Have Wall Street's "Wizards" wreaked lasting market havoc? (by Eric Blair, community guest columnist)
We haven’t been here before:
The 2008 Crash has just one main similarity with the tech bubble of 2000: we were due for a recession after eight years of one-party rule of the White House. Other than that, the two cycles are dramatically dissimilar.
The first major difference lies in the shape of market performance. In the late 1990s the NASDAQ went “parabolic,” with valuations rocketing way ahead of fundamentals. By contrast, in March 2003, after a big bounce at its beginning, the subsequent recovery in equities steadily climbed the “wall of worry” with relatively small corrections, of relatively short duration, when valuation excesses arose. After the initial bump in early 2003, the market marched ahead without the “irrational exuberance” that characterized the late ‘90s. When the S&P 500 failed the test of its new highs in late ’07, in its role as a leading indicator it signaled a recession of some kind likely in the offing, right on schedule with the coming election cycle. But nothing in the market numbers back then would have led one to expect the kind of steep, sharp drop we saw beginning in September 2008.
The second major difference is that while many of us caught speculative fever in the ‘90s, the Fed’s over-correction of interest rates, first to the upside, then to the downside, combined with Wall Street’s creation and promotion of the “toxic assets” we’ve been hearing about -- mortgage-backed securities, collateralized debt obligations, and credit default swaps -- poisoned the most basic asset in America: the family home. Risking a few thousand, or even a few tens of thousands, of retirement cash, or other liquid assets, in the stock market, is one thing; to risk one’s home equity is quite another.
But because of the way Wall Street and its regulators set up the various mortgage-backed instruments, it wasn’t just those who took refi cash out of their homes to buy cool stuff, or make down payments on second homes or vacation condos, or play the stock market or other speculative ventures -- EVERYBODY participated in the risks associated with the creation and distribution of these toxic assets – most of us involuntarily -- because unlike in the 2000 tech bubble the products being marketed weren’t fancy hi-tech gadgets or vaporware that ordinary people could live without. Ultimately, what the creation of mortgage-backed financial instruments and the criminally sloppy way they were marketed and regulated did was put the entire world financial system, ALL OF OUR MONEY, at risk.
No one on Main Street will miss, indeed, few will even remember, many of the companies that were created, and then went boom and bust, since 1990. But a financial industry – in some form -- is something we just can’t run a modern industrialized economy without. Every company, from hi-tech to no-tech, needs access to capital. The US was founded on easy credit. It cannot survive long in its present form without it. The collapse of the real estate market, together with the mortgage securities market, has resulted in an unprecedented threat to our financial system. Money itself, and the circulation of that money, has become the issue. When its blood circulation stops, an organism soon dies. That is now the prospect our economic organism faces. Like the Crash of ’29, and the long depression that followed, individuals, people, and financial institutions are doing the equivalent of hiding it under the mattress, which of course does the opposite of what is needed. Galloping greed has given way to freezing fear. Major companies that have been around forever, like General Electric and American Express, are just as threatened now as any over-leveraged vaporware-producing outfit in Silicon Valley was in 2000. In addition, a whole generation’s worth of equity, both their 401-K retirement funds, and, more importantly, their home equity has been erased.
We’re all in it together:
The global credit crisis is one of a confluence of events (OK, not a graceful phrase, but aren’t you tired of hearing “perfect storm?”) that could not have happened in other times. The economies of nations across the globe, from Asia to Latin America, First World to Third, have become interdependent and synchronized to a greater degree than ever before, so it should be no surprise that they all turned down at about the same time. One o f the scarier consequences of the interdependence and synchronicity is that those nations upon whom the US relies to buy US debt, like China and Saudi Arabia, thereby keeping our credit markets afloat, may not be able to do so this time around or at least not to the extent they once could, or in the amount needed to help, because their economies are also undergoing contractions.
