Market Meltdown

October 14, 2008

United States experiences biggest financial crisis since Great Depression.

Investor Warren Buffett warned shareholders in February 2008 about the folly of gambling on the housing bubble with one of his best-known phrases: “You only learn who has been swimming naked when the tide goes out.”

As Americans have learned to their sorrow, that tide going out was in fact the water receding ahead of the financial tsunami that now threatens the vitality of the U.S. economy. And the naked bodies on the beach–hapless home buyers and the firms who sold them unaffordable mortgages on the assumption that property values would continue their meteoric rise–were just the first victims of the collapse of the subprime mortgage market, not its last.

By late September, members of Congress who had expected to be in their home districts campaigning for the November 4 elections were instead in Washington listening to Treasury secretary Henry M. Paulson Jr. and Federal Reserve chairman Ben S. Bernanke warn that a failure of the financial markets could paralyze Wall Street and trigger a global credit freeze. What seemed just a few months earlier to have been a troublesome slide in housing prices had somehow ballooned into what many economists described as the greatest financial crisis since the 1930s.

Daunting derivatives

It didn’t help that no one could explain what was happening in plain English. Worried Americans, peering through the dense fog of phraseology surrounding mortgage-backed securities–collateralized debt obligations, credit default swaps, mezzanine tranches–were understandably confused, but so were many members of the investment community. In the spring 2008 edition of the Hoover Digest, Senior Fellow Michael J. Boskin wrote about the way in which subprime mortgages were sold, with tiny down payments and no income verification, but marketed as relatively safe investments: “Top executives at leading banks said they had not even heard of some of these complex structures before off-balance-sheet loans went bad.” Although mortgage holders who had bought houses they couldn’t afford were blamed for their naivete, Senior Fellow Gary S. Becker pointed out last summer that “the crisis has also financially ruined many highly educated and sophisticated bankers, hedge fund managers, and others with years of experience in complicated financial assets.”

In late September, Victor Davis Hanson spread the blame to those Americans who thought the housing bubble would never burst: “Let me explain,” wrote the Martin and Illie Anderson Senior Fellow, “The profiteering was not just the result of a few thousand scoundrels on Wall Street or in Washington, as greedy and as bonus-hungry as many of them no doubt were. Look at the housing market as a sort of musical chairs in which everyone profited as long [as] he grabbed a seat when the music stopped. Then those left standing–with high-priced loans and negative equity when the crash came–defaulted and stuck taxpayers with debt in the billions of dollars. But until then, most owners who had sold homes cashed out beyond their wildest dreams.”

With 20/20 hindsight, columnists, editorial writers and bloggers uniformly condemned Wall Street’s complex and fragile house of cards, based on billions of dollars worth of mortgages that had been bundled, sliced and diced in so many ways that no one knew what their true value was. But the house’s shaky foundation was all too real: huge losses on loans taken out by real Americans to buy their homes.

Risky business

As the first noticeable cracks in this foundation appeared–the implosion of Countrywide Financial and other mortgage lenders, plus major bank failures from IndyMac to Bear Stearns–economists debated the “moral hazard” of a government bailout. Would helping the financiers who caused the crisis set a bad precedent: the government using taxpayers’ money to help guilty parties avoid the consequences of their unwise decisions? Senior Fellow Niall Ferguson, comparing financial evolution to biological evolution in the spring of 2008, wrote: “An old question that has raised its head once again in recent months is how far implicit guarantees to bail out banks create a problem of ‘moral hazard,’ encouraging excessive risk taking on the assumption that the state will intervene if an institution is considered too big to fail (meaning too politically sensitive or too likely to bring a lot of other companies down with it). From an evolutionary perspective, however, the problem looks slightly different. It is, in fact, undesirable to have any institutions in the category of ‘too big to fail’ because, without occasional bouts of what Harvard economist Joseph Schumpeter termed creative destruction, the evolutionary process will be thwarted. Japan’s experience in the 1990s stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite underperformance.”

But during the summer, Becker concluded that some sort of action was necessary: “Despite the moral hazard risks, interventionist policies might be justified—not because some borrowers or lenders were taken advantage of but to help the economy recover more quickly and ensure that the recession is neither prolonged nor deep.”

Difficult decisions

By autumn, investors, elected officials, and ordinary Americans were reeling in the face of the government takeover of mortgage giants Fannie Mae and Freddie Mac; the bankruptcy of Lehman Brothers; the $85 billion emergency loan to American International Group, the world’s largest insurer; and more bank failures, including Washington Mutual. Paulson called for a $700 billion program in which the federal government would buy up the toxic mortgages, a rescue plan breathtaking in its size, its risks, its uncertainty–and its potential to alter forever the nation’s economic landscape. When even that wasn’t enough to thaw credit markets, the Fed offered to buy the short-term loans known as commercial paper and then joined with five other central banks, including China’s, to cut interest rates. The Treasury Department floated a proposal to pour funds directly into bank vaults, with the government assuming an ownership stake. And after all this, the consensus of economists was that if a recession hasn’t already arrived, it’s certain to be here soon.

Months or years will go by before Americans can gauge whether any of these actions achieved their stated goal of stabilizing the economy and thawing the credit pipeline. Even if they succeed, the next president and his financial team will need to spend much of their time restoring the careful balancing act between free-market capitalism and responsible regulation on which the U.S. economy depends.