Why investor confidence plunged
Economists and journalists and business professors have struggled to explain the rush of Wall Street firms in the years 2004–06 into creating securities backed by mortgages to marginal borrowers, now seen as the genesis of a global financial panic and possibly a second “Great Depression.” Yet so many stipulations of the standard view are questionable, if not mythical, that the mystery of why we are suffering globally will not be solved by figuring whom to blame for subprime mortgage lending.
For instance, it isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. aig, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.
So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.
Nor is it true that Wall Street executives and ceos had insufficient “skin in the game,” so that “perverse” compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizeable bonuses in the years in which the securities were created and sold. But most also had considerable wealth in the form of stock and stock options in their firms, which bet their own capital on these securities. Many also appear to have invested directly in funds to hold the subprime securities.
They had skin in the game. Personal losses to top executives in banks that failed or whose share prices collapsed were in the millions, hundreds of millions, and in some cases billions of dollars.
Richard Fuld, of failed Lehman Brothers, saw his net worth reduced by at least a hundred million dollars. James Cayne of Bear Stearns was reported to have lost nearly a billion dollars in a matter of a few months. aig’s Hank Greenberg, who remained a giant shareholder despite being removed from the firm he built by New York Attorney General Eliot Spitzer in 2005, lost perhaps $2 billion. Thousands of lower-downs at these firms, those who worked in the mortgage securities departments and those who didn’t, also saw much wealth devastated by the subprime debacle and its aftermath.
It isn’t true, either, that Wall Street manufactured these securities as a purblind bet that home prices only go up. The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred.
The designers of these securities, moreover, knew exactly where a disproportionate share of the underlying mortgages were coming from: a handful of counties in southern California, Arizona, and the environs of Las Vegas as well as Florida, where home prices had been rising vertiginously. Far from swallowing the supposed inviolability of the housing-only-goes-up rule, middle-aged mortgage securitization bankers knew that house prices can correct sharply, having lived through regional housing busts in the southwest in the late 1980s, and in New England and California in the early 1990s. Anyone who works in the business knows that the experience of the past half century has been increasing volatility in home prices and a steady rise in the foreclosure rate — a nine-fold increase that began in the 1960s and accelerated in the prosperous 1980s and 1990s.
Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitive of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it. As noted, they willingly bet their firm’s money on it, and their own personal money on it, in addition to selling it to outsiders.
Ah, you say, but their risk models and assumptions never allowed for a national drop in home prices. Yes, for good reason — there’s no such thing as a national market for houses. Even well into the subprime implosion, as recently as the middle of 2008, the Federal Housing Finance Agency’s House Price Index was continuing to report stable or rising prices in about half of the 292 metropolitan areas it tracks. Half a million new houses are still going up a year — because people want houses where they want houses.
But, you say, didn’t a handful of shrewd hedge fund managers detect a bubble and clean up from betting against it? Yes, fund managers like John Paulson and Kyle Bass made huge fortunes betting against subprime. This doesn’t prove that all the signs were there to be read and so others must have behaved irresponsibly. Think about this: Somebody is always short something, just as others are long the same thing. For every buyer, there is a seller. But those who bet successfully against subprime did so through elaborate, expensive, negotiated deals to purchase credit default swaps or buy “put contracts” on subprime indexes. Had they really seen what was coming, they would saved themselves a great deal of expense and bother by simply shorting Citigroup, Bank of America, Lehman, Bear Stearns, etc. Their profits would have been huger, their workload and hassle factor much less. The reason they didn’t, it’s reasonable to suppose, is because no more than anyone else did they foresee the catastrophic consequences we now suppose were destined to flow from excessive issuance of subprime mortgages.
Risk is risk — it wouldn’t be risk-taking if things couldn’t go wrong, even disastrously wrong. Market efficiency is not market clairvoyance, or market omniscience. Investors and firms do not always have instantaneous or, even in this electronic age, timely information about what other investors and firms are doing. Notice that the “bubble” in subprime lending emerged and burst in a surprisingly short period of time — a number of months in 2005 and 2006. In the dotcom era, dropping a bundle on a new fiber network as the internet was taking off was not necessarily a bad idea. The decision by other people to do the same is what made it a bad idea. That’s what happened in housing too — helped by cheap money from the Federal Reserve and a credit-manufacturing process that gave too many homebuyers a one-way bet on home prices.
