On the Contrary

A while back as the housing bubble was deflating, I was listening to a discussion between two rather frugal and conservative friends of mine discussing how if people would have just not taken loans they couldn’t afford, this collapse would have never happened. It was the blame game that we all participate in and sadly it only touched on the final straw that broke the camel’s back, not the whole underlying failure of our system.  There are multiple causes that snowballed in the last ten years but started over 30 years ago.  By the way, there were two recent television shows that touched on all these problems, CNBC’s House of Cards, and Frontline’s Inside the Meltdown for those of you who like your information delivered by video.  The following are all of the contributing factors that built into the perfect storm:

• “Government is the Problem” – Set the stage for an economic climate that believed that either the stockholders or the board of directors would put the brakes on risky investment and thought government regulation just hindered these natural processes
• Arrogance of the Fed – The belief that the Fed can control all booms or busts with monetary policy (print money or raise or lower interest rates).  Said another way, a belief that Depressions are a thing of the past which led to an environment of unbridled risk taking with a belief the Fed will bail them out (Moral Hazard)
• The Unbridled Growth of Private Debt – Between the 1980s and 2006 private debt (the debt you and I hold, not public debt by federal state and local governments) rocketed from less than 150% of GDP to over 335%.  “…credit markets increasingly are being used less to facilitate economic activity and more to leverage bets on changes in asset prices” (Bad Money, Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism, Kevin Phillips)
• Financial Sector Expansion – “Goods production lost the 2:1 edge in GDP it had enjoyed in the seventies – In 2005, on the cusp of Greenspan’s retirement, financial services – the new uber-category spanning finance, insurance, and real estate – far exceeded other sectors, totaling over one fifth of GDP against manufacturing’s gaunt shrunken 12 percent” (Bad Money).  Basically we no longer invest in goods and services, but in financial markets.  In essence what we were now importing to the world was securitized debt investments.  This one is really important if you want understand that the real money to be made in the stock market is in debit instruments not in investing in business that make anything
• Fed Policy – Fed policy was instituted such that whenever the market’s rate of growth decreased, monetary policy was used to keep the growth strong, encouraging ever growing bubbles.  Some think that growth needs to be managed around a reasonable amount, with policy focused at deflating bubbles and not allowing them to grow out of control.  This means sometimes we have to force small recessions
• Our Psychology of Wealth Creation – A psychological state in which those who create wealth are “the Masters of the Universe” and the wealth is good by definition because it benefits us all.  Although the reality is that only a few rich have benefited from the growing credit bubble, there is a pervasive attitude that no one should question or interfere with their wealth creation since all wealth creation is good by definition
• Exponential increase of unregulated securitized debt instruments – Creation of debt instruments to package debt and the profits from selling these debt instruments.  This by itself is not bad since it provides money for investment, but the investment was primarily in other debt instruments grossly expanding the credit bubble without sufficient equity (in this case a realistic assessment of the equity backing these loans)
• Lack of Regulation – No regulation of the markets selling these instruments and the multiplier effect of leveraging (using debt to invest) which allowed investments that were leverage 30:1 or greater (thirty dollars of borrowing or every one dollar of your own equity).  The effect of this multiplies the gains when your bet wins, but multiplies your losses when you lose
• Failure to Correctly Evaluate Risk – Risky debt repackaged in CDO’s using faulty risk models that assumed normal distribution on price variations (The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy, George Cooper) and did not take into account black swan events. The result was a gaming of the rating system to allow these assets to be improperly rated as AAA.  Basic to this risk model was the assumption that the underlying equity backing up these risky loans, home values, would keep rising forever
• Failure of the Rating Agencies – Rating agencies that were dependent on those they rated for their income and no regulation by the SEC which was a revolving door for the industry
• Credit Default Swaps – Creation of “insurance” called credit default swaps which required no equity backing the insurance and no regulation of their markets.  If the market collapsed, there was no ability to pay these obligations.  You could make these bets even if you didn’t own the stock you were betting on.  Maybe even turning Wall Street into a casino
• Interdependence of all the Banks – With these massive debt and insurance instruments held by almost everyone, based upon housing prices, there was incredible interconnectiveness of the financial institutions so that any default would ripple throughout the industry.  In other words if one institution failed, others would be dragged in
• Greed – Then we get to greed and the idea that greed is good, part of the flow down litany and Masters of the Universe mentality.  In order to continue the amazing profits that were being made by these financial institutions, there was tremendous pressure to keep creating debt so they could repackage it and sell it.  That is when exotic loans for housing really took off
• Risk Transfer – The transfer of risk to the investors relieved the lending agency from holding the loans or being responsible if the loans defaulted. The more loans they issued the more money they made with no risk to them
• Housing Bubble – The belief that housing prices would always rise, allowed almost everyone, even if they couldn’t afford the loan, to take the money thinking they could bail themselves out later if they had to sell.  This is how many of these loans were fostered off on people who had no way to repay
• International Effect – The international impact of this crisis came about because the banks were selling these toxic assets as AAA rated investments and stockholders/voters were demanding more and more return on their investments because everyone else was getting that level of return which leads to the final real straw that broke the camel’s back (bank)
• Group-Think – Finally we have group-think throughout the whole system.  Everyone was making a bundle and everybody wanted a piece of the action.  It is easy to justify what you might consider risky or foolish if everyone around you is making a bundle and you look like a fool for not taking advantage of the easy money.  Anyone who say there is a problem and wanted to put the brakes on, put their institution at risk, not getting the return others were making and were therefore sidelined by their management.  The prevailing mentality was to take the money and run

