Mad Max and the Meltdown

How we went from Christmas to crisis.

Notwithstanding the cardboard Santas who seem to have arrived in stores this year near Halloween, the holiday season starts in seven days with Thanksgiving. And so it will come to pass once again that many people will spend four weeks biting on tongues lest they say “Merry Christmas” and perchance, give offense. Christmas, the holiday that dare not speak its name.

[Wonder Land] Warner Bros./Kobal Collection

Mortgage-backed security survivor.

This year we celebrate the desacralized “holidays” amid what is for many unprecedented economic ruin — fortunes halved, jobs lost, homes foreclosed. People wonder, What happened? One man’s theory: A nation whose people can’t say “Merry Christmas” is a nation capable of ruining its own economy.

One had better explain that.

How the financial markets fell so far so fast will occupy economic seers for years. The path to 50% wealth reductions and the death of Wall Street was paved with good intentions, notably the notion that all should own a house, even if that required giving away the house to untutored borrowers with low-to-no-interest loans.

Did the forces behind the movement to replace “Merry Christmas” with “Happy Holidays” have any correlation to the nation in a financial crisis? Dan Henninger of WSJ Editorial page looks at the issue. (Nov. 20)

This good intention set off history’s largest chain of moral hazard. The great unraveling began sometime between 2005 and 2007, when borrowers, lenders and securitizer shamans all found themselves operating in a zero-gravity environment, aloft on moral hazard.

The technical details have been described with harrowing precision by Robert Stowe England in “Anatomy of a Meltdown” for Mortgage Banker magazine. Briefly: “The underwater earthquake that first rattled the foundations of the mortgage industry came in the form of sharply higher delinquencies and defaults from a book of poorly underwritten subprime loans from the fourth quarter of 2005 through the first quarter of 2007.”

His narrative runs through borrowers making misrepresentations on loan applications (fraud), the collapse of Bear Stearns’s hedge funds, revised ratings-agency methodologies that led to “unprecedented” mass downgrades, causing a contagion that spread from subprime to prime home-equity loans, and a warning from the president of the IndyMac S&L that “the private secondary market is not functioning.” This in turn precipitates a “torrent of deleveraging.” Here’s the best part: Mr. England’s chapter-and-verse article appeared in October — of 2007, one year before the current mass panic.

A more recent, widely emailed article for by Michael Lewis of “Liar’s Poker” fame describes a skeptical hedge-fund manager and his associates walking through the wild world of mortgage-backed securities like stunned characters in “Mad Max,” in effect asking bankers, borrowers and ratings-agency executives one question: Why? Why do you think all of you can get rich, all at the same time, forever?

On Sept. 25, a week after Lehman Brothers declared bankruptcy, Nicolas Sarkozy announced, “Laissez-faire is finished.” Then the Washington Post asked on its front page: “Is American Capitalism Finished?”

Little or nothing that has occurred through this crisis discredits the system of free-market capitalism. Across several centuries of rising world incomes and social gains, the system has proved its worth. In this instance, the system has been badly used — by mere people. Nonetheless, the dimensions of the fall and devastation that originated in subprime mortgages are breathtaking.

Amid all these downward-pushing pressures, occurring in plain sight, hardly anyone or anything stepped up to brake the fall. What happened?

The answer echoing through the marble hallways of Congress and Europe’s ministries is: regulation failed. In short, throw plaster at cracked walls. Trusting the public sector to protect us from financial catastrophe is a bad idea. When the Social Security and Medicare meltdowns arrive, as precisely foretold by their trustees, will we ask again: What were they thinking?

What really went missing through the subprime mortgage years were the three Rs: responsibility, restraint and remorse. They are the ballast that stabilizes two better-known Rs from the world of free markets: risk and reward.

Responsibility and restraint are moral sentiments. Remorse is a product of conscience. None of these grow on trees. Each must be learned, taught, passed down. And so we come back to the disappearance of “Merry Christmas.”

It has been my view that the steady secularizing and insistent effort at dereligioning America has been dangerous. That danger flashed red in the fall into subprime personal behavior by borrowers and bankers, who after all are just people. Northerners and atheists who vilify Southern evangelicals are throwing out nurturers of useful virtue with the bathwater of obnoxious political opinions.