The resulting losses are large — estimated at $435 billion by mid-2008 — though not large in relation to the $167 trillion (to use a McKinsey estimate) global capital market that would have to swallow them. Wall Street perfidy there may have been (there usually is) but it hardly justified or caused a worldwide financial panic. Left unexplained is how, really, a housing boom mostly concentrated in a single, nearly contiguous blob reaching from Sacramento to the environs of Las Vegas and Phoenix was transmuted into a global financial disaster.
There may not be a national housing market, and certainly there isn’t a global one. But there is a national economy, as well as a global economy, and policy structure and political culture, and a media that communicates information and analysis and fears and expectations instantly and globally. Impossible to separate, then, are the precipitous drop of confidence in asset values and a precipitous drop in confidence in government policy, on which asset values necessarily in part depend.
Most of America wasn’t in a housing bubble — yet when confidence crumbled, when borrowers and lenders began retreating willy-nilly from risk, when financing for car sales dried up, when businesses stopped hiring and began laying off, foreclosures everywhere were destined to rise, even in communities where home prices had not grown unreasonably. When one bank is seen to be in trouble, suddenly all banks are in trouble — if depositors and creditors lose confidence in government’s willingness and ability to intervene effectively.
The moment the media and politicians began touting the risk of a “Second Great Depression,” firms and investors around the world began treating it as a real risk. Firms and investors, for the most part, are sophisticated enough to recall that the Great Depression of the 1930s was first and foremost a product of disastrous policy choices made by governments amid what might otherwise have been a normal correction in boomtime asset prices. Indeed, when government begins to aim Herculean measures at the economy, even if those measures are well meant and well designed, it behooves all decision-makers to become cautious. Businesses and consumers of necessity pull back and take stock of the strong possibility of sweeping changes in what had previously seemed reasonable expectations about the future.
None of this is meant, by the way, to exculpate Fannie Mae and Freddie Mac; their enablers in Congress; or the Federal Reserve, which fearing one disaster after the dotcom bubble inadvertently fed another in the housing market. But such errors are routine. They certainly played a role in creating the subprime bubble, but that’s not why we have a global crisis of confidence in asset value. For most of the 80s, after all, the financial world watched Washington mishandle the thrift crisis without melting down. In the 1990s, it watched the 1996 telecom law’s role in attracting hundreds of billions in wasted investment into the telecom business, as regulators tried to conjure a simulacrum of “competition” out of authorizing politically-connected start-ups to leech off the infrastructure of the existing local Bell monopolists. Firms and investors have thick hides for governmentally-induced uncertainty — most of the time.
John Taylor, a Stanford and Hoover Institution economist, has emerged as one of the analytical poles in the post-crisis diagnostic debate. He focuses on the Federal Reserve as the initial cause of the housing bubble, for keeping interest rates low and policy loose too long after the 2001 recession. If the Fed had behaved differently, everything else might have been different. But the Fed’s leaders had good, conscientious reasons for the decisions, and errors, they made. In any case, there is little hope they won’t make errors in the future.
What is most striking about Taylor’s analysis, though, is the extent to which he shows that investors in the global panic were responding not to the exposure of subprime losses, or even the failure of Lehman Brothers, but to what we might call a sudden, sharp explosion of uncertainty about what government might do and what principles or expectations might guide its actions amid the crisis.
Lately a debate has raged over whether Wall Street or Washington is more to blame. But for certain analytical purposes, Wall Street and Washington are not two things but one. The decision to pour much of the nation’s risk capital into housing in the mid-2000s was certainly a joint production. But — at least since banker J.P. Morgan personally intervened in the 1907 Panic — only one party is responsible for systemic confidence anymore. That’s government. When systemic trust falters, all eyes turn in a single direction. Government necessarily becomes the only truly relevant actor, with all the perils and politicization that that portends.
“The only thing we have to fear is fear itself,” fdr said, naming the systemic trust challenge when he took power in the third year of the Depression. He perhaps should have stopped there. He went on to specify a “nameless, unreasoning, unjustified terror,” but fear is anything but “unreasoning” or “unjustified” in certain circumstances. It is a very reasoning and justified fear that money in the banks may not be safe; that when businesses with solid assets cannot raise cash to meet their obligations, they may become insolvent and lose their assets to their creditors. A loss of trust can bring a whole economy to the brink of collapse in a matter of weeks.
