Like many progressives, I blamed the Great Recession on the repeal of Glass-Steagall. But that is only a tiny part of a larger story. (More)

ECONned, Part II: Shadows of a Crash

This week Morning Feature considers Yves Smith’s 2010 book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. Yesterday we looked at the economic theory that enabled the Great Recession. Today we examine how blind faith in that theory led to deregulation, looting, and the shadow banking system collapse. Saturday we’ll conclude with Smith’s proposed remedies and our ideas for talking with median voters like our archetypal Fred.

Yves Smith is the founder of Naked Capitalism and has over 25 years experience in finance. A graduate of Harvard College and Harvard Business School, she has worked in corporate finance for Goldman Sachs, was the head of mergers and acquisitions for Sumitomo Bank, and currently heads Aurora Advisors in New York City. She has written for The New York Times, The Christian Science Monitor, and several other print and online publications.

Selling a Myth

The Wall Street Journal‘s Charles Murray thinks capitalism has an image problem:

Mitt Romney’s résumé at Bain should be a slam dunk. He has been a successful capitalist, and capitalism is the best thing that has ever happened to the material condition of the human race. From the dawn of history until the 18th century, every society in the world was impoverished, with only the thinnest film of wealth on top. Then came capitalism and the Industrial Revolution. Everywhere that capitalism subsequently took hold, national wealth began to increase and poverty began to fall. Everywhere that capitalism didn’t take hold, people remained impoverished. Everywhere that capitalism has been rejected since then, poverty has increased.

“Capitalism” can mean many things, and Murray’s claims about its success do have merit, depending on which definitions you choose. He goes on to argue, as conservatives and libertarians often do, that the Great Recession was a cultural rather than a systemic failure. The problem lay not in capitalism, but rather in the erosion of cultural norms that let greed run amok.

Yet what if pursuing the sort of capitalism Murray proposes – one where government acts only to “enforce laws against the use of force, fraud and criminal collusion, and use tort law to hold people liable for harm they cause others” – was in fact the primary reason those cultural norms eroded?

Deregulation and Drift

Yves Smith makes that case in ECONned. Like many progressives, I blamed the Great Recession mostly on the repeal of the Glass-Steagall Act that, since 1933, had kept investment and commercial banking separate. In fact the repeal of Glass-Steagall was at most a tiny part of the story. Smith argues that law was largely a dead letter by the time of its repeal due to variances granted by regulators, many of them arguably worthwhile. As we’ll discuss tomorrow, Smith acknowledges the economies of scale that allow large banks to offer a range of financial services at lower cost than would dozens of smaller firms offering only one or two services each.

And as the Washington Post‘s Steven Pearlstein notes, the financial firms that collapsed in 2008 were not and had never been commercial banks. Bear Stearns and Lehman Brothers were investment banks. AIG was an insurance company. None would have been regulated under Glass-Steagall, which covered only commercial banks, and commercial banks came through the Great Recession largely intact. So what went wrong?

The problem, Smith argues, was blind faith in the neoclassical dogma of self-correcting markets. That led to many other examples of deregulation, such as changes in accounting rules that let banks and traders overstate their assets and underestimate their risks. It also led to what Paul Pierson and Jacob Hacker call “policy drift,” the failure to create new regulations as complex derivatives emerged and came dominate the credit market. Congress chose not to regulate those derivatives, and by 2005 the total of loans financed by complex derivatives – traded by and through investment banks – exceeded the regulated loans and other instruments offered by commercial banks.

Looting in the Shadows

The rise of this “shadow banking” – leveraged and re-leveraged through borrowing on still more complex derivatives – allowed traders to build enormous levels of risk. In the mythical Marketopia, there was no reason for government to supervise that risk. Investment bank executives would ensure their traders did not put the bank in peril of collapse, and the pension funds and municipalities that bought derivative bonds would apply due diligence to ensure the prices and returns offset their risks.

Meanwhile, back in Realworldia, bank executives lacked the expertise to understand the complex derivatives their traders were creating and selling. Senior executives had no way to know their Value at Risk (VaR) models had badly underestimated how a shock could spread into seemingly unrelated markets, and how quickly the spreading failure could consume their firms’ assets. Worse, accounting rules allowed firms to post the projected future profits on a derivatives bond issue in the quarter that deal closed, and compensation contracts paid executives and traders on those projected future profits – with few if any penalties for underperforming past deals – again on the assumption that the market would expose any shady dealing.

The predictable result was that traders began looting, hiding risks both from the customers who bought derivatives bonds and from their own bosses. So long as the big bonus checks kept rolling in, senior executives had few incentives to have their risk management departments scrutinize the books. Even if they had, their risk management accountants – like the analysts at the ratings agencies that graded the bonds – used the same VaR models and lacked the expertise to challenge the equations or their results. As for the pension and municipal fund managers buying the bonds, they were sheep to be fleeced.

Smith presents compelling evidence that traders creating the shady bonds did know the risks. By 2007, the volume of credit default swaps matched that of new bond issues, and the swaps were hedging against those very same bond issues. The structure of these hedge bets meant traders would only profit if the mortgage-based bonds they sold were indeed junk, letting them claim bonuses on the profits before their firms – and the bondholders and insurers like AIG – were stuck with the losses.

All of that was backstopped by the investment banks’ experience with the “Greenspan Put” and the ongoing, implicit promise by the U.S. and other governments to bail out big financial firms when the house of cards began to collapse. Even had governments wanted to let the firms fail, the “shadow banking” system had become so dominant that its failure threatened the entire global economy. As Smith writes, “It is hard to discipline someone who is holding a knife to your throat.”

Conservatives would point to that last paragraph as proof that the Great Recession was all the government’s fault. If government hadn’t implicitly promised to bail out failing banks, the argument goes, none of the rest would have happened. Executives would have magically acquired the expertise to understand the deals their traders were making, despite the bonuses the executives earned from those deals. Ratings analysts and pension and municipal fund managers would have been more skeptical of the VaR models. The ‘free hand of the market’ would have sorted everything out.

But as we saw yesterday, the conservative argument presumes Marketopia … and this story happened in Realworldia.

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Happy Friday!