How should co-ops should respond to the next financial crisis? One of d@w-DC’s members discusses lessons learned from the 2008 recession. “My attention was recently drawn to the headline of a column written by Steven Perlestein in the July 29, 2018 Washington Post: The Junk Debt That Tanked the Economy? It’s Back in a Big Way.”
“Déjà Vu All Over Again.” How Should Coops Respond To The Next Financial Crisis?
August 6, 2018, By William Davis, Democracy at Work DC
Anxiety In DC
My attention was recently drawn to the headline of a column written by Steven Perlestein in the July 29, 2018 Washington Post: The Junk Debt That Tanked the Economy? It’s Back in a Big Way. Perlestein says financial regulators have allowed corporate credit of declining quality to rapidly increase since 2007.1 This blog entry will discuss how devaluation of Collateralized Mortgage Obligations (CMOs) triggered the financial crisis which led to the Great Recession of 2008; provide evidence that people who obtain little of their income from owning financial assets bore a disproportionate share of the risk of stabilizing our financial system; and conclude by proposing a type of reform which can bring economic justice to those bore the brunt of the risk and cost of stabilizing the economy by promoting the growth of worker owned and operated cooperatives.
Recall, that for a decade before the Great Recession of 2008, “innovations” in the financial sector allowed investors to purchase new debt instruments, generally referred to as collateralized debt obligations (CDOs), which often bundled together thousands of debts with different maturity and risk levels. The devaluation of one type of CDO, collateralized mortgage obligations (CMOs) was responsible for triggering the Great Recession.
Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings were responsible for determining the riskiness of CMOs. It was thought that financial markets would not over-invest in risky assets if their risk level was properly rated. However, these rating agencies gave high ratings to CMOs which contained trillions of dollars of mortgages held by homebuyers with bad credit and undocumented incomes. As CMOs became more heavily weighted with sub-prime mortgage loans, and as interest rates on adjustable rate mortgages began to increase, homeowners began to quickly default on their mortgage payments. This prevented many sellers of CMOs from meeting payment deadlines to their investors, which caused most CMOs to be downgraded to junk status. This in turn, led to the collapse of the investment banks of Bear Stearns, Lehman Brothers, Merrill Lynch, and American International Group (AIG), which triggered a liquidity crisis that threatened to shut down the entire economy and throw the country into economic and political crisis.
The federal government decided to prevent the financial sector from failing by buying equity shares of investment banks considered “too big to fail.” Many analysts refer to the cost of the government bailout as the amount of money the government set aside for the Troubled Asset Relief Fund (TARP), which was approximately $700 billion. A better measure of the cost was provided by The Special Inspector General for TARP, who determined that the total commitment of the government to prop up the financial system was $16.8 trillion dollars with $4.6 trillion paid out between the middle of 2008 to the middle of 2015, or approximately $650 billion per year.2
The government was able to prop up the financial system because the risk it undertook to purchase illiquid equity shares was essentially zero, thanks to its ability to tax. Another way of saying this is that the government financed the bailout of the financial sector by increasing the public deficit, which is paid by taxpayers. No wonder that the political arm of the finance industry sought legislation to reduce tax rates on the wealthiest few, which shifted a greater share of the ongoing and future burdens of financial bailouts onto those whose income did not primarily come from interest earned on investments.
People whose income comes primarily from wages have not received a proportionate share of the benefit from the risk they bore to prop up the financial system during the Great Recession. Income and wealth disparities between the richest Americans and everyone else has increased since the Great Recession. “In 2010, the top 10 percent of earners made about 4.5 times as much as the median family; in 2013, they earned nearly five times as much … [t]he top 3 percent of earners held 54.4 percent of all U.S. wealth in 2013, up from 51.8 percent in 2007 and 44.8 percent in 1989.” This occurred because those with the highest incomes have more than 50 percent of their wealth in stocks, while poorer families have less than a third of their wealth in stocks. Less than half of all families own any stocks at all, even in retirement accounts.3
The Vu From DC
While income disparities increased between wealthy and lower-income households across the country, many measures of growing inequality were greater in DC than elsewhere. For example — DC, along with New Hampshire, had the highest percentage of children (13 percent) with unemployed parents in 2011;4 the 30 percent child poverty rate in DC in 2010 was only exceeded by Mississippi;5 and DC had the highest level of inequality among States as recently as 2016, with the bottom fifth of DC households earning two percent of DC income in 2016, while the top fifth percent earned 56 percent of DC income.6
Perlestein believes today’s financial sector is on the verge of another crisis caused by opaque, securitized, financial instruments. He notes that volume of another type of CDO, collateralized loan obligations (CLOs), have increased by 38% since 2017. CLOs are attractive because they offer interest payments that will increase as global interest rates rise, as expected to the next few years. But as was the case with CMOs, collateralized loan obligations bundle together thousands of corporate loans, many of which have low credit ratings, hence Perlestein’s concern. While I don’t wish for another financial crisis, it would be foolish to believe one is not likely in the near future. It would be equally foolish to expect one and not prepare policy options which, this time, would compensate those who have borne, or will bear, the cost of bailing out the financial system.
