posted April 1, 2008
From Financial Crisis to Global Recession, Part 1

From Financial Crisis to Global Recession, Part 1
by Jack Rasmus
copyright 2008

2007 witnessed the emergence of the most serious financial crisis to hit the American and the greater global economy since the 1930s—a crisis that has already begun to precipitate a major recession in the U.S. in 2008 and, in turn, raising the odds for a wider, synchronized global downturn in 2009.

The following is the first of a two part analysis examining the current financial crisis and its impact on the real, non-financial economy in the U.S. In Part I that follows, parallels between the current financial crisis and similar events in the 1920s that led up to the stock market crash of 1929 are explored. The origins, development, and future direction of the current financial crisis are then described, including in particular its rather rapid transmission to other capital markets in the U.S. and abroad.

The second part of the analysis, in a subsequent article, will explain why the current crisis is fundamentally different and more serious than prior similar financial events in the 1970s and 1980s in the U.S. In particular, Part II will focus on the process by which the current crisis is already evolving rapidly toward a deep recession in the U.S. in 2008, and why the probability is also rising sharply that it will result in the first synchronized global economic downturn in 2009.

Speculation and Income Inequality in the 1920s

History will show a remarkable congruence between the conditions, events and policies of the decade of the 1920s leading up to the financial crisis of 1929 and subsequent deep depression of the 1930s, on the one hand, and the events and policies of the current decade, 1998-2008.

The 1920s were characterized by an over-extended housing and construction boom in mid-decade that imploded well before the decade’s end; a slowdown in investment in the real, productive economy as speculative investment crowded out real investment steadily over the course of the period; a Federal Reserve System that pumped up the money supply without concern for its eventual speculative impact; increasing imbalances in world trade and currency instability; and the near destruction of labor unions—to name but the more notable.

The progressive destruction of unions over the course of the decade, when combined with the radical restructuring of the tax system that provided massive tax cuts for the wealthy and corporations, resulted in a dramatic shift in income distribution toward wealthy investors and corporations from the rest of the working population. The share in relative income of the wealthiest 1% of households doubled over the course of the decade. By 1928 the wealthiest households had raised their share to 22% of all incomes in the country, according to IRS data. Perhaps more than any single contributory factor, the rapid and extreme growth of income inequality during the decade was eventually responsible for the ultimate financial implosion of 1929 and the consequent depression. For it was this income shift, along with government incentives of various kinds, that stimulated the increasingly speculative activity from mid-decade on. The massive shift in incomes that fed the speculation in turn resulted in a still further income shift, as super-profits were realized by the wealthy from the speculative investment frenzy. More concentration of income in turn provoked still more speculative frenzy, in a dizzy spiral of asset price inflation, speculative profits, and a euphoric expectation the process would continue without limit.

The speculative excesses of the 1920s decade were also assisted by a host of shady business practices, in the banking industry in particular, that were condoned by business, media and the government. Some of the more notable practices that fed the speculative extremes of the 1920s included the explosion of buying stocks and securities ‘on margin’—or what is sometime called ‘leveraging’. It included practices that ensured the speculation remained opaque, or near invisible to average investors. Practices by which private businesses responsible for ‘rating’ investments for the general public lied to the public as a consequence of conflicts of interest. And chronic government refusal to monitor or check the speculative excesses.

The foregoing process culminated in the stock market crash of October 1929, once it had become clear that the real economy had begun to decline sharply earlier that same year, in particular in the leading economic sectors of construction and autos. The speculative boom, like all such booms, rested upon an increasingly narrow foundation of skewed inequality of incomes, false assumptions about limitless economic growth, and a growing imbalance between real and speculative investment. Once the cracks in the real economy began to appear clearly by mid-1929, the speculative boom quickly turned to the bust of October 1929. As in all such similar speculative booms and busts, the financial crisis of 1929 in turn exacerbated and accelerated the already declining real economy by freezing up credit for real investment, ensuring further corporate defaults, consequently massive job losses, and subsequent decline. Thus, while the increasingly speculative activity during the decade underlying the general financial crisis was not the sole cause of the crisis, it was nonetheless a very critical and central development provoking the threshold event of the great stock market crash of 1929 and the depression that followed.

