The financial crisis: a perfect financial storm?

Tens if not hundreds of thousands of words have been written about the current financial crisis and the accompanying recession. Much of this analysis has been first rate, but this article will provide an overview of how we came to this pass.

As many before me have said there is plenty of blame to go around.
The current mess was brought about by a combination of government and private sector mistakes. The federal government significantly contributed to this mess in three ways: the Community Reinvestment Act, lax oversight of Fannie Mae and Freddie Mac, and a loose monetary policy.

The CRA was passed during the Carter administration. Its goal was to make affordable housing available to low income borrowers. Unfortunately, the phrase "affordable housing" is a pernicious misnomer. In reality, people were often encouraged to purchase houses that they could not afford, leading to defaults and foreclosures.

Mortgage lenders frequently went along with this scheme, some more eagerly than others, because they could lay off many of these risky loans on somebody else. That is where Fannie and Freddie come in. These government-sponsored enterprises do not originate mortgages. Rather, they purchase mortgages in the aftermarket. Fannie and Freddie hold approximately half of all of the mortgages outstanding in this country. I haven't seen a breakdown, but I would bet that a disproportionate number of mortgages held by Fannie and Freddie are dogs. When the auditors sounded the alarm about what was happening at Fannie and Freddie in 2004, they were savaged by Democrats in Congress, including Maxine Waters and Barney Frank. Real estate prices were still rising, and no one wanted to face the truth.

One reason real estate prices kept rising was that the Federal Reserve pursued a very loose monetary policy, driving short-term interest rates down to historic lows. But eventually the housing boom ended (booms always do), and the house of cards came crashing down.

Interestingly, the mortgage lenders were not those hardest hit. In addition to laying off mortgages on Fannie and Freddie, lenders had also packaged them into derivative securities called Collateralized Debt Obligations. These were snapped up by investment houses that frequently used leverage (borrowed money) to purchase them. When the investments finally had to be marked down, these companies did not have the requisite financial reserves to avoid defaulting on the loans.

The first major company to go was Bear Stearns, followed by Merrill Lynch and Lehman Brothers. American International Group, a huge international insurance company, also found itself in trouble, because it had sold contracts guaranteeing the repayment of the CDOs (called credit default swaps). None of these companies was in the business of making mortgage loans. Their spectacular miscalculations are incomprehensible Three large retail lenders, Countrywide, IndiMac Bank, and Washington Mutual also became insolvent, along with a number of smaller lenders.

We have all learned the hard way that laying off risky loans to other companies doesn't protect you if the entire financial system becomes overburdened and crashes. Our elected officials -- Democrat and Republican alike -- still do not want to face the music. Their frantic efforts to prop up bad loans and insolvent companies may well prolong the problem by preventing the unwinding that has to occur. This same thing happened in Japan during the 1990s, and Japan has still not fully recovered.

The market will eventually self correct, if it is allowed to do so. The process will be painful, but it is necessary to get valuations back to rational levels.

Energy (renewable and traditional): wishing doesn't make it so

The Secretary of Energy designate, Stephen Chu, is no fan of fossil fuels. He thinks they cause climate change (formerly global warming). He is a fan of renewable energy, even advocating converting solar energy into automobile fuel. But, as the title of this post says, wishing doesn't make it so.

The Wall Street Journal reports that renewable energy contributed only 6.7% of the total US energy demand in 2007, down from 7% in 1981. This in spite of the fact that renewables received almost $4.9 billion in federal subsidies in 2007 alone. Renewable energy sources are not likely to dominate the scene anytime in the foreseeable future.

Meanwhile, the news regarding fossil fuels isn't reassuring either. Pemex just announced that its crude oil output fell 6.5% in November year-over-year, largely because production at its Cantarell field declined at a faster-than-expected rate. As I've noted in a previous post, Cantarell is the third-largest producing oil field in the world, and Mexico is one of our largest foreign suppliers of oil. Mexico can't even agree on how to develop the deepwater fields it is counting on to replace Cantarell. I would be surprised to see significant production from those fields within the next 10 years. Saudi Arabia's major field is half a century old, and it's production either is or soon will be declining.

What should we do? The answer is so obvious that I'm surprised there is even an issue: develop and produce our own supplies of domestic oil and natural gas. The logical place to start is the Eastern Gulf of Mexico. The oil companies already have a lot of experience and seismic data regarding formations in the western Gulf. And the extensive infrastructure already in place (particularly the subsea pipelines) can be extended to accommodate the new production. This will not solve the problem, and it may not have an impact overnight, but doing nothing is not a viable option.

