It’s going to be a crummy day on Wall Street (UPDATES) Posted by: McQ
on Monday, September 15, 2008
And that's just the beginning. The bankruptcy of Lehman Brothers, the fourth-largest investment bank, has sent stock futures on the big board into negative 300 territory.
That's not the only reason. Over the weekend - the weekend! - Merrill Lynch, also in deep financial trouble, managed to cobble together a deal to sell itself to Bank of America. On top of that insurance giant AIG is undergoing a radical restructuring plan.
So it is going to hurt today if you have any position in the market at all. But I think that finally letting things go their natural way is a long-term positive. Bail outs may seem like a good move because of the size and impact of failing investment banks on the mortgage market. But the argument has always been that by bailing them out you end up encouraging managers of such institutions to take even greater risks since they were, in essence, rewarded for their previous bad decisions.
That goes for the bailout of Freddie Mac and Fannie Mae as well. Those two institutions -'quasi-governmental' as their called - are freaks which should have been allowed to go under. Since when are we invested in a philosophy of "private profit and public risk?"
One of the problems we've seen give rise to these problems is the political philosophy that treats housing as a "public good" to be managed by government. Freddie and Fannie are manifestations of that new public policy. However, as with most things the government does, they became a bureaucracy which grew powerful and out of control, oversight was lax at best and they sucked up vast amounts of marginal mortgages while becoming top lobbyists in Washington DC (interested in and apparently successfully lobbying for maintaining the status quo).
But back to my point about housing becoming a "public good". Once that political philosophy became accepted in Congress, and with various administrations, it became "appropriate" to bail out the failing instruments of that policy - the investment banks and the "quasi-governmental" organizations Freddie Mac and Fannie Mae. So while in their heyday, they wallowed in private profit, because they support this designated "public good", government feels it is appropriate to use public money to save them from going under.
Private profit - public risk.
Is that the spirit of capitalism or is that the soul of creeping socialism? What will next be declared a "public good?" The auto industry (they're asking for loan guarantees right now)? The airline industry?
Time to let these institutions who knowingly took risks within their industry that they knew weren't prudent suffer the consequences and for the market to work through that turbulence.
That is what is best for our long-term financial benefit. Those who've steered their companies into this financial fiasco need to suffer the inevitable negative consequences of their poor decisions. Those lessons learned will be absorbed by the survivors, internalized, and hopefully never repeated. If they're bailed out, no lessons are learned (except no risk is too great and the bigger you are the more likely you are to be bailed out - because, you know, you're just too big and too damned important to be allowed to fail) and you can expect, at some time in the future, a rerun of what we're suffering now.
UPDATE:Joseph Calhoun has an excellent article about the current crisis, its roots and the long term implications if we continue down our current path:
One of the reasons that Americans increasingly reject free market principles is because they have been convinced that the free market reforms of the Reagan generation have failed. Those reforms - less regulation and lower taxes - are seen as the cause of our problems. Looking at today’s economy one is tempted to agree, but that simple analysis ignores the fact that the Reagan revolution failed in two important areas that are required for the very long term health of our economy: a balanced budget and a stable currency.
Since President Nixon removed the dollar’s last link to gold, monetary policy has been seen by our politicians as the first, and for many the last, tool of economic policy. The only exception is the first term of Ronald Reagan which saw dramatic tax cuts and deregulation of various industries. Those tax cuts and deregulation unleashed a wave of investment from which we still benefit today. Unfortunately, the gains of the Reagan revolution were limited by the lack of monetary reform. Since that time, every economic hiccup has been “solved” by an increase in credit from the Federal Reserve. Meanwhile the value of the dollar, however you define it, has gone through 5 major cycles. It fell after the end of Bretton Woods, rose during Reagan’s first term, fell through the first Bush administration, generally rose during the Clinton years and has fallen again during the second Bush administration.
At the same time, our government has become increasingly reckless with the public purse. From the end of WWII to the end of Bretton Woods, the federal budget quadrupled. That included two wars (Korea and Vietnam) and the budget alternated between minor deficits and minor surpluses. Since ending the last link to gold in 1971, the federal budget has expanded 12 fold and run deficits in all but two years.
The plan we're hearing offered by some politicians?
The prescription offered by these idealistic, if misguided, individuals is a familiar refrain. Raise taxes on the rich to reduce inequality. Increase regulatory oversight in all areas of the economy. Increase government spending on infrastructure. Increase government directed investment in favored industries. Protect American jobs by raising tariffs against low wage countries. Increase union membership and raise the minimum wage through legislative action. Increase healthcare coverage through mandates and direct government spending. Increase taxes on “bad” industries and transfer the revenue to “good” industries or consumers.
