This weekâ€™s financial developments have unfolded in the ways that keep people up at night and spark panic in even seasoned investors. And itâ€™s not over yet â€” weâ€™re perhaps midway through the financial crisis (which actually could get much worse), and headed fast into a serious and disturbing recession.
Itâ€™s as if the economy entered a time warp and we found our way into a 19th century boom and bust cycle â€” and the bust phase is never pleasant. It started, as everyone can now understand, when the bubble in the housing market opened up a new flank in subprime borrowers, Wall Street hotshots packaged those subprime mortgages into securities, bought by the tens of billions with tens of billions in borrowed money; and then even hotter shots created trillions in â€œcredit default swapsâ€ that guaranteed those securities against default. Once the housing market swooned, the rest was dominos, from mortgages to mortgage-backed securities to credit default swaps to the institutions that provided all the borrowed money for both.
You know the rest as the financial system began to crack under the monumental weight of defaulting securities â€” the denizens of free-market capitalism in the Bush administration bailed out Bear Stearns, then took over Fannie Mae and Freddie Mac, and then threw $85 billion in loans at AIG, with all of its assets as the collateral. Lehman Brothers and Merrill Lynch are gone, and in another month, so a number of other major financial institutions will join them.
The time to tackle these problems was during the boom, not during the bust, in extremis. Thatâ€™s especially true with a boom where the risks are as graphic and obvious as they were this time. Instead, the potential costs were consistently denied, set aside, or ignored, and the biggest responsibility lies with those who should have made the long-term health of their companies and our economy their top priority. The titans of Wall Street and senior officials at the Federal Reserve, the Treasury and the White House economic council all understood the nature and extent of the risks. They are the â€œMichael Browniesâ€ of the current financial crisis. (And lest we forget â€” as if anyone could â€” most of the Wall Street titans are walking away with tens of millions of dollars, because their compensation agreements reward them for high profits based on speculative risks and impose no penalty when it all collapses.)
This is a bust that was inevitable. With the enormous expansion in the global capital pool and the stream of hundreds of billions of dollars a year of that capital into the United States, financial institutions found increasingly risky ways to earn fees and other income from all that capital. Our government sat by as largely unregulated funds and investment banks create new securities and then sold them to investors leveraged up to 95 or 97 percent â€” including new funds they created themselves to buy the securities they issued themselves. Where was the Fed, the Treasury and the White House â€” or John McCain â€” when these instruments proliferated into the trillions with little collateral behind them. Ironically, many of these new instruments were intended to diversify risk, such as the credit default swaps. With those, the owner of assets like mortgages, auto loans or credit card debt exchanges a piece of the income stream from those assets for a guarantee that heâ€™d be covered if the debtors defaulted. It works only if the incidence of default is very low â€” and those issuing the guarantees can make good when defaults happen. Indeed, a good of the colossal failure of the Federal Reserve, the Treasury and the administration involves their negligence in insuring that such defaults would remain rare and that those providing the guarantees when did happen could make good on them. Even as the defaults began to rise and the guarantees began to fail, they remain aloof, and their oversight and regulation virtually non-existent. The market became an inverted pyramid that inevitably would topple.
Weâ€™re in the middle of a slow-motion, cascading systemic crisis, and itâ€™s not over yet. In fact, it probably wonâ€™t end until the housing market stabilizes and begins to recover. Meanwhile, it will continue to slowly grind down the economy for everyone. As the institutions that remain absorb more losses, they will have to sell more assets to restore their balance sheets, driving down asset prices, and limit their new lending to businesses. To get some sense of the dimensions, consider that the global market in credit default swaps is an estimated $60 trillion â€” thatâ€™s equal to the estimated value of all assets in the U.S. economy. If five percent of those swaps go bad, thatâ€™s $3 trillion, or six times the size of the Savings & Loan crisis and a nearly one-quarter the size of U.S. GDP. Thatâ€™s another measure of the dimension of the criminal negligence committed by the Federal Reserve, the Treasury, the managements of Lehman Bros., Bear Stearns, AIG, Fannie Mae and Freddie Mac â€” and while weâ€™re at it, thousands of smaller hedge funds.
Now weâ€™re headed for recession. The economy has taken three massive hits â€” first housing, then energy, and now finance â€” and the inevitable result will be real cutbacks in both consumer spending and investment, and with them, growth and employment. The government is spending trillions of dollars to prop up failing institutions, but it has probably reached the limit of its capacity for bail outs, or will soon. Thatâ€™s why, for the first time, the market is pricing the possibility of a U.S. government default.
For now, the best steps we could take would be measures to stop foreclosures and stabilize the housing market. Instead of just lending AIG, which speculated in mortgage-backed securities and the credit default swaps on them, $85 billion, we should make a comparable sum available as special loans to homeowners facing the possibility for personal default and foreclosure. Americans periodically go through phases where they believe that markets can do no harm. But markets fail as well, and this time, the lesson is an especially painful one. Hopefully weâ€™ll learn, and begin at least to regulate financial transactions, wherever they occur, to ensure their basic transparency and a reasonable measure of probity.