What is capitalism? Can you define it? Today, it seems that many people define capitalism as anything that is done in the private sector with the goal of making a profit. On the flip side they define socialism as anything done by the government that could impede the “free markets” and making profits.
According to the definition in Merriam-Webster dictionary capitalism is:
“an economic system characterized by private or corporate ownership of capital goods, by investments that are determined by private decision, and by prices, production, and the distribution of goods that are determined mainly by competition in a free market”
and socialism is defined as:
“any of various economic and political theories advocating collective or governmental ownership and administration of the means of production and distribution of goods a: a system of society or group living in which there is no private property b: a system or condition of society in which the means of production are owned and controlled by the state.”
The term capitalism did not exist until the middle of the 1800’s even though economic trade for profit has existed for millennia. However, over the past forty years the definitions of both capitalism and socialism have been transforming and broadening as Wall Street has become more sophisticated in the field of financial engineering. The shift began slowly as new financial derivative products were introduced such as: foreign currency futures (1972), equity futures (1973), T-bill futures and futures on mortgage backed bonds (1975), currency swaps (1980), equity-index futures (1981), interest rate swaps (1981), collateralized mortgage obligations (CMOs) (1983), futures on the U.S. dollar and municipal bond indices (1985), collateralized debt obligations (CDOs) (1987) and Credit Default Swaps (CDSs) (1994), just to name a few. The early derivatives, such as commodities futures, did retain the basic principals of capitalism. In simple terms, they were private agreements between two parties to deliver a product at a specified price at some future date, and they were traded on an open exchange. But as they became more complex and expanded into other areas they became further detached from any underlying product and entered the realm of “faux capitalism”.
Simultaneously with the growth of derivatives, the groundwork was put in place for the explosion in the credit markets starting with the passage of the Alternative Mortgage Transition Parity Act (AMTPA) (1982) which made it legal for a lender to offer more creative mortgages including Adjustable Rate Mortgages (ARMs), ARM’s with balloon payments, interest only loans, piggyback loans and negative amortization loans. The AMTPA also pre-empted state laws which prevented these types of loans. As the regulatory structure that was put in place during the Great Depression was dismantled and finally eliminated, with the repeal of the Glass-Steagall Act in 1999, the rate of introduction and complexity of new financially engineered products and creative financing both accelerated. Derivatives trading – mostly futures contracts on interest rates, foreign currencies, Treasury bonds, etc. — had reached a level of $1,200 trillion ($1.2 quadrillion) a year. This estimate was based on information available for those derivatives that were traded on exchanges and does not include the large volume of private contracts for CDOs or CDSs which are traded in the opaque OTC market. But even the known volume traded in the open market is huge considering by comparison the U.S. GDP in 2006 was only $12.456 trillion.
Most people still have the old quaint notion that Wall Street’s primary function is the trading of stocks and the allocation of capital so that it can be put to the most productive use to generate economic growth and profits. But today Wall Street’s real business is trading debt, and betting on whose debt will fail. Lou Ranieri, who invented the process of “securitization” in the 1970’s while he was at Solomon Brothers and then worked with the Reagan Administration to deregulate the financial industry in the 1980’s to legalize and legitimize “securitization”, predicted at that time that once the debt securities market took off, it would dwarf equities. He was certianly correct. The total credit market debt as a share of GDP was approximately 130% in 1984, roughly where it had been since 1952. It then exploded to 335% of GDP by 2006. This debt explosion provided Wall Street with the basic material they needed to create an entirely new way to generate fees and trading profits. No longer did they need the private companies who wanted to raise capital by going public, or existing public companies seeking to raise more money by selling secondary placements of stocks or bonds, or even companies looking to do mergers and acquisitions. Sure these services are still provided by Wall Street firms in order to keep up the facade of capitalism, but the real money is made in the “faux capitalism” market of trading and betting on debt. It was the combination of these two factors, the explosion in the derivative and credit markets, that lead to the subprime mortgage crisis and the housing bubble.
