Easy money for speculators in land did it before; can it again?
1929 Redux: Heading for a Crash?
Below follows the testimony before the House Financial Services Committee on October 2 of the author, co-editor of The American Prospect and former investigator for the Senate Banking Committee, which AlterNet posted October 8, 2007. We abridge it with permission.
by Robert KuttnerAs Warren Buffett famously put it, you never know who is swimming naked until the tide goes out.
High rollers borrow most of the cost of their investment. With credit derivatives, they use leverage (borrowed money) at ratios of ten to one, or a hundred to one, limited only by taste for risk. Private equity might be better named private debt -- much is borrowed money, the equity (one’s own money) is fairly small. All the leverage contributes to the asset inflation, conveniently creating higher priced collateral against which to borrow even more money.
Much of the boom of the late 1990s was built on asset bubbles.
To create asset bubbles, purveyors of securities use very high leverage; the securities are sold to the public or to specialized funds with underlying collateral of uncertain value; and financial middlemen extract exorbitant returns at the expense of the real economy.
Securitization of credit is not new. In the 1920s, banks would originate and repackage highly speculative loans, market them as securities through their retail networks, using the prestigious brand name of the bank -- e.g. Morgan or Chase -- as a proxy for the soundness of the security.
In the 1920s, the corrupted insiders were brokers running stock pools and bankers as purveyors of watered stock. 1990s, it was accountants, auditors and stock analysts, who were supposedly agents of investors, but who turned out to be confederates of corporate executives. Today’s conflict arises from bond rating agencies being paid by the firms that issue the bonds. Who gets the business -- the rating agencies with tough standards or generous ones? Are ratings for sale? And what, really, is the technical basis for their ratings?
When big banks lost many tens of billions on third world loans in the 1980s, the Fed and the Treasury collaborated on workouts, and desisted from requiring that the loans be marked to market, lest several money center banks be declared insolvent.
When Citibank was under water in 1990, the president of the Federal Reserve Bank of New York personally undertook a secret mission to Riyadh to persuade a Saudi prince to pump in billions in capital and to agree to be a passive investor.
In 1998, the Fed convened a meeting of the big banks and all but ordered a bailout of Long Term Capital Management, an uninsured and unregulated hedge fund whose collapse was nonetheless putting the broad capital markets at risk.
In August and September, while the Fed and the European Central Bank were flooding markets with liquidity to prevent a deeper crash, the Bank of England decided on a sterner course. It would not reward speculators. The result was an old fashioned run on a large bank, and the Bank of England changed its tune.
Which financial innovations actually enhance economic efficiency and which ones enrich middlemen, strip assets, appropriate wealth, and increase systemic risk? What benefits does securitization of mortgage credit bestow? By the time you net out the fee income taken out by all of the middlemen -- the mortgage broker, the mortgage banker, the investment banker, the bond-rating agency -- it's not clear that the borrower benefits at all. What does increase, however, are the fees and the systemic risks.
While credit derivatives are said to increase liquidity and serve as shock absorbers, their bets are often in the same direction, so in a crisis they can de-stabilize the credit market.
Much of today’s paper is more opaque to bank examiners than its counterparts were in the 1920s. Much of it isn't paper at all but automated formulas in computers.
At the heart of the recent financial crises are three basic abuses: lack of transparency; excessive leverage; and conflicts of interest. Those in turn suggest remedial requirements: greater disclosure either to regulators or the public; increased reserves in direct proportion to how opaque and difficult to value are the assets; and higher walls against conflicts of interest.
Because of the separation of stock ownership from effective control, corporate management is not adequately responsible to shareholders and by extension to society. To hold managers accountable, we need less cronyism on corporate boards, more power for shareholders and other stakeholders such as employees, and proxy rules not tilted to incumbent management but let mutual funds be agents of shareholders.
Also, tax policies could discourage dangerously high leverage ratios, in whatever form.
The fact is that the economic fundamentals are sound -- if you look at the real economy of factories and farms, and internet entrepreneurs, and retailing innovation and scientific research laboratories. It is the financial economy that is dangerously unsound.
JJS: Tax policies that would discourage speculators don’t levy income after it’s been raked in; that leaves the flawed system intact and by then speculators have the power to demand a bailout. Instead, levy a tax on assets not made by anyone -- such as land and oil fields. Most of the “leverage” in bubbles is for investing in real estate’s prime locations. Having to pay over the site value to society, the wealthy would invest only for rational development, not speculation.
Also, don’t lavish public spending on corporations; instead, charge full-market value for privileges such as corporate charters, bank charters, utility franchises, monopoly patents, broadcast licenses, etc. Fair fees for these little pieces of paper would soak up surplus value. So investors would have no reason to bother bidding up asset prices and instead would invest in new ideas that actually improve farms, factories, shops, and labs.
Jeffery J. Smith runs the Forum on Geonomics.
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