Financial Crisis 101

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Mark Alexander
From Patriot Post Vol. 08 No. 39; Published 26 September 2008 | Print Print Email Email PDF PDF

“For years I have been concerned about the regulatory structure that governs Fannie Mae and Freddie Mac … and the sheer magnitude of these companies and the role they play in the housing market. … If Congress does not act, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole.” —John McCain arguing for passage of the Federal Housing Enterprise Regulatory Reform Act (S. 190) in 2005.

While Sen. McCain is being pilloried by his opponent, Barack Hussein Obama, for asserting (correctly) last week that the fundamentals of most U.S. economic sectors are sound, clearly, Sen. McCain has understood for years that irresponsible lending practices for U.S. housing posed “enormous risk … to the housing market, the overall financial system, and the economy as a whole.”

Obama was out politicking, ostensibly itching for a debate that he’d been avoiding all summer, McCain suspended his campaign to work with Republicans in Congress, outlining conditions for an agreement that would both protect the American taxpayer and thwart a meltdown of the U.S. economy. So, “Country First” is not just a campaign slogan…

The enormous risk that Sen. McCain warned of in 2005 has now manifested as a financial crisis of staggering proportions.

That crisis can trace its roots to Bill Clinton’s signature on legislation making it easier for minority constituents with bad credit to obtain mortgages. In 1995, he had his Treasury Secretary, Robert Rubin, rewrite the lending rules for the Community Reinvestment Act, opening the flood gates of mortgage lending to unqualified borrowers.

This legislation, in effect, applied affirmative action to the lending industry, which is to say that the current crisis is NOT a “free market failure” but the result of socially engineered financial policy by the central government. The mortgage markets welcomed their new customers with open arms, fueling a real estate boom across the board.

These so-called “subprime mortgages,” which were offered at variable interest rates, were widely perceived as good investments. Investors used the high-risk instruments to secure assets in other markets fueling profits for investment banks and mortgage lenders. The subprime market thus expanded rapidly and the mortgage instruments were used by other firms as collateral for investments in stocks, commodities and the like.

Unfortunately, other than John McCain, few questioned the pell-mell regulatory system of oversight for these transactions until large cracks appeared in our economy’s foundation, the first being the collapse of Countrywide, the nation’s largest subprime lender. Then banks and mortgage lenders large and small began downsizing, dumping assets and closing their doors. Bear Stearns filed for bankruptcy. Fannie Mae and Freddie Mac, holders of trillions of dollars in mortgages, were bailed out with 200 billion taxpayer dollars. Lehman Brothers filed for bankruptcy, and insurance giant AIG was given an $85-billion taxpayer prop to keep it solvent.

As Congress debated whether to implement the Democrat-backed “bailout plan” or the Republican-backed “workout plan” on Thursday, 25 September, Washington Mutual Inc. was seized by the Federal Deposit Insurance Corporation (FDIC) after collapsing under the weight of reams of bad mortgages. (WaMu, listing $307 billion in assets, becomes the largest bank failure in U.S. history. The FDIC sold WaMu’s assets for $1.9 billion to JPMorgan Chase & Co., which bought Bear Stearns Cos. earlier this year.)

The serious economic calamity confronting our nation, and the world, is being labeled a “credit crisis.” But we are on the verge of a crisis of cascading confidence in the U.S. economy, which, in the absence of aggressive intervention which includes free market reforms, could result in a dramatic recession affecting every sector of the U.S. and, eventually, world economy.

The catastrophe looming just over the horizon is indeed that big, and we must all hope that the solution is big enough to interrupt the domino effect already underway. But the “quick action” called for by President George Bush will likely not be forthcoming as the Democrats will, undoubtedly, attempt to pad their gargantuan bailout package with billions of dollars in earmarks.

Of course, government solutions beg the question, “Is the people’s confidence in their government is sufficient to thwart cascading confidence in our economy?” In the inimitable words of Ronald Reagan, “Government is not the solution to our problem. Government is the problem.” Of course, the only institution big enough to address a problem of this magnitude is the one that created it — our central government.

