Huffington post at http://www.huffingtonpost.com/mort-zuckerman/the-anatomy-of-the-financ_b_136829.html
Mort Zuckerman, October 22, 2008-
Nature of the illness:
Everyone is haunted
by the fear our financial crisis might unwind into something like the Great Depression. The world of finance is undergoing
a collapse compabable to that which occurred in during the Great Depression. Federal
loose-crdit policies has produced the greatest destruction of wealth in our history. It is sweeping away giant blue-chip financial
firms and will cause governments around the world to default on their debts. Because
of a lack of industrial foundation and the impoverishment of the working class along with the continuing power of the world
of finance to influence police, this implosion will turn out worse than most pessimistic of us imagine.
Most critically,
the financial world is seized by a collapse of confidence. The uncertainty over the value of the securities they hold has
led to an enormous risk aversion. Customers, creditors, and shareholders of the major financial firms wonder whether they
might survive. Once confidence collapses, there is no telling when the selling will stop. It all brings to mind the story
of the economist who walked past a hundred dollar bill and didn't pick it up. When asked why, he responded, "It can't be a
hundred dollar bill for, if it were, somebody else would have picked it up by now."
All of this has
produced an unprecedented credit squeeze in which banks are refusing to lend to other banks, much less to businesses and individuals.
This squeeze has had a particular impact on the newly unregulated emergent shadow banking system made up of mortgage lenders,
investment banks, broker-dealers, hedge funds, private equity funds, money market funds, structured investment vehicles and
conduits. Many of these names we have never heard of before but cumulatively, they now provide a majority of America's financing.
They are not banks but they act and seem like banks. They borrow short and invest long, mostly in illiquid securities; they
have more debt in relation to equity than banks but have lacked, until recently, both deposit insurance and the support of
the Federal Reserve as the "lender of last resort." They do not have deposits but have relied on roll-over, short-term funding
obtained through borrowing in the money markets that has left these firms vulnerable to disruptions in the money markets.
To the extent that they have bundled these investments into securities that were sold to the markets, they were are also vulnerable
to mark to market losses when these markets, or their securities, start falling.
This quickly
wiped out the banks' capital base and ended their roll-over funding. The functioning of the credit markets was brought to
a virtual halt. Even worse, there is a quiet run on hedge funds and private equity funds ongoing that threatens to bring the
shadow banking system to its knees. Now the question is whether this will produce an economic contraction on Main Street comparable
to the Great Depression.
The inescapable
bad news is that a serious recession is inevitable given the damage to the financial sector, as well as in the degree to which
business and the general public has been traumatized by collapsing stock prices and the daily headlines. But this does not
mean we are bound to have a spiraling recessionary dynamic comparable to the thirties. The unprecedented debt American families
and businesses have assumed will continue to constrain the easing of the credit crunch. But we have avoided some of the mistakes
of 1929.
Take monetary
policy. This time the Treasury and the Federal Reserve moved quickly and positively. They understood that when banks lose
money they have to shrink their balance sheets and since bank assets are its loans, this would mean a drastic reduction in
credit and worsening business conditions. The Fed has sought to ease the credit crunch by injecting over $1.5 trillion into
the financial system and, most recently, added another $250 billion directly into the banks to re-liquefy them, plus increasing
deposit insurance, extending it to money market funds, aggressively lowering interest rates and, importantly, doing that in
concert with the other major economic powers.
In the early
1930s, the Fed refused credit to bankers and forced more and more of them to sell assets in a frantic dash for liquidity.
Some 10,000 commercial banks, or 40%, failed between 1929 and 1933 compared to only 20 this time. Many people back then stopped
using checks and conducted transactions in cash. The money supply declined by more than a third, creating a major contraction
of credit.
The contrast
in fiscal policy is equally dramatic. A generation of economists inspired by John Maynard Keynes in the 1930s taught us that
the government should not try to run a balanced budget in a crisis of demand, as both Hoover and Roosevelt did. This time
the government is running a $500 billion deficit to stimulate demand, and next year it will exceed $1 trillion. Orthodox adherence
to the gold standard in the thirties didn't help, compared to a free floating US dollar today that has declined by 16% on
a trade weighted basis. Another critical fiscal difference is that the federal government today has more sway. It makes up
21% of GDP compared to just 3%
in 1929. On top of this a large component of GDP is devoted to health and education that is substantially decoupled from the problems
of the private sector, not to mention that the Social Security program adopted in 1935 today provides unemployment benefits.
All these contribute to maintaining the real economy. By the time FDR took over (1933), the economic entrenchment had begun
to feed on itself and turned a serious recession into the decade of the Great Depression.
We still have
in place Social Security and unemployment to slow the doward spiral. But other
things are much worse than during the Great Depression. Household debt rose from
about 50% of a $3 trillion GDP in 1980 to over 100% of a $13 trillion GDP today. The debts of the financial world, which
amounted to 21% of GDP in 1980, soared to 120% of GDP by 2007. The financial world's unprecedented accumulation of debt in relation to equity sometimes with over $30 of debt for every $1 of equity
means that small variations in their asset values, which once produced profits, have now brought them huge losses.
