[OPE] From Global Financial Crisis to Global Recession, Part I

From: glevy@pratt.edu
Date: Thu Mar 27 2008 - 14:40:29 EDT

via Antonio Pagliarone:

>From Global Financial Crisis to Global Recession, Part I 
Precipitating the fall 
March, 01 2008 By Jack Rasmus 

Last year we witnessed the emergence of the most serious financial
crisis to hit the U.S. 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 global downturn in

History will show a remarkable congruence between the
conditions, events, and policies of the decade of the 1920s, on the one
hand, and the events and policies of the past decade. 

1920s were characterized by: 

a.. an over-extended housing and
construction boom in mid-decade that imploded 
b.. a slowdown in
investment in the productive economy as speculative investment steadily
crowded out real investment 
c.. a Federal Reserve System that pumped
up the money supply without concern for its eventual speculative impact

d.. an increasing imbalance in world trade and currency instability

e.. the near destruction of labor unions-to name the more notable

The progressive destruction of unions over the course of the 1920s,
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. By 1928 the
wealthiest households had doubled their share to 22 percent 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. The massive shift in
incomes that fed the speculation in turn resulted in a further income
shift, as super-profits were realized by the wealthy from the speculative
investment frenzy. More concentration of income in turn provoked a dizzy
spiral of asset price inflation, speculative profits, and a euphoric
expectation the process would continue without limit. 

speculative excesses of the 1920s were 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 included the explosion of buying stocks and securities on
margin-or what is sometimes called leveraging. It included practices that
ensured the speculation remained 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. The government refusal to monitor or check the speculative
excesses also contributed. 

The foregoing process culminated in
a stock market crash, once the cracks in the real economy began to appear
and 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 investment, ensuring further corporate defaults,
massive job losses, and subsequent decline. Thus, while the increasingly
speculative activity was not the sole cause of the crisis, it was a
critical and central development provoking the crash and the depression
that followed. 

As in the 1920s, in the last decade the U.S.
has been lurching from one speculative bubble to the next. These include:

a.. the Long Term Capital Management (LTCM) hedge fund bailout
of 1998 
b.. the Asian debt crisis of 1998 (at the center of which
were U.S. money center banks) 
c.. the dot-com technology asset
bubble of 1999-2000 
d.. the recent subprime mortgage bust (the
foundations for which were laid in 2003-04) 
e.. the recent rapid
spread of the subprime crisis in 2007-2008 to other capital markets in the
The series of speculative bubbles from 1998-2008 in each case
were temporarily contained by an unprecedented expansionary monetary
policy engineered by the U.S. Federal Reserve under Alan Greenspan. The
Greenspan Fed thus contributed to the series of bubbles with money
injections designed to stave off the spread of liquidity crises and credit
crunches. The temporary fixes did not solve the problem, but postponed the
crisis for the short term. The result has been a containment each time
that has bottled up pressures, which then emerged once again with
subsequent greater effect. 

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
Reagan and continued unabated under Clinton. In recent years, under George
W. Bush, that inequality has accelerated. Starting with a share of only 9
percent of total national income, for example, by 2006 the wealthiest 1
percent of households had again raised their total share to the 22 percent
they enjoyed in 1928. 

As in the 1920s, the rapid rise of
income inequality has been driven largely by the restructuring of
taxation, as more than $4 trillion of tax cuts were passed in Bush's first
term alone, 80 percent 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 neoliberal trade and

The growth of incomes by the wealthy provided the
huge pool of income and wealth with which to engage in speculative
investment activity. As short term speculative activity resulted in
significantly greater returns than real investment activity, more and more
investment was shifted into speculative activity or from real investment
in the U.S. home market to investment offshore in the so-called emerging
markets-in particular, in China and Asia. In addition to the growing
income imbalance and the easy money policies of the Greenspan Fed, a third
critical element has been the elimination of any semblance of financial
regulation and oversight, which was given a coup-de-grace in 1999 with the
repeal of the 1930s-era Glass- Steagall Act. Glass-Steagall was supposed
to prevent speculative and other abuses. 

As Glass-Steagall was
being progressively undermined under Reagan, Bush I, and Clinton, the
so-called financial revolution was taking off. With that revolution in
finance came a corresponding proliferation of new financial structures and
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 and
globalization has meant further de facto deregulation. 

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
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. We are now beginning to see the consequences of this concurrence
of total financial deregulation, unchecked financial restructuring,
accelerating income inequality, and accommodative government monetary
policy which is now yielding even greater financial crisis, U.S.
recession, and a threat of global instability. 

Derivatives and
the Securitization Revolution 

If Structured Investment
Vehicles (SIVs) and hedge funds are the vehicles of the new speculative
and financial crisis, their products amount to a vast array 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 new institutional structures and
financial devices represent. And the securitization revolution is based
upon the granddaddy 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 or
other financial products. They have virtually no cost of production. Their
costs of distribution and sale are essentially non-existent. 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 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 and brings the rest down with it. 

In today's global economy there are more than $500 trillion in
derivatives 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." 

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 on 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 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: 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 on 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., CLO). Other forms of bundled assets 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 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 and
stave off default. 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 Secured Investment
Vehicles. SIVs 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 banks' balance sheets,
where bank record keeping is subject by law to review by the U.S.
Securities and Exchange Commission. With SIVs typically quickly turning
over, or selling, 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 profit growth of more than 20 percent 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. 

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 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. 

In 1998 the
total international volume of securitized offerings amounted to less than
$100 billion. By 2003 it had risen only to $200 billion, more than $500
billion in 2005, and exceeded $1 trillion in 2006. 

the Subprime-CDO Bubble 

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

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 quantity was
only part of the new profit model. Finance profitability was becoming less
and less dependent on the issuance of loans per se, but increasingly on
derivatives and their supporting institutions. By 2005 more than $635
billion of subprime loans were issued. In 2006 the amount was another $600
billion and the cumulative total by 2007 was more than $1 trillion. 

By mid-2006 it had become 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 would be two to three 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 shut down. 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, the CDOs could 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. When they cannot be
accurately told, their next response is often "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 meant
no price meant no possible valuation estimate and in turn no cash out.
Investors, like the banks and their SIVs, were locked together in many
cases in a death spiral, unable 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 from
Goldman Sachs's low of $211 billion and the OECD's estimate of $300
billion to estimated losses- based on the ABX Index, the official measure
of subprime mortgage securities' value-at approximately $400 billion. In
stark contrast to these estimates the losses admitted by the major banks
as of year end 2007 amounted to only a paltry $60 billion. More, indeed,
much more in terms of bank losses and bank write-downs are yet to come in

But subprime losses and write-downs on bank balance
sheets were only part of the bigger picture. 

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. 

noted, 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 run up 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 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
percent by October 2007 to $172 billion from a May 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 will likely begin to default. That means a sharp rise in business
bankruptcies. For example, non-farm business debt rose by 30 percent in
2004 and continued thereafter at above average levels. Many CDOs helped
hold off defaults and failures between 2003-07 by imbedding their
commercial paper. But with the shutdown of the ABCP markets, 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, predicts an increase in default fates between four and
ten times in the period immediately ahead, the highest since the peak
fallout from the dot-com bust in 2002. 

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 be addressed in Part II of this analysis.



Jack Rasmus is the author of the The War At Home: The
Corporate Offensive 
>From Ronald Reagan to George W. Bush 2006 and
The Trillion Dollar Income Shift: Essays on Income Inequality in America

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