All Commentary
Friday, April 24, 2009

The Trillion Dollar Meltdown: Easy Money, High Rollers, and the Great Credit Crash

The stocks of banks, investment banks, and associated financial institutions declined severely in 2007-08 when their many bad loans, first in subprime mortgages and then in other securities, surfaced. Scholars will be pondering this event for years to come, as they have with the Great Depression.

In this instant and brief history, Charles Morris, lawyer, banker, and author of several previous books, attempts to explain the origins of the bust and suggest remedies. The result, however, is disappointing. Morris dishes out a financial stew consisting of numerous ingredients: Volcker’s and Greenspan’s Feds, bank deregulation, monoline insurers, rating agencies, securitization, the Greenspan put, loose mortgage lending, hedge funds, and more. A reader unfamiliar with these matters will be duly alerted to many interesting features of the recent financial world. But, lacking a viable integrative theme, the sum is a confusing mishmash.

The first third of the book reviews superficially and in broad strokes some of the financial and economic history of the United States since 1973. The middle portion describes some of the signal events and players in the recent credit debacle. In the last third, Morris gives his take on the winners and losers and what should be done.

The story that Morris tells in the first and last parts of the book is the standard political line that the financial sector went too far in the direction of free markets, the financial players performed badly, and now matters must swing back to more government control.

For example, Morris contends that financial oversight by regulators has been lax. There is some truth to this, but Morris fails to view it as a sign of government failure. And he makes no serious attempt to delve into the effects of the panoply of regulations, subsidies, federal guarantees, and tax-code features that promote home ownership for people unable to afford a house.

Like the mainstream consensus, Morris seems to misunderstand what makes a market truly free. The “financial meltdown,” he says, came about from “coddling our financial industry, fertilizing it with free money, propping it up with unusual tax advantages for fund partners, and anointing it with fresh funds whenever it stumbled or scraped a knee.” Those are hardly hallmarks of a free market!

Our financial markets are anything but free. Bond raters have a quasi-cartel. Banks and insurers are heavily regulated. Money is monopolized by the Fed. Institutional investors who are legally separated from their contributors feel free to experiment with hedge funds. Accounting, under the aegis of the SEC and acting in a quasi-governmental way, does not keep up with innovative players. Like most “mainstream” commentators, however, Morris insists that the financial debacle is the fault of our mythical free market.

If markets were free, financial players wouldn’t be lavishing huge campaign contributions on congressmen in key positions. If markets were free, there would be no Fannie Mae and Freddie Mac sopping up mortgages across the nation, while repackaging and reselling them to institutional investors worldwide. If markets were free, Fannie Mae and Freddie Mac would not be in receivership.

Morris’s “very first priority will be to restore effective oversight over the finance industry.” But financial regulators do not now lack sufficient law and penalties. Morris doesn’t realize that there cannot be effective management by Congress or its agencies of the many financial industries and sub-industries when their markets are highly politicized.

The author’s choice of topics and coverage is often perfunctory and eccentric. The genesis of the real estate boom is given short shrift. He writes that it “may be one of those rare beasts conjured into the world solely by financiers.” He does not discuss the role of falling home prices and negative home equity in mortgage defaults. Collateralized mortgage obligations come in for lengthy treatment, but he barely notes Fannie Mae and Freddie Mac’s role in promoting such vehicles.

Behind the current deflation is a preceding inflation that had gone on since 1982. There has been no serious deflationary recession for decades. The Federal Reserve System and government officials encouraged the notion that they would not countenance a serious recession. They would prevent the downside risks of investing. That attitude, along with other political actions, encouraged a large debt or credit bubble to finance stock, bond, and real estate purchases.

The political system enabled a basic financial sin. That sin was overtrading or overleveraging. Market players and borrowers, thinking the risk of loss or downturn was minimal, borrowed too heavily and loaded up too highly on assets. When those asset prices fell, even by moderate amounts, their losses shot upward due to the effect of the borrowing.

This book was among the first published on our current financial debacle. Unfortunately, the author fails to see that the villain is government meddling. Look for something better.