Thursday, September 18, 2008

The Financial Crisis Explained

1. Why did the financial meltdown happen?

2. Who is to blame for it?

3. What, if anything, can be done to fix it?

I know many of you don't have the patience to read more than the absolute minimum, so I start by giving some of the briefest answers possible:

1. Cause? The price of housing - and therefore mortgages - was too high, which in combination with high leverage (such as >30:1) caused those institutions who bet on the wrong direction of the market to go bankrupt in an accelerated fashion.

2. Blame? Most of the blame is simply in the hands of those who were too optimistic on the housing/mortgage market. Those who shorted those markets made lots of money.

3. Solution? Basically nothing. Asset bubbles happen every few years (remember the Internet boom 1999-2000?) and they will happen again. Prices must simply be allowed to adjust down.

Here is more detail:

Why did the financial meltdown happen? In and around 1997, the US Congress – supported by President Clinton – did two things. One was the real estate capital gains tax cut, which eliminated the capital gains tax on primary home real estate held over two years up to $250,000 for a single filer and $500,000 for a married couple. This may be the biggest tax cut ever, and it made real estate the most favored investment class. Small wonder, then, that real estate prices rose in an unprecedented manner for approximately ten years in a row. At some point, however, as in any bubble rising, it went too far. It became easy to see at some point after year 2000 when in many places it had become cheaper to rent than to own, pointing to over-inflated prices.

Around the same time, Congress was persuaded to pressure the mortgage industry to provide loans to those it claimed it had been unjustly denied loans in the past – the poor, blacks, The mortgage companies were basically told to make loans with lower standards than in the past…or else. If they played ball, unlimited funds would be available from Freddie Mac (FRE) and Fannie Mae (FNM). If they didn't play ball… well, John Edwards is a great trial lawyer going after those evil big corporations.

At the center of what turned into a highly unsound feeding frenzy were Freddie Mac and Fannie Mae, ostensibly private companies but ones where the leadership were politically appointed. Basically, these two institutions were run by political hacks from both parties, feeding the mortgage industry with billions of dollars earmarked for loans to those who previously didn't qualify for home ownership.

Around 2003, Fannie/Freddie admitted that their financial statement couldn't be relied upon, and it's not clear that they ever put them in order since. There were several proposals from The White House in recent years to change this system drastically, but efforts to do so were rebuffed by Congress and in particular Chris Dodd and Barney Frank. As long as home prices kept rising, these highly unsound practices didn't bother most people. In fact, the companies who originated the mortgages managed to sell them to Wall Street firms such as Bear Stearns and Lehman Brothers (LEH), who were looking to obtain higher yields on their proprietary trading portfolios. Leveraging up over 30:1, this became very profitable for those firms, until the bubble burst. Remember, at 30:1 leverage, you are bankrupt at as soon as losses exceed 3%.

Who is to blame? If by blame you mean losing money, obviously everyone who were long real estate after the peak in or around 2005 are to blame. But losing money isn't illegal; it happens in the market every single day – for every buyer, there is a seller, but the market only goes in one direction. Per definition, after the fact, every trade has a winner and a loser. What about doing something illegal? If there is something illegal here, I haven't seen it. Lots of stupidity and the usual bubble mania, but those things aren't illegal.

Certainly Congress is at fault for having created the monster organizations Freddie Mac and Fannie Mae. Neither one should have been created to begin with, because the government has no legitimate role in conducting commerce. It is equivalent to the government starting airline companies for the purpose selling subsidized airline tickets. In addition, the pressures Congress put on the mortgage organizations to make loans to those who didn't deserve them were extremely complicit in this debacle. Some of the investment banks shot themselves in the foot by taking on bad mortgage paper and leveraging up, leading to their demise.

What's the solution now? Sadly, the milk has already been spilled, because some people who didn't deserve mortgages already received them, and others bought homes at prices too high. There is simply no painless solution to this fundamental situation; prices must be allowed to fall. Those who are heavily exposed – indeed leveraged – to overvalued financial instruments, will have to take losses and some may go bankrupt.

One final word of caution and moderation: We had a 10-year real estate boom in which more wealth was created than in any previous boom or bubble. In the last 18 months, we have given back some of those gains, but far from all. Booms and busts do happen, but as with the Internet boom a few years earlier, on balance more wealth was created than destroyed as the bubble burst and some of the gains given back. It's happened before, and it will happen again – just like Summer turns to Fall, Fall turns to Winter… bubbles and business cycles are part of economic – and therefore human – nature.

Sunday, September 14, 2008

Why Hillary Voters Switch To Palin

In recent days, the argument has been made by the angry left that the women who voted for Hillary will not consider voting for Sarah Palin because their policy positions are mostly in opposition to each other. Left-wing feminists have said things such as “Palin has only a chromosome in common with Hillary” and equivalent.

This theory would be correct if all women voted for Hillary because of her policy positions to begin with. I doubt that is the case. Hillary's policy positions were 99% identical to Obama’s – and for that matter John Edwards'. Some people voted for Hillary because they disliked Obama’s personality. Other voted for Hillary because they really liked Bill Clinton. But others also voted for Hillary simply because she is a woman. It is that latter group which could very easily fall into Palin’s lap. Clearly, far from all Hillary voters will do so, but it probably doesn’t take more than 5%-10% to swing this election in McCain’s favor.

