PART 2
Lender liability is embodied in common and statutory law covering a broad spectrum of claims surrounding predatory lending. It is a key concept in environmental-cleanup litigation. If a lender knowingly lends to a borrower who is obviously unable to make reasonable beneficial gain from the use of the funds, or causes the borrower to assume responsibilities that are obviously beyond the borrower's capacity, the lender not only risks losing the loan without recourse but is also liable for the financial damage to the borrower caused by such loans. For example, if a bank lends to a trust client who is a minor, or someone who had no business experience, to start a risky business that resulted in the loss not only of the loan but of the client trust account, the bank may well be required by the court to make whole the client.
In the United States, although predatory lending is not defined by federal law, and various states define abusive lending differently, it usually involves practices that strip equity away from a homeowner, or equity from a company, or condemn the debtor into perpetual indenture. Predatory or abusive lending practices can include making a loan to a borrower without regard to the borrower's ability to repay, repeatedly refinancing a loan within a short period of time and charging high points and fees with each refinance, charging excessive rates and fees to a borrower who qualifies for lower rates and/or fees offered by the lender, or imposing new unjustifiably harsh terms for rolling over existing debt. Predation breaks the links between an economy's aggregate resource endowment and aggregate consumption and between the interpersonal distribution of endowments and the interpersonal distribution of consumption.
The choice by some to be predators decreases aggregate consumption, both because the predators' resources are wasted and because producers sacrifice production by allocating resources to guarding against predators. Much of welfare economics is based on the concept of Pareto Optimum, which asserts that resources are optimally distributed when an individual cannot move into a better position without putting someone else into a worse position. In an unjust global society, the Pareto Optimum will perpetuate injustice.
Now, there is a close parallel in most Third World debts and International Monetary Fund (IMF) rescue packages to the above predation examples where sophisticated international bankers knowingly lend to dubious schemes in developing economies merely to get their fees and high interest, knowing that "countries don't go bankrupt", as Walter Wriston of Citibank famously proclaimed. The argument for Third World debt forgiveness contains large measures of lender liability and predatory lending. Debt securitization allows these bankers to pass the risk to the credit markets, socializing the potential damage after skimming off the privatized profits.
Credit is reserved financial resources ready for deployment. Debt basically is unearned money secured with a promise to repay the principal sum plus interest with optimistically anticipated earned money in the future, assuming, for example, that the borrower will not become unemployed through no fault of his own or a business will not be adversely affect by unanticipated shifts in business paradigm, or an economy will not be destroyed by global financial contagion.
Paying down debt with new debt is a Ponzi scheme - the likelihood of its exposure is inversely proportional to its scale of operation. More and more critics are calling the Enron debacle a Ponzi scheme, in that the company filed for bankruptcy even though, for almost a decade up to a few weeks before its bankruptcy filing, many in high places were hailing Enron as the new innovative business model.
Neoliberal economist Paul Krugman publicly hailed Enron as a shining example of free-market entrepreneurship in what he called "a love letter to free markets". He served on its prestigious advisory board for a annual fee of US$50,000. Neoconservative Weekly Standard editor Bill Kristol received $100,000 from the same Enron advisory board, while contributing editor Irwin Stelzer praised Enron for "leading the fight for competition".
On November 13, 2001, two weeks before Enron filed bankruptcy on December 2, the Baker Institute honored Greenspan with its Enron Prize, which the official press release said "gives recognition to outstanding individuals for their contributions to public service. The prize is made possible by a generous gift from the Enron Corp ... one of the world's leading electricity, natural-gas and communications companies. Among the previous recipients of the Enron Prize are Colin Powell, current US secretary of state; Mikhail Gorbachev, former president of the Soviet Union; Nelson Mandela, the first black president of South Africa; and Georgian President Eduard Shevardnadze."
Enron officials have since acknowledged that the company has purposely overstated its profits by billions of dollars since 1997 and has disguised billions in debt as revenue through structured finance via offshore special-purpose vehicles. Top Enron executives cashed out more than $1 billion in company stocks when they were near their peak price of more than $80. In addition, nearly 600 employees deemed critical to Enron's operations received more than $100 million in bonuses in November 2001 while the company was on the brink of bankruptcy. Some commitment to public service.
On the corporate level, debt inevitably alters management behavior. Leverage increases profit margin on successful business plans. As Henry Kravis, king of the leveraged buyout, famously said: "Debt can be an asset. Debt tightens a company." To less creative minds, debt is still a liability, not an asset. But debt also exaggerates losses when business plans fail. In the US financial system, bankruptcy is a legal if not painless way to refute debt. The comfort to lenders is that equity investors are wiped out first before the lenders' various collateralized positions are endangered.
Banks used to be the sole intermediaries of debt. For this reason, a central bank was formed to supervise and provide liquidity to the banking system. Thus a central bank came into existence in the United States in 1913 on the assumption that the existence of a healthy banking system is in the national interest. And to protect the national interest, the central bank, which in the US version is a government institution privately owned by the banks in the Federal Reserve system, is allowed to act as lender of last resort to the nation's commercial banks with public money, or more accurately, through government authority to create fiat money.
Thus regulation on banks is a fair quid pro quo, a social contract. Bank deregulation without corresponding raising of the threshold for central-bank bailout is a direct breach of this social contract. If for the good of the nation banks cannot be allowed to fail, they should also not be allowed to deregulate.
More ominous, the US credit system has broken through the banking system - the bulk of debt now is intermediated through the unregulated credit markets by debt securitization. Securitization acts as more than just providing a vehicle for investment in debt instruments. It restructures simple debt into complex, hybrid instruments sliced infinite ways until the original debt is beyond recognition.
