Last night on Charlie Rose, Treasury Secretary Tim Geithner made an extraordinary admission. Here’s the exchange:
Rose: “Looking back, what are the mistakes, and what should you have done more of? Where were your instincts right but you didn’t go far enough?”
Geithner: “There were three broad types of errors in policy. One was that monetary policy here and around the world was too loose for too long. And, that created just this huge boom in asset prices; money chasing risk; people trying to get a higher return; that was just overwhelmingly powerful.”
Rose: “Money was too easy.”
Geithner: “Money was too easy, yeah . . . . Real interest rates were very low for a long period of time . . . .”
There you have it. Pretty simple. And yet it is the first time I can recall that any U.S. executive branch official, spanning the Bush and Obama Administrations, has admitted monetary policy was even onefactor, let alone the central factor, leading to the crash. This is very big stuff. (more…)
Here we should look to three historical examples where aggressive monetary expansion was wedded to an aggressive fiscal policy: the U.S. during the mid-1930s, Germany through the 1930s, and Japan in the early 2000s. In each case there was a recovery, although policy errors led to significant setbacks. These episodes can help assess U.S. growth prospects, and the risks to a sustainable recovery.
The Great Depression in the U.S. came in two stages, a downturn from 1929-33 in which real GDP collapsed by 26.5% and unemployment rose to 25% from 3%, and a relapse in 1937-1938, with a 3.4% decline in real GDP and a rise in unemployment to 19% from 14%.
The first stage of the depression was associated with a collapsing equity bubble (1929), protectionist tariff legislation (1930), contractionary monetary policy (1931) and a sharp rise in tax rates (1932). Between 1934 and 1937, however, there was a rapid recovery, in part due to the severity of the downturn that preceded it. Real GDP expanded by 9.5% per annum, while the unemployment rate fell 11 percentage points.
The recovery was spurred in no small part by monetary policy. In 1933-34, the dollar was devalued against gold to $35 per ounce from $20.67 per ounce, which allowed the Fed to push reserves into the banking system. This allowed the Fed to finance FDR’s deficits with the printing press. After falling at an average rate of 6.7% per year from 1930-33, the Consumer Price Index rose by an average 2.7% per year from 1934-37.
In testimony before Congress’s Joint Economic Committee today, Fed chairman Ben Bernanke noted that
In contrast to the somewhat better news in the household sector, the available indicators of business investment remain extremely weak.
But it is these key business sectors that are most important for a U.S. — and global — economic recovery. As important as stabilization of the housing sector is, we are not going to be led out of the recession by another housing boom. Nor should we desire that. We need real productivity-enhancing innovation, which is largely enabled by non-real estate investment and entrepreneurship.
Among the myriad policy actions being taken in Washington this year is a potential overhaul of our communications strategy, under the aegis of the FCC’s new Broadband “Notice of Inquiry.” The first goal of this plan should be to to encourage the continued investment in leading-edge information technologies. Broadband communications especially makes all our businesses in every sector more productive and also connects an ever larger number of citizens, especially those who may be struggling the most in this tough economy, to the wider world, improving their prospects for education, health, and new jobs in emerging industries.
Information and communications technology (ICT) accounts for an astounding 43% of non-structure U.S. capital investment, totaling $455 billion 2008. In this new FCC communications policy review, we should do everything possible to keep this huge source of American growth rolling. Any policy obstacles thrown into the path of our information industries would not only reduce this crucial component of absolute capital investment, which is already under strain, but also diminish and delay all the positive cascading follow-on effects of a more networked workforce and world.
One can critique Nobel laureate Robert C. Merton’s work on a number of fronts, from the CAPM model to his involvement with the 1998 failure of Long Term Capital Management. And he still doesn’t get to the true source of the current crisis — monetary policy and an erratic U.S. dollar. But I found this MIT lecture useful in explaining how changes in asset prices can drive both instability and volatility in a highly non-linear, pro-cyclical way and confound all the risk and economic models. Merton also offers a simple method to swap risk and improve returns using right-way contracts. (Hat tip: Gordon Crovitz.)
