Peter Gowan, Crisis in the Heartland
February 5, 2009 5:28 AM   Subscribe

"A striking feature of the New Wall Street System business model was its relentless drive to expand balance sheets, maximizing the asset and liabilities sides. The investment banks used their leverage ratio as the target to be achieved at all times rather than as an outer limit of risk to be reduced where possible by holding surplus capital ... One explanation is that they were doing this in line with the wishes of their shareholders (once they had turned themselves into limited liability companies) ... But there is also another possible explanation for borrowing to the leverage limit: the struggle for market share and for maximum pricing power in trading activities," Against mainstream accounts, Peter Gowan argues that the origins of the global financial crisis lie in the dynamics of the New Wall Street System that has emerged since the 1980s. Contours of the Atlantic model, and implications—geopolitical, ideological, economic—of its blow-out.
posted by geoff. (21 comments total) 6 users marked this as a favorite
 
You know, by many indications I'm an intelligent guy. That's how many people tell me I come across, and that's what those tests I took as a kid say. It's often the first thing people notice about me.

I'm not a doctor, or a lawyer, but I can read a medical study or a legal brief and usually at least get the gist of it. Hell, I can even follow theological arguments.

And yet, when I read about the financial crises, I just feel like a slack-jawed mouth-breathing idiot. Is it something that requires twenty years of study to even begin to grasp? Have I gotten old and stupid? Is it just beyond my ken, or is it that I'm trying of make sense of the Time Cube, but dressed up in a $10,000 suit, diamond cuff-links, and a golden parachute?
posted by orthogonality at 5:46 AM on February 5, 2009 [11 favorites]


It's just that the crisis, like most big events, had multiple causes; so everyone with an axe to grind is grinding merrily away.
posted by TheophileEscargot at 5:50 AM on February 5, 2009


orthogonality, the people running the show don't understand it anymore than you do, not really. They are just much better at convincing others that they understand it.
posted by Vindaloo at 5:55 AM on February 5, 2009


orthogonality: "...or is it that I'm trying of make sense of the Time Cube, but dressed up in a $10,000 suit, diamond cuff-links, and a golden parachute?"

This.
posted by Science! at 5:57 AM on February 5, 2009 [5 favorites]


Before I'm going to accept the willy nilly blaming of a financial crisis on the "What's good for business is good for America" soundbite that the President was pushing some 20-30 years before, I'm going to have to see some kind of historical precident or something....

What? Wilson? Oh. Carry on.
posted by Kid Charlemagne at 6:04 AM on February 5, 2009


Much of the mainstream debate on the causes of the crisis takes the form of an ‘accidents’ theory, explaining the debâcle as the result of contingent actions by, say, Greenspan’s Federal Reserve, the banks, the regulators or the rating agencies. We have argued against this, proposing rather that a relatively coherent structure which we have called the New Wall Street System should be understood as having generated the crisis. But in addition to the argument above, we should note another striking feature of the last twenty years: the extraordinary harmony between Wall Street operators and Washington regulators. Typically in American history there have been phases of great tension, not only between Wall Street and Congress but also between Wall Street and the executive branch. This was true, for example, in much of the 1970s and early 1980s. Yet there has been a clear convergence over the last quarter of a century, the sign of a rather well-integrated project. [30]

