By Rick Morris
This Wall Street crisis that we as a country find ourselves embroiled in cries out for an easily relatable breakdown. So naturally, who better than The FDH Lounge to provide it to you, especially since we delivered a detailed – and prescient, if we may brag a bit – Iraq War FAQ a year ago and we also warned of a huge economic crisis to come back in July. So yeah, we think we can handle this! We have dozens of links to outside sources so that you can further examine the definitions of the words we will use here and the full context of the sources we consulted.
Without further ado, here is the Wall Street Crisis FAQ:
Why does Wall Street need a bailout? What about
Well, this is a great place to start, as pundits have been talking constantly about how unpopular the bailout is and how the American people are dead-set against it. They may well be, but if that is the case, we’re fortunate yet again that this is a constitutional republic and not a democracy – because action is needed here to save the financial system.
By and large, the American people are not to blame for the false framing of the situation that so many of them have – the media and the politicians really have fallen down on the job of explaining everything. The very phrase “Wall Street bailout” is a phrase loaded with connotations that frankly are un-American. But this isn’t really a Wall Street bailout – it’s a rescue of the American economy, because Wall Street is the engine of our economy. Go to an NHRA event and ask any drag racing fan how far a car gets when the engine gets decimated.
This is a country that depends hugely, regrettably, on credit. Over the decades we have become a nation that is completely reliant on paying for today’s goods tomorrow, and that extends to business as well. Businesses cannot function if credit dries up completely, and we may well be on the road to that point without government action. At that point, everything crashes and life as we know it pretty much ceases to exist.
So in other words, anybody asking why Main Street is being neglected at the expense of Wall Street in this bill is either an interest group lobbyist being paid to peddle disingenuous slop, a politician looking to score political points in our worst national financial crisis since the Great Depression, or a citizen who just hasn’t been made to see the big picture. The fact that the bill had to be larded up with pork to pass the House of Representatives on the second go-round is the most eloquent statement possible about the complete and utter lack of statesmanship in government today.
I see a lot of finger-pointing among the politicians. Who’s to blame?
Most of them.
Can you be more specific?
All right. This crisis was pretty much caused by politicians in the federal executive and legislative branches operating from the two extremes of insufficient regulation and too much regulation. We keep hearing about the toxic debt that the government would be buying up with the $700 billion package and in that vein, it’s pretty easy to picture this mess as a toxic stew caused by hair-brained policies from both ideological extremes.
Let’s start with too much regulation. Where did the government go wrong there?
This end of the problem goes back to the Carter Administration, when in the full flush of post-Sixties optimism about the capacity of the federal government to solve the problems of poor people, the Community Reinvestment Act came into being. It was intended to solve the problems of redlining as they applied to the concept of mortgage approvals; long story short, banks were now being pressured by the federal government to be more forthcoming in terms of approving mortgage applications in minority neighborhoods that had previously experienced discrimination. The Clinton Administration subsequently expanded its powers dramatically by tilting the burden of proof for bank compliance significantly.
But isn’t expanded home ownership a good thing for
Absolutely, in a moral sense and almost certainly in a public policy sense as well because it makes more people stakeholders in a growing and prosperous economy. But moral and economically sound ideas can’t be midwifed by nonsensical public policies. Rather than mau-mau this nation’s financial institutions into downgrading their lending standards, the intellectually honest route would have been to embrace Jack Kemp’s crusade back in the 1980s about privatizing public housing by selling units at cut-rate prices to the poor people who were tenants.
Granted, that would have required an outlay, perhaps a substantial one, by the federal government as seed money for the program, but at least the accounting would have been clear and the private financial institutions that help keep this country going would not have been threatened.
Isn’t that just substituting one form of government action for another?
Yes, it would have been substituting clear and effective government action for intellectually dishonest mandates with disastrous consequences for the entire economy. If you learn nothing else by the end of this column, you’ll learn that regardless of what the politicians will tell you, actions by the federal government are not uniformly good or bad. This is not to suggest that massive government regulation is ever helpful, but it is worthwhile to keep in mind that Thomas Paine and Ronald Reagan used to say “That government is best that governs least” – not “That government is best that EXISTS least.”