A Policy To Prevent Déjà Vu
Economists of all stripes have promoted a variety of what I call “reformist” changes in financial policy to reduce the likelihood of another meltdown of the financial system. These policies include: improving the oversight of rating agencies; requiring banks to pass “stress tests”;7 requiring sellers of CDOs and other exotic financial instruments to retain a percentage of their value in cash; requiring a greater share of finance capital to be invested in industrial enterprises; and favoring macro-prudential over micro-prudential regulation of financial markets.8 These policies are reformist because they would continue to place the burden of maintaining liquidity on those whose income is primarily based on wages.
Non-reformist policies seek economic justice by compensating those who earn most of their income from wages for the risks placed upon them to recover from bailouts. One method of implementing a policy of economic justice would value the debt unjustly borne by the public in the last bailout as the price of the “liquidity ‘put’ (i.e. the cost of the U.S. government guarantee) that supports asset values and prevents their disaccumulation.”9 The option to call this debt could be owned or vested in a cooperatively owned and operated institution, such as a cooperative bank. This cooperative bank could be allowed to only partially exercise this option in a given year.
“Calling” only a portion of this option every year would not destroy the stability of the current financial system, which might occur if the full value of the liquidity put was fully exercised. Yet, it would allow a cooperative bank to overcome one of the known barriers to the expansion of cooperative enterprises, namely investment of a magnitude capable of increasing the scale of individual cooperatives as well as the scope of the cooperative ecosystem. By exercising only part of the value of its call option each year, the cooperative bank would retain a flow of value from the remaining value of the option, which it could partially exercise in subsequent years.
Not-for-profit, worker owned and operative cooperatives, are currently a very small part of the economy, but the attractiveness of employment arrangements which give employees more “voice” has been growing since the Great Recession. Proponents of not-for-profit, worker owned and operated cooperatives should begin the task of persuading their supporters, as well as the general public, that the cost of the next bailout should be used to increase the ability of workers in enterprises on the verge of bankruptcy to convert the enterprise to a worker owned and operated cooperative, and to fund a cooperative bank whose mission is to fund not-for-profit, worker owned and operated cooperatives.
1 Washington Post, July 29, 2018.
2 See, The Big Bank Bailout, by Mike Collins, July 14, 2015, Forbes Online, at: https://www.forbes.com/sites/mikecollins/2015/07/14/the-big-bank-bailout/.
3 Economic Inequality Continued To Rise In The U.S. After The Great Recession, by Ben Casselman and Andrew Flowers, FiveThirtyEight, September, 4, 2014, at: https://fivethirtyeight.com/features/economic-inequality-continued-to-rise-in-the-u-s-after-the-great-recession/.
4 The Recession’s Ongoing Impact on America’s Children, by Julia Isaacs, December 20, 2011, Brookings Institution.
6 Income Inequality in DC Highest in the Country, by Minahil Naveed, December 12, 2017, DC Fiscal Policy Institute.
7 A stress test measures whether a bank has a level of equity capable of backing an unexpected increase in demand for liquidity.
8 Macro-prudential policies seek to control the level of systemic financial risk over time, rather than seeking to limit risk associated with individual financial institutions.
9 The value of this debt could be annually updated according to the value of not fully exercising the option of economic justice. See, Reinventing Marx for an Age of Finance, by Robert Meister, Postmodern Culture, vol. 27 no. 2, 2017. Project MUSE, doi:10.1353/pmc.2017.0000. I have drawn on this innovative paper for its concept of economic justice as the option value of sustaining the liquidity of the financial system.