Thursday, September 18, 2008

What Regulation Will Never Stop: Greed & Stupidity

Amidst the recent changes of ownership of several large American financial institutions, there seems to be a lot of misunderstanding and misinformation rampant among the media, political office seekers, and average citizens.

First, there is no new crisis this week directly affecting average American citizens. The overall economy, while slowing, is not in recession. Don Luskin's excellent piece in the Washington Post debunks the myth that we are in a recession, much less something even close to the Great Depression.

What we are seeing is the fairly rapid restructuring, thanks to accounting rules involving mark-to-market of traded securities, of the financial services sector. But no bank accounts of American citizens are at risk. There is, and will be, no bank holiday.

Let me illustrate the non-crisis nature of these actions with a comparative example. Over the past few years, there has been a substantial consolidation in the industrial sector involving minerals extraction. BHP, Rio Tinto, Alcan, Alcoa, FreeportMcMoran and others have been engaged in the buying of competitors to secure supplies of commodities and lower production costs. Especially as global commodity prices soared.

Nobody considered this a crisis. It was simply an industrial structure change in response to changing market conditions.

What we are seeing now in US financial services is the same.

Take Fannie and Freddie. These were not retail banks. They were a misguided, depression-era, and later, boneheaded Democratic party idea for supporting 'affordable housing.' Because of their Congressional (lack of) oversight and bizarre public/private structure, they exploited regulatory gaps, bought favorable treatment from Congress, and evaded harsh regulatory treatment by appealing to their bought Senators and Congressmen (among the top campaign cash recipients were: Chris Dodd (D-CT), Barack Obama (D-IL), and Barney Frank (D-MA).

If there was any material damage from the excessive growth of the two GSEs by securitizing specious mortgages, it was probably by deluding the marginal, recent subprime and alt-a home buyers. By securitizing those mortgages, the GSEs wrongly fostered a sense of real demand for questionable mortgages which probably would never have been made by private conduits, were the GSEs not already doing so with subsidies from their government funding.

Taxpayers are holding the bag for Congressional graft and corruption, but, in general, the average citizen isn't affected in her/his daily life.

What about the exit of Bear Stearns, Lehman, Merrill Lynch, AIG and, probably, Morgan Stanley?

Again, no consumers' bank accounts have been robbed. In the securities arena, the analogue of FDIC bank deposit insurance, known as SIPC, also insurers a like value of brokerage account values.

The three investment banks don't deal with retail customers in much of their business activity. Lehman and Merrill had retail brokerage operations, but, again, no consumers have actually lost money in those accounts.

That's not to say that consumers with money in funds managed by other institutional managers didn't unwisely buy debt or equity of any of these firms, only to see those values crater. But that is a risk every investor takes by choosing to withdraw money from a bank and place it in any uninsured investment vehicle, such as a money market, equity or bond fund.

So, too, have many pension funds which invested with professional money managers lost value because of the stupidity of those managers. But, again, these are risks taken in pursuit of higher returns. Nobody put a gun to the heads of various pension and other fund directors to place money in riskier investment vehicles which, ultimately, have performed poorly.

AIG was perhaps the only company whose demise could have affected the daily lives of US consumers. If insurance policies were not honored, and mutual funds suddenly frozen, that would cause panic and havoc. So, not having the time to organize an orderly separation of those businesses from the riskier, rotten operations that tanked AIG, due to the company's management's own decision to roll the dice on their continued existence throughout this past summer, Paulson's Treasury felt it necessary to seize the firm, rather than lend to or save it.

Again, no citizens have been negatively affected in terms of their assets.

What has occurred is that a lot of financial service sector employees will be out of jobs. Like employees of poorly-run companies in America, eventually, business ebbs, employees are released, and the business dies.

When they are large, old, visible businesses, like Bear Stearns, Lehman, Merrill and AIG, and it happens rapidly, people notice. But it's just a telescoping of normal business cycle events.

So, to my way of thinking, what has occurred thus far in no way constitutes a 'crisis,' a 'broken economy,' or the 'worst economic crisis since the Great Depression.'

More apt comparisons, as my business partner and I recalled over lunch yesterday, are:

-Long Term Capital Management's demise in 1998
-The crash of 1987
-The collapse of the famed 'Go Go' era of mutual funds and the "Nifty Fifty" equities in the 1960s
-The end of fixed foreign exchange prices under Nixon, also known as the end of "Bretton Woods."

All of these were financial-sector sourced phenomena, some of which had ripple effects throughout the real economy. Particularly the last two.

If you really want a comparison with prior real economy crisis, how about these two?

-The closing of the gold window by Nixon after Johnson's inflationary attempts to fund the Vietnam War

-Stagflation under Nixon and Carter resulting, 6 years later, from Johnson's 10% income tax surtax and deficit creation to fund the war.

What we are witnessing now is just the result of too much investment banking capacity having expanded into too many risky businesses, such as securitizing marginally-worthy mortgages. Because securitization results in instruments which, unlike bank loans, must be marked to market, any institution holding them must immediately record capital losses when the trading markets for them disappear or collapse.

If this has been only limited to a few mortgage banks, then the damage might have been lessened. But, thanks to Bob Rubin's and Bill Clinton's tacit removal of the firewall between commercial and investment banking, and insurance, with their explicit approval of Sandy Weill's merger of Citibank with Travelers Insurance (which also owned an investment banking operation), commercial banks and insurance companies co-mingled their normal businesses with these securities underwriting businesses, and related swaps trading.

So, in truth, much of the damage wrought in these past few weeks and months is directly traceable to Federal government lapses. The removal of Glass-Steagall, and the feeding and growth of Fannie Mae and Freddie Mac were direct causes of all of this mess.

Despite what John McCain, Barack Obama, the business media and others will tell you, 'greed' is not the cause.

You can, and should, count on 'opportunism' in the financial services sector, which some call 'greed,' to always exist. We want it to exist.

You will never stop or remove opportunism from the American economy. You won't remove stupidity, either.

Make no mistake, the managements of Bear Stearns, Lehman, Morgan Stanley, AIG, Citigroup and Merrill Lynch all behaved stupidly. So did buyers of their debt and equity. All those who behaved stupidly are now being scorched.

This, too, is not a crisis. It's the market's way of disciplining those who forget that excess returns typically have excess risk.

But all of this is normal in the course of corrections in financial services. Risks are taken, risk is priced too high, then too low, and, eventually, some get burned by attempting to enjoy excess returns without excess risk, for too long.

But our commercial banks still operate. Citizens' deposits are safe. Appropriately-lent mortgages still perform. The financial component of most Americans' lives remain untouched by this past month's events, unlike the fallout of market turmoil which began the Great Depression.

It's a totally different financial services sector today. For the most part, those who were injured were sophisticated investors or vendors who knew, or should have known, the risks they took.


Anonymous said...

Let's not pretend that FNMA and FHLMC only gave to Democrats (as you have implied). Their largesse was bipartisan.

C Neul said...


You evidently did not carefully read my prose.

I stated, truthfully, that Dodd, Frank and Obama are among the largest recipients of Fannie contributions. I don't recall Frank's place in the House, tho I have no doubt it's very high on that list.

In the Senate, Doddering Chris Dodd is numero uno in Fannie cash/graft. The Illinois rookie is.... #2.

It's a fact. I never said GOP legislators did not also take contributions.

But by far the most corrupt have been Democratic legislators.