A prime factor in the creation of “bailout Mania” in late-2008 is that hedge funds accounted for about half of all stock trades earlier in that decade. Hedge funds played a central role in the creation of credit-default swaps and other financial exotica. A credit-default swap (CDS) is a form of insurance which protects the CDS in the case of a loan default. If the loan defaults, the buyer of the CDS can exchange or “swap” the defaulted loan for the face value of the loan. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $38.8 trillion by the end of 2008.
Another contributor to the financial crisis starting in 2007 but coming to a boil in late-2008, was what are called mortgage-backed securities. These are a bundle of securities that have been sold by banks to Fannie Mae, who then repackages them and sells them to individual investors. This process allows the banks and mortgage companies to sell off mortgages and then take them off their balance sheets.
Banks and mortgage companies made loans with no money down. Bundling of securities removed an important discipline for good lending practice.
Another major contributor to the financial crisis was the repeal of the Glass-Steagall Act. Although repealed in November 1999, it took almost a full decade for the repeal to be revealed as a very bad action. Glass-Steagall had created a firewall between investment banks, whcih issue securities, and commercial banks, which accept deposits. Experts believe that the repeal allowed Wall Street investment banking firms to gamble with their depositor’s money, that was held in commercial banks owned or operated by the investment firms.
Goldman Sachs represents an example of how financial firms were deceiving their own clients and profiting at their expense. Goldman Sachs’ employees were making side bets against the very risky investments they were selling. In short, Sachs was selling “short” on the mortgage market meltdown. Brokers were recommending securities to clients that they were disparaging in emails — often in very crude language.
The United States has become much more of a “casino” economy, in which vast sums are wagered on what will happen to various aspects of economic activity in the future. This transition is revealed by the fact that financial companies account for about twice the proportion of the GDP as they did 30 years ago, and up to 40 percent of corporate profits.
The “best and the brightest” of college graduates are being attracted into the financial sector, where they can make big money fast; however, this “churning” of financial assets adds little or nothing to the betterment of society. If manufacturing were a much bigger component of the U.S. economy, many of these graduates could be going into businesses that make useful products for the society.
Is there a high standard of ethics among our Wall Street professionals? A 2007 poll of 2,500 Wall Street professionals painted a troublesome picture. They were asked if they would use inside information to make $10 million if the chances of getting caught were 50 percent. Seven percent said yes. But if there was a zero chance of getting caught, 58 percent said they would break the law.
Some of the questions that could be asked about big business ethics are: “Is corporate corruption, in general, rampant?” “Is ethical bankruptcy on the rise?” “Are corrupt business models becoming more common?” “Has the market become more of an exclusive gambling club for the rich?”
In the wake of the bailout of large financial firms during the Bush administration, public anger was ignited when it was revealed that upper management types were going to swanky clubs and exotic locations for business meetings. This anger became, if anything, more extreme when top executives began to receive large bonuses, even when their companies had taken a bailout because of bad performance.
According to the Wall Street Journal, the years 2009 and 2010 turned out to be record breakers for Wall Street, as total compensation and benefits at the top New York banks, hedge funds, money management firms and security exchanges hit $128 billion and $135 billion, respectively, for the two years.
Despite this generous compensation and the huge bonuses, the financial industry’s performance has been dismal: countless lenders have gone out of business and many still standing have seen their stock prices decimated after they loaned immense amounts of money to people who couldn’t repay it.
What about President Obama’s culpability in the financial meltdown and the attempt to recover from it? He certainly was not responsible for the TARP bailout program, which was legislated during the end of George W. Bush’s tenure in office — although Obama did rally Democratic lawmakers to vote for the bailout program,
In the effort to put more regulatory restraints on the financial industry, Obama has not been very visible nor vocal. The Dodd-Frank bill passed into law has been widely derided as being too weak to curtail destructive actions by financial institutions.
In regard to the Consumer Financial Protection Agency, President Obama sided with the banks in keeping it inside the Federal Reserve system, where critics said it would be swallowed up and lose its independence.
Obama has been very proactive in trying to find a solution for those many homeowners who are deeply underwater in their mortgage payments. The media has done a good job in keeping track of how well the rescue programs have worked. They have found the Obama programs have helped a very small percentage of people, largely in part because the programs have not been well promoted.
President Obama has more recently abandoned his “Yes we can!” rhetoric on the housing crisis, as he told a town hall meeting that the housing crisis was too big a problem for a federal program to solve. He added: “Some folks just bought more home than they could afford, and probably they’re going to be better off renting.”
What, Then, Should Be Done?
Economist James K. Galbraith’s solution is to break up the banks, shrink the financial sector, expose and prosecute fraud, and create incentives for profitable investment in energy conservation, infrastructure and other sectors.
A major initiative being proposed to counter the contention that the financial industry is sitting on $2 trillion in cash is to create an infrastructure bank to provide loans for rebuilding the nation. This action would be similar to the bank to rebuild urban areas proposed by Senator Hubert Humphrey.
Another positive action would be to reinstate the Glass-Steagall Act to restore the firewall between investment banks and commercial banks.
Credit-default swaps should either be outlawed — the preferred option — or made more transparent through reporting requirements.
Bundling securities for home mortgages should also be outlawed to force banks to manage and monitor the mortgages they initiate.
Two recent developments make the case that the financial firms cannot be counted on to solve their own problems. The first was the revelation that JP Morgan had lost $2 billion in a risky investment. First, CEO Jamie Dimon tried to blow off the action as of no consequence; then later explained it as a hedge against losing money, not involving any depositor’s money; and then acknowledged it was a serious error on the part of the company. More recently, Dimon has admitted that the loss was at least four and one-half billion dollars and maybe more.
The second development is the recent scandal involving Great Britain’s Barclays Bank. Barclays manages the libor financial structure. Libor is the rate of interest charged by loans made between and among banks. The scandal is that the libor rate was being manipulated in favor of the banks in the many financial transactions in society that are affected by the libor rates.