6. From the Rise of Finance to the Subprime Crisis

 

 

The term “Long Downturn” would seem to suggest a broad and general dip in the fortunes of the states and economies of the capitalist global North. But if we look in a little more detail, we find that it describes a shift affecting different places and sectors unequally. Indeed, more than perhaps any other sector, it was manufacturing that took the hit, and experienced the most significant downturn at the end of the Long Boom and the onset of the crisis of the welfare state, a tendency that diffused across the economy because manufacturing was arguably the most important sector from an employment perspective.

The forces behind this shift are the subject of much controversy. There is no agreement on what mattered the most, or where its origins lie. Most residents of the wealthy nations will be familiar with the story of the collapse of “good” manufacturing jobs in much of Europe and North America, and the rise of “sweatshops” in the global South, who for subsistence wages now do what “we” once did for “good money.” At a macro scale, it must be said, this story is pretty much true, although its political reasoning can serve reactionary and progressive causes equally well—many efforts to defend this or that nation’s working class unfold quite nicely along exclusionary and nationalist lines. Nevertheless, it is essential to remember that however important it was or is, manufacturing never comprised the entire North American or European economy, neither forty years ago nor today. If every sector of the rich world’s economies had experienced the problems that have plagued their manufacturing sectors since the early 1970s, their capitalisms would be in much worse shape than at present.

Financialization

A more dramatic collapse was avoided because—as every teenage job-seeker (at least in North America) is told over and over again, in an effort to prepare them for the rigours of the “real world”—while manufacturing declined in its relative contribution to economic activity, something called “services” expanded correspondingly. The category “services” covers an enormous range: from coffee shops to hair salons, consulting firms to internet service providers, from auto repair to health care, and more. It also includes “FIRE”: finance, insurance, and real estate. FIRE contains a whole host of activity; financial services on its own includes retail and investment banking, investment advice, accounting, stock brokers, tax services, etc.

The growth of services’ relative contribution to economic activity has been enormous (as measured by conventional indicators like gross domestic product, or GDP). Still, despite what many of us might imagine when we think of services, growth in incomes from the service sector is not primarily a function of the number of coffee shops and sushi restaurants, but of other services—and to a substantial degree to the “F” in FIRE. Financial services’ contribution to overall economic activity has skyrocketed since the late 1970s, from almost nothing to 8 percent of GDP in the US.53 That might not seem like much, but we must remember it means that almost one dollar in ten that moves in the US is associated with finance. Moreover, compared to other large diversified economies, 8 percent is quite large, and much larger than it used to be, especially during the capitalist “golden age” of the post–World War II boom. Eight percent is not that different from the sectoral ratios of nations commonly associated with much greater dependence on finance, nations that have established themselves as regulation- and oversight-free capitalist oases. These nations, many of them “offshore financial centres”—or, more colloquially, “tax havens”—like the Cayman Islands or the Bahamas, have hitched their economic wagons to global finance capital, attracting wealth and income flows with the promise of little regulation, no tax, and secrecy. Singapore, which many think of as a massive city-state organized around international capital flows, has only a little more of its GDP based in finance than the US (the UK is also comparable to the US; Canada is notably less finance-centric).

The story is even more interesting if we focus on corporate profits as opposed to overall spending. That 8 percent is American finance’s contribution to all domestic expenditure, a total that includes spending unassociated with, and not oriented toward, profits: state expenditure (government programs, health care, education, etc.). Relative to the proportion of the economy that is profit-seeking, finance’s contribution is much greater, and growing. It now accounts for more than 40 percent of all corporate profits in the US. Even with economic conditions as bad as were following the financial crisis that began in 2007, 40 percent of all corporate profits is an astounding amount of money, and it has a corresponding influence on the economy and its governance. Moreover, these figures still understate the matter, since they describe domestic profits alone, earned inside or repatriated to the US. They take no account international subsidiaries. Yet much of the world’s financial industry is based in London, Shanghai, etc., where all major North American firms have offices, wholly owned subsidiaries, and extremely active trading desks.

The increased role of finance in overall economic activity and the increased proportion of profits that are realized via financial channels are the two main empirical indicators of a process called financialization. I would like to suggest we work with both a general and a more technical definition of the term. First, in general, financialization describes the increasing role of financial motives, financial markets, financial actors, and financial institutions in the operation of domestic and international economies. Second, from a more technical or specific perspective, financialization is a pattern of capitalist accumulation that relies increasingly on profit-making through financial channels, even for capitalists that are not themselves financial firms.

How and why has capitalism become increasingly financialized over the past three or four decades? What does this mean for capitalism, present and future? There is a great deal of debate among political economists over financialization, and even more over where it’s headed. The answers I offer here are partly my own, and partly drawn from accounts I find compelling.54

To understand the rise of the financial sector—and its associated rise in political power—and to understand the processes of accelerating financialization more generally, we must begin again with the end of the Long Boom, focusing on a series of more finance-specific developments made possible by the macroeconomic changes described in Chapter 5. As with other aspects of the Long Downturn, only an understanding of dynamics behind the 1970s crisis of capitalism can make sense of what has happened since in the realm of finance capital. We must reject the popular idea that the rise of finance (or any other economic change of the 1970s) is an unprecedented restructuring or innovation in economic dynamics, unrelated to what came before. Instead, we can only explain the drastic changes brought about by financialization—a central component of the phenomena associated with neoliberalism—if we put it in the context of the post–World War II economy in the developed world.

At the most rudimentary “economic” level, the rise of finance can be traced to the general fall in the rate of profit in the post–World War II era. The decline began almost unnoticed, when on the surface all seemed to be well. Even in the “golden age” discussed at the beginning of Chapter 5, the rate of profit was actually declining in the US. But “business sentiment” remained high until the late 1960s, as did the rate of investment, which suppressed the effect of falling profits.

Investment stayed up for a variety of reasons, two of which are arguably most important. First, the political peace between big labour unions, big business, and big government (part of what gets called “Fordism”) that characterized this era provided, in a broad sense, a guarantee of high wages, low industrial conflict, and high profits. This reassured capitalists that they would make good money on their investments, even if the overall rate of profit seemed to be dipping a little. Second, rates of capacity utilization, consumption, and government spending meant that even if the profit rate or share was in slight decline, aggregate profits (in terms of amounts of money) stayed strong, which was further reason to invest.

But in the late 1960s, the rather slow fall in the profit rate accelerated markedly, and continued steadily until the Volcker coup of 1979–82. If you have to pick a birthday for neoliberalism, this is it. It had been gestating for a number of years, but more than any other single event, the Fed’s interest rate shock (helpfully coupled with Reagan’s assault on social services and unions) reasserted the dominance of capital in US political economic relations, and by extension throughout much of the developed North. It did so by restarting the profitability of very large corporations, the financial sector in particular. Remember how much they hate inflation?

During the 1970s, rates of investment jumped all over the place: up in response to intermittent monetary and fiscal stimulus by the Nixon, Ford, and Carter governments, and down when inflation retook centre stage. Then, with Volcker’s interest rate hikes, which made investment too expensive for many businesses, everything slowed to a crawl. In combination with the political economic forces that caused problems for the welfare state (like increasing international competition and giving more power and voice to workers), these trends led firms to look for ways of making profits other than through Long Boom–style brick-and-mortar investment.