The events of the last 18 months came so fast and furious, it’s often difficult to remember what in any other time would be singular historic moments, let alone the chronology of the financial meltdown. So Don Luskin does a great service reminding us about just one of many dramas from 2008 — the Wells Fargo acquisition of Wachovia. This week Wells reported a $3 billion profit for the first quarter, shocking the Nationalizers and Depresionistas. How did this happen? Weren’t all the banks supposed to be insolvent? Au contraire:
Last September, Wachovia was the last domino to fall in the horrific sequence of financial firm failures — Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, AIG, Washington Mutual, and finally Wachovia. The Federal Deposit Insurance Corporation forced its acquisition by Citigroup. The deal was that Citi would pay a measly $1 per share of Wachovia, and the FDIC would invest $12 billion and insure Citi against any losses above certain threshold.
Then Wells came on the scene. It offered to buy Wachovia for $7 a share and told the FDIC that it didn’t need any investment or any guarantees. Believe it or not, Citi had the gall to sue to block Wells’ offer even though in every dimension it was superior for Wachovia stakeholders and for the American taxpayer.
You have to wonder what the FDIC was thinking in the first place. Citi had to take two huge capital injections from the U.S. Treasury under the TARP program in order to survive, and it had to have the Federal Reserve guarantee $300 billion of its toxic assets. So what was the point in having a bank that screwed up take over Wachovia?
Inquiring minds want to know. Maybe Wachovia wasn’t in trouble at all in September. Maybe it was always the diamond in the rough that it now so clearly is in Wells’ hands, and the whole idea was really to prop up Citi with Wachovia, not prop up Wachovia with Citi.
But now, even though Wells was conservative and well-managed during the boom, and could help lead the way out of the crash, it is nonetheless forced to comply with all the silly restrictions imposed by Treasury’s TARP.
no good deed goes unpunished. Back in October when Treasury Secretary Henry Paulson first implemented the new TARP program, he forced every major bank — including Wells — to take TARP money whether they wanted it or not. Wells Chairman Richard Kovacevich told Paulson no, but the Treasury Secretary said it was Wells’ patriotic duty to take the taxpayers’ money like all the rest. So Wells played the good soldier and took the money.
And now it’s sorry it did. Now, because it took government money it didn’t even want, its executives have been made subject to new compensation restrictions enacted by Congress and enforced retroactively. The idea was to make sure that the risk-happy fools who created the financial crisis in the first place now don’t benefit at taxpayer expense — but surely Wells shouldn’t be punished: it was one of the good guys.
Wells’ Kovacevich isn’t shy about complaining. In a speech last month, he said “Is this America — when you do what your government asks you to do and then retroactively you also have additional conditions? If we were not forced to take the TARP money, we would have been able to raise private capital at that time.”
Kovacevich isn’t fond of the Treasury’s latest rescue schemes either, especially the “stress tests” to be applied to the 19 largest banks including Wells. He said, “We do stress tests all the time on all of our portfolios. We share those stress tests with our regulators. It is absolutely asinine…”
This crash is going to look much different upon reflection, isn’t it?
Good analysis from, of all people, George Soros. The credit default swap (CDS)/no uptick/mark-to-market/regulatory capital interplay has been a killer.
the CDS market offers a convenient way of shorting bonds, but the risk/reward asymmetry works in the opposite way. Going short on bonds by buying a CDS contract carries limited risk but almost unlimited profit potential. By contrast, selling CDS offers limited profits but practically unlimited risks. This asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. The negative effect is reinforced by the fact that CDS are tradable and therefore tend to be priced as warrants, which can be sold at anytime, not as options, which would require an actual default to be cashed in. People buy them not because they expect an eventual default, but because they expect the CDS to appreciate in response to adverse developments. . . .
The third step is to recognize reflexivity, which means that the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is so dependent on trust. A decline in their share and bond prices can increase their financing costs. That means that bear raids on financial institutions can be self-validating.
1) To the political process all big numbers look alike; above a certain number the money becomes purely symbolic. The general public has no ability to feel the relative weight of 173 billion and 165 million. You can generate as much political action and public anger over millions as you can over billions. Maybe more: the larger the number the more abstract it becomes and, therefore, the easier to ignore. (The trillions we owe foreigners, for example.) (more…)
Must reading from The Wall Street Journal on the never-ending AIG bailout and the political shenanigans and multi-billion-dollar cover-ups that go far beyond $165 million in contractual bonuses.
Taxpayers have already put up $173 billion, or more than a thousand times the amount of those bonuses, to fund the government’s AIG “rescue.” This federal takeover, never approved by AIG shareholders, uses the firm as a conduit to bail out other institutions.
