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.