Thursday, September 25, 2008

Myths About the Current US Financial Debacle

Two days of Congressional hearings have begun to wear heavily on my patience and tolerance for stupidity. The sight and sound of Chuck Schumer, the senior sitting idiot Senator from New York, chairing the proceedings and making statements calculated to play to the crowd, have sickened me.

As I've listened to hours of statements by Treasury Secretary Paulson, Fed Chairman Bernanke, SEC Chairman Cox, and a myriad of Senators and Representatives of both parties, as well as the two Presidential candidates, several incorrect, now-mythical aspects of the current US financial debacle are become frequently repeated and erroneously believed.

Myth 1: American consumers are, or should be, worried about the debacle, and have been directly hurt by CDOs and credit default swaps.

This was patently untrue, at least up until politicians began to keep dragging 'the average, hardworking American' into the fray. Few, if any, 'average Americans,' or 'hard working Americans' bought or hold CDOs or credit default swaps. Those who bought equities in failed institutions knew the risks they were taking by investing in equity markets. The financial services debacle is largely a sector problem, rather than a wide-ranging economic problem.

There have been some follow-on effects due to knee-jerk credit tightening by some financial institutions. And, yes, now that the clear impact of Congress' misguided insistence on the 'mark to market' rule has caused a loss of capital by lending institutions, credit is drying up.

But direct losses by most American consumers from the failure of Lehman, Bear Stearns, Fannie, Freddie, AIG, or Merrill Lynch's sale are non-existent, save for those who chose to work for those firms.

Myth 2: Congress can and should do 'something' about financial executive compensation, especially as taxpayer funds are being considered for buying distress-value mortgage-backed structured financial instruments.

Hard as this is for many people, including Congressional legislators and many Americans, this is not the business of non-shareholders of companies in the financial services sector. Shareholders bear the direct price of excessive executive compensation. Regulators functioned to oversee companies, and their executives. If those regulators saw no illegal activity, then there is no reason for the Federal government, with no proof of illegal activity, to arbitrarily 'take' compensation awarded by shareholders of private, publicly-held companies.

The last time Congress meddled with this, they created the options timing/pricing debacle. Remember when, similarly outraged, a prior Congress limited corporate tax deductions for executive salaries at $1MM? The result was to cause boards to issue generous stock options to executives, instead. When timing of the options pricing became tangled and complicated, Congress then punished that, too. It just never ends.

Perhaps Congressmen, knowing, down deep, how unemployable and inept they really are, harbor a badly-disguised envy and hatred of corporate executives who actually accomplish goals?

Finally, just how would Congress attempt to write a completely ironclad law with respect to executive compensation, in 48 hours, that will not have some overlooked loophole, or lead to some horrendous, unintended consequence. As most of their punitive legislation often does.

The proposed plan by Paulson and Bernanke is more of a 'buy, hold and resell' program, rather than just a straightforward, unrecoverable spending of $700B+ of taxpayer funds. As such, it is not a direct payment by taxpayers to already-richly-compensated financial service sector executives for having ruined their companies, damaged the sector, and general wreaked havoc with US fixed income and business lending activities.

Myth 3: Federal regulators knew that illegal or imprudent actions were being taken by commercial and investment banks, but silently let them continue said activities.

This is not true, per se. In the case of Fannie and Freddie, regulators attempted to raise warnings for over four years. However, Congressmen of both parties, but, particularly, those who received the largest political donations from those GSEs- Senators Chris Dodd and Barack Obama- and Representative Barney Frank, all ignored or otherwise rendered ineffective the regulators' warnings. As for investment and commercial banks, there was a buyer for every seller of a questionable mortgage, mortgage-backed security, or credit default swap.

Nobody put a gun to any buyer's head and forced her/him to purchase a financial asset which is now worth substantially less than it was when purchased.

Our economic system allows for individual action to be free of restraint, unless explicitly prohibited. The notion that the Federal government 'should have known what was going to happen' and, absent a crime, intervened, as Bill O'Reilly and others have harangued, is ludicrous. Millions of transactions occurred to create the current mess. Each was performed consensually by an adult or sophisticated investor. To baselessly prohibit these activities, if they were legal, would have been an inappropriate intrusion of government upon private sector activity.

As I wrote here recently, the ultimate risk management technique in financial transactions is 'investor beware.'

Myth 4: Thousands upon thousands of Americans are defaulting on mortgages because of losses in CDOs or swaps at large US commercial and investment banks or insurance firms, and should be 'saved' by interest rate reductions, mortgage loan amount reductions, payment holidays, or some combination of all three.

These two events are unrelated in the way that Congress and other pundits are describing. Yes, delinquencies and defaults by the marginal, risky borrowers with subprime, variable rate and/or alt-A mortgages, will affect the values of the layered-on securities which they underpin.

But causality does not run the other way. The manufacture, sale and purchase of mortgage-backed securities, and their subsequent creation of unmanageable amounts of counterparty risk, does not feed back to current borrowers.

Simply put, the trouble in the banking sector caused by unwise creation and trading of opaque structured financial instruments backed by mortgages in no way argues for forgiving either payments, rate levels, or other aspects of mortgages freely taken on by homeowners.

This is just a fallacy of apparent relationship. Some homeowners borrowed unwisely. Some investors bought securities backed by mortgages, some of which may default.

Hey, let's forgive both of them!

No, it doesn't work that way. Borrowers who borrowed unwisely must pay the price, else the lesson for them, and their children, will become,

'Yes, son/daughter, and if you get overextended on your mortgage, on the too-large home you buy, don't worry. The government will save you by either reducing your loan amount, or your rate.'

Does anyone really want this to be the lasting lesson of this recent overindulgence in residential homebuilding?

Myth 5: We suffering 'the greatest economic crisis in America since the Great Depression.'

No, we are not. We still, as of late September, 2008, are not in a recession, as measured conventionally by consecutive quarters of GDP growth.

Our politicians, beginning with the freshman Senator from Illinois, who, by the way, is apparently too young and inexperienced to know what a Depression looks like, continue to compare the current mess in one part of our economy- the financial sector- with the entire Great Depression.

Nothing could be further from the truth. If a recession is coming, it is going to be far from the Great Depression in severity or length. The current difficulties in the financial services sector are not, in and of themselves, a Depression.

If anything, today's financial services sector mess more closely resembles the late 1980s real estate market collapse. But it is, at root, a financial sector issue, not an economy-wide problem, per se.

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