I probably missed some stuff, but those are the major elements.  So just blaming it on the end of the chain and people who knowingly took risky loans is a grossly oversimplified view of what happened.  Yes, people lacked discipline and good judgment, but that went throughout the system.  If the system was not so tightly interconnected and we now have a world economy, maybe the damage would have been limited.

Alan Greenspan in the Frontline segment, Meltdown, said he thought that this could not happen because the board of directors would recognize the high level of risk and take the appropriate action to limit these risky bets.  They did not and he was troubled by this.  One might ask why he didn’t take the appropriate action.  The answer that he gave when asked was that he could not imagine that this could happen.  It would appear that a lack of imagination not only is fatal in our Iraq policy, but in our economic policy.

But then he said something very interesting.  To paraphrase him, even if this results in a depression, it is still the best system we have devised to create wealth for the majority of players and we will have to learn to live with it even though these contraction will occur again in the future.  I would agree with him although there are important lessons to be learned here.

First on the wealth issue he is correct and also not so much correct.  In China, millions were being pulled up to a middle class standard of living while in our country, the middle class and poor were losing ground.  One possible conclusion is that the capitalist function of manufacturing and exporting of goods works well to expand wealth in society, while the creation of financial instruments and betting on them with leveraged investments only focuses wealth on the wealthy.

Second it is clear that when we enter a bubble, greed clouds our judgment until the “house of cards” collapses (pun intended).  This says that regulation is the only way to stabilize this system.  Somehow sanity must be restored even though everyone is making money.  We thought we learned this lesson after the Great Depression, but most of these rules were cast aside as impeding profit and being out-dated.

One last thought:  In my essay on Marcoeconomics, I raised the point made by George Cooper in his book The Origins of Economic Crises:  Central Banks, Credit Bubbles, and the Efficient Market Fallacy, which is that markets are inherently unstable and maybe the real job of the Central Banks is not only to stop down turns, but to also moderate growth so that bubbles are small and will not have a destructive effect when they are deflated.

It will be interesting in the days to come to see how Republican laissez-fare dogma will argue against the needed change in rules and how the Fed and our banking system should function in the future.  Since they were the ones who mostly benefited from the old failed system, they will try to reinstitute it while reinventing history.  The question is have we learned our lesson and will we let them.

Note:  No I am not an economist and I could have this wrong but I don’t think so.  I think it is critically important that all of us understand what happened because the future of our system rests on us getting it right.  It is not and has never been about who is to blame.  There is plenty to go around.  It is about understanding what happend to prevent it in the future.  As long as we let experts talk and understand for us, we will be forever be at their mercy, thus my attempt to put into words what I understand, probably only for my own benefit.  There is a excellent web site that explains many of these basic concepts called The Baseline Scenario written by real economists.

The other night I had a good friend over for dinner and the conversation drifted to the melt down on Wall Street.  Since he is a good friend and a conservative, I was not making any partisan statements about the crisis and he being very conservative usually steers completely away from politics.  But on this issue he got excited and I listened and watched at his anger at what had happened there.  For a usually happy go lucky guy he was ready to lynch up the financial managers that had destroyed the market.  I am not kidding.  He was ready to stretch some necks.  People are scared and angry, and the testimony by Lehman Brothers CEO, Richard S. Flud, who took a half a billion home before the firm crashed didn’t help.  But in the end we have no one to really blame because we are all at fault.

