Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System?

Chapter 11  Refocusing Finance-Servicing Both Business and Society

This most important but very short (12-page) chapter contains Ms. Foroohar’s prescriptions “how to put finance back in service to business and society”. It is organized under five topic headings. Each topic lists  a mix of specific “fixes” and more  often than not, only general solutions are offered. These “fixes” are briefly discussed. The most relevant ones include comments made with respect to those of us who are still trying to develop viable projects the real economy.

Changing Our System of Market Capitalism

Market capitalism as we know it has evolved over decades, creating  a finance system that has hindered, rather than helped business and society. There seems to be general agreement that a set of  rules that govern our financial system ought to be made to foster more equitable  wealth distribution and to stimulate economic growth.  And specific rule  changes are now needed to  better regulate finance, fix corporate governance and revise our tax system. Wisely, Ms. Foroohar believes that before any of her prescriptions and reforms that she has identified are made, they ought to hashed out among a broad group of stakeholders, not just shareholders

Comments: This implies economic growth and increases in asset values are not the same thing.

Ending Complexity and Cutting Leverage

Ms. Foroohar believes that most To-Big-To-Fail financial institutions, are too complex to manage. She argues that managers are being asked to fully oversee millions of transactions involving billions of dollars, and that it cannot be assumed that good oversight can easily be achieved. She then explains that complex laws, such as the 2,319 page Dodd Frank Act of 2010, are incredibly complicated and contain many loopholes. She also believes that reinstating  the 37 page Glass-Steagle Act as a way to avoid financial crises may not be the answer either. She is calling for a comprehensive re-analysis of our past financial crises, in order to identify the steps we need to take in order to make our existing laws and regulations more understandable.She  also wants to see measures taken to prevent our financial institutions from gambling with government-insured money.

Specific recommendations cited include:

• • Moving all derivatives trading onto regulated changes;
• • Requiring better regulation over the shadow banking sector;
• • Ending offshore banking tax avoidance practices;
• • Closing tax loopholes;
• • Increasing transparency in all financial dealings;
• • Discouraging investment practices that favor short-termism;
• • Charging banks  fees, when trading stocks, bonds and derivatives;
• • Requiring banks to be more prudent, by having them put more of their own money into risky deals;
• • Reminding  financiers to be aware that they too  will share pain when crises do happen; and,
• • Holding banks to higher standards by emphasizing  the primacy of their role as catalysts to business.

Use of Less Debt and More Equity

Ms.Foroohar makes a compelling case for using less debt and more equity, when trying to stimulate private sector growth. She clearly expresses the view that although increased use of debt (e.g., its credit) can stimulate growth, it has limits. She also argues that large amounts of debt are always a precursor  to financial crises and a larger financial sector often means a less stable economy. She then recommends that banks be required to use at least 20 to 30 percent equity when making investments;

She then warns that if the amount of credit being used to stimulate growth rises too quickly, it increases  the risk of having a financial crisis that would slow any economic recovery.

She realizes that “goosing” the economy in a safer manner is a challenge, requiring: establishing  political consensus for undertaking many of the “fixes” that have been identified; re-educating those in the finance industry who have been engaging in excessive financialization practices; obtaining a consensus from all economic sectors for developing a cohesive national growth strategy that can be sustained without creating bubbles; and, revamping of our tax system that better serves the real economy and bolsters of  the social safety net. Another tall order!

She then identifies a number of discrete steps that could be taken to encourage savings and building equity, other than by self-funding.

Mentioned are such measures as:

• Modifying regulations and tax credits to encourage banks to lend more to socially useful causes versus engaging in short-term trading transactions;
• Allowing debt service payments to be lowered in periods where GDP is temporarily declining; and,
• Allowing mortgage rates to downward adjust in times of falling housing prices,  so that mortgages do not go upside-down to the degree that property owners decide to default on mortgage  payments and walk away from their properties.