Parallels: 1920s and 1998-2008:

Something not unlike the above has been underway over the course of the past decade. As in the 1920s, the U.S. has been lurching from one speculative bubble to the next—from the Long Term Capital Management (LTCM) hedge fund bailout of 1998; the Asian debt crisis of 1998 (at the center of which were U.S. money center banks); the dot-com technology asset bubble of 1999-2000; the recent subprime mortgage bust (the foundations for which were laid in 2003-04); and the recent rapid spread of the subprime crisis in 2007-08 to other capital markets in the U.S. The series of speculative excesses and bubbles from 1998-2008 in each case were temporarily ‘contained’ by an unprecedented expansionary monetary policy engineered by U.S. Federal Reserve under Alan Greenspan. The Greenspan ‘FED’ thus ‘fed’ the series of bubbles ever since 1998 with money injections designed to stave off the spread of liquidity crises and credit crunches. The temporary fixes did not solve the problem but simply postponed the crisis for the short term, to reappear even more dangerously at a later date. The result has been a containment each time that has merely bottled up the pressures, that emerged soon once again with subsequent greater effect. In this manner the LTCM and Asian crisis bank bailouts of the late 1990s fed the dot com bust, the bailout of which in 2001-02 fed the subprime bubble of 2004-06, and so on.

While Federal Reserve policies have thus ‘enabled’ the speculative flames, the rapid growth of income inequality since 2000 provided the kindling. A major, historic shift in incomes in the U.S. clearly began under President Ronald Reagan in the 1980s and continued unabated under Clinton. In recent yers, under George W. Bush, that inequality has accelerated most rapidly. There has been nothing on a par with it since the similar runup in inequality in the 1920s. Starting with a share of only 9% of total national income, for example, by 2006 the wealthiest 1% households had once again raised their total share to the 22% they enjoyed in 1928.

As in the 1920s, the rapid rise of income inequality has been driven largely by the radical restructuring of taxation, as more than $4 trillion of tax cuts were passed in Bush’s first term, 2001-04 alone, 80% of which is projected to accrue to the wealthiest households and large corporations. Further corporate tax cuts of more than a $1 trillion were passed in his second term. Meanwhile, the rest of the population has experienced income stagnation and reduction as the decline of unions has continued, the post World War II pension and health care benefit systems have accelerated their collapse, the shift to part time and temp jobs from full time and permanent employment has continued, and millions of high paid jobs have disappeared due to free trade and offshoring. Compared to the late 1970s decade, more than a $1 trillion a year in income is being shifted every year from the bottom 80% of the workforce (in particular the bottom 50%) to the wealthiest 5% and corporations.

As in the 1920s as well, the income shift has fed the speculative investment excesses of the past decade, 1998-2008. The growth of incomes by the wealthy provided the huge pool of income and wealth with which to engage in speculative investment activity. And as short term speculative activity resulted in significantly greater returns than real investment activity, more and more investment was shifted out of real into speculative activity, or, alternatively, from real investment in the U.S. home market to investment offshore in the so-called emerging markets, in particular in China and Asia. Hence accounting for the rapid growth in those ‘offshore markets’ by US investors and corporations, which has largely been at the expense of investment, growth and employment in the U.S. economy and increasingly so since 2001.

In addition to the growing income imbalance and the ‘easy money’ policies of the Greenspan Federal Reserve since 1998, a third critical element fueling the excessive speculation and current financial crisis has been the elimination of the final vestiges of any semblance of financial regulation and oversight which was given a coup-de-grace in 1999 with the final repeal of the 1930s-era Glass-Steagall Act. Glass-Steagall was enacted in the 1930s in order to prevent speculative and other abuses by the banking system (and the near-collapse of the US Banking system in 1933), and to prevent the speculation excesses and financial crisis that had led up to the October 1929 stock market crash.

