the Economy: Part I

1. the Economy: Part I Prepared by the Issues and Education Committee, Obama for America/Ann Arbor Presented Feb. 1, 2012 For more information, email erica.ackerman@gmail.com Speakers: Tony Kourtakis and Erica Ackerman

2. Back From the Abyss

3. Legacy of Clinton Administration • Created nearly 23 Million jobs (v. 2 Million for Bush) • GDP grew by a total of 35% (over 4% per year) • Median household income rose by 14% • Median income of black families increased by a third • Number of people on welfare fell 60% • 4 years of budget surpluses, despite inheriting massive deficit from Reagan/Bush years

4. How He Did It • Omnibus Budget Reconciliation Act of 1993 • Significant cuts in spending balanced over 5 years • Increased top income tax rate from 31% to 39.6% • Repealed cap on earnings subject to Medicare tax • Increased the corporate income tax rate for profits over $10 million • Passed when Dems still controlled Congress, before Gingrich • Investments in science, technology, infrastructure, and people

5. Legacy of the Bush Administration • Worst recession since the 1930s • $6.5 trillion in home equity wealth destroyed • $6.9 trillion lost on the stock market just in 2008 • High, sustained unemployment rate • Deregulation that led to: • Extreme risk taking on Wall Street • Massive fraud in the housing market, • Set the stage for the financial crisis • Tax cuts for wealthy that have increased the deficit. • Cost of tax cuts and wars will account for half the budget deficit by 2016 • Two unfunded wars • They privatized the profit and socialized the risk

6. Impact of Bush Policies on the Deficit Tax Cuts and Wars Note how small the long-term impact of the Stimulus will be

7. What We Faced • “The Federal Reserve has taken extraordinary actions during the past four years to stem what could have been a meltdown of the financial system and a horrific depression.”- Head of the San Francisco Fed, 11/18/2011

8. How We Got Here 2003 photo op: Bush’s Vice Chairman of the FDIC and his head of the Office of Thrift Supervision (OTS) celebrating deregulation of the banking industry with the heads of three banker trade associations. Between 2004 and 2008 $750B in option Adjustable Rate Mortgages were created, mostly by OTS-regulated banks. These were the loans most likely to fail.

9. Development of the Shadow Banking System • The shadow, or parallel, banking system is a term for all the unregulated portions of the banking system • Depository banks are highly regulated. They must: • Hold liquid reserves • Maintain substantial capital • Pay into a deposit insurance system • Keep their books open to regulators • Investment banks like Lehman Brothers and Goldman Sachs are not regulated in the same way • Hedge funds are completely unregulated • You can make more money without the overhead of regulation, but at greater risk • In 2008, roughly half of the money invested in the US was in the shadow banking system. Because unregulated, no one knows.

10. Shadow Banking System Highly Leveraged • If you are leveraged 33:1, you have borrowed $33 for every $1 you put in to the cost of buying your assets • A 3% rise in the value of your asset base means you made a 100% return on your investment (you doubled your money). • But a 3% drop in the value of your asset base means you are wiped out. • If you shorted or issued a CDS that needs to be paid out and there is more than a 3% drop, you owe money. Maybe lots. • Some hedge funds are leveraged 100 to 1 • In 2004 SEC increased leverage limit from to 40:1

11. Investment Bank Leverage 2003 v. 2007

12. Causes of the Housing Bubble • “Giant pool of money” from US retirement savings looking for higher returns (Warning: this will increase with privatization of Social Security) • “Exotic and opaque” financial innovations in shadow banking system: Collateralized Debt Obligations (CDOs), Credit Default Swaps (CDSs) • Created a market for subprime by getting it rated AAA • Market liked subprime mortgages because interest rates high • Virtually unregulated, so used absurd assumptions about risk • Loose regulation of lending industry • NINJA mortgages (liars loan): No Income, No Job, (No) Assets • Subprime rose to 20% of new mortgages in 2006 • $750 Billion in option Adjustable Rate Mortgages (the type that failed most) 2004-2008 • Publicly traded rating agencies didn’t understand the products they were rating • Because publicly traded, tremendous pressure gain market share, offer the highest rating for the lowest price

13. Number of AAA Securities skyrockets

14. So Do Rating Agency Profits

15. Collateralized Debt Obligations (CDOs) • Made sense if you assumed that housing prices will keep rising, so if a buyer can’t make their payments, they can sell • Create a pool of mortgages, many of which are subprime • Divide the pool up into “tranches” that can be bought and sold • Purchase of a tranche entitles you to a portion of the interest and principal from your tranche • Senior tranches – first in line for payment, last in line for default. Then mezzanine, then equity tranches. • Senior tranches rated AAA even with subprime loans in them, because even with some defaults, surely the defaults wouldn’t reach all the way to the senior tranches.

