Saturday, November 8, 2008

Financial Crisis: The Government Failed In Many Places

I've decided that it doesn't make much sense to attempt an all-encompassing post on the current economic conditions--partly because it would take too much time and effort, and mostly because it would clearly be presumptuous of me to claim to be able to explain it all. But, there are things that people are failing to understand. This is from a Capital (online) letter writer:

Many firms on Wall Street and around the world ran up debt-to-equity ratios
larger than 30 to 1. That means they borrowed $30 for every $1 they actually
had. They didn't get to that point on the strength of mortgages to poor people.
They were playing a leverage casino far beyond the subprime market.

When Lehman Brothers collapsed, its ratio was 45 to 1. That is what is
causing Wall Street to collapse in less than a month, at our great expense. Our
government, including both political parties, have failed us by ignoring the
abuses and failing to exercise proper oversight of the financial industry. Let's
give credit where credit is due.

The stance of many, notably the Obama campaign, is that the blame for our financial crisis lies mainly in the failure of government regulators. I tend to believe that the regulators knew what was going on, but were powerless to do anything because their interests were in conflict with a more momentous political prerogative. Let's discuss!

Leverage is a great way to make money, and a great way to lose it really quick. It's important to understand that leverage is tied to the assets being leveraged (borrowed against). In this case, artificially easy credit and artificially high demand for homes eventually dried up, rendering the writer's leverage complaint valid.

For most people, their homes are their chief investment. Taking that a step further, securities that are tied to mortgages make up a huge pool of investments, and a huge pool of profit for the companies mentioned in the above letter. The government, via Fannie and Freddy, distorted the market for mortgage-backed securities, and essentially forced such risky behavior. Acting on the assumption that every family deserves to own a home--a notion that is much younger than some might think--Fannie and Freddy created demand for sub prime loans by buying them from mortgage lenders. Banks felt the need to participate, lest they lose ground to the competition. Bottom line: the fault does not lie with unregulated capitalism, it lies with the government's forced limitation of free-market principles.

Perhaps more alarming is the preferred method of bailing these companies out. In the late 1990's, a hedge fund named Long Term Capital Management was on the brink of bankruptcy. To put it in perspective, they were leveraged at least 30:1, and probably more--they were very secretive and nobody really knew where their money was or how much was at risk. A failure of LTCM was thought to have far-reaching effects, as many banks had significant stakes. After a bailout offer from Warren Buffet was rejected, the Fed was brought in. BUT, rather than bail the fund out themselves, the Fed merely acted as a mediator--orchestrating a $525 billion bailout from the fund's creditors, and not the taxpayers.

The contemporary method to bail out companies is direct investment or securitization from the government. Unlike the creditors or investors of a company, the government has significantly less expertise in monitoring the company, and significantly less incentive to recover its money (because the government doesn't have its own money, it has our money). And whereas investors only deal with their investments, the government has no clearly defined restraints. First it was only banks that got special protection. Then investment banks. Then an insurance company. Now maybe the auto industry. The list will stop when the government stops sending good money to chase after bad.

1 comment:

Anonymous said...


I write a weekly column for the Capital that's in the Sunday Haven's section. This week, I take a look at the housing market, and how we got to this credit crunch.

My conclusions are similar to yours. By yielding to political, rather than economic pressures, Fannie and Freddie, as GSE's, are primarily responsible for the credit crisis.

The current O'Bama mantra that we got here, because of top down economics is simply wrong. We got here because, Congress failed to require that Fannie and Freddie adhere to sound economic principles.

Blaming it on top down economics is simply another "political" fantasy designed to give rationale for the bottom up theories of O'Bama.

It'll be interesting to see if his bottom up theories work. I have my doubts, in that bottom up measures are a mile wide and an inch deep. As such, they do not magnify the stimulus through the power of leverage, with a focus on growth and job creation. Bottom up theories are like fighting a fire with a gentle rainfall, rather than turning the force of a hose on the source of the blaze. I fear that O'Bama's stimulus will simply evaporate when it hits the heat of this economic crisis.

Bob McWilliams