This makes perfect sense. A firm that sees fewer and fewer opportunities for profit—in the work it does, the markets it serves, or the regions it produces in or sells to—will look around for other opportunities. This is exactly what the 1970s general decline in the rate of profit led US firms to do. And it led to a search for financialized profit. When US investment banks post record profits in the middle of the worst capitalist recession since the 1930s, as they did in 2010 and 2011, the overwhelming success of that search is evident. So while it is certainly true that for manufacturing in particular the Long Downturn has lasted since the 1970s, and that this has had important employment and productivity effects, it is essential to remember that the entire economy did not suffer the same fate as the manufacturing sector after the late 1970s. In fact, by the early 1980s, profits even began picking up generally, as many firms, both financial and nonfinancial, turned to financial channels to produce or protect returns.55

In other words, instead of building plants to augment production, or searching for new markets, many firms took existing profits and invested them in financial instruments, of which—due to computational novelty ennobled by the term “financial innovation”—there was increasing variety to suit an investor’s particular needs. New financial securities either spread investment risk across sectors, times, places, and political-economic risk profiles, or they concentrated them in one sector, or focused on a specific set of flows or eventualities. They could even be customized—an innovation especially important to the insurance industry—whereby firm-specific contracts established a flow of funds over time that could then be marketed to other investors or used as collateral to raise funds to finance further investment.

This reorientation, and the relative smoothness with which financial innovation made it possible, is one of the most important developments in the history of global capitalism. How firms did this—how they renovated themselves for making money via financial channels—reveals much about neoliberal regulatory transformations. Although people barely talk about it any more, not so long ago most capitalist nation-states had regulations that severely constrained firms’ ability to be financialized in the manner they are today. Many of these regulations are known by the umbrella term “capital controls,” and they matter enormously to this story because, when North American capital started looking for ways to generate profits via financial means, they discovered many opportunities abroad. They found foreign stock markets and other financial instruments, or foreign currencies to protect themselves from the falling value of the US dollar. They could purchase bonds from growing economies like Germany.

But during the Long Boom, many governments constructed elaborate regulatory structures to limit or prevent capital movements into and out of a country. The US had the most capital to invest in other places, but the US government was convinced that it would be best to keep as much investment as possible inside the country. This was another lesson drawn from proper “Keynesian” policy. Why let domestically-generated investment capital help other countries grow, when it can create jobs, stimulate technical change and economic growth, and provide tax revenues at home?

The US engineered a whole suite of capital controls, covering many different activities (other countries did the same, but the US rules were the most important for global capitalism). Two of the best known were the “interest equalization tax” and “Regulation Q.” The first imposed an export tariff on all US capital leaving the nation at a rate that equalized opportunities for financial profit at home and abroad. In other words, the US government said: “Sure, go ahead and invest in foreign assets, but the tax you pay to do so will make it not worth doing.”

Regulation Q capped interest rates on domestic demand deposits (basically savings and checking accounts, the bank services from which it is relatively easy to “demand” your money, in contrast, say, to a mutual fund). This was designed to (a) discourage local banks from depositing their money with big banks, and instead to lend local locally, and (b) limit competition among banks, thereby ensuring the stability and survival of those same local banks. Unsurprisingly, Regulation Q’s limits on financial profit sent wealthy people and institutions in search of other places to put their money, especially money markets and markets for other financial instruments. This only increased the pressure driving the financialized profit-seeking that the interest equalization tax (among other legislative means) was supposed to contain.

In a context of declining domestic profit rates, these regulations led firms with the organizational capacity to establish offshore financial arms, mostly wholly owned but independent subsidiaries. This period (1964–73) marks the rise of largely unregulated “Eurodollar” markets—markets in US dollars and financial assets that operate outside the US and beyond its jurisdiction—eventually centred in London. Offshore capital flight continued throughout the late 1960s, 1970s, and early 1980s. Eurodollar markets exploded, abetted in particular by the diligent cultivation of the UK’s Thatcher government, elected in 1979. The plan was to remake the UK as a centre of global finance capital, thereby reestablishing Britain’s international political economic standing, which had waned considerably since World War II. Thatcher’s government was explicitly interested in enabling “the City” (London’s equivalent of Wall Street, which had thrown its considerable financial and organizational resources behind her election campaign) to steal some of New York’s high-powered thunder.

To make this happen, the UK government’s main effort, and its main achievement, was the radical deregulation of finance in the UK. The success of these efforts, which unsurprisingly attracted money-capital from all over the world, drove the deregulation of all main financial channels around the industrialized world. “Financial innovation” blossomed as national authorities across the capitalist global North and beyond were forced to scrap the regulatory apparatus slowly constructed since the Depression to compete for the flow of investment funds. Money markets—which the influential economist Joseph Schumpeter called “the headquarters of the capitalist system” as far back as 1911—exploded in size and sophistication. Increasingly sophisticated technologies of securitization—the seminal steps toward the financial instruments, like “collateralized debt obligations,” that have received so much recent media attention—disseminated rapidly across international asset markets.

Ultimately, these developments produced a significant shift in the centre of gravity of international economic activity. Institutional lending has exploded, but the years since the late 1960s have witnessed an almost constant increase in the ratio of firms’ borrowed funds (borrowed from financial institutions) to gross capital formation, a trajectory only checked by the problems that began in 2007. In other words, firms are borrowing more, but putting a smaller and smaller share of it toward capital formation (plants, training, research and development, etc.). Leverage—financespeak for borrowing money to invest, in the hope that return on investment will more than repay the loan—expanded to an extent unimaginable even thirty years ago. Indeed, up to the financial crisis triggered by the collapse of the “subprime” mortgage market in 2007, astoundingly precarious leverage ratios had become the normal way of doing business in finance. Before the investment bank Lehman Brothers collapsed in September 2008, it was levered 44 to 1. That is to say, it had outstanding loans valued at 44 times the value of its assets. If called upon to repay, which of course it eventually was, it could have covered a little bit less than 2.3 percent of its debt.

However useful spectacular failures like Lehman Brothers are in emphasizing the imbalance and cumulative myopia of modern capitalism’s systemic imperatives, it is perhaps even more important to note that financialization is not confined to the financial sector. Since the 1990s, both financial and nonfinancial firms have eagerly participated in this dynamic. Nonfinancial firms—even firms that do regular old things like manufacturing—now try as often as possible to make profits via financial channels. And they do not do so merely via their own enormously profitable “financial” arms, like car manufacturers endlessly offering “the lowest APR” to help finance the purchase of their products. We are talking about a process whereby, at least up until 2008, nonfinancial firms increasingly invested their income in financial instruments like corporate bonds, mortgage-backed securities, futures, and the like (see below).56

However novel all this seems, “new” developments like financialization are often mistaken for radical breaks with the past when they are in fact the outcome of previous conditions. When the Nixon administration of the late 1960s and early 1970s chose to loosen money (inflate) rather than drive down costs (deflate)—a dilemma that would have been familiar to governments of the early 1930s—it was a fateful decision. The limits of the inflationary “postponement” option for the protection of profits became increasingly apparent as the 1970s unfolded. The pace of capital flight to international money markets accelerated, productivity growth slowed further, and domestic investment and employment fell again and again. The “financialized” way firms escaped falling profits established the foundations for the current neoliberal regime.

Of particular importance for future neoliberal governance, these dynamics reignited capital’s zeal for stable money, an obsession the Keynesian interlude had tried to suppress. The financialized solution of the 1970s and after meant a growing proportion of capital, and a huge proportion of its overall profits, depended more than ever on the suppression of inflation. The profitability of financialization is a straightforward function of monetary stability. Profit accumulated via investment in a financial instrument is diminished by every rise in the price level: if you earn 10 percent profit on an investment, but inflation is at 10 percent, then in real terms your profit is zero.

Moreover, although significant monetary instability will always curtail investment (if the value of money is plummeting, investment seems unwise), a price level rising at the lowest possible rate, or not at all, actually hinders nonfinancial capital formation: mild inflation (in the 3 to 8 percent range, say) is almost always a part of expanding effective demand, and the profits reaped from investment in nonfinancial productivity make a little inflation less troubling. Financial investors, on the other hand, don’t really give a damn about overall economic activity or productivity, except indirectly, i.e., if it slows the accumulation of wealth via financial channels. And what is good for finance is by no means always what is good for the rest of us. In North America, the two decades in which finance became king of the profit world were years of constant declining productivity and workers’ real wages.

