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The current financial crisis: capitalism as usual

May 10, 2009

BY TROY COCHRANE

When the government and media discuss the recent economic crisis, we realize how effectively capitalism has alienated us from our own economic systems. We asked our friend Troy to describe some of the mechanisms of modern capitalism that allowed this crisis to come about, hoping that a clearer understanding will empower us all to understand and articulate the ways in which capitalism is clearly an unsustainable, predatory economic model.

Why did the number of foreclosures increase in the past three years? How did this increase decimate the US and global financial system? What happened to all the money that was ‘lost’? Why is the government handing so much money over to the Big Banks? What did all of these financial going-ons have to do with car manufacturers and other producers of physical goods? Who is to blame?

If you take out a mortgage to buy a house, the bank considers this loan an asset. It gives this asset a value based on 1) expected earnings and 2) expected risk. The expected earnings are the interest made from the loan. The expected risk is the probability of default. If the expected earnings increase or the expected risk decreases, then the value of the asset increases, and vice versa. This is exactly the same way the value of a corporation is assessed. Its market capitalization is based on expected earnings divided by the perceived risk. If the value of a company is decreasing, it is because the expectations for its future profits are decreasing, or there is an increased perceived threat to those profits.

A large portion of the value of the Big Banks is based on expectations concerning the mortgages they hold, as these provide much of their earnings. For a bank to increase its valuation it can a) increase its total lending, b) increase the interest rates it charges or c) decrease the perceived risk associated with default. The banks have done all three. Between 1997 and 2007 the ratio of mortgage debt to wages increased from 136.1% to 229%.

Although interest rates generally remained flat or slightly decreased the much maligned ‘subprime mortgage’ carries higher than usual interest rates and these mortgages have accounted for a disproportionate share of the growth in mortgage lending. In 2003, subprime mortgages were just over three percent of total mortgage debt. By 2008, that had risen to almost 10%.

The expansion of mortgage debt was partially driven by extending higher interest loans to people who had typically been excluded from home ownership, especially people of colour. These loans were considered riskier, which will be discussed in greater detail below. However, the banks managed to reduce the perception of risks through the creation of the infamous ‘derivatives’, which will also be discussed further on. The payoff for this expanded lending, particularly of subprime mortgage with higher interest rates and a reduced perception of risk has been a growth rate of 11.6% per year for the ‘Biggest Banks’ between 2000 and 2007. This compares to 7.3% annual growth for the 500 biggest corporations in general. Lehman Brothers and Bear Stearns, two of the casualties of the financial crisis, had even greater growth rates: 20% and 17.5%, respectively.

‘Subprime mortgages’ have been identified as the primary culprits in the financial crisis. However, the mainstream coverage of the crisis rarely explains what these mortgages are, how they work, or why the rates of default suddenly skyrocketed. Let’s start with the name, which makes little sense if we think of ‘prime’ and ‘subprime’ as referring to interest rates, given that subprime mortgages carry higher interest rates. However, it does make sense when we think of ‘prime’ and ‘subprime’ as referring to the borrowers: prime borrowers get lower rates, ‘subprime losers’[2] get higher rates. Subprime mortgages often had adjustable interest rates. The rate charged moves with changes in the prime rate. The alternative is a fixed rate loan that locks in a certain interest rate for the duration of the loan.

The subprime loans were also occasionally hybrid loans, which had a low fixed rate for the first two years of the loan, meaning even higher rates for the remainder. Sometimes borrowers were offered ‘interest only’ loans for the first five years. This meant that their monthly payments did not reduce the principle and only covered the interest being charged.

So, what caused the spike in defaults among subprime borrowers?

The interest rate of adjustable rate mortgages (ARMs) is ultimately tied to the Fed Fund rate set by the Federal Reserve Board. Beginning in 2000, the Fed Fund began to fall. This also marks the beginning of the rapid expansion of mortgage debt.

For almost 12 months, beginning in late 2003, the Fed Fund rate was held at the extraordinarily low level of one percent. As a result, prime and subprime mortgage rates were very low, making mortgages attractive to potential buyers. Although home prices were rising borrowing money, even for subprime borrowers, was extremely cheap, allowing more people to enter the housing market, driving home prices even higher. It is unclear what proportion of the demand for houses was speculative.

The Federal Reserve began to increase the Fed Fund rate in July of 2004. The official line is that the rate hikes were needed to combat inflation. However, these rates are also what attract investors to US Treasury Bills, the means by which the government funds its deficits.

Of course, the Bush Administration’s tax cuts for the rich and its ‘War on Terror’ resulted in record deficits. Shortly before the Federal Reserve began to increase the Fed Fund, foreign demand for US Treasury bills began to fall. It is possible that the hike was necessary to re-open this important source of credit.

