Will The Guilty Pay — In Washington or Wall Street?
Kurt Brouwer September 19th, 2008
The events of this week and the preceding weekend have been monumental. To make sure you are up-to-date, here is a quick summary of what has been going on.
As you know, the subprime lending mess and falling residential real estate prices are the root of the problem. Of course, you have to couple that with the excesses and extreme leverage or borrowing exhibited by many Wall Street firms. That led to earlier problems with Bear Stearns, which was taken over by J.P. Morgan/Chase with a Fed guarantee of its debt (JP Morgan, Fed Move To Bail Out Bear Stearns).
Then we had the takeover of Fannie Mae and Freddie Mac, two government-sponsored enterprises, that collectively hold $5 trillion in home mortgages (Bill Gross Was Correct — Treasury To Take Over Fannie & Freddie). Those entities had acquired so many troubled mortgages that their capital was inadequate and the Feds felt they had to step in. The shareholders in Fannie and Freddie got wiped out, but debt holders got guaranteed. There are many issues with this situation, but our point in this post is just to help you keep track, not to go into the details of each situation.
If you want more details on some of these deals, see Bad News & Good News On Wall Street.
Lehman Bankruptcy and AIG Takeover
After the takeover of Fannie and Freddie, we saw the bankruptcy of Lehman Brothers. That was viewed as a salubrious and character-building lesson for Wall Street because the Feds just let it fail. On the heels of that morality lesson was the AIG situation in which it became clear that the Feds viewed some companies as ‘too big’ to fail.
Over the weekend, we found out that the Federal government was potentially loaning $85 billion to American International Group, the world’s largest insurance company (see U.S. To Take Over AIG). This loan was given in return for 80% of the company, effectively freezing out the common stockholders. Why did AIG need to be bailed out? Because it guaranteed — against default — the holders of large tranches of mortgage securities. Given that no one wanted these securities anymore, the holders of them naturally looked to AIG for protection and the cost to AIG could have been as much as $57 billion. Yikes.
AIG’s normal insurance operations were largely insulated from this issue, but holders of AIG debt securities — bonds, commercial paper — were not. Failure of those securities would have rippled through the system in unpleasant ways and the Federal Reserve and the U.S. Treasury wanted to avoid that. So, they guaranteed AIG’s debts.
Stock Markets Worldwide React To AIG
The world’s financial markets reacted badly to the AIG takeover — or actually to the need for it — and on Monday, the S&P 500 fell approximately 4.7% . On Tuesday, we had a solid rebound, but then on Wednesday, the heavy selling started all over.
There were many reasons for the selloff in stocks, but the biggest reasons were simply uncertainty and fear, which led to panic selling, Once the Feds were perceived to be taking significant steps to ameliorate the crisis, there was an enormous rebound in stocks. Another rebound is underway today.
Money Market Funds
The panic and uncertainly led to selloffs in stocks, but it also had other effects. For example, conerns over securities from AIG and other troubled companies washed through the $3 trillion plus money market fund system and caused certain funds were forced to mark down some of the short-term money market instruments they held. That led to a bit of a ‘run on the bank’ at some of the money funds so the Feds had to step in and temporarily guarantee them against default. This piece from Bloomberg spells out the $50 billion government backstop for money market funds.
In addition, the Feds have announced the formation of a governmental entity — much like the Resolution Trust Corporation that was used to take over and liquidate failed savings & loan companies in the 1980s. This entity would take over the various forms of real estate-related debt held by banks and other entities. It would do this in return for equity in those entities or as part of a liquidation. The point of this being that a government entity could presumably liquidate these investments — speculations rather — in an orderly manner. Back then, banks and savings & loans companies were failing. Now, we have some banks going under, but it is not anywhere close to the order of magnitude we saw back then:
Source: Calculated Risk
During the savings and loan crisis, we saw hundreds of bank failures every year. Now, there have been some bank failures, but they have been relatively modest, with the exception of IndyMac. However, now we have much bigger entities failing — Bear Stearns, Lehman Brothers, Merrill Lynch, AIG, Fannie Mae and Freddie Mac. Now, technically, these companies, with the exception of Lehman, have not failed. Rather, they have been taken or by another entity or backstopped and guaranteed by the government. However, that’s technical quibbling.
With all of these efforts, it becomes clear that the Feds are trying to stabilize the spooked credit markets, but it is also clear that the government’s role in the economy is now vastly larger and vastly more complicated. So far, they have been quite successful. However, there is plenty of unfinished business. First, are there any other entities that are on the verge of failure and what is the plan for them? Next, how does the government work its way out of this intrusion into the private sector? Government policies led to this problem in part primarily due to the implicit government guarantee behind Fannie Mae and Freddie Mac. Now, what is the plan to get out?
Will The Guilty Pay?
Finally, most of us would like to see serious penalties and consequences for those who have caused this mess. Past and present executives of Fannie Mae and Freddie Mac certainly are high on the list. In addition, top executives of other entities such as Countrywide Financial, Bear Stearns, Lehman Brothers and so on.
