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An unending economic hurricane has been ripping apart the U.S. and world economies since December 2007. In the seventeen months between then and April 2009, the number of unemployed Americans increased by seven million. By April 2009, almost 5.4 million of the nation's 45 million home loans, worth more than $717 billion, were delinquent or in foreclosure.
Although the pace of decline seemed to be slowing by the early summer of 2009, far worse is yet to come in 2010. The Treasury Department's stress test of the nineteen largest banks in early 2009 revealed that they could be forced to write off as much as a fresh $600 billion by the end of 2010, increasing their losses to more than $1 trillion. Most of those mortgage defaults will be by people now at work, who once were thought financially immune to such distress, but now are likely to lose their jobs and then their family homes.
The lender of last resort, the federal government, has tried to blunt this depression with unprecedented levels of money infusions into the U.S. economy. Despite federal commitments of almost $9 trillion for direct investments, $1.7 trillion for guarantees, and $1.4 trillion for loans, plus a cut of the Federal Reserve loan rate to banks of almost zero, the prolonged freeze in credit markets cracked only slightly by the spring of 2009.
In the last quarter of 2008 and the first of 2009, auto production fell by half and global trade declined at the fastest pace since the Great Depression. The governments of Europe, Japan, and China are engaged in massive bailouts of their economies. Yet the bottom of this depression is not visible, let alone a domestic or global upturn.
America's money industry is directly to blame for much of the world's economic meltdown. It gambled with other people's money and lost, used faulty risk-assessment tools, and knowingly sold fraudulent assets, including hundreds of billions of dollars of subprime mortgages, for vast profits. The administrations of Bill Clinton and George W. Bush enabled Wall Street's recklessness by scrapping the regulatory safeguards Franklin Roosevelt had erected in the 1930s. Equally significant, the U.S. Federal Reserve System, Securities and Exchange Commission, and Treasury Department failed to exercise their oversight authority adequately.
The salvage program put into place by both the Bush and Obama administrations is designed to restore the U.S. financial system to the way it was before the crash of 2008, with the same oligarchs in control but with a bit more regulation. If that is all that is accomplished, we will have learned nothing and can be sure that we will have a repeat of the behavior that brought us to this crisis.
We must think bigger about what America wants from the money industry and act accordingly. A strong capitalist system requires an equally strong financial sector, whose integrity is safeguarded by strict federal supervision of all money institutions, bans on Wall Street speculation with other people's money, and an adequate and sound currency, thereby ensuring a steady flow of capital and credit to American businesses of all sizes.
We need a money industry that uses the great reservoirs of other people's money that it holds to serve the real economy, as it did successfully for several decades in the post-World War II era, as opposed to the recent exploitation of privileged access for compensation-based looting, speculation, and selfish schemes. American capitalism needs a long era of dull but prudent banking, overseen by suspicious federal regulators.
The free-market absolutism of the past thirty years, most notably the last ten, created such an antigovernment, antiregulatory bias, coupled with the fantasy that the market always knows best and always regulates itself, that the very will to regulate disappeared at the top levels of American government, academia, and business. For sure, other factors affected this crisis, as subsequent chapters will reveal, but it all came together as a perfect storm in the money industry.
Here are the essentials of what happened and recommendations for rebuilding America's financial system.
The Money Industry
The economic origins of the present crash are the oil shocks of the 1970s, when many major oil-producing countries created their production cartel, the Organization of the Petroleum Exporting Countries (OPEC), and radically increased the price of crude oil. The OPEC nations deposited much of their money for safekeeping in major U.S. banks such as Chase Manhattan, Citibank, Chemical Bank, and Bank of America. These banks recycled hundreds of billions of petrodollar deposits as loans for developing countries, eagerly and often imprudently offering high-interest financing to countries such as Argentina, Brazil, Mexico, Nigeria, Ivory Coast, and the Philippines- nations whose leaders repeatedly stole part of the proceeds, wasted part, and used a little for the intended development.
Forgetting how nations defaulted on loans during economic crises in the 1800s and during the Great Depression, Walter Wriston, chairman of Citibank, then considered America's leading banker, proclaimed in the late 1970s that lending to governments was safe because sovereign nations do not default.
Wriston's maxim was totally wrong. In 1982, when Argentina, Brazil, and Mexico defaulted on more than $300 billion of debt, much of it owed to Citibank, the Federal Reserve and Treasury had to scramble to prevent major U.S. financial institutions, including Citibank, from collapsing. By the end of the 1980s, developing nations had defaulted on more than $1.3 trillion of debt, most of which was owed to U.S. banks. A Washington Post Book Company study revealed that more than one thousand U.S. banks were technically bankrupt by 1992.
