December, 2008 | vol. v, no. 11

QUOTE OF THE MONTH: “One of the things you will find -- which is interesting and people don’t think of it enough -- with most businesses and with most individuals, is life tends to snap you at your weakest link. The two biggest weak links in my experience: I’ve seen more people fail because of liquor and leverage -- leverage being borrowed money.”

Warren Buffet
“Warren Buffett and the Interpretation of Financial Statements”
By Mary Buffett & David Clark

SENSE AND NONSENSE -- THE ECONOMIC MESS

From the editor: First, a disclaimer -- I am not an economist and I do not claim to be even though I am relatively proud that my given name (John Maynard) is the same as my favorite economist (John Maynard Keynes). The following analysis is undoubtedly an oversimplification of the problem, but hopefully it makes a very complicated subject more understandable. To make it understandable, I use two analytical devices: 1) the “rule of three,” (My brain cannot handle more than three of anything at any one time.) and 2) examples to illustrate each of the three causes of the crisis.

The three causes of this financial crisis are: 1) Deregulation and no regulation; 2) Unprecedented speculation; and 3) Supply-side economic theory (variously described as “trickle down,” “voodoo,” and “top-down” economics.

Deregulation and No Regulation

In 2004, the Securities and Exchange Commission (SEC) allowed five Wall Street firms -- Lehman Brothers, Bear Stearns, Merrill Lynch, Morgan Stanley, and Goldman Sachs to change its debt-to-net capital ratio from 12-1 to 40-1. This rule change was a government sponsored green light that allowed the five largest investment firms on Wall Street to invest heavily in risky mortgage-backed securities that had no guarantee the mortgage recipients could repay the loans they received. Under the 2004 rules, these firms could accumulate debt at a rate of 40 times the amount of capital needed to support the level of risk. The rule literally encouraged these firms to become high stakes gamblers with investor dollars and ultimately taxpayer dollars.

Example: The New York Times reported on Sept. 25, 2008 the following: “Consider the Bear Stearns Alt-A Trust 2006-7, a $1.3 billion drop in the sea of risky loans. Here’s how it worked: As the credit bubble grew in 2006, Bear Stearns, then one of the leading mortgage traders on Wall Street, bought 2,871 mortgages from lenders like the Countrywide Financial Corporation. The mortgages, with an average size of about $450,000 were all Alt-A loans -- the kind often referred to as liar loans, because lenders made them without the usual documentation to verify borrowers’ incomes or savings. Nearly 60 percent of the loans were made in California, Florida and Arizona, where home prices rose -- and subsequently fell -- faster than almost anywhere else in the country.”

“Bear Stearns bundled the loans into 37 different kinds of bonds, ranked by varying levels of risk, for sale to investment banks, hedge funds and insurance companies.”

“…it’s a toxic portfolio. Of 2,093 loans that remain (after 778 of the loans were paid off or moved through foreclosure), 23 percent are delinquent or in foreclosure, according to Bloomberg News data.”

“Wall Street took bonds like those of Bear Stearns and bundled and re-bundled them into even trickier investments known as collateralized debt obligations, or C.D.O.’s.

Bear Stearns proved to be an early warning mechanism that went unheeded until the system-wide credit failure in Sept., 2008. Bear Stearns collapsed in March, 2008.The federal government found it necessary to engineer a takeover of Bear Stearns by JP Morgan Chase for $10 a share. The cost of this bailout to taxpayers was $30 billion.

Unprecedented Speculation

The poster child for speculation feeding the financial meltdown is an enigmatic form of insurance called Credit Default Swaps (CDSs). It is difficult to even define the term, much less understand how they work. Simply put, a CDS is an insurance policy issued on very risky loans. If the risky loans default, the entities who bought the insurance file a claim with the firm that issued the Credit Default Swap. As long as residential and commercial real estate prices spiraled upward, insurance companies such as the American International Group (AIG), a London-office of which was described in last month’s Compass, prospered handsomely through fees, premiums, and insurance floats. “Floats” are simply premiums that can be invested to create more money for the insurance company.

Example: Chickens do come home to roost. As loans began to default, the financial institutions filed so many claims, AIG, the world’s largest insurance company, did not have the cash to pay the claims. So by Sept. 16, 2008, the U.S. Treasury and the Federal Reserve decided that AIG was “too big to fail,” and issued $85 billion to save the company. Ultimately the government bailout of AIG totaled $150 billion.

The CDS market exploded since 2000 to more than $45 trillion by mid-2007, according to the International Swaps and Derivatives Association. According to Time Magazine, this is roughly twice the size of the U.S. stock market at $20 trillion and far exceeds the $7.1 trillion mortgage market and $4.4 trillion treasury bill market.

