Walsh: Review and Comment

Walsh: Review and Comment

Quit blaming Wall Street; capitalism didn't fail

By Matt Walsh

It makes you want to go totally postal when you hear Barack Obama say the past eight years were an era when the Bush administration "stripped away all regulation and let the market run wild."

Or when the Republican ticket of McCain-Palin goes about the country blaming the current state of the financial markets on "Wall Street greed."

And it makes you want to throw your shoe through the flat screen when McCain, Palin, Obama, Biden, Pelosi, Waxman, Frank, et al make the pitch for more government intervention as the antidote for our economy.

The indictment, of course, is today's economic climate is a failure of capitalism. And, unfortunately, there are plenty of Americans who absolutely believe that to be true. Indeed, we have two generations - one in young adulthood - that know nothing other than life with a paternalistic, socialistic government.

But au contraire. When this snapshot in time is analyzed and retold in the future, it should be a great tale of how we learn from history that we don't learn from history.

We've been hear before. Remember how the 1986 Tax Reform Act destroyed the commercial real estate and savings and loan industries? Congress changed the rules, and wham! That change destroyed the economy.

As then, history also will show that the economic collapse of 2008 was the effect, not of the failure of capitalism, but of the confluence of many influences; of rational, immoral human behavior; of bad timing; but most of all, and we emphasize most of all, it was the effect of the handiwork that emanates from Washington, D.C. Government intervention.

Criticism of the latter is a common theme in the Review. And while we're probably preaching to the choir (you, our readers), if other Americans had the intellectual curiosity or sense to look at the past seven years in a timeline, they - and perhaps even our politicians - might see that unbridled capitalism was not George Bush's Evil Empire.

Was it a failure of capitalism? We asked Gregory Miller, chief economist of SunTrust Banks Inc. We spoke to Miller after he had finished addressing advertising executives about 10 days ago at a Florida Press Association conference. He had assessed the bailout plan ("awesomely awful policy"); issued his forecast for the U.S. economy (see box above) and declared the results of the upcoming presidential election (see box below).

"It is not fair to characterize this as a failure of capitalism," Miller said.

And then, in econo-speak, he added: "We had a constraint on the mechanism that allows capitalism to work. We had an unintended result of the application of regulatory policy."

In English: Government interference.

"In this case," Miller said, "the failure resulted from the intersection of declining prices, which is OK in capitalism, with the implementation of a regulatory change that disallowed the capitalist response to falling prices."

In other words, "mark to market."

What brought the avalanche

By now, most everyone familiar with the financial crisis is also familiar with "mark to market." It's the accounting rule implemented in November 2007 requiring regulated companies to revalue their assets each quarter according to what similar assets are selling for at that moment on the open market and in turn set aside sufficient capital to support those assets.

The implementation of this rule was the small rock on the mountain that finally gave way after years of pressure from bigger rocks bearing down on it, causing the great avalanche.

But let's go way back. Today's crisis actually began, Miller says, shortly after Sept. 11, 2001.

Miller knows his stuff. In addition to being SunTrust's top economist, he is a Florida State University adjunct professor and sits on a Federal Reserve Bank committee in Washington that critiques Fed policies for the Fed staff before the bank implements its policies. He was among the economists who critiqued the bailout plan that Congress ultimately approved.

Miller has seen the financial crisis rocks forming from the start. "What is going on now has been predictable." In fact, he has been saying so since 2006.

After the 9-11 terrorist disaster, foreign investors - in a surprising show of faith in the United States - unexpectedly began buying up large amounts of U.S. debt (treasury bills and government bonds). They saw, in spite of the attack, the United States still as a safe haven for their money.

In typical debt issues, for instance, foreign investors previously would buy 8% to 10% of the issue. But in 2002 and 2003, foreign governments and investment groups bought 20% of the United States' debt issues.

This flood of dollars back into the U.S. economy came at the same time Alan Greenspan's Federal Reserve Bank lowered interest rates to help stimulate the economy in the wake of the post-9-11 downturn and the dotcom crash.

Suddenly, money was cheap and plentiful.

Happy days were here

Consumers, businesses and governments responded. Homebuilders went on a record-setting building spree, consumers borrowed and spent like never before. And so did governments. And why not? Interest rates were at historic lows. Short-term interest rates were falling to as low as 1%, while long-term rates hovered near 4%.

The economy zoomed. Home prices in the Greater Tampa Bay area rose 40% from 2001 to 2004.

While happy days proceeded here, foreign investors continued to buy increasing amounts of our debt, pouring even more dollars into the economy. In 2005, foreign investors purchased as much as 75% of U.S. debt.

