Crashed
Page 6
As an economist steeped in the disastrous history of the 1920s and 1930s gold-exchange standard, Bernanke knew all too well the perils of a lopsided fixed exchange rate system. He was profoundly critical of China’s currency policy.48 But relations among central bankers are polite. It was not for the Fed to lecture the Chinese on currency policy. The same rules did not apply to the US Treasury or to Congress. In the early 2000s dozens of bills began to move through Congress accusing China of being a currency manipulator in violation of WTO norms and demanding sanctions. It was those initiatives that raised fears in circles like the Hamilton Project about “populist protectionism.” In July 2005, to relieve pressure on the US economy, China began to allow a slow currency appreciation. In due course this would bring about a 23 percent revaluation. But it was painfully slow.
To speed things up, some in Washington favored activating the IMF. Why was the global monetary watchdog not calling on China to address its lopsided balance of payments? In September 2005, Treasury undersecretary Tim Adams remarked in a widely reported speech that the IMF appeared to be “asleep at the wheel.”49 But to promote the IMF as an arbiter had serious implications. China could not be expected to take advice from the IMF until it had representation on the IMF’s board that was commensurate with its size. Furthermore, Beijing would expect IMF monitoring to apply to the United States as well. That wasn’t likely to appeal to a Republican White House.50 Barring market-driven adjustment or international supervision, the balance of “financial terror” was managed by means of summit diplomacy in the manner of the cold war. And it was no coincidence that as his last Treasury secretary President Bush chose Hank Paulson. Paulson, like Rubin, moved to the Treasury from the CEO job at Goldman Sachs. But apart from his investment banking credentials, what recommended Paulson for the job was his reputation as an old China hand. He liked to boast that since the Tiananmen Square massacre, he had visited China seventy times.51 He had no particular fondness for multilateral institutions like the IMF. Instead he preferred bilateral dialogue—what some had taken to calling the “G2” format.52 One of Paulson’s first moves was to initiate a US-China Strategic Economic Dialogue and to take personal charge of the US side.53
IV
In the fall of 2007, even as quite a different crisis loomed on the horizon, it was the dollar that was still at the center of attention. The Economist warned of a “Dollar Panic.”54 Germany’s Spiegel magazine announced a “Pearl Harbor without a war.” Bill Gross, the kingpin at bond trading giant PIMCO, was reported to be selling dollar assets, as was billionaire investor Warren Buffett. In November 2007 Bloomberg reported that the world’s highest-paid supermodel, the Brazilian Gisele Bündchen, had demanded that Procter & Gamble pay her in euros for endorsing their Pantene brand. With a net worth of more than $300 million, Bündchen could not afford to ignore sentiment in the currency markets. Meanwhile, hip-hop star Jay Z took to thumbing wads of euros on MTV.
If the euro was the new bling, was the dollar really about to go out of style? In the summer of 2007, the year before he was awarded the Nobel Prize, Paul Krugman sketched the logic of what he described as a “Wile E. Coyote moment,” in which foreign investors would suddenly realize that there was nothing holding the dollar up other than their own purchasing of it.55 Like the cartoon character suspended in midair by the propeller motion of his own legs, the dollar was hanging above a precipice. It was comforting, Krugman reassured his readers, that most of America’s debts were in its own currency, so the impact of the dollar collapse would be cushioned. It wouldn’t be Argentina. But if the Fed was forced suddenly to hike interest rates, the United States would face a severe contraction. “This,” Krugman concluded, “won’t be fun.”