Despite the rhetoric of market absolutism embraced by every U.S. president from 1981 to 2008, Washington had to bail out the financial services industry eight times, even as it cancelled many of the financial regulations that governed the industry.
1. In 1982, the Federal Reserve and the Treasury bailed out U.S. banks holding Mexican, Argentine, and Brazilian debt.
2. In 1984, Continental Illinois received a $4 billion rescue package.
3. In the late 1980s, the Federal Reserve paid out large loans to save 350 banks that later failed.
4. Between 1989 and 1992, Congress provided $250 billion to support hundreds of insolvent savings and loan institutions.
5. From 1990 to 1992, federal banking authorities provided $4 billion to save the Bank of New England and arranged for Citibank to get capital from Saudi Arabia.
6. In 1994, Congress provided Mexico a $50 billion loan to bail out Goldman Sachs and other U.S. financial institutions that had bought high-yield Mexican debt.
7. In 1997, the Treasury pushed the International Monetary Fund
(IMF) to rescue East Asian currencies in order to save American lenders.
8. In 1998, the Federal Reserve saved Long-Term Capital Management, a massive hedge fund whose investors included leaders from U.S. finance.
Misfeasance, malfeasance, and malversation (corruption of officials) distinguished the finances of this era.
Despite these repeated bailouts and Wall Street's widespread abuse of its clients, federal regulators were extraordinarily tolerant. When a financial institution failed to obey or fulfill a law, regulation, contract, or agreement, punishment was mostly limited to a warning or a fine, sometimes in the hundreds of millions of dollars, followed by a corporate announcement that the company neither admitted nor denied any guilt. Such federal wink-and-nod acceptance facilitated the rise of a gambling culture in the great financial houses where solvency and soundness once reigned.
A Favored Industry
As this lenience suggests, the "money" industry was, and remains, favored in Washington. Although never naming it as such, the federal government in the latter part of the twentieth century put into place, step by step, a long-term national industrial policy that privileged the financial industry over all others, particularly manufacturing. The benefits to finance were enormous, and the consequences to manufacturing were devastating.
By the 1980s, finance dominated the American economy, and what finance wanted was quick cash. Beginning with the merger mania of that decade and continuing through the buyouts, privatization, and outsourcing of subsequent years, our leaders sacrificed the real economy for the financial one. Where our best and brightest graduates had once sought their fortunes in the corporations that created wealth by producing goods and services, these talented young people were soon seeking jobs in financial firms where they sought quick fortunes manipulating paper wealth.
Consequently, the number of jobs in the financial sector (the winner) grew and those in manufacturing (the loser) declined. The math is clear. Between 1981 and 2009, manufacturing employment fell from 18.7 million jobs to barely 12 million, a 40 percent loss, while finance grew from 5.1 million jobs to 8.1 million, a 60 percent increase. America lost almost three jobs for every one it gained in that exchange.
In the process, the Wall Street-driven outsourcing of industrial and service jobs over the past three decades has devastated America's middle class. First, families tried to cope by having both adults work outside the home. When joint incomes were insufficient to maintain family lifestyles and pay bills, families went into debt to credit card companies at usurious rates. During this time, banking institutions financed hundreds of thousands of mortgages, often to unqualified borrowers. Then millions of families borrowed against the equity in their homes to pay off other debts, putting themselves on the financial edge. Millions of those mortgages were "subprime" because the money industry made them to people without the means to service the debt, which the lenders knew.
As many in the American middle class increasingly found themselves in a financial bind, elected federal leaders actually worsened the situation in 2005 by enacting changes in laws that prevented borrowers from discharging credit card and other debt they owed through bankruptcy. Consequently, starting over became impossible for millions of Americans who became legal "debt slaves" to the money industry. When some in Congress tried in 2009 to reverse these bankruptcy laws on credit cards, plus allow bankruptcy judges to alter mortgage terms, they were defeated. But when the money industry crashed because of its greed and incompetence, the same elected officials rushed to bail it out with unseemly, and ultimately costly, haste.
The money industry's demonstrated capacity to obtain trillions of dollars in bailout grants and loans from Washington reflects its extraordinary political power. Indeed, no other special interest has similar influence with the White House, Congress, and both political parties. The fountainhead of that influence is their massive political contributions and lobbying expenditures. Senator Dick Durbin, assistant Senate majority leader, described the dynamics bluntly in an April 2009 radio interview: "And the banks-hard to believe in a time when we're facing a banking crisis that many of the banks created-are still the most powerful lobby on Capitol Hill. And they frankly own the place."
