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A new report by a group of prominent economists this week warned that banks are still engaged in high-risk investing activity that is making another, potentially bigger financial crisis not only likely, but inevitable. The group includes Rob Johnson of the United Nations Commission of Experts on Finance, plus Elizabeth Warren, chair of the Congressional Oversight Panel to oversee the bank bailout. The report, commissioned by the Roosevelt Institute, points out how banks are using borrowed funds to take risks similar to the ones that crashed the economy in 2007 in order to continue to pay big dividends to share-holders and obscenely large bonuses to executives. The economists also urge the President and Congress to strengthen proposed financial regulations to stem the new crisis-in-making, and called out Federal Reserve Chair Ben Bernanke and Treasure Secretary Timothy Geithner for overseeing “policy as the bubble was inflating.” The report said, now “these same men now designing our ‘rescue.'” The report used unusually strong language to warn could happen if no action was taken: “What will happen when the next shock hits? We may be nearing the stage where the answer will be — just as it was in the Great Depression — a calamitous global collapse.”

GUEST: Max Fraad Wolff, an instructor at the Graduate Program in International Affairs at the New School University who regularly writes on the economy

Read the Roosevelt Institute’s report at http://www.makemarketsbemarkets.org/report/MakeMarketsBeMarkets.pdf

Rough Transcript:

SK: I’m assuming you take this report quite seriously.

MFW: The report is a bit of an update. It’s an interesting piece of work from the Roosevelt Institute. Most of what’s in the report is long established to be the positions of the folks who wrote the report. Almost all of them have published the same material on several occasions in other locations but it’s a nice sort of coming-together and brainstorming and they have a very nice website and they got a little bit of press to the report. And part of the reason that it’s kind of an update from them about things they’ve been saying for a while – whether we’re talking about Joe Stiglitz or Elizabeth Warren or Simon Johnson or whomsoever who are sort of the high-profile names of many economists and lawyers and some industry professionals – part of the reason that they’re in the position of giving an update is 18 months after the universal recognition of crisis, we actually have no new regulation passed into law and so we’re forced – those of us who are critical of the path that we’re taking – to kind of give updates because there’s not really a lot of new regulation, actually none, to speak of that we would be commenting on.

SK: Now, what exactly are the banks investing in at this point, given that the mortgage-backed securities that were based on the housing bubble – are they technically even around? I mean, what sort of financial instruments that are extremely risky are these banks still investing in?

MFW: Well, unfortunately, those assets are still around. I think you could find a long list of investors and banks that wish they had somehow vanished. New production of securitized or consumer loans – whether those be most prominently for homes or home-equity lines of credit or credit cards or auto loans, all of which were bundled and sold to investors as securities in a process called securitization – new activity in that business has dropped off to about four or five percent of where it was in 2005, 2006 and even into 2007. So that industry is not producing new loans. However, the loans they did produce, especially across the kind of hectic blow-out bubble period of 2002 – 2007 are unfortunately very much still with us to the tune of about 5 trillion dollars worth of securities, many of which are trading for and are valued at much less than folks had hoped and many of which continue to wreak havoc on banks and balance sheets and for investors. You know, we should keep in mind that when we talk about investors it can be kind of easy for us to paint with too broad of a brush and think of investors as only wealthy individuals but part of the problem that we have and particularly acute in a place like California is that among the largest investors in these things are often state pension funds and municipalities and municipal pension funds and state funds that pay for the retirement of people as well as corporate retirement funds whose various workers, both past and present, are now left to debate less generous benefits because of the losses experienced on those securities.

SK: Do you agree then that… The report – you know, cites that one of the main reasons that banks are continuing to engage in this behavior is because they want to keep paying out big dividends to their shareholders and also because of the very large compensation packages to their executives even though those compensation packages, the bonuses, have come under so much public scrutiny and have sparked so much outrage – are those the main things driving this behavior?

MFW: They’re certainly significant. I mean, there’s no way to debate these practices without noticing that the compensation packages in the senior executive suites of these institutions are beyond generous and while it was probably never a very convincing argument for most people that these enormous compensation packages were due to the fabulous success and profitability of these institutions, it becomes that much more problematic to justify what are probably unjustifiable anyway compensation packages. When you’re running your institution into the wall and asking the public to bail you out it’s even harder to say you’ve earned the money. I think the bigger disconnect which touches everyone’s life here, which is the sort of big problem, is we’ve seen something over the last year that we’ve almost never seen before and I wish the report had made more of this but of course no one can cover everything and that is the following: we’ve seen a constant increase in the deposits that these banks, our largest financial institutions have, and at the same time we would expect and hope, for economic reasons and reasons of opportunity, to see that as these deposits grow- more cash in the banks – they would be lending more. However, they’re lending less. And that creates this situation where they’re more interested in speculating, less interested in lending. And so, we have a situation where individuals and small businesses face enormous difficulty getting loans at the same time that these banks are sitting on mountains of cash. However, if they just sit on the cash, they don’t make any money. So, they have to put it to work and, increasingly, they’re putting it to work, directly and indirectly, in ways that are relatively more risky and involve basically investing and speculating on the future price movements and assets. They’re no longer speculating so much on American homes for obvious reasons but they are speculating on stocks and they are particularly interested in investing in the stock markets and the bond markets in places like India, China and Brazil.