The point for a healthy society of commerce and politics is not that religion saves, but that it keeps most of the players inside the chalk lines. We are erasing the chalk lines.

Feel free: Banish Merry Christmas. Get ready for Mad Max.

Not Everything Can Be Too Big to Fail

There’s a lot of loose talk about ‘systemic’ risk.

There is a really bad idea circulating in the nation’s capital. Of course, that’s not surprising — but when it’s endorsed by the Treasury secretary, we’d better pay attention.

This week, Henry Paulson said in an interview with the Washington Post that he wants the Federal Reserve to be able to regulate and ultimately take over any failing financial institution that it considers crucial — including hedge funds. This echoes a notion that has been endorsed by executives of some industry associations, that to prevent a recurrence of today’s financial crisis it will be necessary to impose tough new regulations on financial institutions deemed “systemically significant.”

If this approach were to be adopted in the panicked Washington of today, it would substantially change our financial system and guarantee — rather than prevent — future crises.

For starters, because the definition of a systemically significant institution is highly dependent on context, it’s impossible to identify one in advance. Consider Drexel Burnham Lambert. When it failed in 1990 it was one of the largest securities firms in the United States, not much smaller in relation to the market at the time than Lehman Brothers was when it collapsed earlier this year. Yet Drexel’s collapse, which happened when the market was functioning normally, did not put the financial system or the economy at risk.

On the other hand, when Germany’s Herstatt Bank failed to meet its international payment obligations in the mid-1970s, that event caused a serious globalized payment-system crisis — even though Herstatt itself would not have been on anyone’s list of major financial institutions at the time.

And then there’s Northern Rock in London. When it collapsed recently, the British government was forced to bail it out even though it was not considered significant before its depositors started to run. In fact, in today’s fragile markets, almost any financial institution is systemically significant — if what we mean by the term is that its collapse will stimulate fear about the stability of others.

In short, predicting the true sources of systemic risk in advance of their actual failure is probably impossible. But even if it could be done, should we want to?

The answer is no. An institution designated as systemically significant, or “crucial,” would be marked as too big to fail. After all, that’s what such a designation means — that the institution’s failure must be avoided because of its potential impact on the economy or financial system. But once we designate a financial institution as too big to fail, and regulate it as such, a lot of unpleasant things follow.

First, we will have created “moral hazard” and impaired market discipline. The markets will understand that a loan to a systemically significant institution will carry less risk than a loan to an institution that does not have this status. Accordingly, systemically significant institutions will have an easier time raising funds than others, will pay lower rates and grow larger than others, and it will be able to take more risks because of the absence of market discipline.

This in a nutshell is the story of Fannie Mae and Freddie Mac. The two companies were implicitly backed by the U.S. government, which in practical terms meant that they would not be allowed to fail. As a result, they were able to borrow as much as they wanted and take risks with those funds that they couldn’t have taken unless the markets believed — correctly as it turned out — that Uncle Sam would stand behind them.

Second, systemically significant institutions would suddenly have an unfair competitive edge that would warp the market. Why? Because their lower funding costs would make them more profitable than others, and enable them — as it enabled Fannie and Freddie — to drive competitors from any markets they enter.

The effect of designating certain companies as systemically significant would cause a consolidation of the industries in which they are located, with the systemically significant companies gobbling up those that couldn’t survive, and others seeking mergers simply to claim designation as systemically significant or too big to fail.

Finally, the support voiced in Washington for the idea of regulating systemically significant financial institutions is based on the fundamental misperception that regulation can prevent them from taking the huge risks their protected status would permit. This New Deal notion should be discarded.

Exhibit A is the banking system, now mired in the worst financial crisis since the Great Depression — even though it has always been the most heavily regulated. Exhibit B is the S&L debacle less than 20 years ago. Thousands of S&Ls and more than 1,500 commercial banks collapsed in another memorable regulatory failure.

It is completely inexplicable — after the blindingly obvious failure of bank regulation — that Washington (and European Union) policy makers would now want to spread regulation beyond banking and into other financial institutions, including hedge funds, brokerage houses and others that the government designates as systemically significant. This would give the government the opportunity to pick winners in each financial industry — ultimately creating Fannies and Freddies everywhere. Among bad ideas, this one stands out.

Mr. Wallison is a senior fellow at the American Enterprise Institute.

