The Anatomy of the Financial Crisis and Why We Must Get It Right

Everyone is haunted by the fear our financial crisis might unwind into something like the Great Depression. The world of finance is undergoing a hundred-year storm. It has inflicted the greatest destruction of wealth in our history. It swept away giant blue-chip financial firms, in a few months, even in a few days of fear, panic, and mistrust, that had made it through the Great Depression. It's turned out worse than the most pessimistic of us imagined.

Most critically, the financial world is seized by a collapse of confidence. The uncertainty over the value of the securities they hold has led to an enormous risk aversion. Customers, creditors, and shareholders of the major financial firms wonder whether they might survive. Once confidence collapses, there is no telling when the selling will stop. It all brings to mind the story of the economist who walked past a hundred dollar bill and didn't pick it up. When asked why, he responded, "It can't be a hundred dollar bill for, if it were, somebody else would have picked it up by now."

All of this has produced an unprecedented credit squeeze in which banks are refusing to lend to other banks, much less to businesses and individuals. This squeeze has had a particular impact on the newly unregulated emergent shadow banking system made up of mortgage lenders, investment banks, broker-dealers, hedge funds, private equity funds, money market funds, structured investment vehicles and conduits. Many of these names we have never heard of before but cumulatively, they now provide a majority of America's financing. They are not banks but they act and seem like banks. They borrow short and invest long, mostly in illiquid securities; they have more debt in relation to equity than banks but have lacked, until recently, both deposit insurance and the support of the Federal Reserve as the "lender of last resort." They do not have deposits but have relied on roll-over, short-term funding obtained through borrowing in the money markets that has left these firms vulnerable to disruptions in the money markets. To the extent that they have bundled these investments into securities that were sold to the markets, they were are also vulnerable to mark to market losses when these markets, or their securities, start falling.

This quickly wiped out the banks' capital base and ended their roll-over funding. The functioning of the credit markets was brought to a virtual halt. Even worse, there is a quiet run on hedge funds and private equity funds ongoing that threatens to bring the shadow banking system to its knees. Now the question is whether this will produce an economic contraction on Main Street comparable to the Great Depression.

The inescapable bad news is that a serious recession is inevitable given the damage to the financial sector, as well as in the degree to which business and the general public has been traumatized by collapsing stock prices and the daily headlines. But this does not mean we are bound to have a spiraling recessionary dynamic comparable to the thirties. The unprecedented debt American families and businesses have assumed will continue to constrain the easing of the credit crunch. But we have avoided some of the mistakes of 1929.

Take monetary policy. This time the Treasury and the Federal Reserve moved quickly and positively. They understood that when banks lose money they have to shrink their balance sheets and since bank assets are its loans, this would mean a drastic reduction in credit and worsening business conditions. The Fed has sought to ease the credit crunch by injecting over $1.5 trillion into the financial system and, most recently, added another $250 billion directly into the banks to re-liquefy them, plus increasing deposit insurance, extending it to money market funds, aggressively lowering interest rates and, importantly, doing that in concert with the other major economic powers.

In the early 1930s, the Fed refused credit to bankers and forced more and more of them to sell assets in a frantic dash for liquidity. Some 10,000 commercial banks, or 40%, failed between 1929 and 1933 compared to only 20 this time. Many people back then stopped using checks and conducted transactions in cash. The money supply declined by more than a third, creating a major contraction of credit.

The contrast in fiscal policy is equally dramatic. A generation of economists inspired by John Maynard Keynes in the 1930s taught us that the government should not try to run a balanced budget in a crisis of demand, as both Hoover and Roosevelt did. This time the government is running a $500 billion deficit to stimulate demand, and next year it will exceed $1 trillion. Orthodox adherence to the gold standard in the thirties didn't help, compared to a free floating US dollar today that has declined by 16% on a trade weighted basis. Another critical fiscal difference is that the federal government today has more sway. It makes up 21% of GDP compared to just 3% in 1929. On top of this a large component of GDP is devoted to health and education that is substantially decoupled from the problems of the private sector, not to mention that the Social Security program adopted in 1935 today provides unemployment benefits. All these contribute to maintaining the real economy.