So there you have it: Some women voted for Hillary because she is a woman. Therefore, it should be no mystery that Palin is picking up many of them.

Talking To Our Enemies

(originally published June 2008)

64 years ago this morning, the largest military operation in history was unleashed from the British Isles onto Normandy, France. As the sun rose on Omaha Beach, ten thousand vessels carrying over a million soldiers approached the German-controlled and fortified beaches. Within two days, these brave men had established a defensible beach-head, marking the beginning of the end of the Nazi regime. The war in Europe would end eleven months later, only days after Hitler's suicide. D-Day was a majestic triumph for Generals Eisenhower, Montgomery and Patton - as well as the political leadership of Winston Churchill and F.D. Roosevelt. Unprecedented in history, most of Europe has since seen a lack of traditional military conflict for over 63 years.

Only months after D-Day, the US fought a fully-fledged naval battle against Japan outside the Philippines. It remains the last such battle fought, and will likely remain so for the rest of history. Technology has made it impossible to launch not only large invasions in secret (such as D-Day), but also to have a naval battle that's basically not over before it's even started.

What does this mean? It means that information technology and the dispersion of destructive power have made wars particularly expensive. Sure, you can always win a war, but they may not be worth launching, even if you win. Witness the high cost to the US of removing one of our contemporary Hitlers, in the form of the Butcher of Bagdhad, Saddam Hussein.

This leads to the present problem of how to depose today's most destructive and dangerous regimes, who threaten the survival of the free world. Regimes in North Korea, Iran, Cuba and Venezuela engage in some combinations of enslavement of their populations and aggression against their neighbors and other countries. Left unchecked, these regimes are on paths to kill millions of people, perhaps many here at home.

Military options against these countries carry high risks and costs. North Korea could wipe out South Korea and perhaps other countries with conventional weapons alone. Nuclear weapons could kill 10 million New Yorkers in one second. Iran may be as little as a year or two from developing those weapons as well. It is starting to look like these situations resemble the cold war, when the US had no military power to take out the Evil Soviet Empire: Mutually Assured Destruction (MAD).

So how did we take down the Evil Soviet Empire? Apart from the fact that it collapsed under its own Obama-nomics weight, we - or rather, Ronald Reagan - engaged in a very public diplomacy to embody our moral superiority over the enemy. Speaking of Obama, it now looks like this is the one limited area where he is actually taking a book from the Reagan playbook, and suggesting we talk to these dicators without preconditions. This is opposed by the Clintons as well as McCain and many others.

The recipe for potential success here is for the current and future US Presidents to realize - just like Reagan did - that we have moved into the TV mass media age, and that it is time to stop hiding. Instead, the US President should fly immediately to Iran and insist on a debate with the leadership - live broadcast on TV for everyone to see.

The point here is that we are now talking to these regimes, but only at lower levels of government, through back-channels and behind closed doors. This is useless. Our enemies can lie, continue to make preposterous claims and break any promises made. It does not help their own peoples to get the courage to depose their oppressors. Obama may have proposed the idea in principle, but McCain may be better in pulling it off, in the form of his most-beloved town-hall debate format. Now, if he only could support the idea to begin with...

This tactic may work in Iran, where there is TV and people have some knowledge of the rest of the world. It would probably not work in North Korea, where until earlier this year a cell phone call carried the death penalty via hanging in public. There is no TV.

No, when it comes to North Korea, a very different form of US Presidential diplomacy is needed. Specifically, the kind employed by an ex-President. And I'm not talking about Jimmy "The Naïve" Carter, who screwed up the North Korean situation to begin with, in 1994. No, rather I'm talking about Bill Clinton.

Former President Clinton needs to take Mr Party Boy leader of North Korea - Kim Jong Mentally Ill - to a weekend in Las Vegas, focusing on the more expensive late-night establishments. Think Eliot Spitzer's preferences, $5,000 an hour. Lots of them. I say, spend $100 million on the weekend. A long weekend.

Then, at the end of that long weekend, Bill Clinton needs to whisper in Kim's ear: "Look, either of the following two things will happen now: We will take a risk and remove your country and its residents from the face of the Earth. Cheney will press the button himself. Or we have option #2 for you."

Kim: "What's option #2?"

Clinton: "That this weekend will never end. We have made available an island in the South Pacific, where we have built a copy of The Playboy Mansion. Hef himself has made sure to guarantee a rotating staff of 500 of his finest friends and acquaintances. I have the pictures and videos of all 500 on this iPod Touch right here, so you can see for yourself right now. We will ensure you will live out your dreams for the rest of your life. All we require is that you never leave the island or have any outgoing communication to the rest of the world. Deal?"

Kim: "Beats a nuclear bomb falling down on my head. Where do I sign up?"

Clinton: "Just follow my lovely friend Monica into that oval room. She will help you use the pencil. Here is a cigar, too."

Conclusion: Deadly world crisis averted.

Alrighty, so it may happen slightly differently, or he may be more suicidal than interested in a good time. But it's worth trying, no?

Nixon turned Red China from foe to friend by going to see Chairman Mao in Peking 1972. Reagan took General Secretary Gorbachev to task in the mid-late 1980s, with several personal TV-broadcast meetings, and stood personally at the Brandenberger Tor gate in Berlin demanding that Gorbachev "open this gate" and "tear down this wall."

Where is Reagan when we need him yet again?