Lessons from Our Financial Meltdown

There's been a lot written on this subject. And, that's good. But, many still don't get it. They ask, "what can we do to keep greed in check?" Or, "how can we apply controls to keep this from happening again." Or, "why have we given money so freely to support banks and yet have been so free with tough love for the car people who employ so many Americans?"

It's a little like asking why can't I make a machine that produces more energy than it consumes? To answer that, you need to know something about physics. When you're discussing banks, you need to know something about economics. It doesn't excite a lot of people. But, since economics does impact jobs, our ability to save, or maybe even to get rich, it's a subject well worth discussing.

American needs a strong banking system. Alexander Hamilton understood that. Andrew Jackson did not. We can't let our banking system fail; not if we want continued growth in America's standard of living.

Cars are important, but (and you may not like to hear this) they're not as important as banks.
For a business to succeed, it must compete. In other words, it must find buyers in an open market. For many years (and this is history) we didn't have much of an open market for cars. What we had was a market dominated by the Big 3 (GM, Ford, and Chrysler). When you dominate a market, you can often get away with lesser quality and higher market costs.

But when the market opens to competition, the tide can change and generally does. The Big 3, who had caved in to every UAW demand suddenly found themselves having to charge about $2,300 more per car than their Japanese competitors, even though the Japanese were assembling their cars in the U.S. using American made parts. It didn't necessarily follow that the price of a Big 3 car had to cost that much more in terms of sticker price. But, if the price was kept the same, it meant that the Japanese car could offer better features. American car makers had nowhere to go but down. Today's union give-backs were inevitable. But, did it require the demise of the American auto industry? Couldn't the union to see that their wages and benefits were unsustainable?

What has any of this to do with America's banking system? Almost nothing, so stop trying to equate what was needed for our automakers with what was needed for our banking system.

What banks must do is provide liquidity (money) for economic growth. We won't go into the ways the federal government does this. Suffice it to say that if they "grow" the money too quickly we will get inflation and devalued money. On the other hand, if the growth of money is insufficient, we will wind up with deflation and hard times. To put it in childish terms, the porridge shouldn't be too cold, or too hot. It should be just right. And, getting it "just right" is one of the key functions of a central bank.

The liquidity so important to an economy is provided through the bank's lending function. It takes some skill, but they generally manage it reasonably well. In other words, they assess risk and give loans to endeavors likely to succeed and withhold it from endeavors that are problematical. And, of course, they earn money by charging interest on the loans.

How much a bank can lend depends on how much money they're sitting on. They can actually lend more money than they have (that's called leverage), but they do need to be holding a certain amount.

I've used the term "money" in a broad way. Liquid assets, such as bonds that can be easily sold off, will do just as well as actual cash. But, when valued assets turn to dirt, a bank can find itself not only unable to make further loans; it might actually cause the bank to fail. And, that's what happened in the great bank disaster of 2008. The banks' assets, based on bundled mortgages, suddenly proved to be malodorous dirt. Assets that had been the foundation of our banking system suddenly slithered down the drain.

So now we have the great blame game. It's sometimes worthwhile having a great failure so as to be able to enjoy the blame game that follows. In this instance the players are as follows:

1. The bankers. (It should be noted that we have a considerable number of entities that provide credit, but are not recognized as "banks." However, these quasi banks were just as involved in this sorry mess as the "bank" banks.)

2. Insurers of securitized mortgages.

3. Mortgage brokers

4. The Federal Reserve

5. The SEC and a myriad of other controlling agencies.

6. Congress; specifically, the committees that provided oversight to the banking and finance industry.

7. Investors

8. The public

We can quickly knock off a number of people on this list. The public, for example, is, and largely remains, clueless. Sure, many have lost their jobs and many have lost a great deal of their savings. But, they then turn around and elect the same imbeciles who got us into this mess in the first place.

"Investors" is really too inclusive a term to be really meaningful. The small investor usually gets his clock cleaned in a financial tsunami like the one we've just experience. But, you do have a few giants like George Soros, Warren Buffett, and Secretary Henry Paulson (the list is actually somewhat longer) who really know money and economics and realize what's happening before most everyone else. They always come out okay. (And that my dear reader is why you should get to know as much about economics as posssible.)

"Mortgage brokers" includes people who sell securities, or in this case mortgages to the public. It's a job and someone's got to do it. In the old days, banks gave mortgages to people wanting to buy homes. It was a loan with the house as security for the loan. And, it was the interest charged by the bank that privided the bank with income.

Two things happened to change this pretty picture. First, for a period of time, interest rates began going up, and going up fast. To give a mortgage paying the bank 6% when the money cost the bank 8% was clearly a losing proposition. Second, banks learned that they could sell their mortgages and thereby earn a fee. This merry-go-round spun ever faster when someone figured out that the mortgages could be "securitized." In other words, they were bundled to gether and sold like shares in a mutual fund.

And, didn't the government guarantee the mortgages? And, didn't we have Fannie Mae and Freddie Mac to become the buyer of last resort for so many of these securitized mortgages?
And, if the government said "this was good," why wouldn't a hallowed rating organization give the resulting security a triple A rating? And, if it was worth a triple A rating, why wouldn't a company like AIG rush in to reinsure the security even further? There was something in it for everyone; namely, fees -- lots and lots of fees. And, for these fees banks paid lots and lots of commissions.

Unfortunately, all these high powered people forgot something many of try to teach our children; namely, "if it's too good to believe, it ain't." The mortgage brokers weren't bad people. They were simply people at the front of the food chain.

Let's see. In the last few paragraph we've covered the mortgage brokers, the bankers and the insurers (or reinsurers) of these mortgages. That just leaves The Fed, the various regulating agencies, and Congress.

Let's look at the regulating agencies like the SEC. It's obvious that they were a bunch of nincompoops. People came to them with one of the biggest Ponzi schemes in the history of this country and they didn't have a clue as to what to do with evidence handed over to them on a silver platter. It seems the SEC was a kind a finishing school for bankers and lawyers. Rich kids graduating from Yale and Harvard would go to the SEC and other regulatory bodies where they would acquire the professional gloss that would allow them to fit in more easily when, after a year or two, they'd move over into the banks they were supposed to have been regulating. The regulators didn't seem to appreciate that 10 young, good-looking, but inexperienced lawyers aren't worth a single, fat, middle-aged accountant.
But members of this fraternity house do know how to stick together, so, it is unlikely that this situation will change any time soon.

It's hard to know what to say about the Fed. About the only thing I can say is that, for an organization that's supposed to know all about credit and how credit is generated, it's hard to see how someone like Alan Greenspan missed this one. How could he have allowed this disaster to slip in under his radar?

And, finally, we come to the Congress. There's a reason this elective body scores so poorly in public opinion polls. They are worse than Liliputians. They're like five-year olds. As the mother stands at the door, struck dumb by the sight of one of her children lying in a pool of blood with a bullet in its head, she hears the other saying, "It wasn't me. I was just looking at daddy's gun when it went 'bang.'"

These elected officials twisted the arms of banks to give out loans to people with no income, no assets, no jobs and very poor prospects of ever getting a job. What in the world did they think would come from such social engineering? (These were the same public officials who used quasi governmental bodies such as Fannie Mae and Freddie Mac to give jobs to their loved ones.)

Quite frankly, it's not misguided communists or socialists that worry me. What worries me are the heads of our Congressional finance committees.