Annals of the Great Recession VIII.

When we say “investors” we naturally think of Thurston Howell III from “Gilligan’s Island.” Nothing could be further from the truth in contemporary America. Now “investors” means banks, insurance companies, hedge funds, and pension funds. Many of these investors are, in turn, owned by mutual funds. These investors had a lot of money to throw around and they wanted safe investments.[1] The banks addressed this dual problem by creating Collateralized Debt Obligations (CDO). Essentially, a CDO is a super-bond that groups together many smaller loans. So, a CDO is a big financial instrument appropriate for a big investor. At the same time, the CDO addressed the safety problem by bundling the few loans anticipated to default with the many that were expected to not default. These CDOs proved to be wildly popular with investors: $550 billion worth of CDOs were issued in 2006 alone.

For a combination of reasons, the risky, or “sub-prime,” share of mortgages greatly expanded. Rather than trying to rein-in the “sub-prime” risk, lenders relied on safety features of the CDO (many presumably sound mortgages bundled together with a handful of presumably bad mortgages). Furthermore, other companies sold insurance for the derivatives, so they seemed very safe. The market in these “financial derivatives” just exploded. Less noticed, many of the loans were also adjustable rate mortgages (ARMs) which allowed the lender to increase the interest rate charged the borrower if interest rates in general began to rise.

Then, in the second half of the 2000s the whole process went into reverse.[2] The Federal Reserve Bank raised the Federal Funds Rate from 1 percent in Summer 2004 to 5.25 percent in 2006, then left it there until Summer 2007.[3] Interest rates began to rise and housing prices began to drop. The adjustable rate mortgages followed the track of interest rates in general, squeezing many marginal home owners to the point where they could not service the mortgage at all. Defaults suddenly began to mount, leading to foreclosures, leading to a glut of homes on an already falling market, leading to a further decline in the value of all homes.

The trouble here finally appeared in the opacity of the CDOs. Once the defaults started to mount, it proved impossible to tell with any certainty how solid any one CDO was. It might be made up of mostly good loans with a few dogs mixed in. It might be a veritable animal rescue society with a few good loans mixed in. As Peter Peterson put it, “you’ve got ten bottles of water and one of them is poisoned; which one do you drink?” There was no way to tell, so people did the safe thing by distrusting all of them.

As the number of worthless mortgages inside the “bundles” of mortgages bought by investors rose sharply, the value of the securities plunged. Banks that had bought these securities as part of their capital, suddenly found their balance sheets showing huge losses. Worse still, the companies which had sold insurance on the derivatives found that they had misunderstood the degree of risk of default and did not have the resources necessary to cover their own losses. Banks started refusing to lend to other banks out of a fear that the loans would not be repaid. Suddenly, the whole financial system seemed to be on the verge of collapse.

The United States had been through this once before, in the early stages of the Great Depression of the Thirties. Inadequate government action then had led to more than a decade of hardship, misery, and political upheaval. This time would be different. Sort of.

[1] “The ‘toxic debt’ tsunami,” The Week, 20 March 2009, p. 13.

[2] “Wall Street’s hidden time bombs,” The Week, 10 October 2008, p. 11.

[3] http://fpc.state.gov/documents/organization/112465.pdf

Annals of the Great Recession VII.

All business decisions are bets on an unknowable future.[1] Faced with uncertainty about the future and the risk that some bets will go bad, businessmen have long sought to build in certainty through contracts and off-set possible losses through hedging. Commodities futures—promises to deliver a set amount and a set price at some future point—have been contracted for and traded for a long time. Commodities futures guarantee sellers a buyer and an income, while guaranteeing purchasers a product at a fixed price.

If uncertainty is one fixture of business, so is innovation. In the 1990s lenders developed a new form of betting on the future. Housing prices had risen steadily in the United States since the 1970s. Believing that housing prices were on a long-term or even permanent upward track, some lenders perceived mortgages issued today as a promise of secure returns tomorrow. Large numbers of newly-issued mortgages were bundled together into securities which were then sold to investors seeking the promise of above-market rates of return. In all lending there is the danger that the borrower cannot or will not repay the loan. The theory appears to have been that a few bad mortgages in any one bundle would not impair the value of all the other sound mortgages in the security.

Democrats wanted to bring these new financial instruments and markets under federal regulation in the same way that the Securities and Exchange Commission over-sees the stock market. Republicans defeated this effort. Indeed, Senator Phil Gramm pushed through a law which exempted such “financial derivatives” from federal regulation. Potentially, the derivative market had become the Wild West. On the other hand, it was a pretty small market in the later 1990s. What’s the worst that could happen?

