This lecture was delivered on March 25, 2009, at Union Theological Seminary in a public forum, "Christianity and the U.S. Crisis," associated with a class co-taught by Cornel West, Serene Jones, and Gary Dorrien. It is an abridged version of a chapter in Dorrien's forthcoming book, Social Justice in Question: Economy, Difference, Empire, and Progressive Christianity (Columbia University Press, 2010).
Today we are caught in a global economic crash and depression, a calamity affecting every nation connected to the global economy, especially poor nations lacking economic reserves. But this crisis also puts into play new possibilities for a democratic surge, perhaps toward economic democracy.
From the perspective of Economics 101, every bubble mania is basically alike, but from the beginning, this one has been harder to swallow, because it started with people who were just trying to buy a house of their own, who usually had no concept of predatory lending, and who had no say in the securitization boondoggle that spliced up various components of risk to trade them separately. It seemed a blessing to get a low-rate mortgage. It was a mystery how the banks did it, but this was their business; we trusted they knew what they were doing. Our banks resold the mortgages to aggregators who bunched them up with thousands of other subprime mortgages, chopped the package into pieces and sold them as corporate bonds to parties looking for extra yield. Our mortgage payments paid for the interest on the bonds.
For twenty years securitizations and derivatives were great at concocting extra yield and allowing the banks to hide their debt. Broadly speaking, a derivative is any contract that derives its value from another underlying asset. More narrowly and pertinently, it's an instrument that allows investors to speculate on the future price of something without having to buy it. The words that are used for this business-securitization, insurance, diversifying risk-sound reassuring, but they mask that the business is pure high-leveraged speculation and gambling. Credit-default swaps are private contracts in a completely unregulated market that allow investors to bet on whether a borrower will default. Ten years ago that market was $150 billion; today it's $62 trillion, and it's at the heart of the meltdown. Credit default sellers are not required to set aside reserves to pay off claims, and in 2000 Congress exempted them from state gaming laws. AIG's derivatives unit was a huge casino, selling phantom insurance with hardly any backing, for which we now have to pay. The tally for the past six months: four bailouts, $160 billion, some very hard-to-take bonus payments, and no bottom in sight for a sinkhole of toxic debt exceeding $1 trillion.
Derivatives created dangerous incentives for false accounting and made it extremely difficult to ascertain a firm's true exposure. They generated huge amounts of leverage and were developed with virtually no consideration of their broad economic consequences.
So many plugged-in players rode this financial lunacy for all it was worth, caught in the terribly real pressure of the market to produce constant short-term gains. Speculators gamed the system and regulators looked the other way. Mortgage brokers sold bad mortgages; bond bundlers packaged the loans into securities; rating agencies gave inflated bond ratings to the loans; corporate executives put the bonds on their balance sheets; and all made fortunes off toxic products they had no business creating or passing off. The chief rating agencies, Moody's and Standard & Poor's, were supposed to expose financial risk. Instead, paid by the very issuers of the bonds they rated, they hung triple-A ratings on rubbish. There was so much money to be made that firms couldn't bear to leave it aside for competitors to grab. The banks got leveraged up to 50-to-1 (that's where Bear Stearns was at the end) and kept piling on debt. The mania for extra yield fed on itself, blowing away business ethics and common sense.
Today we are staring into an economic abyss, a global deflationary spiral. Deflation, once started, has a terrible tendency to feed on itself. Income falls in a recession, which makes debt harder to bear, which discourages investment, which depresses the economy further, which leads to more deflation. To have any chance of breaking the deflationary spiral, the Obama administration has to solve the bank problem and dispose of the toxic debt.
One option is Henry Paulson's original plan, "cash for trash," this time with more public accountability. Another is to ramp up the insurance approach, "ring-fencing" bad assets by providing federal guarantees against losses. But these are more-of-the-same options that coddle the banks and don't solve the valuation problem-that no one trusts anyone else's balance sheet. The banks are holding at least $2 trillion of toxic debt. For the past six months, the banking system has been paralyzed because the big private equity firms and hedge funds are refusing to pay more than thirty cents on the dollar for the mortgage bundles and the banks can't stay in business if they book such huge losses on their holdings. In the meantime the banks are holding out for at least sixty cents and pleading for more relief.
The Latest Bailout Fad: Creating Bad Banks
The third option, the "bad bank" model, creates transitional banks to soak up bad debt. Here the risk of getting prices wrong is even greater, assuming that assets are valued immediately. If the government overpays for toxic securities, taxpayers are cheated; if it doesn't overpay and the banks take mark-to-market prices, many are sure to fail. Some advocates of the bad bank strategy say the government could stall on the price issue, waiting until values rise, but FDIC chair Sheila Bair says no, banking is not alchemy: assets can't be floated into the ether.
Bair and Timothy Geithner have settled on an aggregator bank model that blends the original Paulson plan with some elements of the bad bank topped off with an auction scheme to find private buyers for the toxic debt. Geithner wants the government to create a $2 trillion public-private investment fund that subsidizes up to 95 percent of deals partnered with hedge funds and private equity firms to buy up the bad assets of the zombie banks. The private funds will end up owning the assets; the FDIC will do most of the partnering work; and the Treasury will hire four or five investment management firms.
Since this is apparently what we're going to do, I certainly hope it works. But this plan is by far the most cumbersome and least transparent strategy of all. It coddles the banks. It is based on the dubious hope of finding enough private buyers for rotten goods. It assumes that private fund managers have been wrong thus far about the real value of the mortgage bundles. It offers a taxpayer guarantee to investors to ensure they won't lose money if they get in. And it depends on convincing taxpayers to pony up another $2 trillion for that purpose. Essentially, this is a scheme to pay fantastic bribes to private investors to buy the bad assets for more than they're worth.
Here's A Better Idea: Let's Create Good Banks!
I am for biting the bullet now. It's obscene to keep paying off the very people who created this disaster. It's better to take control of the situation now than to dither for another nine or ten months while we lose 600,000 jobs per month. At some point moral fairness and accountability have to enter this picture. We should nationalize the zombie banks, transfer the bad assets to a reincarnation of the 1980s Resolution Trust Corporation, and sell off the sellable parts to new owners.
Nationalization is cleaner and more transparent than the alternatives. It takes hold of the valuation problem by finding the bottom. It cuts off the gusher of taxpayer gifts to managers and shareholders. It offers taxpayers a way of getting some of their money back. It puts an end to mergers between zombie banks, which create more zombie banks that are too big to fail.
Most importantly to me, an aggressive nationalization strategy would put into play the possibility of something more creative and constructive: establishing publicly funded venture capital banks. If we can seriously talk about creating bad banks or aggregator banks, we ought to be able to talk about creating publicly owned good banks to do good things. Public banks could finance start-ups in green technology that are currently languishing and provide financing for cooperatives spurned by traditional banks. The public banks could be financed by an economic stimulus package, or by claiming the good assets of banks seized by the government, or both.