Perception v. Reality

Essentially, perception defines value, and the shared confidence in our perception of the value of one major sector of our economy, the housing market, has eroded dramatically.

To understand the notion of perceived value, consider all that paper we call currency. If I walk into a store and pull out one of these pieces of paper with Ben Franklin’s picture handsomely printed upon it, the store proprietor will accept that paper in trade for some of his products or services because he believes it to have intrinsic value (which it once did, when it was backed by hard assets — gold and silver). But make no mistake: The value of that piece of paper is nothing more than it is perceived to be. Thus, if the proprietor’s confidence in that perception becomes diminished, he may begin to think such a piece of paper is worth only half its face value, or perhaps nothing at all.

And if my paper is perceived to have no value, I will not be able to do commerce in this or any other store.

For two decades, our confidence in the perceived value of pieces of paper called mortgages has been growing rapidly, and because the prevailing perception has been that a house will be worth more tomorrow than it is today, financial institutions have aggressively enabled buyers to assume mortgages to purchase houses. (Actually, mortgages are now traded electronically as binary data — value that!)

However, in the 18 months, confidence in the perceived value of real estate has far outpaced economic realities, and consequently, mortgage defaults have trended upward. That realization has resulted in what now has become a precipitous erosion of confidence in the value of real estate, and consequently, housing market values have collapsed in many areas of the country where they were unduly inflated.

While perception can be shaped and molded, reality is finite. The reality, in this case, is that a house and its outstanding mortgage are worth not a nickel more than a buyer is willing to and capable of paying for it.

Thus, the devaluation of mortgages has had an enormous financial impact on institutions that trade in “packaged mortgages,” and consequently, on other institutions that trade with them, and, well you get the picture. The dominos have begun to fall.

Moreover in an effort to keep their dominos standing, because of the potential that any new lending would result in additional foreclosure exposure if the housing market continues to decline, banks have restricted lending in order to preserve the capital necessary to cover the cost of a growing number of foreclosures. The constriction of the money supply extends far beyond the housing markets, as loans for business development and expansion are also drying up.

This combination of events creates the perfect economic storm, and the rain has begun.

Consequences of cascading confidence

Confidence in the perceived value of financial instruments, which are the foundation of our economy, is calculated minute by minute by indices such as Dow Jones, Standard and Poor’s, and other measures of financial markets. These measurements amount to investor confidence indices, polls of investor perception about the strength and stability of the economy. The stability and direction of these indices are a good indication of investor confidence.

If the indices indicate significant instability of investor confidence, that instability can cause the financial markets to collapse in a single day. (See: “Great Depression.”)

Here, it’s important to note that the vast majority of Americans are among the “investor class.” This isn’t just about “the rich.” Whether you trade millions of dollars in securities daily or like cream in your coffee, you are a shareholder in our economy, and have a stake in that place called “Wall Street.”

Thus, the plan proposed by President George W. Bush and Treasury Secretary Henry Paulson — waiting for majorities in Congress to determine the details — is an effort to stabilize investor confidence by authorizing up to $700 billion in guarantees for institutions holding mortgages at risk of default. In effect, this will relieve lenders of liability for those mortgages — which constitute about five percent of all mortgages.

Wednesday, 24 September, President Bush addressed the nation with a concise explanation of the current crisis:

“This is an extraordinary period for America’s economy. Over the past few weeks, many Americans have felt anxiety about their finances and their future. I understand their worry and their frustration. We’ve seen triple-digit swings in the stock market. Major financial institutions have teetered on the edge of collapse, and some have failed. As uncertainty has grown, many banks have restricted lending. Credit markets have frozen. And families and businesses have found it harder to borrow money. We’re in the midst of a serious financial crisis… So I’ve proposed that the federal government reduce the risk posed by these troubled assets, and supply urgently needed money so banks and other financial institutions can avoid collapse and resume lending. This rescue effort is not aimed at preserving any individual company or industry — it is aimed at preserving America’s overall economy. It will help American consumers and businesses get credit to meet their daily needs and create jobs. And it will help send a signal to markets around the world that America’s financial system is back on track.”

What about a free-market solution?