China Will Be a Winner in the New Economy

Its cash will help fuel our recovery.

The incoming Obama administration will face formidable challenges, but global economic collapse is no longer imminent. That may be small short-term comfort to the markets and Main Street. But having stared down the abyss, governments around the world appear determined to address root issues. The G-20 gathering of the world’s major powers in Washington on Nov. 15 was only the beginning of a long and constructive process of revising the global system.

In the new system the United States will still be the largest economy but no longer the sole determinant of global economic health. The new winners will be cash and China.

Those without cash are in a precarious position. Tens of millions of homeowners and property owners in the U.S., Europe, the Gulf region and Asia have seen the value of their assets decrease sharply. They either have negative equity or insufficient income to make payments. Pension plans and 401(k) accounts have been devastated by a 50% plunge in global equities. Millions of workers have lost or are about to lose their jobs. The U.S. government balance sheet will become even more debt-laden.

But every crisis creates opportunities — or at least so goes the old Chinese saying. This time is no exception, and China will emerge victorious. As its recently announced $600 billion stimulus package makes clear, those who have cash can spend their way through this global crisis, and China has lots.

The global economy for the past five years has been driven by credit, with cash as currency pushed to the sidelines. With cheap credit, deals got pricier and valuations higher, to the point where some transactions were about as carefully assessed as a Monopoly trade. Now credit is cheap but not readily available. New government regulations and internal risk-mandates will mean that credit won’t flow as promiscuously.

There is more cash sloshing around the world than most people think. The problem for the U.S. and to some extent Europe is that this cash is now in unfamiliar places, some of which — as John McCain reminded us on the campaign trail — can be found in countries that “don’t like us very much.”

The McKinsey Global Institute assessment of global financial assets (which includes bank deposits, stocks, bonds and private equity) released earlier this year showed about $167 trillion world-wide at the end of 2006. That figure is now considerably less but still probably three times global GDP, and represents a massive supply of fuel for economic activity.

Tens of trillions in noninvested money (not in stocks or bonds) sit largely unused. Those who have it are hoarding it, unclear about the short term. As the dust settles, however, that cash will be king.

Some cash will be used for purely private gain, for example by vulture real-estate investors in southern Florida, buying up those unused, unwanted and unsold condos at fire-sale prices. Such cash will do little to enhance the public good. But other uses of cash will.

Corporations in the U.S. alone may have up to $1 trillion reserved, and they will begin to pick at deals amid the market wreckage. They are also likely to weigh future cash flow more cautiously. That doesn’t mean that all deals will turn out well, but the reliance on cash will temper excessive greed and speculation.

Sovereign wealth funds have cash. After being burned in some of their deals at the end of last year, they have become more stringent. But they still have trillions, and they have every intention of investing that money with an eye on future returns, as demonstrated by Abu Dhabi’s recent investment in Barclays, and Saudi Prince Alaweed’s raising his percentage to 5% of deeply depressed Citigroup shares.

Private equity and hedge funds also have pools of cash. We hear about the blowups, but not as much about the ones weathering the storm.

In the next few years, these custodians of private capital are likely to assume the role of venture capitalists, merchant bankers and deal makers all in one. They will take on less leverage (by choice or necessity) and put more of their own skin in the game, which is always a good reason for thinking twice and checking your assumptions.

Then there is China. Yes, the balance of power at the G-20 summit shifted toward Russia, Brazil and its hundreds of billions in reserves, Saudi Arabia, and a rich though still economically stagnant Japan. But China remains in a league of its own.

With $2 trillion in central-bank reserves alone, China is cash-rich and almost debt-free. That is true not just for the government but for many individuals. Because there is no mature bond market and the currency remains unconvertible, individuals in China have a savings rate approaching 50%.

To be sure, there have been real-estate bubbles in many Chinese cities, and these have been popping. But China’s overall cash position is extremely high, and its dependency on exports is less than most suppose.

The immense stimulus package just announced by China should erase fears of a major Chinese slowdown. Yes, some factories will close because labor is cheaper inland than in the more expensive coastal regions. But the shortfall created by sagging exports will be made up by state spending. Beijing has the money, and the willingness to spend it.