Finally, we haven't repeated the great blunder of Hoover's 1930 Smoot-Hawley Tariff Act. It raised duties on some 20,000 foreign goods, causing many other countries to retaliate, reducing world trade by two-thirds. Now growing exports have been a major plus for our economy - something the protectionists in the Democratic Party need to remember.

Since virtually none of the necessary programs to counter the decline were implemented between 1929 and 1933. By the time FDR took over, the economic entrenchment had begun to feed on itself and turned a serious recession into the decade of the Great Depression. The reaction this time was virtually instantaneous.

All to the good, but there's also an "all to the bad" element in our present predicament. Americans are incredibly indebted. Household debt rose from about 50% of a $3 trillion GDP in 1980 to over 100% of a $13 trillion GDP today. The debts of the financial world, which amounted to 21% of GDP in 1980, soared to 120% of GDP by 2007. The financial world's unprecedented accumulation of debt in relation to equity sometimes with over $30 of debt for every $1 of equity means that small variations in their asset values, which once produced profits, have now brought them huge losses.

Much of this debt takes the form of securities and derivatives that remain on their balance sheets. In fact, another systemic risk and one that cannot be measured is based on the opacity and complexity of these exotic securities, mainly credit default swaps and derivatives that remain mainly on unknown financial balance sheets in amounts that exceed $50 trillion. The financial risk and exposure to loss is misunderstood and underestimated even by the credit agencies so the ensuing financial damage could be of a magnitude that could threaten the financial system.

AIG is a classic example of the inability to estimate the exposure. Management first estimated they would need $40 billion to get past their financial crisis; the government increased this to $85 billion; and within thirty days the cost had soared to $121 billion. Lehman is another example. When it went bankrupt, they had to unwind the credit insurance on Lehman, at a cost that has just been revealed to exceed $360 billion, an amount unrecognized by the Treasury when Lehman went under. These kinds of staggering losses could be multiplied many times over by defaults in cascading derivatives.

Then there is the housing bust. The current crisis in housing has an important history. When the Fed tried to respond to the dot.com bust in the year 2000 and 2001, that is when the Internet bubble burst, littering the country with bankruptcies and layoffs -- not to speak of investor losses of more than $1 trillion -- the Fed rapidly increased the money supply to offset these losses and slashed short-term interest rates to 1%, the lowest in 45 years. The result was the greatest housing boom this country had ever encountered. From 2002 to 2006 housing values appreciated at the astonishing rate of 16% per year compared to only 3% for the 55 years between 1945 and the year 2000. We finally came to the point where it was impossible for the typical American family to buy an average priced house using a conventional 30-year mortgage.

The response to this was an explosion of new mortgage products that enticed home buyers into supporting escalating housing prices while reducing their financial requirements. The need for the traditional 20% down payment was eliminated. Then we had interest only loans, low- or no-doc "liar loans," piggyback home-equity loans, as the mortgage and banking industries made it possible for anyone, even without a credit score, to purchase a home. These mortgages were packaged into complex financial products and sold on to other investors, many of whom had no idea what they were buying or the associated risks.

Then the housing bubble burst. Housing prices have dropped roughly 20% and the decline is continuing. Plummeting house prices mean more foreclosures, more homes on the glutted marketplace and a further house-price slump. There are 12 million homes today with negative equity where the mortgage exceeds the home's value and it may rise to 15 million over the next few months. As many as half of them have mortgages that now exceed the value of the homes by over 20%. If half these people drop the keys in a box and walk away, the losses will be in the trillions and may well destroy the equity in our banking system. That is why it is critical to find ways to keep foreclosures to a minimum. The entire attempt to re-liquefy the financial system could be undermined by this collapse in housing prices.

