Greed As National Policy: How We Got Here

Here is an interesting George Soros Interview from October 10, 2008.

George Soros discusses what he calls Free-Market Fundamentalism. He argues that unfettered free markets have an inherent agent-principle problem that can arise due to encouraging everyone to look out for their own self interest above all else. This came about in the mortgage industry where the mortgage issuer's interest lay in reselling the mortgages that they had approved, thereby having no interest in the home owner being able to actually pay off the loan.

Although he doesn't say this explicitly, I am certain that he sees the benefits of completely free markets, and those benefits do outnumber the costs. This would lead to the logical conclusion that it is better to have free markets assuming symmetry in the payoffs. The problem is, and what we are seeing now, is that the payoffs are NOT symmetrical. In other words, all the benefits of no regulation can be trumped by one catastrophic dis-allocation in the market and all those gains would be wiped out and then some.

My View

My view is that dis-allocation was not caused by the free market. In fact, it is a product of regulation itself. What happened in the mortgage industry was that we in effect had a pyramid scheme set up. A pyramid scheme would not occur at this level of sophistication if an artificial floor had not been set up. As we all know, a pyramid scheme ultimately results in the people at the bottom paying the costs up the pyramid and being left with nothing. That wealth is then unevenly distributed up the chain.

However, the whole structure of the pyramid changes when the final player, the ultimate loser, is setup artificially to absorb those losses. That player, or players, were Fannie Mae (FNM) and Freddie Mac (FRE) and the only reason this structure could exist is that they were the backstop; they were pre-destined to absorb all of these losses. The problem is that by going into conservatorship, it is now the government and hence the U.S taxpayers who are being placed at the bottom of this pyramid.

Remember that the ultimate goal of these two GSEs was to increase home ownership, a benefit and a risk for the people. It will go down in the history books that at the height of the leverage cycle, the largest, most leveraged bet was actually a government sponsored one.

Can We Blame Wall Street?

The business of wall street on a purely theoretical level is a noble cause. They are not in the business of reeking havoc, but rather arbitraging inefficiencies. Those actions, like mark-to-market accounting, allow us to get a better picture of the world on any given day (in a stable market). Whether it is reallocating capital from wealthy nations to developing nations in search of more efficient uses of that capital or pushing up the price of credit default swaps to reveal that a company's bonds have more risk than the public thinks - these actions actually protect the public and enhance productivity and growth. Problems usually only arise when politics enters the picture.

What we saw with these GSEs is that there was a major dislocation of risk and reward, and without giving it much thought, these institutions stepped in to do what they do best - arbitrage. After all, the government was taking the risk and the only problem they faced (or so they thought) was that when it all blew up they may be left with some mortgages on their books. The obvious question is, would they have engaged in this massive expansion of the mortgage market without that government backstop? I think the answer is obvious as well.

I will say that wall street got greedy as well, in terms of their use of leverage. You can also argue that their sophistication in the matter, relative to both the public and the government, should have yielded better decision making, but at the end of the day these institutions are comprised of human beings. In that sense they are no different than you or I - they are greedy.

Then There's the Rating Agencies

Another piece of this puzzle is the government appointed Nationally Recognized Statistical Rating Organizations [NRSRO]. I won't spend too much time on this point because most market participants are very aware of what's going on here. Moody's, S&P, Fitch and pals have been given an artificial position through government sponsorship such that their ratings are deemed more important than other firms. Their ratings are used in regulations very often pertaining to what sort of bonds or credit instruments can be held by certain types of funds. It's a sort of financial socialism where certain organizations make the decisions for the entire system. These are the guys that gave the highest possible rating to these mortgages. I'll repeat, these are the guys that facilitated this expansion.

This has a diverse range of consequences. If they give some mortgages the same rating as a municipal bond, but other securities yield several points higher, obviously the fund managers will demand more of these higher yielding 'similar risk' assets. This put extra pressure on wall street to pump out more of these securities and facilitated wall street to continue what seemed like an amazing arbitrage opportunity.

So the Government's to Blame?

Although I am no supporter of central planning and a devout believer in free enterprise, I have never been one to argue for no government whatsoever. However, in preparing for this article I have felt more disgust for government than I have in a while. We have a situation where the government setup a backstop through Fannie and Freddie, facilitated it through these authorized rating agencies, and is now scapegoating wall street for making money off an opportunity that they laid out on a silver platter. It's a perfect example of good government intentions gone wrong.

The Fate of Wall Street

I know that my article will have zero effect on public opinion and that wall street's reputation is ruined, possibly forever. The public is going to go along with this scapegoating because if they were to put the blame on the democratically elected government, then they would in effect be putting blame on themselves, and who wants to do that. These policies reflected the nation's desire to live outside their means, and at the height of the credit bubble, greed was a national policy.

