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Thursday, December 20, 2007

Market Failure V: The Great Financial Sector Crash of 2007

No time and place and situation in postwar America has fallen more completely under the sway of the free market than the first decade of the Twenty-First Century in the banking and financial sector. We may soon see that no financial crisis will cost America more than that composed and orchestrated and performed by this unregulated, unsupervised, predacious sector.

Of course, the financial sector is not by itself in being outside the pale of even rudimentary structure, although because the central bank was under the control of a self-described Libertarian Republican Alan Greenspan, it could be argued that banks and brokers had special access to government largesse. But with George W. Bush in the White House and his handler Dick Cheney never far away, the corporate oligarchy has written the laws that governed their sectors not only in finance, but in energy, health care, media, and more.

The roots of the financial crash.

In the financial sector during the Greenspan/Bush era, innovation was the word of the day. Special accounts or entities called Structured Investment Vehicles (SIVs) were created by banks off the balance sheet to take advantage of special securities called collateralized debt obligations (CDOs). Imaginative modeling was applied to mortgages to take advantage of a housing expansion built on cheap interest. The extra few beeps from these accounting functions found a ready audience in investor capital. The voracious demand for these securities drove ever more predacious mortgage brokers and ever riskier mortgage loans.

All of it was sanitized by an absent Securities and Exchange Commission, by a diffident Fed and by rating agencies – Standard and Poors and Moodys – in thrall to those they rated. Mortgage-backed securities were stamped Triple A whatever their worth and treated as near money for further leveraging. The demand for it drove the whole sorry circus. Meanwhile, hedge funds operated as usual, in a dark shadow. Mortgage brokers were not licensed, nor were their products examined.

Whatever there is to say about the expansion of the financial sector under Bush/Greenspan, government interference is not part of it. Loud and detailed complaints about government arose only after the collapse. They come from all offices on Wall Street and amount to variations on the theme that government was not, and is not, doing enough to clean up the mess. The banking sector is vital. It needs ever more and ever cheaper money. No time to look at the past.

The common name for this financial sector collapse is the Subprime Mortgage Meltdown, as if it were authored solely by those individuals who obtained inappropriate loans. Lenders, in fact, bear the responsibility and ought to bear the costs. As we see less than six months later, lenders can be very discerning in their choices of mortgage buyers.

Facing the nation and the world today is a solvency problem, no matter what brave face the banks may paint on it. And solvency will be assured by you and me. These banks are – and they realize it – too big to faily. You and I are the deep pockets. Debt leveraged by debt was not a very good idea. Every write-down or equity stake sold to a Mideast potentate is accompanied by assurances, not from the corporate offices, please note, but from analysts and fellow travelers, that banks are facing the music, taking their lumps, clearing their books. Bull. Accounting is opaque. Losses are dribbled out over time as slowly as possible with moves designed only to maintain as long as possible a facade of integrity.

Now, as the Fed moseys into the mortgage corral like a self-conscious Barney Fife to finally close the gate, laughably late, with the fences broken and the tumbleweeds rolling across the scene. The horses are gone. Barney's new, weak subprime lending protections are announced to empty stalls. Deputy Fife retires to his offices, knowing as we all do that even before the charade, the subprime mortgage market was forever a thing of the past.

But the bank examiners have still failed to report for duty. So deep in the pockets of the banks is the Fed that it colludes without a second thought. Its role is not to wonder at causes, but to listen and respond to whispers from the big houses. As much as possible the extent of the damage must be kept from the prying eyes of the public. It was an explicit feature of last week's special auction facility that nobody would know who was using it.

It is still our contention that the overall damage will reach toward one point three trillion dollars, with eight hundred to nine hundred billion resting in the American financial sector and the rest lying mostly in Europe. While write-offs, downgrades and bankruptcies will eliminate some of the overhang, on one hand. On the other the government and taxpayer may be on the hook for the biggest bailout of all time. This in addition to the ever broader gusher of liquidity focused on the sector.

There can be no doubt this is a market failure through and through. The government, particularly the Fed under Greenspan did nothing but abet the private financial sector actors.

It will surprise nobody that we propose some real remedies and responses beyond the, Oh well, it is little more than the normal cycle.

But first, a few notes.
  1. One, the authors of this fiasco are the highest paid professionals in the country. These are the brilliant minds of the A list business schools. They are getting millions and hundreds of millions of dollars. This on the premise that they are providing value. Instead they are costing us – hundreds of billions and rocking the foundation of credit for the whole economy. Aside from a few sacrificial lambs who left with nine figure severance packages, nobody has been held accountable.

  2. Two, the problem is not the unraveling and collapse. The problem was the growth on false pretenses, the bubble itself promoted by cheap money and no structure. The collapse was simply the final act.

  3. Three, the best thing the credit markets can do is every day provision of a reliable supply of capital at the lowest rates possible for the productive industries. Slicing and dicing securities and buying and reorganizing and selling companies is very close to a shell game. At best it spruces up the bottom line and makes the stock more attractive. But the economy is not measured in stock prices, it is measured in jobs, security, continuity and maybe a bit of moral integrity. Whatever incentives make this financial gymnastics activity attractive have to be reversed.

So the remedies.
  • Out the securities for the public to examine. These are not so much complicated as they are preposterous.

  • Realign the mortgage seller with the mortgage buyer. Do not allow secondary markets in mortgages. If people want to invest in mortgages, let them invest in the mortgage providers.

  • Institute a financial transactions tax of five one-hundredths of one percent to recoup the immense costs of these bailouts. A standard, minute tax will generate a great deal of revenue and at the same time discourage the day trading and hyperactivity in what amounts to a casino.

  • Establish a marginal income tax rate of at least 50 percent on income above a couple of million per year, all sources. This event is evidence enough that people are paid enormous sums not for value delivered, but for value extracted.

  • If there is going to be a bailout, aside from the cheap money, get a stake in the companies. Why should Dubai have a stake in Citigroup and the USA not? Providing there is a similar investment.

  • And structure this market. Let's not have financial vehicles or securities that are simply some Wharton grad's senior project. Let's get things vetted. Markets can work, but unstructured markets don't work.