Financial Crisis:
The Credit Crisis Hits Home

Apr 11, 2008

Since the previous article was written, the financial crisis has amplified, as illustrated by the sudden and dramatic collapse of Bear Stearns, an 85-year-old company which was the fifth largest investment bank on Wall Street. Bear had been heavily involved in the subprime mortgage business. Already in July, two of its hedge funds specializing in subprime mortgages had gone bankrupt. As the subprime and credit crisis set in, the company began to come under increasing stress, and its profits plunged.

As late as the end of February, the company was said to be worth over 16 billion dollars with its stock trading at around $80 per share. But in late February, the collapse of a hedge fund run by the Carlyle Group and partial collapse of the second biggest independent mortgage lender, Thornburg Mortgage, led to new panic in the financial markets. Big financial institutions began dumping securities and hoarding cash.

Bear Stearns was hit by rumors that it was running out of cash, although some of these rumors may have been started by short sellers, that is, speculators who were betting that the price of Bear’s stock would fall. These rumors proved to be fatal.“The nature of financial companies is that they are pretty much a black box,” Jeff Houston, a bond-fund manager told the Wall Street Journal (March 15). “If people start to worry about what’s in the box, there’s not much the firms can do to demonstrate that they are not as weak as they appear to be.”

Bear’s creditors began to demand that it come up with more cash to cover their loans, and big companies began to pull accounts managed by Bear. Commentators later called it a classic run on the bank, which it was, but with this difference: it wasn’t ordinary depositors who were pulling their deposits, since unlike a commercial bank, Bear did not hold deposits. No, it was a panic and bank run by fund managers, bankers and speculators—the whole Wall Street gang.

This bank run not only threatened Bear Stearns’s existence, but it set off a bigger crisis. Bear was linked to and involved in deals with banks and companies all over the world—deals said to be worth over 13.4 trillion dollars. (U.S. gross domestic product, the size of the entire U.S. economy, is barely more than that, 14 trillion dollars.) On the other side of these contracts and speculative instruments are other banks, brokers and hedge funds, linked to Bear and to each other, like financial spaghetti. How did one company, Bear Stearns, get involved in so much speculation? For one thing, it used what bankers euphemistically call “leverage,” which in plain English means debt. For every dollar of its own capital, Bear borrowed $33. Certainly, this formula paid off in handsome profits when markets were rising, only to turn into a complete catastrophe when markets fell.

Of course, every other big financial company operates using comparable amounts of leverage, rendering the entire financial system into a house of cards. This is held together only by the belief of bankers and other financial interests that when they loan money, they will be repaid. That is, the whole system is based on the confidence between all the different players. When that confidence is lost, credit evaporates, freezes up or creditors even try to get their money back from those who borrowed it. Today, that confidence among the biggest banks and other companies does not exist, and nothing the government has done so far has restored it.

On the evening of March 13, the Federal Reserve sprang into action after Bear Stearns chairman Alan Schwartz reported that his company couldn’t withstand the accelerating run on the bank, and that no private bank would lend them any more money. With the opening of business the next day, the Fed announced that it would provide Bear with a 30 billion dollar line of short-term credit. Legally, the Fed wasn’t permitted to provide financing to Bear, which wasn’t a commercial bank. So, the Fed got around the legal niceties by bringing in J.P. Morgan, the second largest commercial bank, as a conduit for the loan and resuscitated a long-forgotten provision from 1932, to be used in “unusual and exigent circumstances,” as a legal fig leaf for this massive government bailout.

By demonstrating that the Fed stood behind Bear, Fed officials hoped they could restore confidence in the company, so that other bankers and investment houses would stop demanding payments by Bear, and business would return to normal. But that didn’t happen; the run on Bear Stearns continued. So, the Fed in conjunction with the U.S. Treasury engineered the takeover of Bear Stearns by J.P. Morgan with the provision that the Fed would hold 30 billion dollars of Bear’s practically worthless mortgage securities on its own books for a period of 10 years, while forking over a 30-billion-dollar loan to J.P. Morgan.

The Fed’s bailout of Bear Stearns was part of a much broader program to unfreeze credit markets. It had already slashed short-term interest rates to 2.25%, that is, below the rate of inflation. And it vastly increased the use of its discount window for making emergency loans to both commercial banks, as well as investment banks—something it hasn’t done since the Great Depression. The Federal Reserve has pumped about 300 billion dollars into the financial system in about eight months, exchanging about 40% of its stock of 790 billion in what are considered the safest securities, U.S. Treasury bonds and bills, for practically worthless mortgage-backed securities.

