What Caused This Crisis?

I am sure I’m not that different from many others when I ask the simple question, what happened? How did the banks get into such a mess? What didn’t they see, and what regulation failed? Was the reserve ratio that the federal reserve demands too low? Did debt move from regulated to unregulated, and if so, why would that have caused a failure of regulated banks? How is it that the vast amount of debt went unrecorded until recently? And what are we doing wrong now?

The New York Times offers a new insight into what had happened. According to this article, a decision in 2004 by the SEC, headed by William Donaldson at the time, permitted banks to exceed the reserve ratio in their investment houses, and money seemingly flew freely between the two. There was meant to be oversight of the banks’ health at the time, but that oversight never happened.

Why did the banks seek this change in 2004? They did not believe they could compete against the large investment houses with so much money tied up in case of a credit crunch. Put another way, we forgot some of the lessons of the 1920s.

And so it’s now obvious to all. President Bush has not only presided over the worst financial debacle since the Great Depression, but he and his team failed to learn from the mistakes of that era, making him worse than President Hoover, in my book.

What do we need to do to fix the problems? Some of it has already happened. Banks have become very conservative, and perhaps are leaning too far: it’s very hard to tell when the country is teetering on a recession. Some of that conservative nature needs to be codified by reversing the 2004 decision or requiring investment houses to meet the reserve ratio. In order to figure out which we have to question whether or not we can let a large investment house fail. If we cannot, then more regulation is appropriate. One way to split the baby is to require regulation of total assets and debt above a certain number, say the $5 billion talked about in the article.

Will the Bail-Out Help?

Today some of the questions many people wonder are precisely what has gone wrong, what is going wrong, and what will a bailout fix. What has gone wrong is that the credit default swapping market was not sufficiently capitalized to account for a heavy rate of defaults. Normally banks are required to meet a reserve ratio as part of their regulation. However, when debt is sold to non-bank entities, like Merrill Lynch, they no longer have to meet a particular reserve. One of the requirements for Goldman, now that they are a bank, will be to meet this reserve. This is why they needed to find a sugar daddy, like Warren Buffet.

What is going wrong still is that now that banks have been burned they have become increasingly more conservative, and have refused to loan not only home owners money, but also businesses money. Businesses, in turn, are being increasingly conservative with their precious dollars, for fear that they won’t be able to get more of them. Because of this the U.S. is likely to suffer a recession, and no place will suffer worse than the entrepeneurial capital, Silicon Valley.

There is also the matter of all the failed loans. We don’t know where all the debt is, because banks can take their sweet old time deciding when a loan has failed, and hence reporting it to their stockholders. The bailout will give creditors incentives to get rid of debt that is likely bad.

What the bailout may not fix is the confidence problem that creditors now have. Creditors may, however, be of two minds, one being that they could fail by taking on too much debt, and the other being that the U.S. government will provide a backstop to any serious failure. If the latter is true, even if unwsie, then those companies will make capital available.

Who wins in the current climate? Large companies that are their own banks can take advantage of their position, because there will be fewer smaller disruptive competitors. Venture capitalists will win because they will be able to drive better deals with startups. Employers on the whole will win because the job market will slacken.

The consumer, however, may not win. The cost of imported goods and services remains high in this environment, and is unlikely to change for some time, until capital markets open up again. This is because the dollar remains near all time lows. Worse, because other economies are beginning to faulter, we will not be able to export our way out of the hole (we’ve been doing that for some time).

Put another way, everyone is still in for a rough ride.

McCain Tactics Wrong

Americans measure both leaders and potential leaders against how they would handle problems of the day. The problem of the day is the crisis on Wall St., and Senator John McCain is violating the first rule of campaigning: he’s not. Now- if he were the chairman of the Federal Reserve, that might make sense on at least two levels, that he would have been central to having caused the mess, and central to clean it up. But he is neither.

He does not want to show up at a debate on Friday night in Mississippi if the crisis is not resolved. Question: what business gets conducted on a Friday night? Practically none. It’s not to say that people can’t work on Friday night, but very little need be done then. Especially by him.

John McCain made his mark on foreign policy and on generally conservative domestic policies. He is not now, nor has he ever been a banker, sat on a banking committee, or promoted policies relating to banks.

This very much reminds me of the time President Carter barricaded himself in the Whitehouse during the Iranian hostage crisis. McCain should expect the same results Carter got.

Please do not applaud

The market had an “Up” day on Friday, now that Congress and the administration have decided that the crisis is so great that it requires what the Wall Street Journal described on Thursday as the biggest bailout since the 1930s. We are now seven years and eight months into the Bush administration, and the comparisons to Herbert Hoover seem most apt. As I mentioned in a previous blog, it was clear that the administration and this president lacked credibility to calm markets simply by words. Opening up the coffers of future tax payers, however, speaks volumes.

While many will applaud the deal that Congress and the administration have put together to stablize the financial industry we have to ask ourselves how we got here in the first place. While Democrats must take some blame for cowering in the face of anti-government rhetoric, it was the Republicans who clearly controlled the agenda. And now we have seen the results.

There are no good ways to manage a bailout- only bad and worse ways. The good way involves not requiring it in the first place. Oversight of the markets has clearly been lax, as we discussed in the oil and food market. Here now is the difference between a Republican and a Libertarian: a Libertarian’s principles dictate that he or she let the financial markets fail. A Republican wants to be re-elected.

So please, no applause for the government’s move. Our children will pay the bill for us.

Market Turmoil

First let’s agree that the acquisition of Merrill Lynch by Bank of America was a horrible move by one or the other. If Merrill doesn’t understand its exposure, then BoA now has an open exposure. Otherwise, why would they go running into the arms of BofA at such a turbulent point? It doesn’t bode particularly well for the industry either, when you have a maniac whacko at the top of BofA.

While President Bush sought to reassure investors that the market would recover, why would anyone believe that he has any understanding of what the market dynamics are at this point? Ben Bernanke clearly has misread the state of the economy from the outset of his stint as the Fed chairman, and he was the President’s best choice. The only person who seems to have made any sense of this at all is Secretary Paulson, who made it clear to Wall Street that the taxpayers cannot be expected to underwrite every company that would otherwise fail. But he has made no claims about understanding when and where the market will turn around. Good for him.

All of this having been said, clearly the president had to say something, and what he said was the least offensive. Had he real credibility he perhaps could have had more of an impact on prices, but that day is long past (if it ever was).