Bad Money by Kevin Phillips

When the turmoil in the financial sector exploded into full blown crisis with the collapse of Lehman Brothers in September, I found myself disturbingly unfamiliar with the basic subject matter of the ensuing debate. I had a basic understanding of the mortgage market, and knew enough about subprime loans and ARMs to have secured a 30-year fixed rate when we bought our condo. I also had a wealth of anecdotal information from my father in southern California about the skyrocketing home prices and the absurd practices of his neighbors, who were perpetually re-financing in order to put in pools or buy new cars with the equity from these inflated values.

But the terms "collateralized debt obligation" and "credit default swap" were meaningless to me. There was a time when I paid much closer attention to the financial world, but it has been a few years. It seems, though, that even if I had been paying attention, I might not have understood these subjects. They are essentially designed not to be understood. Because as soon as people started paying close enough attention, and realized what was going on, the bottom fell out.

Fortunately (and unfortunately), there were already a few books out that touched on this subject matter with a more popular audience in mind. Fortunately because I had something other than Wikipedia to rely on. Unfortunately because the reason these books had been published was that the crisis really first hit in July 2007 with the collapse of two Bear Sterans hedge funds (which I somehow failed to really notice). This gave book publishers enough time to get books into print by the spring. Yet federal regulators apparently did not act with similar speed; every step in the crisis that has unfolded since them seems to have caught them off guard, from the bailout of Bear Stearns to the takeover of Fannie Mae and Freddie Mac to the collapse of Lehman Brothers.

The first book I turned to was Bad Money by Kevin Phillips. Phillips has made a name for himself over the years for his prophetic analysis of American politics. His rise to prominence came with his 1969 book, The Emerging Republican Majority, which many believe foresaw the rise of Reagan and the conservative realignment (which appears to be over as of November 4, 2008). At that time, Phillips was a major Republican strategist, but over the years he has moved dramatically away from the party. Along the way, he has expanded the scope of his writing to include a focus on the interaction of money and politics, in such books as The Politics of Rich and Poor, Wealth and Democracy and most recently, American Theocracy, in which Phillips discussed the dangerous confluence of expanding debt, financial misbehavior, and the rising cost of oil.

In Bad Money, Phillips opens with a chapter on the rise of financial services and the decline of manufacturing in the U.S. economy. He starts there because it is only once we understand that financial services now account for 20% of America's GDP can we understand how deeply invested we have become in the success of this industry, how reliant we are on it for stability, and thus how important it is that it be properly regulated. This is not something most people understand, and Phillips suggests that government leaders want it this way; that's how they reassured us that a crisis on Wall Street need not become a crisis on Main Street, and thus little regulation was necessary. We know now how wrong that notion was.

Phillips digs deeper into the rise of financial services and suggests that this growth was systematically encouraged by Washington, by what he calls "financial mercantilism." By this, Phillips means the bailouts and socialization of credit risk going back almost three decades, from the 1984 rescue of Continental Illinois through the saving and loans crisis to the Mexican peso rescue to Long-Term Capital Management to the interest rate cuts of the early 2000s (Phillips' book came out too early to include this fall's mother of all bailouts):

After the financial markets' narrow escape in the stock market crash of 1987, some kind of high-level decisions seems to have been reached in Washington to loosely institutionalize a rescue mechanism for the stock market akin to that pursued on an ad hoc basis (by the Fed and the U.S. Treasury) to safeguard major U.S. banks from exposure to domestic and foreign loan and currency crises. Thus the coinage of the phrase "financial mercantilism." For Washington to have made such a tentative choice in 1988 was momentous. Finance became the chosen sector of the U.S. economy--the one that would be protected and promoted because it was too important to fail. Manufacturing would receive no such help, however excited members of Congress might get from time to time.

And it does not appear that the traumas of 2008 have changed anything yet. Just look at the disparate reactions from Republican leaders to the crisis on Wall Street and in the auto industry. The former merits a $700b bailout, the latter can't even get $25b.

Phillips follows this with a chapter on "Bullnomics" in which he reflects on the way that Americans have been manipulated to support an economic system that offers vast rewards to the elite and little for anything else. He touches on such things as the manipulation of the consumer price index and the rise of the prosperity gospel, in which religious Americans are taught that God wants them to be materially rich.

In Chapter 4, Phillips hits the subject I'd been looking for: securitization, which is defined simply as "the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security." It is through the repeated packaging and re-packaging of assets, particularly houses bought via subprime or exotic loans, that what might have been a troubling housing crisis came to nearly destroy the entire U.S. financial industry:

Instead of being kept on firm ledgers, mortgage loans could be stripped of risk by a derivative contract, or in most circumstances old off in a mortgage-backed security or structured CDO. The money received could be used for another loan or mortgage, then again--and again. Lending limitations became nonlimitations. However, as volume swelled, loan- and mortage-making standards dropped. Enticements to sign up marginal borrowers--through the "exotic" forms of mortgages little used boefore--took on an ever-larger role.

The growing disconnect between the broker writing the mortage and the hedge fund that would end up owning a leveraged piece of a CDO that contained the mortgage, destroyed the traditional incentives by which mortgages were made, e.g. a bank only lent money it reasonably expected would be repaid with sufficient interest. Phillips goes through a number of root causes for this phenomena, including the declining importance of depository institutions in the face of mutual funds, hedge funds, security brokers and others, all of which did business largely outside existing government regulations:

Small wonder that.. buyers worldwide found themselves with structured products that lacked (1) opacity and responsible description, (2) disinterested and careful credit ratings, (3) reliable markets to which they could be marked, and (4) practical testing under major credit-crisis conditions. Manufacturers negligent in these ways would be facing large fines or even jail terms.

This securitization process led to a downward spiral in the housing market, with the expansion of easy money and subprime loans, all of which were packaged up into complex CDOs and split a dozen ways so that no one knew how much anything was worth. When people finally started paying attention after the collapse of Bear Stearns, well... check your 401(k).

In the remainder of the book, Phillips reiterates his belief that American reliance on oil will prove to be a crippling failure in this century, with analogies to the decline of the inabilities of the Dutch Empire (reliant on wind and water) and the British Empire (reliant on coal) to adapt to new energy technologies. He further laments the weakness of the dollar, its vulnerability to foreign manipulation, and its dependence on being the principal currency for pricing oil, before a concluding chapter exploring the possibilities that we are seeing the initial signs of the United States as an empire in decline.

The major weakness of the book is that beyond the short chapter on securitization, this is just a regurgitation of what Phillips has already written. His analogy to the Dutch and British empires goes back at least as far as The Politics of Rich and Poor, which he published in 1990. The focus on the rise of the financial sector echoes that of Wealth and Democracy, the discussion of dynastic politics was covered in American Dynasty, and the chapter on peak oil and the dollar-oil nexus is straight out of American Theocracy. So while this serves as a decent first-line introduction to these topics, Phillips himself has recognized that each deserves a book of its own. Tomorrow, I will discuss a short text that serves as a better introduction to the financial crisis itself, Charles Morris' The Trillion Dollar Meltdown.