So — blame government, however unsatisfying and unjust that may seem, for allowing the subprime snafu to become a global panic. Government was the only party in a position to protect systemic confidence, but instead sent mixed signals — saving Bear Stearns, telling the world that there would be no disorderly failures of important financial institutions through bankruptcy; then letting Lehman fail through bankruptcy. It stepped up to save aig and pumped in improbable amounts of taxpayer cash — when it might just have nationalized the firm, declaring its debts sovereign debts, which would have stopped the collateral calls related to its subprime guarantees. How many more times could government possibly repeat the aig fiasco if other large firms needed rescuing? It was a rescue, but a far from credible one.
It didn’t help that the crisis came in the middle of a presidential election, creating even more uncertainty about the future of policy. So the sinews of trust unraveled with unholy speed. In the collapse of willingness of banks to finance international trade, the world witnessed a plummeting of industrial production far steeper than seen even in early 1930s. In Germany, Japan, Taiwan, and China, manufacturing fell by double digits in the last half of 2008. In America, auto production has all but stopped.
Yet at this writing, the major confidence panic does seem to have been overcome by the actions of the Federal Reserve and U.S. Treasury. This has been done, bluntly, through the government putting its ability to print money behind the banking system’s liabilities. Obligations will be honored by the financial firms that hold America’s liquid assets. Deposits will be protected. Dollars held by financial institutions in the names of their clients will be dollars those clients will have access to — though what those dollars will be worth in the future is a sore question. In essence, we’ve traded the threat of system-wide default for the threat of inflation. Most would say, under the circumstance, it was a good trade.
The Fed as savior
Another notable scholar of the debacle, Richard Posner, the federal appeals judge and University of Chicago polymath, puts his finger on the question that should preoccupy us in the aftermath. Blaming bankers and homebuyers for taking unwise risks won’t get us very far — risk-taking is expected behavior and, on the whole, a service to society. Getting rid of Fannie and Freddie and reducing the artificial stimulus to housing investment in the tax code certainly wouldn’t hurt, but these steps hardly mean dangerous panics won’t crop up in the future. The Federal Reserve should be encouraged to avoid monetary errors in the future — though serious monetary errors will continue to occur on an irregular schedule.
By definition, the failure that ignites a global panic comes unexpectedly — whatever we may tell ourselves after the fact. Judge Posner’s question is, How should we respond next time? One lesson, discomfiting to those who worry about “moral hazard,” or the quite reasonable fear bailouts today merely beget excessive risk-taking tomorrow, appears to be that confidence in a crisis is indivisible. If the goal is to show government can prevent systemically important firms from failing, it has to prevent them from failing. Trying to treat moral hazard at the same time as confidence is self-defeating. It confuses the message and invites disaster.
Equally discomfiting to admirers of democratic accountability, another lesson is that regulators need the tools and will to act — they can’t be running to Congress and the political process to decide what to do. The Bush administration unwisely did the latter when it suddenly sought $700 billion in funding from Congress in the wake of the Lehman debacle. Politicizing the bailout opened a can of worms. Onlookers knew it. Ask the hospitality industry or the corporate jet industry what congressional warfare on “banker’s perks” did to their business. Or what Congress’s showy war on bonuses, golden parachutes, and other emblems of “excessive compensation” did to banks struggling to hold to necessary staff. The bluff and hardy American consumer may not have been frightened by all the “crisis” talk on Capitol Hill — but he or she recognized that involving Capitol Hill meant the country’s politics were likely to become dangerously consumed in “bailout” recriminations for months and years to come.
At some reptilian level, official Washington understands all this. Up has gone a cry in the aftermath for some kind of “systemic regulator” to prevent a reoccurrence and spare the political class from having to vote for bailouts in the future — though, in an evasion of reality, this über-regulator is supposed to spot bubbles and unwise risk-taking before they blow up, sounding a whistle just when investors are at the most enthusiastic lest investors inflict more losses on themselves than Congress will decide in retrospect should have been permitted.
In reality, we already have a systemic regulator — the Federal Reserve, whose traditional mission, in the colloquial description, is to “take away the punch bowl just when the party is getting started.” The Fed has been imperfect in this task in the past and will be so in the future.
