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Journal of the Communist Party of Australia
ISSUE 53October 2010
A critical analysis of the US causes of the Global Financial Crisis of 2007-2008
by Ross Morrow*
This paper draws on a Marxist perspective, and a variety of theoretical, empirical and historical material, to explain the main causes of the global financial crisis which first developed in the United States (US) in 2007-2008. It argues that a low rate of profit in the US economy and wide economic inequalities led to increasing capital flow to the financial sector and the increasing provision of credit to US workers whose real incomes had declined. Financial innovations enabled debt to be sold in complex new financial products to investors. Cheap and apparently riskless lending drove the rising leverage of investments. “Securitisation” helped to spread the risks to global financial markets and deficient government regulation facilitated these developments. A huge asset bubble developed in the US housing sector and burst when interest rates rose triggering waves of defaults, institutional insolvency and a severe credit crunch.
This paper focuses on explaining the main causes of the global financial crisis (GFC) which developed in the United States in 2007-2008. There is a burgeoning literature on the GFC, which is characterised by a “vast disagreement about its main causes” (Carmassi, Gros and Micossi, 2009). This paper is an attempt to go beyond speculative, one-sided and individualistic explanations of the crisis which portray it as an “act of God”, or the result of greed and stupidity, herd behaviour, the construction of too many houses, the over-regulation of free markets, neoliberalism or regulatory failure (see, for example, Butler, 2008; Dobson, 2008; Fine, 2008; Maiden, 2008; Stiglitz, 2008; Matchett, 2009; Faber, 2009; Garnaut, 2009; and Rudd, 2009). It also attempts to go beyond official versions of the crisis which portray it as a ‘financial crisis’ divorced from a ‘real economy’ with “sound fundamentals”. This view was favoured and promulgated by politicians and government officials, such as US President George W. Bush, Republican Senator John McCain, Federal Reserve Chair Ben Bernanke and Treasury Secretary Henry Paulson (Henderson, 2005; CBC News, 2007; ABC News, 2007; Xinhua News, 2008a; Xinhua News, 2008b; Stein, 2008).
This paper, by contrast, is an attempt to understand the main causes of the GFC in terms of broader social structures and processes and the way people exercise agency within them. It takes seriously Karl Marx’s (2007 ) methodological advice for studying crises, namely that both the underlying causes and the distinctive aspects of crises have to be accounted for. It also follows his advice to examine the potential for crisis in both the spheres of production and finance, and how these are interrelated (Marx, 1968 ). However, while the paper draws on some key insights from Marx and the Marxist tradition, it also differs from some existing Marxist accounts of the crisis, such as those of Foster and Magdoff (2009) which neglect the issue of the falling rate of profit in the US economy; and the work of Brenner (2009) which refers to a falling rate of profit but which explains it in Smithian rather than Marxian terms (for a critique of Brenner’s approach, see: Marx, 1993 [1939-1941]; Harman, 1999; Shaikh, 1999; and Lebowitz, 2009).
Given that new information is still emerging about the GFC, and that a full history of it has yet to be written, the paper must in some respects be provisional and cannot expect to be the last word on the topic. Nevertheless, it is a systematic attempt to explain and interrelate the key underlying and conjunctive factors which produced the crisis, based on an analysis and synthesis of current research. The argument here is that a number of key factors were involved. These include a low rate of profit in the US economy; wide and growing economic inequalities in US society; increasing investment in the financial sector; the development and use of complex new financial instruments; the global spread of financial risk through “securitisation”; the rising leverage of investments from apparently safe and cheap loans; light or absent government regulation of the financial sector; and the inflation and bursting of an enormous asset bubble in the housing sector.
Main causes of the Global Financial Crisis
It is important to understand the main causes of the GFC — the largest financial crisis since the Great Depression of the 1930s — for a number of different reasons. First, the crisis was largely unforeseen by conventional “neoclassical” economists (Baker, 2009 Hobsbawm, 2009). Second, there are unresolved debates both among scholars and those on the political left about the causes of the crisis (see, for example Choonara, 2009 and McNally, 2009). Third, identifying the main causes could help us to understand why the crisis developed in the way that it did. Finally, knowledge of the causes could potentially be used to prevent such devastating effects in the future, particularly for the working classes and their dependents who are likely to bear the main brunt of the crisis and its economic effects (Hall, 2009). While this paper focuses on the central causes of the crisis in the US, it is not concerned here with explicating the important but complicated after-effects of the GFC or its various implications for policy, politics or collective action. The paper is centred on identifying and explaining the main causes of the crisis and these are discussed below.