Yet another remarkable dispatch from James Fallows on China’s attempts to navigate the global financial crisis. His conclusions:
(1) the Chinese people are less likely to revolt en masse in bad times than is often suspected. Even now, things are a lot better than ever before. Fallows quotes one Shanxi province party official:
Do you understand? If it had not been for Deng Xiaoping, I would be behind an ox in a field right now. . . . Do you understand? My mother has bound feet!
(2) China has at least a very good shot at achieving a truly innovative economy. Listing several new high-tech firms producing the best voice-recognition software he’s ever seen and some of the world’s most advanced batteries for everything from iPhones to new electric cars, Fallows writes:
In Beijing, in Shanghai, in Shenzhen, and elsewhere, I’ve recently visited companies that are trying to use the disruption of this moment to enter wholly new markets and do what so few Chinese firms have yet done: make high-tech, high-value products that bring high rewards.
These largely mirror my own views. In fact I couldn’t help but notice Fallows’ concluding sentences:
Many Chinese companies will fail or make mistakes under today’s intense pressure. But many are using the moment to prepare for their next advance. The question for Americans to think about is how we are using the same moment.
What seems undeniable is that the next hundred years will be a Chinese century. The biggest question for politicians and business leaders in the U.S. is whether, through a recommitment to entrepreneurial capitalism, it will be another American century as well.
Stock markets are up markedly after word spread the last few days that we would finally — finally — get some relief from mark-to-market, or “fair value,” accounting. The Financial Accounting Standards Board today, in a hearing before the House Finance Committee, promised new guidance on FAS 157 in the next few weeks. Many financial stocks are up 50-100% or more since Warren Buffett and many lawmakers commented on the need for reform at the start of the week.
The real credit, however, goes to Brian Wesbury, who’s been pounding away and comments on video here. To Steve Forbes, with his bold Wall Street Journalop-ed that opened the floodgates on the matter last week. And to David Malpass, who identified the mark-to-market problem over a year ago in early 2008.
The S&P 500 is up more than 10% since mark-to-market reform looked possible.
What is most astounding about President Barack Obama’s radical economic recovery program isn’t its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were in themselves repudiations of Franklin Delano Roosevelt, Mr. Obama’s hero.
The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or “fair value” accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down. [...]
Mark-to-market accounting is the principle reason why our financial system is in a meltdown. The destructiveness of mark-to-market — which was in force before the Great Depression — is why FDR suspended it in 1938. It was unnecessarily destroying banks.
There’s a charming lack of financial experience in Icelandic financial-policymaking circles. The minister for business affairs is a philosopher. The finance minister is a veterinarian. The Central Bank governor is a poet.
But don’t feel bad, Iceland. Our central bankers and finance ministers are trained monetary geniuses. And they can match your meltdown any day of the week.
Nassim Taleb is moving along just fine with an elegant critique of banking’s misaligned incentives . . .
In fact, the incentive scheme commonly in place does the exact opposite of what an “incentive” system should be about: it encourages a certain class of risk-hiding and deferred blow-up. It is the reason banks have never made money in the history of banking, losing the equivalent of all their past profits periodically – while bankers strike it rich. Furthermore, it is that incentive scheme that got us in the current mess.
Take two bankers. The first is conservative. He produces one annual dollar of sound returns, with no risk of blow-up. The second looks no less conservative, but makes $2 by making complicated transactions that make a steady income, but are bound to blow up on occasion, losing everything made and more. So while the first banker might end up out of business, under competitive strains, the second is going to do a lot better for himself. Why? Because banking is not about true risks but perceived volatility of returns: you earn a stream of steady bonuses for seven or eight years, then when the losses take place, you are not asked to disburse anything. You might even start again, after blaming a “systemic crisis” or a “black swan” for your losses.
. . . But then, after showing how easy it is for bank management to capture short-term gains without worrying about long-term risks, Taleb concludes that
This is prompting me to call for the nationalisation of the utility part of banking as the only solution in which society does not grant individuals free options to look after its risks.
It’s a big leap from misaligned incentives to only the government can run banks. Doesn’t the expert theoretician of the highly improbable Black Swan understand that highly centralized governments are most often the cause of devastating Black Swan events? The only difference being: we shouldn’t really even call them Black Swans in the case of government failure. These events are not uncommon or unpredictable. The inherent difficulty and high-frequency failure of highly centralized bureaucracies managing dynamic systems is so common and predictable, in fact, that we might call them Black Crows.
