Finance's Debacle, a nutshell explanation

THIS BLOG: My February 2011 essay, the Six Point Program, is a comprehensive proposal to restore prosperity. I recommend it. Go the the column at the right, click-on February, 2011. Look for the Contents page also, December of 2010. We can do two major things in this nation: we can make sure all jobs pay a decent wage -- they don't, believe me --- and democratically we can create jobs for everyone.

The Financial Collapse in a Nutshell

Here is a quantitative analysis of the destruction of the banking system. On September 5 I left this comment on an article by Jack Rasmus at www.jackrasmus.com -----

On page 220 of Epic Recession you list the Federal Reserve Flow of Funds report showing increases of debt, 1978 – 2008, from four sectors,

government debt up 8.0 times,

Consumer debt up 10.3 times,

non-financial corporations up 9.4 times,

and financial corporations up 47 times.

Financial corp. debt from 1998 – 2008 rose from $6.3 trillion to $19.5 trillion, tripling in ten years. (These are Flow of Funds Report figures from the Federal Reserve, 2009)

The book The Great Financial Crisis by Foster and Magdoff shows a chart, page 121, that financial firm debt rose from

10% of GDP in 1970,

to 22% in 1980,

to 45% in 1990,

to 83% in 2000,

to 123% in 2007.

Relative to GDP the financial sector grew by 12 times since 1970.

During 1998 to 2008 the inflation adjusted GDP rose 28% or so, while the financial corporation debt burden tripled in nominal dollars, and inflation adjusted increased by 127%. Financial sector debt very much out-shot economic growth, over-extended. And, financial corporation profits also tripled, there’s a graph in Foster and Magdoff, page 123.

After the crash, banks in the U.S. were "originally committed" $11.5 trillion, were "currently provided" $3.5 trillion in government funded bailout according to Zandi and Blinder report (page 3), of which all but $1.6 trillion will be recovered, they said, but the final amount is yet determined. Another accounting from the New York Times reports that "Through April 30 [2011], the government has made commitments of about $12.2 trillion and spent $2.5 trillion --- but also has collected more than $10 billion in dividends and fees." (Trillions/billion -- the government has collected 0.4% of what it spent.) And many of the large banks are still insolvent. Europe's banks suffer similar weakness but are not insolvent, but they face tremendous losses according to Rasmus' article. The U.S. public is stuck with paying for the bailouts, which raises the national debt. A greater price is paid in terms of low employment, foreclosures, stagnant wages, and reduced government. And hysteria over government debt. Since the lender dictates the terms of any loan, and has more knowledge of the risks, he should take his share of the loss. There was a Plan B in 2008, government taking over the banks, it never was discussed. Be sure to read the section at the bottom of this essay that purports that 30% of mortgage loans were "liar's loans" and over-stated borrower income by 50% during the year 2006. 

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Inequality as the Original Cause

The problem here is inequality of income and wealth over decades, though at first glance it appears to be exuberant loan making. My conclusion is that all that surplus wealth was mis-allocated in the first place into the hands of a wealthy minority. (See U.C. Berkeley Professor Saez report "Striking It Richer" showing the major upward shift of income since 1980.) With a balanced distribution of income real human needs are taken care of, the entire society rises together, and the top-heavy wealthy are deprived of funds to create this monster of a financial system that knows only one law, "more". If economic surplus was distributed in a balanced ratio, more of the wealth would reach the accounts of more households, and more households would spend on real needs such as health, education, housing, city development. And the spending would spill over to inefficient use, but mostly it would produce security and intelligently planned lives for a majority.

This is about the end of this essay. Read on only if you like details.

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See Robin Hahnel's article at Z Communications, Financial Reform, July 2010, for a breakdown on needed reform.
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The surplus from production accumulates in the hands of too few. The top 5% of households own 60% of all assets and about 70% to 75% of all financial assets (see Allegretto, State of Working America's Wealth, page 11). What do they do with their liquid assets? Do they build more businesses and employ more? Yes and no. When there's more surplus than they can use productively or make a profit from, they create a monster of finance. And the record of the financial industry is that it is willing to self-destruct if it brings personal profit. Someone has to police finance, and that means reducing it's size to 1970 levels, 10% to 25% of GDP. Leo Panitch, a Canadian economist, seriously proposes a government take-over of the banking system. It is a utility after all. (See link at bottom, Public Banking)

There are several avenues, apart from take-over, to curtail the financial industry, and I'll mention seven steps below. But more important is to reform the ratios of distribution so that all can participate in economic security. As noted earlier, in 2011 the National Bureau of Economic Research conducted a survey asking adults in the U.S. if they could deal with an emergency expense of $2,000 within 30 days. Half of respondents said "No". Our economy generates over $47,000 per human being each year, and on average over $100,000 per worker (including all the part-time workers). The St. Louis Federal Reserve has a graph showing average value of all workers, and it's over $100,000. Half of all workers receive less than $30,000 a year. When the average value of each worker is over $100,000, how is it that only a mere half of adults can come up with $2,000 in an emergency? Distribution is flawed. Unbalanced. Incomes must rise for the majority.

