Problem, Causes and Professor NoBull's Solution for the Economic Mess

UPDATE: Watch PBS, Frontline, Inside the Meltdown and/or CBS, 60 Minutes, World of Trouble.

What a mess!

The Problem

The problem is two-fold: Main Street and Wall Street.

On Main Street, people are out of work or worried about losing their jobs (government workers excluded) and their assets, including homes and stocks, are losing value.

On Wall Street, it turns out that a substantial part of the financial sector was a fraud so parties can't trust one another. More problematic, the value of assets, particularly collateralized debt obligations (CDOs), are indeterminable. Most credit default swaps (CDSs) are worthless.

(Previously I described CDOs or CDSs? Imagine taking paper debt like mortgages, subprime mortgages, car loans, credit cards loans, and pretty much anything you can imagine. Now combine and mix the paper in a blender, spiking it with worthless rhetorical hyperbole that derivatives are the new paradigm of investments. Then pour the mixture in a pyramid of champagne glasses, to represent the varying levels of return (and risk), with the higher the glass, the lower the risk return and risk. That represents the CDOs. Now as you sell the mess, insure against the risk of the CDOs decreasing in value with CDSs. Presto, $1 trillion of bad loans is transmuted into $62 trillion in faux wealth. An alchemist would be proud.

Since that time, estimates are that there are close to $600 trillion in outstanding CDSs. Whether it is $60 trillion or $600 trillion, the government doesn't have enough money or credit to save zoombie banks like Paulson's Goldman Sachs.)

At the center of it all is the declining value of houses. If housing is fixed, many other problems will resolve themselves.


The Cause

The cause is/was greed in an environment of deregulation and oversight failures leading to 'irrational exuberance' and outright fraud. There is plenty of blame to share, the only debatable point is how to apportion the blame.

For more details, read or watch the following:

The New York Times, The Reckoning series,

Washington Post, The Crash: What Went Wrong?

Village Voice, What Cooked the World's Economy,

Barry Ritholtz, The Big Picture, Bailout Nation,

CNBC, House of Cards, Global Economic Collapse, and

Time, 25 People to Blame for the Financial Crisis,

Personally, I think the Republi-con party's reckless faith in markets and war against the middle class are the fundamental causes of the economic crisis. To repeat a previous post:

"Read The New York Times, Six Errors on the Path to the Financial Crisis. According the writer, the six errors, in chronologically order, omitting mistakes that became clear only in hindsight, and limiting to those where prominent voices advocated a different course at the time, were:

"WILD DERIVATIVES In 1998, when Brooksley E. Born, then chairwoman of the Commodity Futures Trading Commission, sought to extend its regulatory reach into the derivatives world, top officials of the Treasury Department, the Federal Reserve and the Securities and Exchange Commission squelched the idea. While her specific plan may not have been ideal, does anyone doubt that the financial turmoil would have been less severe if derivatives trading had acquired a zookeeper a decade ago?

SKY-HIGH LEVERAGE The second error came in 2004, when the S.E.C. let securities firms raise their leverage sharply. Before then, leverage of 12 to 1 was typical; afterward, it shot up to more like 33 to 1. What were the S.E.C. and the heads of the firms thinking? Remember, under 33-to-1 leverage, a mere 3 percent decline in asset values wipes out a company. Had leverage stayed at 12 to 1, these firms wouldn’t have grown as big or been as fragile.

A SUBPRIME SURGE The next error came in stages, from 2004 to 2007, as subprime lending grew from a small corner of the mortgage market into a large, dangerous one. Lending standards fell disgracefully, and dubious transactions became common. Why wasn’t this insanity stopped? There are two answers, and each holds a lesson. One is that bank regulators were asleep at the switch. Entranced by laissez faire-y tales, they ignored warnings from those like Edward M. Gramlich, then a Fed governor, who saw the problem brewing years before the fall. The other answer is that many of the worst subprime mortgages originated outside the banking system, beyond the reach of any federal regulator. That regulatory hole needs to be plugged.

FIDDLING ON FORECLOSURES The government’s continuing failure to do anything large and serious to limit foreclosures is tragic. The broad contours of the foreclosure tsunami were clear more than a year ago — and people like Representative Barney Frank, Democrat of Massachusetts, and Sheila C. Bair, chairwoman of the Federal Deposit Insurance Corporation, were sounding alarms. Yet the Treasury and Congress fiddled while homes burned. Why? Free-market ideology, denial and an unwillingness to commit taxpayer funds all played roles. Sadly, the problem should now be much smaller than it is.