We can do much better than nationalizing the banks. Boards should obviously reform compensation practices. Today’s shareholders have been mostly wiped out. The shareholders of the “next banks” won’t soon forget. But most crucially we should amend the wildly incoherent monetary policy regime that does more than any other private or government action to misalign incentives. During credit bubbles, dollars are easily vacuumed up by the financial industry. In a very real sense, they would be irresponsible not to exploit the Fed’s explicit free-lunch program of accommodation “for a considerable period.” Remember, Chairman Greenspan virtually ordered Wall Street to lever up.
A stable currency is the ultimate disciplinarian, the incentive aligner par excellence.
Update: See Taleb and Nobel psychologist/behavioral economist Daniel Kahneman discuss these topics at length here.
The history seems clear. Mark-to-market accounting existed in the Great Depression, and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.
Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
Two things are absolutely essential when fixing financial market problems: time and growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
Of the Treasury’s long-awaited non-plan bank plan, Andy Kessler writes, “Mr. Geithner should instead use his ’stress test’ and nationalize the dead banks via the FDIC — but only for a day or so.”
Then,
strip out all the toxic assets and put them into a holding tank inside the Treasury. . . . inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here’s the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.
Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.
Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.
Is Kessler crazy? Well, maybe. In his own creative and boisterous way. But not nearly so crazy as Washington’s fumble-bumble these last few months. I’d much prefer Kessler’s out-of-the-box plan to D.C.’s muddle.
What becomes clearer every day is that all the government’s efforts, from the AIG “bailout” to TARP 1.0 and TARP 2.0 onward, have essentially been efforts to get around the terribly destructive interaction of “mark-to-market” accounting and regulatory capital requirements. A few keen observers — David Malpass (I), Brian Wesbury (I, II, III, IV), Steve Forbes (I, II) – have made this point from the start. But the government and most economists clung stubbornly to “fair value” in an apparent attempt not to “let the banks off the hook.”
But what a time for an attack of conscience, a principled stand for supposed accounting purity! We’ll spend trillions and totally alter the nation’s financial landscape, but a minor (though powerful and free!) accounting change — relaxing mark-to-market — is a bridge too far? Explain that one. (more…)
“This is the killer quote from Geithner’s speech: ‘We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it.’ In other words, we have a plan to have a plan. Ouch.”
The WSJ’s RealTimeEconomics blog reports on Hank Paulson’s clarification to the Chinese over his recent serial blaming of “global imbalances” as the cause of the financial crash.
“In assessing the financial market crisis, I have repeatedly and consistently targeted the vast majority of my criticism at problems in the United States, particularly our flawed and outdated regulatory structure,” Xinhua quoted Mr. Paulson as saying. “Whenever I have commented on global imbalances, it has been against that backdrop and I have gone out of my way to say that no single country is to blame for the imbalances.”
The critical point is to avoid the nightmare of a state-dominated financial sector. The last thing America needs is to have all its banks run like the rail company Amtrak or, worse, the Internal Revenue Service. State life-support for moribund dinosaur banks is an expedient designed to avert the disaster of a generalised banking extinction not a belated victory for socialism. It should not and must not impede the formation of new banks by the private sector. So recapitalisation must be a once-only event, with no enduring government guarantees or subsidies.
David Malpass with a typically cogent column on the crisis of lost capital and plunging consumption, but also the more important factors that drive the future.
Losses in U.S. wealth and self-confidence have been massive, with job conditions still worsening. But a long downtrend into 2010 isn’t inevitable, even assuming a systematic lurch to bigger government. A starting point for optimism is to realize that the creation of new capital is more important than the loss of old capital. This is hard to absorb emotionally during a crisis. The world’s past wealth creation is outstripped every generation by innovation, human progress and the rapid growth of the above-subsistence population.
Consumption may also prove less important to the recovery than asserted in the warnings of another Great Depression. Consumption crashed after theLehman Brothers bankruptcy. With consumption equaling 70% of GDP, a downsizing there would decimate GDP if the economy were static. Yet GDP itself means production, not consumption. A lot of U.S. consumption has been idle or is sourced abroad and won’t be missed. The GDP issue is whether the Crash of ‘08 will cause people to work fewer years, less hard or less productively. That’s unlikely.
Even for those deeply worried about old capital and weak consumption there are grounds for optimism. So far most of the banking sector losses have been accounting writedowns, not cash losses. Layoffs would slow and consumption resume if the Fed sped its asset purchases and Washington stopped imposing arbitrarily low prices on equity holders and regulatory capital in the blind assumption that crisis markets are accurately priced.