By the late 1970s, as capital searched frantically for ways to make financial profit because the old ways didn’t seem to be working, the absolute and unquestionable necessity of capitalist control of monetary authority became glaringly obvious. Volcker’s shock is the best-known instance of this power grab, but the Reagan, Thatcher, and Mulroney administrations of the 1980s, and every American, British, and Canadian government since, have recognized and acted on this imperative. They did so because they all understood that suppressing inflation was predicated on silencing workers, not only to support employers suffering from “wage-push” profit squeeze, but also, and perhaps even more importantly, to protect financial capital and financial profits in economies that were in many ways no longer productively competitive. Finance was about the only realm in which these governments made good on their promises to turn declining incomes around.

Financialization since the 1980s is a product of these longer-term dynamics, as are the fundamental political challenges it creates. The increasing power of monetary authority over its fiscal sisters and brothers, initially stamped so powerfully upon the planet by the Volcker-era Fed, has become normalized. As many have noticed, and as the early responses to the current crisis demonstrated, fiscal policy—taxes, public spending on services and infrastructure—has been effectively and intentionally crippled (and its recent, crisis-inspired new lease on life seems very precarious). Monetary authority is king of the macroeconomic mountain, and the extraordinary accumulation of power in the hands of the Fed and the European Central Bank (ECB) are definitive proof. This is a victory not only for finance and financialized capitalism, but for classical and neoclassical orthodoxy, neither of which could have won the day without the other.

The task of challenging the structures that protect this elaborate privilege is made all the more difficult by the fact that monetary policy-makers in capitalist liberal democracies, as discussed in Chapter 3, are no longer accountable to elected representatives or their constituents. Central banks now control the key arena of monetary authority, and, given the wide belief among neoclassical economists and neoliberal policy-makers that democracy has an inherent “inflationary bias” (that is really the phrase), the consensus “best practice” among all leading capitalist nations is to put these institutions “in the hands of unelected technocrats with long terms of office and insulation from the hurly-burly of politics” (in the words of a noted Ivy League economist and central banker).57

This is no accident. The dominance of monetary policy is absolutely essential to modern capitalism. Indeed (as discussed in Chapter 5), it has allowed the neoliberal state, interlaced as it is with finance capital, to appear to have separated the market from the state, while nevertheless using the market to govern the behaviour of workers and firms. In this sense, financialization has two aspects: it is a strategic priority for capitalist firms and a political priority for the state, which itself becomes dependent, both for tax revenues and overall economic stability, on this marketized mode of social organization. In terms of the relative value of income flows, these processes affect firms much more than households. From a money-making perspective, the financialization of the capitalist global North is more about businesses than consumers. Nonetheless, households, and not only those of the rich, have taken part in very important ways, largely through the skyrocketing accumulation of debt.

The forces behind increased household indebtedness are several. First, the general stagnation of wages since the 1980s. When your nominal wages do not rise at the same rate as the cost of living, or perhaps even fall, then the real value of your income declines over time. To keep consuming at the same level, you must borrow and eat up your savings (if you have any) to cover the loss of real income. Clearly, millions of households ended up in this situation. Household savings rates collapsed, across North America especially, as many owed more than they could possibly bring in. Second, with the overall expansion in available credit, especially after the mid-1980s when interest rates came back down and most financial regulations had been rolled back, a lot more money went into circulation via the bank channels discussed in Chapter 2. All that money, and relatively slower change in what was available to buy—especially in property markets—meant that more money was chasing the same amount of stuff. The result was inflation, which meant real wages fell further. In addition, businesses helped accelerate the problem because they needed to spend more to get the same real level of investment. Both consumers and business borrowed to make up the shortfall.

The result was the rapid financialization of much of everyday consumption via “securitization.” More and more of everyday life became marketable, by finance, to other institutions. Securitization is the process through which rights to present and future flows of income—consumers' credit card payments, students’ loan payments, homeowners’ mortgage payments, pensioners’ life insurance payments, and more—are reconstructed as material assets that can be exchanged on financial markets. The combination of this excessive financialization of the economy and increasing firm and household indebtedness turned out, unsurprisingly, to be a toxic mix. Even Wall Street analysts now admit that the very forces that drive financialization create the seeds of its implosion. This is not exactly news: Marx, Keynes, and others had been making the point for close to two centuries. Today this argument is most closely associated with the late economist Hyman Minsky, who went from being a little-known hero of “post–Keynesians” to a household name in 2008. Minsky says the structure of capitalist finance always leads to increasing risk-taking; in “good times,” capital tends to creep farther and farther out on the leverage limb, an endeavour that by definition cannot go on forever. When the bough breaks, it produces crises like the one we have right now.58

Subprime: A Case Study in Neoliberal Financialized Capitalism

Let’s make things a little more concrete by going over the recent “subprime” crisis in some detail, in light of the dynamics discussed in the previous chapters, as an instance—both typical and atypical—of capitalist dynamics in general and contemporary, neoliberal capitalism specifically. Considering the crisis from different perspectives will help us understand both the details and broader political economic issues. This involves a three-step investigation, starting at the systemic level, moving “down” into the details of subprime mortgages and securities themselves, and then back “up” to the institutional level. We will conclude by positioning these processes in the principal structures and relations of contemporary capitalism.

I lay this out in four subsections: (1) lays out the overall processes that led to the possibility of a credit “bubble”—financialization, the East Asian crisis, the dotcom bust, and low inflation + low interest rates; (2) looks at the way all that easy credit made its way into the hands of borrowers, i.e., how subprime mortgages work; (3) explains in broad brush-strokes the securitization process by which these contracts entered the financial circulatory system; and (4) considers how what we know about capitalism can help us understand all this.

(1) The Systemic Causes of the Liquidity or Credit Bubble

The “subprime” moment did more than anything else to trigger the 2007 crisis, but its specifics are embedded in, and meaningful because of, the decades-long, system-wide processes of financialization and associated capital flows discussed above. The collapse of the subprime market may have unlatched the gates of the financial crisis that enveloped much of the world, but it did not “cause” it.

Nevertheless, it is helpful to set this structural context aside momentarily and start with some key features of global political economy that allowed the crisis to take the subprime form it did. This is a story in which China, perhaps surprisingly, plays a lead role. China is crucial to the health of global capital. Its massive and tumultuous growth depends entirely upon demand for its manufactured exports, and however capitalist or noncapitalist China’s domestic economy is, the concentration of demand in Europe and North America means China has hitched its wagon to the capitalist world. As wages, productivity, and nonfinancial innovation in the capitalist world have declined, so should the international purchasing power of US and European consumers. Given what economists call the underlying “fundamentals” of the US economy, setting aside its role in the international realm, the US dollar should have declined significantly in value over the last three or so decades. The US exports fewer goods, borrows more and more relative to its productive capacity, and the income of much of its population has fallen significantly.

Yet, given Chinese industry’s orientation toward US markets and offshore manufacturing for US (and European) firms, a precipitous fall in US consumption must be avoided at all costs. Consequently, the Chinese state has taken upon itself, especially since the mid-1990s, the task of continually propping up the value of the US dollar and the level of US spending by purchasing US government debt. The Chinese commitment ensures sufficient demand for American debt, which keeps US bond yields far lower than if they were assessed according to the standards by which other nations’ debts are judged. Consequently, the US has been able to borrow enough from China (and other Asian nations) to keep its interest rates low and its consumption levels high. Since much of that consumption demand targets Chinese goods, the cycle continues.

Where does the Chinese state get the money to keep purchasing US debt? Well, for a variety of reasons and despite very low wages for the vast majority of its labour-force, Chinese savings rates are very high. This is probably a function of both cultural norms (which are certainly not fixed, but tend to change relatively gradually) and the low wages and export-orientation of Chinese industry. High saving propensities and low incomes mean that until very recently, China’s domestic consumer markets were relatively underdeveloped. These conditions produced a glut of savings in China. Much of it, at the firm level, is in US dollars (because they sell to Americans). These savings purchase US debt, making China the largest holder of that debt (Japan is second).

