The Financial Equivalent of Snake Oil

In the history of the United States, there were travelling salesmen who sold a variety of different tonics, potions, powders, syrups, pills, and other remedies that, so they claimed, were guaranteed to cure almost any kind of ailment by which a human being could be afflicted. Most of these remedies were of dubious value. An example is snake oil, which gave its name to this entire class of suspect remedies. These salesmen exploited the fear and gullibility of the many uneducated people at the time in order to hawk their wares and make money.

Today, like the chameleon, snake oil salesmen have changed their products and their sales pitch, but they continue to hawk their many worthless wares to unsuspecting buyers. Many are the products which are packaged and marketed to consumers, but which either consumers don’t need, don’t do what they are advertised to do, or malfunction or break down prematurely so they must be repaired or replaced. However, the insistent claims and honeyed promises made by snake oil salesmen are not limited to the realm of physical products. Wherever and whenever human beings have a strong desire for something – whether for sex, food, beauty, health, fitness, pleasure, oblivion from one’s troubles, novelty, comfort, convenience, status, wealth, or luxury – there is an opportunity for individuals to make money, whether legitimately or illegitimately.

One of the strongest desires today is the age-old desire to make even more money than the amount one already has. No matter how much money a person has, whether measured in thousands, millions, billions, or trillions of currency units, there are few people who would turn down the opportunity to make even more money.

Following the spate of financial deregulation that was launched in the United States during the presidency of Ronald Reagan, there arose all sorts of new financial instruments which either didn’t exist before or were not as commonly traded. In the aftermath of the 2008 global financial crisis that began in the United States, it became clear that one of the primary causes was the widespread sale of new financial products like derivatives, collateralized debt obligations, and credit default swaps.

[…]derivatives [were] the financial instruments that made it possible to hedge against price fluctuations of commodities, interest rates, and exchange rates, and to bet on future movements of stock and bond markets. The most basic of these were futures contracts, derivatives that allowed commodity users and traders to hedge against price changes in markets they depended on. For example, wheat farmers bought futures contracts promising to deliver wheat at a specific price to protect the value of their crops; airlines bought futures contracts for aviation fuel to protect against sudden changes in the market price; international corporations bought futures contracts for foreign currencies important to their businesses, to hedge against sudden changes in those currencies’ values. Those older forms of derivatives had been joined in recent years by more exotic derivatives, most notably credit default swaps, a kind of insurance that dealers traded to try to guarantee the value of bonds. AIG’s collapse was caused by reckless trading of credit default swaps, which played an important part in the Great Crash [of 2008].

For nearly thirty years during which the market for derivatives grew exponentially, they remained unregulated.[1]

Most people can understand the purpose and utility of a home mortgage: it enables an individual or family to buy a house or other residence without having to save for many years in order to pay the total cost of the house, in which they can live and which protects them from the elements, while protecting their possessions from thieving humans. But of what use is a financial product that bundles many home mortgages together so it can be sold to others? True, it is possible to make money by buying and selling it. But it is possible to make money from selling many things or engaging in other activities that most people would agree should not be allowed: prostitution, drugs, extortion, and the sale of children or endangered animals are just a few examples. Most people would also agree that gambling is another human activity that needs to be restricted and regulated even though it creates jobs and allows some people to amass large amounts of money. These examples make one thing clear: business or financial activities that have harmful social or economic effects should either be regulated by the government or made illegal so that those who engage in them are subject to criminal prosecution.

To allow financial companies to make up whatever kind of financial instrument they want and then sell it to others is no different from allowing licensed casinos to make up new games of chance and let the public play them in order to take their money, or to allow the operators of horse-race tracks to allow bettors to bet on the bets made by other bettors. Clearly, these financial companies have a strong self-interest to design the new instrument so that it enables them to make the most amount of money as possible.