The New York Times, in its series on the origins of the financial crisis it calls “The Reckoning,” pins our housing and credit bubbles on Chinese savings and the U.S.-China trade gap. This is basically the view of Alan Greenspan and Ben Bernanke. We were helpless. Monetary policy had become ineffective. The New York Times also says the U.S. failed to react to the China-U.S. “imbalances” soon enough, that we took a “passive” approach.
In fact, most of this is backward. We did not under-react to China. We overreacted. The U.S. weak-dollar policy — a combination of historically low Fed interest rates and a Treasury calling for a cheaper currency — was a direct and violent reaction to the trade gap. A series of Treasury secretaries and top U.S. economists, from John Snow and Hank Paulson to John Taylor and Martin Feldstein, explicitly backed this policy as a way to “correct” these “imbalances.” This weak-dollar policy was designed to reduce the trade gap but in fact boosted it by pushing oil and other commodity prices through the roof. It also created and pushed excess dollars into other hard assets like real estate, resulting in the housing boom and then bust.
America’s overreaction to China’s rise in particular and our misunderstanding of global trade and finance in general was thus, I believe, the chief source of our current predicament. The Fed and Treasury failed to grasp the truly global nature of the economy and the centrality of the dollar around the world. I tell the story of Chinese-U.S. interaction in this long paper, “Entrepreneurship and Innovation in China: 1978-2008.”
See my comparison of the state of technology in 2008 versus 1992, when the last Democratic presidential transition took place.
Today, an average consumer can buy a terabyte hard drive (1 million megabytes), on which she might store her family photos, videos and other digital documents for as little as $109.99. In 1992, a terabyte drive, if such a thing had existed, would have cost $5 million.
Go to Forbes.com for the full article: “How Techno-creativity Will Save Us.”
That, it seems, is the economic prognosis of the Obama financial team, looking ahead at a total global “demand collapse” and the total failure of fragile states like Pakistan.
the sense I get from them is that they are very worried that the economy will get a lot worse before it gets better. Not just worse… a lot worse. As in — double digit unemployment without the wiggle factors. Huge declines in aggregate demand. Significant, persistent deficits. That’s one reason why the Obama administration seems to be open to listening to every economist with an idea and is stocking the staff with the leading lights of the field. . . .
Where the discussion isn’t going, at least in public, (or the PR level), is the possibility that the first foreign policy crisis the administration will face will be the complete economic collapse of a large, unstable nation. To be sure, Pakistan is nearly broke, and U.S. policy makers seem to be aware of that; but a worldwide demand crisis could lead to social unrest in countries like Indonesia and Malaysia, Singapore, the Ukraine, Japan, Turkey or Egypt (which is facing an internal political crisis of epic proportions already). The U.S. won’t have the resources to, say, engineer the rescue of the peso again, or intervene in Asia as in 1997.
Team Obama may believe this. And they may be right. But it probably doesn’t hurt their cause to make people think they believe this. If things do get much worse, they can say they anticipated it. If things improve, they can take credit for a heroic and historic rescue. (See, “Committee to Save the World.” ca. 1999.)
My old college roommate Jared Polis, soon to be a Democratic Congressman from Colorado, pens a terrific op-ed in today’s Wall Street Journal offering a unique non-bail-out solution to the automobile meltdown.
By waiving the future capital-gains tax on all investments in the automobile industry, we enhance the projected return models and therefore the likely occurrence of a privately funded “bailout.” There are turnaround firms and funds, and they are experts at what needs to be done. Tax exemption for gains would certainly get their attention. It also wouldn’t cost taxpayers anything because it only forgoes future government revenues that wouldn’t exist absent this incentive.
We are in a new, if entirely predictable, danger zone. The State of Illinois and City of Chicago are now ceasing business with Bank of America because BofA declined to extend credit to Republic Windows and Doors, a plant where workers are now engaged in a sit-in.
The take-over of much of the U.S. financial industry — with health care and maybe energy next — could lead to endless mischief of this sort and much worse.
A friend writes to say: “fascism has come to America.” Alarmist, or prophetic?
Suspending mark-to-market accounting will not keep institutions that took excessive risk from failing. Bad loans are still bad loans and there is no way to avoid the pain that they cause. It will, however, end the negative feedback loop, which drags everyone down. It allows time to see if the wind shifts and keeps the flames from spreading.