Comments: Briefly discussed in recent articles and not specifically addressed in this book are problems that have surfaced as a consequence of allowing consumers easy access to high cost credit especially in the area of credit cards, auto loans and title loans. The excesses that have occurred in this area have contributed to our wealth distribution problems and to a slow economic recovery.  The remedies for these excesses point to the lax lending policies of the issuers  of consumer credit and the usurous terms under which such credit is being issued. And there are some recent reports that there is now a considerable number of auto loans that have become sub-prime, leading to the formation of a secondary market  for bundles of a toxic mix of such loans and their derivatives. This has now reached a point where another bubble  is being created which could burst at any time.

Changing The Corporate Mindset of American Business and Finance

This chapter calls for a re-examination of the notion that companies should be run solely (emphasis added) for the benefit of shareholders.  As previously explained, Ms. Foroohar believes  that this has become a problem because shareholders are “short-term focused” and companies have become “quarterly-results-driven” which is undermining their  “long-term viability”. She also believes that this “mindset” has led to companies “jacking up their share prices and cashing out as quickly as possible”.  She attributes this cycle to  having led to slow economic growth  and the proliferation of consumer debt products that financial institutions now offer. She then warns us again that  “this will lead to creation of risky financial bubbles that explode on a regular basis that will take us all down with them”.

Her remedies for mitigating this effect include

• • Imposing regulations to limit the amount and size offshore buybacks;
• • Raising capital gains taxes using a sliding scale that accounts for how long an asset is held;
• • Imposing regulations to limit the amount of corporate pay that can be awarded in stock options; and,
• • Imposing regulations that would require American corporations to include among their board members representatives from their labor force and from civic leaders,  not just representatives from their exiting investors and other stake holders.

Building A New Growth Model

Ms. Foroohar concludes that “financialization is both a cause and a symptom of slower growth” and “too much finance hinders growth”. She has also observed that slower growth encourages policy makers to use finance as a quick fix to deep structural problems within our financial system and it is these “quick fixes” that have created global market reverberations  that has led us to the dysfunctional cycle of financialization that we now have.

She explains that economic growth of the emerging markets is putting pressure on the US to continue to grow its economy, while at the same time it is creating huge amounts of new wealth for these developing nations that they are now investing into our financial markets. But  she concludes that we have not invested these funds wisely, as they had been used by our financial institutions to create new debt bubbles in the US economy, while slowing down long-term investment and economic growth and creating  a rising inequality in wealth distribution. She observed that from the 1980’s onward  these bubbles had been amplified by deregulation and easy credit and they finally burst in 2008. And as a consequence American companies and American consumers stopped spending and our economic recovery is still lagging. Not good! 

In addressing how to break this dysfunctional cycle, Ms. Foroohar  calls for regional cooperation in the global economy on part of its major emerging partner players, such as China, Japan Europe and America. She is also calling for the establishment of a “strong economic growth model that would bolster the real economy”. She argues that such a model must have as its primary objective, the creation of substantial gains in productivity and innovation of the real economy, that can never be achieved through short-term financialization. This is indeed a “new moonshot goal for economic growth” (her words, not mine), as it requires a broad consensus among the public and private sectors, among regions and a set of longer term commitments.

On a national scale, she envisions that the US should establish a national green stimulus program where sustainable energy technologies are developed and investments made to obtain material sources of sustainable energy, while generating economic growth. As to Europe, she would like to see members of  the EU  create a “federalist system” where wealth transfers between rich and poor countries could then be used to create a sustainable growth model for all members. And as to China, Japan, South Korea, Singapore, and Taiwan, she would hope that they all cooperate in making the transition from  “a manufacturing driven economy”, to “a more sophisticated service-driven economy that also manufactures in a sustainable manner”. She realizes that China in particular, has to sort out whether its  autocracy can coexist with advanced capitalism so it too can avoid financial crises  and recessions and achieve a better and more sustainable way to stimulate growth. A tall order indeed!

Changing The Narrative by Empowering “The Makers” 

Ms Foroohar wraps up her  narrative listing a number of ideas on how to build a healthier market system that put the entire global economy on a better path. She observes that “financialization” of our “market system”  by “moneyed interests”, that “enriches only the select few”, can no longer be expected to support sustainable and widely shared economic growth.