SK: Well, so there’s a couple of things there in what you just said. One, it sounds like banks are essentially morphing into institutions that don’t do much in terms of lending. The thing that we normally know banks for, which is lending to ordinary people, are essentially becoming money-making institutions, money-making for their shareholders and for those who work in those banks – sort of, an institution that exist simply to enrich those that are part of it. And the other thing that you mentioned – the second financial crisis that could happen and that this report says that is inevitable – could that have global proportions and repercussions even more so than the first crisis because of these sorts of speculations on securities and stocks in China and India?

MFW: Absolutely. I mean, well, you know, if you have a passing familiarity with economic history – Will there be another financial crisis is a self-answering question – Yes. Will it be large? Eventually, sure. It’s a question of when and where and those are of course the hardest questions to answer. To me, it would look like, to no small degree, the emerging market space where money is just flooding into places, particularly where they like to call the “brick countries” – Brazil, Russia, India and China but, in there, particularly China and Brazil – and to a whole bunch of emerging markets writ large and some stocks and bonds, corporate bonds in the United States. We do run the significant risk if there’s another asset bubble in there – probably forming now, and as all asset bubbles form, the longer they go and the bigger they get – the more shrapnel and explosive energy they release when they explode and there will unambiguously be another financial crisis eventually, we know this, and it will probably be very international because, after all, we remain in an environment which is almost completely deregulated and in which the financial space is extremely international and it’s becoming more international quickly because it’s all the rage. I mean, one could do a little exercise and you’d find a frightening similarity: If you took articles from 2005 and 2006 about housing and mortgages, and you crossed out the words “housing” and “mortgages”, and you stuck in the words like “natural resources” and “China”, you could probably have the same article, more or less, being written again and again and again and those are indicative of a bubble because the bubble that we take on is a sort of heady confidence and a certainty about the fact that they’re not bubbles right before they explode.

SK: I’m speaking with Max Fraad Wolff, an instructor at the Graduate Program in International Affairs at the New School University in New York. He writes regularly on the economy. We’re talking about a new report that was commissioned by the Roosevelt Institute and features a number of leading economists who are warning of another looming financial crisis that is likely to be much worse than the first one. Let’s talk about the issue of regulation. They point out, as many have pointed out, that Federal Reserve Chair Ben Bernanke and Treasury Secretary Timothy Geithner are not quite the best folks to try to get us out of this crisis given their role in the creation of the first financial crisis. What is the status of financial regulations at Congress and with the White House? Is it these two men and their ideology that is primarily holding back serious financial regulation?

MFW: I don’t think you can say that the impediment to serious financial regulation is as easy to solve as swapping out two or three top posts. It is though, however, worthy of note – and I don’t think the panel there at the Roosevelt Institute was incorrect in mentioning that it does not make it easier to make profound and difficult social changes by keeping in place the same people who erected the system that we have that crumbled so terribly and so demonstrably in 2007. So, I do tend to agree with them on that front. But, I think that there’s a general disinterest/unwillingness of a lot of people in Congress to do this and I think the general public has been a little bit out-to-lunch on the financial regulations because we have a lot of anger, very much justified, from the public about their relationship with the financial institutions but they tend to oscillate wildly between just vilifying these people and getting focused on what are really not the world’s biggest issues – like this or that misadventure or executive bonuses – which, while I understand are upsetting, are not the meat of the matter. And so, we haven’t been able to take constructive and productive steps forward to come toward a new financial regulatory paradigm and if you don’t change the rules of the game, then it’s very unlikely that you’re going to change the outcome. And so far, we actually have fewer financial regulations in place for large institutions than we did in 2007 because, as a response to the crisis, some of the very few existing rules were relaxed and they haven’t actually all been put back into place yet. So, we have less financial regulation now despite all the anger and debates than we had in 2007. And that is kind of remarkable testimony to the slow, inefficient and not quite impressive forward progress we’ve been making in our national regulatory institutions and, particularly, in the House and Senate.

SK: I understand that the Senate Banking Committee is going to unveil its financial regulatory reform proposal sometime next week. Do you have any sense that Congress is working on something stringent enough?

