A Critical Analysis of the U.S. Causes of the Global Financial Crisis of 2007-2008

Published on political affairs pa, by Ross Morrow, January 4, 2011.

… 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’ … (full huge long text and References).

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