This political economic strategy has drawbacks that render it potentially unstable. While it ideally has the capacity to prop up international consumer spending, China’s own pretensions to geopolitical leadership are hindered by playing a supporting role in global political economy. If Chinese capitalists and the Chinese state want to assume a leadership role, China must divest itself, at least to some degree, of its dependence on the US in particular. But this would entail putting its own economic engine at risk.

This situation is further complicated by other dynamics in Asia, many of which are linked to the Asian financial crisis of 1997–98. Among the more devastating of its legacies was the massive devaluation of Asian currencies, largely a product of speculative investment and “hot” capital flows, which fled the region when the crisis began with the collapse of the Thai currency (the baht). Speculative or hot money is an important aspect of neoliberal political economy, a product of precisely those forces Keynes and others hoped to abolish with Bretton Woods, forces that have been unleashed anew by the dismantling of that regime.

If you are unfamiliar with the dynamics of the Asian financial crisis, here are the basics boiled down: in the midst of the boom that powered the growth “miracle” among the “Asian tigers” in the late 1980s and 1990s, the Thai currency came under speculative attack by currency traders working for powerful US and European financial firms. Such speculative attacks follow a standard pattern. Traders first begin to hammer on the currency of a relatively vulnerable nation-state like Thailand by “shorting” it, thereby driving down the value of the currency on international money markets.

Shorting is a fascinating and powerful trick of the financier’s trade. Since the whole point of shorting is to make money as an asset loses value, it is somewhat counter-intuitive for many nonfinance folks, but essential to understand. To “short” a financial asset, a stock, a commodity future, or anything else is to bet that its value is going to drop. In anticipation of this change in price, the shorter borrows some of that asset (say, 10,000 shares or $500,000 in currency) from someone betting the other way. They contract a date at which the borrower must return the same amount of the asset to the lender (plus some fee for the loan). Since they think the asset’s price is going down, the “shorter” sells the assets immediately. If they are correct and the price does indeed fall, then, when the loan comes due, they buy back the same assets for cheaper, return them to the lender, and keep the difference.

The most important things to remember about shorting are (a) as long as there are at least some others out there willing to bet against them, traders can make money when asset prices are going up or down; and (b) if there is a speculative frenzy, when everyone expects something to drop in price, the prophecy is self-fulfilling: as everyone shorts the asset, they flood the markets with “for-sales,” which forces the price down and makes traders’ expectations come true.59 Indeed, if the traders are big enough players, they don’t have to rely on the markets to help them produce panicked selling; they can influence the market enough to create the panic themselves. Whether driven by the interests of one firm or by the oligopoly that controls the currency trade, this is a particularly nasty example of the exercise of market power. For a national currency like the Thai baht, it is a disaster.60 But not for the traders, of course, who bought all the currency back when it hit bottom, waited until international bailouts and time raised the value again, and then sold it anew. They made money all the way down, and all the way back up.

Speculative currency shorting (usually) targets a weaker nation in the global political economy, because stronger nations can fight back by using reserves to purchase their currency on those same markets, thereby maintaining demand and protecting the currency’s exchange rate. It would be impossible (and potentially suicidal, I suppose, at least at present), for bond markets to mount a speculative attack on the US dollar. Thailand had little capacity to defend the baht, and its value plummeted. The ensuing panic engendered similar attacks on other “Asian tiger” currencies, and the frantic flight of hot capital from the whole region. This only drove currency values down further, because as money leaves a country, unless it is the US dollar, it almost always changes form—the money-owner exchanges it into US dollars or some other “trustworthy” currency. This floods the market with (for example) baht, which accordingly falls in price.

The tiger economies’ inability to protect their currencies is widely attributed to a lack of state-held foreign reserves. They learned, consequently, to maintain a huge pile of reserves, in case history repeated itself. They also decided it is smart to keep a lot of those reserves in the form of US securities, because this gives them some capacity to correct exchange rates on their own, even if the US decides not to help much. If the US dollar over-appreciates, thus diminishing the rate of return on sales to the US (because a higher value dollar can buy more exports), then selling some US debt can help depreciate the dollar a bit. Only China and Japan really have the capacity to unilaterally move the market like this. China and much of coastal Asia spent the late 1990s and early 2000s flooding the US with money, accumulating reserves in the form of US bonds, and in the process, giving the US government and consumers billions and billions of dollars to spend—ideally on Chinese and southeast Asian goods.

One notable result of this process was the so-called internet or dotcom bubble, fueled by indebtedness built on Asian (and especially Chinese) debt purchase. When, at the turn of the millennium, the ecstasy of dotcom became the agony of dotcon, not only did the Fed set very low interest rates to stimulate recovery, but a steady supply of money of Asian origin made the “easy money” policy even easier.

For a variety of related reasons, simultaneous with these developments, American banks were completing a business model transition that accelerated foreign capital inflows. Banks’ traditional way of doing business, sometimes called the “net margin” model, involved making loans and holding them till maturity, enjoying borrowers’ interest payments as profit. However, beginning in the 1980s, and even more so in the 1990s, banks shifted to an “originate and distribute,” or O&D, model. With O&D, banks issue loans and then pool them together for sale, via the now-notorious securitization process (which we will get to in a moment). The resulting securities offered lots of opportunities for high returns, money came from all over the world to purchase them, and securitization expanded accordingly.

What all this money in the economy meant—or, in Keynesian terms, what all this liquidity meant—was that money became one of the easiest assets to get your hands on. There seemed to be a virtually unending supply at unbelievably low prices (interest rates sitting at historic lows). The biggest problem for finance capital, and almost anybody else who wanted to borrow to invest, was not where to get the money, but where to put it all—strange as that may sound to the vast majority of the planet’s population, who will never face this “problem.” Idle money is not capital; it is not accumulating (Chapter 2). So, people who could get money cheaply were constantly in search of profitable places to invest it. New securities and lending to new consumers proved highly attractive prospects. This helped ramp up prices, especially in real estate but in all asset markets, because it made sense to bid high, knowing money for the purchase was relatively cheap, and banks were eager to lend it. This was also true of new securities themselves, and financial firms and funds borrowed cheaply to buy those up too.

The upshot was a flood of easy money sloshing around and a real estate market in which it looked like nothing could go wrong—prices just rose and rose. Even if you made a bad call and bought something you couldn’t afford, or loaned someone money who defaulted, you could still cover your bet and more, since the asset in question seemed guaranteed to exceed the value you paid or loaned for it.61

These conditions produced property booms in most of the economies of the global North. From about 2002 to 2006, rising prices and frenzied spending drove the “turn-around” of the traditionally slower-growth, low-wage, less industrialized economies of southern Europe and Ireland, all of which exploded in an unprecedented orgy of new real estate-based riches. Borrowers previously considered too risky became attractive candidates for loans. In the US especially, anybody with a pulse became an attractive candidate for a loan, and some without a pulse. Here lies the story of “subprime” mortgages, the infamous contracts behind the securities that triggered the 2007 crisis.

(2) How Subprime Mortgages Work62

For many of us, discussing financial dynamics like mortgage securitization is intimidating. It seems to demand some level of expertise, and the language sounds unfamiliar and technical, and sometimes doesn’t seem to make a lot of sense. For example, people sometimes ask me why subprime mortgages are bad, since, when they hear “subprime,” they tend to think of “prime rate,” a base interest rate set by banks. Not without reason, I suppose, they assume a “subprime” loan should have an interest rate even lower than prime, which would indeed be very good, almost unimaginable, from a consumer’s perspective. But the prime in subprime does not refer to the interest rate; it refers to the borrowers. A subprime mortgage is subprime because the person borrowing it is subprime, i.e., less than preferable.63

It is worth noting that not all of the mortgages behind the assets that crashed in the subprime crisis were in fact technically subprime; they were not all loans to borrowers who fall below certain credit-rating thresholds or debt-to-income ratios. When the press and policy makers talked about the “subprime crisis” in general, other kinds of mortgages were also involved. The most important of these were so-called “Alt-A” (borrowers with higher-than-subprime credit scores, but inadequate documentation or higher debt loads), and “Jumbo” (where a higher proportion of the asset’s value is being funded by the loan than is considered “secure”). Although “actual” subprime mortgages were the biggest category of mortgages behind the crisis, these others forms—many with just as elevated interest rates or payment burdens—were (and are) also important.