U.S. Finance Capital and their numerous friends in U.S. government had been progressively under-cutting Glass-Steagall since the early Reagan years, and by the mid-1990s had succeeded in shredding many of the provisions of the Act that once constrained the speculative excesses of banks and financial institutions (e.g. practices like over-leveraging, opacity, conflicts of interest with rating agencies, contagion of crises between commercial and investment banks, etc.). By 1999 what remained was repealed altogether.

As Glass-Steagall was being progressively undermined under Reagan, Bush I, and Clinton, the so-called ‘financial revolution’ was also taking off. And with that ‘revolution in finance’ came a corresponding proliferation of new financial structures and financial relations. When combined with new technologies of computer processing power, soft technologies (e.g. quantitative modeling), networking, and the internet, the financial system has become the first sector of economy that has been truly globalized. In turn, with globalization has come the further inability to regulate finance capital and, indeed, even to monitor its activity accurately. Thus, deregulation plus technology-globalization has meant even further de facto deregulation.

In other words, virtually fully unregulated since 1999, in the past decade U.S. finance capital has been unleashed, as it once was in the 1920s, to do whatever it wishes and to push the speculative investing envelop as far and in whatever direction it pleases. It is therefore no mere coincidence that since the late 1990s the U.S. economy has veered headlong from one financial crisis to another with virtually no ‘breathing space’ in between, from LTCM/Asia to the dotcom bust to the subprime mortgage crisis to what follows. We are now, in 2008, beginning to see the full consequences of this concurrence of total financial deregulation, unchecked financial restructuring, accelerating income inequality, accommodative government monetary policy which is now yielding its full result of even greater financial crisis, US recession, and threat of global instability the likes of which have not been seen since the 1930s.

Derivatives and the Securitization Revolution

At the heart of the current financial crisis are new financial instruments, devices and related institutions that have been vehicles of the financial revolution and have enabled the ever-accelerating speculative excesses of the past decade: Hedge funds, Private Equity firms, Structured Investment Vehicles (SIVs), and the like are the most notable of the new institutions. All lie outside any regulatory overview, even by the US Securities and Exchange Commission—let alone the now defunct Glass-Steagall Act. All exhibit differing degrees of opacity and misrepresentation to their investors. All are examples of excessive leveraging of non-productive investments. And all are beginning to reveal the prevalence of significant conflicts of interest.

If SIVs and hedge Funds are the ‘vehicles’ of the new speculative and financial crisis, their products amount to a vast array of financial devices and instruments that are a financial buffet of acronyms like CDOs, ABCP, CBO, CMBS, CLO, CDS, CDPO, and so on. To understand the current financial crisis it is first necessary to understand the so-called ‘securitization revolution’ that the above new institutional structures and financial devices represent. And the securitization revolution is based upon the grand-daddy of over-leveraging called ‘derivatives’.

Derivatives involve the fictitious development of financial asset products offered for sale to investors, private and corporate. They have no intrinsic value. They ‘derive’ their value from other real assets. They are financial products for sale that are ‘derived’ from other financial products. They have virtually no ‘cost of production’. Their costs of distribution and sale are essentially non-existent. And their market price is largely the outcome of speculative demand and, to a lesser extent, how fast financial institutions can create the original financial assets (e.g. mortgage loans) on which the derivatives are then in turn developed. Moreover, derivatives can be created on top of derivatives, in an unlimited pyramid of speculative financial offerings. Like a house of cards, the offerings may be stacked upon each other, until such time as one of the cards slips out of place bringing the rest down with it.