Granted that loans do drive economic growth, but healthy loans still need a base of income earners to realistically generate future earnings to repay the loans. We do not have future earnings for enough workers. The next decades present a future of out-sourced jobs in the millions through advanced tele-communications, and continued off-shoring of manufacturing jobs. Since 2000 about 6 million jobs were lost in manufacturing, a third of total, and it's almost impossible to compete with Chinese manufacturing labor that pays $1.36 an hour versus $34 an hour in the U.S. (that's $2,800 a year versus $70,000 a year) -- (see Monthly Labor Review, March 2011, Department of Labor). High paying manufacturing has been the backbone of a middle class that produced the expansion of the past 70 years. Growing the financial system is no way to grow the economy.

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L. Randal Wray posted this article "Bye-bye to Bernanke's 'Insidious Banks': End 'Too Big to Fail' in 2 Easy Steps", published at New Deal 2.0, March 22, 2010.

http://www.newdeal20.org/2010/03/22/bye-bye-to-bernankes-insidious-banks-end-too-big-to-fail-in-2-easy-steps-9120/

Clearly there was a dramatic concentration of banking over the 1990s and early 2000s. Not coincidentally, this coincided with the explosion of innovations that changed the focus of the biggest banks away from making and holding loans in the case of commercial banks, or from underwriting and placing corporate equities and bonds in the case of investment banks, to trading. In 1999 Washington eliminated any separation between investment and commercial banking, allowing all of the big institutions to focus more of their business on marketing risk — earning fee income by selling products (largely derivatives, including asset-backed securities) to money managers, as well as trading for their own account. . . .

Lowenstein also rightly argues that the Wall Street institutions no longer serve any public purpose: “At Goldman, trading and investing for the firm’s account produced 76 percent of revenue last year. Investment banking, which raises capital for productive enterprise, accounted for a mere 11 percent.” And what kinds of trades and investments does Goldman pursue? It helps Greece and other clients hide debt, and then it bets they will default. These firms act against the public purpose, as Blankfein uncannily admitted to the Financial Crisis Inquiry Commission when he said that “we represent the other side of what people want to do.” You want to buy a house, build a factory, or provide government services to your citizens? Goldman wants to bet that you will fail. . . .

So how do we get to the elimination of Bernanke’s “insidious” too-big-to-fail institutions? We will not get there through increased regulation or supervision; we will not get there by improving system “resilience”; and we will not get there by propping them up with trillions of bail-out funds whilst waiting for them to fail so that we can resolve them.

So let’s try a much simpler, two-pronged approach.

1. After January 1, 2011 the FDIC will no longer provide deposit insurance to any financial institution that holds more than a one percent share of insured deposits. For the purposes of calculating market share, a bank holding company must include deposits of all subsidiaries — with the one percent share restriction applying to the aggregate total.

2. After January 1, 2011, institutions that issue FDIC-insured deposits are restricted to holding cash, reserves at the Fed, whole loans and corporate and government bonds. They may not hold any securitized products or derivatives; they may not move anything off-balance sheet; and they may not hold interest in any subsidiaries that are not subject to the same rules.

These two measures will eliminate most of the advantages to bigness.

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The Federal Reserve Bank in St. Louis has a FAQ section with this question

Why is the government reluctant to let large financial firms file for bankruptcy protection?

Federal Reserve and Treasury officials believe that bankruptcy is not a viable option for resolving very large financial firms because, under current law, bankruptcy proceedings can be protracted and entail considerable uncertainty, which would tend to exacerbate a financial crisis. FDIC Chairman Sheila Bair recently argued that "the legal features of a bankruptcy filing itself triggered asset fire sales and destroyed the liquidity of a large share of claims against Lehman ... The liquidity and asset fire sale shock from the Lehman bankruptcy caused a market-wide liquidity shortage."* Federal Reserve and Treasury officials have asked Congress to enact legislation for new authority and procedures for resolving failures of large financial institutions.

*Congressional testimony, May 6, 2009. Seehttp://www.fdic.gov/news/news/speeches/chairman/spmay0609.html.

