At this point governments around the world are grappling with a major financial crisis, no more so than the U.S. Government. At this time, they have presented a Bill before Congress for the transfer of $700 billion taxpayer dollars to purchase the distress assets of several failed financial institutions. This was rejected on Sept. 29 2008 (yesterday). The question now arises: What are the options for the U.S. Government now?
As an Economist (and I have not written about such matters in a while), I have watched this situation transpire over the last five to six years, and am somewhat amazed that things have reached this point. It was clear at the end of 2006 that this was all going to fall apart. However, from a public policy and pollster perspective, things break down into five (5) key issues.
1. The Big Pool of Money
Back in the early part of this decade, and shortly before the events of 9/11, the world capital markets were at their highest point in history to the tune of $36 trillion. The managers of those funds, traditionally very conservative (and loving low-risk, high yielding instruments) with this critical pool of funds, were seeking to invest in treasury instruments in established economies, with one of their favourite being U.S. Treasury bonds.
However, with Alan Greenspan’s announcement that they were taking a very conservative approach in terms of interest rate policy, the guidance was that the U.S. was not a good place to invest.
Alan Greenspan: The FOMC stands prepared to maintain a highly accommodative stance of policy for as long as needed to promote satisfactory economic performance.
This effectively signaled to global capital markets that there was not a chance that they were going make a lot of money from U.S. treasury bonds and to look elsewhere.
At this same point, with these funds available and seeking investments, the only asset that seemed to have any buoyancy was the U.S. housing market. Investors were attracted to the stable 5% to 10% annual returns that regular home mortgages offered. At this point, hedge fund managers became quite creative and developed mortgage-backed securities, which in principle made sense based on a cash flow basis. Given the structure of these instruments, they were very attractive to global investors and were initially rated by the credit agencies as “money good” (i.e. that they were very safe (“Class A”) investments). At the time, based on the criteria for issuing credit in the market in the early part of this decade, this made sense.
However, this led to two further issues.
2. Group Think and Collective Greed
With the success of the mortgage-backed securities, global investors and the capital markets loved them. Then they got more creative. Jim Finkel (a legend in financial markets) created a CDO (collateralized debt obligation) that stripped down these mortgage securities further into their component parts and then pooled them. It appeared that the portfolios within these securities were adequately diversified to mitigate risk and investors fell in love with them. What happened concurrently and subsequently was a result of lack of oversight, as well as excessive creativity within the financial sector.
Via a network of players from investment brokerages to intermediaries who were buying the mortgages back from regional banks, the demand for mortgages increased to a point where the issuing of mortgages became the critical driving force in the “sustainability” of these mortgage-backed instruments. As a result, the criteria for qualification, while stringent at first, became extremely lax to the point that they were fraudulently issued (who in there right mind would ever issue a NINA loan (No Income, No Assets). Thousands of people who would have never have qualified under the due diligence of these financial institutions now qualified for a ridiculously large loan. (It is noted the opportunities for easy money were glamorized in a host television show on how to flip homes.)
The amount of these loans issued were nowhere near anything that these individuals could pay back and this was noted in early 2006 (relatively early) by some players at the local acquisition level. But to the securities analysts things appeared to be working reasonably well in terms of how these assets were performing. Which leads to the third issue…
3. The Lucas Critique
Dr. Robert Lucas, the renowned macro-economist from the University of Chicago, back in 1976 presented his groundbreaking paper that is now referred to as the “Lucas Critique.” According to the Wikipedia summary on this, in a 1976 paper, he (Lucas) drove home the point that it is naive to try to predict the effects of a change in economic policy entirely on the basis of relationships observed in historical data.
Because the parameters of these economic and financial models were not structural – that is not policy invariant – they would necessarily change whenever policy – the rules of the game – were changed.
Simply put, policies & market conditions change, assumptions and parameters driving these models were no longer valid. Policy conclusions based on those models would therefore be potentially misleading.
This argument called into question the prevailing large scale, statistical (econometric) models that lacked foundations in dynamic economic theory. Based on standard financial instrument analysis (including capital asset pricing models (CAPM)) these mortgage-backed instruments were performing well and within the tolerance of “acceptable” financial risk. That is, the failure rate at that time when they were evaluated, within a year of most of these instruments were issued, was below the 5%-8% acceptable failure rate.
What the models failed to capture was that the fundamentals of the parameters that drove the models had drastically changed and by the time the information was captured to recalibrate the models – based on actual information and not the models’ estimation parameters – failure rates on some of these instruments were to the tune of 50%. The question arises: How could investment houses have been so naive to not change their models to assess the risks of these financial instruments? This is now combined with the fourth and the fifth most critical issues.