In the past, banks and other financial institutions that made bad loans which were unlikely to be paid back simply had to swallow their losses and deduct them from their annual profits, or declare them as losses. As a result of these losses, they were cautious about lending their money, which were the savings entrusted to them by individuals and businesses. The mischief started when some cunning financial snake oil salesman got the idea of bundling together the loans issued by banks and credit card companies and selling them as a new kind of investment. The unjustified optimism in these new investments was encouraged by the naive proclamations of economists and others who declared that, by averaging the risk of default among many hundreds or thousands of loans, they were as safe as, or even more safe than, more traditional forms of investment. Because of the prevailing greed that afflicts many people and companies today, there were many eager buyers for these unsound investments. Hence, due to the great demand for CDOs, it led to the unsound financial practice of giving mortgages to people who were at high risk of default.

A bank loaned maybe 100,000 dollars each to 10,000 American families. That was one billion dollars that the bank would get back over the next twenty-five years. Now the bank created a paper that said whoever owns this paper would have a right to money from the loans. The bank then sold the paper to someone else (for example, a pension fund) and as if by magic got back a new, cool billion to loan to 100,000 new families.

It was magical. You lend one billion, sell the loan on and get one billion. But the only thing you’ve really sold is a bundle of debts. More money. Less risk. Everyone wins. This fundamentally changed the operations of many bankers. Of course, the problem was that the risk was still there. Somewhere in the system.[2]

The reality is a little more complex than the situation described in the last excerpt, since a bank would not sell the loans for exactly the same amount as the nominal value of the loans it had issued, since in that case it would make no money; moreover, by issuing large quantities of loans to individuals who previously would not have received loans, it greatly increased the total risk in the financial sector, since these individuals were at higher risk of defaulting on their loans. But it does describe more or less what was happening in the American financial system. In Liar’s Poker, Michael Lewis, who worked for Salomon Brothers in the 1980s, an investment bank that specialized in buying and selling bonds, described how Lewis Rainieri, who was the head of Salomon’s mortgage bond division, greatly amplified the practice of buying large amounts of mortgages at a discount from American Savings and Loans, whose sole function is to lend money with their deposits to home buyers, and then reselling these mortgages, after they were repackaged in the form of bonds, at a higher price to other financial institutions, at first to other Savings and Loans, and later to a wide variety of institutions, as more and more of them became interested in purchasing these new financial “products.”

There are many rules and regulations in the banking industry. One of the most basic is that a commercial bank, one that lends money to home owners, individuals, and small businesses, must not issue more loans than a certain percentage of its total deposits. The intention of this limit, called the reserve requirement, is obvious – to ensure that the bank has sufficient funds, or liquidity, to meets its many financial obligations, such as paying its operating costs, or when its depositors, who provide the funds with which the bank issues loans, withdraw money, write cheques, make purchases, and so forth. In addition, only commercial banks can issue these kinds of loans. In other words, other kinds of financial institutions, including investment banks, cannot issue home mortgages.

We can now see what was happening when the mortgage bond market, which operated largely without government supervision during the economically licentious and promiscuous 1980s, rapidly expanded. Presumably, the Savings and Loans that sold their loans to investment banks such as Salomon Brothers, which repackaged these loans as bonds and then resold them, had reached the limit of their lending capacity. In other words, if they had not been able to sell their loans to another financial company, they would not have been allowed to issue more loans without violating their legal reserve requirement obligation. But because they were able to sell these loans, which historically was a radically new development, they received a new chunk of money with which they could issue many more loans, meaning that they were able to issue a much larger quantity of loans than they could have otherwise.

Another way to look at this situation is by considering the final holders of these loans. As the mortgage bond market expanded, many financial institutions, including pension funds, investment banks, mutual fund companies, and even national and state governments, began to purchase these new “investments.” But what is true of the great majority of these holders is that not a single one of them would have been permitted to issue these loans themselves.[3] In other words, whether one looks at what happened from the perspective of the commercial banks that made the loans and then sold them to others, or from the perspective of the individuals and institutions that bought them, there occurred an enormous violation of the banking rules that regulate the lending of money. Put another way, although the buying and selling of mortgage bonds did not violate the letter of the law, since the Savings and Loans were not technically exceeding their reserve requirements, and those who purchased their loans had not actually issued them, there was very clearly a massive violation of the spirit, or intention, of the law.