In March 2009, two watchdog groups, Essential Information and the Consumer Education Foundation, released Sold Out, a report that documents $1.7 billion in campaign contributions made by the finance industry from 1998 to 2008, plus another $3.4 billion spent on lobbying. Year by year, company by company, politician by politician, the report identifies who gave what to whom. It also identifies former congressional staff members, ex-members of the House and Senate, and former White House and other executive branch officials whom the finance industry hired as lobbyists and what they did.
Such lobbying is Washington's growth industry, producing about $10 billion in business annually. It is changing the very concept of public service. Over the past decade, for instance, more than thirty- three thousand people registered as lobbyists with the Senate Office of Public Records, including half of all senators and representatives who left office. Washington's revolving door is simply out of control.
The Money Industry's People
Money buys access and position in Washington. Thus, our political leaders regularly appoint money people to senior positions in both Republican and Democratic administrations.
For instance, President Clinton's principal economic advisor and later treasury secretary was Robert Rubin, former cochairman of Goldman Sachs and subsequent director and senior advisor at Citigroup. Rubin mentored Lawrence Summers, who succeeded him as treasury secretary in 1999, and Timothy F. Geithner, who worked for both Rubin and Summers.
While advising candidate Obama in the 2008 elections, Summers also worked as a part-time managing director at the $30 billion hedge fund D. E. Shaw, which paid him $5.2 million for one-day-a-week's work over a two-year period. He also received $2.7 million for forty speeches, primarily to large Wall Street companies including Citigroup, JPMorgan Chase, and Goldman Sachs, later beneficiaries of the federal bailouts that he now oversees.
Geithner became chairman of the Federal Reserve Bank of New York in November 2003, was responsible for overseeing the New York banks, and was intimately involved in the federal bailouts of Wall Street financial institutions when they failed. President Obama appointed him treasury secretary in 2009, and the U.S. Senate confirmed him for the position. His chief of staff is Mark Patterson, who left his job as a top lobbyist for Goldman Sachs in April 2009. Michael Paese, who had been the top staffer at the House Financial Services Committee, which helped structure the bailout of Wall Street in 2008, filled the resulting vacuum at Goldman's Washington office.
After leaving office in 2001, Bill Clinton advised several Wall Street investment funds, while his vice president, Al Gore, is cofounder of Generation Investment Management with David Blood, an investment banker formerly of Goldman Sachs. Lombard Odier Darier Hentsch & Cie, a Swiss bank, is the largest investor in the fund, whose assets include stock in companies such a Novo Nordisk A/S, the world's largest insulin maker, and Johnson Controls, which makes auto seats and batteries.
The giant hedge fund Paulson & Co. in 2008 hired Alan Greenspan, former chairman of the Federal Reserve (1987-2006). This fund made a reported $15 billion profit in 2007 by shorting stocks of those holding subprime mortgages.
The Bush family has long been connected with Wall Street; Prescott Bush, father of George H. W. Bush and grandfather of George W. Bush, headed the investment firm Brown Brothers Harriman in the 1930s and 1940s. After George H. W. Bush left the presidency, he advised the Carlyle Group, a major investment fund, and Citigroup.
John W. Snow, who was George W. Bush's treasury secretary from February 2003 to June 2006, became chairman of Cerberus, a private investment firm that does billions of dollars of contract work for the federal government, owned Chrysler, and was the recipient of $4 billion in federal rescue funds in late 2008. Henry Paulson, the ex- chairman of Goldman Sachs, replaced Snow at the Treasury and led the bailout of the financial industry, including Goldman Sachs, which got a $10 billion investment by the Treasury at about the same time investor Warren Buffett bought into the firm for $5 billion. The deal Paulson negotiated with his old firm gave taxpayers less than half what Buffett got, but at twice the price.
• Buffett received 43.5 million options worth $1.8 billion for his $5 billion. Taxpayers got only 9.5 million options worth $500 million for their $10 billion investment.
• Buffett is being paid 10 percent interest on his preferred stock. Taxpayers get 5 percent for five years and then 9 percent for five years.
• Buffett has a 10 percent call premium. Taxpayers have no premium rights.
• Buffett got $5 billion of present value for this $5 billion investment. Taxpayers have $4.9 billion of present value for their $10 billion.
From the Trade Paperback edition.