Financial Engineering the American Nightmare

I frequently listen to the Reading radio for the Blind and Print Handicapped station here in Southeastern Louisiana(WRBH88.3 FM) on my way home from work. I had the absolute pleasure yesterday to listen to an article on the FIRE lobby and the huge amount of power it wields in the beltway from the last issue of Mother Jones. I did a little Google research on the topic since both the Davos World Economic Forum and the meaningless rhetoric delivered last night in the last SOTU have some hint of a call for financial market regulation. Of course, you know, as an ex banker, ex central banker, and a financial economist, I’ve got more than a passing interest in what used to be the boring little business of taking in small savings accounts and making loans for houses, businesses, and cars. It used to be funding the American dream. Since the 1980s, they’ve been financial engineering an American nightmare and making a tidy profit to do so. It’s just one big game of passing the trash to a higher bidder in a fixed game of who can leverage themselves into the highest arbitrage profits by creating false momentum now.

The chart here (you know me and my love of nifty graphs) shows a most interesting modern trend that fits in easily with the time line when politicians and regulators completely left financial institutions to police themselves. You can also see the 2008 crash and the current return to business-as-usual for extraordinary profits of Financial Institutions vs. the rest of the industries in the U.S. economy. Lenin would love this. It shows a complete siphoning of money from everything else to banks. It also shows that they damn near brought the U.S. and global economy to their knees and they’re happily doing it again. Now, this graph is from the Financial Times. As usual, I have to go to European sources these days to find worthwhile journalism. The numbers themselves and the analysis actually comes from the Deutsche Bank. The graph was first introduced in an article back in 2008 but was just recently updated. The bottom line of the analysis (based on the statistical technique called mean reversion or regression toward the mean) was astounding then but is appalling now given everything we’ve been suffering.

The US Financial sector has made around 1.2 Trillion ($1,200bn) of “excess” profits in the last decade relative to nominal GDP.

So mean reversion would suggest that $1.2 trillion of profits need to be wiped out before the US financial sector can be cleansed of the excesses of the last decade.

Basically, the article concluded that the banks were getting extraordinary profits on a historical basis starting around 1991 up until the financial crisis. It’s particularly interesting because it compares banking profits to profits from doing business in any other industry. They were unique. They made money like successful bandits and thieves.

So that article concluded that perhaps we’d seen the correction needed to bring the financial institution profits back to their historical trend. No such luck. The new graph just shows they’ve been able to go right back at it again. So, why should we believe that the incredible amount of leverage and risk-taking it took to create this giant bubble of profits isn’t going to repeat itself? At the moment, nothing really, because we’ve yet to see the changes in legislation that we need to remove the sources of systemic risk. These essentially are the risk from market concentration (i.e. several players going under brings down the entire industry because the top 10 players or so make up the majority of the market) and from being able to leverage themselves beyond reason (i.e. removal of strict capital requirements in the early 2000s) and also there’s the fact nearly all of them are out there running giant speculative hedge funds; even the ones with fiduciary responsibility. The only difference now is that they are using tax payer funds and low interest money compliments of the Federal Reserve Bank.

So this brings me back to the series of articles in Mother Jones and rent seeking. There was a concerted effort on the part of the FIRE lobby (financial institutions and real estate) to ease their way out of strict regulations that resulted from the last time they brought the U.S. and world economy to a grinding halt. That would be, of course, the period of the Great Depression. That is also where their rent-seeking activities paid off handsomely in the profits generated as illustrated by that nifty graph. That’s a terrific ROE illustrated up there in that graph. The U.S. Congress, the SEC and the FED, Fannie and Freddie and the lot of politicians who write state and local banking laws were very good investments.

I listened to Kevin Drum’s “Capital City” read aloud and was appalled at the flagrant examples influence peddling. He takes the story of the crash of 2008 and puts it purely into the world of political lobbying and investing in politicians. I’m now convinced nothing will really change until we rid the world of Senators like Chuck Schumer. Chuck Schumer is on the top of my list. Thankfully, Dodd’s gone and Biden is carefully tucked into a job where he can do no real harm. Please read the article and be prepared to be appalled.

THIS STORY IS NOT ABOUT THE origins of 2008’s financial meltdown. You’ve probably read more than enough of those already. To make a long story short, it was a perfect storm. Reckless lending enabled a historic housing bubble; an overseas savings glut and an unprecedented Fed policy of easy money enabled skyrocketing debt; excessive leverage made the global banking system so fragile that it couldn’t withstand a tremor, let alone the Big One; the financial system squirreled away trainloads of risk via byzantine credit derivatives and other devices; and banks grew so towering and so interconnected that they became too big to be allowed to fail. With all that in place, it took only a small nudge to bring the entire house of cards crashing to the ground.

But that’s a story about finance and economics. This is a story about politics. It’s about how Congress and the president and the Federal Reserve were persuaded to let all this happen in the first place. In other words, it’s about the finance lobby—the people who, as Sen. Dick Durbin (D-Ill.) put it last April, even after nearly destroying the world are “still the most powerful lobby on Capitol Hill. And they frankly own the place.”