In today’s global economy there are more than $500 trillion in derivative outstanding. That compares to a global annual gross domestic product for all the nations of the world of less than $50 trillion. And to the U.S. annual GDP of approximately $13 trillion. In other words, there are now more than ten times in derivative contracts than all the real goods and services produced by all economies in the world annually. The world’s wealthiest investor, Warren Buffet, has called derivatives “time bombs both for the parties that deal in them and the economic system?. They represent, according to Buffet, “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal?.

From Derivatives to CDOs and Subprimes

Subprime mortgages represent one relatively small ‘land mine’ in the panoply of ‘financial weapons of mass destruction’ described by Buffet. Subprimes are an essential element of just one example of super speculative investment built upon one form of derivative called a CDO, a ‘collateralized debt obligation’. Subprime mortgages lay at the foundation of the CDO’s derivative pyramid. The mortgages themselves represent the value of a real asset—i.e. the housing product on which the mortgage is based. The mortgages are then packaged into the fictitious financial asset package, called the CDO, which is then in turn marked up by the financial institution which sells the CDO to wealthy investors, hedge funds, other funds, or corporations. The mortgages themselves are not packaged in original form in the CDO, but instead are broken up, i.e. divided into ‘slices’ that may be distributed across various CDOs. Only parts of any given subprime mortgage may thus reside in any given CDO offering. Since only parts of a subprime mortgage may be included in a given CDO, parts of other assets are typically ‘sausaged’ into the same CDO alongside the subprime ‘slice’ as well. These other assets may themselves be fictitious in character (i.e. not based on any real physical asset), or may be based upon some real asset—for example Commercial Paper issued by some real company to raise funds to carry on or expand its real business. Or a loan issued by a bank backed by real collateral (e.g. a Collateralized Loan Obligation, or CLO). But other forms of fictitious assets may also be bundled for mark up in the given CDO, alongside the subprime slice or Commercial Paper of company ‘x’. These may include fictitious ‘securities’ issued based on expectations of future ticket sales for sports events, a rock star’s future concert royalties, or even more absurd examples of so-called ‘bonds’.

Not all CDOs of course have subprime mortgages bundled within their packaged market offering. Some may have slices of higher grade mortgages, or what are called ‘Alt-A’ mortgages. Or they may have both. Many CDOs also include what are called Asset Backed Commercial Paper (ABCP). Many companies with doubtful performance and future prospects unable to raise capital more economically from other sources have entered the ABCP market in recent years to raise cash to stave off default by entering that market. Their ‘commercial paper’ is then bundled with a CDO and offered to market. Thus shaky subprime mortgages may be packaged with equally shaky corporate commercial paper.

But the banks and other institutions that eventually sell the CDOs were, at least until the recent crisis began to appear in late summer 2007, not all that concerned about the quality of such derivative-CDOs. Their relative unconcern flowed from their ability to buy ‘insurance’ for the CDO, in the form of yet another derivative called a ‘Credit Debt Swap’ or CDS. Yet another means by which banks attempted to insulate themselves from the shaky quality of speculative investments has been their creation of the new institution called the SIV, or ‘Secured Investment Vehicles’. SIVs are bank-created electronic institutions set up ‘off balance sheet’ from the original bank. They are in essence electronic shadow banks set up by investment and commercial banks like Morgan Stanley, Bear Stearns, Citigroup, Bank of America (and virtually every known national or regional major bank in the U.S.) to offload potentially risky CDOs from the the banks’ balance sheets, where bank record keeping is subject by law to review by the US Securities and Exchange Commission. With SIVs typically quickly ‘turning over’, or selling, the CDOs to hedge funds and other wealthy investors and corporations, a third ‘safety valve’ presumably existed.

