The Independent (Kampala)

Uganda: Obama or Romney, America Has No Choice

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As the American election gets near, the partisans on either side have assembled to criticise one another and show that there are actually serious policy differences between the Democrats and Republics and between President Barak Obama and his challenger, Mitt Romney.

Yet increasingly, the United States has degenerated into a one party state divided into two factions: one calling itself Democratic and the other, Republican. The two parties keep recycling the same people who have promoted policies that have left the US as the world's most indebted nation. The genius of this system is to make most Americans believe if offers alternatives.

For example, although Democrats claim that the cause of the 2008 financial crisis was caused by George W. Bush, the deregulation of the financial sector that began under Ronald Reagan (a Republican) were carried through with passion and zeal by the Bill Clinton administration (Democrats) supported by leading Republicans in the House and Senate. Bush only carried to the logical, albeit tragic, conclusion what both parties had promoted.

For instance, in 1998 Citicorp and Travelers Group merged to form Citi Group. This merger violated the Glass-Steagall Act, which had been passed in 1933 after the Great Depression to prevent commercial banks with customer deposits from engaging in risky investment activities. The Federal Reserve (or Fed) under Allan Greenspan should have intervened to stop this merger. Instead, it gave them an exemption for one year.

Clinton's Treasury Secretary, Robert Rubin strongly supported the act. Rubin had been the Chief Executive Officer (CEO) of Goldman Sachs. In 1999, Congress passed the Gramm-Leach-Bliley Act, which overturned Glass-Steagall and paved way for deregulation. Senator Phil Gramm, one of the sponsors of this act was the Republican chairman of the Senate banking committee. From then onwards, the combination of commercial banking with investment finance and securities trading proceeded without hindrance and was to become the leading cause of the 2008 financial meltdown.

In fact, there had been an attempt to stop this slide into financial madness by the chairperson of the Commodities Futures Trading Commission (CFTC), Brooksley Born. In 1998, she raised alarm bells that trade in unregulated Over the Counter Derivatives (OCDs) was likely to lead to chaos. Inside the Clinton Administration, a coalition of Greenspan, Rubin, his deputy Larry Summers, then chairman of the Securities Exchange Commission (SEC), Arthur Levitt worked tirelessly with the Republican controlled Congress to block Born's attempted regulation forcing her to resign in 1999.

When he left government, Rubin became vice chairman of Citi Group and made US$ 126m in that capacity. When Gramm left the senate, he became vice chairman of UBS, one of the leading banks trading in derivatives. Gramm's wife had served on the board of the energy giant, Enron, which later collapsed amidst corruption and fraud. Summers went on to become and earn millions of dollars as a consultant to Wall Street financial firms. When Obama came to office, he hired Summers as his economic advisor - which is like putting Dracula in charge of the blood bank.

First, a background: Previously in America and Europe, like in East Africa today, a bank lent its own money (or customers' deposits) to a borrower - for example, to buy a home. Because the mortgage takes long to repay (anything between 15 to 30 years), banks are always careful to evaluate the credit worthiness of the borrower to ensure he/she pays back. So if you have a regular income from a job or a business and your bank records show a specific amount of income per month, you are approved for the loan. This means that there is a direct relationship between a home buyer and the lending bank. If the borrower fails to pay, the lending bank suffers.

Then came securitisation. Here, a bank lends money to many home buyers. It then bundles together thousands of these loans and issues a bond, otherwise called a "mortgage backed security". It would then sell the bond to an investment bank. A bond is a piece of paper saying: If you buy this paper, I promise to pay you back with an interest of X percent per month for Y years. The investment bank would sell them to investors. So the lending bank would collect the money from the borrower, pay itself a commission and pass on the balance to the investment bank, which would in turn pass it on to the final investor. This secondary mortgage market (otherwise called a securities market) separated the borrower from the lender. It also transferred the risk in the event of default to the holder of the bond - the investor.

Although I have used the home buyers, there were other forms of credit which were also traded. Investment banks would combine car loans, student loans, credit card debt, corporate buy-out debt, commercial mortgages etc. into complex derivatives called Collateralised Debt Obligations (or CDOs). Investment banks would then sell these CDOs to investors all over the world. These investors were often pension funds. Because they carry long term liabilities, pension funds need long term investments to match their obligations. Since money financing such debt did not come from the commercial bank but these investors, it meant that these investors were the ultimate lenders. But this also meant that the lender did not know the borrower anymore.

Thus, when the borrower paid their mortgage, credit card debt, student loan or car loan, the money would go through the chain: the lending bank to investment bank (each of whom would collect their commission) and finally to the investors. In effect, these intermediary banks became commission agents only collecting fees. This separation of the lender from borrower encouraged intermediaries - lending banks and investment banks - to indulge in excesses. Lending banks had little interest in evaluating the credit worthiness of their borrower. They earned more money by passing on the mortgages to investment banks and hence raising more liquidity to lend to more and more people.

Investment banks enjoyed a similar incentive structure. The more CDOs they sold, the more money they made - a factor that encouraged banks to give ever more and more risky loans and investment banks to sell ever more and more toxic derivatives. In one dramatic case, a bank in California gave a US$ 720,000 home loan to a Mexican berry picker who was earning US$ 1,100 per month. This is a classic case of subprime lending gone nuts. And many of the CDOs issued against such subprime mortgages were rated AAA by rating agencies.