These are substantial threats and for all the measures (belatedly taken) distrust remains. American policymakers have seemed to be responding at an ad hoc, unfocused fashion, not fully taking into account the looming insolvency issues and the frightening complexity of the bundles of exotic securities. It is fair to acknowledge that they've been dealing with a crisis on a scale not seen before, and one that unfolded with terrifying speed. But the fact remains that by the time they acted, measures that might have re-stabilized the markets were ineffective. Robert Brusca of FAO Economics, captured it well when he said, "There is sense that if policymakers were surfers, they would have missed every wave."

Lehman's bankruptcy is a case study in government ineptitude. It was the $785 million of losses on Lehman's securities that pushed the value of the assets of a major money market firm below their $1 per share paid value, described as "breaking the buck." This caused $400 billion to be taken out of money market funds in a matter of days, while the rest of the funds were frozen in anticipation of further withdrawals. Banks were relying heavily on these funds for their commercial paper and the result was a spiral of illiquidity. The Lehman decision prompted the following from the French Minister of Finance, "Horrendous!" an assessment echoed by many others.

It remains puzzling that our Treasury officials did not foresee that the Lehman failure would not be just another failure, but a catastrophic failure undermining faith in the system. After Lehman, all remaining trust vanished in the financial world. Money market and interbank lending froze virtually completely. The spread on credit default swaps rose to levels that caused fear and speculation.

This mistake was followed by the Treasury scheme to buy toxic mortgage-backed securities. It was a flawed approach from day one. If the government bought them at a price above market and thus provided a huge bailout of Wall Street, it would have caused a political upheaval for it would have been seen to rescue them from the consequences of their misjudgment and greed. But if the government bought at current market prices financial firms would take enormous write-offs. In turn that would dramatically damage their balance sheets and force them to freeze their lending, the exact opposite of the purpose of this program.

Alas, the necessary defeat in Congress of Bailout Mark 1 was followed by Bailout Mark 2, purchased from politicians at the cost of a wholly unjustified $120 billion in additional pork barrel tax benefits.

The wiser approach, now adopted by the Treasury, but long advocated by economists and privately favored by Fed Chief Bernanke, according to the New York Times, has been for the government to invest in preferred stock in banks. This stock, convertible into common stocks if the companies later do well, is a much better deal for the taxpayer and assigns the sifting of the toxic assets to the system that created them.

What next?

Here are some proposals:

1. We must have a quick and efficient way to sustain more banks with capital injections, not just the major banks, using appropriate information gathered by bank supervisors.

2. We need to expand the definition of banks to extend appropriate regulatory regimes to the shadow banking system.

3. We will have to oblige the newly defined banking system to build up equity capital when their lending is expanding, for financial busts too often follow credit booms.

4. We must establish a standard for risk management and risk assessment covering mortgages, derivatives, debt, and even equity and especially on new financial instruments.

5. The Fed will have to continue to guarantee interbank borrowing by banks eligible for recapitalization to reactivate the interbank lending market and reduce abnormally high rates of interest on loans that float above the LIBOR interbank rate.

6. If there is to be a fiscal stimulus program, it should be primarily in infrastructure and not on tax cuts: these tend to be saved and not spent (and Obama's are more of a new entitlement program to people who don't pay any tax at all)

The danger is that politicians, who have little understanding of the financial world, may draw the wrong conclusions from Wall Street follies and make the wrong decisions, as they try to revive our financial system.

We must get this right. The new administration must draft the best of our national talent into shaping and administering these new policies. Otherwise the recession will not be U-shaped and relatively short. It will be L-shaped and extend for many unnecessary years.

Comments

[slowtono]

I see the post as to complicated. Your seeking how to sustain power. That was given up when Wall street failed to police itself. It was surrendered when thieves were accepted and said they couldn't be touched. Wall street is presently seen as nothing but purse snatchers. Even if the monies come back the commoner will pull out with there losses and lick their wounds quietly and they are the base. Wall street will have to have a giant going out of business sale. See what the arrogant don't know, without citizens you've got nothing. What must be faced in all this hub bub is that short term economic stimulus plans like s&l's, enron. mortgage bundling, property swells, day marketers are all BS with emphasis on the S. Long term growth is all that will sustain the market if it's possible. That means no short term gains accept those that are natural, not manipulated, manufactured or padded. I think your screwed! You did it to yourselves and now the boats sinking, were gonna drown. The big world things about to fall back to the local entrepreneurs success. Local banks, local investors small time money makers. Course you could start by collecting stolen unearned funds and make people believe your sincere and to be trusted. But that seems below wall street.