There is a reason for the strict rules that exist in the banking industry, which is to prevent precisely the kind of catastrophic event that occurred in 2008 in the United States, when humanity’s penchant for behaving foolishly and irrationally leads people to make a very big collective mistake, via the mechanism of one human fool doing something different and then many other human fools imitating him, thus greatly magnifying the scope and seriousness of the original fool’s mistake.

The conclusion is obvious: if the rules that were in place, which prevented commercial banks from issuing more loans than their total deposits, and also prevented any other kind of company, individual, or institution from issuing these kinds of loans, were sound, then allowing these banks to sell their loans to others was completely unsound, precisely because it resulted in a massive violation of these rules. It is also obvious what the U.S. government, or its financial regulatory agency, called the Securities and Exchange Commission, should have done: since the end result of reselling loans to a third party led either to a gross violation of the commercial banks’ reserve requirement, or to loans in effect being issued by individuals, companies, and institutions that did not have the authority to issue them, it should have declared this practice illegal and put an end to it. Had it acted in this sensible manner, and thereby preserved the integrity of the banking rules, the 2008 financial crisis almost certainly would not have occurred.

And “we didn’t need a Pecora Commission to find out what was going wrong. We had mortgages being sold in this country to people who couldn’t afford them, marketing them in a way that guaranteed failure, securitizing them so [their creators] could be paid and then skipping town in a sense.”[4]

Of course, when the market for this new form of financial snake oil was not yet saturated with competing brands, and the stream of gullible buyers had yet to dry out, it was possible to make money by buying and selling them. But eventually the tide turned, when many home owners began defaulting on their mortgages, and then it was understood, to their owners’ chagrin, that they had foolishly paid many millions or billions of dollars for what amounted to financial feces – the smelly remains of other institutions’ failed or unsound financial transactions.

It is to the everlasting shame of Americans that their government allowed these new financial products to be marketed and sold to wealthy individuals and financial institutions. So strong is the hold of the ideology of free-market capitalism in the United States at the present time that many Americans naively believe that whatever is done or produced by the free market must be good, and therefore it should be allowed without any restrictions, regulations, prosecutions, or punishments for bad behaviour.

Established by Congress in 1974, the CFTC [Commodity Futures Trading Commission] is an independent federal agency whose purpose is to assure an open and honest market in the financial products variously known as swaps, futures, and derivatives. In 1998, with the support of the Clinton administration, Congress barred the CFTC from making any new regulations of the booming market in “over-the-counter derivatives,” often exotic swaps that became extremely popular with the mathematical wizards of Wall Street. The Dodd-Frank Act[5] formally regulated this market and gave substantial new powers to the CFTC.[6]

Just as the sale of dubious remedies such as snake oil was eventually regulated by the government in order to protect consumers from useless or dangerous products, it is also necessary to regulate financial products in order to protect investors, which includes protecting them at times from their own ignorance, gullibility, greed, and their proclivity to imitate unsound practices. And in order to accomplish this vital objective, it is first necessary to discredit the many free-market fanatics who hold deregulation as one of the fundamental tenets of their mistaken ideology of free-market capitalism.

[1] Act of Congress: How America’s Essential Institution Works, and How It Doesn’t by Robert G. Kaiser, chapter 7. Alfred A. Knopf, New York, 2013.

[2] Who Cooked Adam Smith’s Dinner? A story about women and economics by Katrine Marçal, pp. 86-87. Translated by Saskia Vogel. Portobello Books, London, 2015.

[3] Another way of considering the final outcome is that commercial banks were permitted to issue large amounts of loans on behalf of a third party which provided the money that was loaned, while charging this party a commission for its services. Again, stated in this manner, it is unlikely that a government would have allowed this practice to develop and become as widespread as it did.

[4] Former U.S. Senator Chris Dodd in Act of Congress, chapter 23.

[5] However, due to strenuous lobbying by financial companies, many of the measures contained in the Dodd-Frank Act have been weakened or eliminated.

[6] Act of Congress, Principal Organizations and Institutions.