Subprime mortgages, bundled within CDOs, issued by SIVs, and held off balance sheet by the big banks represent a highly profitable enterprise for the banks. First, the banks make money from fees issuing the CDO. Second, they are able to offload assets from their bank balance sheets thereby both reducing capital carrying costs as well as making available more bank reserves for loaning out at interest. Third, their SIVs make money from marking up and selling the CDOs as well as from insuring them at an additional charge with credit debt swaps. It is therefore not surprising that mainline investment and commercial banks experienced compound profits growth of more than 20% per year collectively for each year from 2004 through 2006—i.e. roughly the period of the most explosive growth of subprime mortgages bundled with CDOs.

The above scenario is sometimes referred to as an example of the so-called ‘securitization’ revolution in finance. Securitization is the process of assembling assets on which new securities are issued and then sold to investors who are (in theory) paid from the income flow created by the assets. The more risky the assets contained within the CDOs, the lower the credit ratings but the higher the potential return. The justification for the highly speculative and high risk character of the offerings is that by ‘slicing’ the CDOs into tranches, based on the degree of risk in the assets in the given CDO, the more that the risk would be dispersed among a large population of investors. In reality, however, the result was the dispersion of contagion not dispersion of risk from the risky investments.

This ‘securitization revolution’ is largely a product of the post 1998 period. In 1998 the total international volume of securitized offerings amounted to less than $100 billion. By 2003 it had risen only to $200 billion. By 2003 to more than $320 billion, more than $500 billion in 2005, and exceeded $1 trillion in 2006.

Bursting the Subprime-CDO Bubble

Business press pundits repeatedly query about how is it that so many subprime mortgages were issued to home buyers who clearly could not qualify for mortgage loans on any reasonable criteria, or who would obviously be unable to make payments on their mortgages once interest rates inevitably rose to normal levels. What the pundits don’t understand is that, given the increasingly trend over time toward a greater relative mix of speculative to total investment arrangements in the 21st century capitalist economy, it is quantity, not quality, of investment opportunity that takes precedence. Since 2003 the practice of the banks had been to encourage mortgage loan companies to produce more loans regardless of the quality of those loans. Mortgage loan companies in turn incented real estate brokers to deliver more loans without consideration of quality. And real estate brokers, like the good used car salesmen they are, said whatever was necessary to close the deal with the home buyers.

In other words, the faster and easier it became to crank out a larger volume of mortgage loans the greater the volume of CDOs and related derivatives that could be packaged and marked up at profit by the banks and their ‘shadow banks’, the SIVs. No matter if the total volume of mortgage loans by 2005-06 were more subprime than not. The quantity of loans, not their quality now mattered most. And even quantity was only part of the new profit model. Finance profitability in 21st century finance capitalism was becoming less and less dependent on the issuance of loans per se, but increasingly on the edifice of derivatives and their supporting institutions built upon loans and their assets.

The U.S. subprime mortgage market accelerated in 2003-04. By 2005 more than $635 billion of subprime loans were issued. In 2006 the amount was another $600 billion. The cumulative total by 2007 was more than $1 trillion in subprime loans.
By mid-2006 it had become quite clear that the subprime mortgage market was in freefall. Home buyers with subprime mortgages were now defaulting on payments at record rates and foreclosures were beginning to rise. By late summer 2007 it was estimated that there were 2 to 3 million potential foreclosures over the next few years. The value of subprime mortgages quickly plummeted, and with them many of those CDOs in which they were imbedded. The subprime mortgage market virtually shutdown. It was not possible to accurately estimate the magnitude of the losses from the subprimes since they were ‘sliced’ and distributed within different CDO offerings. And if the losses for the subprime elements in CDOs could not be accurately valued, so too could the CDOs themselves not be accurately valued. Nor could the asset backed commercial paper often bundled with the CDOs. And so on.

The typical response of investors in such situations is to ask how much their investments were ‘under water’. And when they could not be accurately told, their next response is ‘sell my investment’ and give me the cash remaining. But with no markets for subprimes by late 2007 their remaining value was impossible to estimate. No sales mean no price mean no possible valuation estimate and in turn no cash out possible. Investors, like the banks and their SIVs, were thus together locked in many cases in a death spiral, unable even to bail out and destined to ride the doomed vehicle into the ground.

