The End Of The World As We Know It

The End Of The World As We Know It

 
Eight or nine months ago when the effects of the collapsing housing bubble finally became serious enough to warrant attention in the mainstream national press, speculation arose as to whether and to what extent the government should intervene in the crisis. At the time fallout seemed limited to overextended subprime homebuyers. Calls for increased regulation were easily beaten back. The financial industry prevailed upon regulators and politicians not to overreact. There was no reason for government to meddle in the highly profitable financial sector. 
But of course the danger was much greater than record levels of foreclosures for homeowners living above their means. The more housing prices dropped the more dangerous became all those mortgage backed securities siting on the balance sheets of every financial institution on the planet. So enthusiastic were investors to get in on the U.S. housing bubble, a bubble that even a financial troglodyte like myself knew was not sustainable, that CDOs, CDSs, CLOs, and SIVs (and probably a few other acronyms) filtered through the world economy like metastasizing cancer cells. And what's worse, from the point of view of the market, the utter lack of transparency in these instruments meant that it was impossible to really know how dangerous these things were. 
 
And even when Bear Stearns went belly up in March of this year the danger was not brought home to us. Though the markets were shaken, the fallout didn't seem too bad. Perhaps Bear Stearns would be the only victim. Calls for reform of the financial industry continued, but there was certainly no consensus on increased regulation. Indeed Treasury Secretary Paulson's plan for reform  actually called for less government intervention. There was also a belief that major financial crises simply didn't happen any more.
 
The events of the last couple of weeks have certainly changed that belief. On September 8th Fannie Mae and Freddie Mac were nationalized by the U.S. Government in an effort to prevent their collapse. The combined liabilities of those two companies is over 5 trillion. Then Lehman Brothers went into bankruptcy after the government refused to save it. Merrill Lynch sold itself to Bank of America in an effort to avoid bankruptcy. Next up came the nationalization of AIG.  Seeing Ben Bernanke and Henry Paulson, sober men with hardly a trace of wild-eyed, unrepentant Trotskyite between them, nationalizing one of the world's largest insurance companies was difficult to process. Nationalizing companies and industries is what third world populist governments do. It's not something the U.S. Government is in the habit of doing. Perhaps that's why it went down with nary a word of protest. We were all in shock. And the irony of a company in the business of assessing risk being brought down by an investment too opaque for the risk to be known was too much. It would be funny if it were not so tragic.
 
It wasn't long before we learned that the other big investment houses, Goldman Sachs, Morgan Stanley, Wachovia, were also in trouble and looking for buyers. By the time this is over there won't be an independent investment bank left in the country. Stock markets across the globe fluctuated wildly bouncing back and forth between news of collapse and rescue. The interest rates on T-Bills dropped to levels not seen since the 1940s, and in fact briefly went negative. The TED spread, the difference between the three month T-bill and the LIBOR interest rate - a measure of the level of fear in the market- went above 3 percent. It's usually around 0.5 percent. The SEC stepped in to stopped short selling stocks of financial institutions. The treasury moved  to insure money market funds, some of the safest investment available, in the same way that deposit accounts are insured.  At this point one can't help but wonder if there are comparisons to 1929, but apparently these event have no easy historical parallel.
 
On Thursday evening Bernanke and Paulson met with congressional leaders to discuss the crisis. Lawmakers were apparently stunned into silence  as they were told that we were days "from a complete meltdown of our financial system."  Bernanke and Paulson have proposed a plan to deal with the crisis. Though the details have yet to be hashed out it appears that they propose to create an entity to buy up all the toxic debt at a significant discount in an effort to move it off the books of financial institutions and thereby restore confidence in the system. Banks will no longer be afraid to lend to each other and credit will start to flow again. The government would ultimately sell the debt back onto the open market. While this may indeed restore confidence it would still leave enormous holes in the balance sheets of financial institutions. 
 
Comparisons have been made to the Resolution Trust Corporation, the entity created in the late Eighties to liquid the assets of failed Savings and Loans. But the RTC didn't buy assets, merely liquidated assets it took control of. More ominously, comparisons have also been made to the Reconstruction Finance Corporation, a Depression Era entity of the Hoover administration created to help recapitalize banks by buying their preferred stock.
  
The ultimate cost of the plan is unknown. Estimates range from a few hundred billion to over a trillion.  A draft proposal of the plan  authorizes 700 billion outstanding at any one time and raises the debt limit to $11.315 trillion. It also puts all actions of the Treasury Secretary pursuant to the plan beyond the reach of the courts.
 
We are, I think, witnessing the end of the 30 year experiment to deregulate the financial industry. No one can now believe that the financial industry, left to its own devices, will right itself without causing untold hardship across the planet. You cannot now argue that the government should refrain from meddling in the financial industry because it is now deeply invested in that industry. And we are apparently about to spend at least 700 billion to save the financial industry from itself. If we do not insist on rational regulation of that industry in return then we have just signed on to the largest welfare program in the history of the human race. This is money that is sorely needed for infrastructure and education in this country. In my heart, I find it hard to believe that the American public will allow their government to spend this much of their hard earned tax dollars without getting something in return. The argument is over. Re-regulation of the financial sector is coming. All that remains are the details.