In the 1980s, loan problems took down thousands of banks, but because we did not force fair value accounting, the economy and stock market actually thrived. Every money center bank would have been insolvent in the early 1980s if they were forced to write down Latin American debt to 10 cents on the dollar. Add in bad oil loans which took down Pen Sqaure and Continental and bad S&L loans, and it is easy to see that the bank problems in the early 1980s were much more severe than those of the 2000s. But the rules were not as inflexible as their are today. Problems did not spread, many banks eventually recovered their principle on Latin American debt and the economy grew.
In contrast, today’s problems are expanding, and have now caused the government to put almost $4 trillion of taxpayer funds at risk to support the financial system. This is an amazing sum of money, equaling 28% of GDP, or 42% of total US stock market capitalization, or more than a quarter of all household debt outstanding, or nearly 40% of all private household mortgage debt, or three times the amount of subprime loans outstanding at their peak.
The government has tried multiple strategies. The only thing they have in common is that they are designed to offset or stop the damage caused by mark-to-market accounting.
Andrew Ross Sorkin asks a good question, and some Wall Streeters answered.
“We have only two things to say about Tim Geithner, who we do not know: A.I.G. and Lehman Brothers,” said Christopher Whalen of Institutional Risk Analytics. “Throw in the Bear Stearns/Maiden Lane fiasco for good measure,” he said.
“All of these ‘rescues’ are a disaster for the taxpayer, for the financial markets and also for the Federal Reserve System as an organization. Geithner, in our view, deserves retirement, not promotion.”
And perhaps the biggest bungle of them all:
It was Mr. Geithner, not Mr. Paulson, for example, who put together the original rescue plan for the American International Group.
AIG could probably have been saved with a bridge loan. But the government took 80% of the company. AIG set the precedent for wiping out equity shareholders and put other financial firms on the precipice and put a target on their back for short-seller snipers. In combination with a series of other errors — clearly not all Geithner’s fault or doing — this move helped undo Wall Street and continues to wreak havoc among insurance companies.
It does appear that we are finally getting some much needed action on mortgage rates. Instead of focusing on “foreclosures,” the Treasury should have told Fannie and Freddie to lower their commitment rate, which would have automatically brought down mortgage rates, which have not followed the 10-year Treasury down. Lower mortgage rates could help restart turnover in the housing market and thus relieve much of the worst-case uncertainty in the MBS and larger credit markets. With the 10-year close to 3%, we could get 30-year mortgage rates into the mid-4s. Let’s hope, after lots of bumbling and fumbling, they’re finally moving in this direction.
Whether the topic is football or finance, Michael Lewis is maybe the best non-fiction story teller of our times. Now this author of Liar’s Poker, the smart-ass inside tale of Eighties Wall Street excess, finds the man who helped expose today’s housing charade and learns about real excess — the ’80s, how quaint — as he chronicles the 2008 crash.
More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens. “The price was absurd, and they were giving her a low-down-payment option-ARM,” says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he’d hired back in 1997 to take care of his newborn twin daughters phoned him. “She was this lovely woman from Jamaica,” he says. “One day she calls me and says she and her sister own five townhouses in Queens. I said, ‘How did that happen?’ ” It happened because after they bought the first one and its value rose, the lenders came and suggested they refinance and take out $250,000, which they used to buy another one. Then the price of that one rose too, and they repeated the experiment. “By the time they were done,” Eisman says, “they owned five of them, the market was falling, and they couldn’t make any of the payments.”
But the sub-prime detective Eisman still had not fully grasped the enormity and breadth of the problem.
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower.
Finally, Lewis lunches with his long-ago boss John Gutfreund, the Salomon Brothers CEO who he skewered almost 30 years ago.
[Gutfreund] thought the cause of the financial crisis was “simple. Greed on both sides—greed of investors and the greed of the bankers.” I thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.
Indeed, greed is ever-present. And not just on Wall Street. It is the incentives and discipline — the structure — of the market that keeps greed from pushing us over the cliff. It is this discipline of the market that makes service to others, in the words of George Gilder, more valuable than self-centered avarice. Had he taken it one step further, Lewis might have said that the ultimate disciplinarian — the taskmaster that demands real value instead of greed, froth, and fraud — is a rock-solid dollar.
The prolific Niall Ferguson with a long narrative of the financial crash in Vanity Fair:
The key point is that without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission and commission of central banks.