Top-down Economic Theory

In unusually candid testimony before the House Committee on Oversight and Government Reform, former Federal Reserve Chairman Alan Greenspan said, “Those of us who have looked to the self-interest of lending institutions to protect shareholder equity, myself especially, are in a state of shocked disbelief.” Greenspan was expressing his disbelief that the fictional “free market,” he defended over his 20-year reign as Fed chairman, could collapse where “enlightened self-interest” would theoretically keep it from doing so. “Yes, I found a flaw,” he continued. “That is precisely the reason I was shocked, because I’d been going for 40 years or more with very considerable evidence that it was working well.”

Greenspan is one of many influential economists who sat at the knee of novelist and philosopher Ayn Rand, and internalized her political-economic theory expressed in her 1957 book entitled, “Atlas Shrugged.” Rand’s theory of “Objectivism,” basically calls for laissez-faire capitalism where government plays no role in financial markets.

Adam Smith, Ayn Rand, and University of Chicago economist Milton Friedman all argued for a financial market that regulates itself through “enlightened self-interest.” The influence of these three individuals provides the foundation and philosophical environment that allows “free marketers” to ignore and rationalize the “dark side” of human nature -- the chief characteristic of which is greed.

Supply-siders are simply saying, “Don’t regulate me while I acquire unlimited riches at the expense of the working class, the middle class, and fellow citizens who struggle to escape the energy-draining ravages of poverty. The disclosure of Bernard Madoff’s $50 billion Ponzi-scheme is the perfect example of the fatal flaw in supply-side and top-down economics. Theologians call it “Original Sin.” Keynesian economists call it “predictable.” Psychologists and sociologists call it “socio-pathic behavior.”

All of these descriptions are accurate. Supply-siders historically maintain that such behavior exists in the other guy -- the evil person, but not in myself -- the good and enlightened person. Financial markets are created, influenced, and driven by human behavior that requires regulation and oversight capable of controlling abuse of such markets. This is the criterium against which the Obama Administration will be judged. In the primary and general elections, he sounded like someone who will not ignore the “follies” of man. It remains to be seen whether he will ignore this part of human nature as he governs.

Example: On Friday, October 3, 2008, the U.S. House of Representatives passed legislation and President Bush signed the $700 billion bailout package known as the Troubled Asset Relief Program (TARP). The original intent of the bailout was to purchase bad mortgages from lenders so they could remove them from their balance sheets. However, within 10 days, the federal government led by Treasury Secretary Henry Paulson decided to give the first $125 billion of the bailout package directly to the nine largest banks in the country without giving any relief to individuals facing foreclosures on their homes. Another $125 billion went to targeted regional banks across the country. Paulson’s stated reason was to provide much-needed liquidity to the financial system.

Unbelievably, at least three of the CEOs of the nine banks who were called post haste into a Treasury Department conference room at 3 p.m. on Monday, October 13, did not need or want the money. Yet, they were pressured into signing the agreement to take the money by Paulson.

The chairman of Wells Fargo Bank, Richard M. Kovacevich, initially resisted taking the money. His bank was not in trouble precisely because his bank had not invested in toxic mortgages.. Kenneth D. Lewis, chairman of Bank of America, also objected saying his bank had just raised $10 billion on its own initiative, according to the New York Times. And John J. Mack said his bank, Morgan Stanley, did not need capital from the Treasury. It had just received a $9 billion infusion of cash from a large Japanese bank.

However, by 6:30 p.m., all nine bank executives had signed an agreement with the Treasury to take the bailout money. The nine banks receiving the money were Wells Fargo, Bank of America, Morgan Stanley, JP Morgan Chase who had purchased Bear Stearns earlier in the year, Goldman Sachs, Citigroup, Merrill Lynch, Washington Mutual and Wachovia. Three of these banks (Merrill Lynch, Washington Mutual, and Wachovia) have since been purchased by other members of the group.

Once again, “top-down” economics had prevailed and the needs of Main Street America had lost out to powerful Wall Street financial institutions. In addition to the cash injection, the agreement stipulated that the federal government would guarantee $1.5 trillion in new debt issued by banks and insure an additional $500 billion on noninterest-bearing deposits held by banks.

The total potential cost of this government largesse to banks is $2.25 trillion, triple the size of the original $700 billion bailout.

Incredibly, but not surprisingly, the agreement signed by the bankers contained no written requirements about how or when the banks must use the money. The New York Times quotes former federal comptroller general David M. Walker in its October 17, 2008 edition:

“This is the people’s money. They’re giving it out with no rules.”

Maynard Chapman, Editor
The Compass Newsletter

Copyright © 2008, The Compass Society