What I find really interesting is this is a circumstance in which Republicans are mad at Republicans.  Let’s face it.  Those guys who made a fortune were all good Republicans living out their Republican dream.  Fuld opened his testimony declaring, “I take full responsibility for the decisions that I made and for the actions that I took,” but he conceded no errors or misjudgments in the chaotic period that led to the firm’s bankruptcy (Associated Press).  Of course not.  Somewhere in there is the attitude that I am worth every penny and as he later said, “This is a pain that will stay with me for the rest of my life”.  Yes as he pines away on his yacht in the Bahamas struggling to make ends meet on a meager $20 million a year, he will suffer greatly.  But we created him.  We all bought into this idea that creating great wealth would make us all wealthy.  Those who could do it were masters of the universe who could and should negotiate their own deal at whatever rate the market will bear.  Remember ENRON?  Before it failed, the financial analysts in New York and the media were worshipping their affluence as the new model of doing business.  And we learned nothing.  In many ways the present crisis in the world economy mirrors Enron where they were using fake companies to forecast returns that were highly inflated if not non-existent.  They were leveraged to the hilt.  Then their financial house of cards collapsed.  This is not too different from the false and unknown worth of the securities that provided the capital for the mortgage debacle when the housing bubble burst.

But what really happened, as I understand it, is very complicated and I apologize in advance for the length of this blog.  But I think I have all the basics and here they are:

First of all there was a bundle of cash available to invest as a result of the world economy and capital from around the world flowing/flooding to hotspots where the highest rate of return could be obtained.  The markets were flooded with cheap money.  The biggest market to invest in was the home mortgage market and in order to expand that market to absorb all the cash, risky investments had to be made un-risky, so along comes the mortgage derivatives.  These were basically risky investments earning a higher rate of return, but supposedly made unrisky by the way they were sliced and diced making them attractive investments with good rates of return.  These were so complicated that the rating companies had no idea what rating they were giving these instruments but there was tremendous pressure to keep the money flowing.   Because no one person or institution held these loans, and money was made by making the loan with no risk to the loaner who passed the risk on, abuse and false appraisals were a natural offshoot to keep the money from fees coming in.  Make loans, make loans, make loans.  It was nothing more than a ponzi scheme and at the very base of this complicated economic edifice were some very risky loans.  But that is not the whole problem.

Now step back a minute and look at how Mr. Fulding and his boys played into this.  First the financial wizards, using mathematicians and physicists (no I am not kidding), created these complicated instruments of debt that they thought spread out and took away the risk by slicing and dicing good and risky mortgages.  They were on the cutting edge of new age financial markets.  Second, as noted above, there was a ton of money to invest which was driving this creation.  Third, these financial managers were and are rewarded by short-term growth.  In other words there was tremendous bonus pressure to engage in this market and earn ever-increasing fees by selling these derivatives.  Third there were stockholders who wanted ever increasing rates of return on their investments in these firms and put pressure on these managers to invest in the derivatives themselves with the fees they were earning on selling them.  That would have been okay, but to increase their rate of return, they leveraged themselves (borrowed) with all the cheap money floating around to buy up these derivatives.  Then they created another instrument called credit default swaps that were insurance sold to buyers of derivatives to make buying them even more attractive by insuring their risk.  Note that this is nothing but insurance, but it wasn’t called insurance so they didn’t have to have capital reserves required by regulations to back them up.  I think they truly believed that they had adequately parsed the risk and they would never have to pay on them and this was a way to double their earnings.

Now lets look at the third leg of the stool, regulation.  This is the part where we are all culpable.  Starting with the Reagan years, government has been the problem.  Markets will determine where value lies and make the appropriate choices with the invisible hand; and that these allocations are neutral and fair and to be preferred to any government solution.  So regulation was under attack from way back in the 80’s.  I think we all bought into it.  Some regulation can be stifling, but some is essential.  We forgot that and with the idea that greed is good, we were on our way.  But I think the fateful decision occurred in a basement meeting room of the SEC in 2004.  According to a New York Times article, “Agency’s ’04 Rule Let Banks Pile Up New Debt”, the brokerage firms wanted “an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.”  Let the games begin.  The government, like the rest of us, thought that the brokerage firms and their computer programs had parsed the risk to sufficiently remove it and they trusted the brokerage firms to basically regulate themselves through their computer programs.  Note this decision was made in a meeting that lasted 55 minutes and was not reviewed in any public way.  Once these requirements were removed their debt ratios rose significantly up to 33 to 1 ($33 of debt for every $1 of equity).  And we all trusted in the markets and demanded ever increasing rates of return.