Falling and low rates of profit: leaving the “golden age” of US capitalism
In Marxist theory, the rate of profit is usually seen as the main factor which determines the overall state of capitalist economies (Moseley, 2003: 212). When there is a high rate of profit in a capitalist economy there is generally more prosperity: business investment and employment is high and workers’ living standards tend to increase. This is what happened during the so-called “golden age” of capitalism during the early post-war boom. However, when there is a low rate of profit, prosperity declines and may turn into recession. Business investment falls or is stagnant, unemployment rises and people’s living standards fall (Moseley, 2003: 212).
According to the Marxist economist, Fred Moseley (1991; 2003: 212), the most important cause of the stagflation (high unemployment and high inflation) in the US economy at the end of the post-war boom was a significant decline in the overall rate of profit (understood in his study as “the ratio of total profit to total capital invested”). He estimates that “From 1950 to the mid-1970s, the rate of profit in the US economy declined almost 50 per cent, from around 22 percent to around 12 percent” (Moseley, 1991; 2003: 212). This lowered business investment, employment and economic growth. As the government responded to higher unemployment by adopting Keynesian type economic policies of lower taxes, lower interest rates and higher government spending to stimulate the economy, capitalist firms tried to restore the rate of profit by raising their prices faster rather than by “increasing output and employment”. This led to higher rates of inflation in the economy (Moseley, 2003: 213).
Moseley (2003) argues that there were two main factors which caused the rate of profit to fall between 1950 and the mid-1970s. First, there was an “increase in the capital invested per worker”, which occurs within capitalist economies as workers (who are the source of surplus value and profit) are increasingly replaced or superseded by machines. As technological change makes the total capital invested rise faster than the number of workers employed, the rate of profit tends to fall (Moseley, 2003: 216). Second, there was an increase in the ratio of unproductive to productive labour in the economy. In Marxist theory, surplus value (and profit) is only produced by “productive” workers directly or indirectly involved in designing, making or transporting commodities. “Unproductive” workers, such as sales and supervisory staff, do not produce surplus value and profit even though their employment is necessary for other reasons within capitalist firms. If the proportion of unproductive labour in the economy rises faster than that of productive labour then the rate of profit in the economy will tend to fall as costs increase but profit does not. Moseley (2003: 218) argues that these two factors contributed almost equally to the total fall in the rate of profit between 1950 and the mid-1970s.
By contrast, conventional economic explanations of the end of the post-war boom and the stagflation that followed completely missed the significant fall in the rate of profit in the US economy. These explanations instead focused on exogenous and accidental factors such as the OPEC oil price rise in the 1970s, mistakes in government policy and an unexplained slowdown in productivity growth (Moseley, 2003: 213, 215).
Moseley’s (2003) research shows that the rate of profit fell from around 12 percent in the mid-1970s to a low point of about 10 percent in 1980. It then climbed in a cyclical way to about 18 percent by 1997 before falling to 14 percent in 2002. At that time it was still about 30 percent lower than the peak rate of profit in the early post-war period. He noted that the “absence of a full recovery in the rate of profit is the main reason why the US economy has not returned in recent decades to the more prosperous conditions of the ‘golden age’” (Moseley, 2003: 214).
Moseley’s (1991; 2003) research on the rate of profit in the post-war US economy was published before the onset of the global financial crisis and so did not address its causes. However, his work has important implications for understanding the causes of this crisis. It is important to focus on the rate of profit because when profit rates are low in the productive economy investors seek more profitable outlets for investment. In this case, capitalists and other wealthy investors began to invest large amounts of money into financial assets (Harman, 2007a: 132; 2007b; Choonara, 2009). Without the higher costs associated with the production and sale of commodities, financial assets are usually more profitable than investments in physical asset capital. Furthermore, financial assets can now be traded in a global market place where there is immediate global demand due to the development of information technology and global financial deregulation (Rasmus, 2009: 41). Between 1997 and 2007, over $US20 trillion of “securitised” debt was sold to investors (Whitney, 2009). The “financial sector’s share of GDP [Gross Domestic Product] increased from 13 percent in 1970 to 20 percent in 2007” (International Labour Organisation, 2009: 1) and its share of total US corporate profits increased from 14 percent in 1981 to 40 percent by 2006 (Choonara, 2009). The latter figure would be an underestimate given that part of the profit accruing to the financial sector takes the form of huge bonus payments to employees (Gowan, 2009: 7).