Much of this
debt takes the form of securities and derivatives that remain on their balance sheets. In fact, another systemic risk and
one that cannot be measured is based on the opacity and complexity of these exotic securities, mainly credit default swaps
and derivatives that remain mainly on financial balance sheets exceed $50 trillion. Debt requires
payment of interest, the fainancial institutions act as a great vacccum cleaner. As
long as debt rose, prices on stocks and and properties rose. Now the combination
of falling property and stock prices, reduced consumer demand, rising unemployment, tightening credit, falling wages, and
a lack of confidence by the consumer, the banker, and the business community, all these entail that a major correction is
under way, one which will likely rival the Great Depression.
Then there is
the housing bust. The current crisis in housing has an important history. When the Fed tried to respond to the dot.com bust
in the year 2000 and 2001, that is when the Internet bubble burst, littering the country with bankruptcies and layoffs --
not to speak of investor losses of more than $1 trillion -- the Fed rapidly increased the money supply to offset these losses
and slashed short-term interest rates to 1%, the lowest in 45 years. The result was the greatest housing boom this country
had ever encountered. From 2002 to 2006 housing values appreciated at the astonishing rate of 16% per year compared to only 3% for the 55 years between
1945 and the year 2000. We finally came to the point where it was impossible for the typical American family to buy an average
priced house using a conventional 30-year mortgage.
Then the housing
bubble burst. Housing prices have dropped roughly 30% and the decline is continuing. Plummeting house prices mean more foreclosures,
more homes on the glutted marketplace and a further house-price slump. There are 15 million homes today with negative equity
where the mortgage exceeds the home's value and it may rise to 20 million over the next few months. Most of them have mortgages
that now exceed the value of the homes by over 20%. If half these people drop the keys in a box and walk away, the losses
will be in the trillions and may well destroy the equity in our banking system. That is why it is critical to find ways to
keep foreclosures to a minimum. The entire attempt to re-liquefy the financial system could be undermined by this collapse
in housing prices.
These are substantial
threats and for all the measures (belatedly taken) distrust remains. American policymakers have seemed to be responding at
an ad hoc, unfocused fashion, not fully taking into account the looming insolvency issues and the frightening complexity of
the bundles of exotic securities. It is fair to acknowledge that they've been dealing with a crisis on a scale not seen before,
and one that unfolded with terrifying speed. But the fact remains that by the time they acted, measures that might have re-stabilized
the markets were ineffective. Robert Brusca of FAO Economics, captured it well when he said, "There is sense that if policymakers
were surfers, they would have missed every wave." {Inaction is the mantra of neocons, who believe that the free market is a self-correcting system, and that intervention
in the long term makes things worse.}
Lehman's bankruptcy
is a case study in government ineptitude. It was the $785 million of losses on Lehman's securities that pushed the value of
the assets of a major money market firm below their $1 per share paid value, described as "breaking the buck." This caused
$400 billion to be taken out of money market funds in a matter of days, while the rest of the funds were frozen in anticipation
of further withdrawals. Banks were relying heavily on these funds for their commercial paper and the result was a spiral of
illiquidity. The Lehman decision prompted the following from the French Minister of Finance, "Horrendous!" an assessment echoed
by many others. It remains puzzling that our Treasury officials did not foresee that the Lehman failure would not be just
another failure, but a catastrophic failure undermining faith in the system. After Lehman, all remaining trust vanished in
the financial world. Money market and interbank lending froze virtually completely. The spread on credit default swaps rose
to levels that caused fear and speculation.
What next?
Here are some
proposals:
1. We must have
a quick and efficient way to sustain more banks with capital injections, not just the major banks, using appropriate information
gathered by bank supervisors.
2. We need to
expand the definition of banks to extend appropriate regulatory regimes to the shadow banking system.
3. We will have
to oblige the newly defined banking system to build up equity capital when their lending is expanding, for financial busts
too often follow credit booms.
4. We must establish
a standard for risk management and risk assessment covering mortgages, derivatives, debt, and even equity and especially on
new financial instruments.
5. The Fed will
have to continue to guarantee interbank borrowing by banks eligible for recapitalization to reactivate the interbank lending
market and reduce abnormally high rates of interest on loans that float above the LIBOR interbank rate.
6. If there is
to be a fiscal stimulus program, it should be primarily in infrastructure and not on tax cuts: these tend to be saved and
not spent (and Obama's are more of a new entitlement program to people who don't pay any tax at all)
The danger is
that politicians, who have little understanding of the financial world, may draw the wrong conclusions from Wall Street follies
and make the wrong decisions, as they try to revive our financial system.
We must get this
right. The new administration must draft the best of our national talent into shaping and administering these new policies.
Otherwise the recession will not be U-shaped and relatively short. It will be L-shaped and extend for many unnecessary years