The “dot.com boom” was one of the hall-marks of the late 1990s.[2] It turned out to be a bubble and the bubble popped in 2001. Then the 9/11 attacks administered a second shock to the system. Rather than put the United States through a financial crisis and recession, the Federal Reserve Bank pumped a lot of money into the economy and cut the short-term interest rate from 6.5 percent to 1 percent. Banks borrowed money cheaply, then re-lent it to others at a somewhat higher rate of interest. Pretty soon all the reasonable loans had been made, but there was still a lot of money to lend. What to do?

Make unreasonable loans, that’s what. Mathematical risk models for these loans, based on an extremely shallow historical record, predicted only a few defaults and constantly rising house prices. The usual standards for making a loan to someone were diluted. This allowed banks to lend to people and for purposes that normally would not have been acceptable. Some of it went to home loans that were labeled “sub-prime”; some of it went for auto loans, credit card debt, student loans, and commercial mortgages. In short, it financed a lot of consumption by ordinary Americans that otherwise would not have been possible.

So, the banks and non-bank financial institutions (mortgage originators) made all these loans. What to do with them? One answer would be “sit on them and collect the interest and principle until the loan is repaid, then make another loan.” Another answer would be “sell the loans (i.e. the right to be repaid by the original borrower) to investors looking for a steady income stream.” Mostly the banks chose the latter course. Selling the loans brought in cash immediately and earned fees for the banks. It transferred the assets to the “investors.”

[1] “Wall Street’s hidden time bombs,” The Week, 10 October 2008, p. 11.

[2] “The ‘toxic debt’ tsunami,” The Week, 20 March 2009, p. 13.

Which Sides Are You On?

Americans are ambivalent about public unions.  In early industrial capitalism, all the power lay with employers. There were always more people seeking work than there were jobs, while state and local governments were there for the buying. As a result, wages were low, hours were long, working conditions were abominable, and job security was non-existent. Only unions offered any chance at improving the lives of workers. Union-organizing, however, proved to be hard and dangerous work. Employers resisted with every means possible and often did not stop at the edge of legality. Moreover, the very idea of a union clashed with the individualistic values upheld by most Americans. Only with the Depression and the New Deal did mass unionization sweep over heavy industry.

Public-sector unionization did not amount to much for a very long time. For one thing, the large American state is a fairly recent creation. More importantly, most people distinguished between public and private unions. On the one hand, public employment seemed far more secure than did private sector work and often seemed subject to various kinds of patronage. On the other hand, government provided services for which there was no alternative. While breaking a police strike in Boston, Calvin Coolidge declared that “there is no right to strike against the public safety.” Most people agreed with the sentiment for half a century. However, in 1962 President John Kennedy issued an executive order allowing many federal employees to unionize. The movement then spread to the state and local levels. Membership in public-sector unions now outnumbers membership in private-sector unions. Because the courts have upheld the right of unions to collect dues from all members, unions have deep pockets for political action.[1]

Amity Shlaes argues that there is an important emotional component to public attitudes toward unions. People have a positive view of Franklin D. Roosevelt and Roosevelt’s New Deal promoted mass unionization. Most people wouldn’t run into a burning building, or pull over a car on a dark night, or try to wrangle a room full of 14 year-olds, so they admire those who will do those things. So, public sector unions are approved on an emotional level. [2]

While the national media are interested in labor’s role in national politics, the unions actually focus most of their efforts lower down the food-chain. Local government elections often run in the “off” years between national elections. Turn-out is about a third lower in the local elections. When unions can turn out voters and supply campaign funds, they can have a disproportionate impact on the governments with which unions will then negotiate contracts.

Since they depend on union support in elections, Democrats tend to fold up under pressure. Since Americans don’t want to pay more taxes, local governments find their way out of the immediate dilemma by granting generous pension benefits that someone else in the years ahead with have to figure out how to pay. We can see the consequences in the balance sheets of some American cities. Dallas, a non-union town if ever I saw one, pays $74 a ton for garbage collection and disposal. Chicago, the union-city par excellence now that Detroit has cratered, pays $231 a ton. Speaking of Detroit, in 2013 the city sank under more than $18 billion in long-term debt. Half of that debt was for pension and health-care benefits for employees that could not be supported from the shrinking tax base.

Exasperated Republicans just want to cut government services to get rid of the burden of the unions. It’s difficult to see this as anything except a different kind of “strike against the public safety.” As with many things in contemporary America, some fresh thinking is needed.

[1] Daniel DiSalvo, Government Against Itself: Public Union Power and Its Consequences (2015).

[2] Her own sentimental attachments lie elsewhere. See: Amity Schlaes, Coolidge (2013).