The growth of inequality
One of the main underlying causes of the US financial crisis was the wide and growing inequalities of income and wealth between households in US society and between capital and labour (Kotz, 2009). This is an important aspect of the GFC, which has, at best, been under-explored (see, for example, Faber, 2009; Garnaut, 2009; and Munchau, 2010). In terms of income inequality, the Economic Policy Institute (2009a: 1) estimates that between 1979-2006, about 91 percent of all income growth in the country went to the top 10 percent of income groups. At the same time, the highest paid 1 percent of the population more than doubled their share of total income from about 10 percent to almost 23 percent. By contrast, between “1973 and 2002, average real incomes for the bottom 90 percent of Americans fell by 9 per cent” (McNally, 2009: 60). Over a quarter of all workers in the US (26.4 percent) in 2007 were, in fact, earning poverty-level wages (Economic Policy Institute, 2009b: 6).
The situation is even more unequal when it comes to wealth. Between 1991 and 2003, the wealthiest 1 percent of Americans increased their share of corporate wealth from 38.7 percent to 57.5 percent (McNally, 2009: 60). In 2004, the wealthiest 1 percent of households owned more of the national wealth than the bottom 90 percent of households combined (Economic Policy Institute, 2009b: 10). The concentration of wealth at the top has also increased over time. Between 1962-2004, the wealth of the bottom 80 percent of the population decreased from 19.1 percent to 15.3 percent and this wealth was shifted to the wealthiest 5 percent of the population. About one in six households have no net wealth at all and nearly one-third of households (30 percent) have a net worth under $10,000 (Economic Policy Institute, 2009b: 10-11).
There has also been widening inequality between wages and profits in the US economy. Between 1979-2007, real output per hour increased by 1.91 percent while the real average hourly earnings of non-supervisory workers fell by 0.04 percent. This suggests a transfer of income from labour to capital. Similarly, productivity growth for the same period was 4.6 percent while real compensation per hour (including fringe benefits) for all employees including managers increased by only 1.1 percent. Finally, real profits in the corporate sector over the same time period increased by 4.6 percent while real employee compensation grew by only 2 percent (Kotz, 2009).
There are a number of main causes of these inequalities. They include an economic system of class exploitation in which surplus value is extracted and expropriated from the direct producers, and where class relations of exploitation are reproduced over time; successful efforts by capital to raise the rate of profit by holding wages down, increasing the duration and intensity of labour, and relocating production to low-wage parts of the world; a weakened trade union movement where the rate of unionisation of the workforce fell from 43.1 percent in 1978 to only 19.2 percent in 2005; tax cuts which have disproportionately favoured business and the wealthy; the use of tax havens and other forms of tax avoidance and evasion by the wealthy; generous corporate welfare funded by taxpayers; privatisation of public services, and deregulation of sectors such as energy, transport and communications which have led to reduced wage costs for employers; reductions in the “social wage” which previously supported workers’ living standards and bargaining power; and the intersection of other structural forms of inequality including those of gender, “race” and ethnicity (Marx, 1990 ; Bartlett and Steele, 1998; Yuen and Weaver, 1999; Moseley, 2003; Magdoff, 2006; Harman, 2007a; Tabb, 2008; Turner, 2008; Economic Policy Institute, 2009b; Kotz, 2009; Larudee, 2009; and Black, B. 2010).
This wide and growing inequality of wealth and income in US society had two main consequences which laid the basis for the GFC. First, for the wealthy it produced a large and expanding volume of funds that sought the most profitable investment opportunities. “Capital flocked to high-return, high risk investments in the unproductive financial sector because [the] profit rate in the real economy was low” (Kuhn, 2008). There was high demand for interest-paying financial instruments, and as funds poured into securities and real estate, favourable conditions were created for an asset bubble to develop (Kotz, 2009: 308; McNally, 2009: 67). Second, with declining real incomes and standards of living, many workers found it necessary to borrow money against their houses in order to maintain their standards of living (Sustar, 2008). Between 1997 and 2005, household debt increased from 67 percent to 92 percent of GDP (Magdoff, 2006). As millions of families tried to survive economically, it was easy for mortgage purveyors to entice people to borrow money against their homes, often at low initial interest rates, in order to pay their bills. As Barbara Ehrenreich aptly put it, “Easy credit has been America’s substitute for decent wages” (Baertlein, 2009). Most of the subprime mortgage loans taken out between 2000 and 2007 were by people refinancing their homes rather than for buying new homes (Kotz, 2009: 313). According to Sheila Bair, Chairman of the US Federal Deposit Insurance Corporation, 75 percent of subprime mortgage loans turned out to be for people who were refinancing their mortgages (Faber, 2009: 54). Reynolds (2008) reports that between 1998 and 2006 the figure was as high as 90 percent. In turn, the credit extended to working class people in the form of credit cards, mortgages and housing-backed loans provided the basis of the interest-bearing securities that wealthy investors wanted to own (McNally, 2009: 67).