No quick turnaround in sight:
If, as has been estimated, the entire increment in consumer spending from 2000 through 2008 is roughly equal to the amount of home equity gained, then lost, during the same period, then it is unlikely that any public or private initiatives can bring back the good times in short order. If we learn to live within our means, it will result in a smaller economy for some time to come. If we find a way to borrow more money to re-stimulate more consumer demand to pre-recession levels without also finding a way to raise real incomes, it will only postpone the day of reckoning further into the future.
Pointing the finger where it belongs:
The behavior of the big money-center banks lies at the heart of the crisis. Their creation and marketing of complex, poorly understood, and badly managed security instruments has created a mess so convoluted and widespread that once the full extent of it is known we may discover that there might not be enough time and government-backed credit to solve it. If so, the Crash of ’08 might make the Crash of ’29 seem tame by comparison.
Consider what is probably the most dangerous of these paper viruses, the credit default swap (CDS). A CDS is an insurance policy against the risk that a borrower will default on the principal of a loan – and the loan can be any form of debt instrument; typically it is a corporate bond, or a home mortgage, or a package of any of those, which itself can be re-sold as a security. (For a clear discussion of all of the “toxic assets,” see http://baselinescenario.com/financial-crisis-for-beginners/). CDSs themselves can be packaged into groups and sold and re-sold to many different parties, and that’s one of the things the big banks did that has got them into so much trouble. Big insurance companies like AIG dove right into that market, writing and selling these CDS insurance policies on debt they apparently assumed was a pretty safe bet.
But it wasn’t. When the housing bubble burst and the default rate on home mortgages skyrocketed, the buyers of CDSs found themselves with huge gains, on paper. But the gains were illusory if the insurers, like AIG, couldn’t pay the principal owing on the CDS. Since the pool of funds they had available to pay off such insurance policies was a small fraction of their total exposure, they got in deep trouble real fast. And when they couldn’t pay off the principal they insured through the CDS, then not only they, but also the buyers of the CDSs, got in deep trouble. What is the total extent of that exposure? Nobody really knows yet, because of the complex way these paper viruses have been spread around, but it is probably in the trillions. And guess who holds the bulk of the CDSs? That’s right, the same big money-center banks that are the focus of the ‘nationalization’ debate. And now you can see why. Thus, those who claim that major banks like Citi, or insurers like AIG, are “too big to fail,” do have a point. But it’s not a pretty one.
So it turns out that the Bernie Madoff story is not the coda of the crisis; rather, his scheme symbolized the central paradigm of the money-center banking system: a giant Ponzi scheme in which everyone’s money was risked in a game that sooner or later had to go bust.
Bankers: I’ve got to ask: What were they thinking? ALL markets go in cycles. To bet on a continuous climb in anything is foolish. To bet everything on that outcome is just insane. Yet that is what they appear to have done.
Bankers: We trusted them with our money, ALL of it. Ironically, it was the traditional image of bankers as cold-hearted cool-headed skeptics who made loans based upon hard facts, not on hope -- certainly not on their belief, faith, or trust in their borrowers – that provided the basis upon which we trusted them to handle our money. Now that traditional image has been shattered by the revelations of their irrational binge in toxic assets. Now that their profiles have been downgraded to that of gambling addicts, we won’t be using words like belief, faith and trust in them any more, not at least for a long time to come. Nor is hope likely to return anytime soon, either.
There’s plenty of blame to go around:
We have the best Congress money can buy. Encouraged by lobbyists, members of both parties have routinely binged on deficit spending pork projects and encouraged risky lending practices, through Fannie Mae and Freddy Mac, for example, that at the very least helped make the financial mess worse.
The big money-center banks have more effective lobbyists and contribute more money to candidates than whatever interests might have raised concern about the direction our financial system was heading. Congressional perfidy and ineptitude are reasons to temper calls for more federal involvement in the financial system. The recent congressional hearings before which big bank CEOs were grilled by those whom we elect to look out for the common good and who are the stewards of taxpayer dollars were a pathetic exercise in deception and hypocrisy on both sides of the table. Which side earned the Baloney Award? I call it a tie.