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William Tabb, author of The Amoral Elephant (2001Monthly Review Press), warns of the enormous global capital flow that washes into to various pools of profit opportunity. It takes capital resoures, the fruit of economic surplus, and feeds on more profit. The allocation of resources is determined by only one criterium, profit.

Tabb, page 205, The Amoral Elephant,

"The basic ideas are simple enough. Citizens could demand structural changes in economic relations to comply, as I've suggested, with the principles of the Universal Declaration of Human Rights. Written in a postwar period of great energy devoted to seeing that humans would be wiser in the future and avoid the causes of war, it declared that everyone has the right to work, to free choice of employment, to just and favorable conditions of work, and to protection against unemployment. That is all in Article 23. 'Everyone who works has the right to just and favorable remuneration ensuring for himself [which we now understand can be read as himself or herself] and his [or her[ family an existence worthy of human dignity, and supplemented, if necessary, by other means of social protection.'"

Tabb continues, "In an age in which capital's audacity seems boundless in its efforts to impose a new feudalism, in which the masters of the universe can use an internationalized state and its local subsidiaries to remake the world in their image, it does not seem amiss to celebrate the fiftieth anniversary of the Universal Declaration of Human Rights, to remind ourselves what the global financial institutions, the transnational corporations, and the governments that do their bidding are attempting to steal. People's rights come before capital's. . . . It is the organization of class-conscious political movements that know what they want and are willing to struggle to achieve their goals [that can make a difference]."

The world's richest 20 percent now receive 86 percent of the world's gross domestic product, the poorest 20 percent have only 1 percent, and the middle 60 percent just 13 percent [year 2000]. . . . The world's richest three people have assets greater than the combined output of the forty-eight poorest countries. . . . Consider: the 1999 United Nations World Development Report says that for $40 billion, basic health and nutrition, basic education, water sanitation, reproductive health, and family planning could be extended to the entire world's population. . . . A Tobin Tax on all international financial transaction would raise $45 billion a month [$540 billion a year], and then there are those military budgets. Finding the money hardly seems a problem. Getting those who have it now to give it up, ah, there's a problem."

From his last paragraph,

"I would conclude then, as I began, by reasserting that in the current situation of increased globalization, the universalization of capital is a long-standing process, but one that takes on specific meanings in our time. Rank-and-file citizens of the world must have a position not simply on trade issues and collective bargaining, but a political position on capital controls and other legislation that empowers progressive politics by limiting the power of finance capital. We are being forced by history to learn to think in systemic terms. Were we to do so with any consistency, we would be drawn to a return as well to our more radical social traditions."

Should Chinese labor have independent democratic unions? Should we allow the products of slave or near slave labor to enter onto our merchants' shelves? If Disney pays 16 cents an hour in Haiti, and Nike pays 25 cents an hour in Indonesia, and Apple pays $1 an hour in China, and Sony pays 80 cents an hour and Ford $1.20 an hour in Hermosillo Mexico -- should those products be for sale in the U.S. market? Should finance be free to jump into and out of national markets instantly without penalty? Is there a place for a more severe short-term capital gains penalty? Can we afford or is it morally neutral not to have an opinion?

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Here are six short suggestions about limiting finance:

1. Banks that fail should be declared bankrupt and dissolved. No more bail-outs. Let shareholders and management be aware. In the U.S. companies that run their business into the ground go out of business. Government's role is to take over management temporarily, settle debts, run the corporation until private investment bids to buy out government, as we did with Chrysler in the 1990s. As Sweden's government did when their banks failed.

2. A short-term capital gains tax penalty. Presently capital gains on assets held for less than one year are taxed at normal income rates, and assets held longer are taxed at 20% (or is it 15%?). This should change to normal tax rate for assets held more than 3 years, an additional 15% tax on assets held one to three years, and an additional 30% on assets held less than one year.

Investment not speculation is the rewarded behavior. Where to explore ideas about capital gains rates? I do not know.

3. A Tobin tax on financial transactions. The Chicago Political Economic Group claims that over $800 billion a year could be raised in the U.S. alone. (See this essay.) In France there is a group Attac, the Association for the Taxation of Financial Transactions for the Aid of Citizens. Many economists have advocated this tax since Tobin first introduced the idea. See Widipedia.

4. Jan Shakowsky presented an alternative federal budget proposal in February 2011 in which $77 billion of tax-expenditure would be eliminated (a net revenue increase of $77 billion annually). The expenditure allows financial corporations to deduct the interest payments on their loans. This is a government subsidy to an industry that needs no subsidy.