Are there any more examples of how over-regulation helped get us into this mess?
Unfortunately, there are. “Mark to market” accounting procedures, which were mandated last November as part of the Financial Accounting Standards Board Statement #157 “Fair Value Measurements,” force companies to determine a value for a holding based on the current rate of what it could fetch on the market. This was an effort to force more honesty into the market after copious accounting scandals in which companies were committing blatant fraud in terms of claiming a value for their holdings. As with the goal of eliminating redlining, a worthy goal was pursued with haphazard means. Like many of the aspects of this crisis that were brought about by too little regulation, this misapplication of regulation failed to take into account what would happen outside of normal circumstances. In a market like we’ve seen in the ruinous year of 2008, some aspects of financial life simply don’t apply in a rational way. How do you fairly price an asset to sell when the entire market for it is crashing? A rolling snowball of paper losses then becomes an avalanche due to the chain reaction of a market being forced into a vicious downward spiral. Assets cannot be pegged to a market that is out of whack either positively – because that can create “paper winnings” that are completely illusory – or negative – because that can fuel an artificial dive of the market and eventually, the entire financial system. Previously, holdings were valued based on what could be deemed as their historical level of value.
Are there any other major factors relating from over-regulation?
Not as such, but we will start breaking down the aspects of under-regulation by looking at an example that bridges the two. We’ll deal subsequently with subprime mortgage loans and some of the other instruments that were part of the whole “expanding home ownership” climate that produced the aforementioned Community Reinvestment Act. Most Americans would probably be shocked to know that there were mass efforts a few years ago to provide mortgage opportunities for illegal immigrants! Columnist Michelle Malkin has written about this extensively, and while most of government’s faults here came from a hands-off stance in regards to the situation (from the federal apathy about border security on down), one quasi-governmental agency actually made matters worse by sticking their fingers in the pie. The Wisconsin Housing and Economic Development Authority (WHEDA) got involved by aiding and abetting the process of providing mortgages to those who were in this country illegally. Now, leave aside the merits of the immigration debate for a moment, because there are those who like the fact that Uncle Sam hasn’t been particularly interested in securing our country’s borders over the years. Different strokes for different folks. But whatever your political point of view on the subject, it is indisputable that mortgages for illegal immigrants are as risky as they come, inasmuch as the home buyers are subject to being deported when their cover is blown! Having an agency associated with state government attempt to regulate a process by which this can be accomplished is the most irresponsible betrayal of taxpayers possible.
OK, but that seems to have more to do with under-regulation of potential homeowners. Give me some more examples.
Gladly. To provide a logical segue, we’ll continue with the previous example and how counter-intuitive the politics were on these matters. Traditionally, Democrats and liberals are associated with pleas for regulation and conversely, Republicans and conservatives are considered advocates for deregulation. But the old saw about “whose ox is being gored” applies to this situation, as it seemingly does with everything in politics. Many Democrats and liberal interest groups were among those objecting to the notion of trying to screen illegal immigrants out of the pool of potential mortgage recipients – and Republicans and conservative advocacy groups were only too happy to get Uncle Sam involved when it came to what they considered an issue of border security and national sovereignty. But a much stronger example of this came with the Fannie Mae and Freddie Mac breakdowns.
Both of these companies were government sponsored enterprises (GSEs) that were really “neither fish nor fowl” in terms of whether they were public or private (and indeed, Fannie Mae was an actual appendage of the
So with their institutions now more directly facilitating the acquisition of home loans by the economically disadvantaged, Fannie and Freddie found themselves the objects of even greater affection by liberal politicians. Powerful House Financial Services Committee Chairman Barney Frank opposed the Bush Administration’s attempt at GSE reform in 2005, as did Senate Banking Committee Chairman Christopher Dodd. For what it is worth, Fannie and Freddie have been longtime contributors to primarily Democratic candidates for office and many of the recipients of this campaign cash just happened to share Fannie and Freddie’s objections to the (unsuccessful) proposed reforms. We’ll allow you to connect the dots regarding their lobbying operation, campaign contributions to key Congressional players and the fact that they successfully eluded the kind of regulation that the Bush Administration, John McCain and others had in mind for them.
