by Constance Daley
American Reporter Correspondent
St. Simons Island, Ga.
September 21, 2008
DUMMERSTON, Vt. -- Those who thought that last week's government bailout of Fannie Mae and Freddie Mac would stabilize the financial markets got a wakeup call this week.
Lehman Brothers, the fourth-largest U.S. investment bank, succumbed to the subprime mortgage crisis it helped create with the biggest bankruptcy filing in history. The collapse of the 158-year-old firm, which listed more than $613 billion of debt, dwarfs the previous record-setting bankruptcies of WorldCom in 2002 and Drexel Burnham Lambert in 1990.
Merrill Lynch, the world's largest and most widely recognized brokerage, tried to avoid a similar fate with a $50 billion transaction to become part of Bank of America Corp. The deal creates a financial giant rivaling Citigroup, the biggest U.S. bank in terms of assets. But Bank of America is still trying to digest another troubled company - Countrywide Financial, the leading subprime mortgage lender that was about to go belly-up before BofA took it over earlier this year.
And on Wednesday morning, Americans woke up to the news that they were new owners of the world's largest insurance company. The Federal Reserve on Tuesday night employed powers granted during the Great Depression to extend an emergency loan worth up to $85 billion that effectively gives taxpayers an 80 percent stake in the company.
The one thread in these companies' fates is that all were heavily exposed in the new world of finance that helped spawn the subprime crisis.
Once upon a time, a bank accepted deposits and lent the money out to stable long-term clients. The deposits were federally-insured and if the bank found itself in a cash crunch, the Federal Reserve stood by to offer a line of credit. Now, most of the business of finance is carried out by "nondepository" institutions - investment banks such as the late Bear Stearns and Lehman Brothers, which shuffle money through hedge funds, structured investment vehicles and credit default swaps.
These high risk, high leverage activities aren't sustainable when no one knows what anything is worth. That's because many of these investments are backed by assets that no longer have value, such as the hundreds of thousands of foreclosed houses across America.
This is completely uncharted territory for the U.S. economy. It's not just what's become known as the "shadow banking sector" that's in trouble. It's the regular banks and insurers that are looking more and more precarious.
Between $200 billion to rescue mortgage finance firms Fannie Fae and Freddie Mac, the $29 billion loan to broker the forced sale of Bear Stearns to J.P. Morgan Chase last March, the $300 billion for the Federal Housing Administration and the billions of dollars the Fed has pumped into commercial banks, investment banks and AIG to keep them afloat, taxpayers are now potentially on the hook for morethan $900 billion of dubious investments.
If no one else comes knocking at the Fed's door, that $900 billion is daunting enough. Auto makers, airlines and other struggling businesses will be looking for the same treatment as AIG. We are seeing the federal government expand an economic system where profits are privatized and losses are socialized.
It's been six months since the Fed stepped in to broker the sale of Bear Stearns. There still is no plan for an orderly liquidation of assets of the failing financial institutions. There has been no real effort to crack down on the shadow banking sector and to re-regulate financial markets.
What happens next? We could be in a situation where everyone tries to sell off their assets only to find there are few or no buyers. The result is that the value of these assets fall, and you have a situation where everything is for sale but no one has the money to buy.
That's what happened in the Great Depression, and only the massive mobilization of the American economy to fight World War II pulled this country out of the ditch. Those were the days when the United States had lots of oil and was the world's mightiest industrial power. Now we import 80 percent of our oil, have outsourced our industry and are watching mind-boggling amounts of capital vanish.
This is truly a frightening time. Neither Barack Obama nor John McCain seem to understand the enormity of what is facing the country, and neither have been honest about what it will mean for every American. Neither have come up with plausible solutions. And regardless of who wins in November, they will get clobbered by the ugly reality of an economic crisis without precedent.
Many are calling for the creation of a new version of the Resolution Trust Corp., the largely-taxpayer financed company that was created in 1989 to deal with the aftermath of the failure of hundreds of savings and loans. The RTC seized and liquidated the failed institutions and then went out of business.
A new RTC could perform a similar role in the current crisis by buying and selling the now-toxic, mortgage-backed assets that are dragging down banks and Wall Street firms. It would work a lot better than arbitrarily picking out the winners and losers.
Other reforms are needed, starting with restoring the Glass-Steagall Act of 1933. After wild speculation brought on the Great Depression, the Roosevelt Administration pushed for restraints on Wall Street. Glass-Steagall separated government-insured commercial banks and the non-federally backed investment banks. By keeping consumer and speculative capital separate, it made it possible to understand the activities of all financial organizations.
In 1999, Congress repealed Glass-Steagall and replaced it with the Gramm-Leach-Bliley Act. It allowed the stockbrokers, insurance companies and banks to merge for the first time since the 1930s, and ushered in this era of financial irresponsibility.
It's not the Fed's responsibility, or the government's, to back investment bank speculation and bail out the losers. That's why sweeping, decisive regulation is needed before things get worse.
Randolph T. Holhut has been a journalist in New England for nearly 30 years. He edited "The George Seldes Reader" (Barricade Books). He can be reached at email@example.com.