More government (the "hopey-changitude" platform). The plan not being offered by most politicians?
The path to recovery for our economy is well worn and proven. Corporate taxes should be reduced dramatically or preferably eliminated. Individual taxes should not be raised and preferably reduced. Regulation should be limited and effective. Banking reform should include a gradual increase in capital requirements. Trade should be expanded, not limited through tariffs and stealthy “fair” trade laments. Most importantly, the Federal Reserve should be reformed and given one mission – a stable currency. Not a rising dollar, not a falling dollar, but a stable dollar. The best way to accomplish that mission is by stabilizing the price of gold. A stable currency, once again linked to gold, will eliminate inflation and limit government spending.
While I agree with most of Calhoun's prescription and echo his point about stabilizing the dollar, I'm afraid I don't see any chance of re-linking the dollar to gold ever happening. Just as I don't ever see the tax code ever really being reformed to the point that politicians can't use it to engage in social engineering instead of a vehicle that funds government. Those that must do the reforming have too much of an vested interest in the power of the status quo. But on his other points, Calhoun is absolutely correct.
And if you want to see an economic recovery, and if this is really all about "the economy stupid", you'd better take a hard look beyond the sound-bites and figure out which of the two parties is most likely to implement Calhoun's prescription and which will implement the "more of the same" solution which got us to this point in the first place.
UPDATE II: Douglas Peta, a market strategist at J. &W. Seligman & Company says:
“We are in the grip of a vicious circle and the only thing that to me will break that is for home prices to stop going down.”
The most dangerous thing we can do right now is to assume that massive government intervention is needed to shore up home prices. After all, massive government intervention is what caused the housing bubble in the first place.
Fannie Mae and Freddie Mac were created by Presidents Franklin D. Roosevelt and Lyndon B. Johnson to make homes more affordable for Americans. They accomplish this by buying, repackaging and then selling home loans that other institutions make, thus freeing institutions to offer more loans. Contrary to what some defenders of big government assert, Fannie and Freddie were also key players in the subprime mortgage market. In 2004 alone, they bought 44% of all subprime securities. Every dollar that Fannie and Freddie gave to companies like Countrywide Financial for bundled subprime mortgages was another dollar Countrywide gave out in new subprime mortgages.
When President Bill Clinton took office, Fannie and Freddie were viewed as “key” to Clinton’s plans to expand home ownership. The Washington Post reports: “The result was a period of unrestrained growth for the companies. … The companies increasingly were seen as the engine of the housing boom.” As the companies grew, conservatives repeatedly warned that their size posed a systemic risk to the financial system. As Sarah Palin put it, thanks to the implicit federal guarantee of their debt, Fannie and Freddie had become too big and too expensive to the taxpayers.
But Fannie and Freddie pushed back hard, turning to friends on the left for protection. Former Walter Mondale and Barack Obama campaign adviser James Johnson led a fierce lobbying campaign to fight reform of Freddie and Fannie. Clinton administration OMB director Franklin Raines told investors when he was Fannie Mae CEO in 1999: “We manage our political risk with the same intensity that we manage our credit and interest rate risks.” Fannie and Freddie’s lobbying power over the left continues to be strong to this day. According to the Center for Responsive Politics, the top three recipients of campaign donations from Freddie and Fannie’s PACs and employees are all Democrats. From 1989 through today, Sen. Chris Dodd received $165,400, Barack Obama $126,349, and John Kerry $111,000. The Washington Post concludes: “Blessed with the advantages of a government agency and a private company at the same time, Fannie Mae and Freddie Mac used their windfall profits to co-opt the politicians who were supposed to control them.”
Nobody wants to see anybody lose their home. The current Wall Street turbulence will not settle until home prices do. But before we move to some new massive government spending effort to prop up home prices at some artificial level, we should also remember what the historical record teaches us about the unintended consequences of well-meaning market interventions.
So it is going to hurt today if you have any position in the market at all. But I think that finally letting things go their natural way is a long-term positive.
Agreed. I also have to think that a lot of investors saw this coming. They know who has balance sheets that are heavily invested into mortgages at this point. The drop likely reflects the surprise that they weren’t bailed out/bought.
I also have to think that a lot of investors saw this coming.
It’s déjà-vu all over again.
I can recall thinking back when Greenspan began lowering rates to the 1% range that this was the making of another bubble and that there was no way it would end nicely. One would think that, with the Dot-Bomb and prior S & L meltdowns still reasonably fresh in memory people would have known better. I thought that especially Alan G. should have.
Look in the mirror folks; we usually get what we deserve.