I don’t claim to be a financial expert at any level, but I do feel like I have somewhat of a grasp on what is going on in our economy recently. I’d invite some of our other contributors to jump in and add their knowledge as well, so we can get as complete a picture as possible here. It’s only then that we can begin to look at possible solutions to this crisis – solutions beyond “Trust me because I’ve fought tougher guys before” and “Fiorina said McCain or Palin couldn’t run a company!” (Hey, she said neither could Obama or Biden, either, but who in the media is really asking for a quote in context these days?)
The only thing close to a real policy in response to all of this has been Joe Biden today, who blamed the whole thing on Bush’s tax cuts for the rich and promised to increase taxes. Oh, yeah – that’s going to do wonders, Joe. Just brilliant. Other than that, McCain and Obama are both on the books now as speaking in incredibly vague terms and promising more government oversight and regulations, and McCain even implicitly admitted he had no idea what was going on when he called for the creation of a 9/11 commission to study and investigate just what went wrong with our economy.
So here’s an intro course and some very simplified explanations of our current economic state.
So who exactly are we talking about here?
At the beginning of 2008, the investment banking sector of the American economy – arguably one of the most important sectors – for nearly all intents and purposes consisted of five investment banks: Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. Those five banks had employees worldwide — and debts worldwide as well.
As of today, only two of those five remain: Goldman Sachs and Morgan Stanley. Lehman Brothers, as we know, went bankrupt, Merrill Lynch was just bought out by Bank of America, and Bear Stearns was bought out by JP Morgan Chase earlier this year. This is remarkable and sobering because these five institutions have long been thought to be vaunted, bedrock institutions that could never fail.
What happened then to cause those three banks to collapse? Does this have anything to do with the sub-prime mortgage crisis?
Yes, it does. These were investment banks, and as with any investment there are risks involved. And usually, the higher the risk, the higher the reward. This mess began when mortgages were being lent to people who really had little means with which to pay them back.
Many folks got stuck in adjustable rate mortgages or balloon mortgages because they failed to understand what they were getting themselves into. Lending institutions gave them the loans based on the high risk/high reward theory (a bank would get far more out of a successfully paid ARM than a 30-year fixed, for example). These loans are known as “subprime” loans because they did not, for one reason or another, meet Fannie Mae or Freddie Mac guidelines for a conventional home loan. For example, if a borrowers’ debt-to-income ratio was too high or their income too low or their job history not established enough, they couldn’t get a conventional mortgage and were offered subprime mortgages.
And then, these loans were sometimes in turn “bundled”, rated, and passed on to major investment banks. These investment banks chose to gamble by purchasing these loan bundles as part of their portfolios, as it were. Some banks became heavily invested in sub-prime mortgages (such as Lehman Brothers) in order to maximize the high rewards they promised.
When people all over the country started defaulting on these loans and foreclosing on their homes, these mortgages lost a lot of their value. This means that these investment banks took on a lot of debt because of their choice to invest in subprime mortgages.
Okay, that makes sense. So what’s this ‘credit crunch’ I keep hearing about?
Most financial analysts believe the subprime mortgage crisis led to a recent credit crunch — which basically means that it’s tougher to get loans or credit from banking institutions now. In the simplest terms possible, once these five major banks each began carrying on debt because of the subprime mortgages going belly up, they were afraid to lend to one another because they didn’t know how much debt the other banks were carrying and if they had enough to guarantee the loan. In fact, banks began charging much higher interest rates to borrow money from each other (which you can track by looking up the “LIBOR” or London Inter-bank Offered Rate – the higher the LIBOR, the worse the credit crunch, generally).
Because of this, it became more difficult for individual consumers to get loans – mortgages, car loans, personal loans, etc. and caused interest rates on loans to raise as well as caused most banks and lending institutions to require more in terms of down payment or collateral to obtain a loan. Thus, a “credit crunch.”
Is Gramm-Leach-Bliley to blame for this mess?
In short, not really.
Up until recently, the US (as well as Canada) maintained a separation between investment banks (such as the five listed above) and commercial banks (such as Bank of America, for example). In 1999, the Gramm-Leach-Bliley Act repealed portions of the 1933 Glass-Steagall Act in order to allow commercial and investment banks to consolidate.
Far from being a Republican bill, it passed the Senate 90-8 and the House 362-57 and was signed by Bill Clinton. So everyone at the time thought it was a good idea.
