Rotten Paper Could Bring the House Down

Rotten Paper Could Bring the House Down

by William Greider

For the first time in this unfolding financial crisis, I felt
personally scared by the news. Not about my money, but about the
potential for catastrophe. The Federal Reserve's lightning rescue of
AIG has the smell of systemic fear. The house of global finance is on
fire and everyone is running for the exits, no sure way to turn them
around. What's next? The question itself is ominous, because there are
no good answers.
The US central bank and other nations acted with speed, and good that
they did--an emergency loan of $85 billion to prop up the failing
insurance giant, plus another $75 billion in liquidity pumped into the
banking system to calm nervous bankers worldwide who abruptly stopped
lending. The international rate for overnight lending among banks has
doubled, an expression of fear that describes the potential danger of
a sudden freeze in lending, more or less everywhere. That would
deliver a deep shock to real economic activity, not just in the United
States but worldwide. This feels ominously parallel to the financial
chaos that followed the crash of 1929 and led to global economic
collapse.
Government is much better equipped this time with various safeguards
to defend the system against an implosion--including Fed Chairman Ben
Bernanke's personal willingness to act swiftly with unorthodox
measures. But the case of AIG suggests the present unwinding has a
malignant dynamic to it that might even overwhelm the authorities'
capacity to put out fires. That's scary. I hope I'm wrong.
The reason the Fed was compelled to save an American insurance company
in order to save the global financial system goes to the source of the
rot--the "new financial architecture" developed during the last
generation. These innovations allowed banking and finance to expand
their leverage explosively, borrowing and lending far beyond the
traditional limits defined as prudent risk-taking. One gimmick that
supposedly made this okay was the creation of esoteric insurance
derivatives--the so-called "credit default swaps" that supposedly
protected investors and firms against losses in mortgage securities
and other debt paper.
Critics repeatedly warned that these derivatives were a time bomb--
trillions of dollars in risk insurance that would be exposed as
meaningless if financial markets ever experienced a sharp fall in
asset values. Politicians and regulators from both parties brushed
aside the critics and led cheers for Wall Street's fancy new ways of
guaranteeing risk.
AIG sold those guarantees in huge volume. It assumed potential
liabilities far beyond the firm's capacity to make good on the deals
if something went terribly wrong. The problem is global because AIG--
an imperious promoter of globalized finance--sold this rotten paper
all around the world to big investors and leading banks. If AIG is
suddenly insolvent, the pain and loss are spread instantly to
thousands of balance sheets in Asia and Europe--banks and corporations
that must suddenly write down their own assets. That's why the Fed
could not wait to find out what would happen if AIG was allowed to
fail.
But the system is not free of these troubles. AIG was not the only
high flier peddling false hope to supposedly sophisticated financiers
and bankers. Some of the largest, most respectable banks--led by
JPMorgan Chase--did the same thing. It was a highly profitable line of
business. The gimmick insurance was widely admired by financial
economists and approved by the supposedly objective rating agencies.
It is not clear to me how government intervention can unwind this
feature of our corrupted financial system--short of making good on the
trillions in these essentially fraudulent contracts. Not even the
Federal Reserve has the assets to swallow all of Wall Street's folly
and deception.
If my fears are right, a more fundamental reckoning may lie ahead and
Washington will have to take far more decisive action. At some point,
the new president might have to do what FDR did in the wreckage of
early 1933--declare a "bank holiday" and announce emergency rules to
govern banking and finance until the crisis is broken. For the
country's sake, I think this a better approach than buying up junked
banks and failed financial firms, one by one. People have the right to
ask: what exactly are the rest of us getting for our money?

Copyright © 2008 The Nation

William Greider, a prominent political journalist and author, has been
a reporter for more than 35 years for newspapers, magazines and
television. Over the past two decades, he has persistently challenged
mainstream thinking on economics.