This shows that the incentive for banks was to maximise the volume of mortgages, not their quality. Investment banks preferred subprime mortgages because they had higher interest earnings on them. In the decade between 1996 and 2006, subprime lending grew from US$ 30 billion to US$ 600 billion. With huge profits being made, banks were encouraged to borrow heavily to issue more mortgages. The ratio of borrowed funds to a bank's own capital is called "leverage." By 2008 when the crisis set in, many banks were leveraged to a factor of 1:20 with some going to 1:33. This meant that the slightest percentage drop in their value would lead to insolvency.

There was, of course, something like a check on this system. Investment banks that sold these CDOs would actually give them to rating agencies to evaluate their worth. Often, the rating agencies gave them AAA ratings - the best in the world. It was because of such ratings that investors bought the CDOs. There is a problem with rating agencies: First, the higher the ratings they give, the more money they get paid. So they have an inbuilt incentive to give high ratings. Second, investment banks are the ones that paid rating agencies for these ratings - a clear case of conflict of interest. This system has a fundamental flaw: if a rating agency rated a particular CDO poorly, the investment bank can easily take the business to its rival who is willing to give a better rating.

Worse still, the rating agencies suffer no risk if their evaluation of a particular CDO turns out to be wrong. Therefore, they have incentive to give the investment banks the ratings they want regardless of the quality of the underlying assets; in fact, they carried no civil or criminal liability over their evaluations. When their ratings were questioned, they appealed to the First Amendment, which guarantees freedom of speech saying their evaluations were simply their opinion. Technically they were right. Morally?

One could counter this by saying that rating agencies are big global business and therefore have reputations to keep. But reputational costs are illusory since they occupy an oligopolistic market. I know only three such agencies - Standard and Poor (or S&P), Fitch and Moody's. If all of them are doing the same thing, there is no risk to anyone of them. And there must be high barriers to entry that have kept this market so narrow. Even today after their ratings have been found to have been dubious, these three firms still dominate the market.

There was another cushion, which seemed to solve this problem. Once investment banks had sold CDOs, they went to insurance companies and ensured themselves against the risk of default. These insurance policies name to be called Credit Default Swaps (CDS) and the largest dealer in them was the American Insurance Group (AIG). So an investor who bought a CDS would pay AIG a monthly or quarterly premium. In return, AIG would promise to compensate them should the CDO go bad.

A secondary market for CDSs emerged which was unregulated and was to have catastrophic consequences for taxpayers and profits for Wall Street. In the regular insurance market, you can only insure only that which you own - and you can only insure it once. But in the derivatives market, anyone could buy CDSs from AIG - thus allowing them to bet on CDOs against which they were issued i.e. anyone could buy an insurance policy on assets they did not own and the same asset could be insured by 20 or 30 people. If such an insured asset failed, the amount of losses in the insurance market would become disproportionately larger than anything that asset represented. Since CDSs were not regulated, AIG did not have to set aside any money to cover potential losses. That is why when many CDOs went bad, AIG was exposed.

These activities increased the supply of money in the home market and equally led to many abuses. For example, a broker who sold the house and the one who sold the CDO plus the one who sold the CDS all got paid bonuses upon concluding the sale. This allowed brokers and banks to sell houses even to those who would not qualify. On many homes, buyers were paying less than one percent of the home price - meaning they had little at risk. In a regular home market, the homeowner puts up anything between 20 to 30 percent of the price of the house and the bank finances the balance. This means that there is a share risk between the borrower and the lender. Without this, the borrower can easily walk out of the mortgage at the slightest sign of reduced value.

Among those betting on AIG's CDOs was the world's largest investment bank, Goldman Sachs. It would buy CDSs from AIG and then take an insurance policy in case AIG collapsed. At the height of trade in these derivatives, Goldman Sachs went further - it began to sell more CDOs specifically designed in such a way that the more money its customers lost, the more money it made. Its biggest client was AIG. Other investment banks did the same. When AIG was about to collapse, the US government intervened to save it using taxpayers' money. Government literally took over the insurance giant.

Immediately it took over AIG, government literally forced the insurance giant to pay out US$ 61 billion it owed to investment banks for CDSs - Goldman Sachs alone was paid US$ 14 billion. AIG was not even allowed to negotiate. It had to pay 100 cents on the dollar. And who were the government officials forcing this deal down the throat of a now government owned AIG? Treasury Secretary, Hank Paulsen who had been Chief Executive Officer (CEO) of Goldman Sachs only two years earlier, Ben Bananke, the chairman of the Fed and plus Timothy Geithner, then president of the New York Fed and board member of the US Fed. Obama was later to appoint Geithner as new Treasury Secretary.

The genius (and evil) of Wall Street and its control over the US government regardless of which political party is in its power to privatise profits and nationalise loses. When companies are doing well, their executives and shareholders reap all the benefits - in form of high pay, bonuses, dividends and high stock prices. However, when their excesses push them to the brink of collapse, they use government, which they control, to commandeer taxpayer money to bail themselves out. I know no system, not even Marshal Mobutu Sese Seko's in former Zaire, that is as corrupt as the US system - only that its corruption is perfectly legal.

Both Obama and Romney are slight variants of drivers of a train that has lost its brakes. That is why I wonder how people find the energy to support either side in an American presidential election.

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