Who does the financing and what is financed have always been key questions in the evolution and behavior of American capitalism. Historically, powerful financial institutions in the United States have tended to follow a strategy of profiting from the capital development of the country. But over the past 25 years, “sophisticated” financial players (investment banks, the major money center banks, hedge funds, and Government Sponsored Enterprises (GSEs)—all implicitly backed by the Federal Reserve and the U.S. Treasury—have come to dominate financial decision-making and, in turn, the American economy.[1] The essence of their recently acquired power was in their ability to create and finance enormous quantities of new debt through the manufacture of “innovative” financial instruments. As a consequence, financial profits as a percentage of U.S. corporate profits grew from a low of 12% in 1984 to 37.6% in 2007, with non-productive debt supplanting the financing of sound business investment.[2]
The creation of such financial profits was, in turn, dependent upon professional expertise. Over the years Paul Piccone has argued, in the pages of Telos, that a managerial New Class operating in both the public and private sectors used its cultural capital (knowledge) to secure a privileged social position for itself while simultaneously arguing on a policy level for a greater centralization of its own political power through an expansion of the institutional reach of the public and private entities which they increasingly controlled. This relatively new power position was based not so much on ownership as on the invention and manipulation of concepts and symbols.[3] Looking more closely at the process of financial “innovation” in mortgage-backed securities and their derivative products in both the public and private sectors reveals a striking example of managerial New Class dynamics of domination in full swing.
Private-Sector Intellectuals and Mortgage-Backed Securities
The idea of a derivative or a financial product whose price is dependent or derived from an underlying asset was invented by young investment bankers in the mid-1980s.[4] The initial product was called an interest-rate swap or foreign exchange swap, which enabled investors to place bets on movements in interest rates or currencies. Government Sponsored Enterprises (GSEs) (such as Fannie Mae and Freddie Mac) were early users of these instruments to both control their interest rate risk and to manage exchange rate risk associated with their foreign currency denominated debt.
In the mid-1990s, another group of bright young bankers working in J.P. Morgan’s derivative department, known within the industry as the Morgan Mafia, met in Boca Raton, Florida, to brainstorm. They came up with the idea of applying derivatives for the first time to credit, specifically corporate loans. According to Gillian Tett, at that time Capital Markets Editor for the Financial Times, the individual in charge of the Florida meeting was a then 29-year-old Peter Hancock, described as “a highly intellectual man, with an amiable face who exuded the courteous manner of an English country doctor rather than a Wall Street financier.” Tett relates that initially Hancock had little interest in becoming a banker but instead wanted to be an inventor. He drifted into derivatives because it was an area in banking that came close to offering the thrill of scientific research. Other people in Hancock’s brain trust were Tim Frost, who had an economics degree from the London School of Economics, Terri Duhon, who studied math at MIT, and Blythe Masters, who attended King’s public school in Canterbury before completing an economics degree at Cambridge University. She stated to Tett that derivatives appealed to her because they required so much creativity. Masters later went on to become chief financial officer at JPMorgan Chase.[5]
J.P. Morgan’s top management also had a compelling reason to “innovate” at that time. The bank had so many loans on its books that it was finding it expensive to keep doing business since it needed large “rainy day” reserves to protect against the possibility of these loans on its balance sheet going bad. The cultural capital people who made up the derivatives team at J.P. Morgan then came up with the idea to sell the “default risk” to somebody else by re-packaging the loans into a derivative, thus persuading regulators that the bank did not need such big reserves to protect themselves and thereby allowing the bank to free up funds to make even more loans. This esoteric product can to be known later as a collateralized debt obligation (CDO) or a financial security backed by a pool of loans.[6]
In 1997, Tett notes, other investment banking teams that traditionally handled subprime mortgages—or loans extended to borrowers with a poor credit history—started talking with derivatives groups. Tett states that the bingo moment was in the Chicago office of J.P. Morgan when the credit derivatives people and the securitization people met in the same coffee line. Out of this collusion bankers began to use subprime loans to create bundles of loan default risk.[7] J.P. Morgan thus became more of a manufacturer of loans that were both originated and sold over a short period of time, with the selling of the loans removing credit risks from its balance sheet.
Back in the good ole days, prior to 1980, home ownership was seen as a sign of middle-class status and as way to create better neighbors and stronger communities. The average home owner took out a 30-year fixed rate mortgage from his local banker who had personally evaluated his credit worthiness, put 20% down, and made monthly payments of principal and interest. This model of making money in the financial industry was called “originate and hold.” The local bank held onto the mortgage until it was paid off by the homeowner.