The key point is that because the borrowers and borrowing conditions are subprime, the interest rates are extremely superprime—super-duper-prime, even. They consequently impose an extraordinary burden on borrowers, a burden exacerbated by the loan’s contractual structure. It is easier to understand this burden if you understand how a conventional mortgage like mine is usually structured. Mortgages are debt contracts backed by real property, and the standard variety has several characteristics. First, they are “fixed-rate” mortgages, or FRMs. With FRMs, monthly payments are fixed over a set period (usually five years), and the interest rate on debt outstanding is readjusted at the end of each period for the life of the loan (usually twenty-five years, but thirty or forty is increasingly common).64

Many wealthy capitalist countries have industry-wide regulations or standards that define conventional mortgages by limiting the value of a mortgage according to two main criteria. The first, how much money the household earns, matters as a “rule of thumb.” Under non-orgiastic conditions, for example, it is common for banks to limit loan sizes so total monthly debt payments do not exceed approximately one-third of regular household income. The second determinant of the size of a conventional mortgage is a general practice (sometimes legally required, sometimes not): capping the loan at some maximum percentage of the value of the property. For example, if the maximum loan-to-value ratio is 75 percent, then you need to come up with one quarter of the total cost as a down-payment to put toward purchase. In most cases, the bank can exceed this limit, but often with additional penalty costs and potentially higher interest rates (in US terms, this is a Jumbo mortgage). When my family borrowed from the local credit union to buy a home, we had to come up with a quarter of the cost ourselves to avoid extra debt, and we could only consider houses with prices that kept our mortgage payments below one-third of our total income.

Subprime mortgages are structured very differently. First, they are virtually all “adjustable-rate” mortgages, or ARMs. With a subprime ARM, the mortgage is structured so that for the first two or three years of the loan, the borrower pays a so-called “teaser” interest rate, which, after the preliminary period, adjusts to a level determined by some fluctuating rate on the financial markets (like six-month LIBOR—a key international interbank lending rate) plus a “marginal” or add-on percentage that is fixed for the term of the loan. These mortgages, most of which have a thirty-year duration, are called 2/28 or 3/27 mortgages, the first number being the teaser years, the second the remainder of the loan period at the “adjusted rate” (say, six-month LIBOR + 5 percent). The interest rates in the post-teaser period are readjusted every 6 months, and payments are readjusted on that interval as well. This means the borrower or mortgagor has to re-budget every 6 months to make sure he or she can cover the payments, which often rise to quite a substantial portion of his or her income.

You might think a “teaser” rate would be pretty attractive, perhaps quite low. But given the extent to which subprime borrowers are restricted in their access to credit—they are often in the almost-impossible-to-get-a-loan category—“teaser” rates are nothing to write home about relative to what “prime” borrowers get. For example, in 2006, the teaser rate for subprime borrowers was around 8.6 percent, when central bank rates were about 5.5 percent. As soon as the teaser period is over—a moment called “reset”—rates on these loans rise dramatically, and monthly payments jump accordingly. For example, in a 2/28 ARM, rates around 8 or 9 percent often reset about 12 percent. As a minimal form of borrower protection, there are usually caps on the amount rates can rise in a single six-month period, commonly about 1.5 percent, and there is a ceiling on the interest rate over the life of the loan (15–16 percent), above which it cannot rise. But, there is also a floor, usually the teaser rate, below which the loan’s interest rate will not drop, even if market rates are lower.

An important result of this arrangement is that at reset, expenses go up a great deal—in the example I have been using (a “real” subprime mortgage), the household’s monthly payments rose by 15 percent after two years, and by another 12 percent six months later. If the borrower originally committed to mortgage payments that demanded 40 percent of monthly income, then two-and-a-half years into the loan, she or he will owe monthly payments amounting to more than half of income (assuming real income and the base market interest rate stays around the same level as at the time of purchase). In other words, there is no need for the borrower’s wages to fall or interest rates to rise to rapidly make the loan untenable. It is structured to become extraordinarily burdensome, and fast—there is no need for bad luck or volatility. To top it all off, the loan I am describing is among the better in the subprime category. There are worse arrangements. In one, the first five years are interest-only payments, which means that reset at the five-year mark raises payments enormously. In another, the payments are amortized over forty years, to keep them low, but are scheduled on a thirty-year payback, meaning the homeowner had to have 120 months of cash at the end of the mortgage to cover the remaining debt (a so-called “balloon” payment).

Ultimately, there are three features to note about the structure of these debts:

 

(a) Unlike FRMs, the ARM borrower bears almost all the interest rate risk. In conventional mortgages, at least over the (optional) five-year fixed-rate periods, the lender bears the interest rate risk; if market rates skyrocket tomorrow, mine stays the same, at least until renegotiation. In a subprime mortgage it is adjusted every six months.

(b) Unless the borrower’s income rises substantially during the teaser period, there is a good chance the increased payments after reset will be unaffordable. The only way to deal with this additional monthly burden (aside from defaulting, as so many did) is to sell the property and repay the loan (with prepayment penalties), or to refinance the mortgage (renegotiate the payment schedule and rate if possible).

(c) The only way these loans make sense, especially given the probability of default after reset, is if housing prices rise continually. If they fall, then selling the property, or refinancing, will not cover the loan, and the borrower will have “negative equity,” lose his or her property, and the lender will probably lose money on the loan.

(3) How these Mortgages Entered the Financial System, or “Securitization”

These mortgage and real estate dynamics have come to matter a lot in recent years. These loans are not merely some shadowy sideshow contracts between predatory lenders and “financially unsophisticated” borrowers at the margins of modern capitalism. The lenders include both shifty mortgage brokers and established (but perhaps no less shifty) commercial banks, and the loans themselves are an important object of the “securitization” process that lies at the heart of modern, financialized neoliberalism.

Securitization, as mentioned earlier, is a process through which flows of funds (like monthly mortgage payments) are turned into transferable assets. More precisely, it is how loans leave the hands of the lenders (where they would have stayed in the old “net margin” banking model), are purchased and used to issue into debt securities—circulating financial assets that are purchased and sold by investors in financial markets. Not only are these securities transferable on the market, they are part of an effort to off-load the risk taken by the lender. At this level, the process is reasonably straightforward, but in practice it can demand computational wizardry and organizational capacity.

The practical side of mortgage securitization involves five main steps.65 First, the lender, or “originator,” loans money to borrowers (the people actually purchasing a home). This debt contract is the mortgage proper. The originator then pools mortgages together in a portfolio (containing, on average 3000 to 4000 mortgages), which it sells, as a unit, to an “arranger” or “issuer.” An arranger wants to own a portfolio of thousands of mortgages because whoever holds a mortgage receives the debtor’s monthly payments. If you own a portfolio of 3500 mortgages, each of which owes on average $1500 monthly, then you receive $5.25 million dollars in payments every month, if the debtors don’t default.

Leading up to the collapse of the subprime market, such loan-pooling was not difficult. While there were many small lenders involved in subprime mortgage lending, a substantial portion of loan origination (the “O” in O&D banking) was undertaken by very large financial firms, or arms of such firms, some of which have since vanished from the face of the Earth (e.g., Washington Mutual or New Century Financial). The size of the many these firms allowed them to make enormous numbers of loans, which they could pool together “in-house,” and then sell for a profit. For example, a portfolio of 3500 loans valued at $100 million, based on the income flows from 3500 households’ monthly payments, might be sold to an arranger for $102 million.

