Great Leap Forward

The Global Financial Crisis: No Lessons Learned

As a reminder, my blog addresses economic issues from the perspective of what is commonly called “modern money theory”. (As the great philosopher Yogi Berra said, “you can look it up”—or Google it.) However, the subjects tackled go far beyond the topic of monetary theory, hence, I also draw on other traditions including Keynesian theory, the Institutionalist approach, and the work of Hyman Minsky (my dissertation advisor). Still, as indicated by the masthead the blog is mostly forward-looking–with a glance back to history. As Minsky always told me, “we stand on the shoulders of giants”. The perspective adopted in all my blogs is unashamedly progressive and unapologetically critical. As we always said in the 1960’s, “question authority”. If I haven’t pissed-off somebody each week, I’ve failed.

On to the topic for today: the lessons we should have learned from the Global Financial Crisis (GFC), but didn’t. Here we are, half a decade into the Collapse of Western Society.

Yes, you read that right. It’s over. I’ll say more about that in coming days. But let us review the recent past before we look to the future.

For Washington and Wall Street (is there any longer a difference?) the GFC is but a distant memory. The tens of trillions of dollars (that is not an exaggeration) committed by Uncle Sam to the bail-out of banksters has been claimed to be a great success. Wall Street’s share is back up to 40% of all corporate profits. The rich are doing just fine, thank you. Compensation, profits, stock options, and bonuses are up for our elite class. According to a new study (by Andrew Sum, Ishwar Khatiwada, Joseph McLaughlin and Sheila Palma at Northeastern), since “recovery” began in the second quarter of 2009 corporate profits took 88% of the growth in national income. Workers? Oh, they captured just 1% of that growth. And all of that was in the form of benefits (thanks to rising healthcare costs!)—real wages and salaries actually fell for the first time ever in a “recovery”. Needless to say, it is also a jobless recovery—the worst performance ever in terms of employment creation, too.

But that is easy to overlook in Washington/Wall Street since the biggest financial institutions escaped with barely a scratch, and have returned to the same practices and rewards that caused the GFC. By hook and by crook, Wall Street also escaped re-regulation as the flaccid Dodd-Frank Act avoided any fundamental reform. In any case, the Republicans have made clear that they will not provide new funding to regulatory agencies, so even the weak rules in the Act will never get enforced. And, so far (fingers crossed!) none of the big Wall Street crooks has been prosecuted for high crimes. Yes there have been some fines and civil cases, and a few lesser criminals like Bernie Madoff were sacrificed, but all the big banksters are not only free—they are still running their criminal organizations (called “chartered banks” in polite conversation), advising the White House, and gearing up to fund the next presidential campaign.

All of that is to say that financial reform is deader than Elvis. Nothing can be done until the next Wall Street-induced crash. But I am an eternal optimist—the crash will come soon—and so it is time to enumerate the lessons we should have learned from the GFC so as to prepare the reforms that should have been adopted.

1.      The GFC was not a “liquidity crisis”. At a recent conference, one of the Treasury officials who participated in the bail-out told me that the crisis really just amounted to a “global missed payment”. The whole world was just short a few bucks in its checking account. Uncle Sam provided overdraft facilities and resolved the problem. No harm, no foul (the Treasury official actually used those words). As granddad would say, “bullpucky”. What actually happened is that default rates on risky mortgage loans rose sharply while home prices plateaued. Megabanks took a look at their balance sheets and realized they were not only holding trashy mortgage products, but also lots of liabilities of other mega financial institutions. It suddenly dawned on them that all the others probably had balance sheets as bad as theirs, so they refused to roll-over those short-term liabilities. And since the Leviathans were highly interconnected, when they stopped lending to one another the whole Ponzi pyramid scheme collapsed.

