“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning." – Winston Churchill
There is a saying on Wall Street that goes, "The market can stay irrational longer than you can stay solvent."
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Scared and confused, consumers stared Monday at computer screens showing a jaw-dropping 777-point, one-day drop of the Dow Jones Industrials in response to the House of Representatives rejection of the proposed $700 billion dollar bailout plan.
They wondered what could be so awful that our government tells us that we need to provide the financial markets a $700B fix NOW, when until recently many of our leaders said the economy was doing just fine, and if anything, we were envious of the superstars of finance, the investment bank CEOs, private equity types and hedge funders, who seemingly could turn lead into gold.
Moreover, we’ve been taught since the Reagan era about the efficiencies of Mr. Market, that “greed is good” because it motivates wealth creation, and that this wealth trickles down to one and all. What has changed, we wondered?
A Primer on What is Happening on Wall Street
First, a quickie primer on what is going on. Deregulation lead to a financial market where credit was cheap and easy to get. This drove up the consumption of that credit to unsustainable and ultimately, unsupportable levels.
On Main Street, the best example of this is the person who couldn’t qualify to get a loan to buy a $20,000 car (because auto loan underwriting standards are fairly stringent), yet nonetheless could get a loan to buy a $700,000 home. Intuitively, that doesn’t make sense, right?
Part of what makes the great engine of the financial marketplace work is a process whereby all of the different types of outstanding loans are chopped up and re-packaged into securities 'baskets' based on the loan type and underlying credit-worthiness of the borrowers associated with a particular basket.
These securities are then sold in secondary markets as a faceless class of investment (versus a direct stake in Joe or Mary's home mortgage), with the buyers being other banks, mutual funds and the like.
Independent credit rating agencies are the entities that bless these securities by assigning risk levels associated with a given security class, which drives the risk premium investors expect as an incentive to buy these securities.
What supercharged this long-standing part of the way the financial marketplace works, and ultimately set the stage for a full collapse is two things:
- As Wall Street's bread-and-butter business of investment banking and trading stocks became less profitable (when electronic trading took hold), i-bankers started to re-direct their massive pools of capital into complex derivative financial instruments such as yield-enhanced, sub-prime mortgage loans (e.g., collateralized debt obligations – CDOs), often at an eye-popping 30-to-1 leverage.
- Buyers of theses securities thought that these investments were "made safe" by a type of insurance product known as a credit default swap, a credit derivative from companies, such as AIG.
Unfortunately, the same credit ratings agencies that have (relatively) safely weighted the risk of default on less exotic financial instruments, like bonds and mortgage-backed securities, were now attaching their stamp of predictability to infinitely more complex types of derivative instruments.
And as history now shows, they were seismically wrong, turning what might have been a disruptive tremor into a massive financial earthquake.
(The fact the agencies themselves were 'polluted,' operating in financial self-interest in using their trusted seal to extol the predictiveness of these incredibly complex, volatile financial instruments is for another post.)
The bottom line is that when housing turned down, the mortgages and derivatives were worth a lot less and no one would lend Wall Street money anymore. Then, as Andy Kessler notes, in an excellent post:
“The piling on started. Hedge funds could short financial stocks and then bid down the prices of CDOs stuck on Wall Street's balance sheets. This was pretty easy to do in an illiquid market. Because of the Federal Accounting Standards Board's mark-to-market 157 rule, Wall Street had to write off the lower value of these securities and raise more capital, diluting shareholders. So the stock prices would drop, which is what the shorts wanted in the first place. It was all legitimate.”
Legitimate maybe, but parasitic on our economy, just the same. Not only did this take down banks and brokerage houses, but given the fundamental misread of risk, it took down the insurance companies like AIG, which were underwriting the credit default swaps, and suddenly hit with unfathomed levels of defaults.
When risk assumptions go out the window, strong and weak look alike, and because borrowers and lenders have commingled, non-transparent interlocking interests, everyone knows that today’s predator may be tomorrow’s lunch. This gives rise to a liquidity crisis.
Why? Simply put, no one trusts anyone else. Banks certainly don’t trust one another, given all of the downside surprises and each side’s vested interest in selective disclosure. Thus, experience suggests that in times like these, the smart money should sit on the sidelines until the massacre has played out.
A scarcity of ready capital in financial markets is, by definition, what a liquidity crisis is.
Why Main Street Should Care
While it is trite to think that those greedy bastards created this mess, let them choke on their own blood, the unfortunate truth is that once lenders stopped lending to one another, all forms of borrowing become either completely unavailable or incredibly expensive.
This means that businesses can’t borrow, which forces them to adjust their operating expenses to the levels that cash flow can support. Since most business rely on variants of business loans, credit lines and the like, they need to cut back spending dramatically, which means cutting personnel, cutting capital investments and the like.
Now, Wall Street’s problem is your problem because you are unemployed and/or unable to borrow, or if you are a small business, suddenly you are faced with businesses/consumers that have stopped buying.
It is easy to see how this becomes a vicious cycle, and that it what has everyone freaked out, since it is a lot harder to re-start a seized engine than to keep it from failing in the first place.