As this shift occurred, the financial services sector went from being 14.0% of the U.S. Gross Domestic Product (GDP) and only 20% of total U.S. corporate profits in the 1970’s to 20.4% of GDP and 45% of total U.S. corporate profits in 2004. At the same time manufacturing went from 23.8% of GDP to just 12.0% of GDP. So we transitioned from a country that makes things to a country that makes things up. During this period another important transition occurred. The Wall Street investment firms went from partnerships to publicly traded corporations. This allowed the partners in the firm to stop risking their own capital and begin using other peoples money. They no longer shared the same level of risk with their clients and their compensation packages became tied to short-term performance as opposed to sounder long-term investing decisions. Churning stocks and other investment products in order to generate more fees and short-term profits led to inventions like high-frequency trading in their own proprietary accounts. High-frequency trading uses complex computerized mathmatical algorithms to analyze market data and implement proprietary trading strategies in investment positions which are held only for very brief periods of time. They will rapidly traded into and out of those positions, sometimes thousands or tens of thousands of times a day, and at the end of a trading day there is no net investment position remaining. By 2010 high-frequency trading accounted for over 70% of all equity trades taking place in the U.S. Trading into and out of a position in a matter of seconds, minutes or even hours certainly does not fall withing the definition of investing.
However, just because it is a new “financial product” which is being created or a new high speed trading system being implemented, does that automatically qualify it as capitalism? In the 1920’s Charles Ponzi created a new financially engineered product, and it made a profit, at least for those who invested early. But I don’t think there is anyone today that will argue that a Ponzi scheme is capitalism. Nor can you find anyone today who will defend Bernie Madoff as a capitalist. But ten years ago, those people who are still defending Wall Street’s actions and their innovative products like derivatives also were defenders of Bernie Madoff.
An economic bubble is similar to a Ponzi scheme in that one participant gets paid by contributions from a subsequent participant until inevitable collapse ocurs. A bubble involves ever-rising prices in an open market where prices rise because new buyers bid more because prices are rising. As with the Ponzi scheme, the price eventually exceeds the intrinsic value of the item; unlike the Ponzi scheme, there is no one person misrepresenting the intrinsic value. It is a systemic misrepresentation by many participants operating in the open market with each participant providing their own contribution.
The housing bubble in large part was created by Wall Street’s introduction of a new financially engineered product called collateralized debt obligations (CDOs). The first CDO was issued in 1987 for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation, which was an early version of a government bailout for the failed savings and loan industry. The collapse of the S&L’s was a precursor for what was to come and should have been a warning to everyone. However, ten years later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. The bubble was fueled by easy credit given to borrowers, many unqualified, by the fractional reserve banking sysytem and the shadow banking system, together with low interest rates and easy monitary policies from the Federal Reserve. There were mortgage brokers and other lenders who were playing fast and lose with the few regulations that were still in place. These loan orginators would pass the debt along to Wall Street who would “securitize” the loans into CDOs. There were rating agencies that were giving triple-A ratings to investment products that they clearly didn’t understand so they had to rely on the computer modeling provided to them by the company creating the product being rated. This was because the mathmatical formulas were too difficult to recreate, especially when the rating agency didn’t have the underlying data to do an independent analysis. Then these CDOs were sold all over the world as if they were some of the safest investments.
But one of the most important factors that fueled the housing bubble, which is rarely discussed, is the decoupling of the lender from the borrower. Before the deregulation of the financial industry there was a direct connection between lender and borrower. The lender had a strong financial motive to make sure that borrowers were qualified and that they would make their payments. Even though some of these loans may have been packaged together and sold off to private investors or entities such pension funds, Fannie May or Freddie Mac, these activities clearly fell within the definition of capitalism. It represented the efficient use of savings and investment capital with the banking system acting as the intermediary and charging fees for their services.
But deregulation of the financial services industry and the lack of any regulations or transparency in the fast growing derivatives markets changed everything. First, the deregulation led to a significant consolodation in the financial industry. Banks grew bigger and services such as commercial banking, investment banking, insurance and brokerage service and the ratings agencies could now be provided by one fully integrated company. There were a few early critics that warned this would lead to big problems down the road because these companies would become too big and they would be able to stovepipe these new financial products that were being created with little or no transparancy, to the detriment of the consumer and investor. But the critics were dismissed, deregulation proceeded and the creation of new financially engineered products such as CDOs, synthetic CDOs and Credit Default Swaps (CDSs) exploded in the 1990’s and early 2000’s.