The development and use of new financial instruments
The collapse of the gold-dollar standard in 1971, the move to floating exchange rates, the deregulation of finance and the removal of controls on capital flows between countries led to a major reorganisation of capitalist finance. New financial instruments and institutions were developed or re-engineered by academics, bankers, insurers and fund managers to boost income, hedge financial and monetary risks, evade regulations, and hide or pass on risks to “less savvy” clients or the state (McNally, 2009: 46; Gowan, 2009; Hildyard, 2008).
Banks and mortgage brokers, which earned fees for writing mortgages, found they could generate additional fees by “securitising” mortgages. “Securitisation” became an important component of financial markets in the 1980s (Hildyard, 2008: 4; Morris, 2009: 60; Rasmus, 2009: 44). It involves bundling different financial assets, such as mortgages, loans and corporate bonds together and converting them into new types of securities, such as mortgage backed securities (MBSs) and collateralised debt obligations (CDOs). Despite their exotic names, they are essentially “debt obligations that involve titles to interest payments and principal on a large number of loans” (McNally, 2008). A mortgage backed security, for example, might contain several thousand mortgages, and a collateralised debt obligation might contain up to 150 mortgage backed securities (Crotty, 2008: 25-26).
These financial products are extremely complex and opaque. They cannot be sold on exchanges because there is uncertainty about how to evaluate their risk (Crotty, 2008: 22). Instead, they are sold by originating investment banks “over the counter” and through negotiation with a small number of customers (Crotty, 2008: 24). Given their complexity, financial firms lack the time, ability or incentive to evaluate the risks involved when there may be “tens of thousands of mortgages ... in a CDO” (Crotty, 2008: 26). Instead, the investment banks that create these products, and the credit ratings agencies, such as Moody’s, Standard and Poor’s and Fitch Ratings, rely on simulation models to gauge the risks of these instruments and their tranches. However, the models are “unreliable and easily manipulated” (Crotty, 2008: 27). The credit ratings agencies are also paid by the investment banks to rate their products. This means there is a financial incentive for the agencies to give favourable ratings because their profits depend on keeping the banks happy. If a credit ratings “agency gave a realistic assessment of the high risk associated with CDOs while others did not, that firm would see its profit and market share plummet” (Crotty, 2008: 22). A Securities and Exchange Commission (2008: 17-18) investigation of the credit ratings agencies in 2007 discovered that they did not even check or verify any of the loan data at the basis of the financial products they were rating. As they worked to increase the size of the CDO market, and their own profits, one analytical manager at a ratings agency in 2006 wrote to a colleague, “Let’s hope we are all wealthy and retired by the time this house of cards falters” (Securities and Exchange Commission, 2008: 12).
The intention behind products, such as mortgage backed securities and collateralised debt obligations, was to sell mortgages on to other buyers so that competing lenders would have more funds for lending rather than being restricted by their own capital reserves. The products were also intended to reduce the risks of additional lending by allowing loans to be grouped into tranches with varying levels of risk. These would be sold to investors who paid up front to receive relatively high returns as people paid off their mortgages. While allowance was made for a small proportion of mortgage defaults, these were not seen as a threat to the investment overall (Bone, 2009).
Investors and financial institutions could also insure against the risk of holding these parcels of loans by purchasing a credit default swap (CDS), a type of insurance contract that would pay out if there was a default on debt (Bone, 2009). Between 2001 and 2007, the investments covered by credit default swaps grew from just under $1 trillion to around $62.2 trillion (International Swaps and Derivatives Association, 2001; 2007). Credit default swaps allowed investors to avoid “having to raise extra capital to cover potential losses” (Sustar, 2008). However, any investors could buy credit default swaps without having to own any shares in the relevant company or financial institution. This encouraged speculators to bet on companies defaulting on their debts so they could get payouts many times the price they paid for their credit default swaps. As speculative bets against a company increase, the insurer who sells the CDSs becomes responsible for more and more claims if a company defaults on its debt. There is a risk that the insurer itself will go under and be unable to pay every claimant (McNally, 2009: 68). According to Moody’s, “this is the biggest systemic risk posed by the CDS market” (Guerrera and Bullock, 2008). In that scenario, no one is protected against default and “that means complete and total financial market-panic” (McNally, 2009: 68).