Back to wall street's future and it is unfortunately, dire. The regular functioning of its institutions and the many efficiencies they bring to society, such as getting credit to credit worthy businesses and individuals, is not functioning. The fact that it all didn't end up in the GSEs, and the speed at which this played out, has left these institutions with more exposure than they would have liked. Plus, the uncertainty of how much they really have is killing confidence in their regular business. We don't have an accurate picture of how much things are worth, not because the future is unknown, but because these players have lost the ability to function properly. Some of the currency derivatives that I hold are seeing spreads five to ten times wider than I am used to and volume is down significantly as well.

I think that there is a demand in the market for regular functions, but the leverage will decrease dramatically. What we are likely to see is a more tame, lower risk wall street.

The Unraveling of the Pyramid

Usually a pyramid is a zero-sum game. Money is simply shifted from the people at the bottom to the people at the top, although if you look at it from an economic value sense (time, opportunity cost, etc) there are actually intangible losses. This pyramid is different and the payoffs are very asymmetrical.

Firstly let me say that everyone loses, except for a small group of people that won, and they include the people that worked on wall street and got out before this crash, stock options and all, and the people that actually own a house now that wouldn't have otherwise.

However, the truth is that both of these are a very small percentage. The people at the top would be the people making money issuing these mortgages, but that irresponsible act has caused a lot of those businesses to close their doors, with some owners to be indicted and scores of people to lose their jobs. What may have been a short term gain is ultimately a loss. In the middle of the chain are these institutions who are clearly paying the price and who might possibly lose their futures. Finally the people at the bottom, with the GSEs now in conservatorship, are the government and hence the taxpayers. It all comes back to the terribly risky policy of expanding home ownership and the people will have to pay the cost for embracing such a strategy.

In Closing

There is not much to be optimistic about here. The companies that are failing are considered to be weak. I am not of the belief that this is a good thing. There is the argument from the 'free market fundamentalists' that we should just let these companies fail, it's good for the market, but this is having a far wider effect. Companies that were very competitive in some areas are being shut down as an entire business because of one mistake. A lot of real wealth is being destroyed simply due to a lack of confidence and not real economic loss.

Yes, weaker businesses should be weeded out, but in an orderly manner. What we are seeing is the whiplash from distorting the market so much in the first place, and although we need to do something, we should be careful about not doing too much. Remember, that is how we got into these problems in the first place.

Comments

[Moonflye:]

good stuff, Adam.

2008 Oct 12 08:39 AM

[venividivici:]

This a system filled with parasites, piranhas and sharks that are currently engaged in a demented feeding frenzy, devouring each other.
As to whose principally responsible for anything in life there is one very simple way to find out. You simply look for those who most benefitted from all of the shenanigans. Now who was it who got countless billions of dollars in pay packets, bonuses and assorted goodies? Golly gee, I have plum forgotten.

2008 Oct 12 08:56 AM

[Georgen:]

Had there been no Fannie or Freddie, the free market would have handled this. Their implicit (and now explicit) guarantee allowed greed to run wild. In a free market, greed is self-correcting. Not so in this situation.

2008 Oct 12 09:15 AM

[Straight:]

This article fails to recognize that there are primary and secondary markets for mortgages. It was the unregulated private, non-banking lenders who made 80%+ of the sub-prime morgages in the free primary market followed by banks. Fannie Mae and Freddie Mac do not make mortgages. They buy them and leverage them as mortgage- backed securities. FRE and FNM bought these risky mortgages on the secondary market after the private, free market, unregulated lenders made them. The cash received by the private, non-bank lenders allowed them to offer more subprime mortgages and to sell them again for cash. Freddie Mac and Fannie Mae in turn sold these mortgage-backed securities for cash to investment banks and other financial institutions.The financial institutions used their money and investors money to purchase these securiites and hoped they would increase in value with housing price increases. But housing prices declined. The bet was lost. So who is left holding an empty bag when homeowners defaulted on loans as housing prices declined? Anyone who lent a subprime mortgage and owns it or who owns subprime mortgage-backed securities. As the article correctly states, the loss is spread across lending banks, investment banks, financial institutions and individual investors all over the country. Sub-prime mortgages were and are a known risk, but there was money to made by lending, selling, reselling and insuring them. Those who rid themselves of these loans and securities before housing prices decreased, lending rates going up the sell off panic spread profited. Also, before September 8, 2008, the federal government did not guarantee funds to support Freddie Mac or Fannie Mae. They were not taking a risk. These were not government entities. Perhaps, the government is more at fault for being irresponsible, ignorant and unwilling to take keep a finger on the pulse of the economy or to regulate it. But is that their constitutional job? Most of them had and have no idea about fiscal and economic realities. These facts are important to get a clear picture of what happened and they are left out of this article. If one wishes to understand what lead to the crisis, getting the basic facts straight goes a long way to see things as they are and not as an opinion based on partially completed research.

