Wall Street: The Decline and Fall
Years hence, some Edward Gibbon of American finance will wander among the wreckage of the Great Deleveraging of 2008 and brood on what went wrong. He will likely contemplate a crumbled plinth that once bore a statue to the freewheeling bond traders of one forgotten investment bank; or an obelisk, its inscription obscured by the sands of time, celebrating the credit default swap business of another.
Gibbon, a son of the Enlightenment, attributed the collapse of the Roman Empire to the "triumph of barbarism and religion." Today's chattering classes blame the free markets. Free-market capitalism — which with the rule of law, the sanctity of contracts, individual liberty, and religious tolerance is one of the cornerstones of Anglo-American democracy as articulated from the Puritan Revolution of the 17th century onward — failed, is dead, and not worthy of mourning, preach the oracles of anchor desk and opinion page. The animal spirits of the market must be confined, they say, if not in the dangerous predator enclosures of the Bronx Zoo, then among the bones of Tyrannosaurus rex in the American Museum of Natural History.
Something went wrong. Something did, indeed, fail. But it was not the free market. What collapsed, we think, were some of the policies that, though marketed by Wall Street, were the construct of Washington.
Governments, observed the authors of the Declaration of Independence, exist to secure the rights of individuals to life, liberty, and the pursuit of happiness. Earlier this decade, however, Washington decided that these inalienable rights included home ownership — and not merely home ownership, but "affordable housing." (One could argue that the seeds of the crisis were planted in 1977, after the well-intentioned Community Reinvestment Act passed.)
This did not mean an increase in the supply of affordable homes. It meant an explosion in the supply of easy-to-obtain money. The standards that had guided the decisions of loan officers from time immemorial — 20% down, good credit — were swept into the dustbin of history. Credit rating a bit shabby? Rather not provide proof of income? No problem! Washington wants you housed — so subprime and Alt-A loans grew from around 8% of all mortgages in 2003 to more than 20% in 2006, according to the public policy research group American Enterprise Institute.
At this point, the mortgage industry was no longer about "affordable housing" for working Americans. It was all about quick bucks, "Flip This House," a reality-TV version of Tulipmania or the South Sea Bubble.
It also meant, given the role of government-sponsored entities in the housing market, and the implicit (now explicit) backing of their securities by Washington, the privatization of profit and the socialization of risk, as the Cato Institute's Arnold Kling famously put it.
In such a milieu, says Steve Biggar, managing director of Global Equity Research for Standard & Poor's, the basic rule of investing — adjusting expectations for risk — was thrown out the window. Lending and the extension of credit, Biggar says, "hit speculative levels somewhere in outer space."
The failure of Bear Stearns represented the beginning of a return to realistic assessments of risk. "A year ago, financial markets were overly complacent," says David Wyss, S&P's chief economist. "But at this point, they've swung to total terror — and frozen."
And what forced this reassessment of risk, and the concomitant failure of firms?
Nicole Gelinas, senior fellow at the Manhattan Institute, a think tank, says that the failure of a broad array of financial institutions does not represent a failure of free markets — quite the opposite.
"The role of the market is to assess and mitigate risk, and in the end, that's what it did," says Gelinas. "Failure is a part of capitalism; to claim the bankruptcy of a financial firm represents the bankruptcy of capitalism is incorrect."
Given that raising capital — by bank lending to consumers and businesses, and the issuance of equity or debt — is the lifeblood of American business, Gelinas argues financial firms can't be permitted to fail on a mass scale. She supports "predictable" government response to the crisis — as differentiated from the "piecemeal" approaches previously taken.
However, Gelinas would rather the government inject capital into ailing institutions through the purchase of preferred shares, as opposed to Washington taking outright control of institutions. This would result in a "haircut" for existing bondholders, but would provide a valuable lesson in the importance of realistic risk assessment.
Biggar agrees. "All in all, this is a healthy reintroduction of risk into the equation, a flushing out of speculative excess."
Wyss believes conditions will eventually settle. Michael Thompson, managing director for S&P's Market, Credit and Risk Strategies, which operates independently of S&P Equity Research, recommends investors watch for real estate values to stabilize or edge higher; a rebound in existing and new home sales; an easing of credit conditions; and a decline and stabilization in crude oil prices.
Still, the current bailout package under discussion by our nation's Solons bears close watching. Washington bears no small responsibility for the current crisis; it's to be hoped that any remedy will not cause a sickness worse than the initial disease.
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