The reason folks are attacking it now is that it in essence deregulated some of the banking industry, an industry where everything was now more interconnected than ever. And without these things being so interconnected, or with proper government oversight, an economic disaster like the one we are in the middle of wouldn’t have happened. Or so the argument goes.
The best parallel I’ve heard of is this: blaming the current economic mess on Gramm-Leach-Bliley is like blaming drunk driving deaths on the repeal of prohibition. Are the two linked? Somehow, at some level, sure. Is one responsible for the other? No.
Another interesting way to look at it is this: without Gramm-Leach-Bliley, Bank of America would never have been allowed to step in and save Merrill Lynch.
What does all this have to do with the average American worker?
Most Americans have retirement or savings plans that are invested in mutual funds at some level, and these investment banks going bankrupt or losing much of the value of their shares directly impacts the value of your IRA or 401(k) or other market investments. Additionally, the shockwave ripples sent throughout the markets will further reduce investment values.
Finally, the credit crunch is likely to worsen for a while now as banks become even more hesitant to take risks and lend money. Banks will most likely be looking for low risk/low return type investments in the short term, so unless your credit is perfect or you have a lot of collateral to offer it might be tough to get a loan.
What is the term ‘moral hazard’ some folks keep throwing around?
“Moral hazard” is an idea that if you insulate someone from the failures of the risks they take, they are more likely to take worse risks in the future thinking you’ll protect them again.
In the case of this economic crisis, it specifically refers to whether or not the federal government should bail out organizations such as Lehman Brothers when they are about to fail. The arguments on both sides are fairly compelling: on one hand, Lehman Brothers was a private institution that made poor decisions and took unnecessary risks on bad subprime mortgage bundles – so the federal government was right to let them fail. On the other hand, we saw the awful economic ramifications of allowing Lehman Brothers to fail, and the fact remains that a major institution such as an investment bank with the status of Lehman Brothers has a wide-reaching impact on global economies.
Moral hazard would say if the government had bailed Lehman Brothers out, then other companies would be asking the federal government for bailouts as well – and there has to be some kind of tipping point where it does more harm than good for the government to do that. In the next instance of a company asking for a bailout, AIG, the government reneged and gave them $85 billion to save them from collapse. In that situation, the government weighed the prospect of AIG (the world’s largest insurer) going under as greater detriment than moral hazard. But as Jim Geraghty over at Campaign Spot notes,
You’re going to see a lot of companies, interest groups, lawyers representing class-action suits, etc., knocking on the Treasury’s door chanting, “bail us out, bail us out!” The temptation for Congress and the president to look “decisive” and “compassionate” will be enormous. No one wants to be the one saying, “Let ‘em fail, even if that means lots of people lose their jobs.”
Moral hazard in a nutshell says that if the government continues to bail these companies out, they will continue taking unnecessary risks because the government will bail them out again in the future. A high risk/high reward scenario becomes low risk/high reward to companies when this precedent is set. The government is perceived by some to have drawn a line in the sand with Lehman, only to cave when backed into a corner by AIG.
So then, what’s the solution to this problem?
Well, I’m not exactly sure. That’s what I want your help figuring out. I can tell you what it isn’t, though: exactly right where we’re heading. The federal government now owns 79.9% of AIG (their buyout was purchasing that percentage of stock), so they have controlling interest of what used to be a private company.
McCain and Obama are both calling for increased federal oversight and regulation of the banking industry, which will only do two things: choke the life out of that massively important sector of our economy and cost the taxpayers billions of dollars for something that will, again, ultimately fail.
Calling for more regulation of banks in a crisis like this is just like calling for more gun control after a school shooting: it’s something that makes sense on the surface and satisfies the public’s need for a scapegoat and an easy solution, but offers no real solution and harms the country in the long run.
So there are two major problems and precedents to avoid setting in the aftermath of this economic chaos: that of the government taking over private institutions (denying free market principles which states that failure should not only be allowed but is necessary for such a market to survive), and that of the government increasing oversight and regulation of private sectors of the economy (which leads to the things previously outlined).
So without doing either of those two things, what are your proposals to solving this current crisis?
September 17th, 2008 at 4:31 pm
Please God, we must elect McCain–mainly because of the three Supremes that the next Pres might
name. But with the economy now front and center and McCain saying blaming it all on “greed”,
don’t we all miss Gov. Romney now?
