Saturday, September 20, 2008

Financial Meltdown or Miraculous Recovery? 

The financial markets have been on an unbelievable roller coaster ride this week, with some relief Thursday and Friday as the US Government moved to put full faith and credit behind some unprecedented moves to stabilize the credit markets. Story here.

The talking heads say this can all be traced back to the subprime mortgage debacle, and the presidential candidates are falling all over themselves trying to blame each other. I am of the opinion that the President has very little control over the economy, and generally speaking it's better to let financial kinks work themselves out without government intervention. The problem now is, that strategy apparently carries a significant risk of shutting down the nation's, and possibly the world's, credit markets. That would be catastrophic, so I guess it's appropriate for the government to step in. One thing's certain: no other government has the capability of doing anything about this mess. The danger is, of course, that the cure will be worse than the disease.

My take on the subprime market issue is that the problem was caused by two main factors. First, it was absolutely stupid during an obvious housing bubble to lend money to people who had no hope of ever making their mortgage payments. It was even more stupid to lend to mortgagees without even doing the most elementary due diligence. Second, one reason for such rampant stupidity among (presumably) rational business people was, everyone in the chain from mortgage originators to the banks to Fanny and Freddie and the investment banks who bought the mortgage backed securities believed that someone else would ultimately take the hit if the mortgages went bad, and they grossly underestimated the likelihood of that happening. Also, I suspect at some point the herd instinct had something to do with it--some companies invested heavily in the mortgage backed securities because someone else was doing it. I absolutely believe that in each and every one of those companies that invested heavily in those securities, some lonely voice warned against the risk, but was ignored because of the profit potential, and besides, "everyone's doing it." Obviously those decision-makers were taking some kind of youth drug, because they reverted to teenage logic. Great argument for the "CEOs are grossly overpaid" crowd, don'tcha think?

As I understand it, the reason those securities are not tradable right now is that nobody knows what they're worth. Lehman, AIG, Fanny and Freddie and Bear all had significant portions of their assets tied up in those securities, and as a result of their being unsellable and mark-to-market accounting rules, they had to revalue those assets to zero. It's almost the same effect as if the bank was robbed, with no deposit insurance.

I'm not a financial professional, and I've never taken any courses in finance except in the College of Life; this stuff is way too complex for me to analyze with any kind of scholarly precision, but it seems obvious to me that the best-of-both-worlds status of Fannie and Freddie had a lot to do with this mess, as did the do-gooder regulations imposed by Sarbanes-Oxley. I expect a lot of rules and regs will be rewritten as a result of this, and I can only hope and pray that those who are doing the rewriting look at the whole system using dynamic analysis techniques, and that lots of time is spent looking for unintended consequences. The taxpayers who are now on the hook for approximately $1 Trillion deserve nothing less.

BTW, I sure would like to know what George Soros has been doing with his money for the last few months, especially the last few weeks. Just sayin'.

UPDATE 20080920:1510PDT: Tom Maguire has an excellent informative and educational discussion of the issue here.

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