2008 Oct 12 11:12 AM

[pkscottx:]

Are you kidding me? Lets blame the evil's of sub-prime lending/borrowing. It was a SYMPTOM of a disease that was allowed to infect the entire bloody world because of DEREGULATION and the frigging totally unregulated and completely OPAQUE derivatives market.
This was a Ponzi scheme of debt creation that was destined to collapse when the borrowers were ultimately TAPPED OUT.
Last time I looked these "exotic financial instruments" were created by Wall Street and the notional "value" of these marvels of alchemy was estimated at $1.125 QUADRILLION against the entire annual global GDP of $50 trillion. (that sound you hear is a sucking black hole)

They have ZERO underlying real assets and were based on complicated "models" of things like income streams.

They were, for the most part "insurance" against risk (although NOT called insurance because then they would have been regulated and someone would have been checking to see if there was any one with the ability to pay up) that was sliced, diced, packaged, swapped and sold off to the corners of the known universe with commissions taken at every step. "Profits" were booked when the deal was made, not when the actual income arrived (or didn't as it turned out), bonuses were had by all. (Party on, dudes!)
Unfortunately the bonds that they were insuring against loss started to crater (lehmans auction just went for less than 10 cents on the dollar.)
The sellers of the "insurance" were so positive that this was a "sure thing" that they used insane leverage and some had as little as 5 cents of assets to cover one dollars worth of risk.
Nobody knows for sure who has or how much liability but EVERYBODY has a mountain of this garbage swept under the carpet. This is what has banks hoarding cash and eying each other with suspicion. Geeze louizey!
I happen to think that free markets are a good idea, but somebody should have been minding the store on this one. At the very least, there should have been transparency and some sort of clearing house to make sure that institutions weren't writing contacts that they had no ability to deliver on.
If my house is hit by a tornado I expect my insurance company to pay for the damages. If they say, "OOPS we underestimated the risk and don't have the cash to pay you." I have a contract so we go to court and, as they are bankrupt, they are scrapped and sold for parts while I line up with all the other creditors to collect my measly 5 cents on the dollar, which is probably LESS than the premiums I have been paying them since they had "booked" their non-existan profits and paid themselves big honking huge commissions and bonuses. The investors in said insurance company are in line after me and will get nothing back.

If the government steps in and pays up, I get my money (or at least part of it) but guess what, as a taxpayer I am going to pay that money back with interest as taxes.

A really truly free market would wipe anybody who was stupid enough to even touch a derivative of the face of the financial earth. I know, the pain, the pain. Investors, pension funds, lots and lots of banks, horror, horror and blood in the streets.

Don't look now but it's happening anyway.

2008 Oct 12 11:45 AM

[john s. gordon:]

pkscott - your grandchildren will get to pay it off, unless the u.s paper currency is repudiated by the govt. remember the german & hungarian hyperinflations of the 1920's.
> jack

2008 Oct 12 01:38 PM

[Straight:]

Kidding about what? Just pointing out that the article missed two important points. Also, There is no need to lay blame. Blaming does not help, especially when nothing practical can result from that except blowing off steam at one's losses, financial and/or psychologcial. Waking up to reality is more like it.

It is better to understand clearly what went wrong. Think. If an individual investor puts cash money in the hands of a persons and/or financial institutions who were making extremely risky investments in subprime mortgages, credit defaults swaps, collateralized debt obligations and other risky ventures based in a changing housing market, then they were not thinking or reasoning.They were, to put it bluntly, blindly investing into what was promoted as a good buy, properly informed, but not listening and investing, informed but not understanding or simply not responsible for carefully minding and monitoring investment options, the investments themselves or the market in general by allowing others do it for them.

The overall market began a gradual decline in the last quarter of 2007 and by mid-year 2008 it was clear that the market was sliding steadily downward. The time to rethink one's investments and move to safer bets was there and before.......

These exotics worked at first because investors paid into them, knowing or not knowing what they were, to get profit. They would not have worked and would not affect individual investors in the first place if investors informed themselves of the risk so that there was no cash flowing from them to these financial institutions for risky investments. If these institutions used their own money, then they would collapse and we, the people, would not be hurt and no rescue/bailout would necessary. Let them go down. But, greed and ignorance at every level of market investment blinds and millions of ordinary people became involved, not just corporate institutions; not just "Wall Street."