September 17th, 2008 at 4:48 pm
On #1. There’s a difference between who would be better at solving the problem (Rommey) versus who the American people would think would be better at solving the problem (McCain).
September 17th, 2008 at 4:52 pm
It’s an awful choice. Take a truly hands-off approach and let the chips
fall where they may will allow the market sort itself out eventually. The
logic is they made this mess, clean it up. The cost to the global economy
will be enormous, shocking and swift and take out the good with the bad.
A Great Depression-scenario is not at all out of the question.
On the other hand, we can intervene, allowing smaller institution (Lehman
Indymac) to fail and prop-up and sell off the rest in an orderly fasion
with the Feds and other Central banks injecting liquidity when ever
a crisis gets rolling. Some degree of re-regulation would get introduced.
No out-and-out panic but the tresury cost would dwarf the Iraq costs and
pretty much guarentee a decade or more of no growth. All of us would slowly
get poorer as economic activity slowly plods along while inflation continues
to eat at our real incomes. Think Japan after 1990, but with increased fuel
and healthcare costs.
Yay. What a choice
September 17th, 2008 at 5:07 pm
What a horrendous couple of choices. It’s scary because whatever direction is chosen will not be good for this country one way or the other. I echo all that was mentioned in #3.
September 17th, 2008 at 5:52 pm
I think that McCain needs to shift the economic blame to the Democrats and to President Clinton. I admit that I was somewhat disappointed to hear McCain reverse course on the AIG bailout. I would prefer that he vigorously oppose Government bailouts and socialization of the banking and insurance industries.
September 17th, 2008 at 6:17 pm
How can a post like this only get 5 responses? This is the pressing issue of this election and out of all of the readers on this site we only get 5 responses – wth?
Regardless of politics and this election coming up I have to stick with my guns on this and say let the industry hash it out themselves. We saw after Lehman’s bankruptcy that Barclay’s was all too ready to swoop in and buy the parts that they wanted. Who’s to say the same wouldn’t have happened with AIG?
If the government had stayed out of the housing market and never forced all of these mortgage companies to give loans to unqualified buyers we wouldn’t be in this place to begin with. This whole subprime crash is exactly why the government should stay out of private industry.
I am not at all surprised that McCain is now supporting the bailout of AIG and more government regulation. I’ll stay off of my soap box, but is anyone really that surprised at how McCain has reacted to this?
September 17th, 2008 at 7:30 pm
This narrative misses some key facets of the CDO mess. First, a large part of the problem was generated at two firms: Bear Stearns and Merrill Lynch.
Merrill Lynch was big into repackaging subprime mortgages and then re-selling them at a higher rate of return than they would normally earn. In inexplicably, Merrill started buying its own CDO products under the direction of CDO chief Chris Ricciardi. According to an article in Fortune magazine (Nov 26 2007) “”They must have had their eyes on the fees and not the risk,”
Bear Stearns was another deal entirely. Ralph R. Cioffi and Matthew Tannin were hedge fund managers who got hooked on CDO’s as if they were crack. According to an article in BusinessWeek (Oct 22, 20007 ) “But his investment strategy turned into subtraction soup: The more he ate, the hungrier he got. The funds’ voracious buying of lightly traded bonds drove down their yields, meaning Cioffi’s team had to buy more and more of them to boost returns. That meant more borrowing. Banks such as Merrill Lynch, Goldman Sachs, Bank of America, and JPMorgan Chase lent the funds at least $14 billion all told. Cioffi also used a type of short-term debt to borrow billions more; in some cases he managed to buy $60 worth of securities for every $1 of investors’ money. But he made a critical trade-off: For lower interest rates, he gave lenders the right to demand immediate repayment.”
Eventually this Ponzi scheme imploded when Barclay’s exercised it rights to demand payment and get out of the funds.
Folks, this was plain evil-doing by some bad actors who chose to get rich quick rather than earn it the old fashioned way. McCain needs to follow his promise with respect to earmarkers… he needs to make these people famous.
September 17th, 2008 at 7:32 pm
Amen RayinNH,
McCain needs to stick to a FREE MARKET capitalist policy and vigorously oppose all bailouts. McCain also needs to stick to his guns as a champion of deregulation. More deregulation not regulation will solve this. And folks, we are not in a crisis – all too often we fall into the MSM trap of over reacting to the ups and downs of the stock market. The economy remains strong and we are better off than we were 8 years ago. If anything Clinton got us into this mess.