Institutional investors, such as insurance companies, pension funds and hedge funds, wanted to buy products, such as mortgage backed securities and collateralised debt obligations, for two main reasons. Firstly, they were given high credit ratings by the credit ratings agencies. About 80 percent of CDO tranches were given triple A ratings. The institutions relied on these ratings because they were “arms length buyers” without the capacity to investigate the nature of the underlying collateral. Secondly, these securities produced higher returns than corporate bonds with equivalent credit ratings. This made them very attractive in a period of low interest rates in order to meet their fixed and future financial obligations (Crotty, 2008: 3, 28-29).
Crotty (2008: 3) points out, however, that “[d]ifferent returns on products with identical risk ratings should have signaled that something was seriously wrong with the way markets priced risk”. Indeed, there is evidence that executives and fund managers knew there were higher risks involved in making these investments (Faber, 2009: 168-169). Competitive pressure to maximise returns meant that if fund managers did not make these investments while their competitors did, then their investment performances would suffer, their firms would lose market share, money would go elsewhere, and their firm’s stock market capitalisation would fall (Faber, 2009: 168-169; Zandi, 2009: 92).
In Australia, the buyers of financial securities included local councils, charities, community groups and superannuation funds. They invested $625.6 million in Lehmann Brothers securities before it went bankrupt. These securities, including CDOs, were aggressively marketed to councils by, in some cases, the same people who were providing them with financial advice. Councils invested in these products to get the highest returns they could while still maintaining investments with AA or AAA credit ratings. However, financial advice from state governments was inadequate, insufficient care was taken by councils in scrutinising and understanding the investment products, and the councils relied on the high ratings of the products given by the credit ratings agencies (Desiatnik, 2008; Whitehouse and Ng, 2008; House of Representatives Standing Committee on Infrastructure, Transport, Regional Development and Local Government, 2009; Peacock, 2009; Yeates, 2009).
The growing investor demand for high yield mortgage products and the large fee income generated by them led banks and mortgage brokers to sell mortgages to people who could not afford them in the so-called subprime mortgage market. The terms of these mortgages ensured there would be large defaults when interest rates rose or the housing bubble burst (Crotty, 2008: 3). These innovative new mortgage products included the “liar loan” where borrowers could simply state their income without providing any evidence of it; the “piggyback loan” in which a borrower takes out two mortgages to eliminate the need for any down-payment; the “teaser” loan where initial low interest rates reset to higher rates after two years which the borrower cannot afford; and “NINJA” loans made to people with no income, no job and no assets (Pearlstein, 2007).
The lack of underwriting checks on the liar loans opened the way to endemic fraud in the mortgage industry. In 2006, for example, there was no verification of key underwriting data in almost half of the subprime loans issued nor in the “alt-a” loans (the category of loans in between prime and subprime loans) which were made to people whose annual incomes meant they could not afford the houses they wanted. In 2006, about 40 percent of mortgage loans were non-prime loans consisting of about half subprime loans and half alt-a loans (Black, W., 2010; Faber, 2009: 37-38; Zandi, 2009: 37). The Federal Bureau of Investigation (FBI) had warned in 2004 of an epidemic of fraud in the mortgage industry (Frieden, 2004), and when the Fitch Ratings (2007: 4) agency checked a small sample of non-prime loans they found “the appearance of fraud or misrepresentation in almost every file”. Mortgage lenders were estimated to have initiated the fraud in about 80 percent of cases, primarily so that those in charge could maximise their “reported income and their executive compensation” (Black, W. 2009; Black, W. 2010: 18). There was no effective response to the fraud from the US Federal Reserve Board or the Securities and Exchange Commission. The FBI, while aware of the problem, lost the capacity to deal with it. After the 9/11 terrorist attacks, 500 of its white-collar crime specialists were transferred to work on national security issues and were not replaced by the Bush administration (Black, W. 2010). The fraudulent loans were later pooled and securitised to form the basis of more sophisticated financial instruments, such as mortgage backed securities and collateralised debt obligations (Black, W. 2009).
The annual volume of subprime loans increased from “$145 billion in 2001 to $625 billion in 2005” making up over 20 percent of total loans issued, and with over a third of these loans being for 100 percent of the house value (Morris, 2009: 69). Because lenders could sell their loans on to other investors, so that defaults became the end investors’ problem, the conditions under which loans were made became less important than their volume. There was growing demand from investors for these products which had apparently good credit ratings and the financial institutions could earn large fees by packaging and selling them (Bone, 2009). “The whole process was driven by accelerating leverage&rd, that is, the use of borrowed money to fund investments (Crotty, 2008: 3).
