Brace For Impact

It has been four years since the economic implosion caused by financial derivatives, housing bubbles, and big banks putting trillions of dollars at risk on casino style bets for which there was no collateral. The result was the vaporization of untold trillions of dollars, an unprecedented bailout of the financial industry, the largest financial crisis since the great depression, and the loss of millions of jobs throughout the American economy.

Since then, our economy has been sluggish at best, crawling along through a painfully slow and anemic recovery. Now, as we start to see what may be the light at the end of the tunnel, the same exact thing is going to happen again, but this time it's going to be even worse.

I'm not talking about the fiscal cliff that Congress boxed themselves into with their inability to come to an agreement on something as mundane as raising the debt ceiling. I'm talking about a re-run of the entire economic collapse of 2008, with even worse results for our country and its citizens.

How could this happen so soon after the economic collapse of 2008? In order to answer that, let's take a brief look back at what caused the collapse four years ago.

The root cause of all of the problems that we are currently facing are the passage of two laws in 1999 and 2000 sponsored by Republicans in Congress and enthusiastically supported and signed into law by Democratic President Bill Clinton. These two laws, Gramm-Leach-Bliley and the Commodity Futures Modernization Act, eliminated the Depression era separation of commercial banks, investment banks, and insurance companies, and insured that the complex financial instruments known as derivatives would remain unregulated. This was hailed as the beginning of a new financial golden age which would lead to unrivaled prosperity and wealth creation. In reality what it did was turn the world of finance into a casino and spread the risk throughout the economy so that even regular everyday banking customers with a passbook savings account were on the hook when everything went to hell.

The casino's main instrument was a derivative called a collateralized debt obligation (CDO) which is an investment wherein a bunch of consumer debt is purchased, combined, split up into tranches and sold to investors as securities. Any kind of consumer debt can be used for CDOs but the most attractive one in 1990s and 2000s was the residential mortgage.

In abstract, mortgages would seem to be a safe debt to use for these investments. Because mortgages traditionally used strict underwriting and financial requirements they were seen as a pretty safe investment. They also rarely had defaults because of these safeguards.

However, as we saw, the amount of money being made in these investments caused banks to create more and more of these types of investments requiring more and more mortgages to securitize. Combined with an official seal of approval from the president to increase non-traditional lending, mortgage lenders started giving mortgages to anyone with a pulse, throwing caution to the wind as the amount of sub prime loans started ballooning as lenders sold their mortgage loans as soon as they closed them. The lend to securitize movement erupted, sending housing prices skyward while at the same time eroding the very foundation of the industry making these once safe investments riskier and riskier.

In the end there were an awful lot of people with mortgages they couldn't afford and a lot of securities that were about to become worthless due to the high number of defaults that inevitably occur when you have people with no income owning $3 million homes.

There was another derivative product called a credit default swap (CDS) which made things even worse. CDS's were sort of like insurance in that you could pay a premium based on the risk that a particular CDO was assigned and if that CDO collapsed because the of defaults on the mortgages that made up the CDO, you would be paid the amount of the investment in the CDO. The only problem was, that these weren't insurance policies, they were derivatives and therefore required no reserves. The insurance giant AIG was bankrupted because they sold endless amounts of CDS's, believing that the real estate market would always go up and that these investments would never default. They had no money in reserve to pay claims in the event of a default. When the real estate bubble burst, AIG's entire worth was wiped out and the entire financial market put at risk as the investors in CDS's discovered that their investments were worthless.

So, how could this happen again? Weren't there reforms put in place to avoid this?

In a word: no.

The one grand financial reform bill passed by Congress in the wake of the 2008 economic collapse, the Dodd- Frank Act, really did nothing to prevent this same scenario from happening again. This is because Congress purposely adopted Wall Street's narrative of what caused the collapse of 2008 - that is that greedy and irresponsible homebuyers ran up too much debt causing the real estate market to collapse. This completely ignored the true causes of the collapse and failed to address the systemic problems in the financial industry itself. Therefore, Dodd-Frank's reforms were aimed directly at the mortgage industry and not at the derivatives market. In other words, they treated the symptoms while ignoring the disease.

There were some significant reforms put into place in Dodd-Frank that have made the mortgage industry safer -- especially reforms which took away incentives for banks and brokers to push riskier sub prime loans, and some higher reserve requirements for certain types of investments. These are good things for the economy and for consumers.

But it's what Dodd-Frank failed to do that creates the collapse that we are about to face. Dodd-Frank failed to do anything to reform the derivatives market, which remains for the most part unregulated. This wasn't by accident. Chris Dodd and Barney Frank, both Democrats and both chairs of their respective banking committees in the Senate and House were among the largest recipients of banking industry money in Congress. These two powerful law makers understood as well as anyone the root causes of the crisis and what would truly prevent it from happening again and yet they both chose to ignore real reform and instead protect the industry which had showed them such tremendous financial support over the years. So, suggestions that derivatives be traded on an open market rather than over the counter, that credit default swaps be regulated as insurance policies with reserve requirements and oversight, that large banks be separated into commercial and investment segments were ignored. The casino was reopened and now had the government's backing for its risk taking.

This brings us today. So how could this happen again? Mortgages have been reined in, housing hasn't recovered from its collapse, so how could a 2008 style collapse happen now?

Well, since nothing has been done to reform the derivatives market, Wall Street just needed a new market to pump up, securitize, and sell. Enter the ever increasing student loan market.

During the last several decades, tuition at four year collegiate institutions has increased exponentially. Just in the last ten years for which data is available from the U.S. Department of Education, tuition and room and board at public four year institutions has increased 37%, whereas tuition at private four year institutions has increased 25% during that same period. Average tuition in the 2009-10 academic year for public four year institutions was $14,870 and $32,475 for private four year institutions compared to $10,609 and $26,795 just ten years earlier when adjusted for inflation.

