From a financial, economic and political standpoint, in the the last week or two we have witnessed perhaps the most serious and far-reaching crisis facing the country since the years of the Great Depression in the 1930's. While many important, necessary but controversial corrective steps have been taken by the federal government, it's still far too early to see how this will end up and how our economy is likely to fare the rest of this year and in 2009. An economic depression or continuance of the de facto recession are still both possibilities.
The majority of leading economists and financial market observers have placed primary blame on overly aggressive, high-risk taking, greedy and imprudent mortgage lenders and investment bankers who unwisely were confident that home values would continue to rise for an extended further period. The mortgage lenders, such as Countrywide Financial and Washington Mutual (WaMu), very successful for a number of years, made aggressive loans requiring inadequate or even no down payment to frequently unsophisticated borrowers who in many cases could not afford the loans they were granted. Many of these loans were risky, rate adjustable loans with initial 'teaser' rates to make the loans appear more attractive to borrowers. Blame also has been fairly placed on inadequate oversight and outdated regulation by federal agencies, including the SEC, FDIC, Treasury Department and the Federal Reserve System (the Fed).
Investment bankers, many with weak balance sheets, made a big, initially profitable business of purchasing the mortgage loans without much analysis and securitizing them into so-called mortgage-backed securities, and selling them to institutional investors, including insurance companies, pension funds and other banks. To a great extent the investment banks purchased the mortgages by borrowing a great deal of money from the larger banks, putting a lot of debt on their books and thereby leveraging their balance sheets. They also used cash they had on hand, which began to impair their liquidity.
This worked out very well for several years, until home prices began to fall significantly in many of the country's key housing markets towards the second half of 2007 and this year, the result being that a high percentage of the mortgage loans became larger than the current market value of the homes securing the loans. This understandably caused a lot of anxiety among the lenders who became pressured to recognize substantial losses on their income statements, impairing credit ratings, and initiate foreclosure proceedings against the great number of homeowners involved. Another negative factor was a rising unemployment rate caused by a number of factors: a dramatic slowdown in construction activity; globalization, including corporate outsourcing to purchase products and components abroad, especially from China, where they could be made much more cheaply; and initiatives by U. S. companies to reduce expenses to better compete through laying off people and employing more technology and productivity-enhancing measures.
All this led to a lack of liquidity, poor credit availability, declining stock and bond markets, and an overall crisis of confidence in our financial system threatening our economy and that of our allies abroad. A team led by Treasury Secretary Paulson and Fed Chairman Bernanke concluded that immediate and drastic government intervention was needed and they acted decisively in a series of high-level meetings. As most of us know, the outcome included so far the bankruptcy of Lehman Brothers, one of the major investment banks; government takeover/bailout of Freddie Mac and Fannie Mae, the huge mortgage buyers; the takeover/bailout of AIG, the country's largest insurance company; the Bank of America's takeover of Merrill-Lynch, one of the other major investment banks; and the plan led by Paulson and Bernanke for the federal government to purchase up to $700 billion of "toxic", high-risk and illiquid investments held by investment banks and commercial banks, including the infamous mortgage-backed securities.
The only two major independent U. S. investment banks left at present are Morgan Stanley and Goldman Sachs. Morgan Stanley has apparently entered into merger talks with Wachovia, one of our largest commercial banks, and over the weekend the Fed agreed to convert the two of them into better regulated traditional bank holding companies.
Most of our political leaders and market analysts seem to support the government intervention as led by Paulson and Bernanke, although great concern has been raised by many of the dangerous precedent this has set, the great concentration of political and economic power involved, and the liability and debt load facing the country and the taxpayers. However, the consensus key objective is quickly restoring confidence and stability to our financial and housing markets. Importantly there is also a general conclusion that this intervention will likely have a very restrictive impact on the next presidential administration to carry out its political agenda.
As a former career banker, I generally agree with all these points. Given the impressive track record and resumes of Paulson and his highly experienced lieutenants, it will not be easy for critics to make a compelling case that a different course should have been pursued. As Paulson conveyed in an interview over the weekend, the decisions made were very difficult and complex and definitely involved controversial issues, but there was no good option. That said, it's probably a fair criticism that Paulson, his Treasury colleagues, supported by the regulators, should have anticipated the looming problems sooner and acted sooner. Paulson, after all, has been in office since July 2006. Moreover, his boss, President Bush, has been in office for nearly eight years.
The Executive Branch and the Congress now need to work on an urgent, constructive, and bipartisan basis to complete the overhaul to our financial system, including overseeing completion of the initiatives taken to date, and, over the next several months, prudently updating and streamlining regulatory oversight of our commercial and financial institutions.
Completion of the initiatives includes particularly Congressional action with respect to the pending $700 billion rescue plan proposed by Paulsen and Bernanke. Congressional leaders have acknowledged that they need to move fairly quickly, but are anxious to reassert their authority and include provisions for oversight, fairness and support for deserving homeowners and taxpayers, as well as limits to executive compensation at the institutions who have gotten themselves into trouble by poor management.
Given the urgency of the need to restore confidence in the markets, and the importance of structuring the right legislation for reform, the best approach might be to agree to a two-part solution. This would cover, initially, timely approval by Congress this week of the primary components of the Paulsen/Bernanke plan with limited tweaking and delay, and then, secondly, a subsequent broadly supported, comprehensive financial system reform bill hopefully to be signed into law by the next president after pragmatic deliberations and productive hearings by the Congress.