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.