As such, you had the interesting picture that had liberals opposing further regulation of certain enterprises lest they have a chilling effect on the cause of promoting home ownership to a high-risk segment of the populace – and on the other hand, you had conservatives clamoring for more regulation! That certainly seems a bit counter-intuitive, but it fits the D.C. template of promoting or opposing efforts based on how your (financial) allies line up on a given issue. Republicans traditionally didn’t get many campaign contributions from Fannie and Freddie anyway – and for a political party that has tried to shake accusations of financial anarchy ever since Ronald Reagan reversed America’s course away from higher regulation, well, what better way to prove that you do support some regulation? However, they never invested much political capital in the issue, using it mostly as a way to blunt the anti-regulation extremist image and the agencies continued uninterrupted down their respective paths of doom.
Additionally, there was actual scandal for the Republicans to try to expose as they were seeking to burnish at least some regulatory credentials. Falsification of some key accounting measures led to some bad headlines for Fannie Mae and some legal problems for key executives, but no structural reform in terms of how the company conducted their business. Actually, matters ended up getting worse: Fannie and Freddie executives cynically calculated that they needed increased cover from their liberal patrons and the best way to accomplish this was to double down on their exposure to subprime and other risky loans that held the purported purpose of leading more poor people down the path to home ownership. Sadly, the maneuver worked and once the Fannie/Freddie-friendly Democratic leadership took over both houses of Congress in the Republican wipeout of ’06, the chances of averting this crisis disappeared altogether.
You mentioned those subprime loans and I’ve heard about them and Freddie and Fannie in the news. What’s the connection?
Well, as we started to mention, Fannie and Freddie started to become a part of the subprime picture back during the Clinton Administration. Their moves into that market fit the politically correct template of helping poor people to achieve home ownership and so their shift in focus was not greeted with the scrutiny it deserved. After all, as organizations straddling that sometimes-nebulous line between public and private, they were viewed in a unique light by many – too big to fail. The thought was that if these companies ended up making any catastrophic mistakes that Uncle Sam would bail them out – which happened recently. So when the subprimes hit the fan, We The People ended up shouldering some of the responsibility in an attempt to keep stable the $6 trillion in mortgages in this country that they either own or guarantee.
So Fannie and Freddie got involved in subprime loans and bad consequences resulted. You mentioned that subprimes are inherently high-risk, but risky loans have been around since the beginning of time. How did these instruments end up imperiling our entire financial system?
You have heard this situation referred to as a “housing bubble,” right?
Well, the overall housing market was highly susceptible to dangerous influence from subprime loans and other similar methods of financing mortgages, such as adjustable rate mortgages, which left many people of the people who chose not to lock in their lending rate completely unprepared when it rose on them. Perhaps the most radical form of permissiveness came in the form of the “Ninja loan” – No Income, No Job, No Assets. As with the part about facilitating mortgages for illegal immigrants, we feel compelled to note that we are not making this up. Some financial institutions decided to grant the significant loans inherent in mortgage packages to folks with no income, no job and no assets!
How was that even remotely possible?
It goes back to what we said about a “housing bubble” and the very nature of what constitutes a bubble in the business sense. It’s the notion that assets in a given market can only rise.
Think back to the dot-com boom. So many Internet-based companies were valued way out of whack with what any of the fundamental statistics would have recommended, simply because the notion of “what goes up must come down” was not at all in play. In fairness to those who got caught up in that way of thinking, the Internet provided such immense advancements in so many areas of economic life that it was easy to imagine that basic rules of financial gravity might not apply in exactly the same way with such an explosive medium. But, seemingly justified or not, a classic “bubble mentality” was at work.