What Congress doesn’t want to admit is that it wants not a systemic regulator, but a systemic savior — an institution that can step forward and stop panic in its tracks. But we have one of those too — the Fed again. For all the arguments heard on Capitol Hill last fall that only a $700 billion appropriation stood between us and financial Armageddon, that $700 billion sum has proved a pittance compared to the resources the Fed, under Ben Bernanke, has deployed out of its hip pocket. The Fed has bought unwanted assets and issued guarantees to the tune of more than $1 trillion. It has created untold billions in excess bank liquidity through monetary policy. If we’re honest, the Fed’s ability to print money stands behind the fdic, which insures the nation’s bank deposits. It stands behind Fannie and Freddie, which are increasingly in the business of losing money on purpose to help the housing market. Even the U.S. Treasury has been edging sideways toward relying on the Federal Reserve to finance the exploding national debt.
We have a systemic savior — the Federal Reserve. And all that remains to be seen is how much its efforts this time will ultimately cost in the erosion of the purchasing power of the U.S. dollar.
The other cost, inevitably, will be in the loss of efficiency from greater government involvement in the economy, nominally necessitated by the lessons of the debacle and actually necessitated by political opportunism. The future of Wall Street, much debated, some in Congress wish to be settled in a replay of the so-called Pecora hearings of 1932, so-named for Ferdinand Pecora, an assistant district attorney for New York County, who was assigned by Congress to get to the bottom of Wall Street skullduggery that preceded the 1929 crash and, in the popular mind, created the Great Depression.
Pecora gave rise to a hulking new regulatory apparatus, including the Securities and Exchange Act, the Glass Steagall Act, and (fitting the temper of the fdr administration at the time) other restrictions mainly aimed at turning the banking system into a cartel at the expense of its customers. Paul Krugman and others call for a return to this “boring” banking of the 1950s, which means restricting what kinds of loans and investments banks can make, and restricting competition between banks and other financial firms for depositors funds. In the 1950s, for instance, it was against the law to pay interest on checking accounts.
Krugman will be disappointed. Competition for investor funds is out of the bag and global — from checkable mutual fund accounts to exchange traded funds. And Congress’s reregulatory urge already is headed in a different direction, in favor of gestures of consumer protection, such as restricting credit card interest rates and making it easier for homeowners to renege on their mortgages. Whatever its merits, this is the opposite of the “boring bank” formula — which essentially tried to secure the banking system by limiting competition and making it easier for banks to gouge their customers. Rather, the agenda now taking shape is one in which the government plays a bigger role in deciding who gets a loan and on what terms, with politics, not profit, being the uppermost consideration.
From the other end of the political spectrum, conservatives crave a cure for “too big to fail.” They will be disappointed too. Big government and big financial firms just go together — especially in a crisis. No matter how unwieldy and accident-prone Citigroup might be, Washington was only too glad to make it even bigger by having it absorb the struggling Wachovia — until officials decided to merge Wachovia with another giant, Wells Fargo, instead. The behemoth JPMorgan wasn’t asked to get smaller — it was asked to get bigger, taking over Bear Stearns and Washington Mutual. As for Bank of America, the Fed and the Treasury practically put a gun to its head to make it absorb Merrill Lynch. Previously, BofA had delighted the political class by taking over giant (and sagging) mortgage lender Countrywide Financial.
True, these initiatives in the direction of even greater bigness took place under the Bush administration. Yet Team Obama finds bigness also convenient, using its regulatory sway and direct investment stakes in the biggest banks (acquired through the misnamed Troubled Asset Relief Program), for instance, not to slim them down, but to make them instruments of government policy. Case in point: In an act of surpassing corporatism, Chrysler’s secured lenders, including Citigroup, Goldman Sachs, JPMorgan Chase, and Morgan Stanley, were pressured to relinquish their claims to aid the administration’s efforts to rehabilitate the carmaker for the benefit of its unionized workforce, led by the United Auto Workers, which invested $ 55 million in electing Democrats in the last election cycle.
Banks “too big to fail” are big enough to be useful to politicians. Even in their present straitened circumstances, the country’s biggest banks have increasingly become a soft touch for struggling businesses that can get the political class’s attention — Republic Windows and Doors, a Chicago firm whose employees took to the streets when BofA threatened to call a loan, is the prototypical case. As time goes on, we can expect more of this. The “stress tests” imposed on the 19 biggest banks, if you listened closely, were not aimed at curbing risk-taking. Team Obama sees the biggest banks as the primary source of capital in the future to make the economy grow. The administration wants the banks to lend, lend, lend — hence Treasury Secretary Tim Geithner’s demand that, with public money or private, banks beef up their capital so they can support more credit creation.