The problem also stems from having trust in people and institutions that do not deserve such trust, ever. Why do you think every one of these financial persons and/or institutions they work in (Not an anonymous Wall Street) have disclosures that you must agree to and sign that put them beyond almost all legal and financial responsibilty if an investment they manage for you goes to zero. "Tough luck if things go south" is the simply summary for all of these disclosures.

One should handle their own earnings and if one gives earnings to someone else to invest, it is better to make sure that one does not get screwed by others taking unwarranted risks with your cash, pension fund and what have you. So, if one is willing to sign or agree to such an agreement that clearly states it is on your head if things go wrong; if there is a loss, it is one's own responsibility. To say that one did not know is no excuse.

Fixing what is broken requires a clear mind. Greed is not a new financial entity nor is cleverness and cunning mixed with greed something exotic when it creates complex financial instruments designed to milk profits from an unregulated market in them. It is human financial behavior.

Your introduction to credit default swaps and one must include associated collateralized debt and bond obligations are a step up in the argument that shows that the article above misses another key factor that played a central role in Lehman's downfall and a huge ripple that widened to affect all financial institutions that used the compicated financial instruments.

With that addition, we are one step closer here to understanding the complexity and responsibilty involved in the fiscal crisis.

No kidding.

And the market will rebound as it has before and will start again. perhaps with investors somewhat wiser, if realizations set in. Now is good time not to panic but to learn about investing and financial markets and to see what next can be done to regain, if possible, what was lost.

2008 Oct 12 02:10 PM

[henarl:]

Straight: The problem with being an "informed" investor is that you have to rely on faulty information to make your investment decisions. When everyone in the system, including company representatives, brokers, accountants and auditors, rating companies, and politicians and government agencies has an incentive to slant the facts to his advantage or outright lie, due diligence becomes an oxymoron. If a potential investor realizes this, he might not invest at all. But then our entire capitalistic system completely fails. So, what choice does an investor have but to hope his research is based on accurate information. Unfortunately this sometimes to be of an act of misplaced faith.

2008 Oct 12 06:43 PM

[Straight:]

Hernal: Indeed! There is no such thing as perfect market information or any other kind of information, data or knowledge. Estimations, approximations, best guesses is all we have. Yet, with those we carry on our daily life, whether crossing a busy street against the light, launching a satellite or buying shares of stock. Then there are the unaccountable factors that suddenly appear from seemingly nowhere to lay waste to well made plans. Such is life. Crossing the street can suddenly turn unexpectedly into a deadly event. However such events are not in the majority and thus there are probabilities of disaster and success and these can be and are calculated very rapidly, well or poorly, depending on our individual capacities. Being able to do this allows us to leave our homes everyday feeling and thinking silently that everything will be alright.....today.

The choice an investor has is two. Do it on one's own with all decisions made by self and meditated only through a broker, personally or electronically; stock selection, entry price, share amount, buy - , stock selection, exit price share amount, sell. Pay fees and taxes. Simple.

Of course, like all things of a less than intuitive nature one must study up or be prone to failure among more adept individuals and unforgiven enviroments. In this way, one is responsible for one's financial business and knowingly enters an arena fraught with possibilites of success and failure. I prefer this way. I trust me to do the best for me since I cannot find someone to do it for me as I would for myself.

The other method is to find someone who one knows and who knows you intimately and personally, who is intelligent, capable and humane, who will tell you of all benefits and risks in clear and simple language and who will work, if employed, to personally protect your investment with integrity and wisdom. The chances of finding someone like that today where brokerages and investment firms have one person handle many small accounts are slim though not impossible. It is easily done when you command big money and can pay for such personal attention to be given.

That is the way it is. Any other way than these two, for me, is not worth the risk.

A simple example. In my TIAA-CREF portfolio, I transferred all my stock investments to real estate and the traditional annuity in September because a quarterly report showed a decline in profit for the 3rd quarter 2007. A little research showed there was not much hope in the CREF Stock or the Equity Index. They did not alert me or advise me of my losses.

Losses to the real estate account for the last quarter were also not reported as they occurred. So I wanted to move my funds to the annuity. When I tried to do this online, it was not permitted. When I called to have it done, I was told that it will be ok and if I put it in the annuity I would not be able to get it out again and the real estate market will be ok. Well, that is not my concern, the real estate market will not be fine for a while. Yet, instead of comlying with my wishes, I was told again everything would be ok. I want it there so why the blockade by someone who does not know me or my account? As you said they have their advantage to think of and work for that. It is all understandable. I just have to look out for my best interests and not expect unknown others to do that for me, especially not in America 2008.

So, I would rather fail on my own and be responsible for it than to have someone else fail who never knew me and does not care to because I am financially to them one bit of financial information in their portfolio.

2008 Oct 12 08:12 PM