The same concept applied exactly to the American housing market, which was already on the rise coming into the new millennium in part due to Fannie and Freddie’s aforementioned actions which were taken with the goal of increasing home ownership in mind. Shortly after the twenty-first century began, the economy shouldered two body-blows in two years: the bursting of the dot-com bubble and 9/11. A recession was inevitable; the only question was how long it would linger and how severe it would be.
Fed Chairman Alan Greenspan’s decades at the epicenter of global monetary policy had taught him that consumer purchasing power (and a high tolerance for debt) was the element that drove the American economy. In tough times, he knew that his countrymen would spend if they perceived that their home equity rendered them economically secure. So, with no fear of the housing bubble that would ensue, the Fed slashed the Federal funds rate all the way down to 1.75%. This fueled a refinancing boom that allowed homeowners to take profit from their rising home values and it helped keep the economy going strong as Greenspan hoped.
Low fixed rates and low initial rates on adjustable mortgages also caused homes to be treated as commodities. A great many people took out extravagant loans just to finance the purchase of homes they would never occupy. Why? For the purpose of “flipping” the homes, or reselling them quickly for profit. In a climate where home values were thought to be immune to the laws of gravity, many people treated their home equity as an irreversible asset and spent accordingly.
Many homeowners gave into greed when they saw the dollar signs, a greed that was mirrored by so many predatory lenders. The high-risk loans we have spoken of can be dangerous enough to the economy – when offered by folks like those who have gone to jail for committing fraud in these matters the past few years, the effect can be devastating.
So as with the dot-com mania, an irrational mindset had clearly set in, just as it has with countless bubbles before and doubtless will happen on and off for the rest of human history. As long as the bubble has not occurred previously in the same industry, all but a few lonely voices in the wind are generally unable to spot the danger signs until it is too late. In a housing bubble, with the notion that prime properties can only appreciate in perpetuity, it’s not irrational to lend money to citizens who could legally be deported at a moment’s notice. In a housing bubble, it’s not irrational to give out Ninja loans because of the belief that equity in the house alone can enrich someone with no income, job or assets. And in a housing bubble, subprime and other high-risk loans can do disproportionate damage to the economy because they were extended – and sought – so freely.
So a lot of people defaulted on high-risk loans. I don’t know a tremendous amount about the economy, but it seems hard to believe the high foreclosure rates alone brought us to this point of ruin.
They didn’t. These defaults were just part of a very lethal cocktail.
Subprime and other high-risk loans were bundled into these securities and pushed off onto other parts of the economy. Theoretically, risk was being spread and collectively negated in this process. In reality, it was the equivalent of taking a vial full of lethal disease in a lab and spreading it widely in small doses. Here was where the popping of the housing bubble caused havoc, because as homeowners defaulted on their high-risk loans and the downward spiral in real estate prices resulted, the subprime disease coursed through the bloodstream of the economy with demented abandon.
I understand how many homeowners and lenders gave in to greed during a housing bubble. That makes sense. But how could the contagion spread to other parts of the economy? Did the lenders really think somebody else could be left “holding the bag” with these risky mortgages?
Yes, they did. One unfortunate element that shows up in any bubble is the tendency for bad actors to make greedy decisions and push off the consequences on to somebody else and this instance was no exception.
The concept of “moral hazard” explains this: when a party believes they are insulated from risk, they behave in artificial ways that end up harming the market. In this instance, lenders were happy to push off the risky mortgages they sold into securities that would only end up hurting other suckers.
But where did the lenders find suckers? Nobody would willingly purchase securities that had a good chance of becoming worthless.
Of course there were special circumstances that allowed tainted securities to cause damage in the markets, as it is obvious that nobody would willingly take the gross risks these securities offered. Wall Street’s rating agencies pegged many of these securities as a much safer bet than circumstances later indicated was warranted. Why? Standard & Poor’s referred to what it called “unprecedented levels of misrepresentation and fraud, combined with potentially shoddy initial loan data. So the ratings agencies, which are responsible for collectively setting the standards for how to evaluate the reliability of securities, were fed fraudulent information in some instances and as a result, many of the securities containing high-risk loans were misperceived as safer than they really were.
Does this explain why so many large institutions have been caught up in this? Even AIG – an insurance company – required an $85 billion assist from the government to remain in business recently.
