What Went Wrong in 2008?

There are plenty of "Year in Review" articles in mainstream media and on the Web. Here 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 (LEHMQ.PK). 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.

Comments

[john s. gordon:]

well said.
> jack

Jan 06 08:20 AM

[axelrod608:]

"Leverage" was not the culprit. Leverage resulted from a fiscal policy that encouraged way too much cheap, easy money. When money is scarce, people safeguard it and use it wisely. When oceans of money are all around, people look for ways to creatively put it to all kinds of marginally safe purposes.

NO lender would have made a single subprime loan if money was scarce. Same goes for the liars' loans, Alt-A's and most derivatives.

Read a thousad articles and books on problem solving and they all will offer one piece of advice - it is impossible to solve a problem until one determines exactly WHAT the problem is. With that in mind, all the idiotic "bailout" programs haven't a snowball's chance in hell of solving the problem. Or as our Treas. Sec. puts it - no playbook. Playbook ? They don't even seem to know what game they're playing.

Keep flooding the economy with easy cheap credit and I'll guarantee the problems will persist.

Jan 06 09:28 AM

[User 268734:]

Yes indeed, root causes always need to be addressed. Trouble is that the underlying root cause of many of today's problems is a broken economic model based on overindebtedness, overconsumption, and the subordination of genuine wealth creation to financial smoke and mirrors. Unfortunately, there is no Plan B - so nobody is addressing the root cause. Instead, one easy, expensive, and ultimately futile 'fix' after another is being rolled out in pursuit of a Hollywood ending - a quick and painless solution that in the real world does not exist. The only open questions are how gullible the public in general and investors in particular are going to be, and how much the bail-outs and market manipulations will delay a soundly based recovery.

Jan 06 09:39 AM

[xmplary:]

The outsourcing of jobs is a clear root cause of the crisis. When people dont have jobs, how are they going to pay for the mortgages? which in turn adds to the downward spiral of the real estate market. Another is the pure greed of unregulated CDS xmplary.blogspot.com/2...

Jan 06 11:16 AM

[John Lounsbury:]

The stock market drop in the weeks following the Lehman collapse was due primarily to the recogition of the extent of the exposure inherent in the CDS pyramid. It took that event to bring home the risk to financial institutions around the world posed by a network of guarantees against defaults in underlying debt instruments and other financial assets. This network was perceived to be like a circle of dominos stacked on end. The perception was that, with the tipping over of the Lehman domino, the entire circle would fall.

This has not happened (at least not yet), in part because of the TARP legislation. However, there is still no transparency in this area and we can not be sure the crisis has passed. If another major financial institution fails, or is rumored near failure, the entire fear cycle could be repeated. Financial stocks would drop further and the rest of the market would follow.

One way to relieve this overhanging threat would be to broker the swapping out of CDSs in self-cancelling trades. This is something that CDS holders and issuers should welcome because it is believed that many of the CDS instruments offer guarantees by those with insufficient assets to make the "insurance payments" specified in the case of default in the "protected" securities. Government expenditure to operate this brokerage might be much less costly and far more effective than such grandiose schemes as the TARP.

Jan 06 01:54 PM

[xmichaelx:]

"The outsourcing of jobs is a clear root cause of the crisis." - No. In fact, this was totally unrelated. Jobs have been fleeing since the '80s. If you haven't adapted, you were laid off 10 years ago.

This article touches on the root cause: AAA ratings of securities that should have had less-than-junk status. The problem was actually slightly worse that that: Bonds without a (less-than-junk) real estate angle actually had a hard time GETTING a AAA rating!

The root cause has already been addressed -- the next 2-3 years will simply be fallout. There may be other disasters to come, but they will be unrelated to the current crisis.

Jan 06 01:55 PM

[carey_jim:]

It's too early to conclude that 2008 is just 'business as usual' in America, which is to say just one more dip in a business cycle which is part of a long history of expansions and contractions dating from 1789.

But even if 2008 turns out to be another 'big one' and not just an ordinary recession, we've had big ones in the past, before the Great Depression, and we have recovered from all of them, obviously.

It seems to me that America represents what is best and worst in the tradition of Western Civilization, dating all the way back to the Greeks and Romans.

Economic virtue, which is represented by such concepts as hard work, personal responsibility, saving for a rainy day, trustworthiness, respect for other people, fair play, etc., is contrasted with economic sin which is represented by greed, dishonesty, profligacy, disrespect for the rights of others, lack of respect for the law, not saving for a rainy day, etc.

The ups and downs of capitalism reflect the ups and downs of our collective economic virtue and, just as we have to pay for our sins in our personal lives, we have to pay for our collective sins in our economic life as a country.

The good side of a Great Financial Reckoning is that, as a country, we have the opportunity to learn to live 'economically virtuously' again and that is a good thing ;)

But most economists don't factor morality into their equations and look elsewhere for explanations of recessions, such as the money supply.

Jan 06 02:13 PM

[henarl:]

"just as we have to pay for our sins in our personal lives we have to pay for our collective sins in our economic life as a country"

Unfortunately, most of those who have profited immensely from their personal and collective economic sins in the current situation will not be the ones who ultimately pay for their transgressions. Rather it will be future generations that will have to pick up the tab.

Jan 06 03:25 PM

[carey_jim:]

As one of the great books of the Western tradition teaches us:

You shall not bow yourself down to them, nor serve them. For I the LORD your God am a jealous God, visiting the iniquity of the fathers upon the sons to the third and fourth generation of those who hate Me, and doing mercy to thousands of those who love Me and keep My commandments.

Deuteronomy Chapter 5

Jan 06 04:22 PM

[carey_jim:]

Minus 2 for God?

I only quoted the Old Guy for the benefit of henarl. Don't give ME negative points for that.

(I wouldn't advise giving His word negative points either: He might get even.)

Jan 07 12:00 AM