Second, the arranger (usually a firm) who buys the portfolio creates what is called a “bankruptcy-remote” trust, a wholly owned but legally separate entity housed with a “trustee,” generally a big commercial bank. The trust “purchases” the package of mortgages. The arranger—often but not only an investment bank like Goldman Sachs—is doing this complicated institutional and legal dance because it does not want to carry the mortgage risk anymore than the originator. The trust is legally structured so that if it goes bankrupt because the borrowers default (for instance), the investors who bought the loan portfolio do not go down with it.

Now, the arranger had to pay the originator millions of dollars for the original portfolio, money it obviously cannot recoup until the deal has been finalized and the securities issued and sold. If the arranger is a big financial firm, they can cover the costs themselves while everything is sewn up. But many arrangers, sometimes even big firms, cover those costs by borrowing from a firm called a “warehouse lender,” which lends against the value of the mortgages as collateral.66 This loan usually requires a “haircut” or “over-collateralization”: the warehouse lender demands collateral posted against the loan worth more than the loan itself. This is how a warehouse lender attempts to guarantee itself a profit if the arranger defaults. Given the institutional and contractual structure of the loan, however, it turned out to be ineffective, since when the arranger failed to repay the loan during the crisis, it was due to a collapse in the value of the collateral (the mortgage portfolio). It is precisely this accumulation of risk on an inadequate material basis that led to the cascade of failure when the portfolios did begin to “underperform.”

Third, the arranger then initiates the process of securitization proper, i.e., going through the steps involved in issuing securities, the value of which is “backed” by the loan portfolio. This is why the securities that became notorious during the crisis were called “mortgage-backed” or “asset-backed” securities (MBSs or ABSs). These steps are largely administrative or institutional: obtaining credit ratings for the securities to be issued; hiring, if necessary, experts to structure the deal from a legal and accounting perspective (this is what investment banks specialize in); covering the costs associated with issuing the securities; filing with the necessary regulators, etc. This is all worth the arranger’s time because it receives fees for such services, charged to the purchasers of the securities, and its profit is the value of the securities at sale, less the amount originally paid for the portfolio of loans and the costs of arranging.

Fourth, the trust, which legally holds the mortgages, hires a “servicer” to make sure the mortgagors make their payments. The servicer is paid a monthly fee based on the value of loans outstanding. Here, however, we run up against one of the more glaring principal-agent problems in a process packed with them. The servicer clearly has an incentive to keep the mortgages in the portfolio from being repaid, because its fee is based on the value of debts outstanding. So the trust usually hires a “master servicer” to monitor the servicer. (You might be forgiven for thinking this could become a bit of a joke: who monitors the master servicer? The headmaster servicer! And the lord headmaster servicer monitors the headmaster … ) This is only another example of the way in which all sorts of other considerations beyond supply and demand enter into contracting and pricing.

Fifth, the securities are finally issued, or put on the market, and purchased by “asset managers” (pension fund managers, hedge fund managers etc.) who are acting for their funds’ investors. The firms involved in arranging may sometimes keep some of the securities for themselves, or sell them to another arm of the firm. But whichever financial firm or trader comes to hold these securities will buy and sell them in an attempt to maximize the value of their “assets under management.”

You might be wondering what the end-product of this process, the securities themselves, are exactly. What do they look like? How do they work? If they can provide a return to an investor, how does that work? These securities, like all the complex financial instruments designed over the last couple of decades, are the outcome of well-remunerated computational and organizational creativity, involving “innovative” rethinking of everything from the tax code to mathematical models. Much of the wizardry happens with the arranger. Take Goldman Sachs, for example. As an arranger, Goldman will create a “bankruptcy-remote” trust that is essentially one big pile of mortgages. With our hypothetical 3500–mortgage pool, the trust has a potential monthly income of $5.25 million. That is a lot of money.

In the financial world, an anticipated and consistent flow of income in the future is an “asset,” and its value is based on the volume of the flow and the risk that all or some of it might dry up, temporarily or permanently. The larger the future flow, and the more a “sure thing” it appears, the more valuable it is as an asset in the present. This is the same principle a bank relies on when it lends you money for big-ticket items you do not presently have the capacity to purchase without the loan. The bank considers your monthly income, assesses its level and how steady it is likely to be in the future, and considers that future income your “asset” in the present. This anticipated income, which you will use to repay the bank, is the basis upon which the bank decides if lending you the money is or is not a good idea. Similarly, with the portfolio of mortgages, Goldman’s trust has an asset whose value depends on (a) a potential monthly income of $5.25 million; and (b) the likely level of expected or “actually realized” income (which, given defaults, late payments, and other complications, will never be 100 percent).

In the financial world, you can do one of three things with an asset. You can hold it, and enjoy the income associated with holding it (in this case, the monthly mortgage payments). You can sell it, as you would your bicycle or your car. Or, you can borrow money against it, treating it as collateral: you might say to your friend, “If you lend me $400, I will pay you back in a year, with interest. If I don’t, you can have my bicycle, which is worth $425,”67 In our example, Goldman owns a (potentially) valuable asset in the pool of mortgages, which if it does not choose to hold on to, it can just plain sell—which might still involve securitization—or it can borrow against it. If it chooses the latter, then it will issue “securities” as the means to do that borrowing. This is the key moment of “financial innovation.” Goldman, the arranger, issues debt securities (structurally similar to bonds) backed by its asset, a flow of mortgage payments that is, for all intents and purposes, a constant money-producing tube. Just as in the cases of Brazil and Canada discussed in Chapter 5, it borrows money from investors by selling bonds promising a yield it, and presumably the investors, believes it can deliver.

The bonds in this case are the asset-backed or mortgage-backed securities we hear so much about. Investors purchase asset-backed securities because the promised yield is worth the investment. The higher the risk associated with the security, the higher the yield or interest rate the arranger/issuer promises to pay the investor. Goldman’s motivation for issuing the securities lies not solely in the additional profits it hopes to earn with the sale of the securities. If it simply keeps the asset on hand to enjoy the income flow, it is bearing the risks associated with the loans all by itself. It—or more precisely, its “bankruptcy-remote” trust—is the loser if people default. So it issues securities both to make a profit (via fees and price markups) and to spread the risk. (Investment bankers like to say “distribute” the risk, since they see their primary social function, the “good” they do in the world, as that of “distributing” risk to those who can bear it. We can see now how well this works, and how valuable this “social function” is. In practice, it is merely a variation on “privatize the gains, socialize the losses.”)

One of the reasons for spreading the risk of subprime mortgage default to investors is that it is, in fact, highly likely. After following the steps in subprime mortgage securitization, it is easy to forget that the pool of debts consists of high interest loans made to many who are not likely to manage the payments very easily. This means that the assets “backing” the securities may not appear all that secure to investors. The problem for the arranger is thus how to get investors to buy securities that look like they could turn to ashes at a moment’s notice.

The solution to this problem is to “structure” the financial instruments (the securities) associated with the underlying asset. “Structured” finance is one of the most important “developments” in the history of “financial innovation.” It involves issuing securities divided into “tranches” (French for “slices”) ranked in terms of the certainty their holders will receive payouts. In other words, each tranche contains securities to which a relative level of risk is attached. For any pool of mortgages, a range of different securities is issued, some marked as low risk, some medium, some high. Lowest-risk securities earn the lowest rates of interest, highest-risk earn the highest.