Yes, it does. To further explain, we need to work just a few more definitions into the mix.
Derivatives are instruments that are supposed to facilitate the process of conducting transactions involving debt – such as the aforementioned securities – but they are obviously unable to function as they are supposed to if the information about the risk involved with the securities is inaccurate. This is especially true for the subset of derivatives known as credit default swaps, which are supposed to measure the creditworthiness of companies. One can readily understand why credit default swaps would be dependent on accurate information about the risks involved in subprime loans that were bundled into some of these securities!
Derivatives in general increase the extent to which major institutions are interconnected – which brings us back full-circle to why the government has had to rescue some of these companies this year. They have spread like wildfire, from $100 trillion in 2002 to $516 trillion just five years later (for what it’s worth, the entire US money supply is a “mere” $15 trillion). During this span, Warren Buffett, universally regarded as one of the world’s wisest investors, put great time and expense into the effort of ridding his Berkshire Hathaway company of derivatives because they terrified him: he just couldn’t figure out how they were supposed to operate as promised without presenting horrific risk. He called them a “time bomb” and “financial weapons of mass destruction,” and he has been proven right as the domino effect of one company being toppled after another has pointed out the frightening fragility of the entire market. In all, there is a tremendous amount of leverage between institutions that is completely outside the purview of federal regulators. This is rather remarkable in light of the influence that those wielding this leverage have been shown to have over our entire financial system.
So in this crisis, we had overregulation, with the government reacting to redlining in an inappropriate way by facilitating bad loans just to help more poor people own homes. We had more overregulation with mark to market accounting requirements that forced companies to price their assets to a plunging market that just fueled an overall death spiral for values. We had underregulation in terms of lax oversight of the mortgage operations at Fannie Mae and Freddie Mac, as well as with lax lending standards and all of the misrepresentation with high-risk loans in general. From there, bad loans getting packaged into securities poisoned the market, as did the fact that derivatives connected so many major players of the market and all but insured that the collapse of one major institution could threaten several others. Is there anything else?
Sadly, there is. Many politicians have been using “short sellers” as a political punching bag. Investors who practice short selling are essentially placing bets that a stock’s value will decrease by borrowing the stock, then actually purchasing it later on – with the hopes that a profit will ensue from the previously agreed-upon price and what the investor believes will be a lower price at the time the transaction actually occurs. In and of itself, there is nothing wrong with this practice and indeed, it helps contribute to the equilibrium of the market and keeps institutions honest. But there is a sinister variation of the practice that just fueled the “perfect storm” that brought this country’s finances to the precipice.
“Naked short selling” involved going through the short process, sans the actual borrowing of stock. So essentially, they don’t have to risk anything in order to chase their profit. A great many naked short sellers can best be likened to pirates, who ruthlessly reduce companies to ruins, then feast on the remains. Not all abusive short sellers are of the naked variety, however – we at FDH knew a rather reprehensible individual who bragged after 9/11 about how much money he was making by shorting stocks that were plummeting at that time. And whether naked or clothed, short sellers looking to make a quick and crooked buck can use all types of nefarious means to drive down the price of stocks in order to enrich themselves. The SEC is presently investigating whether bogus rumor campaigns illegally drove down the price of Bear Stearns and Lehman Brothers stock before both of these institutions collapsed. To make matters worse, in 2007 the SEC eliminated the “uptick rule,” which ended up facilitating short selling at record levels. While the SEC has officially been working to stop naked short selling all along, their level of attention to the problem has come under question. In what seems to be a tacit admission that they did not fully appreciate some of the problems that short selling excesses can impose on the market, in September the SEC temporarily banned shorting the stocks of 799 financial companies.
Let’s bring this full circle. You alluded in one of your first answers about how Wall Street is the engine of the economy and how the crisis there is going to topple
No offense taken. People can’t be blamed for taking the notion of major financial institutions needing taxpayer help on faith, especially given their incessant lobbying for favors in D.C. The aforementioned fact that a bill designed to hold off a grave national emergency couldn’t pass without some odious pork pretty much proves that it’s impossible to be too cynical about money and Congress. Additionally, the answers you have read thus far about this crisis indicate that greed, especially relating to the housing bubble, fueled this nightmare and it’s human nature to want to see bad guys punished and not rewarded.