To label that a liquidity crisis is silly. It was massive insolvency on a Biblical scale that led to the “run on liquidity” (really, a refusal to refinance one’s fellow crooks—criminal enterprise always relies on trust, you know). The banks had no good assets, just trashy real estate derivatives plus loans to each other, all backed by nothing other than a fog of deceit. All it took was for one gambling banker to call the bluff. Every banker looked for an even bigger sucker to refinance the junk. The only saps left standing sat (so to speak) in Washington. And that is why it took tens of trillions of lending, spending, and guaranteeing of trash by Uncle Sam acting as sucker of last resort to stop the carnage. (As every gambler knows, if you do not know who the sucker is within 5 minutes of beginning the game, you are the sucker.)

All the big banks are still insolvent. It is only the backing provided by Tim Geithner and Ben Bernanke as well as the “extend and pretend” policy adopted by regulators that keeps them open. As we know from the Savings and Loan crisis of the 1980s, leaving insolvent institutions open only blows the hole bigger—especially when you leave the fraudsters in charge so they can run what my colleague Bill Black calls a “control fraud” that loots the institution to pay top management huge bonuses. Sound familiar? As our philosopher Yogi says, it’s déjà vu all over again. But this time the vu is a heck of a lot bigger than the déjà.

2.      We should have learned that underwriting matters. That is the process of determining credit-worthiness of borrowers and putting in place incentives to ensure payments will be made as they come due. All the big institutions involved in home finance eliminated underwriting over the past decade. The “efficient markets” hypothesis said you really do not need that because markets will discover the proper prices for securitized loans; and lending was so much easier and cheaper to do if you did not bother to check the financial capacity of the borrower. Hence, Liar’s Loans and NINJA Loans (no income, no job, no assets, no problem!).

If you look closely at recent financial crises you find that the cause is usually deterioration of underwriting standards. Market discipline does not work because when some asset class is booming, lenders come to expect that prices of those assets will continue to rise. Lenders will lend more relative to value, current income, and expected cash flow because asset price appreciation makes most loans good. If things do not work out, loans can be refinanced, or the collateral can be seized and sold. It goes on until someone asks about the Emperor’s New Clothes. The discovery that the asset is as naked as the Emperor’s derrière causes prices to reverse course and then to collapse, so borrowers sink underwater and lenders are left insolvent.

I realize that it appears banks have retrenched, tightening standards and cutting off loans to all but the most credit-worthy. They apparently learned their lesson? That always happens in the aftermath. But the point is that there have been no significant regulatory and supervisory reforms put in place to deal with the next euphoric boom. Hence, underwriting standards will again decline—gradually at first and then with a rush to the bottom, with those lenders willing to adopt the lowest standards “winning”. Market “discipline” is always perverse—there is no lending when it is most needed, and no underwriting when that is most needed.

3.      The third lesson is that unregulated and unsupervised financial institutions naturally evolve into control frauds. As Willy Sutton responded when he was asked why he robbed banks, he said “because that’s where the money is.” Of course, he was small time. According to Bill Black, the best way to rob a bank is to own one. Well, it’s even better to run one—just ask Bob Rubin or Hank Paulson or Jamie Dimon, or “doing God’s work” Lloyd Blankfein. The hired gun in charge can strip the bank of far more money than the owners will ever get—and one CEO’s take can dwarf the sum total of all bank robbers in recent US history.

But, we still do not want to recognize that there is fraud everywhere you look. We know that the banks committed lender fraud on an unprecedented scale (the best estimate is that 80% of all mortgage fraud was committed by lenders); we know they continue to commit foreclosure fraud (and that their creation, MERS, has irretrievably damaged the nation’s property records—this will take a decade to sort out); and we know they duped investors into buying toxic waste securities (using bait and switch—substituting the worst mortgages into the pools) and then bet against them using credit default swaps. Every time an investigator finally musters the courage to go after one of these banks, fraud is uncovered and a settlement is recovered.

Fraud became normal business practice. I have compared the home finance food chain to Shrek’s onion: every layer was fraudulent, from the real estate agents to the appraisers and mortgage brokers who overpriced the property and induced borrowers into terms they could not afford, to the investment banks and their subsidiary trusts that securitized the mortgages, to the credit ratings agencies and accounting firms that validated values and practices, to the servicers and judges who allow banks to steal homes, and on to CEOs and lawyers who signed off on the fraud. To say that this is the biggest scandal in human history is an understatement.