How, you may wonder, with a pool of three or four thousand basically similar mortgages, can you issue securities with different risks and returns? This is how: the arranger structures the securities so that the lowest-risk ones are considered low risk because they are the first to receive their payments on schedule. If there is a problem with the flow of funds from the money-tube, and only enough comes in to cover thee-quarters of the issuer’s debt payments, then those holding the highest-yielding (but riskiest) quarter of the securities don’t receive payment. The lowest-risk tranches are called “senior,” the middle are called “mezzanine,” and the highest-risk, nicknamed “toxic waste” in the industry, are—in a sort of perverse inside joke—called “equity” tranches. Who doesn’t want some “equity?” Oh, I’ll take some of that, yes, please.

From the perspective of finance capital (which includes the issuer and the investor or security-purchaser), the most important part of the “innovation” in structuring is the mathematical modeling that “proves” its sound business sense. Worked out by financial economists, computer scientists, and other financial industry “quants,” that modeling demonstrates that if the risk of default among the mortgages in the pool is uncorrelated—i.e., it is statistically unlikely that a substantial proportion will default at the same time—then even though the individual loans themselves are very risky, those holding the lowest risk, “senior” securities will likely be paid. Indeed, the modeling, with the help of very compliant and enormously powerful credit-rating agencies, allowed issuers to classify a large part of the securities as senior, and they consequently received quite a high credit rating.

This credit rating matters a great deal, because the structuring of subprime mortgage-backed securities allowed firms to sell the securities to many financial market participants who otherwise would not have risked it, or who would have been legally prevented from doing so. For example, many pension fund managers are barred from buying assets that are not “investment grade” (at least an “A” rating by the credit agencies). Without the “structuring” process, it would be absolutely impossible for these securities to be rated highly enough to circulate so widely and in such volumes. But structuring is a way of turning BBB loans into AAA-rated securities, with the help of credit agencies who are paid by the arrangers to “rate” the securities.

(4) The Blow-Up (or Meltdown) and Capitalism

We all know where this wound up—and how it continues to spin out of control. In truth, the “financial innovation” got quite a bit more complicated than I have related here. Of several features I have not covered in detail, one might mention credit default swaps, or CDSs. A CDS is essentially an insurance contract covering losses associated with the premature end of payments on a financial asset. Just as in other insurance contracts, one party agrees to pay a regular fee, equivalent to a small fraction of the value of the security. In return, the counterparty insures the value of the security in the event that it fails to bring in the anticipated payments. Moreover—and this often shocks us nonfinanciers, as it should—finance capitalists freely write CDS contracts for securities they do not even own. In other words, and this is not at all uncommon, they can own the rights to insurance payouts for assets they do not hold. This is opportunism turned up to eleven, and in the months following the subprime collapse in 2007–2008, many firms intentionally drove down certain markets to force their own CDS payouts. CDSs greatly exacerbated the effects of the market’s implosion, since they grossly multiplied the number of securities whose value depended upon the underlying asset-base. American Insurance Group (AIG), perhaps the single biggest player in the CDS market, had to be bailed out by the US government to the tune of more than $120 billion dollars.

Subprime-based financial instruments multiplied (for example, “interest rate swaps,” transferable securities that allowed financiers to switch the interest rate that determined an asset’s returns from fixed-rate to variable, were also used throughout the process). So much so that the value of circulating securities increased exponentially as financial firms doubled, and sometimes tripled, the complexity by repeating the pooling process, this time using the asset-backed securities themselves, as opposed to the original mortgages. These pools were then structured into so-called collateralized debt obligations (CDOs), with securities issued just like the first time around. The resulting income was then reinvested in more such securities, and so on. The dynamic seemed to have no meaningful limits.

All of these securities are basically different types of derivatives, in the sense that they are derived from the value of an original asset—in this case, the money coming in from a pool of mortgage payments. The problem is, like the subprime business on which it was precariously balanced, the whole structure was premised on rising real estate prices and low and uncorrelated default rates: if a borrower could not pay their mortgage, they could sell their home for more than what they paid for it, repay the lender, and the process could start again.

Then, in February 2007, subprime mortgage defaults started to increase, a couple of mortgage originators went under, and everyone started to get a bit nervous. The models that promised the impossibility of correlated mass default no longer seemed accurate descriptions of reality. By July and August, it was getting hard to sell the securities associated with the mortgages, be they MBSs, CDSs, CDOs or any other ladle-full of alphabet soup. Mortgage originators and arrangers were left holding enormous piles of risky loans—borrowers defaulted by the thousands and they carried the risk. Many went bankrupt. Poof!

Then all hell broke loose. Securities issuers had to start selling what they had on their hands, just to pay people clamouring for the money they were promised when purchasing the securities. But selling en masse only drove down prices further, so the fire-sales earned asset holders less and less. To make matters worse, it is common practice in finance to write contracts (and securities are debtor-creditor contracts) that stipulate that when the value of the security drops below a predetermined threshold, the issuer has either to pay the debt-holders higher yield, or to put up more collateral. But the issuers, in this case investment banks and others, had panic-sold most of their even remotely valuable assets, and thus could neither pay the debt-holders nor post more collateral.

On top of that, when they tried to “unwind” the mortgage-backed securities, and get back to the underlying assets—the real estate—to which they now had some legal claim (since the home-purchasers had defaulted), it proved enormously, even impossibly, complicated. In any one pool thousands of mortgages were spread all over the US. If you were a German bank, for example, the distance only created additional obstacles to figuring this out. And this leaves aside that a lot of the real estate wasn’t worth much anyway, consisting as it did of properties suffering from plummeting housing prices and an unprecedented supply glut, much of it in previously (and now once more) less-than-“desirable” locales like the suburbs of the US South and Midwest. It turned out that the models were useless, “correlation” was in fact more than possible, and simultaneous default on a colossal scale was a reality.

Those holding credit default swaps called their counterparties to demand payment. Most of the counterparties, like AIG, had spent the money they made from CDS payments on more of the same and other asset-backed securities. They were not even close to being able to meet their obligations without selling what they had. But much of what they had was absolutely worthless—literally worthless: not “of considerably less value,” but of no value at all. What was worth something they put up for sale on markets now flooded with similar assets, which of course pushed prices into the abyss, and the spiral accelerated.

By mid-2008, major financial institutions like the Wall Street investment bank Bear Stearns were going under, and the US government stepped in to contain a potential meltdown. Other firms were teetering, many of them large. But the scale of what was to come only became visible in September, when the Treasury and the Fed made the fateful decision to let Lehman Brothers, an elite financial goliath of Wall Street, go down. In so doing, they actually let their orthodoxy prove its worth by allowing something like the “free market” to do its work in the financial sector. The result, from the perspective of capital at least, was catastrophe. Market indexes across the world, already shaky, dropped off a cliff. In allowing Lehman to fail—which, as fun as it was to watch in a “chickens coming home to roost” way, hurt a lot of innocent working people very badly—the US government called the bluff of financiers playing the moral hazard game. The conservative right that has since coagulated as the Tea Party loved it. But as problematic as the opportunistic risk-taking of these massive firms was, Lehman’s collapse also suggested that if worse came to worst, there was no guarantee the state would step in—the one thing that always stood behind the financial house of cards, in good times and in bad.