But in this case, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke are correct that the crisis is so grave that it threatens a total collapse of the world financial system – a sort of “Mad Max Beyond Thunderdome” scenario where life as we know it is ended. Think of the worst Y2K fears as a realistic baseline for expectations.
Whether on the left or the right, opposition to this bailout seemed to forget the notion that no man is an island, especially in a global economy that we have already stated is completely interconnected. Left-wing congressmen fulminated against their favorite villains, evil businessmen who drove Mercedes. Those on the right who happily rubber-stamped every Big Government initiative during the Bush Administration chose this particular moment to demonstrate their free market bona fides and bemoan the march of “socialism.”
Some observers have long theorized that the political spectrum is not actually a straight line, but rather a circle in which people at the extremes actually overlap in some of their beliefs. We have seen this recently in foreign policy with some on the left and the right opposing the Iraq War for different reasons and it’s not unusual for “strange bedfellows” to align on different issues, but this level of agreement on an economic matter is most unusual. Those on the left are notorious for believing that rich people live in a universe of their own, completely unconnected to anything relating to the rest of us and that they can be taxed punitively and otherwise treated harshly with no harmful affect to the rest of us. So at least those who voted against this bill on the basis of class warfare were being true to their own beliefs, as disconnected from economic reality as they are. Conversely, those on the right who opposed the bill are, by and large, aware of the interconnected reality of the modern world and should have been aware of the damage that a domino effect can inflict on
So what the ultimate consequences of failing to arrest this situation? Two realities at the moment are particularly horrifying:
^ LIBOR is the rate at which banks all over the world lend to one another. Essentially, it’s the basis for lending worldwide and it hit a new high this past week in the midst of the global crisis.
^ Commercial paper is a money-market security that businesses routinely use to finance short-term debt. Because of the effects of the Lehman Brothers crash in mid-September, the market for commercial paper has all but been destroyed at this time. Fearing that this once-stable form of investment is now unsafe because of the number of large companies that may be following Lehman Brothers into Chapter 11, buyers of commercial paper – at least at reasonable prices – are quite scarce.
With LIBOR and the commercial paper markets completely haywire, this picture is at long last connected back to
This bailout will allow the federal government to buy up as much as $700 billion in “toxic debt” from the nation’s banks. The government will try to rebuild the value of the assets for resale at a later date, while theoretically the banks will be able to get their books in much healthier order and be able to start priming the economy with the capacity to loan money once again. That’s the hope, anyway, because the consequences of failure are unthinkable.
Just one more question: what’s the most important thing to implement to avoid a repeat of this situation, assuming we don’t all get pitched off the abyss first?
A solution along the lines of the Base Realignment and Closure (BRAC) would seem to be called for here. Knowing full well that individual members of Congress would never cast a vote to shut down a military base just in their home state or district, BRAC was set up in the late 1980s as a blue-ribbon commission with the authority to compile a master list and schedule for military bases to be shuttered. Then, the recommendations were submitted to Congress for an up-or-down vote to be sent to the president to be signed into law. This proved to be the only possible way to get Congress to put aside the parochial concerns of individual states and districts and vote to put the national interest first in terms of allocating defense resources in the best way.
The next Congress needs to set up a federal commission to study the nation’s regulatory processes for the market top-to-bottom, taking into account some of the aforementioned financial inventions and trends of recent decades. In addition to rewriting the laws from the ground up, means of obtaining cooperation with other regulatory agencies around the globe dealing with similar issues should be obtained as well. The guiding principles should be the ones laid out here in terms of enough regulation to avoid chaos and not enough to lead to bureaucratic inefficiency at the other end of the spectrum. The BRAC process is a good model for what needs to be done here, because if the lessons of this crisis have reinforced once and for all what a lost art statesmanship is in