Let’s take a little detour to explain and Fannie Mae and Freddie Mac got caught up in this.   In the blame game these guys caused everything, but as usual it is a little more complicated than that.  First of all these two private corporations were created to be a middleman between banks and loan companies that directly loan to borrows providing them a source of funds.  But these two guys are held by private investors and they wanted a bigger return on their money and banks and loan companies were threatening to go around them directly to the investment companies if they didn’t provide funding for the sub prime.  In addition, Congress wanted lower income people to have a fair chance at loans so they also entered the derivative market and sub prime loans.

So is there enough blame to go around?  When the housing bubble burst should we blame people who hold the bad loans when they started defaulting on and put the whole system at risk?  Actually if we could separate out these loans from the others it would be controllable.  But because they were sliced and diced nobody knows what their investments are worth any more so should we blame the investment bankers?  Or should we blame the SEC for reducing the debit to equity ratio?  Or should we blame stockholders who pushed their companies into ever higher rates of return.  Should we blame the incentive program that rewards CEO’s for taking more and more risks?  Should we blame Congress for the pressure they put and Freddie and Fannie?  Take your pick, they were all involved and they all forgot that what goes up must come down.

So who are you going to blame?  Get a mirror.  We all want more and sooner or later you can’t have more, and you have to pay for what you have.  For those of you that really want to know how to fix this I recommend you read Roger Cohen Op-Ed in the New York Times on Monday (Kiplin’ versus Palin).

I don’t think the American people have any idea how much trouble we are in yet.  Right now the high priests of “let the market place decide” and keeping government’s hands off the tiller are jumping in to control the market place and have government take over the market with assets and regulations.  This ought to give you pause, not in their perceived hypocrisy, but on how bad and how dangerous things are.  I personally think Secretary Henry Paulson and Fed Chairman Ben Bernanke are working as hard as they can to try and keep the system in operation.  They are doing what really good mangers do in a crisis;  they throw out the conventional wisdom and do whatever it takes to keep the ship afloat.  There will be a lot of Monday morning quarterbacking and falling back on old dogma, but right now you have to make decisions on the fly, right or wrong.

Okay, we know we have a problem, but what is the cause of the problem?  The problem itself and the cause are two different things and until we fully understand the cause, solutions are hit and miss.  Right now Paulson and Bernanke are focusing and treating the problems to keep the system afloat, but the solutions will come later if they can plug the leaks for now.   Is capitalism basically flawed?  Is absolute faith in the market place misplaced? What should really give you pause is that the people who are answering these questions are the ones who got us into this problem, didn’t see it coming, and marginalized those who warned of the coming debacle. But now they are all talking heads telling us what our next move should be.

I will now use my PhD in Economics (I don’t have one) and my many contacts in the incestuous pool of economic/market talking heads (I don’t have any) to tell you what I think has happened.  The housing bubble is not the cause of this problem, just the vehicle that manifested the underlying problems.  Note problems, plural here.

First lets start with basic conservative economic belief, that has to some extent been co-opted by the Democrats.  The first element of this is that the market place is the engine that drives our well-being.  Yes it is and that hasn’t changed for us or the world.  The next element of this is that government interference just hinders the natural working and balance of the market place.  This one, which should now be obvious, is flawed.  Good capitalist are always gaming the system to gain an advantage.  It is government’s role to keep the marketplace a level playing field for all, including investors and workers.  The key is smart regulation, not necessary burdensome regulation, but you have to keep your eye on those who came to the party saying all regulation is bad. They will promise rules, but then will fall back into old habits.

Now the third element is the one that has gotten us in real trouble:  Greed is good and your goodness and success are measured by your accumulation of wealth, and the more wealth you accumulate the better it is for the entire economy.  These are perversions of the maxim in capitalist thinking that if everyone seeks their own your self-interest, the market will balance these for the benefit of all.  Self-interest implies that you look at the long-term effects of your actions and their results.  Greed and wealth accumulation as a measure of good and success means a short-term evaluation.  Once the focus is on short-term gains, long-term consequences are ignored.  We as a society have come to this short-term thinking if you look at the debt we are incurring as individuals.  The increase of wealth by the wealthy benefits all has been a failure that is obvious in the increasing reduction in the middle class.

So in an ideological atmosphere of low regulation, the market is always right, and greed is good, wealth for the wealthy makes us all gain, what happened?  The first hint was an interview on the Bill Moyer’s Journal last year with John Bogle, when he maintained that the financial sector of the market had become way out of balance, where wealth was being created through obscure financial instruments and not in the investing in goods and services that give people jobs.  In other words the investment in real industry was being robbed by the profit being taken out of the system in creating financial instruments that were highly profitable, but created no jobs, no products.  The system always needs capital, but when the creation of capital becomes the dominate factor, the system becomes self destructive.

