Understanding the 2008 Financial Crisis

Nicoli Nattrass Centre for Social Science Research

University of Cape Town

January 2015

5. The aftermath and policy

Quantitative Easing • First round in the USA in 2009/2010 (followed by two

further phases). Central banks buys bonds (i.e. debt), the idea being to lower interest rates and encourage investment and growth. About $6.8 trillion was injected this way over 5 years. It ended late last year.

• But these real effects were limited and some industry insiders now claim it was ‘the greatest backdoor Wall Street bailout of all time’ because instead of lending the money to businesses, the banks invested it in stock and bond markets (http://www.ibtimes.com/was-qe-effective-europe-awaits-qe-questions-remain-about-its-success-us-1793564)

• This week the EU Central Bank announced QE of $69 billion per month…..

The Stimulus…. • TARP, $700 billion

• Obama stimulus $832 billion in the US over 2 years (Krugman, Stiglitz and other economists were calling for more). ‘It improved 42,000 miles of road, fixed or replaced 2,700 bridges, and bought more than 12,000 transit vehicles. It cleaned up water supplies, created the school reforms of the Race to the Top program, and greatly expanded the use of renewable energy and broadband Internet service.’ http://www.nytimes.com/2014/02/23/opinion/sunday/what-the-stimulus-accomplished.html?_r=0

• 2010 tax cuts worth $558 billion.

$51,719

But median household income is still 8% lower in 2014 than before the crisis: http://research.stlouisfed.org/fred2/series/MEHOINUSA672N

Keynesian analysis of the impact of policy post the crisis

1) Profits mostly go to investment, savings and financial speculation

2) Wages fuel consumption (demand) and hence are vital for economic growth

3) This implies that rising inequality is bad for growth…..

Investment

QE

Stimulus ProfitsWages

Consumption spending

Financial markets….. Lower interest rates

Short-term portfolio investment in emerging markets

Some economists supported the various stimulus packages (for standard Keynesian reasons) but some also worry about rising government debt.

NB: Rising government debt has not yet pushed up interest rates.

The 90% debt threshold?

http://delong.typepad.com/sdj/2013/05/accurate-and-inaccurate-ways-of-portraying-the-debt-and-growth-association.html

See also http://krugman.blogs.nytimes.com/2013/05/26/reinhart-and-rogoff-are-not-happy/?_r=0#

BASEL III

• Both the UK and US have accepted Basel III measures to raise minimal capital standards and lower overall leverage

• Basel III requires that capital must increase to 10% of risk weighted assets by 2019 (and that 75% be high-quality Tier 1 capital). Another 2.5% ‘capital conservation buffer’ and another 2.5% kicks in during periods of ‘excessive aggregate capital growth’

• 2012 the UK pushed capital requirements to 17% for ‘systemically important institutions’ and ‘ring fenced’ normal high street banking from riskier investment banking. But ring fencing can be gamed….

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010)

• Complex, over 800 pages, has already resulted in years of wrangling over the details…

• Requires enhanced prudential requirements for larger banks and financial entities of assets of more than $50 billion.

• Section 165 requires a tighter leverage ratio than Basel III, specifying debt to equity ratio of no more than 15: 1.

• Tackles the ‘too big to fail’ problem by insisting on ‘living wills’ for systemically important financial institutions, ruling out bailouts and requiring bail-ins for shareholders and creditors

Volcker Rule (section 619 of the

Dodd-Frank Act)

• It disallows short-term proprietary trading of securities, derivatives, commodity futures and options on these instruments for banks’ own accounts under the premise that these activities do not benefit banks’ customers. In other words, banks cannot use their own funds to make these types of investments to increase their profits.

• Went into effect April 2014, banks’ full compliance required by 21 July 2015 …….. BUT

“Last month, Congress repealed an anti-speculation provision of Dodd-Frank that would have prevented federally insured banks from conducting several types of swap transactions. In addition, the Federal Reserve recently gave the banks two extra years to meet a Dodd-Frank provision requiring them to sell their investments in private equity funds and hedge funds. The next crisis will differ from the last crisis in its origins and effects. But it is probably safe to assume that sooner or later, poorly regulated credit derivatives will again play a role in damaging the economy” New York Times, 2 January 2015 http://www.nytimes.com/2015/01/03/opinion/betting-on-default.html

See also Bankers and lobbyists gut Dodd-Frank Act in December 2014 as part of a spending bill: http://thinkprogress.org/economy/2014/12/12/3603194/dodd-frank-cromulent-phil-gramm

Research from 2012 showed that the global derivatives market had been estimated at 20 times the size of the global GDP. It is not clear if this is, or if it will become, a problem…. http://www.globalresearch.ca/financial-implosion-global-derivatives-market-at-1-200-trillion-dollars-20-times-the-world-economy/30944

The Bonus issue…..