Federal intervention: a treatment, a cure, or part of the disease? When the first bank bailouts were announced during the darkest days of 2008, even the skeptics agreed the situation was dire enough that “something has to be done.” As the crisis seemed to abate, however, criticism of the use of the federal funds rose. When the Treasury under Paulson changed its strategy away from purchasing toxic assets to taking equity positions in the banks, many disagreed. When the auto companies jumped on the bandwagon, many cried out in alarm: “They’re going to fail anyway, why postpone the inevitable?” “Who’s next?” “Where does it stop?”
The new President offered hope, offered change we could believe in. Yet when the so-called ‘stimulus bill’ fell far short of the President’s pledge of no earmarks, disappointment rose and expectations, and the markets, fell.
When new Treasury Secretary Timothy Geithner --reported to be a protégé of Goldman-Sachs alumnus Robert Rubin – bombed in his first presentation of his financial system rescue plan, expectations and markets waned further. And skepticism from all quarters rose to a crescendo.
Many objected to the bank bailout as nothing more than the privatization of profit coupled with the socialization of risk: the bankers win in good times, while government bailouts mean the taxpayers lose when things go wrong. What else can you call it?
The recent mortgage holders’ bailout has stimulated the most criticism to date. Most famously, CNBC correspondent Rick Santelli took off on that subject in what the station later called “The Shout heard ‘round the world.” The link to that post might still be found here: http://www.cnbc.com/id/29283701/. A link to Santelli’s brief biography and set of recent videos on the government bailout and related issues might still be found here: http://www.cnbc.com/id/15837966.
Santelli was later criticized for aiming his remarks at the distressed homeowners the program was intended to rescue. Yet to long-time watchers of the station, and of Santelli’s recent commentaries in particular, the context might show otherwise. He has consistently placed himself among the skeptics of the bank bailout. I certainly can’t speak for him, but based on the totality of his recent comments I expect he would agree with these points: Who really gets bailed out by any homeowner rescue package? Well, where does the money for the mortgage payments wind up? At the banks. Where did the TARP money wind up? At the banks. When consumers receive their economic stimulus checks, they will most likely use it to pay down credit card debt, or save it. Where will that money wind up? In the banks. Are you beginning to see a pattern here?
To me, and I expect to other critics of the bailouts like Santelli, the real ‘moral hazard’ lies in rewarding bad behavior, no matter whose it is, especially by using the tax money of those who didn’t engage in that behavior, which is the majority of today’s taxpayers, for they are unlikely to owe any taxes if they are among those eligible for government relief.
In his rant Santelli referenced Ayn Rand, author of Atlas Shrugged, who back in the 1950s began warning of the consequences of government intervention in the free market. It would appear her prophecies have been coming true for some time.
I know, let’s blame the ‘free market:’
Those with a left leaning political persuasion, along with those simply disgusted by the apparent unlimited reign of blind greed on Wall Street, are wont to blame ‘the system.’ In a recent column Mona Charen dispensed with that argument in passing, by pointing out that the last eight years saw at least as much pork barrel spending as the previous eight, and that the former Congress and President had “managed to discredit free market capitalism without ever practicing it.” http://townhall.com/columnists/MonaCharen/2009/01/27/where_is_free_market_economics_when_we_need_it_most
Little more on that topic needs be said.
Are we, the people, ultimately to blame?
Some of us more than others, to be sure. Those of us who took out home mortgages we didn’t have the income to support. Those of us who took out home equity loans and spent the money on cool stuff like plasma TVs with little or no resale value, or assets that suddenly fell in value, like second homes and stocks. Those of us who used credit cards to finance any or all of the above, or just used them to live on when our expenses began to exceed our incomes. We bet things would continue to get better, without end, and we were wrong.
Aren’t we ALL to blame, ultimately?
Don’t we, the people, bear the ultimate responsibility for what our government does for us, and to us? Isn't that the price we pay for being a republic of, by, and for the people? We elect the congress critters who are supposed to look out for our interests, and election after election we return most of the incumbents, like the undisputed King of Pork, Robert Byrd of West Virginia, who according to one of his colleagues in the Senate got $75 million to construct a new ``security training'' facility for State Department security officers to be built in his state out of the ‘stimulus’ bill. How many terms has he served in the Senate?