The major fundamental changes she foresees as being sorely needed include:

• • Reigning in of banking sector lobbying;
• • Making labor relations more productive and less contentious;
• • Instituting incentive pay reforms;
• • Closing  tax loopholes;
• • Making  market capitalism more transparent and less subject to fraud and abuse;
• • Changing the mindset of business leaders to modify their financing practices to be more of a ”helpmeet to business”, not just a way to accumulate wealth as “an end in and of itself”.

She then mentions a government agency-the Office of Financial Research in the US Department of Treasury (“The OFR”) that was created after the 2008 crisis “to examine where risks might lurk in the financial system” She claims that “it has already done great work” and recommends that it be given further independence and put outside of the jurisdiction of The Treasury and be used to “further explore ways to avoid financial crises in the future”. 

Observation: Although using The OFR in this way sounds like a good idea, the question remains as to whether regulators and the finance industry will take their advise.

Commentary: If one agrees with Ms. Foroohar that most, if not all of prescriptions for “fixing” our financial system are needed, questions remain as to who will take the initiative to see that these fixes are adequately considered or initiated let alone undertaken. Much depends on changes that are needed in the mindset of those decision makers who  are involved with the “Makers and Takers” of American business, and with our governmental agencies , our international partners, our politicians,  and our voting public.

To bring about such widespread changes in thinking, it will require sustained leadership and cooperation, that I believe is not in-the-cards, unless there is another occurence of some economic catastrophe. But there  are a number of suggestions being made that could go a long way to answering the basic question: “ Can We Avoid Another Cataclysmic Meltdown Of The Global  Financial System?”

Ms. Foroohar and others believe such a meltdown is still highly probable 

Can We Avoid Another Cataclysmic Meltdown Of The Global Financial System

As previously indicated, this is the fundamental question Ms. Foroohar raised in her Time Magazine article. After reading her article titled “Saving Capitalism” and her book on which it is based, titled “Makers and Takers” and after having prepared this synopsis, I still do not have the prescience to answer this question with any certainty.

However, I have since come across a number of articles that shed some light on what we can expect to happen and what if  anything can be done to reduce the risk of another meltdown.

One such article that I found most relevant, just appeared in The Economist magazine on August 20^th titled “Comradely Capitalism”. It is a briefing on the current status of the housing market in America  and why the authors of this article believe  another cataclysmic meltdown could happen, if we do nothing to fix some of its systemic problems.

It also addresses what can be done to lessen the likelihood of such an event occurring in the next several years. In addition, the essence of what is said has been extracted from this brief synopsis, before presenting an independent assessment of what we can expect, if we do not fix this system, and what will happen if we do.

A Summary of “Comradely Capitalism”

Major Take-aways

• The signs of the 2008 meltdown were evident before the collapse of Lehman Brothers. In August 2006 housing prices in America had already began to fall, leading to a spike in mortgage defaults in early 2007 and a mounting financial turmoil in Wall Street that ended 31 months later in late 2011.

• It took 10 years for America’s banks  to recover as the banking industry’s core capital is now $1.2 trillion, 2 times its crisis levels. And banks are now reporting a respectable 10% rate of earnings .

• America’s mortgage finance system with its $11 trillion of debt, creates almost as much credit as do the banks. Yet this system is in much worse shape, as it is very badly capitalized, and barely profitable.

• Unlike the banking system, this system is no longer privately owned and operated, as much of its securitization and guarantee functions have been nationalized, as they are subject to the Government’s administrative control.

• America’s housing stock has recovered in valued and was recently estimated to be $26 trillion, almost as much as the America’s stock market. It represents the largest asset class in the world.

• The Americas housing and mortgage banking systems continue to be closely linked to the Global Financial System, as $1 trillion of mortgage debt is owned abroad and American banks still own 23% of all government backed mortgage bonds.

• Problems in America’s housing market and the mortgage banking system had triggered the most recent crisis and could do so again, as many needed reforms have yet to be made.

