Monday, October 13, 2008

Eamonn Fingleton: Getting the American economy back on solid ground will require new financial regulations.

Street Sweeping: Getting the American economy back on solid ground will require new financial regulations. Goldman Sachs alums aren’t the men for the job.
By Eamonn Fingleton
The American Conservative

As bewildered Americans survey the wreckage of their nation’s once vaunted financial system, they could do worse than reacquaint themselves with one of Wall Street’s oldest and most revealing parables.

The story goes that an out-of-town customer dropped by to talk to his broker and afterwards was ushered around Lower Manhattan’s yacht-filled docks.

“Here is Mr. Morgan’s yacht,” his guide pointed out. “This is Mr. Bache’s, and over there is Mr. Drexel’s.”

“Where are the customers’ yachts?” the visitor naïvely asked.

The story is at least a century old and its punch line long ago figured as the title of a hilarious tell-all book by a Wall Street insider. But if we substitute executive jets for yachts, the message remains as true today as ever: Wall Street is run for the benefit of Wall Street.

This goes a long way toward explaining the origins of the current crisis. The subprime bubble was pumped up by a massive blast of “don’t worry, be happy” sales talk. Powerfully incentivized salespeople who pushed so much toxic debt on to unwitting investors were making far too much money in the short run to worry about the long-term havoc they were creating for everyone else, not least stockholders in their own firms.

The parable also illuminates the mindset guiding the bailout effort. Both Treasury Secretary Henry Paulson and his key adviser, Neel Kashkari, formerly held top jobs at Goldman Sachs, and it seems clear that their highly controversial and, to economic historians, bafflingly unorthodox bailout plan serves Wall Street’s interests—particularly those of their former employer—far more than the American public’s.

The amazing aptitude of Wall Street insiders to feather their own nests at the taxpayers’ expense should be a crucial concern as legislators try to craft a stable and productive future for the American financial system. A key question is how Wall Street’s greed can be reined in. In truth, there is no substitute for regulation.

This isn’t a view that will find immediate favor with conservative readers. But it is being espoused by no less a plutocrat than Michael Bloomberg, the former Wall Street insider who has recently morphed into a budget-cutting mayor of New York. More significantly, it has been vociferously championed by Paul Craig Roberts, the chief architect of President Ronald Reagan’s economic program.

Before we consider in detail the case for a return to regulation, let’s first understand how we have come to this pass.

Think of it this way: there is a hierarchy of lenders and sublenders that begins with, say, a saver in Germany who puts money on deposit in a Berlin bank. This deposit, along with countless others, is used to buy highly complex U.S. mortgage-backed securities peddled by an American investment banker in Frankfurt. These securities are a claim on thousands of mortgages advanced to homeowners in the United States by various American mortgage lenders. In an ideal world, all the American borrowers remain happily solvent and make their repayments on time. Out of these repayments the German bank will receive a regular flow of interest followed eventually by the return of its capital—after various middlemen have taken juicy cuts, not least the American investment banker, who has already taken a nice commission upfront.

As long as home prices continue to rise, the system works. That’s the theory. But in reality, a natural real estate correction—along with rampant corruption—combined to produce devastating effects.

In the search for someone to blame, predatory lenders are obvious culprits. As the subprime mortgage industry grew, so did the tendency to seek out weak borrowers, particularly elderly people with valuable homes but little income. In one case reported to the Senate Special Committee on Aging, an elderly couple living on Social Security in Brooklyn was sucked into a financial quagmire after a salesman promised he could have their windows repaired for payments of $43 a month over 15 years—a grand total of less than $8,000. Six years later, they had paid tens of thousands of dollars in fees, accumulated $88,000 in new debt, and been served with foreclosure papers.

Situations like this meant fat income for the predatory lender, with the added bonus of exorbitant rake-offs when he foreclosed on the unfortunate borrower. The whole plot was funded by an expected rise in home values.

And for a time, prices soared—124 percent between 1997 and 2006. Lured by teaser rates and convinced that they could either refinance later or flip for big gains, average Americans got in the game. As of March 2007, the value of subprimes was estimated at $1.3 trillion of the $12 trillion total U.S. mortgage market—a significant proportion, to be sure. But not all lenders were trawling for defaults; money was cheap and the market was hot.

Far from putting on the brakes, government revved the engine. President Bush advanced his notion of the “ownership society” as integral to national identity: “the idea of people owning a home is part of the American Dream.” Legislation like the Home Mortgage Disclosure Act and the Community Reinvestment Act facilitated risky lending. The Federal Reserve contributed to the problem as well. “The Fed’s loose money policies under Alan Greenspan encouraged the technology bubble” of the 1990s, notes sociology professor Walden Bello, a leading critic of globalization. “When it collapsed, Greenspan, to try to counter a long recession, cut the prime rate to a 45-year low of one percent in June 2003 and kept it there for over a year. This had the effect of encouraging another bubble—in real estate.”

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