By design, a CDO was intended to be complex and difficult for most people to understand. But the regulators were told they didn’t need to worry about them because they were a private contract between two sophisticated counterparties who understood the complexity and risk. In simple terms, a CDO is a financial product that is created by packaging together loans (home loans, car loans, student loans, bonds, etc.) and their value is derived based on the anticipated cash flow from these loans. Packaging loans was not new but the twist with these new financial engineered CDO’s was that the underlying loans were tranched and put into multipule CDO’s. In therory this was done to spread the risk and allow those who could afford to assume more risk to recieve a higher return. So a loan would be divided up into a hundred or thousand parts, known as “tranches”. Each of these parts would go into different CDO’s with other tranched loans. Each tranche coming from a loan offered a varying degree of risk and return and they would be combined so as to meet various investors desires. “Senior” tranches are considered the safest securities. Interest and principal payments from the underlying loans were made in order of seniority, so that junior tranches offered higher payments and interest rates or lower prices to compensate for additional risk of default. Once the loans were tranched and the CDO was sold off to investors, the lenders and borrowers were decoupled. A service company was then placed in the middle, usually the same one that created the CDO, which would take in payments and pay out to the various CDO’s investors the appropriate proportion of the payment to each CDO that owned a tranche of that loan. Of course they charged fees for providing this service, just as they had charged fees for creating the CDO in the first place. But the loan servicer had no real interest in making sure that the loans were performing.
The inital loan between lender and borower is clearly within the definition of capitalism. Even packaging whole loans and selling them to investors falls within the definition of capitalism. But once a new financial product is created which derives its value from some other financial product, then we have entered the relm of “faux capitalism”.
But Wall Street didn’t stop at the creation of just CDOs. They went farther and created synthetic CDOs, also known as CDOs squared. These were CDOs that were not based on underlying loans. They were based on other CDOs being the underlying asset that was being securitized. So they were two off from the initial loan. What would be the benefit of creating a synthetic CDO, other than collecting more fees? What Wall Street was able to accomplish with synthetic CDOs was to create more triple-A rated products out of CDOs that were of higher risk and lower ratings. The triple-A rating is important because many institutional investors are restricted to buying only the safest investments with the triple-A rating. There were not enough investors to buy all of the junior level tranched products, but by combining the riskier CDOs into a synthetic CDO, the senior tranches of this new product would get a triple-A rating from the agencies. Obtaining a “faux triple-A” rating on these synthetic CDOs derived from riskier CDOs is clearly “faux capitalism.”
However since the payouts from the underlying loans went to the original CDO, the synthetic CDOs could only work if there was an investor on both the long and short side of every tranche. In order for this to happen, the invention of two additional financial products was necessary. The first of these was Credit Default Swap (CDS), which was the inital way to take a short position on a CDO, and the second was the creation of the ABX index which made shorting the mortgage market easier. This exploded the subprime mortgage market and the dollar volume of the derivatives market.
The first CDS was created in 1994. A CDS is a private agreement whereby the seller of the CDS will compensate the buyer in the event of loan default. The buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if the loan defaults. In effect it is an insurance policy against a potential default. There is no restriction on who can purchase a CDS. Even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan can purchase a CDS. When this occurs it is referred to as a “naked” CDS. The buyers of the CDS are effictively betting on a default in hopes of a big payoff.
The ABX is an index based on subprime mortgages which began trading in January 2006. It traded just like any other index fund and the ABX made shorting the mortgage market much easier than it had been previously.
The result was a dramatic increase in the amount of money that moved among market participants and, of course, the fees being charged by the middle men on Wall Street. Since multiple insurance policies or “bets” could be stacked on the same CDO or synthetic CDO, there was no longer a limiting factor such as the dollar amount of underlying loans to place a cap on the expansion of the derivatives market. All that was needed was someone to take each side of the bet. Because the derivatives market was unregulated and opaque, there was no way to determine the exact value of the outstanding bets. But the Bank for International Settlements estimated it to be $681 trillion dollars in 2008. That is more than ten times the output of the entire world economy. It is analogous to a bookie taking on as many bets as he can on the Cowboys-Redskins game and taking his cut for facilitating the bet, with no concern for the overall dollar volume being bet. No one would call the bookie a capitalist, nor would they call a bet on a football game capitalism. So why call the big Wall Street firms capitalists for facilitating bets on CDOs? Shouldn’t we call them what the are, “faux capitalists” or con-men who created the biggest economic bubble in history?