But it’s also about something even bigger. It’s about the way that lobby—with the eager support of a resurgent conservative movement and a handful of powerful backers—was able to fundamentally change the way we think about the world. Call it a virus. Call it a meme. Call it the power of a big idea. Whatever you call it, for three decades they had us convinced that the success of the financial sector should be measured not by how well it provides financial services to actual consumers and corporations, but by how effectively financial firms make money for themselves. It sounds crazy when you put it that way, but stripped to its bones, that’s what they pulled off.

Kevin Drum’s article is a must read for ANYONE that lives in the shadow of the U.S. financial industry. It is both a historical narrative as well as a cautionary tale. Much of our national treasure is no longer going to actually producing goods and services. (I had to laugh when I read the SOTU speech and the promise of the return to an export economy. What are we going to sell other than our natural resources and people?) The high rates of return are based on loan shark returns from things like overdraft protection and making arbitrage profits when big players with enough clout force small enough moves in market momentum–that when leveraged to incredible levels–create incredible bonuses and profits.

There are some high profile people–including Paul Volcker one of my personal heros–trying to prevent a repeat of this catastrophe. (See the Volcker Rule.) However, the depressing thing is that it appears that the FIRE lobby owns so much of the Congress and Executive Branch– and possibly SCOTUS given that damnable ruling last week–that it will be hard to pull them back to size. Perhaps the international community will be able to do it on a global basis and the Davos forum could lead to a new Basel Accord. That still leaves us here in the United States hopelessly indentured to the banking system.

Now, I could be a good researcher and run a really great little econometrics model specifying something to the effect like dollars spent on lobbying by FIRE = f(bank profits, decreased capital requirements, exotic unregulated derivatives, regulator capture, market concentration) and a huge amount of other variables that are basically not in the public interest but in the bankers’ interest but low and behold, I found one done by the IMF just recently released. Surprise, surprise–the primary investigators were WOMEN economists. Here’s a link to Lobbying and the Financial Crisis at VOX EU. Notice again, I’m having to go to European sources since the media industry here is financed by the US banking industry, they certainly don’t want their financiers to turn off their cash spigots and access to seasoned equity offers.

If regulatory action would have been an effective response to deteriorating lending standards, why didn’t the political process result in such an outcome? Questions about the political process, through which financial reforms are adopted, are very timely now that the US Congress is considering financial regulatory reform bills.

A recent study by Mian, Sufi and Trebbi (forthcoming) shows, for example, that constituent and special interests theories explain voting on key bills, such as the American Housing Rescue and Foreclosure Prevention Act of 2008 and the Emergency Economic Stabilization Act of 2008, that were passed as policy responses to the crisis.

A number of news articles have reported anecdotal evidence that, in the run up to the crisis, large financial institutions were strongly lobbying against certain proposed legal changes and prevented a tightening of regulations that might have contained reckless lending practices. For example, the Wall Street Journal reported on 31 December 2007 that Ameriquest Mortgage and Countrywide Financial spent millions of dollars in political donations, campaign contributions, and lobbying activities from 2002 through 2006 to defeat anti-predatory-lending legislation.

There has, however, been no careful statistical analysis backing claims that lobbying practices may have been related to lending standards. In a recent paper (Igan, Mishra and Tressel, 2009), we provide the first empirical analysis of the relationship between lobbying by US financial institutions and their lending behaviour in the run up to the crisis.

This is the academic equivalent of the Mother Jones’ article. Here’s one more NIFTY GRAPH and here’s the explanation to go along with it.

The striking picture is that financial institutions lobbying on specific issues related to mortgage lending and securitisation adopted significantly riskier mortgage lending strategies in the run-up to the crisis.

We considered three measures of ex-ante loan characteristics: the loan-to-income ratio of mortgages, the proportion of mortgages securitised, and the growth rate of loans originated. The loan-to-income ratio measures whether a borrower can afford repaying a loan; as mortgage payments increase in proportion of income, servicing the loan becomes more difficult, and the probability of default increases. Recourse to securitisation is often considered to weaken monitoring incentives; hence, a higher proportion of mortgages securitised can be associated with lower credit standards. Fast expansion of credit could be associated with low lending standards if, for example, competitive pressures compel lenders to loosen lending standards in order to preserve market shares.

We find that, between 2000 and 2006, the lenders that lobbied most intensively to prevent a tightening of laws and regulations related to mortgage lending also:

  • originated mortgages with higher loan-to-income ratios,
  • increased their recourse to securitisation more rapidly than other lenders, and
  • had faster-growing mortgage-loan portfolios.

These findings suggest that lobbying by financial institutions was a factor contributing to the deterioration in credit quality and contributed to the build-up of risks prior to the crisis.

How does it feel to know that you’re an indentured servant and that all the businesses you work for or do business with are dependent on entirely legal group of thieves and extortionists?

GET YOUR MONEY out of BIG BANKS now. You’re helping to finance your own contract with the devil. They’re throttling democracy and making a huge buck off of it in the process. Try to primary and remove ANY politician who has been heavily financed by FIRE. Spread this message far and wide.