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Financial Crisis

September 21, 2008 · Leave a Comment

McCain, as one of the chief Senate supporters of rampant deregulation, is very much to blame for today’s financial crisis.  Don’t let his scapegoating of Chris Cox fool you; he was right there every step of the way, dismantling regulatory agencies and programs, preaching an unfettered free market.

I like to think of myself as relatively sophisticated when it comes to financial matters. I’ve got a top-tier MBA, and track my investments closely. But the latest financial crises and bailouts are enough to make one’s head spin.

I alternate between extreme concern, and trying not to over-react or let fear mongering take over.

The extremes of deregulation led to both unprecedented profits on Wall Street, and now the near collapse of our financial system. Sound extreme? Maybe. But the systematic dismantling of regulation that has occurred mostly under Republican administrations allowed for both innovation in financial markets, but also the inability to accurately measure and report on risk, heightened leverage, and the creation of an inordinately complex relationship of investments and risk, whereby when stress and the reduction of liquidity has led to ripple effects that now threaten the entire network. The proponents of deregulation include Phil Graham, Chris Cox, George W. Bush, and yes John McCain.

See CNN’s story on McCain’s flip-flop on regulation:  McCain drifts away from a legacy of deregulation.

The first major stress on the system was revealed with the failure of Enron. Yes, that far back. Enron took all sorts of complex sources of risk, “productized” them, and then traded them. In essence they were a market maker. Before the collapse, they were said to be thinking about creating a weathers future market, where futures on the outcome of weather could be bought and sold. Yes, a weather futures market. A market can be created around anything that moves. Literally. Witness the 16th century Dutch tulip bulb investing craze. The problem is that sometimes the products become obscure, and the people trading don’t know what they represent. Can you figure out what an option straddle on only the interest portion of a bundle of mortgages is worth, especially when you can’t quickly figure out the default risk on the underlying mortgages? Add to this computer-driven trading to take advantage of risk and price spreads (arbitrage), and you have the recipe for interconnected poorly understood markets.

With deregulation, not only did new unique instruments pop up, but the traditional boundaries of what investments different kinds of institutions can invest in fell. Suddenly banks and insurance companies, investment banks and savings and loans, hedge funds and mutual funds could invest in all kinds on new instruments, most with huge leverage.

Leverage is the ratio of “actual” to borrowed money underlying an investment. If I have $100 and want to invest in something, that’s not leveraged. If the investment goes up 20%, I make $20 or 20%. But if I borrow another $1000 (a 10x leverage), and invest $1100, and it goes up by that same 20%, and I have to pay 4% on my borrowed money, I’ve just made $220 ($1100 x 20%), and had to pay $40 in interest, so net of costs I’ve made $180, on my original $100 – I’ve made 180% profit! Hugely profitable? Yes. Risky? Oh yeah. Why? Well, what if the investment goes down? Then I can lose even more than I’ve got invested! If the asset went down by 20%, I’d lose $220, more than I had to start, plus the interest on the borrowed money, so I’m $260 in the hole.  What if I don’t have it?  I default on the loan.  Then who owns the investment?  The person I borrowed from, probably, but they don’t want it, especially if it looks like it’s continuing to fall in value.  That’s leverage. Just like a physical lever lets you move more weight than you could do directly, financial leverage let’s you make (OR LOSE) more money than you could otherwise.  The biggest leverage most Americans have is when they take out a mortgage to buy a house.  But Wall Street bought those same mortgages, and sold them again, using leveraged money.  Now you start to get an idea for how dropping housing prices could ricochet through the economy, as it is now.

So, why are so many people mad at Alan Greenspan? Mostly because he followed a course of low, easy credit for a long period of time. He kept interest rates low to keep the economy expanding far beyond its “natural” capacity. Because interest was so low, and American culture has devalued saving in favor of current consumption, our already low saving rate went negative. The housing bubble developed. The economy expanded. But what was fueling this? China was buying up our Treasury Bills. We were borrowing money to fuel this orgy of consumption. As a result the value of the dollar against other currencies plummeted. The rest of the world could see that this was not sustainable, but the US, as the largest economy in the world, fueled a huge global expansion on the back of its borrowing and spending.

Add to this a disastrous Bush administration, who went into a foolish and costly war in Iraq, and choosing to fund the war not in the current budget, but – you guessed it – with more debt.

The economy is not set up for some very bad days ahead. We will either have to inflate or grow our way out of this mess. We inflated our way out of paying for the Viet Nam war, which we also funded from debt. Remember the ugly stagflation days of the 1970’s? Gas lines? High inflation? Low growth. That’s because we were inflating our way out of our war debt. Who won? Those who held debt, including a lot of Americans who’d bought homes with fixed mortgages. Who lost? Those who owned real assets – like stock, or companies, or retired people on an income that was fixed (and not tied to increases in inflation). I’d predict that you’d best look to the 1970’s and early 1980’s for a road map for the next decade.  We enjoyed the party a little too much, now we have to face up to the fact that our hangover will be with us for a while.

Now the Treasury Department and the Fed have stepped into the economy in ways that would historically have been unthinkable, guaranteeing instruments that did not have government backing, propping up companies about to go under and facilitating private sale (Bear Stearns), privatizing huge companies (Freddie Mac and Fannie Mae), injecting huge amounts of liquidity into the system by lending money to banks and investment banks, and now proposing to create a huge fund to buy up distressed assets, mostly bad mortgage packages and related securities.

I wish I’d moved everything to cash and gold a year ago. But I didn’t, so I’ve lost a chunk.

The decision from here, however, isn’t to cry over spilled milk, it’s to put your money where it has the best chance of growing for an acceptable, minimized risk profile. I did take my portfolio to “moderately conservative” from “moderately aggressive” about 6 months ago. Now it’s time to watch the news carefully, and decide what asset classes have the best chance to appreciate at the lowest risk – even to call a bottom in real estate and stock.

Here’s a great story from today’s New York Times about the latest Bush administration bailout plan:  The Wall Street Bailout, Explained.

Treasury Seeks Asset-Buying Power Unchecked by Courts, on Bloomberg.

Categories: Bush · Finance · McCain
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