All this is sounding a bit Japanese — though not in the way meant by those who (like Krugman again) see Washington’s failure to get tough enough with the banks leading to a replay of Japan’s “lost decade” following its own property bubble of the 1980s. The problem in Japan was a political consensus to prop up the banks as a way to prop up their borrowers — to keep “zombie” manufacturers and real estate developers and department stores afloat. Japan’s entrepreneurs and healthy firms, waiting for a shakeout that never came, held back their own efforts and investment. The economy stagnated for a decade. Mercifully, with the exception of a few Washington-directed cases like the auto sector, U.S. banks act aggressively with deadbeat borrowers. Markets are allowed to clear. One Texas bank recently even foreclosed on a California real estate developer and, coldly calculating the cost to complete and maintain several dozen nearly finished McMansions, instead sent in the bulldozers.
No, if America suffers its own “lost decade,” it won’t be for the reason Japan did. It won’t be because of zombie banks. It will be because of government’s insistence on taking over the direction of capital to new investment purposes. Already mortgage lending and student loans are 100 percent government-owned industries in the wake of last year’s credit crunch. President Obama has let it be known that the proper use of America’s financial capital is to develop “green” energy. He intends to use government to lean heavily on the private sector through tax incentives, loan guarantees, and direct lending to make sure that happens. Entrepreneurs and disruptive innovators will be crowded out in favor of a centralized financial system, more Japan-like, focused on handful of giants banks serving as government’s assistants.
Not his finest moment, Alan Greenspan appeared before Congress last year and uttered comments widely seen as heralding the end of trust in unfettered capitalism. He seemed to admit to disillusionment with “the market” because of the surprising and disappointing discovery that financial firms had taken risks that caused some to fail.
As Judge Posner points out, to be in business, by definition, is to court failure. A firm so fearful of risk that it won’t chance failure is quickly buried by competitors who will. Such firms will refrain from pursuing novel projects or technologies or market opportunities and dooms itself to be left behind by an advancing economy.
The danger, with Washington playing a bigger role in allocating capital in the economy, is not too much failure, but not enough.
Predictably, the next crisis will be our Japanese “lost decade” crisis — when, for instance, the political class must vindicate at all cost its investment in gm and Chrysler, even if it means using import tariffs and mandatory unionization and environmental mandates to disadvantage their foreign-owned competitors. It has already begun: With its tough new fuel mileage mandates, Congress also authorized $25 billion in energy department loans to help automakers develop the required “green” cars — while drafting the rules to make sure only Ford, General Motors, and Chrysler would be eligible. Regardless of profit, Obama wants to march Americans into the cars not of their choice — small electric cars, along with the close-to-home lifestyles that go with them. An industry dependent on government to force people to buy its products is not an industry dynamically driven by changing opportunities in the marketplace and in the public’s desires and aspirations.
In the 1980s, America flirted with industrial policy and protectionism to meet what was regarded as a Japanese economic threat. But our entrepreneurial bias prevailed in the end: While the Japanese bureaucracy was directing that country’s technology giants to dominate the manufacture of computer memory chips, perceived as the “strategic” resource of the 21st century, Silicon Valley was mostly left to its own chaotic, mercurial devices — and ended up focusing on microprocessors, software, multimedia, and networking. Given birth were the personal computer industry and, in due course, the internet. Try to imagine Microsoft or Google springing from the plan of a bureaucrat at Japan’s Ministry of International Trade and Industry.
That’s a nonmistake we apparently won’t make again. With its vast ambitions across broad swaths of the economy — from health care to energy to education — look for endless acts of industrial favoritism from Obamanomics. President Obama, with his confident judgment that the future is “green” energy, that government can deliver “affordable” health care, that everyone can and should go to college, has all the hubris of a miti bureaucrat of the mid-1980s and little apparent appreciation that America’s strength is the decentralized economic agenda thrown up by entrepreneurs and inventors and opportunists whose every impulse Washington doesn’t try to corral and control with mandates and incentives.
In sum, the global financial panic sparked by the behavior of subprime mortgage loans is probably best understood as an unforecastable accident of history. Another accident, brought on by the first, is the empowering of the Obama agenda, born in the inexperienced mind of a Chicago academic and state legislator. It is likely to end badly, as such dirigiste overreaching always does.
Holman W. Jenkins Jr. is a columnist and editorial board member for the Wall Street Journal.