Debt securitization is guerrilla warfare against a sound credit system. Debt proceeds can be disguised as current income, distorting the financial performance of the debtor. In these brave new credit markets, the government is generally only an interested bystander, so far quite unwilling to regulate even over-the-counter (OTC) derivative trading by banks, which are suppose to be regulated, with an "if I don't smoke, someone else will" mentality.
OTC derivatives are traded off exchanges, directly between counterparties, and as such are not subject to disclosure rules. Adding estimated data from the Bank for International Settlements for OTC derivatives to published figures for exchange-traded derivatives, the total notional principal balance of the reported derivatives market in June 2001 was $119 trillion, about four times the gross domestic product (GDP) of the Organization of Economic Cooperation and Development (OECD) countries and twice the value of global trade. The amount unreported remains unknown.
This shows that derivatives performed more than a hedge function, as apologists claim. Derivative trading has become a profit center for banks and non-bank financial institutions. True, the notional principal amount is never at risk, because no principal payments are exchanged. The interest payments that are linked to that notional principal amount are at risk. A loss on a derivative contract becomes possible when (a) interest rates or commodity prices move in a direction that makes the contract more or less valuable, and (b) the counterparty on the other side of the contract defaults. Derivatives credit exposure is the present value of the cost of restoring the economic value of a contract should a counterparty default.
All kinds of street rumors are flying at this very moment that one of the world's biggest banks is exposed to derivative trades that would cause serious counterparty credit problems if the market capitalization of this bank should fall below a triggering level, or the price of commodities or interest rates should move against its derivative positions. Because there is no way to dispel or confirm such rumors, and the bank involved remains tight-lipped about its true financial conditions, the uncertainties weigh down on the economy.
There is ample evidence that the level of interest rates does not always control the aggregate level of debt in an economy, popular expectations notwithstanding. When interest rates are high, they often merely reflect the systemic credit-unworthiness of borrowers as a group or the high risk assumed by lenders collectively. High interest rates in fact create more incentive for both lenders and borrowers to take higher risk to shoot for the higher returns needed to meet higher interest cost. High interest rates also direct money to more desperate borrowers. As William Zeckendorf, the bankrupt real-estate tycoon, once said: "I'd rather be alive at 30 percent interest than be dead at 3 percent."
However, interest rates do affect the distribution of credit in the economy. When rationed by interest rates, debt actually puts money to work for those who need it most desperately, and not necessarily the highest and best use in the economy, or where it is socially needed most. Debts at high interest rates can only be justified by high risk, which tends to destabilize the economy. Debt securitization actually lowers systemic credit quality by socializing risk across the whole system rather than concentrating it on singular, isolatable defaults.
The US Federal Reserve's fixation on interest-rate policy as the sole tool of regulating monetary policy is increasingly taking on the look of shadow boxing, with declining effect on the economy. As chairman Greenspan is fond of saying: "Bad loans are made in good times." As interest rates are artificially raised by Fed action to tighten money supply, distressed borrowers with bad loans made in good times will need to borrow more, thus enlarging the credit pool, defeating the Fed's purpose of a tight monetary policy. As interest rates are artificially lowered by Fed action to stimulate a slowing economy, banks raise their credit threshold to compensate for the narrowing of rate spread, thus reducing the number of qualified borrowers and shrinking aggregate loan volume. This is known as the Fed pushing on a credit string.
Credit rationed by interest rates also discourages economic democracy, since the poor generally find it much harder to obtain or afford credit. The poor also do not have the sophistication to participate in structured finance. There is much truth is the saying that it is not how much you own, it is how much you owe that measures how rich or financially powerful you are.
Debt also encourages carelessness with money, since lending implies faith in the borrower's ability to repay in the future. People tend to be more careful with money they earned in the past in the form of savings because they remember how hard they had to work for it. In contrast, debt is based on future earnings, which is deemed easier money by the existence of debt itself. High interest rates also encourage high risks to justify the high cost of money.
The problem with debt is that it needs to be serviced regularly (except zero coupons, which are discounted from the principal sum at the outset and cost more and are monitored with bond covenants and triggers to activate automatic foreclosure). Unlike a credit-driven economy, a debt-propelled economy will inevitably reach a point where its ability to service the growing debt is exceeded, unless inflation stays ahead of interest charges, in which case the banking system will fail. Thus runaway systemic debt frequently leads to hyperinflation.
Bankruptcy only relieves the debtor, not the economy. If, as economist Hyman Minsky claimed, money is created whenever credit is extended, then the erasure of debt destroys money and shrinks the economy.
There is a circular link among deregulation, debt, overcapacity and bankruptcy. Deregulation has created a havoc of bankruptcy in the airline, health-care, communication, energy and finance sectors. Deregulation permits predatory pricing in the name of competition, which often leads to monopolistic consolidation within industries. The surviving giants then take on massive debt to acquire vanquished competitors and to expand capacity in anticipation of increased demand and soon reach a point where increased sales do not increase net revenue to offset low margin. Once a company is trapped in the whirlpool of debt, a downward spiral of low prices and shrinking revenue will push the cost of debt beyond sustainability, leading to bankruptcy. This is known as the bursting of the debt bubble.
In March 1980, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) was enacted in the United States. It was a deregulation initiative by the administration of president Jimmy Carter aimed at eliminating many of the distinctions among different types of depository institutions and ultimately removing interest rate ceiling on deposit accounts. Authority for federal savings and loan associations to make risky ADC (acquisition, development, construction) loans was expanded, which ended up with the savings and loan (S&L) crisis five years later. Deregulation of airlines also began under Carter, leading to recurring waves of bankruptcy. |
