Cullen Roche, who runs the popular blog Pragmatic Capitalism, put out an interesting piece this week titled "Lessons from Five Years of Economic Crisis" It provides an excellent overview of the past five years.
Some of the commentary I have made previously on the topic of the credit crisis can be read here and here. The global credit crisis had many moving parts and in Mr. Roche's article he discusses the interplay between austerity, economics, monetary system and the role/influence between capitalism and socialism.
This article will attempt to expound on some of the issues raised in Mr. Roche's keen perspective.
Credit implosions are not manifested from any singular event, but rather from the cumulative effects of numerous events. For the sake of this discussion we will go back to the Clinton White House years as a starting point to highlight some anecdotal observations in the decade leading into the credit crisis.
Although it is a generally accepted view that the credit crisis was sparked by a collapse in the housing market, there were several peripheral events during the Clinton Administration which may possibly have set a preamble for what would come years later. Clinton signed the reversal of the Glass-Steagall Act which was designed to prevent financial institutions from getting too big to fail. He also signed the Commodity Futures Modernization Act which legalized over-the-counter derivatives.
Additionally, the Clinton Administration claimed to have produced the first federal budget surpluses since 1969.
Clinton's Budget Surpluses: Consider the fact that while Bill Clinton was President, the US Government went from a deficit of $29.2 billion (1997) to a surplus of $69.2 billion (1998). At first glance, it would appear Clinton is a fiscal genius. How did he pull this off? According to some experts, it was accomplished with financial engineering.
In a brilliant 1999 Barron's article titled "See, it's a surplus," author Gene Epstein writes:
If you listen to the folks in Washington, you might think the federal government had a surplus of $69.2 billion for the fiscal year ended last September. This supposed surplus, coming after nearly 30 years of government deficits, has been cited as a cause for great rejoicing. Indeed, the Clinton Administration and the Republican-controlled Congress celebrated the surplus last fall in the way politicians enjoy most: They spent some more money. They were feeling so good that they increased their spending plans for the current fiscal year by $21.4 billion.
Here's how it affects the budget. By adding the Social Security system's $99.2 billion surplus to last year's $29.9 billion government deficit, voila, the federal bean-counters have created their $69.2 billion surplus (see charts). The same ploy is being used to transform this year's deficit into a surplus.
- Gene Epstein; "See, It's a Surplus"; March 1, 1999; Barron's cover story
However, this is not an indictment against the Democrats or the Clinton administration. It would also implicate the Republican-held Congress later too as they continued tapping into trust funds at the same relative rate when George W. Bush came into office. Yet, to a politician on either side of the aisle, it doesn't get much better than a "surplus". Democrats railed for spending on new programs while the GOP salivated over the prospects of tax cuts.
The Clinton era boasted a flourish and the economy was arguably quite healthy for a peacetime era. Companies were building capacity, unemployment nudged below 4% and inflation was manageable.
Unfortunately, it would be over-capacity that came back to haunt in the form of a post-Clinton recession which started in March 2001 (two months after Clinton left office). Of course, spending under Bush escalated with wars in Iraq, Afghanistan and again following the tragic September 11 attacks in the US.
Federal Reserve to the Rescue: By then it was quite clear to Alan Greenspan that downsizing and excess capacity would put a damper on capital spending by business. It would be up to the consumer to carry the economic torch.
In late 2001, Greenspan's Fed started cutting interest rates to 1% by 2004. This led to an unheralded wave of home buying and refinancing, not to mention home equity being turned into ATM machines. Banks such as Countrywide, WAMU and others were eager to oblige with lending. Thanks to cheerleading efforts of proponents favoring the easing of lending standards, loans were easy to get with little or no document requirements.
The banks, meanwhile, realized that the party would not last forever. To mitigate their portfolio risks, they promptly securitized large tranches of the RMBS/MBS notes and sold them to investors all over the world.
Of Note: WaMu was once the nation's largest thrift and a leading issuer of home loans. From 2000 to 2007, Washington Mutual and Long Beach (its subprime lender) securitized at least $77 billion in subprime and home equity loans. WaMu also sold or securitized at least $115 billion in Option ARM loans. Between 2000 and 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, accounting for more than a quarter of every dollar in loans WaMu originated.
In 2004, the Fed starting raising rates in an effort to stem the asset inflation caused by the easy monetary policy in the previous several years. This had an adverse impact on the popular adjustable rate loans that would eventually re-set at higher rates. Within the course of several years Fed funds rates rose to 5.25%.
As homeowners found themselves underwater, banks, lenders and institutions holding the notes, derivatives (which Greenspan also opposed regulating) and mortgage backed instruments saw the value of their paper plummet along with home values. Nobody had expected the party to end so soon.
Who is complicit to this credit disaster? Pretty much everyone, it would seem, from politicians, lobbyists, regulators, banks and all the way down the food chain to the homeowners themselves.
Also, let's not forget what happened to other areas of the commercial paper market. One unusually disturbing aspect of the malaise was in the auction rate securities (ARS) market. For many years these auctions were fluid and active. Some touted ARSs as near cash equivalents and slightly subordinate (risk wise) to CDs. In August 2008 these auctions failed and came to a grinding halt. Big investment banks also refused to support the auctions, due in part to a dearth of interbank lending. Put simply, the key liquidity providers of the economy (banks) were wary of one another.