4.      And the worst part is the cover-up. We should have known since the Watergate years that it is the cover-up that really bites. If you think about the real estate food chain, it all begins with some poor slob mortgage broker working out of his garage. He’s told that if he can increase his through-put and induce borrowers to take more expensive loans than they actually qualify for, his rewards will be increased. The lender banks created Orwellian-named “affordability products” that insiders called neutron bomb mortgages (designed to blow up and kill the borrower, but leave the home standing) and told the brokers to make those and to refuse the usual documents required for loans—such as W-2 forms and bank account information. Why? As Ollie North put it, “plausible deniability”. Hey, we didn’t know this unemployed guy couldn’t afford a half million dollar home in Brookside Acres with an exploding adjustable rate mortgage loan at 120% of home value! That borrower defrauded us (add whimpers for effect)!

Once you’ve made a Liar’s loan, every other link in the home finance chain must be tainted. And that means every transaction, every certification, every rating, every signature all the way up to the CEO of the investment bank is part of the cover-up. Not to mention the President of the New York Fed (oh, remind me, where did he go?) who has access to the doctored bank books.  And remember those “stress tests”, passed by all the banks, whose balance sheets were government-certified A-OK? Who was it that signed off on that?

We do not need to make the accusation of conspiracy. Individual self-interest (known as “covering one’s rear-end”) will do the trick. The only questions remaining for everyone operating in that chain were these: how can I make a buck?, how can I get out of this Ponzi scheme before it collapses?, and how can I stay out of jail? Well, they made the bucks; most did not exit before the collapse, but Uncle Sam covered their tails; and now they are waiting for the statute of limitations to run out while the nation’s top cops look the other way. That clock is ticking.

But we haven’t learned any of these lessons. We’ve done no reforming. We let the Ponzi schemes continue, run by the same crooks. We’re going to let them contribute the estimated $1 billion that will flow to the reelection campaign of President Obama. And we expect that history will not repeat itself. Isn’t that the clinical definition of insanity?

32 Responses to “The Global Financial Crisis: No Lessons Learned”

eaandersDecember 16th, 2013 at 12:27 am

"We’re going to let them contribute the estimated $1 billion that will flow to the reelection campaign of President Obama".

Well, this certainly seems peculiar, since Obama was already elected for the last time.

AJSDecember 16th, 2013 at 1:16 am

Ha nice one Prof Wray.
Clearly the peculiar aspect of this post is the unusual degree of restraint and use of euphemism, rather than telling it how it is. 🙂

Either that at it’s the time shift at the end that indicates this was written pre Obama’s re-election (the one where he fail to challenge Romney on the myth that China pays for the US gov deficit). So not only have we learnt nothing – we still haven’t earner anything a couple if years later.

BTW UK property market already looks like it’s back in lax mortgage standards zone.

JohnZelnickerDecember 16th, 2013 at 1:29 am

Prof. Wray — I'm not sure about what peculiarity you refer to, but I was in the streets questioning authority and protesting the Vietnam War and the draft in the '60's, including the March on Washington in the winter of 1969 and you look way too young to have been there.

Great post, by the way. Spot on.

JohnZelnickerDecember 16th, 2013 at 1:52 am

Not meant to be flattering, just what I see. Maybe the picture of you used here is old. 🙂

Ok, second try. There is nothing in this post that I can see that refers, even indirectly, to MMT.

L. Randall Wray L. Randall WrayDecember 16th, 2013 at 2:26 am

JZ: you are hot; darned hot. But not there yet. Good find, tho.

yes i know it doesn’t mention mmt, but i’m not a one-note charley, as I said in this post–right?

AJSDecember 16th, 2013 at 3:34 am

OK found it – this post is (bar the first paragraph) from your July 6th, 2011 post on this site, entitled: lessons we should have learned.