Following the burst of the housing bubble and after they secured their taxpayer bailouts, in classic con-man mentality, Wall Street and their media mouthpieces began to blame the marks. In their view, the housing bubble was caused by subprime mortgage borrowers who were too stupid or greedy or both. They tell us we shouldn’t blame Wall Street for the naivety of the people who took out loans they could not afford. But are we supposed to believe that a bunch of people, who didn’t know each other, had limited financial knowledge and poor credit histories, outsmarted and tricked the MBA’s and PhD’s on Wall Street and created the housing bubble. Really?
The “blame the victim” argument started in February 2009 when CNBC’s Rick Santelli, in a broadcast from the floor of the Chicago Mercantile Exchange where derivatives are traded, went on a rant in opposition to a proposed government plan to refinance mortgages. He said that those plans were “promoting bad behavior” by “subsidizing losers’ mortgages”. It is quite ironic considering Wall Street had just recieved $780 billion from taxpayers in the TARP bailout and, as we would find out later, over $7 trillion in assistance from the Federal Reserve, rewarding their bad behavior. In addition, the Federal government took over AIG, the worlds largest insurer, who had issued many CDSs that were on the losing end of the bets, and proceeded to pay out 100 cents on the dollar, thereby “subsidizing loser bets” with more taxpayer dollars. Of course Mr. Santelli did not provide a similar rant against Wall Street’s “bad behavior” or its “loser CDOs”.
Unless we begin to distinguish “real” capitalism from “faux” capitalism, the anti-Wall Street sentiment will continue to grow. The next time a financially engineered crisis is brought on by the “faux” capitalists it may bring down the entire economic system and representative democracy with it. What is needed are laws that make these “faux capitalist” schemes illegal just as a Ponzi scheme was made illegal.
FDR understood after the banking collapse that you could not just tell people that the banks were safe and expect them to accept that. He knew strict regulations were needed so we got the Glass-Stegall Act. We can no longer tell people that whatever Wall Street does is called “capitalism” and expect they will accept that. We must pass regulations to severely restrict financial engineering coming from the “faux” capitalists. Too many of the best and brightest students have gone into the financial sector because that is where the big money can be made. We need to get back to making things.
As Paul Volker once said to an old civil engineering professor who was lamenting the fact that there is hardly an elite university in the United States who pays attention to civil engineering, “The trouble with the United States recently is we spent several decades not producing many civil engineers and producing a huge number of financial engineers. And the result is shitty bridges and a shitty financial system.” Mr. Volker, the former Federal Reserve chairman from 1979 to 1987, is from an era when Wall Street was still a bastion of “real” capitalism. Reagan replaced Volker with Alan Greenspan, who brought a new ideology and played a significant role in the development of “faux capitalism.” Greenspan, as the top regulator over Wall Street, believed that banks could better assess their own risk tolerance level, set their own capital ratios, and that they would do a better job of regulating themselves based on their own rational self-interests. He even testified before Congress in favor of an unregulated derivatives market. It was only after the housing bubble had burst and Wall Street had been bailed out with taxpayer dollars that Alan Greenspan finally admited there was a flaw in his ideology. Before a House Congressional committee, he was questioned about the role his “free market” ideology played in his decision making process. Greenspan responded, “You have to — to exist, you need an ideology. The question is whether it is accurate or not. And what I am saying to you is, yes, I found a flaw. I don’t know how significant or permanent it is, but I’ve been very distressed by that fact.” When pressed a little farther by Representative Henry Waxman who asked, “In other words, you found that your view of the world, your ideology, was not right, it was not working?” Mr. Greenspan, a man known for his ability to use Fed speak to obfuscate his real intent, made one of his clearest statements he ever made before Congress replying, “That is — precisely. No, that is precisely the reason I was shocked, because I have been going on for forty years or more with very considerable evidence that it was working exceptionally well.”
In a nut shell, that is precisely the problem with “faux capitalism”. It seems to work well right up to the point when it doesn’t and collapses the entire economy. Since 2008, Wall Street has made a spectacular comeback but Main Street has been left behind. Nothing has changed significantly and the Dodd-Frank legislation only made some initial first steps in an attempt to reign in Wall Street excesses. But the “faux capitalists”, with their bought and paid for allies in Congress, are attempting to undermine or repeal even these initial steps. What we need is for the American public to reach the epiphany that Alan Greenspan had, which is an unregulated free market ideology is flawed, and then demand that Congress regulate Wall Street and make “faux capitalism” just as illegal as a Ponzi scheme.