The best and brightest in American economic policy were not wrong to worry about the Sino-American imbalance. If it had blown up, it would have been a disaster. Ten years on, the scenario still hangs over the world economy. The threat of crisis was contained in 2008 because there were deep interests engaged on both sides and because it was handled as a matter of top priority by both Washington and Beijing. From the outset, Sino-American financial relations were explicitly politicized and were understood as a matter of great power diplomacy. No one was under any illusion that it was simply a market relationship, a matter of business as usual. When Paulson was worried about a Chinese dollar sell-off, he knew whom in Beijing to call. Larry Summers’s cold war analogy proved more apt than he realized. The balance of financial terror held.56 But in the meantime, what became increasingly clear was that the US policy-making elite had been focused, as Bradford DeLong would put it, on the “wrong crisis.”57 The crisis that will forever be associated with 2008 was not an American sovereign debt crisis driven by a Chinese sell-off but a crisis fully native to Western capitalism—a meltdown on Wall Street driven by toxic securitized subprime mortgages that threatened to take Europe down with it.
Chapter 2
SUBPRIME
When the economists linked to the Hamilton Project envisioned disaster, they worried about excessive public debt, underperforming schools and a Chinese sell-off. What they did not put in question was the basic functioning of America’s economy, its banks and financial markets. America’s problems were its people, its society, its politics, not its economy as such. And yet by 2006, if one looked in the right place, it was evident that something was seriously amiss. Since the early 2000s the American economy had been buoyed not only by huge fiscal deficits but by a sustained surge in house prices. Now, in some of the most challenged neighborhoods in the country, tens of thousands of families who had recently taken out home loans were failing to make payments. In marginal ethnic minority communities in cities like Cincinnati and Cleveland, but also in ribbon developments in the sunshine states, mortgages were failing en masse. America’s housing market bull run was about to come to a juddering halt. And as it did so, it would precipitate a global crisis.
For tens of millions of Americans this crisis hit them where it hurt most, at home. But compared with the grand sweep of global economic imbalances and the Sino-American relationship, the mechanics of American mortgage finance cannot but appear a parochial concern. How could this domestic drama shake the world’s financial system and precipitate a global crisis? The simple answer is that real estate may be mundane, and McMansions may be nondescript, but they account for a huge share of total marketable wealth worldwide. By one estimate, the share of American real estate in global wealth is as much as 20 percent.1 American homes account for 9 percent of the total. At the time of the crisis 70 percent of American households owned their own home—more than 80 million in total. Those same households were the greatest source of demand for the world economy. In 2007 American consumers bought c. 16 percent of global output, and nothing made them feel better than surging real estate prices. As America’s home prices almost doubled in the ten years leading to 2006, this raised household wealth by $6.5 trillion, delivering a giant boost not just to the United States but to the world economy.2 As US consumer spending surged toward $10 trillion, it added $937 billion to global demand between 2000 and 2007.3
Fluctuations on such huge scales can clearly help account for a business-cycle downturn in 2007. But to explain how this could trigger a financial crisis, with bank failures spreading panic and a credit crunch across the world, there is one crucial thing to add: Real estate is not only the largest single form of wealth, it is also the most important form of collateral for borrowing.4 It is mortgage debt that both amplifies the broader economic cycle and links the house price cycle to the financial crisis.5 Between the 1990s and the outbreak of the crisis in 2007, American housing finance was turned into a dynamic and destabilizing force by a fourfold transformation—the securitization of mortgages, their incorporation into expansive and high-risk strategies of banking growth, the mobilization of new funding sources and internationalization. All four of these changes can be traced back to the transformation in world economic affairs between the la
te 1970s and the early 1980s in the wake of the collapse of Bretton Woods.
I
On October 6, 1979, after an unscheduled meeting of the Federal Reserve’s key interest-rate-setting committee, the Federal Open Market Committee (FOMC), Paul Volcker, the Fed chair, announced that the Fed would henceforth attempt to tightly regulate bank reserves and that interest rates could be expected to rise.6 It was the Fed’s response to a wave of inflation that was threatening domestic instability, America’s global standing and the status of the dollar. Since Nixon had unhooked the dollar from gold, the world’s currencies had floated against one another without a metallic anchor. Only political discipline prevented limitless printing of currency. Contrary to some fears, there was no runaway inflation. But with prices accelerating toward annual increases of 14 percent in 1979, Volcker and the Fed decided that it was time to apply the brakes. It was the moment the power of the modern Fed was born. The interest rate was its weapon. As Germany’s outspoken chancellor Helmut Schmidt put it, Volcker pushed real interest rates (interest rates adjusted for inflation) to levels not seen “since the birth of Christ.”7 He did not exaggerate. In June 1981 the prime lending rate touched 21 percent.