Beginning with the derivatives created in the mid-1980s, risk began moving from bank balance sheets, where it was regulated and more or less observable, to places where it was not regulated and not observable. Securitization—the pooling of assets to serve as collateral against issued securities—formalized the “originate and distribute” model of financial practice. Nouriel Roubini has described how the securitized mortgage product was “distributed.”[8] It started with peddling mortgages that were toxic in every aspect of their features: no down payment; no verification of income, assets, or jobs (effectively “liar loans”); interest rate only mortgages; negative amortization mortgages; and teaser rates. Mortgage lenders, including banks, were then able to generate more loans by packaging up their mortgages (usually 1,000 to 5,000 individual mortgages) into mortgage backed securities (MBS), making a fee in the process and transferring the risk down the line.
All of these securitized financial instruments were given high credit ratings by the major credit-rating agencies like Moody’s and Standard and Poor’s. The credit rating agencies, in turn, received a fee for the services. This fee generation machine also included the home appraiser, who was being paid by the mortgage originators and had all the incentive to inflate the appraised value of the home. In addition, the mortgage service companies received a fee from servicing the mortgages.[9]
The securitization food chain then went to the investment banks, who sliced and diced the MBS into various levels of risk and repackaged them into collateralized debt obligations (CDOs), making fees on that process as well as on their management of the instruments. These investment banks were transformed through this dynamic, moving from simply facilitating access to capital markets to becoming gigantic manufacturers of all forms of credit assets.[10]
The volume of new financial instruments created through securitization was astounding. At the end of 2007, it was estimated that the total U.S. securitized bond market was $10.2 trillion, of which the type of residential mortgage-backed securities described by Roubini made up $7.1 trillion (with so-called prime mortgages at $5.8 trillion, subprime at $1.3 trillion, and commercial mortgage-backed securities at $650 billion). Other asset-backed securities of the type originated by JPMorgan Chase totaled nearly $2.5 trillion, including home equity, credit card, student loans, auto-related, and CDOs.[11]
As a result of the process of securitization, individual financial incentives within financial companies no longer had much linkage to traditional capital development of the economy but were based instead on a continued expansion of financial debt instruments. At its peak, in 2006-2007, securitization seemed to imply an almost unlimited capacity for creating credit and for generating personal wealth for the private sector intellectuals involved.
Public Sector Intellectuals and Mortgage-Backed Securities
Without Government Sponsored Enterprises (GSEs) being the primary buyers of mortgage-backed securities, the Wall Street credit boom would never have reached its present magnitude. At present, a crucial role of key public-sector intellectuals at the Federal Reserve and the U.S. Treasury (i.e., Ben Bernanke and Hank Paulson), along with a largely bought-off U.S. Congress, is to transfer the liability of these increasingly worthless financial instruments that still exist in the balance sheets of both the private sector financial houses and the GSEs as well as in the portfolios of major world central banks, to the American taxpayer.
As the socialization of losses accelerates, it will also be important to monitor emerging political relations. The Federal Reserve and the U.S. Treasury will enjoy greatly expanded powers. The most prominent remaining portions of Wall Street (firms like Goldman Sachs and JPMorgan Chase) will consolidate their control over the private financial sphere. And the same private and public sector intellectuals who were responsible for generating the creation and distribution of mortgage-backed securities will remain financially and politically secure because they will be in charge of the new administrative regime—Wall Street Socialism.
Notes
1. See, in particular, Doug Noland, “Financial Arbitrage Capitalism,” Credit Bubble Bulletin, December 27, 2001; and “Revisiting Financial Arbitrage Capitalism,” Credit Bubble Bulletin, May 2, 2008.
2. “The Close of the Era of Peace and Quiet,” Grant’s Interest Rate Observer, May 2, 2008, p. 4.
3. See, for example, Paul Piccone, “Postmodern Populism,” Telos 103 (Spring 1995): 45-86.
4. Gillian Tett, “The Dream Machine,” Financial Times, March 25-26, 2006, pp. W1-W2.
5. Ibid., and Gillian Tett, “Derivative Thinking,” Financial Times, May 30, 2008.
6. Ibid.
7. Ibid.
8. Nouriel Roubini, “How Will Financial Institutions Make Money Now That the Securitization Food Chain is Broken?” RGE Monitor, May 19, 2008.
9. Ibid.
10. Ibid.
11. L. Randall Wray, “Financial Market Meltdown: What We Can Learn from Minsky,” The Levy Economic Institute of Bard College Public Policy Brief, no. 94 (2008): 15.