This huge increase in tuition, led to a huge increase in student loan borrowing as well. Again, looking at statistics available from the Department of Education, in the 2007-08 academic year, the average debt burden for students graduating with a four year degree from public institutions was $19,839 with 61.1% of undergraduate students at four year public institutions borrowing. For private four year institutions the amount was $27,349 with 70.6% of students taking out loans.

The stratospheric increase in tuition amounts and the amount of loans being taken out by students in order to pay for these increases has presented fertile new market for Wall Street to exploit through financial derivatives. As the real estate market has continued to sputter, the student loan market has taken the lead in consumer loans. As was done with residential mortgages, Wall Street is now carving up these new loans, securitizing them, dividing them into tranches and selling them as new CDO products to investors looking for larger returns than they can find elsewhere in the bond markets.

In a way, student loans are the perfect consumer debt from which to create CDO's. First, many of the loans are subsidized by the Federal government. This means that if the borrower defaults, the government guarantees payment. The other reason these are prime for derivatives is that all student loans, whether subsidized or private are not dischargeable in bankruptcy, making it more difficult for the borrower to escape responsibility for paying back the loans.

However, despite the apparent security of CDO's based on student loans, you still have the same problems associated with the residential mortgage CDO's that collapsed the entire economy in 2008. First, the fact that these are overtly subsidized by the government is a bad thing for the American taxpayer when you look at defaults on student loan backed CDO's. The nature of the subsidization means that a TARP style bailout of the institutions issuing and purchasing these investments is almost inevitable. Second, none of these safeties prevents default on these CDO's. Even though the loans are not dischargeable in bankruptcy, that doesn't make the borrower pay back the loan, and with the job market failing to return to anything near what would be expected in a healthy economy, the chances of default are becoming greater and greater every day.

But what should frighten the American taxpayer the most about these CDO's is that the requirements for student loans are even less stringent that the requirements for residential mortgages even in the boom days of the sub prime mortgage bonanza. Most of the individuals taking out these loans are teenagers with no credit whatsoever and little knowledge about finances. With nothing done in any of the reform legislation passed after 2008 to curb lend to securitize behavior, and therefore very little risk placed on the initial lender, there is no reason for lenders not to lend to any student applying for these loans.

If you are looking for the types of "liar loans" that earned such infamy during the sub prime boom, with migrant farm workers buying $350,000 homes with 100% financing, look no further than the growth in for-profit educational institutions. According to the Department of Education, in 2007-08 the average amount borrowed for a student at a four-year private for profit institution was $24,635, with a whopping 97% of students borrowing to pay for the for profit educational experience. So, nearly every individual attending a for profit undergrad school is borrowing money, while at the same time the only requirement for admission seems to be a pulse and the prospect for employment after graduation seems illusory at best. These are loans that are guaranteed to fail and end up in default.

Another frightening development is the amount students are borrowing for post-secondary and professional degrees. Again, according to the U.S. Department of Education, in the 2007-08 academic year, law students were graduating with an average law school debt of $80,081 and an overall academic debt of $92,937. Medical students medical school debt for the same year was $119,424 with an overall academic debt of $127,272. These continue to increase in the years since. The problem is that although the cost of professional schools has continued to increase, the job market for these graduates has dried up in the years since the 2008 collapse. Add to this that with the advent of for profit law and medical schools, more and more people are pursuing professional degrees and taking on an ever increasing debt burden to do so, you have a recipe for financial disaster.

What all of this leads to is that student loan market is about to bust and bust big time. So, why will this be worse than the near total collapse of the economy in 2008?

There are a number of reasons this will be worse. The first and most obvious one is that the result of the collapse in 2008, the emergence of the Too Big To Fail financial institution which rather than making the economy safer has put it more at risk. A more apt name for these institutions would be Systematically Dangerous Institutions. Because of their enormous size, the failure of any one of these institutions puts the entire economic system in danger. These huge institutions are so enormous, that the taxpayer has no choice but to bail them out if there was anything approaching defaults in the derivative markets like there were in 2008.

Furthermore, despite what the TBTF institutions claim, the U.S. government still owns a large percentage of these institutions as they have not been able to repay the loans that were forwarded to them during the last bail out. If these institutions collapse, the American taxpayer is on the hook, as both the Treasury and the Federal Reserve are still holding huge amounts of toxic investments that the banks could not get rid of. For the last four plus years the Treasury and the Fed have been propping up these institutions and yet requiring nothing in return for their investment.

Another reason that the coming collapse is going to be worse is that the Federal Reserve allowed the huge investment banks such as Goldman-Sachs, JP Morgan and Morgan Stanley to restructure as bank holding companies following the bail out. This not only allowed these banks to have access to cheap Fed loans, but also allowed them to further delve into commercial banking and further eroded what little separation there was from commercial and investment banking. The FDIC simply doesn't have enough money to cover the collapses that could result from the bursting of the student loan bubble, even though they could be on the hook for just such an occurrence if and when it happens (just look at what Bank of America and its subsidiary Merrill Lynch did when they were concerned about a European debt crisis here).

This collapse is going to happen. I can't tell you when. It could be this week, or this year, or in the next couple of years. There is nothing that either Barack Obama or Mitt Romney are proposing that will stop it. While we debate whether to extend tax cuts to the rich or to the middle class, while we worry about fiscal cliffs, while both sides of the aisle play chicken beating their chests for political gain, the greatest threat to our economy, a giant ticking time bomb of debt, is being ignored and will be ignored by both Democrats and Republicans.

But it will explode. And the results will be disastrous. And both sides will say no one saw it coming. And will blame each other. And we, the taxpayers, will suffer the consequences.