What Went Wrong

There are plenty of “Year in Review” articles in mainstream media and on the Web. Here at “A Dash” we try to add value, so we are not going to tread the same ground. Instead, let us offer a few ideas that seem to have been neglected.

Looking for Causation

Investors looking forward, as they should, need to understand what happened in 2008. The easy explanation, which has plenty of truth, is that there was too much leverage, too much greed, a poor job by rating agencies, and a system that sold homes with teaser rates to many who could not afford adjusted payments.

Having made this bow to the obvious, the story is a bit more complicated. Understanding what happened is important. Why? How else can one know if there is a real solution?

What Went Wrong

Our analysis of problems, as noted, is not intended as comprehensive. It is an addition to what readers have already seen.

There was a real problem in excessive leverage at some Wall Street firms, excessive lending to home buyers, packaging of securities in complex derivatives, and rating agency failures in certifying these securities as AAA. This partly reflected the conflict of public policy – trying to help an aspiring class of homeowners – with the reality of sound lending practices. It was also a manifestation of greed on the part of many participants in the process. Government was slow to address the housing issue. It came at the worst possible time, when we had a President whose strength was limited by an unpopular war. Government agencies did not, and perhaps could not, react with sufficient speed. Few realize that problems must gain widespread perception before they can be addressed. Despite many innovative efforts, government agencies were playing catch up.

There were many who were celebrating this failure. Some hedge funds took advantage of the unregulated credit default swap market to undermine confidence in financial institutions. They “bid up” prices in this thin market, betting on the failure of certain firms. They bought put options, which would pay off if the firms failed. The failures cascaded since mark-to-market accounting rules forced other institutions to write down their holdings, even those that were performing assets. This created an environment that was much worse than the original problem. We were sucking assets out of our lending institutions at WARP speed. There was agreement that leverage was excessive, but no agreement on what level was appropriate, nor how to get from point A to point B. There is an appropriate level of leverage, not zero, and not 40-1.

Because of the general bias against “bailouts” the government chose to allow the failure of Lehman Brothers. This led to an environment where no financial institution believed in the viability of any other. Normal lending – not the leveraged stuff or the national debt – came to a halt. This meant that companies that relied on borrowing to finance inventory through commercial paper could not operate normally. It was a full-fledged credit crisis.

The Bush Administration reacted by going to Congress for a massive plan, hurriedly created and with little detail or oversight. President Bush should be congratulated for action, but there was little time. Congress balked, resulting in a better and more flexible approach. This new TARP plan quickly morphed into a generalized program of preventing the failure of financial institutions through direct investment. Others can and have criticized this action, but there was really little choice. Treasury Secretary Paulson was acting to prevent the dominoes from falling. The Lehman example made the risk obvious to all.

The result is now a holding action, where one administration is fighting to prevent things from getting worse, while we wait for a new one to take power.

What to Watch

As we evaluate the proposals from the Obama Administration, it is important to look for actions that address root causes. Some of these are already in place, including stimulating inter-bank lending and reducing mortgage rates.

The missing pieces are those directed to the dysfunctional reaction of financial markets. It is important to prevent attacks on specific firms via the thinly traded credit default swap market. It is important to break the cycle of forced write-downs of performing assets. It is important to address – quite directly – the housing market, helping new buyers and existing owners alike.

These are all death spirals. Stopping them is the key to limiting the recession effects.


You may also like


  • Russ Wood January 6, 2009  

    I think you do add value, and this post is better than much of the other attempts I have read. I have one quibble, your use of “greed” as a cause. Greed has been with us since man first walked the earth. If greed was a cause, it would have manifested itself long ago.
    I am sympathetic to your solutions to watch for. However, I worry that policy makers are attempting to fix a situation partly caused by easy credit and high debt with more easy credit and debt. Where is a pro-growth agenda?
    Thanks, as always for your insights.
    View Russell Wood's LinkedIn profileView Russell Wood’s profile

  • Jeff Miller January 6, 2009  

    Russ — It is always difficult to decide how much detail to include. Those of us who understand and believe in markets endorse self-interested behavior and incentives. Doesn’t a Gordon Gekko type of greed go a bit too far? I really meant to refer to those in the mortgage lending business who were willing to ignore the best practices of their profession in order to make a fee. You and I would not do such a thing — pushing a client into an inappropriate investment, for example.
    More later on the intriguing topic of how much debt might be OK.
    Thanks for the kind words, and for taking time to comment.

  • RB January 6, 2009  

    This may not have been Russ Wood’s argument, but typically those who claim “greed is not the root cause” are promoting the “Fannie Mae and CRA were the root cause.” Similarly, it could be argued that Fannie Mae has been around since 1938 and therefore could not have been the cause. Its not that Fannie Mae was not culpable, but the questioners want to get at a root cause (while naming other “causes” as effects) and the expected answer usually divides along party lines. This whole root cause thing is not so easy. You could go to Raghuram Rajan’s paper describing financial innovation . Or, you could go to the root cause for financial innovation starting with cash-starved tech companies. Or, if you had to ask why Fannie Mae became so big , you could go to Reagan’s deregulation of the savings and loan industry. I guess this is just not as easy as some popular Youtube videos.