An alternative explanation, much favoured in social-democratic circles, argues that both Wall Street and Washington were gripped by a false ‘neo-liberal’ or ‘free-market’ ideology, which led them astray. An ingenious right-wing twist on this suggests that the problematic ideology was ‘laissez-faire’—that is, no regulation—while what is needed is ‘free-market thinking’, which implies some regulation. The consequence of either version is usually a rather rudderless discussion of ‘how much’ and ‘what kind’ of regulation would set matters straight. [31] The problem with this explanation is that, while the New Wall Street System was legitimated by free-market, laissez-faire or neo-liberal outlooks, these do not seem to have been operative ideologies for its practitioners, whether in Wall Street or in Washington. Philip Augar’s detailed study of the Wall Street investment banks, The Greed Merchants, cited above, argues that they have actually operated in large part as a conscious cartel—the opposite of a free market. It is evident that neither Greenspan nor the bank chiefs believed in the serious version of this creed: neo-classical financial economics. Greenspan has not argued that financial markets are efficient or transparent; he has fully accepted that they can tend towards bubbles and blow-outs. He and his colleagues have been well aware of the risk of serious financial crisis, in which the American state would have to throw huge amounts of tax-payers’ money into saving the system. They also grasped that all the various risk models used by the Wall Street banks were flawed, and were bound to be, since they presupposed a general context of financial market stability, within which one bank, in one market sector, might face a sudden threat; their solutions were in essence about diversification of risk across markets. The models therefore assumed away the systemic threat that Greenspan and others were well aware of: namely, a sudden negative turn across all markets. [32]

Greenspan’s two main claims were rather different. The first was that, between blow-outs, the best way for the financial sector to make large amounts of money is to sweep away restrictions on what private actors get up to; a heavily regulated sector will make far less. This claim is surely true. His second claim has been that, when bubbles burst and blow-outs occur, the banks, strongly aided by the actions of the state authorities, can cope with the consequences. As William White of the bis has pointed out, this was also an article of faith for Bernanke., [33]
posted by geos at 6:10 AM on February 5, 2009 [1 favorite]


I think the basics of the crisis are pretty simple. For the last decade or so, there was too much money and credit sloshing around the economy. To try to lend out this all this extra money at a profit, the lenders got sloppy about who they lent it to. With all this money in the hands of borrowers, the price of houses got pushed up unrealistically high.

Eventually, it became clear that house prices were too high, and prices fell. It became clear that the sloppy lenders weren't going to get their money back and they started to fail. The previously-sloppy lenders now became ultra-paranoid and refused to lend to even regular guys. Regular guys then stopped being able to borrow money to outfit their shops, buy new vehicles, build factories and do all the stuff it's useful to be able to borrow money for.

Things only get complicated when you start to ask the fundamental human question: So who do we blame?

There were multiple factors behind the excess of money/credit. There are multiple links in the chain of events.

Some factors behind the excess of money:
1. Low interest rates from the Treasury (easy monetary policy)
2. China's low-valued currency. Normally, when China or Japan sells a toaster to the US, they get paid in dollars. They then convert that to their currency to spend their profits. Their currency then goes up, and they get less competitive. To stop that happening, China invested their excess dollars in the US instead.
3. Deregulation allowed greater leverage. A bank with given assets could lend more of its money.

Some links in the chain.
A. Academic economists encouraged greater deregulation, and more leverage.
B. The credit rating agencies, who are supposed to stop lenders getting too sloppy, didn't.
C. Complicated financial instruments made it hard to tell which lenders were getting sloppy.
D. Governments encouraged lending to poorer people who would normally have found it hard to get credit.

So where things get complicated, is which links and causes you choose to stress, in order to fit in with your belief systems.

If you're right-wing, you don't trust governments, so you want to stress 1 and D.

If you're left-wing, you don't trust big business, so you stress 3, B and C.

If you don't trust foreigners, you want to stress 2 and D.

Hence most of the arguments are about trying to stress your own causes, and devalue the causes your opponents are trying to stress.
posted by TheophileEscargot at 6:14 AM on February 5, 2009 [10 favorites]


So is this the thread where the smart economic types can explain to me how the Senate's $15,000 home buyer tax credit could potentially affect me, a first time home buyer whose purchase offer was agreed to on the same day? Because if so, keen.
posted by robocop is bleeding at 6:20 AM on February 5, 2009


can explain to me how the Senate's $15,000 home buyer tax credit could potentially affect me

Well, it could give you 15,000 off your taxes in the next year you file, if you opt for the credit. But there's a catch: It's called a credit, but it's actually an interest-free loan, which you have to pay back in extra assessed taxes each year over the next fifteen years (so an extra $1,000 a year tax liability, basically).