[RichardfromHB]

Paulson just GAVE mortgage co. PNC $7.7 Billion to do mortgage modifications whithout requiring that ANY mortgages acually bE modified. Talk about wealth redistribution. By the way, did you know that bancruptcy judges already have the power to modify the repayment terms of second, vacation, and investment homes (and luxury boat loans), just no power for primary residence nodifications. It is not socialism to have the same "perks" apply to all folk. The elites already see the "bottom up" help on the way in the new administration, versus the current "top down" approach of Paulson. http://seekingalpha.com/article/101965-hedge-funds-threaten-to-block-mortgage-modifications

[themodernleader]

Without jobs and a viable, equitable economy there will be no freedom except for the rulers. Freedom and a declining organization or inversely related.

[Pragmatus]

Dear moderator--what in God's name was wrong with this post that caused it to be deleted?????

While I defer to Mr. Zuckerman's much wider experience and education, I cannot agree that forced stabilization of housing prices is going to solve anything. This is nothing more than wage/price controls, which have NEVER worked. It only allows pricing pressures to build up, that when released merely make a bigger mess.

Mr. Zuckerman, you will need to bite the bullet on this one. Out of the wreckage of this crisis I think you will still have enough money to more than take care of the needs of you and your family. If that's small comfort to you, think of how many people will come out of this crisis utterly ruined. Not the folks on Wall Street of course, I'm talking about the poor working schlubs who will lose their homes, jobs and health insurance.

[joebhed]

Too much anatomy there, Mort.

Here's a clue.
The inflationary housing asset bubble was NOT the cause of our coming depression.
It was a necessary measure taken to create another wave of debts that enslave the American people through debt-money capitalism.
Each boom-bust cycle is necessary because at the contraction phase of each bust all we really do is to wipe out some of the unsustainable debts that have been created in the previous boom.

Debt-money IS the issue.
Debt-money is unnecessary.
Until we do away with debt-money, all we are doing is restarting the next cycle.

Yes, owner-occupied housing need a legislative fix.
Housing the people is a correct function of public policy.
But it does nothing to solve the real cause of the crisis.

Back in the sixties when my Dad was educating me on the fallacy of the debt-money system, we had not reached an accumulation of ONE TRILLION dollars in economic measures - debt or credit or whatever. We crossed the $1Trillion threshold in the early seventies.
Everything that was built by that time took $1Trillion. So that was like two hundred years of progress.

My Dad warned that if we continued with debt-money, at some point we would we would be creating a TRILLION in new debts IN ONE YEAR.
And then there would be an insurmountable crash.
Welcome to some point in the future.

Time for public credit and debt-free money.

[PacificGatePost]

HUMANS ACTING HUMAN

HOWEVER THE PAIN IS PAINTED OR PRESENTED, TAXPAYERS FOOT THE BILL

Billions were made through this bubble, and there is plenty of blame to be spread around, however, where will the magic come from to REALLY solve this mess?

http://pacificgatepost.blogspot.com/2008/10/leadership-missing-in-action-dont-blame.html

[Jewitt]

I agree "that it is critical to find ways to keep foreclosures to a minimum. The entire attempt to re-liquefy the financial system could be undermined by this collapse in housing prices." The purchase of MBSs doesn't provide any control. The purchase of mortgages at full face amounts, as McCain's proposes, transfers the losses to taxpayers and a moratorium on foreclosures, as Obama proposes, only defers the problem and encourages the mortgagors not to pay.

The free market system will eventually established realistic values but in the short term foreclosures, auctions and fire sales will depress the real estate market and related industries at a time you need to encourage economic growth.