16. From Subprime To AAA

17. Credit Default Swaps (CDS) • “Financial weapons of mass destruction” – Warren Buffett • Meant to function as insurance, but unregulated • You’re an auto parts supplier who would be impacted by a GM bankruptcy • You take out a CDS on GM so that you’ll get paid money if GM fails • Complex computer models used to calculate risk • If you could tweak your computer model to show low risk, you didn’t have to hold a lot of money in reserve, so profits high • Compensation incentives didn’t take risk into account - people got rich off bonuses for deals that could bankrupt the company • You didn’t have to own the asset to insure it with a CDS • Anything could be “insured” with a CDS, including the survival of a company such as GM or the weather – basically a bet. • Multiple CDSs could be taken out on a single asset, such as the value of GM • This amplified the effect of any one bankruptcy • If 10 companies have CDSs on one company, if that company goes bankrupt, insurance has to be paid out to all 10 companies

18. Credit Default Swaps Amplified Risk to System

19. Newly Created market for Subprime Loans

20. $300B in Bad Loans Bring Down Entire Financial System • How could $300 billion in bad mortgages bring down the financial sector worth 10s or 100s of trillions of dollars? • Collateralized Debt Obligations made sale of subprime respectable (AAA ratings) • Existence of Credit Default Swap “insurance” made riskiest CDO tranches attractive (high rate of return and apparently low risk) • Credit Default Swaps multiplied the number of securities based on the same underlying risky debt • Swaps linked together thousands of firms so that failure of a few could paralyze entire system • Investment banks highly leveraged and without adequate reserves • This was not just poor people buying houses they couldn’t afford • The whole shadow banking system was a house of cards (lack of regulation)

21. A Note on Fannie Mae and Freddie Mac • An article of faith on the right is that the housing bubble was due to Fannie Mae and Freddie Mac forcing banks to give mortgages to poor people who couldn’t afford them • Reality: • 84% of subprime mortgages in 2006 were issued by private banks, and 71% of all mortgages issued by private banks were subprime • Fannie and Freddie had accounting scandals in the early 2000s that resulted in greater scrutiny of them. As a consequence, they were mostly on the sidelines for the housing bubble • Fannie and Freddie backed mortgages have had a much lower default rate than commercial mortgages • The financial industry with its enormous appetite for subprime mortgages forced borrowing standards lower, resulting in predatory lending, NINJA loans, etc.

22. The Credit Crisis • Credit Crisis – bank to bank lending came to a halt • If I know that my portfolio is junk, why should I believe the next guy’s isn’t? • If his portfolio is junk, too, how will he be able to pay me back? • So I won’t lend to him. Or to anyone else. • 2008 was a classic run on the banks • But depository banks actually did okay • The run was primarily on the unregulated, shadow banking system • Investment banks like Lehman Brothers, Bear Stearns, Merrill Lynch that had dealt heavily in derivatives • Insurers like AIG that had issued credit default swaps without setting aside adequate reserves

23. Inter-Bank Lending Comes to a Halt

24. Trading in Securitizations Stops

25. Vicious Cycle of Deleveraging • Leverage magnifies profits, but also losses. • Deleveraging: when you have to make good on your debts (like payment due on credit default swap you issued), you have to sell assets quickly • If everyone sells at the same time, the price goes down fast • Large portions of the market are legally restricted to investment grade assets (e.g., pension funds, insurance companies, banks) • When CDOs were downgraded, they had to be sold. Quick. • Collapse of prices puts pressure on others, who end up having to sell, too, putting pressure on others, and so on

26. Bush Was Right to Bail Out the Banks • The bank bailouts averted a catastrophe – they needed to be done • Commerce would have frozen if firms couldn’t get money to meet payroll, buy goods to sell, or purchase materials for manufacture • What should have happened in return was serious, fundamental reform: • Change in the salary/bonus incentive structure so that only “risk-adjusted” deals are rewarded • Remove conflict of interest for rating agencies • More appropriate capital requirements to limit excessive leveraging • Create a clearinghouse and reporting requirements for Credit Default Swaps so regulators know what is going on • Many more… • In order to push through reform that goes beyond Dodd-Frank, Obama needs a mandate

27. Where Things Stood When Obama Took Office • The economy was contracting at a rate well over $1 Trillion per year (8.9%) • Estimates at the time were only 3.8% contraction, later revised • Jobs in free fall: • 4 million jobs had been lost under Bush • 750,000 jobs were being lost a month • Total 8.8 million jobs lost in first year • 2 weeks before the inauguration, the Congressional Budget Office (CBO) estimated 2009 deficit would be well over $1 Trillion.