We should all hope that Republicans can succeed in crafting legislation that is more workout than bailout, the former requiring implementation of market solutions and accountability, as proposed by Sen. McCain and former House Speaker Newt Gingrich. If not, the cure may be worse than the disease. After all, it was the suspension of free-market principles that got us into this mess.

But I agree with President Bush’s comments regarding the necessity of intervention: “I’m a strong believer in free enterprise. So my natural instinct is to oppose government intervention. I believe companies that make bad decisions should be allowed to go out of business. Under normal circumstances, I would have followed this course. But these are not normal circumstances. The market is not functioning properly. There’s been a widespread loss of confidence. And major sectors of America’s financial system are at risk of shutting down.”

Further, he is correct in this assessment: “More banks could fail, including some in your community. The stock market would drop even more, which would reduce the value of your retirement account. The value of your home could plummet. Foreclosures would rise dramatically. And if you own a business or a farm, you would find it harder and more expensive to get credit. More businesses would close their doors, and millions of Americans could lose their jobs. Even if you have good credit history, it would be more difficult for you to get the loans you need to buy a car or send your children to college. And ultimately, our country could experience a long and painful recession.”

It is worth noting that $700 billion is a bargain compared to the implications for taxpayers if the economy spirals into a severe recession — or worse.

It should also be noted here that there are significant, albeit unspoken, national security implications of a precipitous economic decline in the U.S. Where our economy goes, the world economy follows, and there will be significant national security consequences. For example, if China’s economy contracts more rapidly than at present, keeping pace with U.S. economic decline, the consequences will likely be some significant internal and external “mischief” scripted by the Communist Party. As for India and Pakistan…you get the picture.

(Memo to Congressional Republicans: As you consider how to salvage the financial markets, consider repealing Sarbox, the Sarbanes-Oxley Public Company Accounting Reform and Investor Protection Act of 2002, which has maintained a choke hold on financial institutions and is high on the list of proximate causes for the failure of Countrywide and Bear Stearns.)

Can any of this colossal expense be recovered?

Fortunately, there are real assets backing up these mortgages — bricks and mortar, and the land upon which the foundations rest — but this is no “deal for taxpayers.”

Yes, the proposal is to exchange Treasury notes for illiquid mortgage-backed securities, the latter being greatly depreciated now that the overinflated and over-leveraged real estate bubble has burst. And yes, most of those mortgages will be sold back to into the market for more than the government purchase price. But, to suggest that the “taxpayers will be paid back” is disingenuous, if not a massive, outright deception.

Congress is going to serve as the “watchdog” over the dispensing and recovery of these funds? Can you say, “fox in the henhouse”?

Even if Congress sets up a “trust fund” in order to use recovered funds to pay down the debt incurred to back financial institutions, we should consider that “lockbox” to be as safe as the Social Security Trust Fund lockbox. Every dime paid into Social Security has been spent on government programs, leaving that fund with a bunch of IOUs.

No doubt, every dime recovered from the private sector will be treated as revenue to expand government programs, and the debt will be left on the books.

To pay for the bailout, Democrats are sure to demand higher taxes from “the rich Wall Street fat cats who got us into this mess.” While this mess clearly ended on Wall Street, it didn’t start there, but, undeterred, the Democrats will always bank on this observation from George Bernard Shaw: “A government which robs Peter to pay Paul can always depend on the support of Paul.”

And, of course, if the current plan to restore economic confidence does not succeed, you know the Demos have “Plan B.” Don’t ask…

Economics as political fodder?

One staple of the Democrats’ political playbook is the use of scare tactics to rally constituencies. Indeed, Obama and other Demos have been dishing out a steady stream of dire economic rhetoric in order to keep their constituents in line. Undoubtedly, all that economic hyperbole has influenced public perception of our economy and confidence in our economy. High on the list of issues President Bush discussed with candidates McCain and Obama when he called them to Washington five weeks ahead of the presidential election was a request that they (read: “Obama”) cease and desist using volatile housing and financial markets as political fodder.

Chances are slim to none that Obama will not make hay of the current crisis for political gain, but then, few Democrats have ever put country first.

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