Mariana Mazzucato - The Value of Everything - Making and Taking in the Global Economy

As we saw in Chapter 3, banks mark up borrowers’ interest rates as an indication of value added (FISIM): an obvious example of fictitious financial value. But this is only the tip of the iceberg. Today, leading investment banks like Goldman Sachs and J. P. Morgan don’t attribute their employees’ vast salaries to success in ordinary borrowing and lending. The great bulk of these banks’ profits comes from activities such as underwriting the initial public offerings (IPOs) of corporate bonds and shares, financing mergers and acquisitions, writing futures and options contracts that take over risk from non-financial businesses, and trading in these and other financial instruments for capital gain.

The subtle yet fundamental change in the way that the banking sector’s productivity has been redefined over the last two decades or so has corresponded with its increasing capture of the economy’s surplus. The massive and disproportionate growth of the financial sector (and with it the origins of the global financial crisis) can be traced back to the early 2000s, when banks began increasingly to lend to other financial institutions via wholesale markets, making loans not matched by deposits. In the UK the ‘customer funding gap’ between loans advanced and deposits from households (traditionally viewed as the most stable form of bank financing) widened from zero in 2001 to more than £900 billion ($1,300 billion) in 2008, before the crisis cut it to less than £300 billion in 2011. 36Banks and other lenders found that wholesale funds could be raised much more cheaply than deposits from retail or business customers, especially by using their customers’ existing loans, such as mortgages, as security for more borrowing. These lenders benefited from a seemingly virtuous circle in which additional lending raised financial asset prices, which strengthened their balance sheets, giving them the scope to borrow and lend more within existing minimum capital ratios, the amount of capital banks had to retain relative to their lending.

As well as lending more to one another and to retail clients, over the past three decades banks began to target their loans at riskier prospects offering higher rates of return. This is the part of the story that most people now understand, having been well covered in the media and popular culture, in books and films such as Inside Job , Margin Call and The Big Short . Banks felt they needed to take more risks because, with governments trying to balance budgets and reduce public borrowing requirements, the yields on low-risk assets (such as US and European government debt) had fallen very low. Banks also believed that they had become much better at handling risk: by configuring the right portfolio, insuring themselves against it (especially through credit default swaps – CDSs – that would pay out if a borrower didn’t pay back), or selling it on to other investors with a greater risk appetite. Investment banks lent to hedge funds and private equity firms and developed and traded exotic instruments based on assets like subprime mortgages, because the returns were higher than lending to industry or government.

When channelling short-term deposits into long-term loans, banks traditionally took a risk – especially when the loans went to borrowers who would need a windfall gain (a business that took off, a house price that rose) to pay back their loans. Ostensibly, that risk disappeared in the 1990s and early 2000s, when securitization turned a bundle of subprime mortgages or other loans into a bond with a prime (even triple-A) credit rating in the shape of a mortgage-backed security (MBS).

Securitization can and does play a valuable role in diversifying risk and increasing liquidity in the financial system. In 2006 Alan Greenspan, then Chairman of the US Federal Reserve, and Tim Geithner, the former President of the Federal Reserve Bank of New York, claimed that derivatives were a stabilizing factor because they spread the risk among the financial institutions best equipped to deal with it. 37Greenspan had, a decade before the crisis struck, vetoed a proposal to regulate over-the-counter (OTC) derivatives, claiming that on the contrary ‘the fact that OTC markets function so effectively without the benefits of the Commodity Exchange Act [CEA] provides a strong argument for development of a less burdensome regulatory regime for financial derivatives traded on futures exchanges’. Passed in 1936, the CEA requires all futures contracts for physical commodities to be traded on an organized exchange. As was spectacularly shown in 2008, derivatives’ capacity to transfer and defray risk really exists only at the individual level. At the aggregate level, the individual risk is merely transferred to other intermediaries in the form of counter-party risk. Its disappearance from the balance sheets of the original holders, and the frequent lack of clarity about who has taken it over, makes the market situation even more precarious. 38

Securitization was also abused, sometimes in ways that bordered on fraudulence, and that abuse certainly influenced regulators in the years following the financial crisis. The transformation of relatively low-quality loans into triple-A-rated securities occurred largely because credit-rating agencies routinely gave high valuations to securitizations of low-grade debt, underestimating the likelihood of default, especially on residential mortgages. To be doubly sure that their high returns were sheltered from a comparably high risk, banks ‘transferred’ their risk by assigning the securitized debt to ‘special purpose vehicles’ (SPVs), whose liabilities did not show up on the banks’ own balance sheets. When lower-income borrowers began struggling to repay their debts after 2005, the securitized bonds turned out to be much less safe than their triple-A rating suggested, and the SPVs bounced back onto the banks’ balance sheets. The golden combination of high return and low risk turned out to be a statistical illusion, but one that national accounting had promoted just as enthusiastically as had banks’ pre-2008 corporate accounts.

A DEBT IN THE FAMILY

Since the 1970s, the growing inequality of wealth and income has profoundly shaped the way in which finance has developed. The growth of finance has also fed the growth of inequality, not least by adding to the influence and lobbying power of financiers who tend to favour reduction of taxes and social expenditures, and promoting the financial-market volatility that boosts the fortunes of those who serially buy low and sell high.

Following deregulation, the enormous increase in finance available to households was the main reason for the rise in banks’ profits. Commercial banks profited from direct loans for anything from cars to homes to holidays, and from credit cards. Investment banks made money by securitizing commercial-bank ‘products’ and trading the derivatives they ‘manufactured’. Legislators allowed financial intermediaries to regulate themselves, or imposed only minimal regulation because their operations were too complex to be understood. Markets (following the marginalists) were considered to be ‘efficient’ – healthy competition would deter financial intermediaries from reckless behaviour.

As previously prudent banks bombarded customers with offers of credit – the age of tempting credit card promotions dropping almost daily through millions of letter boxes had arrived – household borrowing began to rise inexorably. Across the financial sector more broadly, the relaxation of controls on mortgage lending became another source of profit and also fuelled the increased household borrowing. Whereas in the 1970s mortgages had been rationed in the UK, by the early 2000s house buyers could borrow 100 per cent or even more of the value of a property. By 2016, total cumulative household borrowing in the UK had reached £1.5 trillion – about 83 per cent of national output, and equivalent to nearly £30,000 for each adult in the land – well above average earnings. 39