There have been real concerns as to fraud and other governance issues at Fannie and Freddie dating back for many years as this 2003 piece [emphasis added] from the New York Times indicates. Back in 2003, there was a plan to reform these two agencies, however, Congress shot it down. And, Congress has consistently thwarted any meaningful reform of Fannie and Freddie:
New Agency Proposed To Oversee Fannie Mae and Freddie Mac (New York Times, September 11, 2003, Stephen Labaton)
The plan is an acknowledgment by the administration that oversight of Fannie Mae and Freddie Mac — which together have issued more than $1.5 trillion in outstanding debt — is broken. A report by outside investigators in July concluded that Freddie Mac manipulated its accounting to mislead investors, and critics have said Fannie Mae does not adequately hedge against rising interest rates.
”There is a general recognition that the supervisory system for housing-related government-sponsored enterprises neither has the tools, nor the stature, to deal effectively with the current size, complexity and importance of these enterprises,” Treasury Secretary John W. Snow told the House Financial Services Committee in an appearance with Housing Secretary Mel Martinez, who also backed the plan.
They were too big to regulate back then when they held $1.5 trillion in mortgages. Well, now they hold $5 trillion in mortgages. This is a good example of the old adage that problems deferred just get bigger. The NY Times piece continued:
…Fannie Mae, which was previously known as the Federal National Mortgage Association, and Freddie Mac, which was the Federal Home Loan Mortgage Corporation, have been criticized by rivals for exerting too much influence over their regulators.
”The regulator has not only been outmanned, it has been outlobbied,” said Representative Richard H. Baker, the Louisiana Republican who has proposed legislation similar to the administration proposal and who leads a subcommittee that oversees the companies. ”Being underfunded does not explain how a glowing report of Freddie’s operations was released only hours before the managerial upheaval that followed. This is not world-class regulatory work.”
Significant details must still be worked out before Congress can approve a bill. Among the groups denouncing the proposal today were the National Association of Home Builders and Congressional Democrats who fear that tighter regulation of the companies could sharply reduce their commitment to financing low-income and affordable housing.
‘‘These two entities — Fannie Mae and Freddie Mac — are not facing any kind of financial crisis,” said Representative Barney Frank of Massachusetts, the ranking Democrat on the Financial Services Committee. ”The more people exaggerate these problems, the more pressure there is on these companies, the less we will see in terms of affordable housing.”
Representative Melvin L. Watt, Democrat of North Carolina, agreed.
”I don’t see much other than a shell game going on here, moving something from one agency to another and in the process weakening the bargaining power of poorer families and their ability to get affordable housing,” Mr. Watt said.
As we now know, an unholy alliance of home builders, mortgage lenders, Congressional leaders, well-intentioned, but naive housing advocates, Wall Street mavens and others got us into mess. As always, it will be up to taxpayers to get us out.
However, we really need some adult supervision in Congress. It is no wonder that approval ratings for that body are so low as this Gallup poll shows:
Source: Gallup
…Congress’ job approval rating has dropped five percentage points over the past month, from 19% in June to 14% in July, making the current reading the lowest congressional job approval rating in the 34-year Gallup Poll history of asking the question. The previous low was 18%, last reached in May.
I believe we are beginning to see some daylight at the end of this financial panic, but we are not done with it yet. And, when the financial markets get back to a more normal environment, it will be up to us as voters and taxpayers to make sure we not only clean up the mess, but that we also clean out the culprits, whether they are on Wall Street or in Washington.
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- Comments(3)
Did you enjoy this article?
Dear Kurt, I am not as financially astute as most of the people who comment here.
All I can say is, the more social power one has, the great the opportunity to avoid paying consequences for one’s bad or inept behavior.
In short, golden handshakes and parachutes for incompetant CEOs who, and a pink slip or termination of contract for the ordinary bloke who malfunctions at work.
Selling those exploding ARM mortgages was the equivalent of selling baggies of happy powder at the 16th and Mission BART station. (Dope dealer central in San Francisco, for those of you who dont know what this means).
The CEO’s getting people high on the unrealistic dream of home ownership on limited income, who pushed exploding ARMs and invested in debt generated by thousands of such deals, were manipulating greed and excitement just like dope dealers.
The CEOs wont get perp walked as the dope dealers are–unless a staggering number of people raise hell and inject some courage into the backbones of Congress.
And here is a citizen’s gripe: most of our elected representatives are rich. There is nothing wrong with being wealthy.
But what’s the point of wealth if it doesnt free a person up to do the right thing, rather than play it safe? The rationale for wealth was it gave fiscal independence that would support a person to take stands and incur a higher level of risk in serving his or her country as public servant. You could take positions and risk being voted out of office and still be able to support your family.
Our congress people are wealthy, but instead of using that freedom to be brave and insist on justice for citizens who elected them to office, they’ve been the exact opposite.
From:
The person who, thanks to BJ has had the time to learn to bake and
brings in evil treats each Christimas to the gang in Tiburon.
I look forward to doing this again. Thank you Kurt and all the staff at BJ for having given me the gift of time for so many years.
To answer your question: no.
Thanks December Baker for all the goodies. And the kind comments. As we saw in the rapid downfall of NY Governor Elliot Spitzer, even those who are supposedly our watchdogs seem to get drunk with power. Unfortunately, I think our elected officials are just as addicted to control and power as they are to money issues. Ideally, our leaders would transcend the muck and mire and do what’s right. Unfortunately, extended exposure to the halls of power in Washington D.C. or Sacramento seems to lead to less idealism and less concern among politicians for the long-term good of our country or our state.
And, Gurgle, I agree with you. In most cases, the guilty will not pay.