The result was to send a shuddering shock through both the American and the global economies. The dollar surged, as did unemployment. Inflation collapsed from 14.8 percent in March 1980 to 3 percent by 1983. In Britain this was the crisis with which the Thatcher government began. In Germany it would contribute to Schmidt’s unseating and his replacement by the conservative government of Helmut Kohl.8 France’s Socialist government under President François Mitterrand would be forced into line in 1983. Volcker’s shock set the stage for what Ben Bernanke would later dub the great moderation.9 It was an end not just to inflation but to a large part of the manufacturing base in the Western economies, and with it the bargaining power of the trade unions. No longer would they be able to drive up wages in line with prices. And there was another part of America’s postwar political economy that did not survive the disinflationary shock of the 1980s: the peculiar system of housing finance that had emerged from the New Deal era.
Since the 1930s, America’s housing finance had been based on commercial banks and local savings banks, so-called savings and loans, making long-term fixed interest loans. By the late 1960s thirty-year fixed interest loans had become normal, with as little as 5 percent in down payment.10 The funding was provided by depository institutions, which offered government-insured savings accounts with capped interest rates. This was the basis on which home ownership had expanded to almost 66 percent of households by the 1970s. For home owners on fixed interest, long-term mortgages, the inflation of the post–Bretton Woods era was a windfall. The real value of their loans was eaten up while their interest rates remained fixed. For the banks that lent to them it was a disaster. In an era of inflation and fluctuating interest rates, at the capped interest rates inherited from the 1950s they could not retain their depositors, let alone attract new ones. To borrow from money markets or issue bonds, they now faced the withering interest rates set by the Fed. Meanwhile, their portfolios of fixed interest mortgages were devalued as rates on new loans soared.11 By the early 1980s the vast majority of the almost four thousand savings-and-loan banks still in operation were insolvent. Given the cost of cleaning them up and the prevailing free market ideology of the Reagan era, the path of least resistance was to deregulate and lower capital standards in the hope that they could grow themselves out of trouble. The commercial banks survived this trial by fire; the savings and loans did not. More than a thousand failed. Most of the rest were bailed out, bought up or amalgamated. The resolution costs to the taxpayer were around $124 billion in 1990s dollars.12
By the late 1980s the macroeconomic picture was stabilizing. Inflation was down and interest rates were falling. Whereas most bond investors did well in the new era, anyone who held mortgage loans had to reckon with another risk. American mortgage borrowers have the right to repay early and refinance at lower rates. This boosts the economy, as borrowers can reduce their mortgage payments and as borrowers they tend to have a higher propensity to consume than those they borrow from.13 But for the lender it means that the US mortgage contract is highly one-sided. During a period of rising rates their fixed-rate loans will devalue. During a loosening of monetary policy, when rates fall, the borrowers refinance. Lending for thirty-year terms at fixed rates is a viable business proposition only under the kinds of conditions of stability that prevailed under Bretton Woods between 1945 and 1971. In a new age of flexible monetary arrangements it was dangerously one-sided, especially if the risks were concentrated in small mortgage lenders with limited means of funding themselves. The solution was to go for scale, to adopt a new market-based model of financing and to place government institutions at the center of the system.
