The Independent Uganda: You get the Truth we Pay the Price
The presidential election in America, although run by two political parties, actually offers little choice for the ordinary voter
As the American election gets near, the partisans on either side have assembled to criticise one another and show that there are actually serious policy differences between the Democrats and Republics and between President Barak Obama and his challenger, Mitt Romney. Yet increasingly, the United States has degenerated into a one party state divided into two factions: one calling itself Democratic and the other, Republican. The two parties keep recycling the same people who have promoted policies that have left the US as the world’s most indebted nation. The genius of this system is to make most Americans believe if offers alternatives.
For example, although Democrats claim that the cause of the 2008 financial crisis was caused by George W. Bush, the deregulation of the financial sector that began under Ronald Reagan (a Republican) were carried through with passion and zeal by the Bill Clinton administration (Democrats) supported by leading Republicans in the House and Senate. Bush only carried to the logical, albeit tragic, conclusion what both parties had promoted.
For instance, in 1998 Citicorp and Travelers Group merged to form Citi Group. This merger violated the Glass-Steagall Act, which had been passed in 1933 after the Great Depression to prevent commercial banks with customer deposits from engaging in risky investment activities. The Federal Reserve (or Fed) under Allan Greenspan should have intervened to stop this merger. Instead, it gave them an exemption for one year.
Clinton’s Treasury Secretary, Robert Rubin strongly supported the act. Rubin had been the Chief Executive Officer (CEO) of Goldman Sachs. In 1999, Congress passed the Gramm-Leach-Bliley Act, which overturned Glass-Steagall and paved way for deregulation. Senator Phil Gramm, one of the sponsors of this act was the Republican chairman of the Senate banking committee. From then onwards, the combination of commercial banking with investment finance and securities trading proceeded without hindrance and was to become the leading cause of the 2008 financial meltdown.
In fact, there had been an attempt to stop this slide into financial madness by the chairperson of the Commodities Futures Trading Commission (CFTC), Brooksley Born. In 1998, she raised alarm bells that trade in unregulated Over the Counter Derivatives (OCDs) was likely to lead to chaos. Inside the Clinton Administration, a coalition of Greenspan, Rubin, his deputy Larry Summers, then chairman of the Securities Exchange Commission (SEC), Arthur Levitt worked tirelessly with the Republican controlled Congress to block Born’s attempted regulation forcing her to resign in 1999.
When he left government, Rubin became vice chairman of Citi Group and made US$ 126m in that capacity. When Gramm left the senate, he became vice chairman of UBS, one of the leading banks trading in derivatives. Gramm’s wife had served on the board of the energy giant, Enron, which later collapsed amidst corruption and fraud. Summers went on to become and earn millions of dollars as a consultant to Wall Street financial firms. When Obama came to office, he hired Summers as his economic advisor – which is like putting Dracula in charge of the blood bank.
First, a background: Previously in America and Europe, like in East Africa today, a bank lent its own money (or customers’ deposits) to a borrower – for example, to buy a home. Because the mortgage takes long to repay (anything between 15 to 30 years), banks are always careful to evaluate the credit worthiness of the borrower to ensure he/she pays back. So if you have a regular income from a job or a business and your bank records show a specific amount of income per month, you are approved for the loan. This means that there is a direct relationship between a home buyer and the lending bank. If the borrower fails to pay, the lending bank suffers.
Then came securitisation. Here, a bank lends money to many home buyers. It then bundles together thousands of these loans and issues a bond, otherwise called a “mortgage backed security”. It would then sell the bond to an investment bank. A bond is a piece of paper saying: If you buy this paper, I promise to pay you back with an interest of X percent per month for Y years. The investment bank would sell them to investors. So the lending bank would collect the money from the borrower, pay itself a commission and pass on the balance to the investment bank, which would in turn pass it on to the final investor. This secondary mortgage market (otherwise called a securities market) separated the borrower from the lender. It also transferred the risk in the event of default to the holder of the bond – the investor.
Although I have used the home buyers, there were other forms of credit which were also traded. Investment banks would combine car loans, student loans, credit card debt, corporate buy-out debt, commercial mortgages etc. into complex derivatives called Collateralised Debt Obligations (or CDOs). Investment banks would then sell these CDOs to investors all over the world. These investors were often pension funds. Because they carry long term liabilities, pension funds need long term investments to match their obligations. Since money financing such debt did not come from the commercial bank but these investors, it meant that these investors were the ultimate lenders. But this also meant that the lender did not know the borrower anymore.
Thus, when the borrower paid their mortgage, credit card debt, student loan or car loan, the money would go through the chain: the lending bank to investment bank (each of whom would collect their commission) and finally to the investors. In effect, these intermediary banks became commission agents only collecting fees. This separation of the lender from borrower encouraged intermediaries – lending banks and investment banks – to indulge in excesses. Lending banks had little interest in evaluating the credit worthiness of their borrower. They earned more money by passing on the mortgages to investment banks and hence raising more liquidity to lend to more and more people.
Investment banks enjoyed a similar incentive structure. The more CDOs they sold, the more money they made – a factor that encouraged banks to give ever more and more risky loans and investment banks to sell ever more and more toxic derivatives. In one dramatic case, a bank in California gave a US$ 720,000 home loan to a Mexican berry picker who was earning US$ 1,100 per month. This is a classic case of subprime lending gone nuts. And many of the CDOs issued against such subprime mortgages were rated AAA by rating agencies.
This shows that the incentive for banks was to maximise the volume of mortgages, not their quality. Investment banks preferred subprime mortgages because they had higher interest earnings on them. In the decade between 1996 and 2006, subprime lending grew from US$ 30 billion to US$ 600 billion. With huge profits being made, banks were encouraged to borrow heavily to issue more mortgages. The ratio of borrowed funds to a bank’s own capital is called “leverage.” By 2008 when the crisis set in, many banks were leveraged to a factor of 1:20 with some going to 1:33. This meant that the slightest percentage drop in their value would lead to insolvency.
There was, of course, something like a check on this system. Investment banks that sold these CDOs would actually give them to rating agencies to evaluate their worth. Often, the rating agencies gave them AAA ratings – the best in the world. It was because of such ratings that investors bought the CDOs. There is a problem with rating agencies: First, the higher the ratings they give, the more money they get paid. So they have an inbuilt incentive to give high ratings. Second, investment banks are the ones that paid rating agencies for these ratings – a clear case of conflict of interest. This system has a fundamental flaw: if a rating agency rated a particular CDO poorly, the investment bank can easily take the business to its rival who is willing to give a better rating.