LETTING LEHMAN GO The next whopper came in September, when Lehman Brothers, unlike Bear Stearns before it, was allowed to fail. Perhaps it was a case of misjudgment by officials who deemed Lehman neither too big nor too entangled — with other financial institutions — to fail. Or perhaps they wanted to make an offering to the moral-hazard gods. Regardless, everything fell apart after Lehman. People in the market often say they can make money under any set of rules, as long as they know what they are. Coming just six months after Bear’s rescue, the Lehman decision tossed the presumed rule book out the window. If Bear was too big to fail, how could Lehman, at twice its size, not be? If Bear was too entangled to fail, why was Lehman not? After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time.

TARP’S DETOUR The final major error is mismanagement of the Troubled Asset Relief Program, the $700 billion bailout fund. As I wrote here last month, decisions of Henry M. Paulson Jr., the former Treasury secretary, about using the TARP’s first $350 billion were an inconsistent mess. Instead of pursuing the TARP’s intended purposes, he used most of the funds to inject capital into banks — which he did poorly."

Note that with the exception of the first error, they all occurred under Bush. Senior "Clinton administration officials, including Treasury Secretary Lawrence H. Summers, joined by the Federal Reserve chairman, Alan Greenspan, and Arthur Levitt Jr., the head of the Securities and Exchange Commission, issued a report that instead recommended legislation exempting many kinds of derivatives from federal oversight." Republi-con Senator Phil Gramm was only too happy to help pass, in the Republi-con-controlled Senate and House, the Commodity Futures Modernization Act, which deregulated credit default swaps, the real cause of this economic collapse.

And a historical not-so footnote, the Commodity Futures Modernization Act included the so-called "Enron loophole," which exempts most over-the-counter energy trades and trading on electronic energy commodity markets. The "loophole" was drafted by lobbyists for Enron working with Gramm to create a deregulated atmosphere for their new experiment, "Enron On-line." You might also recall that Gramm's wife, Wendy Lee Gramm, was on the board of directors of Enron when it collapsed.

So remember this as you listen to the newly self-righteous Republi-cons praise the false gods of less taxes and less government, they are largely responsible for the mess, they have no, zero, zilch, nadda credibility with me, and I haven't heard a better idea from them yet. Have you?"

The cause was certainly not Carter and the Community Reinvestment Act (CRA) of 1977. Only a Republi-con would tell you otherwise.


The Solution

Who knows, a Japanese proverb states: "An inch ahead is darkness." Pretty prophetic for this situation.

The solution certainly is not a repeat of Hoover's initial response to the Great Depression.

But history does offer some guidance, Roosevelt's New Deal, the S & L Crisis in the late 1980s,

(Historical footnote: Neil Bush, son of then Vice President of the United States George H. W. Bush, was Director of the Silverado Savings and Loan, which collapsed in 1988, costing taxpayers $1.3 billion.)

Japan's banking crisis and subsequent 'lost decade,' and Sweden's banking crisis.

In a previous post in early October I suggested:

The 1929 depression offers a valuable lesson. A recent article in Time, Are Paulson and Bernanke Running Out of Options? states that:

"After the 1929 collapse, which at its worst left a quarter of the workforce jobless, the U.S. instituted safeguards to ensure liquidity, confidence and trust in the U.S. financial system. There were four pillars: insuring the bank deposits of everyday Americans, allowing access to government funds in case of a panic, providing a regime for the orderly failure of badly run companies and limiting how much credit could be leveraged off a particular asset."

The government should do the same now, defend depository institutions and provide a regime for the orderly failure of badly run non-depository financial institutions and insurance companies. In the process the government and the public will have to make some tough choices and learn to live within a budget.

In addition to that I would set short and long term objectives:

In the short-term:

• Suspend the collection of all payroll taxes for 1-2 months,
• Extend unemployment compensation and other assistance programs,
• Invalidate all CDSs, and
  
• Nationalize insolvent banks.

In the long term:

• Remortgage America,
• Complete government reform, which would include:

• Regulatory, organizational, and tax reform as I have described in the past as GRAC,
  
• Reduce/cut all government salaries, assistance payments, etc. by 10% of the first $100,000/year and 50% thereafter,
  
• Reduce all retirement and disability payments by 30%.

• A $1/gallon gas tax,
• An Incompetence Tax, and
• Ban the Democratic and Republican parties from future office.
  

OK, the last measure might require a Constitutional amendment, but I can dream can't I.

This is a work in progress., your suggestions are welcome.