The Perfect Storm

Grab your pocketbooks. We are in for it. First the bail out of Bear Stearns earlier this year, then the assumed conservatorship of Fannie Mae and Freddie Mac last week, and finally the government is saying "no more" to a bail out of Lehman Brothers. Of course I agree with this decision. Taxpayer dollars should not be used to bail out individuals and companies who make bad decisions. Bush is doing his best to try and maintain confidence in our economy and financial sector, but the cracks are long past beginning to show. So, why isn't the government bailing out Lehman Brothers? I think they realize this is just the beginning.

Even with my limited knowledge as a business student, I predicted this back in 2000. I had to do an analysis of the economy, and what I saw looked pretty dark. Why? Debt. It's that simple. I've been saying for a couple of years now that I won't even bat an eye until the Dow Jones Industrial Average falls below 11,000. It did today.

Let's stop for a brief history lesson. During the roaring 20s, capital was easy to come by. American consumers relied on cheap credit to finance consumer goods, and businesses relied on cheap capital to expand. This fueled strong short-term growth but led to deep debt. Eventually, both individuals and companies had to cut back on spending to cover debt payments. This lowered demand for new goods, which caused companies to cut back or fail, leading to massive layoffs. The unemployment rate shot to 25%. As debtors began to default, some banks began to fail. As banks began to fail, depositors got scared and began to withdraw, causing a "run on the banks". To cover the deposits, banks called loans they couldn't collect. More banks failed. Others stopped lending. This caused the economy to contract and was known as The Great Depression.

Some blame it on the government because the government didn't do "enough" about it after it happened (Greenspan appears to fall into this group). I blame it on the government for not doing enough about it before it happened. Roosevelt felt the same way (yes, I am in agreement with a Democrat, but wait - it gets even better). Part of his New Deal was the Glass-Steagall Act that included reforms designed to protect depositors, control speculation (by separating investment and commercial banking), and, in general, prevent the conditions that would lead to another Great Depression. It worked for about 50 years.

In the 1980's, (under Reagan) congress passed a series of acts to begin deregulating the banking industry. Guess what happened? Well, because Savings & Loans (S&Ls) could now compete on the rates they offered depositors, they made risky investments, including speculative real estate deals they didn't know much about, through brokers. The net result was the Savings & Loan Crisis. A lot of S&Ls started to go under. The government bailed them out. The Federal Savings and Loan Insurance Corporation, which insured S&Ls like the FDIC insures bank accounts, paid all depositors whose money was lost. And who paid the FSLIC? You got it! Taxpayers. (Many other banks failed as well - bailed out by the FDIC).

How did this differ from the Great Depression? Both were caused by an unregulated financial market, but only the Saving & Loan crisis was mitigated by government involvement. Sure, the government involvement may have mitigated the crisis to individuals, but it also set up a "moral hazard".

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions . . . Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses.

So, what did the government do after that? Well, they deregulated again, of course! In 1999, President Clinton signed the Gramm-Leach-Bliley Act that effectively removed all of the regulations left over from the Glass-Steagall Act. What else was going on at this time? The dot com bubble was still growing, growing, growing, sending the stock market soaring until it burst in 2001 (same time that the Gramm-Leach-Bliley Act became effective). Venture capitalists, day traders, speculators had all poured money into dot coms and now either lost it or needed to put it elsewhere. Conveniently, most lending regulations had been removed, so bankers could start making risky loans again.

Here is the housing bubble in a nutshell (see if it sounds familiar): mortgage brokers act as salesmen to "sell" the loan (developers/builders frequently act as brokers). They are supposed to gather all the information, make sure it is accurate, and give it to the underwriter. They have incentive to fudge the numbers or overlook risks or overextend the borrower because they only make money on the sale - they are not responsible if the loans default.

The underwriter is the actual lender. They assess the information and determine if they want to lend money to the borrower. The information they have is only as good as the information they get from the broker. Although they theoretically assume the risk, most lenders then bundle the mortgages and sell them to investors.

The investor could be an investment firm either here or abroad, or it could be Fannie Mae or Freddie Mac (who hold about half of all mortgages in the U.S.). Fannie and Freddie operate on the secondary mortgage market to buy mortgages from banks, savings and loans, mortgage companies, etc. and either hold or repackage them into mortgage-backed securities to sell. This provides liquidity in the mortgage industry. Although there was no actual government guarantee on Fannie and Freddie securities, it was widely assumed that they had an implicit guarantee. In an attempt to give confidence to the world markets, the government has taken conservatorship of Fannie and Freddie to turn an implied guarantee into an actual guarantee. The result is that the federal government is taking on their debt and adding it to the national deficit. Guess who gets to pay for that? Yup, the taxpayers AGAIN.

Not surprisingly, this was all very predictable. In 1999, as deregulation was ending and the dot com bubble was growing, the World Socialist Website (see? I told you it would get better. How is that for shocking?) published an article that said:

Legislation first adopted to save American capitalism from the consequences of the 1929 Wall Street Crash is being abolished just at the point where the conditions are emerging for an even greater speculative financial collapse. The enormous volatility in the stock exchange in recent months has been accompanied by repeated warnings that stocks are grossly overvalued, with some computer and Internet stocks selling at prices 100 times earnings or even greater.