The effect: Inflation was gaining momentum. From 2002 to 2004, our inflation rate rose 68%, from 1.59% to 2.68%.

The Federal Reserve responded. It began raising interest rates in 2005. But there was a side effect to this that was akin to lightning striking the mountain side, causing the rocks to shift. Economists call it the inverted yield curve.

This is not good. It means that short-term interest rates were rising faster and higher than long-term interest rates. And every banker knows the effect of an inverted yield curve: Banks can't make money on their core business of lending. Typically, banks borrow short term and lend long term. Their profit is the difference between the interest earned on long-term loans and the interest they pay on short-term borrowings. If the long-term rates are lower than short-term rates, they'll earn nothing. As Miller put it: "You can't make that up in volume."

This is what occurred from February 2006 through June 2007. Financial institutions needed an antidote, and Wall Street's genious MBAs provided it.

Intoxicating fuel

Derivatives, CMOs, MBSs. These became the intoxicating fuel for the world's financial institutions to keep the housing boom booming.

Faced with an inverted yield curve, banks needed investments that could generate higher interest yields than standard mortgages. So the Wall Street brainiacs responded by creating the now-famous packages of mortgage-backed securities and collateralized mortgage obligations. They were like buying a child's Halloween goodie bag without really studying the contents. Say you buy the bag on good faith, knowing that some of the candy will be big chocolate candy bars (AAA-rated mortgages), some will be good-to-mediocre candy (A-rated mortgages) and some will be bruised and rotten apples (subprime and dead-on-arrival mortgages).

But you're willing to pay a premium for the entire bag because it meant you didn't have to go door-to-door trick or treating yourself.

This is what many banks did. Even though they originated bundles of mortgages and sold them to Fannie Mae and Freddie Mac, many banks purchased these packages of mortgages because they generated higher yields than normal bank loans.

It was a great concept. But it required at least two constants: "It worked as long as the prices of the underlying assets (the homes) continued to appreciate and as long as homeowners paid their mortgages," Miller said.

So many banks and savings banks were doing this (i.e. Countrywide, WaMu, Golden West), that the leaders of Fannie Mae and Freddie Mac - secure with the full backing of federal guarantees and encouragement from their Democratic friends in Congress - fueled the market. As the Fannies sold off packages of mortgages, they obtained more cash to be able to fund more mortgages. Likewise with the Wall Street investment banks.

This spawned armies of mortgage brokers and loan originators, many of whom we now know were unscrupulous. These brokers enabled speculators and unqualified buyers to obtain too-good-to-be-true, adjustable-rate mortgages with no downpayments, no credit scoring and sometimes 110% financing.

Miller says this is when rational and immoral behavior often occurred. Enticed by the easy terms and low cost of money, couples would obtain variable-rate mortgages with payments lower than their monthly rents, knowing that if they defaulted, they would walk away. Likewise with the flippers.

Confluence of negatives

Home sales peaked in mid-2005. Yet, prices continued to rise - for another 12 months.

By the second half of 2005, buyers began pulling back. By 2006, prices were irrational.

This commenced a confluence of negative influences. Inflation: rising. Interest rates: rising (to calm inflation). This in turn triggered higher rates on adjustable-rate mortgages. Oil prices spiked after Hurricane Katrina.

With fewer and fewer buyers in the market, many of the flippers and overleveraged homeowners found themselves unable to continue their mortgage payments.

By 2006, the first wave of foreclosures was under way. By July 2006, home prices peaked and began falling. By November 2007, mark to market went into effect. The avalanche had begun.

The timing for mark to market could not have been worse. Here's why:

With foreclosures rising and home prices falling, mark to market suddenly required financial institutions to lower the value of their assets on their balance sheets. Every time they did this, that required a corresponding increase in capital set aside for potential loan defaults. Every time more capital was set aside for bad loans, banks had that much less money to lend to keep the economy growing and functioning.

"This virtually assures the assets will continue to fall in value," Miller says of implementing mark to market in an economic downturn. "If you combine the expectation that prices will continue to fall along with a dearth of capital available for credit, then you eliminate the ability of investors to discover the low-market clearing price."

Let's be blunt here: The present crisis is the sum of government intervention - Greenspan setting and extending artificially low interest rates; the U.S. government issuing more and more debt; Congress pushing Fannie and Freddie to make and guarantee more loans; bank and SEC regulators unable or slow to enforce the rules; the implementation of a new rule that triggered the rock slide.

Says Miller: "Economic regulation is not an element of capitalism. It's a step back from capitalism."

It's a distorting disruption. "Laissez-faire," said the French farmer to the king's minister of finance during the French Revolution. "Leave us alone."