The combination of rising interest rates and the hybrid mortgages meant borrowers had to make substantially higher monthly payments. In late 2005, as the Fed Fund rate continued to rise, the mortgage defaults began to increase. By 2008 almost 20% of subprime borrowers’s accounts were ‘delinquent’ and just under 12% had been foreclosed upon. This means that the value of roughly one out of every eight subprime mortgages had dropped to almost zero[3]. Yet, the banks lost far more than one eighth of their value, and the losses happened sooner and faster than the rise in defaults. This is because of the derivatives the banks created and owned as a means of ‘managing risk.’

I noted above that the value of a mortgage for the bank is the expected earnings divided by the risk of default. A subprime mortgage has a higher perceived risk of default. In order to compensate banks charge higher interest rates to increase the expected earnings. The higher returns are supposed to be a reward to the lender for taking on the higher risk. With the use of derivatives the banks thought they had greatly reduced the risk associated with these loans, when really they had just masked it. The particular kind of derivatives that have been the focal point of the current crisis are the ‘mortgage backed securities’ (MBSs).

Imagine you have $200,000 to invest. You decide to get into the mortgage lending game. That $200,000 will likely only be enough for one mortgage. That means all of your money is riding on a single borrower. If it is a subprime borrower, there is a 6% chance of default[4]. If one hundred people did this, then six of them will lose their money. You are better off purchasing MBSs instead. The bank could group together these hundred mortgages and then sells off newly created assets to the 100 investors, with the interest from all the mortgages as the assets’s source of income.

This way the risk is shared among all the purchasers of the derived asset. Instead of six investors losing all of their investment, all one hundred would lose 6%.

This is a very simply example of a derivative and they can be much, much more complex. In fact, many financial insiders are now saying they did not entirely understand how some of these derivatives worked. Nevertheless, all of the troubled assets are backed by mortgages, especially subprime mortgages. Subprime derived mortgages were especially desirable because they had such high returns based on their high interest rates. Further, ARMs held out the promise of even greater returns as interest rates rose. Someone holding a derivative makes money from it two ways: 1) the aforementioned interest earnings and 2) if the price of the asset increases. It was the second phenomenon that sank the banks.

The market for mortgage backed securities exploded, especially for those backed by subprime mortgages, with their high returns. Much of the spike in demand was the perception that the risk associated with these mortgages had almost disappeared through the creation of derivatives. The rising value of these assets drove the banks to ever greater levels of lending in order to create more assets. The values of the banks skyrocketed as the values of their assets climbed. Citigroup, one of the survivors of the crisis, went from being the 78th largest US corporation in 1996 to the 2nd largest in 2006. Since then it has lost more than 90% of its value.

As mortgage defaults rose on rising interest rates it became clear that the risk associated with the assets backed by these mortgages had been greatly underestimated. Although expected earnings were falling because of the defaults, it was the perception of increased risk that most affected the value of the mortgage-backed securities. Demand for the assets dried up and their value plummeted.

Banks carry large amounts of debt as part of their operation. They require the constant creation of new debt in order to meet existing debt obligations. When their asset values were high and they appeared to be safe and sound, it was not difficult for them to get these loans. When the value of their assets fell they could no longer get the loans they needed and were themselves at risk of default. Further, they shutdown their own lending. This is how manufacturers like GM got mixed up in the crisis. They also require new lines of credit to meet existing obligations, including wages and pensions. Without access to credit they are at risk of bankruptcy. This is why the government has stepped in. They are buying the risky ‘toxic assets’ from the banks and providing loans to the automobile industry to prevent it from collapsing.

Foreclosures have disproportionately hit the poor, immigrants, people of color, and other disadvantaged groups and yet they are also the one’s being ultimately blamed for the crisis. Although a lot of attention is being directed at poorly constructed derivative valuation programs, unscrupulous lending and other finance industry misdeeds, the underlying accusation is that borrowers were irresponsible. However, the mortgages they were being offered were time bombs constructed by a finance industry desperate for profit. Homeowners became the collateral damage when the bombs exploded.

In testimony before Congress former Federal Reserve Chairman Alan Greenspan, as much an architect of the crisis as anyone, asserted, “I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works.” But the crisis is really just capitalism as usual. The greed of the vested interests created the conditions for collapse, the government steps in to bail them out and the masses pay the price.

[1] By ‘Biggest Banks’ I mean the finance corporations included among the 500 largest corporations as measured by market value.

[2] This refers to a comment on CNBC by commentator Rick Santelli: “Why don’t you put up a website and have people vote on the internet, as a referendum, to see if we really want to subsidize the losers’ mortgages.” In an interaction between Santelli and the host, he goes on to state that even with -2% interest rates, most of these ‘losers’ couldn’t service their mortgages.

[3] It isn’t zero because the bank ends up with the home. However, with housing prices falling, and credit drying up, these are not exactly valuable assets, as far as they are concerned.

[4] This was about the average default rate prior to the recent crisis.

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