And there is much more recent experience than 1929 to serve as a cautionary tale. A financial deregulation bill was passed in the early 1980s under the Reagan Administration, lifting many restrictions on the activities of savings and loan associations, which had previously been limited primarily to the home-loan market. The result was an orgy of speculation, profiteering, and outright plundering of assets, culminating in collapse and the biggest financial bailout in U.S. history, costing the federal government more than $500 billion. The repetition of such events in the much larger banking and securities market would be beyond the scope of any federal bailout.

Scared yet? When the speculators left the housing market, where did they go? Ding, ding, ding if you guessed oil! Lax regulation over speculation in the oil futures market allowed for manipulation of the market, and it has affected nearly every other industry: airline, shipping, food, etc. The average American is suffering because of this manipulation. After oil, where did speculators move to next? My guess is commodities. Wonder why gold is so high right now?

Look, I have nothing against lending, investing, providing capital for small businesses to grow or mortgages so people can purchase homes. I have nothing against capitalism in general (in fact, I am a big proponent!). Our capitalistic system fosters economic growth and prosperity. In its purest form, speculation allows risk-takers to use their own capital to bet on movements in the market. They stand to lose a lot, or they stand to gain a lot, but if they are playing with their own money, it doesn't bother me. However, it's when they have the ability to manipulate the markets that I have a problem with. Speculation can (and does) cause economic crisis. Is it fair to subject the entire population (world even) to the risk of economic collapse? In my opinion, NO.

The government didn't necessarily "create" this crisis. Average people are in too much debt and took out bigger mortgages then they could afford. Banks made risky investment decisions. Speculators have been moving the markets. However, it has been government's complete laissez-faire approach to the financial sector, along with setting up moral hazard in the 80s, that has allowed this crisis to happen. So what should they do now?

For one, the federal government should NOT bail out banks or individuals. Taxpayers should not be responsible for paying for the irresponsibility of others. We are already going to hurt enough through the crisis as we deal with the economy contracting (far too big of a problem for government to effectively deal with). Please don't tax us anymore.

For two, please, for the love of Pete, REGULATE!!! We are deep into our third cycle. The pattern is the same every time: lax regulation and easy credit lead to overextended borrowers and speculators who drive up prices. When the cracks start to show, lenders pull out, leaving borrowers with assets worth less than they owe. The market contracts, and we are left with economic crisis.

I am pleased that both Obama and McCain agree to no more bailouts. However, I think Obama is misguided in his attacks on McCain over the issue.

"This country cannot afford four more years of this failed philosophy", Obama . . . told a cheering outdoor rally in western Colorado . . . Obama chided McCain for a new commercial that promises "change we need". "Sound familiar?" said Obama, who has made change the central theme of his campaign. "Let me tell you. Instead of borrowing my lines, he needs to borrow some of my ideas. Change isn't about slogans. It's about substance . . . I certainly don't fault Sen. McCain for these problems . . . but I do fault the economic philosophy he subscribes to. It's the same philosophy we've had for the past eight years, one that said we should give more and more to those with the most and hope that prosperity trickles down to everyone else. It's a philosophy that says even common regulations are unnecessary, unwise".

Let's see. Deregulation is what got us into this mess, and Bill Clinton is the one who signed the final bill that went into effect while Bush was in office. What ideas has Obama put forth that McCain should "borrow" that would address this crisis? What failed "philosophy" is Obama referring to? Capitalism? It is true that in theory capitalism rejects "even common regulations", but the U.S. currently operates under a mixed economy. What change of "philosophy" is Obama promising? Socialism? Yeah, we need change, but not that kind of change.

McCain also spoke today. In a statement issued this morning, he said

"I am glad to see that the Federal Reserve and the Treasury Department have said no to using taxpayer money to bailout Lehman Brothers . . . major reform must be made in Washington and on Wall Street. We cannot tolerate a system that handicaps our markets and our banks and places at-risk the savings of hard-working Americans and investors. The McCain-Palin Administration will replace the outdated and ineffective patchwork quilt of regulatory oversight in Washington and bring transparency and accountability to Wall Street".

At a speech given this morning, McCain promised to "never put America in this position again . . . We believe the time has come and gone where the taxpayers should be viewed as the solution to the problems that are not of their making. We will reform the regulatory bodies of government".

Yeah, that sounds about right to me. So, what's the bottom line? The bottom line is that it is going to get ugly - very, very ugly. The blame goes individuals, corporations, banks, investors, etc. who made stupid decisions AND to politicians on both sides of the aisle who removed necessary regulation from the financial industry. The economy will contract, and there is nothing the government can do to stop it. It is going to hurt. We're going to have to suffer through it this time and put regulations in place to prevent it from happening a fourth time. Sure, Obama wants that (in addition to much more government oversight and interference and taxation that looks an awful lot like socialism), but McCain wants that in the context of maintaining a mixed economy closer to capitalism. And THAT is change I can believe in.