The American Dream Rip-off. Part II

Securitization has another weakness. It made renegotiating mortgages more difficult when problems arose, especially as mortgages were sold, resold and the friendly local banker disappeared. Responsibility for managing the mortgages was assigned to a new player – the mortgage servicers. The mortgage holders were worried that these mortgage servicers might be too soft on the borrowers. As a result, investors put in restrictions making renegotiation more problematic, resulting in a larger number of foreclosures.

There are better and fairer ways to deal with the foreclosure problem. One could be to bail out the lenders while writing down the loans. People could stay in their homes, and lenders would avoid taking a hit to their balance sheets. At the same time, the government taking the risk off of the banks’ balance sheets would help alleviate the credit crunch.

Another option is lowering the principal. This discourages people from bailing out of their mortgages. For the banks, it means coming to terms with the truth and the fact that they lended money based on prices that were inflated by a bubble. From a societal perspective, it makes more sense than anything done so far. And it would also prove that we are really in a free market, where risk also has a downside.

The success of the financial sector is finally measured in the well-being that it delivers for regular citizens, since either capital is allocated better or risk is managed better. Yet In spite of all the arrogance about innovation in the ballooned financial sector, it is not clear to this day what innovations actually contributed to the economy’s success or the living standards of the vast majority of people around the globe.

Free marketers like to call the banking system the heart of the economy. They argue that it pumps money to the places where it is needed most. With the banking system at the brink of collapse in the fall of 2008, lending drying up and the government striding in to bail out the banks, it has never been farther from the truth. I definitely believe that now is the perfect time to start developing a truly efficient financial system that directs capital to where it is needed and where it is most efficient. A financial system that helps households and corporations alike manage risk, and that offers the basis of a fast and low-cost payment system.

As an economic system, capitalism can tolerate a high level of inequality, and there is disagreement on why the inequality exists. Some say it is the way to motivate people. I couldn’t disagree more. Instead, let’s give rewards commensurate with one’s contributions to society. This will produce a more efficient economy – instead of so generously rewarding those during the housing bubble who didn’t make society more efficient or contribute to it by any measure available. These free-market principles, for a while, may have made the economy grow like never before, but it was an illusion. Eventually, they imposed huge costs on people all over the world. Capitalism can’t work if private rewards are unrelated to social returns. We need to get rid of this American-style financial capitalism and make room for a new, fairer social-capitalism.

There are multiple reasons why the financial system has performed so badly, and we have to understand them if we are to fix things. Incentives are important, and as mentioned above there is a total mismatch between social vs. private returns. Unless these are closely aligned, the market system cannot work well. “Too big to fail” institutions are very expensive to save, so they should be broken down. Securitization has some virtues, but it has to be carefully managed – something both those in the financial system and the deregulators didn’t do. Commercial banks sought to imitate the high risk/high returns of investment firms; then again, banking should go back to being boring. Those who need the thrill of gambling should go to Las Vegas or Macau to play with their own damn money. Bankers forgot that they should be responsible citizens and not target the poorest and the most vulnerable. Sadly, people around the world trusted that these pillars of the community had a moral conscience, when in reality greed had engrossed them.

The government should have played by the rules of capitalism and enforced a mandatory financial reorganization, giving a fresh start to those who played closer to the rules. Certainly, they might represent the beginning of a new world – one in which incentives are better aligned and lending is revitalized, reducing the need for taxpayer money or even further government involvement. I truly believe that all of the discussion about “too big to fail” banks was just a stunt; a maneuver that worked, as always, based on fear-mongering. Just as Bush used 9/11 and the fears of terrorism to validate so much of what he did, the Treasury under both Bush and Obama used 9/15 (the day Lehman collapsed) and the fears of another meltdown as an instrument to funnel capital to the banks and the bankers that had brought the world to the edge of economic ruin. And the argument that “if only Lehman Brothers had been rescued, all would have been fine” is utter nonsense. Lehman Brothers was a consequence, not a cause. It was the consequence of faulty lending practices and laughable oversight by regulators. Whether Lehman Brothers had or had not been bailed out, the global economy was headed for difficulties that had to be addressed more seriously.

By October 2009, the International Monetary Fund (IMF) reported that global losses in the financial sector were in the order of $3.6 trillion. The banks had admitted to losses of a much smaller amount, so the difference was a kind of dark matter … everyone knew it was in the system, but no one knew where it was. The real issue became that a bank (like Citibank) that has its losses insured by the government has little or no incentive to renegotiate mortgages or extend new credit. Instead of trying to save the existing banks, which had thoroughly demonstrated their incompetence, the government could have given the $700 billion to the few healthy and well-managed banks or even used it to establish a set of new banks. At a modest 12-to-1 leverage, that would have generated $8.4 trillion of new credit – more than enough for the economy’s needs.

In the name of maintaining free market economics, what the government was creating was far from a true market. While the Obama administration had avoided the conservatorship route, what it did was far worse than nationalization. It is ersatz capitalism: The privatizing of gains and the socializing of losses: Socialism for the rich, capitalism for the poor. (By the way…this is the working title of my new book).