Low interest rates, cheap loans and the rising leverage of investments
Between 1996 and 2004 there was a significant decline in long-term interest rates in the US. This was associated with a high and rising current account (and trade) deficit. The US had to borrow large sums of money from abroad, particularly from China, the oil producing countries and Russia, to finance the deficit. This inflow of foreign funds lowered long-term interest rates and was re-loaned by US financial institutions to consumers, homebuyers and financial investors (Labonte and Makinen, 2004; Bernanke, 2005; 2007; Foley, 2009: 13; Morris 2009: 88-91, 98; Munchau, 2010: 198-206).
After the collapse of the 1990s’ stock market boom (the dot-com boom), the US Federal Reserve cut short term interest rates in late 2000 in order to stimulate the economy. It held them at record lows until mid-2004. Real interest rates, adjusted for inflation, were actually negative in this period up to mid-2005 (Crotty, 2008: 51; Morris, 2009: 59). That is, for bankers the “money was free” (Morris, 2009: 59). Financial firms of various kinds could then borrow very cheaply and use the extra funds to increase their loans and profit margins (Crotty, 2008: 51). As long as they borrowed money at a lower rate than they received on their investments, leverage could greatly increase their financial returns. US financial institutions nearly doubled their borrowing from 62 percent of GDP in 1997 to 114 percent of GDP in 2007 (Crotty, 2008: 50). At the same time, lending was becoming costless as mortgages and commercial loans were being parcelled up and sold on to other investors, and with the rise of credit insurance, investors believed they were not at risk of loan defaults. “When money is free, and lending is costless and riskless, the rational lender will keep lending until there is no one else to lend to” (Morris, 2009: 61).
The large investment banks increased their asset-to-equity (or leverage) ratios from twenty-three in 2004 to thirty by 2007. That means that for every one dollar of equity or capital the banks had twenty-three to thirty dollars in assets funded by lending. A ratio of thirty-three, however, also means that for every one dollar of capital, the banks had thirty-two dollars worth of liabilities. By the end of the year, the investment banks, Morgan Stanley and Bear Stearns, had reached asset-to-equity ratios of thirty-three to one (Crotty, 2008: 50). The commercial banks were also dangerously leveraged but this was not apparent because they kept a large proportion of their assets, in some cases more than half, off their balance sheets. This amounted to trillions of dollars worth of assets (Crotty, 2008: 52).
The economist Nouriel Roubini (2007) has outlined how easy and risky it was to develop very high levels of leverage for investment:
… today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds [an investment fund that has a portfolio of other investment funds] that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we (sic) got an overall leverage ratio of 100 to 1. Then, even a small 1 percent fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards.
The rise in leveraging vastly inflated the size of financial markets in relation to the real economy (Crotty, 2008: 52). The value of US financial assets was “less than five times larger than US GDP in 1980, but over ten times as large in 2007” (Crotty, 2008: 10). High levels of leveraging increased the financial fragility of the system and the prospect of a breakdown. With high rates of leveraging, even a small fall in asset prices can trigger a crisis (Crotty, 2008: 51-52).
The spread of risk throughout world financial markets
Securitisation also played a major role in spreading financial risks globally. Once financial assets, such as debts, were securitised into MBSs and CDOs they were sold to central banks, private banks and wealthy investment funds around the world. Virtually all major financial institutions were involved in creating and selling these products. The government sponsored enterprises, Fannie Mae and Freddie Mac, were a major source of these risky securities as they were legally required “to buy the ‘bad’ subprime mortgage loans created by private lenders” (Rasmus, 2009: 44). They owned or guaranteed almost half of the $12 trillion worth of US mortgage loans (Sustar, 2008). Fannie and Freddie then resold about $1.7 trillion of this debt to central banks and other banks around the world (Rasmus, 2009: 44).