• The deepest problems are rooted in our mortgage finance system, where financiers suffer from a debt addiction, where hidden subsidies are extensively relied upon to mitigate inequality, and where ongoing political gridlock  remains as an impediment to further implementation of needed reforms
• Home mortgages continue to be offered to American home buyers on very generous terms, thus perpetuating all of the  housing market’s vulnerabilities. Not only is cheap credit funneled to home owners at subsidized interest rates, risky lending is encouraged by low equity requirements, and federal guarantors are  still underwriting bondholders’ losses.

• Banks have partially withdrawn from originating mortgages, as a plethora of new rules with harsh fines for misconduct have been issued in the aftermath of the 2008 meltdown.

• Although most banks still own mortgage backed bonds, new independent firms such as Quicken Loans  and Freedom Mortgage, now fill the demand for  mortgages that are no longer being originated by some banks.

• Mortgages are still being bundled and sold both as mortgaged backed bonds and as derivatives such as CDO’s, CLOs and Swaps. But derivative trading activity in these amplifying mechanisms has fallen by 90% after the last crisis as many private derivative traders are no longer in business.

• Mortgage bonds are widely held, but not evenly distributed. Due in part to its asset purchasing scheme, the Federal Reserve now holds 27% of $1.8 million of the total government backed mortgage bonds that have been issued. And the combined percentage holdings of the Federal Reserve and private investment funds are estimated to be  85%. The other 15% of these bond holdings are estimated to be in the hands of foreign central banks, private banks other financial firms.  This indicates that the risks associated with this  $1.8 trillion debt load, is not being shared proportionately and this uneven distribution has placed the Federal Reserve at risk for $486 billion of this amount. Not good! 

• Mortgage guarantees are primarily being provided by five  “temporarily nationalized securitizers” that are operated as conservatorships under government administrative fiat. These five “State-run Securitizers” are Fanny Mae, Freddie Mac, Ginnie Mae, VA, and FHA. They now own or have guaranteed $6.4 trillion of loans and have an exposure to losses that is three times larger than then a mega-bank such as Goldman Sachs.

• The mortgage bonds that State-run Securitizers create from their bundles of mortgage loans are surprisingly perceived by investors as being almost as safe as treasury bonds. And even though these State-run Securitizers charge investors fees for such guarantees, the actual guarantee is an implied one, as the ultimate risk is being borne by US taxpayers.

Major Flaws 

Our mortgage banking system has a number of flaws, three of which had been described in The Economists’ recent article.

1. 1) The regulations that funnel loans to the five “State-run Securitizers” are recognized as being “too loose”; as they are not able to “magically transform risky mortgages into risk-free bonds”.

1. 2) There is not enough legislation and regulation in place to lower the Loan-to-Value (“LTV”) ratio on borrowers.

1. 3) There is an impending “affordability crisis”, that is impeding home ownership, especially among the young and minorities.

With respect to the first flaw (that of the having a “mortgage machine” that is under-regulating lending practices), has led to perverse consequences for mortgage originators, as they still have an appetite for issuing risky mortgages, because they can readily shift the risk.

With respect to the second flaw, (that of having too many homeowners whose mortgages are at risk of going underwater), it has been found that 20% of all mortgage loans granted since 2012 have LTV ratios of 95%, meaning that a 5% decline in housing prices for such borrowers could put their mortgages under water, and if this occurs ,defaults on these high risk mortgage loans could cost the government an additional  10-15% loss when these loans are re-purchased, bundled, securitized and re-sold. It could become 2008 all over again! 

With respect to the third flaw, (the impending affordability crisis) home ownership rates have dropped  from a high of 69% pre-2008, to  a low of  ~63% shortly after 2008. Part of the problem is that there have been rule changes that now screen out undesirable loans and less qualified buyers before loan origination and securitization takes place. Potential borrowers are now being profiled based on their debt-to-income ratios. They are increasing being required to make larger down payments. They are being restricting in their use balloon payments as a way to lower their uniform mortgage payments.  And loan guarantors who had once been able to insure sub-prime mortgages against losses in default, are faced with increasing their capital requirements, making sub-prime financing more difficult and more costly to obtain.