I think I like this so-called stimulus provision almost least of all. It just seems misleading and not especially helpful.
posted by saulgoodman at 7:23 AM on February 5, 2009


I'm not a smart economic type, btw, but I've been paying attention to the tax credit thing.
posted by saulgoodman at 7:25 AM on February 5, 2009


Wait - it has to be paid back? I thought the House version of the bill removed that.
posted by robocop is bleeding at 7:50 AM on February 5, 2009


See here.

What's I'm worried about is the timing. The plan only affects those who buy after it's enacted, but at the same time, it meddles with the previous 7,500 interest-free-loan, 'sunsetting' it or whatever that means.

My closing is set for the 13th of March and I'm concerned that we'll be cutting it close.
posted by robocop is bleeding at 7:56 AM on February 5, 2009


TheophileEscargot forgets a few things in a reasonably cogent argument.

E. Financial ratings agency conspired with securities issuers to artificially rate as AAA certain instruments whose ratings should have been much lower due to faulty assumptions about the risk of significant disconnects in the housing and interest rate markets. Just because something hasn't happened in the last 20 or so years, doesn't mean it won't happen.

F. The financial media has a significant stake in sensationalizing events, no vested interest in fact-checking, and a lot of time to fill with various pundits and must package this pap so that a mass market that has very low actual financial literacy can be deluded into thinking it understands it. Of course, our politicians are completely swayed by the resulting popular opinion.

G. Current banking regulations assume that the only value that exists is that which an assumed liquid market offers, when that market lack liquidity, due to rampant fear caused by all of the above, assets which produce positive cash flows might not be accurately valued. These are known as the mark-to-market regs which you probably have heard of. This has had a huge effect in the current crisis.

There are a few more but I have to go...
posted by sfts2 at 8:03 AM on February 5, 2009


My lay understanding:

Leverage ratio, I think, is fractional-reserve lending, say 10:1 (the ratio is set by the gov't [I think]). Targeting that ratio is maximum leverage -- every time the reserve increases there better be loans totaling 10x that number.

If I'm a bank and someone deposits $1, I can lend you $10 (say at 10% interest). My capital reserve is $1, and I cannot loan out any more money unless and until my reserves increase -- I'm at max leverage. Increases come from profit: interest from loan repayments, fees, etc. To keep it simple, lets say it comes only from repayment. After you pay off that $10 loan, my reserve is now $2 ($1 original + $1 interest from the loan); I can lend out $20 now.

I'm again at my max leverage on my $2 reserve: two loans totaling $20 at 10% interest. I'm expecting $22 at some point in the future, expecting my reserves to double to $4. My liability is $20, my asset is the expected $2 from interest. But someone defaults on their loan. That's $11 lost (one of the loans, and the expected interest). Assuming full repayment on the other loan, my reserves go up to $3.

Again I go to my targeted max leverage. I have a $3 reserve, so at most I can lend out $30. But I lost $10 on that defaulted loan, so I can really lend only $20. Repeat continually.

I soon discover that I can make money on those liabilities by selling them to someone else: a new product is born, the value of which is based on the original loans I made, thus a derivative. How that value is determined comes from some physics or maths PhD. The "valuation" then helps determine what I should charge for these new products. That price, when someone pays to buy these derivatives, becomes an asset for me, it can go to my reserves, and suddenly I can lend out huge amounts more than before. And since I can sell those loans as another product, I want to lend out as much as possible.