China’s actions could also have direct — and positive — effects on the U.S. economy. An investment arm of the Chinese government is now deep in talks to buy up parts of AIG. China is already the primary source of growth for many U.S. companies, including ones like Caterpillar that make things in the U.S. and export them to China. As the developed world sags, China is becoming even more important to the global system.

China also needs a vibrant U.S. (and Europe). Beijing will likely take action to prevent a collapse by continuing to purchase U.S. Treasuries. We may not like the fact that China is our creditor, but having no creditor would be a good deal worse.

The U.S. government can spend for a time, provided the dollar remains the currency of last resort and buyers like China keep lending. But as the New Deal showed, and as Barack Obama understands, government alone cannot fuel the economy. Government must jump-start the system when it stalls, but after that, cash and China will drive the recovery.

Mr. Karabell is the president of River Twice Research. His book on China and the United States will be published by Simon & Schuster next year.

Obama seeks to create 2.5m jobs

President-elect Barack Obama on acting “swiftly and boldy” to create new jobs

US President-elect Barack Obama says he wants his economic team to find ways to generate 2.5 million new jobs during his first two years in office.

In a weekly address on the internet, Mr Obama said he wanted to sign the plan soon after taking office on 20 January.

The message came as unemployment claims rose by 540,000 in the US, taking the total to 1.2 million jobs lost in 2008.

Mr Obama, said to have chosen Timothy Geithner as treasury secretary, is due to name his economic team on Monday.

Mr Geithner, currently chairman of the Federal Reserve Bank of New York, has been deeply involved in the efforts to cope with the current financial crisis.

He previously worked in the Bill Clinton White House, where he worked through the fallout of the Asian financial crisis of the 1990s.

US shares rose sharply on Friday as word spread of Mr Obama’s reported choice, calming investor fears.

Building jobs

Talking about his desire to put job-creation at the heart of the economic policy of the incoming administration, Mr Obama said new unemployment figures reinforced the impression of an economic crisis of “historic proportions”.

Chief of staff: Rahm Emanuel, a deputy chief of staff to Bill Clinton
Senior advisers: David Axelrod, Valerie Jarrett, Peter Rouse and John Podesta (formerly chief of staff to Bill Clinton)
Press secretary: Robert Gibbs
White House counsel: Greg Craig, formerly special counsel to Bill Clinton
Vice-president’s chief of staff: Ron Klain, formerly chief of staff to Al Gore
Staff secretary: Lisa Brown, formerly counsel to Al Gore

He hailed congressional approval of a boost in unemployment benefits, adding that the latest gloomy figures had only reinforced his determination to revitalise the economy.

“We must do more to put people back to work, and get our economy moving again,” the president-elect said.

He said his economic priority would be a two-year, nationwide effort to “jumpstart job-creation in America and lay the foundation for a strong and growing economy”.

Ageing public infrastructure would be rebuilt, Mr Obama said, adding that his administration would look quickly at developing and building sources of renewable energy, such as wind farms, designed to “free” the US from its “dependency” foreign oil.

He suggested he would need cross-party support to get his plan through, despite his Democratic party holding a majority in both houses of Congress.

“Right now there are millions of mothers and fathers who are lying awake at night wondering if next week’s pay check will cover next month’s bills.

“There are Americans showing up to work in the morning only to have cleared out their desks by the afternoon. These Americans need help and they need it now,” Mr Obama said.

Clinton rumours

The president-elect’s public preoccupation with economic matters masks moves towards other key appointments elsewhere in his transition team, reports say.

Barack Obama and Hillary Clinton chat during the election campaign, Ocotober 2008

Mrs Clinton seems poised to serve under her former presidential rival

New York Senator Hillary Clinton, once Mr Obama’s rival for the Democratic presidential nomination, is said to be ready to accept the position of secretary of state, according to the New York Times.

The newspaper said two “confidants” had confirmed that the former first lady would take on the role.

A spokesman for Mrs Clinton told the BBC only that the two camps were in discussions, which were “very much on track”.

Much like the anticipated unveiling of his economic team, Mr Obama is reported to want to unveil his national security team in one fell swoop, and is said to be considering keeping incumbent Defence Secretary Robert Gates in his current job.

To date, the most senior appointment made by Mr Obama, who succeeds President Bush in January, is Rahm Emanuel as his chief of staff.

He is expected to announce a round of appointments after the Thanksgiving holiday next Thursday.

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