5. The foreign derivative market is immense and needs regulating if such derivatives are sold in the U.S. But Treasury Secretary Geithner will not support transparency or regulation of such derivatives. The entire derivative market needs a progressive response and re-ordering.

6. Shadow banking, Special Investment Vehicles, should be legislatively eliminated. Regulated banking now is less than half of the financial market. I'm not an expert, and I do not know where to seek out progressive proposals.

7. Futures trading should be managed and restricted to participants who have a distributive function in the market. Speculative participants should be eliminated from the destructive playing and manipulation of these markets. Speculation in grain prices raised the price of tortillas in Mexico touching off large protests.

I wrote a long essay about the original problem, the finance industry. What follows is my case against them. A further essay should explain how to cut it back to size. And a further should explain how to increase income for the majority, but the February 2011 is my standard answer thus far.

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The Consequences of the Financial Crash

Chairman Greenspan said in 2004, "Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient." And in 2008 Senator Christopher Dodd said, "we're literally days away from a complete meltdown of our financial system, with all the implications here at home and globally." (Quotes from Foster and Magdoff, pages 125 and 112)

In the report State of Working America's Wealth, University of California at Berkeley professor Sylvia Allegretto reports "The destruction of wealth that resulted from the Great Recession was widespread but not uniform. From 2007 to 2009, average annualized household declines in wealth were 16% for the richest fifth of Americans and 25% for the remaining four-fifths." I will explain it this way: In 1998 the average wealth index is at 0, nine year's later in 2007 it's at 56, and in 2009 it drops back to 11. So we saw that the GDP had grown by 28% (1998-2008), but wealth grew by 56% (1998 - 2007). That's double the rate of growth for GDP. And then wealth dropped off in a crash. So wealth grew by 11% 1998 - 2009. But it went up as high as 56% before the drop-off. The wealth pie got bigger, then smaller. The output (GDP) pie got bigger, and then shrunk by 5.1% for 18 months till the end of the recession, and then recovered it's pre-recession shape (GDP) in July 2011.

Remember that 87% of the assets are held by 20% of the households, and that banks own 61% of all housing equity. The net worth of the country, between 2007 - 2009, dropped by 16%. But for the household in the middle, the median or typical household, net worth 2007 - 2009 dropped by 41%, from $106K to 62.2K, to levels below the 1983 level. Since 1962, 47 years ago, the wealth of the typical (median) household has increased by 22%, from $52.2K to $62.2K. The economy's economic output per capita expanded by 64%, I think, close to 64%. The lower 40% of households own 0.3% of the nation's net worth, their net worth on average is $2,200. (I don't think anyone can take in all those numbers, so don't worry. I can't just state something uncomplicated, you have to stretch a little.) I sometimes cite a 2011 study from the National Bureau of Economic Research: half of adults in the U.S. could not deal with a $2,000 emergency within 30 days without borrowing or selling something. They asked about 1,500 people, "If you had an unexpected expense of $2,000, could you handle it from savings within 30 days?" No, said half.

This sort of number description may drive you crazy or bore you to death. It does bore most people, but not me. It means that the wealthy households actually got richer relative to others during this crash period and the middle level households lost a lot of savings, about $40,000 for the middle family. To me, my interpretation, the financial industry created the method of deceiving millions and millions of home owners that their residences, their houses, were worth far more money than they really were. This deception lasted about 8 years before it crashed. When the artificial bubble burst, the people who lost money were the poorer borrowers, and the richer lenders did well, made money. Here's a source with a cool graph: http://designandgeography.com/2011/05/17/inflation-adjusted-housing-prices-by-state-1991-2010/housing/

Was it deceit or incompetence? If bankers did not understand what was going on, they were incompetent, if they did understand they were thieves. What do you make of Greenspan's statement above? I'm putting Greenspan, Bernanke, the Ph.D.s working for the Fed and mutual funds, securities traders, and most heads of major banks into this rogues gallery of unflattering masterminds. The latter may have been too busy making millions to analyze what societal effects they were having, but any rational person would have noticed the major risk facing all of society.

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Sources for information:

I recommend essays at New Deal 2.0 and Robert Kuttner's analysis at American Prospect for understanding society's role in managing banks and the financial sector.

A graph of this same data I used in this essay can be found in a recent magazine article by Allan Sloan in Fortune Magazine, September 2011, and his source, the St. Louis Federal Reserve Bank.

http://finance.fortune.cnn.com/2011/08/18/how-washington-is-destroying-the-economy/

http://research.stlouisfed.org/fred2/series/GFDEBTN

And a series of graphs from the Center for Budget and Policy Priorities

shows the course of the economy through the recession:

http://www.cbpp.org/cms/index.cfm?fa=view&id=3252

And the Economic Policy Center has many graphs and studies.