Light or absent government regulation of the financial sector
There are three main aspects to the light or absent regulation of the financial sector: government deregulation of financial activity; the lack of regulation of parts of the financial sector; and regulatory failure. One important example of the deregulation of finance in the US was the repeal of the Glass-Steagall provisions of the Banking Act 1933. This act was introduced by the Roosevelt administration in the wake of the Great Depression of the 1930s. The aim of the Glass-Steagall provisions was to separate commercial and investment banking. The government believed that, when these two forms of banking were mixed, commercial banks might use their deposit base to make questionable loans, such as for financial speculation or for bailing out their insolvent investment bank affiliates. The US Federal Government believed that the role of commercial banks in financial speculation in the 1930s contributed to their insolvency and the loss of public confidence in the banking system (Russell, 2008: 253). Wall Street banks lobbied the US Congress for over 25 years to repeal the Glass-Steagall provisions. In 1987 they were successful in having most of the provisions removed. President Bill Clinton removed the remaining restrictions on the banks in 1999. This allowed them to operate in a similar way to banks before the 1929 stock market crash (Whitney, 2008: 199). Banks were again free to make risky investments provided they did so through their affiliated hedge funds and special investment vehicles. These risky investments included the complex derivatives, such as mortgage backed securities and collateralised debt obligations, that even experts had trouble understanding and pricing (Canova, 2008: 46; Whitney, 2008: 199).
A second important example of financial deregulation was the gradual removal of “selective credit controls”. Starting with the administration of Jimmy Carter and continuing through to the Clinton years, Federal Reserve regulations that required minimum down-payments and maximum periods of repayment for various types of loans were repealed. These were designed to reduce financial risk by discouraging subprime mortgage loans for borrowers likely to fall behind or default on their repayments. Without these controls, loans could be made to people without minimum down-payments or even any documentation of income (Canova, 2008: 43). Finally, the Securities and Exchange Commission relaxed capital-base and leverage restrictions on large investment banks in 2004. This allowed the banks to use their capital for new activities and to choose their own leverage ratios based on their own models of risk. The result was a big rise in the banks’ leverage ratios and the transfer of capital to collateralised debt obligations (Gowan, 2009: 15).
Parts of the financial sector were also unregulated or had, at best, minimal regulation. There was virtually no regulation of the so-called “shadow banking system”: the powerful non-bank financial institutions, such as bank-created special investment vehicles, private equity funds and hedge funds (Crotty, 2008: 7). The combined assets of this system were estimated to be about $10.5 trillion (Geithner, 2008). In 2000, after sustained lobbying from Wall Street banks, President Clinton signed into law an act (the Commodity Futures Modernization Act) which protected derivatives markets from regulation (Canova, 2008: 46). Most derivatives, including credit default swaps, are sold outside regulated markets so no one really knows what the total exposure is, who holds which derivatives, or what their value is. When Lehman Brothers bank got into financial trouble in September 2008, neither they nor the government had any idea of what their exposure to derivatives was. This can make banks wary of lending to each other when some of them are sitting on time bombs of toxic financial waste (Guerrera and Bullock, 2008; McNally, 2009: 69).
Finally, there were important failures of regulatory oversight and action. Regulatory officials, including the Federal Reserve Chairman, Alan Greenspan, failed to properly supervise the banks, understand the poor risk management practices of private lenders, take action against predatory lending practices on high-interest payday loans and subprime mortgages, and failed to act on warnings of financial and economic danger ahead. Greenspan was awarded an honorary knighthood by Queen Elizabeth II in 2002 for his “contribution to global economic stability” (BBC News World Edition, 2002; Canova, 2008: 43; Garnaut, 2009; Hale, 2009: 31; Kotz, 2009: 313-314; Morris, 2009: 68-69).
The failure of regulators and regulatory bodies can be explained, in part, by the significant degree of “regulatory capture” effected by the US financial sector. Regulatory capture is when regulators — those who supervise and police an industry in the public interest — come to advocate for the interests of those they are supposed to regulate (Garnaut, 2009: 75). This is evident in the way senior personnel from the finance sector with anti-regulatory views and agendas came to hold top positions in key institutions, such as the Treasury and Federal Reserve. Alan Greenspan, for example, left JP Morgan Bank to become Chairman of the US Federal Reserve in 1987, and both Robert Rubin and Henry Paulson left Goldman Sachs, as co-chairman and chief executive officer (CEO) respectively, to work as Treasury Secretaries under Bill Clinton and George W. Bush. Greenspan and Rubin, among other things, used their positions to prevent the regulation of the shadow banking system. They then returned to lucrative positions in the financial sector (Johnson, 2009; Garnaut, 2009: 76-77). Paulson, while CEO at Goldman Sachs, had the bank buy heavily into CDOs based on mainly fraudulent liar loans. When he became US Treasury Secretary, he “launched a successful war against securities and banking regulation” (Black, B. 2010). These high profile examples are just the tip of the iceberg. According to Johnson (2009) the personal connections between the financial sector and politics ”were multiplied many times over at the lower levels of the past three presidential administrations, strengthening the ties between Washington and Wall Street”.