By late 2007 various estimates place the value of expected losses from the subprime market collapse range from Goldman Sachs’ low of $211 billion, to the OECD’s estimate of $300 billion, to estimates based on the ABX Index, the official measure of subprime mortgage securities’ value, which by late November 2007, estimated losses for the market at approximately $400 billion. In stark contrast to these estimates, however, the losses admitted by the major banks as of year end 2007 amounted to only a paltry $60 billion total. More, indeed, much more in terms of bank losses and bank write-downs due to the subprime market meltdown are yet to come in 2008.

But subprime losses and write-downs on bank balance sheets were—and still remain—only part of the bigger picture and potential financial crisis.

Spreading the Subprime-CDO Pain

The estimated total volume of all CDOs worldwide (not all of which have subprime mortgages bundled with them) is, according to the OECD, approximately $3 trillion in total value. Approximately half that total is held by hedge funds, a fourth by banks, and the remaining exposure by asset managers and insurers. CDOs with subprime mortgage slices are only part of this much larger picture.

As noted previously, many of CDOs also bundled Commercial Paper—sometimes with subprimes and often without. But asset backed commercial paper appears equally at risk as subprime mortgages and the consequences of its collapsed are yet to be fully realized.

Like the subprime mortgage market, the ABCP market experienced a sharp runup between 2003-07 in conjunction with the acceleration of CDOs and other derivatives. Many companies in trouble financially and unable to raise capital to continue, or only able to do so at great expense elsewhere, turned to the ABCP to issue commercial paper on their remaining real assets to raise cash for operations or investment purposes. Much of their risky commercial paper was bundled with CDOs. But like the subprime market the ABCP market has virtually shut down as well since the advent of the financial crisis in late summer 2007. The ABCP market in the U.S. peaked at $1.2 trillion in August 2007 and had fallen to $700 billion by year end. By June 2008 an additional $300 billion is projected to come due. That’s another $300 billion banks may have to provide for on their balance sheets, in addition to the $400 billion in additional subprimes coming due. In Europe the commercial paper market is also declining rapidly, having fallen 44% by October 2007 to $172 billion from a May 2007 peak of $308 billion.

With the ABCP market largely shutting down, many corporations straining to stay in business in recent years by selling their commercial paper in that market will likely now begin to default. That means a sharp rise in business bankruptcies. For example, nonfarm business debt rose by 30% in 2004 and continued thereafter at levels greater than the historical average. Many CDOs imbedding their commercial paper helped hold off defaults and failures between 2003-07. But with the shutdown of the ABCP markets, the built up pressures for corporate defaults will be released with the consequent result of sharp increases in corporate bankruptcies in 2008-09. The corporate ratings agency, Moody’s, in fact predicts an increase in default fates between four and ten times the most recent rate in the period immediately ahead, and the highest since the peak fallout from the dotcom bust in 2002.

Together, general loans to business and commercial paper are two capital markets which companies most heavily rely upon to finance their short term business operations. The two combined had a total of $3.3 trillion in outstanding credit to businesses in August 2007. However, in a matter of only three months, total loans had fallen by more than $300 billion. There is no way such a rapid contraction of credit can fail to result in a sharp drop off in general business investment and a recession in the U.S. economy in 2008. In fact, a much smaller percentage decline of business loans from these two sources immediately preceded the last two recessions in the U.S. Even more worrisome, it appears in recent months that other capital markets are now being increasingly affected by the growing generalization of the financial crisis beyond the subprime mortgage and commercial paper markets.

How the current financial crisis has been spreading at an historically rapid rate from the subprime to other capital markets, and how the crisis is being transmitted in turn from those latter markets to the general economy in the U.S.—thereby guaranteeing a recession in the U.S. in 2008 and threatening to expand globally in 2009—will addressed in detail in Part II of this analysis to follow.

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