Jay Currie's blog

I recently came across a blog that deals with some of the same subjects that I post on. You can find it here. His posts get down into the weeds much deeper than mine, i.e. they are longer and more detailed. If you are interested in a subject discussed on this blog, but would like to read even more about it, you might want to check out Jay Currie's blog.

Is the federal bailout working?

If you believe the answer to the question in the title is yes, please post a comment and tell me why. I have to agree with Jonah Goldberg's recent article essentially characterizing the government's response as a financial panic. See link. We've gone from TARP to CARP to an auto company bail out. And others on both sides of the aisle are claiming that we are not doing enough to aid people who can't pay for the houses they've "bought."


Big Bill Tilden, a tennis great before my time, had a simple approach to the game: "Never change a winning strategy, always change a losing strategy." But that presupposes you have a strategy. If Paulson has a strategy, other than throwing as much money as he can get his hands on against the wall, I haven't seen it. And of course, now every one has their hand out asking for federal money.

The current situation in Iraq

Charles Krauthammer has an excellent article (as usual) about recent events in Iraq here. (HT:RobinsonandLong). As he points out, in a little over two years, Iraq has been transformed from a country in a state of chaos and incipient civil war to an ally with a democratically elected parliamentary government. This week, that government ratified military and strategic-cooperation agreements with the United States. This is a remarkable turnaround and a huge setback for Iran. Iraq may yet become the Middle East's version of a shining city on the hill.

Now, to paraphrase Charlie Wilson (of "Charlie Wilson's War"), we need to make sure that we don't screw up the endgame.

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FDIC boondoggle

I read this morning that the Chairman of the FDIC, Sheila Bair, is "frustrated" by the lack of support from the current administration for her proposal to have the United States guarantee troubled mortgages. Her plan is estimated to cost somewhere between $24 billion and $70 billion and involves restructuring mortgages that home "buyers" can't pay. The plan involves restructuring the troubled mortgages with the federal government guaranteeing them . Even if the plan is enacted, the default rate on the restructured mortgages is expected to exceed 30%.

This would be a really bad joke, except that it isn't a joke. Thank God the Bush administration hasn't completely taken leave of its senses (although it has come perilously close). Obviously, if this program is enacted, the federal government will have to stay on the hook for these mortgages for 15 to 30 years. All so that people can continue to live in houses they can't afford. If the mortgage lenders foreclose on these houses, they will eventually resell them to people who can actually afford to live in them. Isn't that the way it is supposed to work? Today's article in the WSJ, , validates this argument.

Your tax dollars and government spending

The courts have a doctrine called standing to sue, which requires a plaintiff to show individual or particularized harm or impact in order to contest the legality of a government expenditure or program. Simply having paid taxes to the government is not sufficient. This is a salutary doctrine: it prevents the courts from becoming even bigger political footballs.

But it is a legal doctrine, not a political doctrine. In evaluating the desirability of governmental activity, I assume that the money being spent by the government is my tax money. Money, after all, is fungible, and it makes just as much sense to assume that the government is spending my tax dollars as to assume that it is spending somebody else's tax dollars.

Thus, I ask myself whether I want to government spending my money to [fill in the blank]. For example, do I want the government to spend my money to pay off other peoples' mortgages? Or their credit card bills? The answer is obvious: no, heck no. We bought our house the old-fashioned way -- we paid for it, over the course of many years.

Do I want the government to spend my money to bail out Ford, GM, and Chrysler? The answer may not be as obvious, but it is still no. The so-called big three automakers have avoided making tough decisions regarding labor costs, the number of dealerships they support, and the number of plants they operate (or own but don't operate) for decades. If a government bailout would resolve these issues, it might make sense. But the automobile manufacturers want a bail out so that they can continue to avoid making these hard choices. In that respect, it really would be corporate welfare: the automakers would remain uncompetitive and continue to rely on government financial support indefinitely. The only way I know of for these companies to become competitive is to go through bankruptcy reorganization. That would be painful to be sure, but it would allow for the necessary restructuring.

So the next time you think about an existing or proposed government program, assume that your money will be paying for it, because it will be. There is no government money, just money that we earn and send to the government. I try never to lose sight of that fact.