Thursday, March 19, 2009

Circular Looting

Please click on the image to see the model

“Looting” is a concept in economics developed by two American economists called George Åkerlöf and Paul Romer. This term was recently put into the framework of the current crisis by David Leonhardt of the New York Times, and I believe that it is very helpful to do so.

I also believe that there is more to the story than the original concept of financial looting, namely that of collaboration from politicians, which creates a type of perpetual motion of looting that I call Circular Looting.

The concept of looting in economics is rather simple:

It means that corporations that know that they will be bailed out by the government if they are at risk of going bankrupt, act irresponsibly in order to make as much short-term profit as possible, without regard to the long-term consequences.

In other words, corporations “loot” the economy instead of trying to make a profit with an investment strategy that they genuinely think will work. Corporations always know that the looting business strategy will fail eventually, but when it does, it’s the government’s problem.

What comes to mind first is obviously sub prime mortgages. In Vallejo, California, a man whose profession was to be a strawberry picker, was in 2006 approved for a $720,000 mortgage for a house. Needless to say, this man did not meet the traditional requirements for such a large mortgage, and defaulted on the mortgage rather quickly.

This particular mortgage makes for a good example of what has been happening over the last few years. As the strawberry picker signed up for the mortgage, there was a string of people who were given large fees, going all the way back to Wall Street itself.

These fees, and the overall profit from all the investments related to the sub prime market, are what constitutes the “loot” in the looting cycle that has been going on over the last decade or so.

Here’s what most likely happened in the Vallejo example:

- the bank received mortgage origination fees

- the bank sold the mortgage to an investment bank (like Lehman Brothers), and got a fee

- Lehman Brothers packaged the strawberry picker’s mortgage with others, created a “mortgage-backed security” and sold that to Wall Street, and received a fee

- Wall Street traders bought and sold the securities, and received large commissions

Obviously, everybody in the chain knew that a strawberry picker was not going to be able to pay this mortgage, but everyone was making money in the meantime, so the looting was a win-win situation, for a period of time.

This describes how looting is a good idea for corporations that engage in it, while being ready to run for the hills when everything comes falling down. Now we’ll move on to the political connection.

There are not that many companies in the United States that can depend on being bailed out by the government, but the exception to the rule is the financial sector. In other words, large banks, investment banks and any other financial institutions that are deemed to be important enough for the local or national economy, can usually count on being bailed out.

Bailouts don’t only concern the institutions that are considered “too big to fail”, which is evidenced by Åkerlöf and Romer’s report, “Looting”, which describes the looting behavior of smaller, local banks in Texas.

The financial industry in the United States donates enormous amounts of money to virtually all politicians in Congress and those running for President. This has been going on for so many years that it is now a Washington institution.

This behavior obviously creates a dependency on the part of politicians on the financial industry, without which they would not be able to become elected.

This, along with the promise of a bailout when the financial institutions are about to go under, creates an utterly symbiotic relationship between politicians and the financial industry.

This symbiotic relationship is described by the following four stages of the Circular Looting that you can see in the model at the beginning of the text:

1. Donations from the financial industry to every imaginable political campaign.

2. The donations force politicians to create and perpetuate a business friendly climate with low taxes, virtually no financial regulation or oversight, and the absence of labor rights.

3. In such a “business friendly” climate, corporations are free to engage in whatever kind of business they desire, because they are left alone, and because of extremely low taxes, they can reap all the rewards instantly. Looting is created on a massive scale.

4. There is only so much looting that can go on until the market is depleted. Eventually the bubble has to pop, either because of inflated values, or because of exposed fraud. It is then that the politicians come back and help their friends in the financial industry with bailouts.

If looting is to be successful in the end, individuals who are working for the financial institutions must be sure to not invest in their own companies too much, and cash bonuses are essential to the scheme.

What AIG recently did when executives were given bonuses after the bailout had already happened is remarkable. Even after the looting was done, the executives were able to extract bonuses directly from taxpayer money. This must surely be unprecedented prior to this crisis.

Looting, bailouts and political donations make American society eerily reminiscent of the feudal society of Europe during the middle ages, where most people were serfs, and everything and everyone was controlled by the aristocracy.

Moreover, I advise that the winner-takes-all voting system should be destroyed.


Anonymous said...

The power of money has got to be appreciated for what it is. People are finding it troubling to part with their hard earned dough, we must never give it up without a fight, bargaining over price was meant to be more important. i don't think it is a crime to offer to do it for less,to ask that it be done for less. We have got to find the way to walk away ,before we are broke.

Anonymous said...

I must say, your explanations about what's going on with this entire crisis have been excellent.

This blog will eventually pick up in terms of it's readership.

Moving on...

Spitzer is back and he's telling people to hone in on the money that AIG paid to counterparties like Goldman Sachs because that's where the real outrageousness is. Care to explain that?

Do investment banks like Goldman Sach's realize that they are going to have to change their entire business model?

And I'm so sick of hearing about how smart all these guys are! they're not rocket scientists or doctors.

Jacob said...

Thank you. What Spitzer is talking about is not really the same thing as the bonuses. A bonus is something that is supposed to be given by an employer to an employee for a job exceedingly well done, and when the government is the employer, that becomes a tricky question no matter what the contract says.

How many people would be OK with a $30 million bonus to the head of the department of agriculture?

The payments to counterparties of AIG that Spitzer is talking about are truly binding contracts. There are no grey zones: if A happens, AIG gets to keep the money, if B happens, AIG has to pay. B happened, and now AIG has to pay or be sued.

Although we're talking about huge sums, there is nothing to be discussed or negotiated until AIG files for bankruptcy. You can't negotiate with a black jack dealer to get your money back, nor can he negotiate with you when you've won.

A lot of people realize that the era of investment banking is over. Without leverage, there is no investment banking, unless it is done in the old-fashioned way: by smaller, privately held companies with a few partners. In other words, a few old, rich guys.

Similarly, the era of banking services and loans for everybody is over. Community banking is coming back, which might sound cozy, but it means the same thing as it used to: fewer loans for minorities and low income people.