Muddling toward a short-term fix while looking for a long-term solution:
To solve this unprecedented financial crisis, the government needs a new model to work from, a model that fits Einstein’s criterion: “Everything should be made as simple as possible, but not simpler." Perhaps the recent crash landing of US Airways flight 1549 into the Hudson River might prove a fruitful analogy upon which to base such a model. If the President’s economic team studied five critical elements of that incident they might find a template for how to proceed to do their jobs somewhere nearly as well as the aircrew of Flight 1549 did theirs.
First, sometime circumstances force us to acknowledge that a situation has gone past the point of normal recovery. The ignorant news media have referred to the fate of Flight 1549 as a crash, when in fact it was a crash landing. The difference might appear academic, but it isn’t to the passengers and crew. Here are the results: “The FAA reports everyone, including one baby, is off safely. There are no life threatening injuries. There is a flight attendant with an arm fracture, a leg break, and some non-threatening cases of hypothermia.” [from The Huffington Post: http://www.huffingtonpost.com/2009/01/15/usair-plane-crashed-in-hu_n_158263.html]. As veteran pilots are wont to say -- only partially in jest -- any landing you can walk (or swim) away from is a good one. Ditching in the icy waters of the Hudson River in January is not anybody’s idea of a fun trip, but it was the best decision under the circumstances.
Second, the air crew’s decision making process was superb: in a highly compressed time frame and operating under the stress imposed by the threat of imminent loss of the lives of all those for whom they were responsible, as well as their own, they made a clear-eyed and cool-headed assessment of ALL the facts, discarded the many tempting conventional solutions that would have likely caused tremendous collateral damage (such as attempting to return to their airfield or an alternate), to choose the only course that, no matter what the outcome, would at least limit the damage to those who were directly involved.
Third, the results demonstrate that the crew not only made the right decision, they executed it flawlessly. They paid their full attention to each detail in the proper sequence. As they say in Ranger jump school, ‘monotony is the awful reward of the careful.’
Fourth, the air crew, confronted with a complex set of instructions for re-starting the engines, never stopped trying to do so, despite the low probability of success.
Fifth: you can bet the airline, the NTSB, and all others concerned with this matter will perform a thorough forensic investigation to determine if there are any lessons to be learned, or new safety procedures that should be followed, to further enhance flight safety in the future.
So from this incident we can learn the following that might be applicable to the financial crisis:
1. Face the situation directly and completely: assess ALL the facts; don’t discount any facts that are scary or don’t fit your model of the world.
2. Don’t shrink from taking the best action available simply because it might have unpleasant consequences.
3. Don’t give in to false hopes that are likely to have even worse outcomes.
4.Make the best decision that will minimize the damage to those not directly involved.
5. You will pay the price for your mistakes, anyway, so take their benefits: learn from them; improve procedures going forward.
6. Successful execution of any plan means focusing all your attention on each of the details in sequence, and using every tool at your disposal no matter how difficult the circumstances you face.
7. Don’t give up on trying everything that has any chance of working, until time runs out.
While the best solutions to the financial crisis are difficult to identify, certain aspects are easier than others. Here are some key elements that some knowledgeable observers and experienced players might endorse:
Improve Transparency. A key underlying premise of laissez-faire, buyer beware, is undermined when both public agencies and private organizations are permitted to operate behind closed doors. Competitive advantage requires that trade secrets be kept, but accounting practices and other aspects of financial operations must become more transparent before the average investor can feel comfortable with equities investing again.
Sufficient Simplicity is a virtue: Recall Einstein’s criterion cited above. And a corollary is: If you don’t understand it, leave it alone, as Home Depot’s venture capitalist Ken Langone recently advised us all on his appearance on CNBC Friday February 20 2009.