September 17th, 2008 at 8:07 pm
If we really want to solve this problem, here’s what we need to do:
1). Cut off Treasury lines of credit to all private institutions.
2). Draw a REAL line in the sand. No more government bailouts. Never again. EVER.
3). Let any insolvent institutions fail, and let the market reallocate resources to their most profitable lines. Forcing resources to be employed in less efficient lines than market forces want them to be is merely the destruction of wealth. Frederic Bastiat disposed of this idea long ago.
4). Move to a 100% reserve banking system. All deposits backed by full reserves, with loans being made out of excess reserves, so that losses never hurt innocent depositors.
5). Most importantly: the Federal Reserve needs to step back and allow the MARKET to set interest rates. It was the Federal Reserve’s aggressively inflationary monetary policy that resulted in the excessive credit in the first place, which created this bubble. Only the free market, the interplay of millions of Americans all making voluntary mutually-beneficial exchanges, can correctly determine interest rates, not a handful of unelected technoratic elites in New York and Washington.
A recession IS coming and MUST come. It will be painful, but it will be cleansing and necessary. The Fed and the Treasury can either let it happen now, or they can put it off until later and give us a Great Depression, or they can refuse to ever let it happen and send us hurtling into hyperinflation which will collapse our entire economy down to third-world status. The latter two options wouldn’t surprise me anymore.
Recessions and failures are the natural and helpful redirection of resources by the market into more efficient employment. They come about because of clusters of business errors, which arise when the Federal Reserve attempts to manipulate interest rates, causing businessmen to make bad decisions because they cannot accurately read the distorted market signals. We need to end the central planning of monetary policy, pronto, and save the dollar.
September 17th, 2008 at 8:13 pm
Much of this is Clinton’s fault and McCain needs to be hammering that home.
September 17th, 2008 at 8:45 pm
#10: Downplaying the economy, then trashing some guy who has been out of office for almost 8 years for today’s mess will almost certainly help elect Obama.
September 17th, 2008 at 8:49 pm
No PeaJay,
Only if you accept the hyperventilating media that this is a “crisis” or that we are in “recession.” Both of those premises are false and McCain was right the first time – “the fundamentals of the economy are strong.” We should not run away from touting the economic successes of the last eight years of growth and prosperity just because the MSM says so.
September 17th, 2008 at 8:56 pm
AuH20: I don’t know where you come up with your ideas… but you sound like a Ron Paul-ite. There is no evidence that the Fed’s policy has been “aggressively” inflationary… in fact M2 growth has stayed in or near the target range since 2001. The growth in the money supply did not create this bubble… wall street morons trying to get rich quick with a Ponzi scheme did… In fact, it was the Fed’s actions increasing interest rates in the middle part of 2007 that led lenders to call their loans.
Your point at #4 is also misplaced… if all deposits are backed by 100% reserves there can be no excess reserves. The only available money to lend would then come from investor’s in the bank… therefore there would be no motivation for banks to even offer deposit services because they couldn’t earn enough revenue to pay the promised interest rates.
September 17th, 2008 at 9:04 pm
10, 11, and 12: McCain needs to turn this into a leadership/country first attack. Rather than attack Clinton, McCain needs to attack Obama as someone who is trying scare people for his own election purposes. He needs to stress all of the negative things Obama is saying about the economy and the country and then ask why Obama doesn’t want to drill, doesn’t want nuclear, but does want to raise FICA taxes, capital gains taxes, impose a health care tax on millions of businesses, and create several new government bureaucracies.
September 17th, 2008 at 9:26 pm
The economy is strong and the last 8 years have seen unprecedented growth.
September 17th, 2008 at 9:34 pm
JA ~ I think “unprecedented growth” is going to far… the economy grew much faster over other periods of time…
September 17th, 2008 at 10:30 pm
JA Pruce,
Nearly 90% of Americans believe we are in a recession. Since consumer spending makes up over 2/3 of our total economy, I’d say even though we aren’t meeting the “official” definition of a recession (that of two quarters of negative growth), we’re at the very least heading that way in a hurry.
Going around disagreeing with 90% of the electorate on anything isn’t a good way to improve electoral chances.
September 17th, 2008 at 10:47 pm
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September 17th, 2008 at 11:59 pm
People, we are feeling the after effects of Clintonomics. If the next President presides over a booming economy it will be because Bush laid the ground work for it.
September 29th, 2008 at 8:23 am
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