I could have subtitled this post "Or...Where the hell is my damn pitchfork?!?!?!?!"
You might wonder why I am complaining that interest rates are at zero percent at least through 2014 if we are to believe the FOMC (and there is no reason not to). Let's face it, there are lots of benefits to low interest rates for consumers -- cheap credit, lower car payments, lower mortgage payments, etc. So why in the world would I be arguing for interest rates to increase?
The simple answer is that it encourages economic responsibility in that higher interest rates encourage saving and right now savers are getting royally screwed in favor of speculators.
But if we look at what led to the economic collapse of 2008 and beyond, we see what real destructive effects debt and low interest rates have had on our economy as a whole and if you really start to understand what is going on, you too will be looking for your own pitchfork (or an arsenal of high powered assault rifles).
I will focus on one scenario here. One of the biggest investors in bond markets are pensions. I'm sure that you've heard all sorts of stories about the trouble that large pensions, especially public employees pensions and unionized manufacturers like automobile companies have had since the collapse in 2008. Often, especially over the last two years this has been used as an excuse for right wing politicians to attack unions and in some cases such as Wisconsin, Indiana, Ohio and elsewhere to actually attempt to eliminate the right of public employees to bargain collectively. It is the wasteful, overpaid union employees that lead to the unaffordable pensions.
This is nonsense of course, and hopefully you'll see why once you've finished.
Pensions focus on bonds because they are historically the safest investments around. Bonds generally have a guaranteed rate of return at a specific date. Bonds do not have a high rate of return, but they also do not pose much of a risk. However, the rate of return on a bond is effected by the interest rate which is set by the Federal Reserve. When interest rates are high, bonds are a better investment as they have a higher rate of return. However, when interest rates are low, the rate of return on those investments is lower making them a worse investment.
During the 2000s, the FOMC set interest rates at historically low levels. Many times this was in response to huge economic emergencies such as the 9/11 attacks. But as a general rule the decade saw the lowest interest rates overall in recent history, holding for long periods below 2% and spending most of the decade well below 5%.
Because of this, pensions found themselves getting less and less of a return on their usual investments in bonds. This is the major reason that large bond investors such as government and large corporate pension funds started looking elsewhere for places to invest their money. The Trustees of these funds had a duty to maintain a certain level of return for their beneficiaries and the bond market was simply not providing them an avenue in which to find these returns.
Wall Street banks offered a solution to this in the form of derivatives. Derivatives of course are the complex financial instruments such as collateralized debt obligations and credit default swaps which played the largest role in the economic collapse and were responsible for the annihilation of trillions of dollars of wealth in 2008 after the collapse of Bear Stearns, Lehman Brothers, and the rest of the large Wall Street financial institutions.
What derivatives such as CDOs were in their simplest form were securities that were made up of other debts or financial instruments. Say bank A makes 1,000 loans to consumers and then sells those loans to Investment Bank B who then carves up the 1,000 loans into a security. The best loans are Pool 1, the middle loans somewhat riskier are Pool 2 and the worst of the loans which are the most likely to default are Pool 3. These are then sold to investors with a price and return that is equal to the risk that each pool's individual risks.
As long as everyone played by the rules, these were pretty basic, pretty vanilla investments. Sure, they were sexier than your run of the mill bonds like T-Bills, since they would provide a slightly better rate of return since they involved slightly more risk, but they weren't any kind of economic succubus which would devour the entire economy either. The problem was, that as long as interest rates remained relatively normal (5%-7% or higher), there really wasn't a huge market for these types of investments among large pension funds, since the risk simply wasn't worth the slightly higher return.
When interest rates tanked and large investors like pension funds started looking for new ways to satisfy their duties to their beneficiaries is when everyone stopped playing by the rules.
Faced with this huge market of new potential investors, the banks started aggressively marketing these investments which up until that point had been seen as exotic creatures that were far beyond the pale of anything that a wise principled conservative investor like a pension fund would invest in. However, seeing the opportunity to make boatloads of money, these investments were marketed as virtually risk-free investments much like Treasury bonds but with a much higher rate of return.
Once the pension funds (along with other traditionally conservative investors such as life insurance companies, nonprofits, hospitals and the like) were hooked, this is when things went horribly awry. With a sudden increase in demand for CDOs which were mostly based on residential mortgages, there was a need for more product. As a result, there was greater and greater pressure placed on lenders to make more and more mortgages. Inevitably, standards for mortgages dropped. Traditional requirements for a mortgage like having 20% equity as a down payment, a certain level of income, or stability in employment were quickly abandoned, as the goal for many lenders simply became to lend so that the mortgages could be sold to investment banks who would securitize the mortgages into CDOs.
This erosion of traditional standards of lending led to riskier and riskier mortgages making up the CDOs that were being sold as risk-free investments. However, the ratings agencies, who were being paid by the very investment banks whose instruments they were supposed to be scrutinizing, went along for the ride, abandoning their own underwriting standards and continuing to give these increasingly risky investments the highly sought after AAA rating.
As time went on, many of the firms began slicing up these pools of investments even further to create as if out of thin air new AAA investments. In many cases what they would do is take the worst investments of one CDO (Pool 3 for instance) and then slice that up further to create a new CDO with three new levels with the new Pool 1 receiving a AAA rating, even though it was previously considered the lowest level of the prior CDO in which it was included.
The worst offenders (Goldman Sachs and JP Morgan Chase are among this group and have paid civil fines in the billions of dollars to settle charges of this without acknowledging wrongdoing) would intentionally create CDOs that were made out of complete junk (the notorious "shitty deals" referred to in Senate hearings on the subject), sell them as AAA risk-free investments to institutional investors and then bet against them, making billions upon billions of dollars as the investments acting exactly as they were designed to, with all of the loans that made up the CDOs defaulting and the value of the investment going to zero.
We know what eventually happened. Plain simple logic would dictate that this type of scheme could not last forever, and the cracks in the foundations started being seen in 2007 and then imploding completely in 2008. The large banks which were responsible for most of what led to the implosion were bailed out and essentially absolved of their wrongdoing with a waive of the hand of Tim Geithner and Ben Bernanke.
Although there has been some reform in lending institutions (for instance, the ridiculous interest-only loans and adjustable rate mortgages have been for the most part abandoned and many equity requirements have been reintroduced) the underlying problem that led in great part to the collapse has not only not been remedied, but has become worse. Interest rates have been at 0% for more than three years and the FOMC has said that they will remain there at least through 2014. This policy encourages increases in both institutional and consumer debt as well as discouraging savings. Large investors are still faced with taking on greater and greater risk in order to satisfy their requirements on return. Conservative investors are being squeezed out of the market altogether as there is simply no incentive to save or invest in low risk, low return instruments.
This is how bubbles are created. This is how economies are ruined. This is how nations are destroyed.
What I have presented here is a very bare-bones example of the effect of the FOMC's policies over the last couple of decades. The realities are obviously more complex and more difficult to understand. However, what I have set forth is no less true. The more we pay attention to these machinations, the more we learn how the cards are being stacked against ordinary Americans by our own government and financial institutions. The more we pay attention, the less likely we are to stand by and say nothing or believe the talking heads on CNBC who say "it's all a part of the market and there's nothing we can do about it." The more we pay attention, the more likely we are to demand change.
Are you looking for your pitchfork yet?
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