The basic concepts of mortgage-backed securities, collateralized debt obligations, and credit default swaps were not toxic in and of themselves. Out of the context in which the ignorant and the greedy ultimately placed them, they each made a certain amount of sense. But when the complexity of the instrument outstrips the means of accountability, trouble is sure to follow at the first sign of a change in market direction.
Government action in the credit markets must be as sure as it is swift: Do it quickly, but do it right. As Wyatt Earp supposedly said: “Speed is fine, accuracy is final! You need to learn to be slow in a hurry.” The risk of moving too slowly must be balanced with the consequences of getting it wrong. The problem wasn’t so much with Geithner’s presentation as it was with the expectations the President created the day before that led us to believe that the Treasury Secretary would provide all of the details the following day.
Full Faith and Credit of U.S. is NOT unlimited: The ability of the US to provide bailouts and stimulus spending through deficit financing depends upon the willingness and ability of US creditors, including other nations like China and Saudi Arabia, to continue purchasing US treasury debt. Whatever the state of their willingness, their ability is also finite. To put it in perspective, Nouriel Roubini’s estimate of the total amount of illiquid debt of US banks, some $3.6 Trillion, is greater than all of China’s foreign currency cash reserves. Check out his site at: http://www.nrgmonitor.com/.
These grim facts underscore the tragedy of the so-called stimulus bill, where every dollar wasted on pork reduced the capital available to the Treasury to restore the financial system. Maybe only fifteen or twenty percent of the stimulus was pork -- as opposed to job-creating or job-maintaining investments, and safety net components like unemployment insurance -- but that still amounts to between $120 and $160 Billion dollars. Here’s a sick joke: I’m so old I can remember when a billion dollars was real money. Not long ago $100 Billion dollars was REAL BIG money. And you know what? It still is, just not in the US Congress, where a majority probably are disappointed they couldn’t cross the $1 Trillion mark in their relentless quest to spend our way into prosperity.
Another CNBC contributor, Jim Cramer, has suggested a broader mortgage rescue plan, that he feels would achieve these goals: “… to keep people in their homes, save the banks and create jobs.” The link might still be found here: http://www.cnbc.com/id/29308196
But should we be so worried about saving the big money-center banks in their present form? The government in effect ‘nationalized’ the savings and loan industry through the Resolution Trust Corporation (RTC), a system that appears to have worked. We should hope the current administration does not automatically discard such a solution for fear of the popular reaction to the concept of ‘nationalization.’ Certainly the government should not run the banks that survive, but might we be confronting a situation now that is similar to that which confronted the air crew of Flight 1549, where the choice of a crash landing, as unpalatable as it was, would be the best one? If the toxic assets hidden in these big banks balance sheets are as bad as some suggest, might it not be better to put them down than keep them on life support with continuous injections from the dwindling supply of US credit? I’m not concluding that’s certainly the right answer; I’m saying that choice should not be automatically discarded for political or emotional reasons that cannot afford to hold sway in Washington DC any more than they could in the cockpit of that airliner.
So, let’s put this proposal on the table: give the TARP recipients a date certain by which they must repay the taxpayers, or they will be taken over and put into an RTC-like process and liquidated (and their CEO’s will be hauled before more grandstanding congressional hearings.)
Regulation: not a matter of whether, but how:
Certainly regulation will have to change before faith and trust will be restored. As the President said during one of his recent press conferences, it’s not about bigger or smaller government, it’s about smarter government. Amen to that.
Yet the problem doesn’t go away just by identifying it.
The revolving door needs to close. Yet don’t the President’s cabinet and other appointments come from the same ranks as those of previous administrations? Meet the new boss, same as the old boss? How many federal financial regulators are former employees of investment banks like Goldman-Sachs? Isn’t that kind of like recruiting jail inmates to be Sheriff’s deputies? Why was Lehman Brothers allowed to fail while Citi was not? Who sits on the boards of the survivors, versus those who were allowed to fail? Was the current crisis simply the result of a confluence of foolishness and greed, or something worse? To what extent did access to congress via lobbyists, play a role in determining who survived on Wall Street and who did not?
