Excerpt From Foreign Policy Paper On Financial Crisis

Global Implications

The most significant foreign policy crisis is actually occurring domestically: it is our faltering economy.  The current financial crisis has caused what Niall Ferguson, economic historian at Harvard University, has called, a “crisis of globalization.”  The United States has less money to consume foreign products and less money and incentive to invest in foreign enterprises and products.  Because the United States is the economic hub of the world, our recessions send shock waves globally and trade is a two way street.  Our recessions lead to less demand for foreign products, creating unemployment abroad.  Global unemployment in turn creates less demand for American exports; a vicious cycle is created.

Our recession is also drying up local, state, and federal coffers.  Funds for all kinds of basic services are no longer being counted on.  Policemen, fire fighters, public health workers, social workers, public administrators, and educators all around the country are being laid off.  This drying up of funds includes many non-profit charitable and humanitarian organizations which have proven to be crucial to the well-being of the most vulnerable populations in our world.

Lastly, the United States is forced to spend a lot of money shoring up the so-called “too-big-to-fail” companies (e.g. AIG, GM, Citi) and providing liquidity to failing banks.  This, of course, increases the already large debt.  For years, most Americans have cared little how financing debt works because it has never been a problem.  Now, we are keenly aware that China is a huge financier of America’s debt.  With China’s own need for domestic economic growth and its Communist Party’s fear of domestic uprisings, it stands to reason that China could eventually become unwilling to finance America’s debt and instead focus its attention more inwardly.  The other possibility is that China might insist on raising interest rates on the money we borrow, a scenario we would be powerless to resist.

The Root of the Problem

The key to shoring up the the economy is both complicated and simple.  To understand the solution, it is important to understand the actual problem.  Unfortunately, the masses seem content to blame easy targets such as large banks, sub-prime mortgages, President Bush’s tax cuts, Fannie Mae and Freddie Mac, corporate greed, and Americans living on too much credit.  While many of these may have contributed to the problem, they all miss the underlying problem.

Before the turn of the century, any person wanting to get a mortgage would usually need three things: about a 25% down payment, a fairly steady job, and good credit.  Loan officers essentially made their money (and banks stayed in business) based on how well their loan recipients paid back their loans.  This system had more or less been in place for as long as our modern banking system.  However, when the mortgage-backed security (MBS) was invented during the late 80s, and came alive during the late 90s, everything began to erode.  Commercial banks (i.e. your basic savings and loan institutions) could issue mortgages to interested homeowners and sell them to investment banks (e.g. Citigroup, Solomon Brothers, Bank of America, JP Morgan Chase, etc.) for fees.  The investment banks would then bundle up those mortgages and sell them as investments.  The investors’ returns were essentially made up of the interest on each loan.  If the average interest on the mortgages was 8%, investors could expect roughly an 8% gain (minus the percent of defaulted mortgages).  Eventually, there were not enough mortgages to support the demand for MBSs.  Because of this, commercial banks relaxed their issuance standards to increase the number of people who were eligible for mortgages.  As more and more people became eligible to take out mortgages, demand for real estate went up sharply, dramatically raising property values.

When property values appreciate sharply, as they did from 2001 to 2006, it becomes almost impossible to default on a loan.  Suppose an individual takes out a $500,000 mortgage.  If, by the time he cannot make his payments, the value of his home has risen to $550,000, he can simply sell his house.  He will get $50,000 and the bank will eventually get its $500,000 plus interest, so both are happy.  Traditionally, mortgage loan officers’ pay has been based on the volume of loans that get paid back. The system, which worked for centuries, provided incentive for prudence and caution while the new system encouraged recklessness.  The more loan officers loaned, the more they made in fees.

Unfortunately, the ratings agencies saw it the same way.  Mortgages that would ordinarily be given terrible ratings were given the AAA rating (the highest rating) because they were not defaulting.  The ratings agencies did not take into account that the low default rates were due to artificially rising real estate values.  Because of the AAA ratings, investors felt very safe with the MBSs and invested all the more.

As you can see, a vicious cycle was created.  Many people were getting rich between 2001 and 2006.  Homeowners were using their rising home equity to pay off their mortgages and even as modified debit cards, spurring on artificial consumer demand.  Commercial banks were making money issuing home loans and selling them to investment banks for fees.  Investment banks were making money on brokerage fees from investors and investors were making money from the securities themselves.

The Solution

Overall, the banking system was not in terrible shape when it crashed.  Centuries of solid banking practices were overwhelmed by a single financial instrument that created a system of perverse incentives.  The problem is simple: commercial banks and investment banks were never meant to be married.  Allowing the two to intermingle creates all kinds of conflicts of interest and threatens the integrity of the entire banking system.  Therefore, solution is two-fold.  First, the two types of banks need to be made separate.  The Glass-Steagle Act of 1933 was enacted for this very purpose.  However, it was overturned in 1999 by the Gramm-Leach-Bliley Act of 1999.  The Glass-Steagle Act needs to be reenacted.  Doing so would restore much lost confidence in the financial sector.

The second fix has to do with the toxic assets that banks have on their books.  These are mostly the horrible sub-prime mortgages which became woefully unrepayable after the mortgage bubble burst.  The government is attempting to purchase these assets from the banks but they are having trouble because of the inherent difficulty in trying to determine their true value.  Unfortunately, the banks are probably going to win the appraisal battle, which means the government can either purchase these toxic assets at higher valuations now, or they can do it later, as Japan did in the 90s.  The US Treasury should purchase these assets now and get it over with.  Otherwise, like Japan, we will encounter a decade of zombie banks and financial stagnation.

A healthy financial sector is the key to the modern American economy.  Restoring its potency, prominence, and trustworthiness will inevitably create reverberations throughout the economy, as industries will have their lines of credit restored and be able to hire more workers; demand will rise, deflation will reverse and the states’ and federal coffers will begin filling again.