How credit malaise relates to austerity depends on what lessons have been learned, ideas echoed in Mr. Roche's article. Like him, I too am a capitalist and agree that to be a good one, you must understand the system we have designed and what makes it tick. You also have to know what the rules of engagement are. If you don't, identifying the mistakes and preventing future ones can be difficult.
I would respectfully disagree with Roche's view that capitalists were powerless to prevent further malaise without help from an "outside entity". It wasn't capitalism in itself or free market enterprise that failed so much as the poor judgment of its participants and the structural deficiencies within the system they operate.
Similarly, it might not be an issue of less or more government needed, but rather of how effective or not lawmakers and the legislative process is. Sensible legislation is always welcome, but over regulation is often expensive and burdensome. Take Dodd-Frank for example.
Chief architects of the financial reform legislation were Sen. Chris Dodd (D-CN) and Rep. Barney Frank (D-MA). Both men were ranking members of financial industry legislative committees. In the aftermath of the financial crisis, it was obvious some financial reform was necessary, if not critical.
Yet, Dodd is on record for writing language which allowed for bonuses to be paid to AIG executives at a time when the US government had essentially taken over the failing insurance giant. Dodd had initially denied that he had anything to do with adding the language, which has been used by officials at insurance giant AIG to justify paying millions of dollars in bonuses to executives after receiving a federal bailout. Dodd also received significant campaign contributions from AIG.
Congressman Frank was a vocal proponent of easing Fannie/Freddie lending standards and a strong backer of affordable housing. He is also on record for suggesting prior to the credit implosion that (in reference to Freddie & Fannie) - "These two entities ...are not facing any kind of financial crisis".
However, with Dodd-Frank we have a major tome of legislation sponsored by two authors who found themselves squarely amidst the problems.
I also don't agree with the notion that capitalism makes socialism possible or that more recently, socialism made capitalism possible as suggested by Mr. Roche. Rather, they are strange bedfellows with similar needs and wants. While Mr. Roche is referring to government as the "public" entity, it would be unfair to consider taxpayers (those funding this "public" entity) as socialists.
Capitalism employs "private investment" where the economic return or benefit is realized by those taking the risk. Socialism is an economic and political system based on public or collective ownership of the means of production. In theory, capitalists use their own money while socialism uses other people's money.
As for the problems in Europe, the idea of a monetary union between disparate participants (economic, cultural and political) will be a challenging proposition at the outset. The economic issues facing Greece for example are much different than those of Spain. Greece's bloated public service sector is highly unionized and accounts for almost a quarter of the country's total workforce. It will take more than tourism, Retsina and olives to pencil in such costs. In Spain, over-development and real state speculation led to an asset bubble similar to what the US experienced previously. Spain's bad loan rate is almost 9.5%.
Both countries have socialist political elements and much of Europe as a whole has been shifting to left-of-center leadership as evidenced in recent elections. Does this shift portend an anti-capitalist sentiment or just an aversion to swallowing bitter medicine? With Spain, you might argue that banking reform would be useful in their learning curve. As for Greece, a case could be made that four day work weeks and bureaucratic largesse is not sustainable.
With respect to austerity, any state of reduced spending and/or increased frugality will depend on to whom or what the circumstances apply. Austerity measures generally refer to the measures taken by governments to reduce expenditures in an attempt to shrink their growing budget deficits.
Fortunately, and as Roche points out, our monetary system in the US, while flawed by policy at times, is able to harness the public/private resources more expeditiously than that of the Euro member constituents. You can't blame Germany for wanting to push austerity measures on their ECU counterparts. Yet, to the average Greek citizen who is being asked to settle for less, austerity can be hard to swallow.
On the other hand, the average Greek probably does not dwell on the risks facing their country's sovereign debt woes. As an investor, why would I want to hold bonds with little or no prospect of being paid or serviced? Why risk my hard earned "capitalist" duckets on a scenario with little near-term prospect to be remedied? I might change my mind if there were progressive changes and a sense of urgency by all parties concerned.
Personal retrospect: The collapse of General Motors (GM) resonates with me as I was both a senior and unsecured creditor. I took the risk, and was fortunate enough to walk away with modest losses (thanks to interest received in years prior to default). I was also betting the company would opt not to file bankruptcy, but bet incorrectly.
However, with respect to the unsecured debt, the UAW (through its healthcare trust VEBA) received a 17.5% stake in the "new" GM. All other unsecured creditors received only 10%. To me as a capitalist and one who is willing to take financial risk, the social/public distribution of equity in this arrangement leaves the feeling of being short-changed. Why should the UAW (an unsecured creditor) walk away with more than those who put up their own capital? Is this how public / private exchanges should be conducted?
A sound financial system and economic stability are traits both capitalists and "socialists" can embrace. So, what other lessons might be learned from the past five years? As an investor, here are a few that come to mind.
- Massive credit can (and will) lead to massive debt
- Printing too much money is dangerous (no two fiat currencies are alike)
- Never underestimate the political risk of any investment
- Financial engineering is not limited to the private sector
- Public / Private economic relationships do not guarantee equitable outcomes
There are many more lessons to be learned from the credit crisis and these are but a few. However, Mr. Roche offered a fascinating perspective from which to build on the discussion. As I mentioned earlier, there were many moving parts leading into the crisis.