Monday, March 31, 2008
How Wall Street crashed on Main Street
From the RoundTable blog
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John Freivalds
Freivalds runs an international firm in Lexington and once worked for a Wall Street firm.
Usually we pay little attention to Wall Street and the various indices going up or down, or even what companies' stocks comprise them, but when the crisis affects homeownership and the most sacred cow of all -- home prices should always go up -- everybody notices. We got into this mess by forgetting what history has told us, that we all are affected by greed and we all feel there is such a thing as a free lunch.
First, history: "A Republican moralist was in the White House. War was fresh in mind. Immigration was fueling dramatic changes in society. New technologies were changing people's everyday lives. Business consolidation was creating new combinations through mergers and acquisitions while the government was investigating prominent executives -- led by an aggressive young prosecutor from New York. The public's attitude toward business leaders fooled by a muckraking press was largely negative."
What does that paragraph refer to? Today? Nope, 1907, 101 years ago, which in many ways was worse than the more well-known crash of 1929. The quote above is from an interesting new book, "The Panic of 1907," by economist authors Robert F. Bruner and Sean D. Carr. They recount how, when there was no government regulation, the collapse of one major bank that made many bad loans almost took the financial system down. It was J.P. Morgan who stepped in and saved the system.
Today, Bear Sterns and J.P. Morgan's successor, Morgan Stanley Chase, stepped in and shored up the system. So here we are, 101 years later, repeating the same mistake, which is leading to bank failures.
Second, greed. I once worked for the Wall Street brokerage firm E.F. Hutton (now merged out of existence), which had a wonderful advertising slogan: "When E.F. Hutton talks, people listen." Wall Street has solid function in raising capital for business, but in the case of this mortgage mess it was solely to create financial instruments (read mumbo-jumbo) that people thought would help them avoid risk. The culprits here are the unregulated derivatives market and hedge funds.
I learned that the key to getting other people's money and to avoid government regulation is to create obtuse financial instruments like "derivative sinking fund debentures." Or how about "zero down negative amortizations" and, finally, "collaterized debt obligations." These instruments packaged mortgages (a lot of them subprime) that were resold as commodities just like wheat or oil. And the bet, the end game, was simple: Prices would go up or down.
Personal greed got into this. A tenet of our economic system is that house prices should always go up. This way you have equity when you sell so you can buy something else or, since America is up to its ears in debt, get a home equity loan to tide you over. Of course, there were a lot of abusers to all this, people who bought many homes on easy credit and then "flipped" (sold them for a quick profit).
But when people who made $50,000 a year were given mortgages on $700,000 homes with $7,000-a-month payments, you knew there would be trouble. Home prices got too high, no one could pay the mortgages, values fell and there was no equity in people's houses to save them. It was a giant Ponzi scheme that finally was revealed.
Finally, this once again points out that there is no free lunch in our economic system. You don't get anything without taking a risk, and Wall Street and Main Street both bet that home prices and mortgages were a sure thing, and they both crashed.
And the free lunch philosophy continues because many people think there should always be upside capitalism (take those gains when prices go up) and downside socialism (the government should step in and save us from ourselves when they don't).
So what to do? Ask tough questions of the presidential candidates and demand to know what they would do to regulate the hedge funds and derivatives market that brought cash and then the collapse of the home mortgage market so something like this won't happen again. Well, at least for another 101 years.