I like this one about the labor market.

http://www.epi.org/publication/labor-day-by-the-numbers-2011/

And State of Working America also has a long series of graphs

to help simplify this complex phenomenon, the economy:

http://www.stateofworkingamerica.org/

The Chicago Political Economy Group
Eisenhower Era Income Tax Rates on the Upper 10% of Families Would Immediately Erase the Federal Deficit, this paper states, "Though media pundits and political leaders have incessantly claimed that we cannot solve the federal budget deficit simply by taxing the rich so that the middle class "must accept some pain," estimates shown in this paper demonstrate that this is not true (see Section 4 below). In fact, as Section 2 below shows, the bottom 90% of families (or everyone except what can only be called the "upper class") have been "accepting pain" for 35 years while the highest income and especially the very highest income, families have been reaping massive and ever increasing rewards for the same period of time."

http://www.cpegonline.org/workingpapers/CPEGWP2011-2.pdf

The St. Louis Federal Reserve Bank has a series of charts and graphs.

I don't find them very helpful, but they are official. Take a look.

Increase of monetary base:

http://research.stlouisfed.org/fred2/series/BASE

Public debt

http://research.stlouisfed.org/fred2/series/GFDEBTN

http://research.stlouisfed.org/fred2/series/USAEPRNA?cid=32267

http://www.cpegonline.org/workingpapers/CPEGWP2011-2.pdfhttp://www.cpegonline.org/workingpapers/CPEGWP2011-2.pdf

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This post deserves a few more references for readers:

Here is an article that spells out how the ten largest banks issue half the mortgages in the nation, and the largest five banks own 95 percent of the derivative market, and together the large banks own the industry (and Congress). 

The article fails to spell out that banking corporations are a minority in the world of finance and debt creation. Hedge funds and other institutions that fall outside the regulatory purview control more assets. From Epic Recession by Jack Rasmus, page 217, "The summary showed that the shadow banking sector in late 2007 was even larger than the commercial sector (disregarding the latter's participation in the shadow sector). Shadow banking assets were worth $10.5 trillion compared to commercial banking's $10.0 trillion."

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Public banking is an alternative to the commercial stranglehold of the largest banks. This web page has an educational video explaining it.

Yet public banking does nothing to alleviate the greater problem of extreme concentration of wealth. 
See inequality.org --- http://www.inequality.org

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This 2011 article by William K. Black in Dollars and Sense magazine sums up the harm the banks have wreaked. 

• Made the systemically dangerous megabanks even more dangerous
• Made our financial system even more parasitic, harming the real economy

Here's a sample from Black's essay:

"According to Credit Suisse, for instance, 49% of all mortgage originations in 2006 were stated-income loans, meaning loans based on applicants’ self-reported incomes with no verification."

From the Mortgage Bankers Association:

One of MARI’s customers recently reviewed a sample of 100 stated income loans upon which they had IRS Forms 4506. When the stated incomes were compared to the IRS figures, the resulting differences were dramatic. Ninety percent of the stated incomes were exaggerated by 5% or more. More disturbingly, almost 60% of the stated amounts were exaggerated by more than 50%. These results suggest that the stated income loan deserves the nickname used by many in the industry, the “liar’s loan.”

(My note: 30% of all mortgage loans in 2006 were "exaggerated by more than 50%." The "sample was only "100 stated income loans", but doesn't this indicate the need for an investigation? Jack Rasmus states that $17 trillion of mortgage loans were issued 2000-2007, so about $2 trillion mortgage loans were issued in 2006. 30% of that amount is $600 billion. If they were clearly fraudulent, if the sample's pattern holds, then a $600 billion major fraud was perpetrated in just one year, and no one is in jail.)

Black asks: 

Why would scores of lenders specialize in making liar’s loans after being warned by their own experts and even by the FBI that such loans led to endemic fraud? (Not that they needed any warnings. Bankers have known for centuries that underwriting is essential to survival in mortgage lending. Even the label “liar’s loan,” widely used in the industry, shows that bankers knew such loans were commonly fraudulent.) How could these fraudulent loans be sold to purportedly the most sophisticated underwriters in the history of the world at grossly inflated values blessed by the world’s top audit firms? How could hundreds of thousands of fraudulent loans be pooled into securities, the now-infamous collateralized debt obligations (CDOs), and receive “AAA” ratings from the top rating agencies? How could markets that are supposed to exclude all fraud instead accommodate millions of fraudulent loans that hyper-inflated the largest financial bubble in history and triggered the Great Recession?