A “West Point” for regulators? The dilemma has always been, where to find competent people to fill positions regulating such a complex industry as banking and finance, if not from that very sector? The idea has been floated that the feds should create a kind of military academy for financial regulators. The devil would be in the details, as usual, but it’s an idea worth considering.
One thing’s for sure: better regulation is needed but even at its best it will not solve the whole problem. We should limit our expectations regarding the efficacy of regulations in general; the regulatory system is as complex as the toxic assets that system should have regulated. The Code of Federal Regulations (http://www.access.gpo.gov/nara/cfr/cfr-table-search.html#page1) is a vast maze consisting of thousands of pages of rules; there are already too many of them; they are too complex, too difficult to administer, even by those who are not looking to land a fat job on Wall Street after their term as a regulator, or coming from Wall Street to begin with. To achieve the President’s smarter government, we need a complete overhaul of our regulatory system.
As Ayn Rand has pointed out, government regulation can often create a vicious cycle such that the more the government does to fix the problem, the worse the problem gets.
And when a group of governments gets together, the tendency only compounds. Consider the upcoming G20 summit. “The push to re-regulate, which is the focus of the G20 intergovernmental process process (with the next summit set for April 2), could lead to a potentially dangerous procyclical set of policies that can exacerbate the downturn and prolong the recovery. There is currently nothing on the G20 agenda that will help slow the global decline and start a recovery.” (from The Baseline Scenario: http://baselinescenario.com/category/baseline/.
Closer to home, here is yet another example of the law of unintended consequences: Our own taxpayer money being used against us: Have you had this experience? A few months before September 2008, I’m told, negotiating a better rate on a credit card with a major bank was a relatively easy process. Now, it’s a different story. The difference is TARP, the government program that gave that bank, and its sisters, enough capital to survive even if folks like you and I, facing exorbitant credit card rates, default on those loans. The banks don’t care so long as the taxpayers are going to bail them out, so rather than negotiate a good rate, they hit you for the highest rate they can, hoping to squeeze every last dime out of you before you stop paying them altogether – whereupon they can ask the government for more of our money to keep bailing them out. That such consumer defaults represent yet another shock to the economic system, and thus should be avoided, should be obvious to everyone, but the perverse unintended consequences of the government bailout are likely to produce more of what we don’t want and least need.
Not that there aren’t government intervention models that have worked, and worked well. In late 1987 the equities markets melted down due to a vicious cycle, so the government designed a circuit breaker system. The RTC is yet another example. More recently, the US Treasury apparently intervened to stop a nascent run on the banks in Sept 08, and then temporarily (so they say) doubled federal deposit insurance.
Incentives that work: We should re-design the tax system and federal spending programs to encourage counter-cyclic behavior. For example, there should be built-in incentives in the tax code to reward savings during boom times (when people have more disposable income), and to increase spending during down times (when the economy needs stimulation and prices are lower); instead, we’re doing the reverse, adding to momentum of the vicious cycle. Tax policies could help, if they were quick, nimble, and surefooted, but when was the last time Congress was nimble about anything other than pork barrel spending?
Some people are already figuring their own way out of the mortgage default situation, by challenging their lender’s possession of the original promissory note upon which the mortgage and deed of trust are based; if the lender cannot produce the note, the mortgage is invalid. Even if the lender can produce the original note, the process at least buys the borrower some time to scramble around and try to find a way to stay in their homes.
The Critical Role of ‘the People’s Lobbyist:’
If the Congress is firmly controlled by the lobbyists of the well heeled, how are the people to prevail? Don ‘t we have the best lobbyist of all? Isn’t the President of the United States the chief lobbyist of the American people?
As others have said, it’s time for the President to stop campaigning and deliver on his promise for change we can believe in. He wasn’t elected to perpetuate business as usual. In the federal system of balanced powers, he can’t do it all, but he can and should do whatever it takes to point us in the right direction, and put the onus on Congress to do the right thing, rather than give into politics as usual.