By late 2008, there was hardly a single player or firm in global finance that was not worried they were about to go under, and everyone was terrified that any fund or individual or bank to whom they loaned money to was about to collapse under the weight of its debts. As a result, no one would lend to anyone, and the liquidity that so recently soaked the economy dried up almost entirely. Everyone fretted they might lend money today to a bank that would be bankrupt tomorrow, or buy the corporate bonds (or “paper”) of a firm moments away from bankruptcy. Mortgage loans even for the most “credit-worthy” borrowers were restricted, and banks held back on the interbank market that is the key to the everyday function of the monetary system. This is how the “subprime crisis” turned into the “credit crunch.” The state, having learned the Lehman lesson, then stepped in aggressively. With the help of Ivy League economists who quickly and conveniently forgot that the crisis was supposed to be impossible according to policy “wisdom” they had been flogging for two decades, the state identified firms considered “too big too fail” (like AIG), and frantically propped them up with whatever they could muster. Treasuries found buckets of money that for some reason only months before had been impossible to find for schools or health care. Central banks cut interest rates to unprecedented lows, pumped money into the banking system, accepted almost anything as collateral against massive low-interest loans to the financial sector, and took virtual ownership of major institutions.68

If there is one thing all of this makes clear, it is that this (increasingly frequent) kind of crisis is a product of capitalism. Capitalism, at least to this point in human history, is the only mode of production that makes this possible. And it is precisely those aspects of capitalism that make it such an organizational wonder historically—its decentralized mechanisms, its profit imperative, its competitiveness—that also make it prone to crises. Capitalism’s tendency to incorporate things that once hindered it, to integrate economic relations more and more tightly—often via monetary or financial mechanisms—end up making it likely, when one car tips, that the whole train will derail. To the extent that neoliberalism involves the systematic prioritization of precisely these features of capitalism, to the naïve neglect of political and economic stabilization and legitimation, this roller coaster gets more and more crazy over time, its “ups” lifting fewer people with each climb.

Whether we can have a capitalism that is not defined by these characteristics remains unknown; we cannot say what the future holds. History, however, suggests it is highly unlikely, even if we leave aside (as capitalists prefer) looming environmental and/or social catastrophe—which seems unwise. I am not inclined to press our luck on this front.

  

53 Measuring aggregate economic activity is a complicated process, and the quantitative indicators economists and policy-makers use are fraught with categorical, technical, practical, and ethical problems. GDP is a classic case. Even if we set aside—as almost everyone almost always does—the problems associated with measuring or valuing “capital” that Keynesians have been demonstrating for decades, GDP still causes economists trouble. Among other limitations, it can only measure what gets recorded as spending and thus both misses a significant amount of economic activity and depends upon firms’ and individuals’ reporting; it attempts to measure only “domestic” economic activity in an era in which the line between “domestic” spending (inside the nation-state) and “national” spending (by any government, firm, or individual based in the nation-state) is only arbitrary; and it has no way of managing the qualitative differences in what money is spent on, so that what you pay for medical care after a bicycling accident contributes just as positively to GDP as spending on your or your child’s education. In addition, GDP has no sensitivity to distribution; if in a nation-state with 100 citizens, one had an income of $1,100, and all the rest had incomes of $1, then if the rich citizen’s income doubled and everyone else’s stayed the same, the national economy would appear to be doing twice as well, while in actual fact the relative (and most likely absolute) poverty of 99 percent of the population declined. These measurement issues multiply, because GDP is the basis of many other key policy indicators, like inflation. There are ongoing efforts on the part of “heterodox” economists to replace GDP with a better measure of overall economic activity and well-being, but alternatives have yet to be widely taken up. I use GDP here only because it is the form in which data are presently available.

54 These include Giovanni Arrighi, Adam Smith in Beijing (London: Verso, 2010); Robin Blackburn, “The Subprime Crisis,” New Left Review, series II, no. 50 (2008), 63–105; Robert Brenner, The Economics of Global Turbulence (London: Verso, 2006); Andrew Glyn, Capitalism Unleashed (Oxford: Oxford University Press, 2006); William Greider, Secrets of the Temple: How the Federal Reserve Runs the Country (New York: Simon and Schuster, 1987); David Harvey, A Brief History of Neoliberalism (Oxford: Oxford University Press, 2005); Geoffrey Ingham, The Nature of Money (Cambridge: Polity, 2004); John Lanchester, I.O.U.: Why Everyone Owes and No One Can Pay (New York: Simon & Schuster, 2010); Stephen Marglin and Juliet Schor (eds.), The Golden Age of Capitalism: Reinterpreting the Postwar Experience (Oxford: Clarendon Press, 1990); Lance Taylor, Reconstructing Macroeconomics (Cambridge: Harvard University Press, 2004). They range from the fairly technical (Taylor) to the reads-like-a-good-thriller (Greider) to the hilarious (Lanchester). All are excellent.

55 The post–World War II rate of profit in the US reached its peak right in the mid- to late-1940s, immediately after the war ended. Although there have been some drastic downs and some exuberant ups in the intervening years (the early 1960s and the late 1990s, for example), the overall pattern is steady decline since then. Neither the renewal of profits in the mid-1980s, nor the financialized booms of the late 1990s and early 2000s led to rates of profit comparable to those of the “golden age.”

56 The person who has done most to help us understand the dynamics of this process across the modern capitalist economy is the sociologist Greta Krippner. See especially her ground-breaking 2005 article, “The Financialization of the American Economy” (Socio-Economic Review volume 3, no. 2, 173–208), and Capitalizing on Crisis (Cambridge: Harvard University Press, 2011).

57 Alan Blinder, Central Banking in Theory and Practice (Cambridge: M.I.T. Press, 1998), 58. The need to de-democratize monetary governance is not merely some extreme market fundamentalist article of faith. Blinder is not a Chicago School free-marketeer who accepts monetary absolutism as a regrettable but necessary feature of modern capitalism. On the contrary, he has recently been one of the more “reasonable” liberal critics of financial deregulation.

58 The implosion of the subprime mortgage market in the US is frequently called a “Minsky moment.” Minsky’s argument can at times get a little “technical,” but it is really worth a read. See “The Financial Instability Hypothesis—A Restatement,” in Can “It” Happen Again? (Armonk, NY: M. E. Sharpe, 1982), 90–116 (the “It” in the title is the Great Depression).

59 There are even common ways of getting around the fact that when prices are obviously tanking, it is hard to find someone stupid enough bet the other way and lend assets to the would-be shorter. This so-called “naked” shorting is risky, but prior to the crisis it was a widespread practice, and continues in many jurisdictions.

60 Because shorting can wreak havoc, and because largely deregulated financial asset markets and complex “innovations” in securities have made shorting an everyday practice, it played a key part in the 2007 financial crisis. One of the first (and only) meaningful regulations the US imposed in the months immediately following the collapse of the market in subprime mortgage-backed assets was to ban some forms of shorting.

61 And to top it all off, in the US, mortgage interest is deducted from income for tax purposes, and upon mortgage default, the creditor has no access to the debtors’ other assets.

62 Much of the explanation and examples in this section are drawn from Adam Ashcraft and Til Schuermann’s extraordinarily helpful “Understanding the Securitization of Subprime Mortgage Credit,” Federal Reserve Bank of New York, Staff Report no. 318 (March 2008).

63 Of course, the lenders would not put it that way—they would say it is the credit conditions of the loan that are subprime, not the borrower him or herself—but however much the lender believes it, this “newspeak” is patent Orwellian manipulation. The industry does not really speak of “prime” mortgages; the adjective only comes up in the context of subprime markets.

64 As a “prime” borrower you can also get a floating or “variable” rate mortgage, which has similar arrangements for payment and purchase. The difference is that the interest accrued is affected by ongoing shifts in some other market interest rate. But payments are fixed in amount, and the bank just keeps a running tab as to how much you have paid down in interest or principal.

65 Mortgage securitization is ongoing; it did not end with the subprime crisis.

66 “Collateral” describes any asset used to “secure” a loan. It is the stuff the borrower agrees to forfeit to the lender in the event of default. This is the same principle behind pawnshops: you bring in your bicycle, the pawnbroker lends you money, and if you don’t repay the loan and interest, the pawnbroker keeps the bicycle. A mortgage is distinguished by the fact that the “collateral” is not something you already own, but the property purchased with the loan.

67 This is an example of over-collateralization.

68 A lot of these efforts focused on getting “toxic” assets off financial firms’ balance sheets so they could “recapitalize”—i.e., look sound enough on paper to borrow money again. To this end, the state took possession of much of the alphabet-soup assets. The ABSs, CDOs, etc. did not just disappear, as it sometimes seems. They are still there, their risks being borne by the public sector, in the hope that one day the markets will revive and the state will be able to unload them.