I believe one solution is for the government to buy the houses at the current market value on the condition the proceeds discharges the mortgage in full and the current owner rents the home providing a return to the government of say 5%. The current owner would be given an option to buy the house back, for a period of time, at the government's cost provided the rent is kept current.

This approach keeps the houses off the market, the government earns a return on the investment, and the losses stay where they properly reside - with the lender. The lender however eliminates the very real likelihood of further losses should the current scenario continue and is provided liquidity. If this approach potentially bankrupts any financial institution the government can consider whether it warrants financial assistance.

[OkieMon]

this financial crisis is caused by bush's 150 dollar a barrel oil....the marginal people in mortgages (just a few percent at most) were the first to go when the higher costs of everything, induced by higher oil costs, resulted in them foreclosing first....now the higher cost of living has creeped into the mortgage market decimating the ability of the lower 15% of mortgages to be solvent....crisis probably won't stop until close to 20% of all mortgages become insolvent because the people at the lower end simply can't afford their mortgages anymore due to the high cost of everything induced by bush's 150 dollar a barrel oil!!!!!!!!

[marinade]

What are you saying Mort? Bernanke is wise, Bernanke endorses Obama, you endorse Obama?

Like Obama says, a country that is weak economically is going to have a problem maintaining its military might. That's a bad thing for our allies.

[MScott80]

I was skeptical of the de-regulation crowd until I read Steve Forbes new article, "How Capitalism Will Save Us." http://www.forbes.com/forbes/2008/1110/018.html

He demonstrates pretty convincingly how poor Bush Administration monetary policies, bad decisions by the Fed, and Wall Street corruption caused the current crisis. Also, Forbes shows how every other American financial crisis has been caused by too much government action, versus not enough.

It is disappointing that McCain an Obama are unwilling to look at the positive side of deregulation. Forbes thinks if we let free market policies run their course, the crisis will be over in less than a year.

[idest]

We've been letting free market policies run their course, that's how we've gotten to where we are. And how many people lose their savings, their retirement, their homes during that year?

It's awfully easy to argue for market deregulation when you've made your fortune off the market. A bit harder when your house, your job and your future are in jeopardy.

[BillZBubb]

Wow, Steve Forbes! Why don't we go back on the gold standard like Forbes wants too?

You read one propaganda piece by Forbes--who BACKED BUSH 100%-and your position changed? Right.

[SteveMDFP]

Steve Forbes is just goofy. Returning to some version of the gold standard will NOT stabilize the currency. The dollar's value has been FAR MORE STABLE than gold. The value of the dollar is inexorably determined by how many dollars are chasing available goods, services, and property. Attempting to define a dollar's value in any other way is idiotic.


The money creation/destruction dynamic alters constantly as a function of overall faith that account balances represent the same thing as physical currency. As faith falls, demands to cash out accounts (of all kinds) increase. As currency is withdrawn, total money in existence disappears.

What we have here is a money supply that is subject to POSITIVE FEEDBACK. As any engineer will tell you, positive feedback systems oscillate. They natually go up and down, up and down, up and down.

Managing the economy really does require a Federal Reserve Bank. The economy, left without active management, would naturally be cycling between ruinous inflation and chaotic deflation with an irregular, unpredictable periodicity.

Since most money now exists as electronic information that can be transmitted around the globe at the speed of light and according to computer program instructions, the task of managing a stable money supply by the central banks is becoming a nightmare.

This is what happened over the past 6 months. With global anxieties peaking, the money supply very suddenly took a nosedive. At electronic speed, the world entered into a deflationary death spiral.


http://stevemdfp.blogspot.com/

[Pulemerci]

I'm confused. Didn't this credit crisis begin with mortgage regulations being loosened to allow people to buy homes that they couldn't afford? This Sunday Times had an article on Henry Cisneros who was Bill Clinton's HUD chief. He was apparently the architecht for this fiasco by carrying out Clinton's policy.

