water and just one of
them has arsenic in it. It becomes impossible to sell any of the other
bottles because no one knows which one contains the poison."

And that's exactly what happened. The market for structured debt crashed,
stocks began to plummet, and the Fed had to step in to save the system.
Unfortunately, that same deeply-flawed system is being rebuilt brick by
brick without any substantive changes.. The Fed and Treasury support this
effort, because--as agents of the banks--they are willing to sacrifice
their own credibility to defend the primary profit-generating instruments
of the industry leaders. (Goldman, JPM, etc) That means that Bernanke and
Geithner will go to the mat to oppose any additional regulation on
derivatives, securitization and off-balance sheet operations, the same
lethal devices that triggered the financial crisis.

So, there was no conspiracy to blow up the financial system, but there is
an implicit understanding that the Fed will serve the interests of Wall
Street by facilitating asset bubbles through "accommodative" monetary
policy and by opposing regulation. It's just "business as usual", but it's
far more damaging than any conspiracy, because it ensures that the economy
will continue to stagnate, that inequality will continue to grow, and that
the gigantic upward transfer of wealth will continue without pause.

Mike Whitney lives in Washington state. He can be reached at

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