Enter the Bailout
Let me assert that some form of rescue, bailout or whatever is the most palatable term you prefer, is critical and needed fast (i.e., formally COMMITTED within days, not weeks), since every day that passes is a form of financial Russian roulette.
The problem, however, in getting a consensus on what the right form of bailout is four-fold:
- Complex Message: It is too complex for the layman to grok why a bailout is necessary. The interplay between collateralized debt obligations, credit default swaps, massive leverage and the dynamics/dynamite of short selling hedge funds is akin to E=MC2 for most folk (myself included). In fact, it took me about 700 words to explain this, and I was trying to be concise!
- Pattern Recognition: The message of bailout is incongruent with our pattern recognition about market efficiency and the government having no place to be a player is such an environment. We read about billionaires and their hedge funds, superstar CEOs, etc. and are told that their reward in commensurate with their results (as risk takers), but now in crash times, we are told about the consumer needing to bail out the system. Does not compute, and being intellectually honest, there is no one right formula for how such a bailout should work so the pre-disposition to do nothing is very strong.
- Bush's Bucket List: There is such tremendous distrust of a Bush administration that has played the Ready, Fire, Aim game more than once that people hear "Fire" and they tune out. From Iraq and Enron to Katrina and now this, in the annals of ineptitude, history will show that GWB was a master...of disaster.
- Common Good v. Self-Preservation: With Bush as a lame-duck president, and the presidential election just 60 days away, not only is the concept of a bailout heavily politicized (read: McCain’s cynical, deeply dangerous, ‘suspension’ of his campaign and polluted messages/actions that followed), but Congress, especially the Republicans, are faced with the unenviable task of deciding between what is right and what will get them re-elected. Self-preservation versus selflessness. Unsurprisingly, the members of the House of Representatives in the mostly tightly contested races were the ones mostly likely to vote against the plan.
Where Do We Go From Here
What is needed is a front man that is trust-worthy like Treasury Secretary Henry Paulson (perhaps surrounded by Obama, McCain and a couple of finance luminaries - like Warren Buffett - no one trusts economists) who can explain in a Town Hall format the WHAT, WHY and WHY NOW of the bailout
This should spell out the fact that this is not just a bailout, but if done right, a future nest egg for our economy, with an explicit message that the government is working on behalf of the consumer, not the financial institutions, and a clear articulation of goals and how it will be transparent -- i.e., the antithesis of what everyone has come to associate with the Bush administration.
You sell this one once you feel that the House/Senate is lined up (behind closed doors without cameras) so Congress gets the halo of having gotten something done, and this is kept as apolitical as possible.
Beyond the downside that this post focuses on, the upside is that, because the US Government is truly the buyer in an extreme ‘buyer's market,’ if structured properly, Paulson could pull off the mother of all trades, and net a trillion dollars for the American people over the next 5-7 years. That would be penicillin for the budget deficit. (Here is a link to an interview with Warren Buffett on the upside scenario.)
Regardless, maybe the sight of blood on the streets will sharpen this deal a bit further on the one side, and give the naysayers a little less bravado on the other, as the alternative of doing nothing seems pretty ugly and irresponsible.
UPDATE 1: Save the Fat Cats (NYT Op-Ed Piece by Nicholas Kristof on lessons learned from Japan, which had a similar crisis in the 90s but opted against a bailout). Here is an excerpt:
Japan’s failure to respond urgently and decisively to its banking mess caused the country to endure a “lost decade” of economic stagnation. If America wants to avoid Japan’s decline, the House should follow the Senate’s lead and approve the bailout — immediately…For those of you accustomed to bull markets, who think we’re sure to come out of this quickly, remember this: Japan’s main stock index is still less than one-third of its level of 19 years ago.
UPDATE 2: 'S.E.C. No Evil' (Conde Nast Portfolio article on how, under chairman Christopher Cox, the commission has neutered its enforcement staff, yet another legacy of the ‘just do it’ Bush administration. Here is an excerpt:
The departing chairman, Donaldson, was a Bush family friend who had been appointed by the White House with the expectation that he would temper the S.E.C.’s activism. Instead, he embraced the agency’s role as cop. The business community felt “that Donaldson was too tough on corporate America and Wall Street,” says a former enforcement official. “Cox was brought in to chill it out.”..Besides pulling back on enforcement, Cox also cut back on the S.E.C.’s new risk-assessment office, created under Donaldson to help the agency do a better job of anticipating financial upheavals.
Related Posts:
- Black Swans and Bank Runs: on why this crisis was predictable.
- Financial Tsunamis: connecting the dots in the sub-prime mess.
- Oil, Vinegar and Volatility: on the history of volatility in the market, and missed opportunities to move away from foreign oil dependence.
- How Speculative Markets Crush Amateur Investors: why amateur investors fail to grasp that what goes up inevitability comes (crashing) down.
Okay, so now that we have answered the Big Question, we need to collectively start focusing on a bunch of little questions…
On a completely different front, this model changes the nature of the traditional six-month product development 'develop,' 'release' and 'update' cycle. 