28. What Obama Did • Administered TARP bank bailouts started by Bush to combat the credit crisis • Bailed out the auto industry • Saved a 1-3 million jobs throughout the auto industry supply chain • Prevented a $1 trillion loss in the credit default swap market • Passed $787 billion stimulus (Feb. 2009) • 1/3 to states to prevent the layoff of police officers, teachers, etc. at risk of losing their jobs because of state budget shortfalls ($300 Billion) • 1/3 in tax cuts for working-class families (over $200 Billion) • 1/3 to states for infrastructure projects ($300 Billion) • Extended unemployment benefits • Payroll tax cut • Middle class tax cuts affecting 95% of taxpayers • Small business tax cuts • Small business loans • Passed banking regulation (Dodd-Frank)

29. Accuracy of Predictions for the Stimulus • Republicans often point to early prediction by the Obama administration for what the stimulus would do: • Keep unemployment rate below 8% • The size of the stimulus was based on a gross underestimate of the size of the US contraction (3.8% rather than the actual 8.9%) • Predictions for the effects of the stimulus were based on that low estimate • The stimulus actually did what was predicted if you adjust for the greater contraction. • Was predicted to create or save 4 million jobs • Several independent studies estimate job creation around that level

30. How a Stimulus Works • Many people are honestly confused about stimulus – why it isn’t just a one-to-one robbing Peter to pay Paul • In a recession there is plenty of supply(factories, workers, money), but no demand. The trick is to get that supply working again. • Government steps in and supplies the demand until market can right itself • Prevents unnecessary bankruptcies of businesses and individuals • Government expenditures (if wisely chosen) have a “multiplier effect” • Each dollar spent can result in significantly more than a dollar’s worth of income generation.

31. Stimulus Effect on GDP: Research by Moody’s Analytics

32. Results • Since the bottom in 2010 we have added 2.4 million jobs (more than during the entire Bush administration) • Stimulus: • Up to 3.7 million jobs created or saved (1/3 of stimulus was to save jobs) • 114,400 teaching jobs saved • 45,000 jobs added in auto industry since bailout • Increased GDP by up to 3.1% • Stimulus decreased unemployment by up to 1.8% • Extension of unemployment benefits saved millions of jobs by allowing people to continue buying -- supported businesses • Saved 1.6 million jobs per quarter • Reduced the fall in GDP by 18.3% • Since 8.8 million jobs lost (half under Bush, half under Obama), we are still digging our way out

33. Why Taxing the Wealthy is Simply Fair: Part I • Republican rallying cry of the late 1990s: “It’s our money. We earned it.” • They earned it by capitalizing on inventions created by government investment in research and development • The public-private partnership of the last 70 years has been the greatest engine of wealth creation the world has ever seen. • Now they want to kill the goose that laid the golden egg

34. Where Would the “Job Creators” Be Without These? • Just in computers: • The transistor (basis of the modern computer chip) • Semiconductors • The concept of operating systems and programming languages, Unix (the basis of Mac and Linux), C, C++ • Word processors • Spreadsheets • Databases • Computer Aided Design (all modern manufacturing design) • Computer graphics • The Internet and company intranets

35. Why Taxing the Wealthy Is Fair: Part II • Without the colossal rescue of the financial system, they would have no wealth today, taxable or not • $700 Billion TARP (under Bush) • $7.7 TRILLION (half of the US production for a year) between 2007 and 2010 in below market rate loans from Fed to banks • Quantitative Easing (Credit Easing and QE2) • Just 1 example: in 2010 the Fed bought $1.25 Trillion in Mortgage Backed Securities

36. What Awaits Us if the Republicans Win • The Republican emphasis on cutting the deficit by cutting spending is contractionary – it will shrink the economy • English recovery has stalled out since Cameron instituted austerity

37. What to Take Away • Lack of regulation in the banking industry had disastrous consequences • We need to give Obama a mandate for further banking reform • The stimulus was the right action to take, and it did what it promised, if you adjust for