• The EU caps the bonuses of bankers at twice their annual salary. (The UK tried to resist this but dropped the case after a preliminary ruling against them). It is resulting in rising salaries, though…..

• Some banks are paying ‘role based allowances’ (disguised bonuses) but the EU regulators are on to them.

• William Dudley (New York brank of the Fed) is proposing ‘performance bonds’ where bonuses are parked for 10 years and take a hit if performance is bad. He is supported by Mark Carney (Governor of the Bank of England)

US Financial Institutions Banks remain powerful, and increasingly concentrated…..

The Big 6 US banks:

“own 85 percent of deposits of all the commercial banks, 84 percent of assets of all the commercial banks, and control 96 percent of all of the derivatives that financial institutions that are backed by the government utilize today, and 45 percent of the world’s derivatives” Nomi Prins

$2.4 trillion in assets (absorbed Bear Stearns and Washington Mutual)

$2.2 trillion in assets (absorbed Merrill Lynch)

$1.9 trillion in assets

$1.4 trillion in assets (absorbed Wachovia)

$356 billion in assets $355 billion in assets

Power and accountability?

• The ongoing power of Wall Street: The Inside Job: 1.33.35 – 1.41.04

• Countrywide’s Mozilo got off with $22.5 million in penalties and no acknowledgement of wrong-doing.

• AIG FP’s Joseph Cassano was never prosecuted. • Fines (e.g. JP Morgan Chase paid $9 billion to avoid

prosecution over securities fraud; Bank of America and Citgroup also settled (cash for secrecy – see http://www.rollingstone.com/politics/news/the-9-billion-witness-20141106

• Nomi Prins (All the Presidents’ Bankers, 2014): http://www.democracynow.org/2014/4/8/all_the_presidents_bankers_nomi_prins (from 25 minutes to 34.30 minutes – says that the power of Goldman started in the FDR era)

Why have no bankers gone to jail?

• The financial crisis was facilitated by fraud at all levels: in the loan origination process, Lanny Breuer, former head of the US Dept of Justice’s criminal division, returned to his law firm, Covington and Burling which routinely defends the clients he was supposed to be prosecuting.

• Eric Holder, the US attorney general opted not to go after the banks and will be returning to his private practice (Covington and Burling)

• http://www.theguardian.com/money/us-money-blog/2014/sep/25/eric-holder-resign-mortgage-abuses-americans

Provisions in the 2002 Sarbanes-Oxley Act could hold CEOs

criminally responsible for misrepresenting their risk

management controls to regulators.

The 2009 Fraud Enforcement and Recovery Act gave $165

million to the Justice Department to staff the investigations

necessary to bring those accountable for the financial crisis

to justice.

Yet not one high-profile participant in the crisis has gone to

jail. (After the Savings and Loan scandal there were 1,100

prosecutions and more than 800 bank officials went to jail)

Criminal intent difficult to prove but failure to manage and

disclose risk could have been investigated more….

There was fraud at every level of the mortgage process:

origination fraud (faulty appraisals and undisclosed trickery);

servicing fraud (illegal fees and unnecessary foreclosures);

securities fraud (failing to inform investors of the poor

underwriting on loans they packaged into securities); mass

document fraud in creating mortgage-backed securities.

“By the time the bubble collapsed, the recession hit and Eric

Holder took over the Justice Department, Wall Street was a

target-rich environment for any federal prosecutor. Physical

evidence to an untold number of crimes was available in

court filings and county recording offices…. Any prosecutor

worth his salt could have gone up the chain of command and implicated top banking executives.” (The Guardian, 25 Sept 2014. http://www.theguardian.com/money/us-

money-blog/2014/sep/25/eric-holder-resign-mortgage-abuses-americans

What can be done?

• Rely on the political process to reign in Wall Street? (Occupy Wall Street has had some effect shaping values)

• Rely on the economy, regulations and more active shareholders to restrain financial managers. (NB: profits are down in the financial sector and Wall Street is cutting 50,000 jobs and slashing bonuses in 2015….)

• Address inequality and assist the bottom 20%? • Increase taxes. Estate taxes? Wealth taxes

(‘mansion taxes’)? Income taxes? • Tax on financial transactions and currency

transactions (Tobin tax)? • Stronger role for government (higher taxation,

greater spending on investment, redistribution….)? • Protect the poor from predatory lending?