In addition, between 1998-2008, US financial firms spent over $5.1 billion purchasing political influence in Washington for their corporate interests, including a deregulated financial environment. They spent over $1.7 billion on election funding in this period with about 55 percent of funding going to the Republicans and 45 percent of funding going to the Democrats. They also spent over $3.4 billion on lobbying federal officials for policies favourable to the sector. They employed nearly 3000 lobbyists in 2007 to advocate for their interests, with more than five paid lobbyists for every Member of Congress. A survey of just the top twenty financial firms between 1998-2008 found they employed 142 lobbyists who were previously top officials in government, Members of Congress or members of congressional staff (Weissman and Donahue, 2009). Having worked in government, these lobbyists would have had the advantages of inside knowledge of the political system, personal connections to key contacts, decision makers, and their staff, and enhanced access to the corridors of power.
The US housing asset bubble
Between the end of the Second World War and 1995, US house prices were generally in step with the overall rate of inflation. However, between 1995 and the summer of 2007, house prices rose by 70 percent even after allowing for increases associated with the overall rate of inflation. This represented some $8 trillion in inflated new housing wealth or 40 per cent of a total housing wealth of $20 trillion (Baker, 2007: 2; Kotz, 2009: 311). The rapid rise in house prices was due to a range of factors, including growing demand for homes, government and private sector promotion of home ownership, the growing supply of credit that was available for mortgages, very low interest rates, financial speculation by investors hoping to profit from rising house prices, and fears among some home buyers, such as first-time home buyers, that if they did not enter the housing market they would be permanently unable to afford a home (Beitel, 2008: 32-34; Stanford 2008). In Marxist terms, the asset bubble arose from an attempt to expand the economy faster than the flow of new value which was being generated in production. This new value provides the basis of the wages and salaries people use to pay their mortgages. When house prices increased much faster than workers’ incomes, an unsustainable bubble was created (Kliman, 2009: 52).
The bubble started to burst in 2006 as rising interest rates reduced house prices (Foster and Magdoff, 2009: 97) and “increasing numbers of largely black, Latino and working-class white families in the US” began defaulting on their mortgages (dos Santos, 2009: 180-181). The financial system was so fragile at this point that probably any one of a number of factors could have triggered the crisis, including defaults on credit card debts or commercial loans (Foley, 2009: 13).
The “credit crunch”
As people defaulted on their mortgages, the value of their assets (houses) declined, and the institutions that held those assets were threatened with insolvency (Foley, 2009: 13). When two Bear Stearns hedge funds collapsed in July 2007 a severe credit crunch developed (Foster and Magdoff, 2009: 98). Institutions were unwilling to lend freely to each other because they were unsure of the levels of toxic assets they were holding. It was the start of the global financial crisis and the flow of credit to the real economy threatened to dry up (Foley, 2009: 14).
This paper has argued that the global financial crisis of 2007-2008 had a complex set of causes. These were connected to underlying features of the US capitalist economy where the crisis began. A low rate of profit and large economic inequalities led to increasing capital flow into the financial sector and increasing recourse to credit by US workers whose real incomes were in decline from the early 1970s. New financial innovations, which developed in the wake of financial deregulation and floating exchange rates, enabled debt to be parcelled into complex and opaque new financial products. These could be sold on to other investors freeing up capital for more loans, generating fee income and passing risk down a chain of buyers. Risky financial products were given favourable credit ratings by credit ratings agencies whose own profits depended on their inflated ratings. Credit default swaps seemed to provide extra insurance for mortgage-backed and other securities but heightened the risks to the financial system of a complete meltdown. The availability of free money, with cheap and apparently riskless lending enabled the rising leverage of investments; securitisation helped to spread the risks to global financial markets; and light or absent government regulation of finance cleared the way for these developments. A huge asset bubble developed in the housing sector which burst when interest rates rose and people began defaulting on their mortgages. As the value of housing assets fell, the institutions that held those assets were threatened with insolvency. A severe credit crunch developed when these institutions would no longer lend to each other.
This paper is a revised version of a paper presented at the International Conference on Financial Crises: Causes, Characteristics and Effects, Edith Cowan University, Perth, Western Australia, November 2009.
I would particularly like to thank Peter Khoury and Elaine Granger for encouraging my work on this paper, and for helping me locate some of the research material. I would also like to thank Eddie Clynes for his helpful editorial comments on the paper.
* Dr Ross Morrow, Department of Sociology and Social Policy, University of Sydney
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