[Overd0g]

Nope. It began when people started borrowing more than they could repay. Theoretically, we are adults (otherwise we should have our voting rights revoked). Lots of people made a big, high risk, gamble on real estate and lost. And now all that phony "wealth" (that never really existed) is disappearing like the illusion it was.

[nezumi]

All the phony 'value' assigned to paper money disappearing like the illusion it was.
Don't discount illusion, there is no such thing as a real price, only in hind sight.

And the real reason behind all this debt is low interest rates, that, among others, discouraged saving.

[idest]

Nope. The mortgage crisis began by lenders offering complex mortgage arrangements with hidden rate increases to people who did not have the resources to parse the mortgage documents and without an explanation of the rate increase.

The credit crisis occurred because investment banks bought up these mortgages and resold them as "securities" to other investment banks and institutions, all which were allowed to have a higher debt-to-asset ratio than ever previously allowed (thanks Republicans). So when the rate increases hit and people defaulted on their debt, the investment banks also had debt they couldn't repay. This caused some banks to go belly-up, but most tightened lending, which has slowed down the economy tremendously.

I'd suggest in the future not basing your entire argument about a complex economic issue on a single article in the "Sunday Times".

[BillZBubb]

Was that the "Moonie Times"?

Funny how a supposed action by Clinton didn't cause a problem in his term, didn't cause a problem in the recession at the start of the Bush administration, yet all of the sudden pops up at the end of Bush's second term when the economy was supposedly doing well. Maybe a little critical thinking is in order?

The party of "responsibility" guys sure are good at passing the buck. Bush and the Republicans own this mess--it was their policies, no one else's that led to this.

[Oldbuck]

The thing that has been proven is that Laissez - faire in its truest form will not work it has been proven over and over since we got past the barter system and went to monetary system this has been proven over and over. Their has to be some controlled socialism in our system are it will fail no one wants to admit that we had created one of the strongest economy in the world after WW ll. We then started to mess with it. Creative accounting has caused many of our problems by changing the real tried and true accounting principle we hide the real creeping problems we have. We have screw with figuring the inflation rate so much we don't know what it is. The root cause of our problems was a political philosophy which prior to the great depression was used then again in the 1980 we started this again and here we are today.

[Overd0g]

Why do you think it doesn't work? Capitalism is about freedom, not security.

[idest]

Capitalism is about profit, not freedom. Do you know any capitalists who would sacrifice profit for themselves for freedom for another? I don't.

[WritingFrontier]

Want to understand just how much trouble we're in? You first need to understand what a a trillion dollars means to you. See Writing Frontier's "One trillion dollars" at

http://writingfrontier.com/2008/10/22/one-trillion-dollars/

[CroatianCritter]

I enjoyed your post but disagree on a few points. First, the pumping into the system of new money in 2000-2001 and in the present is causing an inflationary crisis. Instead of crashing, we are going to enter a slow decline that will destroy our empire. Secondly, the tactics taken by the Federal Reserve to help us out of the tech crash directly led to this more serious Wall Street crash. If they had allowed the normal fallback of the tech companies that would have occurred anyway, this whole mess could have been avoided. I believe this was all the Fed's fault when it comes to this current problem. And now with our debt problem and more money being injected into a system creating more inflation, we are going to have an even more painful recession.

[Overd0g]

If the govt. winds up with a larger percentage of the economy than it already has, then we are finished.

[Paul]

Too bad the free market screwed itself.

Why does it always do that?

[SteveMDFP]

Inflation? Six months ago, we had inflation, maybe. Since the start of the criisis, virutally all prices have been falling fast. Think about it: oil, gasoline, stocks, real estate, commodities of all sorts (even gold!!).

This is a DEFLATIONARY DEATH SPIRAL

http://stevemdfp.blogspot.com/

[scordsdu]

Dear Publius:
take the idea of laissez-faire to its extreme by opposing all compulsory state intervention including taxation, preferring that law and order be privately funded. Laissez-faire (pronunciation: French, [lɛsefɛʁ] (help·info); English, ˌleɪseɪˈfɛər (help·info)) is a French phrase literally meaning Let do (“allow to do”). ie)wikipedia