MFW: I have a sense that Congress is working. I mean, we still are in what looks like the first step of a significant watering-down of the Consumer Financial Protection Agency coming out of the Democrat from Connecticut who’s leaving – Christopher Dodd’s proposals about that – and would probably come underneath the Bernanke Fed, this new Consumer Financial Protection Agency would be a sub-portion. I mean, this isn’t a done deal yet. The House did pass a tighter series of financial regulations quite some time ago but before the Senate passes one, you can’t even go into the period of regulatory reconciliation and deal-cutting. And, you know, I do have a sense that the White House is not taking front and center on this, basically ignores this a lot of the time, brings it up in occasional speeches when they know the public’s really angry and is highly-focused – right to the point of this morning’s stories about canceling the trip to Indonesia – highly focused on health care and the long term focus on health care and the lack of significant progress on health care reform in the House and Senate has pulled the attention of the White House and the Congress and the public and the news media away from financial regulation and re-centered it on health care and I don’t really see that changing, at least until the Spring recess comes at the end of this month in Congress.

SK: So, you mentioned earlier that this new report we’re talking about did get a little bit of press…

MFW: …not much…

SK: …but, honestly, in scouring the press it really didn’t get that much press. I mean, it just got a few articles here and there. ABC covered it and, you know, there’s just been a little bit of press. But what they are saying, and I want to re-quote what I quoted earlier – they are warning of “ a calamitous global collapse” – something that really resembles the Great Depression and the Great Depression – most of us didn’t live through it but if you look back on history – was one of the darkest periods in American history. And many are saying that the first financial crisis in 2007 – we got lucky! – we managed to stave off some of the worst aspects of the Great Depression, but we may not be so lucky the second time around. There really isn’t much news coverage.

MFW: Yeah, and I think what they’re saying is, by the way, consistent with what one hears at the industry events and what professional investment economists and professional investment strategists have been saying for the better part of the year which is mostly what we’ve done in the last eighteen months is spend several trillion dollars of government money and kick the can down the road. And so I don’t think that what they’re saying is particularly off the page with the conventional wisdom in the financial industry, they just have a very different set of people they’d like to see blamed for this and a very different set of regulatory approaches that they’d like to see pushed in to solve this problem. But I think part of the reason this is getting less press is – it is a Great Depression-like scenario for an awful lot of Americans!

SK: Absolutely.

MFW: In fact, we’re poised to see cuts in education and social benefits on the state level as bad, and in some cases, worse than we saw in many states during the Great Depression. We see the great state of California, really, in an existential struggle on a budgetary level. There are 7 million homes right now in the United States in the foreclosure pipeline. So, for an awful lot of people, an awful lot of households in this country, between the weakness in the labor market and trouble in the housing market and their inability to get new loans and reaching the limits on their credit card maximums, they don’t need a bunch of experts to tell them that times could become really bad in the future. They’re really angry because times are pretty darn bad around the kitchen table tonight and tomorrow night and last night. So, I think part of what’s happening here is I think it was a good report – it’s always good to issue these things and have the conferences and stay in the public mind and crystallize and refine what you’ve been saying. But, I think there’s frustration from those people who wanted to see real regulation and real change here because there hasn’t been. And because the old architecture that produced the crisis of 2007 – because we still have that architecture now in 2010 – it’s a bit of a less than shocking revelation that if we have the same system running that we did three years ago and three years ago it produced an ongoing social calamity which still reverberates painfully around the American consciousness and in the American economy, then, of course, there’s the risk of a double dip and to the extent that we’ve seen large financial institutions take the bailout monies that they’ve gotten and take the opportunities that have arisen not to invest in the jobs-creating and consumption-creating consumer lending and small business lending that they were doing for the last 20 years, but instead go more into the financial markets, we’re beginning to have a “Tale of Two Trains” – a train with 80% of the country on it, headed south economically, and a train with 10 – 20% of the country very beholden, very dependent on financial markets and tax rates that’s going north. So, we have the sense that things are better and I think that that sense of things are better is really for the top 20% and, unfortunately, our consciousness in our media, present company obviously excluded, tends to focus virtually exclusively on the most fortunate among us who are doing a lot better but really only account for about one in five of our citizens.

SK: Well, Max, I want to thank you so much for joining us today and we hope to have you back on in the future.

MFW: It’s always a pleasure. I hope that I was able to do some little bit of lifting for the good questions that you always have and thank you out there for listening.

SK: Thank you so much. You certainly did enlighten us. Max Fraad Wolff, an instructor at the Graduate Program in International Affairs at the New School University writes regularly on the economy.

Special thanks to Julie Svendsen for transcribing this interview