4. Moral Hazard
They were not that naïve.
The market rewards risk. We love it when our investments make high yields. And those who get those high yields for us have a strong incentive to maximize our returns with attractive commissions. With the mortgage-backed CDOs, investment firms were free wheeling and took these risks to extreme… while investors remained happy with the return and the sense that there was the “sugar daddy” of government should things fall apart (as they have done so in the past). This is what we refer to as “moral hazard.”
Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.
The investment bankers, by mid- to late-2006 had more information than the public, and acted accordingly.
5. Deception and Willful Neglect
We are now at this point based on a number of very critical decisions or lack thereof.
First, the breaking up of banks and allowing investment houses to get into banking was a critical step, and such deregulation led to more “creativity” within the financial sector. Part of this creativity was driven by the fact that inflation was beaten down in the 80s and with the lack of this “fuel” within the system, the financial sector had to seek new and creative means to raise yields. While creativity is not necessarily a bad thing, when it extends to investment banks colluding with credit rating agencies to provide low quality assets excellent ratings is downright corrupt. It was well-known early in the game that these securities were of questionable quality and were labeled “toxic waste.”
As of how we arrived at September 2008, is a result of a sequence of events. My sense is that once the ball started rolling and the money was coming in based on an incentive-based system to keep selling more of these high-risk assets, so that commissions lined the pockets of the players from the regional banks to the intermediaries to investment houses and onto investors, everybody was very happy. Those who were early in the game did very well and have long since cashed out and left the party.
But, who was overseeing this process? The Chairman of the S.C.C. had little to say and the key players in the U.S. Government have only recently “appeared” to come to the table. There were signs very early on that this was going to be a major issue and these players could have taken action to mitigate the crisis that has arisen. However, with a “commitment” to the philosophy of free market economics, few politicians were ready to intervene.
This leads me to postulate that there were some interests being protected (and I am not one to chase conspiracy theories, but based on the sequence of events, this needs to be part of the explanation of how things got to this point). With Henry Paulson, a former Wall Street man (Goldman Sachs) heading up the Treasury, one may guess that people needed some time to work their way out of the situation, clear their money out of toxic instruments and to wipe their hands free of any of these assets, so that those who came later in the game are stuck with the problem.
This may be a harsh assertion, but in reviewing the initial Bill being presented before Congress, Section 8 is especially illuminating. Section 8 reads in its entirety:
Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.
These 32 words are shocking. To go to the American public to ask for $700 billion and not be accountable for it, does indicate that somewhere along the line there are people with things to hide. It is noted that these 32 words came under intense scrutiny and were subsequently removed. But, the mere fact that they made it into the original request indicates persistent bankrupt behaviour.
This is indicative of the current administration. With the unfortunate turn of events of 9/11, there has been a systematic pillaging of the public coffers and officials’ accountability in the United States from the war in Iraq, to creative changes to the overview of the Government, be it through the judiciary or the Vice-President stating that his actions are not a matter of the Executive Office and thus no records need to be kept of them (Dick Cheney). This does appear, at one level, to be one of the final acts and opportunities to loot the public coffers (while credit markets are seizing up). With the debt of the U.S. Government approaching $10 trillion and asking taxpayers to come up with almost $2,400 each of their own money to bail out people who have pillaged the public is unreasonable.
We also know why this failed in Congress – public opinion was not on the side of the decision. While there were members of the public who need to take some responsibility for taking “easy money,” they are relatively small in number compared to the majority of Americans who are hardworking and try to play by the rules of trying to live within their means. It does also appear that the interests of the wealthy investment bankers are being addressed, while the needs of the average American are not. The optics of trying to protect institutions who should have been serving the public interest is not going to be palatable with politicians who are balancing the needs to serve their constituents and stay in office. At this time. President Bush has expended all of his political capital and appears practically powerless on a crisis that arose under his administration.
Further, in the financial sector the “free market” and diminished regulation DOES NOT WORK. Financial markets want less regulation when things are good to that they can take more risks to obtain higher yields. However, when they fail, they embrace government (via corporate socialism) and turn to the treasury to absolve them from their sins (for squandering their and the public’s money). This is painfully clear from what has transpired. The public’s assets need a higher level of protection and oversight, and the creativity of financial institutions needs to be reigned in.
One can hope that there is careful scrutiny of this bill and a balanced approach of addressing the needs of the public and the credit markets is adopted. Also, we can learn from this so that there is more oversight of the financial sector and the creativity that is being explored is held in check as well as their accountability scrutinized of those overseeing these players.
Another Handy Resource: NPR’s Planet Money.