Larger and larger portions of the reserves are vaporous, based on nothing more than what I expect to be paid back on those original loans. Now more and more people default on these loans -- I'm not getting that money back plus the expected interest. But I still have to pay the people that bought those derivatives plus the promised return. And I can't, because I don't have the cash. So to meet those obligations, I have to take loans from other banks or from the Fed ("easy money policy" makes this cheap, so banks might consider these sources as being practically part of their reserves)

Now I'm in triage mode: I need capital to meet these obligations, which means I shouldn't really be lending out any more money, and if I do, I want to get more back for it, so I charge higher interest rates. Businesses take out the largest loans but suddenly can't get them. Now they have to go into triage mode to ensure they can meet their own obligations. So they start cutting costs (jobs). People without jobs (supposedly) won't spending money. Since people aren't buying things, inventories go up. Stores won't buy more stuff from manufacturers, so production decreases. Those companies now have to cut costs. Further job losses, even more people not spending money. The manufacturers aren't making new things, they really don't have any need on "new" advertising, so they recycle old ads that they already paid for, and the advertising companies lose business. They have to cut costs. Further job losses.
posted by jma at 8:16 AM on February 5, 2009


ah robocop--didn't know about the amendment to waive the requirement to pay it back. still, i'd watch carefully to see if that amendment makes it into the final reconciled version of the bill worked out in conference. it's very likely it could be stripped out.
posted by saulgoodman at 8:16 AM on February 5, 2009


No matter what we do to "fix" this economic mess the fact remains that wages/earnings have remained flat since the 1980's. Until wages begin to rise for the average worker there will be no sustained recovery
posted by robbyrobs at 9:38 AM on February 5, 2009 [1 favorite]


OLD JOKE: An economic forecaster is like a cross-eyed javelin thrower: they don't win many accuracy contests, but they keep the crowd's attention.
posted by Bitter soylent at 11:21 AM on February 5, 2009


"I think the basics of the crisis are pretty simple. For the last decade or so, there was too much money and credit sloshing around the economy. To try to lend out this all this extra money at a profit, the lenders got sloppy about who they lent it to. With all this money in the hands of borrowers, the price of houses got pushed up unrealistically high."

Don't forget that this debt was securitized in ways that were so complicated that nobody could realistically infer a valuation, with hedges that were equally complicated and opaque. Most of this toxic debt is now worthless, but it hasn't worked its way completely though the system, as some investors still hold portions of it. Without this investment backing, it would be difficult to find origination for these highly risky loans.
posted by krinklyfig at 11:30 AM on February 5, 2009


Leverage ratio, I think, is fractional-reserve lending, say 10:1 (the ratio is set by the gov't [I think]). Targeting that ratio is maximum leverage -- every time the reserve increases there better be loans totaling 10x that number.

That there is reserve ratio.
Generally when people talk about leverage ratios they aren't talking about deposit banks, which is what you go into. They're talking about investment banks.
Leverage ratio doesn't really have anything to do with "deposit $1, lend out $10." That's deposit (retail) banks.

Investment bank leverage is the amount of assets to the amount of debt. If I put $1 in a Goldman Sachs investment vehicle, they will invest my $1 (and everyone else's $1, and some of their own $1s). They can also borrow--just like you and I can, from a bank, to purchase things--from other banks, and invest that as well.

So Goldman Sachs may have $10 from investors like me and you, but they also have $300 that they've borrowed from other banks. In that case their "leverage ratio" is 30:1 (not unheard of).

This inflates profits pretty heavily. If they get a 10% profit in a year, they've turned that $310 ($10 invested + $300 borrowed) into $341. Then they pay back their $300 loan (let's assume 0% interest for simplicity), and have $41 left. Well they effectively earned 410% on the $10 from investors.

Only problem is it magnifies losses just as heavily. If they start with $310 and are levered 30x, they only have to lose $10 (3.2%) to be completely wiped out.

HTH
posted by jckll at 12:57 PM on February 5, 2009 [2 favorites]


thanks for that clear explanation, cklennon.
posted by saulgoodman at 1:06 PM on February 5, 2009


retail banks are leveraged with the banks shareholder equity against depositors and other creditors.
If I'm a bank and someone deposits $1, I can lend you $10 (say at 10% interest).
and if the banks really were able to do this they would be much more profitable :) i think what you were looking for is the hard money supply is expanded by $1 and the banks are able to increase loans by $10.
posted by drscroogemcduck at 10:07 AM on February 7, 2009


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