You have this system that is looking to primarily create wealth through financial instruments, you have financial instruments created to be outside regulation of banks, you have a greed is good philosophy, managers and CEO’s compensated based on high rate of returns in the short term, no transparency of their financial institutions or their instruments,  low interest capital, no requirement for minimum capitalization, and what you get is massive leveraging to place bets on the latest income producer, and that was the instruments to finance mortgages.  If it hadn’t been mortgages it would have been something else.  Although the current feeling is that we need to go punish all those evildoers that participated in this system, the real culprit is the system itself.  It reminds me of steroids in baseball.  We want to go out and punish all those cheating baseball players but we don’t take a hard look at a system that looked the other way and athletes were left to compete with other athletes who were cheating.  Soon they are all cheating if they wanted to stay in the big leagues.  It is no different in the financial markets.

So not only do we need structural changes in the market to address all those problems identified above, we need a whole change in mindset.  The world is no longer the place we knew.  America has lost its place not only in world affairs, moral leadership, but now in financial leadership.  The challenges that we are going to face are nothing like what we think they are going to be. There going to massively larger.   Thomas Friedman, in his book “Hot, Flat, and Crowded”, describes our economy and our level of consumption of resources and energy in the United States as a unit he named an Americums.   He points out that there have been two Americums in the world, one in Europe and one, of course, in America.  But now China has created one, with another about to develop, with the same in India.  These levels of growing consumption of energy and resources simply cannot be maintained without disastrous consequences to our climate, our ecosphere, and our economies.  The approach to all these problems is not more regulation, lower taxes, or some other dogma driven approach that the marketplace will solve all these problems.  It is a comprehensive approach to our future that was best represented by Mayor Michael Bloomberg on Meet the Press on Sunday:

“There are two crises.  One is the crisis in the financial market, a lack of confidence that almost closed down the financial system this past week and that Hank has to address.  And it’s up to the Treasury with the acquiescence of Congress, but to do something quickly.  And nobody knows exactly what they should do, but anything is better than nothing.  You’ve got to restore the public’s belief and the market’s belief that we will go on.  And this is not just an American problem, it’s financial markets around the world that are all interlinked and they’re all collapsing.

The second problem, which is up to Congress, it’s a much longer-term problem and may be the genesis of the problem that we have today in the financial markets, and that is that people are losing their homes, deserted homes are destroying neighborhoods, people are losing their jobs.  We have some industries that Congress tried to protect, and instead of protecting them they’ve caused them to not keep up in a competitive world with new products.  We have an education system that isn’t preparing us for the future, and we have a retirement system that’s just not going to be there when we need it.  So there’s two things here:  One you got to do quickly; one you really need a lot more thought about and that Congress should spend that time debating.”

It is not pointing the finger at evil funds manager, send them to prison,  and create some rules for the future.  It is a comprehensive approach to our economy that includes, infrastructure improvements, innovation, acknowledging the limits of our power, and real energy solutions.  I strongly recommend that you click on that link and read his idea and vision of what we need to do.

Finally I will leave you with the words of Fareed Zakaria of CNN’s GPS last Sunday after a most enlightening interview with international economic experts and an interview with Singapore’s former Prime Minister,  Lee Kuan Yew:

ZAKARIA: “Thirty-three years ago this week, a young woman with a thin resume was elected leader of Britain’s Conservative Party. Thus began the remarkable career of Margaret Thatcher, who both spurred and symbolized one of the most dramatic eras of change in modern history — the rise of free markets, free trade, privatization and deregulation.

Addressing herself to the core problems of the 1970s — inflation, stagnation, over-regulation, slow growth — Thatcher, and with her, Ronald Reagan, enacted their economic agenda. Initially highly controversial, as Britain and America prospered and the Soviet Union collapsed, Thatcherite ideas became mainstream, accepted by the likes of Bill Clinton and Tony Blair.

But the problems of today do not seem as easily solved by Thatcherism — tax cuts, deregulation, privatization. People are worried about widening inequalities of wealth, soaring health care costs, the competition from emerging market countries.

The next governing ideology is likely to be something that, while still friendly to markets and trade, finds a way to address itself to these problems and anxieties. Whoever captures this new ground will dominate the next era, as Thatcher did hers.”

I don’t think this person is  reactive John McCain who lives in the 80’s or the Republicans who are less likely to embrace real change than the Democrats, but if you select him and them, enjoy your poverty as they have no plan to deal the massive problems that face us.