No going to risk posting the link in case that blocks this comment.

L. Randall Wray L. Randall WrayDecember 16th, 2013 at 3:37 am

BINGO. Ok, what prize do you want? How about half price registration at the upcoming Big, 20th meeting of the Post Keynesian conference in beautiful Kansas City? You can meet all the MMTers in person.

lrwrayDecember 16th, 2013 at 3:43 am

I was making a point. Two and a half years later, much water under the bridge, 200+ blog posts here on GLF AND THE USA ECONOMY IS STILL STUCK WHERE IT WAS WHEN I WROTE THE FIRST DARNED POST. I think almost everything I said turned out to be true, in spades. The Fraudster Banks are all over all the front pages. Caught redhanded, paying fines for all manner of criminal activity. Still engaged in home stealing. All the USA property records are still a mess. Obama adminstration still protecting the worst crooks. No one going to jail. Read it and weep. This is the End of Western Society, folks. You are watching Rome Burn while our leaders fiddle.

eaandersDecember 16th, 2013 at 3:44 am

Were you referring to the "Collapse of Western Society" on YouTube?

Otherwise, why would you capitalize it like a title?

Also, "you can look it up" is attributed to "Casey Stengel"

L. Randall Wray L. Randall WrayDecember 16th, 2013 at 12:29 pm

OK Note also that it was my FIRST GLF post. We need to figure out the runner-up prize. First prize was half-price registration to the upcoming PK conference in KC. How about choosing one of the following:
a) I’ll name my next child after you if you tell me how to prounounce AJS.
b) Full price registration to the next MMR/MR conference.
c) or????

rakddsDecember 16th, 2013 at 1:17 pm

I have been following MMT since Warren came out with 7DIF. I read it because I have met Warren a few times through a mutual friend via a charity bike ride we all do annually. This past August, I actually spent the good part of an afternoon chewing the fat with Warren about MMT and the politics it is up against and we talked about your (plural) efforts at UMKC.

I love following MMT, but as a dentist my sphere of influence is pretty limited. My warped sense of humor tells me should give my prize to Cullen Roche. I would consider going just because it would be a cool thing to do for me personally, but the prize might be better served for someone in the field.
By the way, I read Understanding Modern Money and your year long Primer. You may have a progressive lean, but one of the qualities I admire, is your ability to fully grasp and explain MMT from all points of view. I look forward to your posts and occasional videos that pop up.

L. Randall Wray L. Randall WrayDecember 16th, 2013 at 2:07 pm

Rakdds: aha i figured i knew what the dds was. Well, when you’ve got someone pinned to the chair and mouth full, that’s the perfect time to teach MMT. Captive audience, so to speak.
I can’t think of a better person to come to the PK conference. The registration fee is low anyway–but the offer stands. When you register, just let them know you are a prize winner.

Adam_SmithDecember 17th, 2013 at 4:02 pm

Thank you Professor Wray. With so many prominent economists such as Paul Krugman and Larry Summers treating the GFC like an amusing academic puzzle, not to be probed too deeply so as to not be outcast from the established order, your blunt appraisal is very refreshing. I assume you have tenure.

PZ_December 18th, 2013 at 2:14 pm

Are you saying that GLF shoud have made the difference? One wonders how many readers you have here anyway and why not cross-post at least some of the stuff to NEP where there is much more audience one presumes.

This has been excellent blog, I have enjoyed it. So it is that more shame when I presume that audience here is small, so that few people get to enjoy it. Thank you for all the work you have done and merry cristmas! 🙂

L. Randall Wray L. Randall WrayDecember 18th, 2013 at 7:25 pm

Actually readership here is good. The idea always was: a) to supplement NEP, not replace it; people like you are already reading MMT and related stuff at NEP. Economonitor had a different readership. Maybe they are converging, I do not know;
and b) let me harp on idiosyncratic topics of interest to me.
BTW: NEP is out in front of our critics in terms of blog rankings.