Yet, none of this restored enough confidence among the banks and investment houses that lend and trade with each other to unfreeze the credit markets. And the unending drumbeat of more losses continued to undermine any chance of that happening. Last fall, analysts said they expected 100 billion dollars in financial losses. A few months ago, they raised their estimates to 400 billion dollars. In early April, the International Monetary Fund (IMF) estimated financial losses at close to a trillion dollars from bad mortgages, commercial real estate and other loans to consumers and companies. Other economists put the total even higher. According to the economist Nouriel Roubini in recent testimony before the House Financial Services Committee, if house prices drop 30%—as now expected—the banks would lose over one trillion dollars from home mortgages alone.

The enormous injection of money by the Fed into the financial system didn’t stop the crisis from getting worse. In fact, it added to it. It fueled inflation. It caused the dollar to lose value. And it handed over more money to speculators—some of the same ones who also created the housing crisis by driving up prices—who turned around and speculated on basic commodities like oil, wheat, corn, soybeans. So while the value of people’s homes dropped, everything that people pay for has shot up, with estimates that we could soon be paying $4 a gallon for gas, $5 for a gallon of milk, $4 for a loaf of bread, etc. Credit also became more expensive. For even as the Fed lowered interest rates for money it lends to the banks, the banks turned around and hiked interest rates they charge consumers for mortgages, credit cards and auto loans.

Nor did the Fed’s enormous aid to the financial system prevent the housing crisis from getting much worse. Already, 1.1 million households, mainly of workers, have lost their homes. Moody’s estimates that in 2007 and 2008, there will be 3.3 million home-mortgage defaults, with the vast majority going to foreclosure. The fall in housing prices has wreaked havoc on people’s financial situation. By the end of the year, economists are saying that one-third of all homeowners will be under water, that is, they will owe more on their outstanding mortgage than what their house is worth. No, the Fed’s intervention had no impact on falling house prices.

While economists and government officials debate endlessly whether or not there is a recession, or when the recession started, the capitalists have not waited to cut their workforce in order to protect their profits. In March, employers slashed 80,000 jobs, the most in five years. “Job losses,” according to the Associated Press, “are nearing the staggering level of a quarter-million this year in just three months...” Since the beginning of the year, manufacturing lost 94,000 jobs and construction lost 88,000 jobs. As for financial services, there have been 16,000 job losses, but, according to David Rosenberg, an economist at Merrill Lynch, “...there is much more to come in the aftermath of the credit crunch.”

The level of unemployment is much higher than the official level of 5.1%. When it includes those so discouraged they stopped looking for work, as well as those who are working part-time because they can’t find a full-time job, the rate jumps to 12.6% unemployment, or more than 17 million unemployed. The pressure of that great mass of unemployed pushed family income down over the last period, compared to ten years ago, as measured by the U.S. Census Bureau. This is the first time that has happened since the government started keeping those statistics a half century ago.

To continue to pay their bills, despite growing unemployment, falling income and rising prices, workers have gone deeper into debt. They continue to borrow against their homes (despite falling home prices), as well as take on much more credit card debt. They have also greatly increased how much they borrow against their 401(k) plans, with many more workers cashing out of their 401(k)’s completely. Consumer debt is already at record heights, and its growth is actually accelerating.

With the working class sinking into a desperate situation, the government only bails out the financial companies, that is, those who caused all the problems. Of course, officials claim that they have no choice. They say they have to spend all that money to save the economy from crashing, prevent even worse times. But, in fact, the only thing they are saving is the fortunes of the very companies and speculators who caused the crisis and reaped great profits, and continue to profit.

To cover the cost of the bailout, they will weigh more heavily on the population than anything we have seen up until now. Already public services and other government programs that serve the population—including public education, health care, minimal income support for the very poor and disabled, as well as spending on the infrastructure—are in terrible shape, worse than bare bones. And yet, public officials are already gearing up to make much more drastic cuts, throwing public services, education, social services back decades, if not a century.

Working people didn’t cause the housing bubble, the housing crisis or the credit crisis. And yet the criminals who did cause these disasters expect to be bailed out by imposing much bigger hardships on the working population. There is no future for ordinary people in this criminal system that robs from the working population to serve the wealthy.