The basic anchor of America’s mortgage system in the aftermath of the savings-and-loans debacle was the so-called government-sponsored enterprise (GSE).14 The mother ship of the GSEs was Fannie Mae, founded in 1938 to create a secondary market for lenders who were willing to issue the new type of government-insured Federal Housing Authority mortgages promoted by the New Deal. Fannie Mae did not issue mortgages. It bought them mainly from commercial banks across the United States that specialized in issuing FHA-insured mortgages. By acting as a backstop, Fannie Mae lowered the cost of lending and set a national standard for both lenders and “prime” borrowers. It helped to unify America through mortgage debt. Fannie Mae was able to fund its purchases of these standardized mortgages cheaply because its credit rating was that of a government agency that could not fail. So-called agency debt was equivalent to that of the Treasury. By the same token, the obligations of Fannie Mae featured on the federal government’s balance sheet. To get them off at a time of fiscal stress during the Vietnam War, in 1968 Fannie Mae was privatized. The branch still devoted to making loans to public employees and veterans was split off as Ginnie Mae. “New Fannie Mae” was licensed to buy any mortgages, government guaranteed or not, that conformed to certain quality standards—so-called conforming loans. And in 1970 Congress legislated into existence a third agency, the Federal Home Loan Mortgage Corporation, or Freddie Mac, to level the playing field by buying up mortgage loans issued by savings and loans.
Despite this government guarantee, with their large portfolios of fixed interest loans, the GSEs were hit hard by the Volcker shock of the early 1980s. Fannie Mae came close to failure. But it survived, and as the housing market recovered in the 1990s, the GSEs flourished. Thanks to their residual tie to the federal government, the GSEs continued to enjoy a substantial discount in funding costs. By the end of the century Fannie Mae and Freddie Mac together were backstopping at least 50 percent of the total national mortgage market. Creating conforming loans—loans that qualified for GSE backstop—was the basis of the American home loan business. It is a deep irony that the era in which America is commonly thought of as leading the world in a market revolution saw its housing market become dependent on a government-sponsored mortgage machine descended from the New Deal. It was also the source of deep and irreducible politicization of the mortgage issue in the United States.
American housing policy and mortgage practice since the war had systematically favored home ownership for the white majority.15 In the 1990s promoting home ownership for lower-income and “underserved” minority communities became a congressional priority. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 called for lending goals to be set for the GSEs. In December 1995 the government issued targets for underserved areas and low-income housing. Many of the new home owners in the 1990s and 2000s were ethnic minority families who had been denied mortgages for decades under the regime of “redlining” institutionalized by New Deal housing policy. Viewed in this way the real estate boom was part of the rise of the diverse African American and Latino middle class on which the Democrats as a political party had a lot riding.16 On the bac
k of their influence over the Democratic Party, the GSEs built one of the most powerful lobbies in Washington, DC. Their political firepower was legendary. By the same token, the GSE mortgage regime always attracted the ire of the American Right. Deep down most free market advocates are convinced that the interferences of the GSEs were responsible for the disaster that was beginning to unfold in 2006. The GSEs had political mandates set by progressives to funnel money into underserved communities. They had a market-distorting funding advantage due to their attachment to the federal government. When you distort the market, crises are inevitable.17 It was this conservative critique of the GSEs that shaped the Republican reaction when the crisis reached fever pitch in 2008. For many in Congress the bailout was not just of the banks—they at least were private businesses trying to make a buck. The bailout was also a desperate effort to make the taxpayer pay for the rescue of a Democrat-controlled parastate housing welfare apparatus designed to serve pampered minorities.
This was powerful mobilizing rhetoric for the Republican base. But as an explanation of the crisis that was brewing in 2006, this political critique is wide of the mark. Fannie Mae and Freddie Mac set a high minimum standard for the quality of loans they would buy. The GSEs didn’t support the kind of low-quality, subprime loans that were beginning to fail in droves in 2005–2006. Those toxic loans were the products of a new system of mortgage finance driven by private lenders that came into full force in the early 2000s. Though the GSEs met their government lending quotas, private lenders driven by the search for profit were far more adventurous in lending to underserved communities.18 In this sense the GSEs did not create the crisis. But what they did contribute were two innovations without which the crisis is hard to imagine: the originate-to-distribute mortgage lending system and securitization.