This is the text of a talk that I gave at North chapter of the Rotary Club in Sioux Falls yesterday. I only had 20 minutes so I did the ad lib thang for most of it. It summarizes the stuff I discussed at the South Dakota Chamber meeting a few weeks ago (see below) but with a new twist and some new stories. The best part is the ending, where I suggest that before Congress tries to fix health care and the financial system it ought to fix itself first. Cheers!
Is the Financial Crisis Over or Just Beginning?
Even though various economic indicators are looking better, I’m considerably more pessimistic about the answer to that question than I was when I gave a similar talk before the South Dakota Chamber of Commerce a few weeks ago. The reason is that the Obama administration and Congress are suddenly starting to make headway on some reform measures. Unfortunately, the bills now in motion appear to aim at the wrong targets.
One possible economic path before us is a so-called double dip or W-shaped recession where the economy begins to grow robustly for a short time before again plunging into recession. Such a path could be caused by any number of shocks, including but not limited to:
1. excessive uncertainty caused by government policy debates, including healthcare and insurance reform like that which passed the House last weekend and punitive financial reforms like those put forth today by Senator Dodd, the white-haired Demicrit from Connecticut;
2. the overhang of toxic assets on bank’s balance sheets, specifically those related to commercial mortgage lending and credit cards, which have taken a beating during the recession;
3. new asset bubbles in gold, rare earth metals, oil, and equities. Once the current rallies end, lenders may discover once again that they have lent too much to borrowers banking on irrationally high future valuations.
The return of weakness in the dollar means that, should the financial sector take another tumble, the government will be even more ill-prepared to combat the inevitable economic downturn than it was during the last go round. I fear, too, that the political fallout of another big bailout could get quite ugly indeed.
Don’t get me wrong, I am bullish on America. For all its faults, it’s still demonstrably better than most other nations. Our many John Galts are still hard at work. But we are in a dangerous period because if the government goes much further the Galts may strike. That’s a double entendre by the way. I myself have wondered why I put in 70+ hours a week only to see it frittered away by the half-wits that inhabit Washington.
Yes, I said half-wits. When the serial killer in the horror flick Saw VI more accurately and succinctly outlines the problems with the current healthcare system than federal politicians, bureaucrats, and pundits do, there is a real problem. It all comes down to incentives, Jigsaw noted between torture scenes. In short, health insurance should not be linked to employment any more than automobile insurance should be and doctors ought to get paid when their patients are well, not when they are sick. On those points, I tend to agree with that sadistic lunatic. The so-called public option can’t help, and neither can anything else, until we get the incentives straight.
The financial system will be a bit more difficult to fix because the causes of its pathos are less obvious and more numerous. To date, none of the reforms before Congress come close to fixing the system’s root problems and if anything the government’s bailouts have made matters worse. In the interest of time, I’ll limit myself to the 11 most important causes of the crisis:
1) Bubble, bubble, toil and trouble. It’s pretty clear that people can and do invest irrationally at times, paying much too much for assets. Nevertheless, many economists still believe that asset bubbles are impossible, that prices always reflect so-called fundamentals like interest rates and expectations of future prices. Following their lead, the Federal Reserve does not try to identify bubbles ex ante, which is to say before they burst and cause trouble. No other part of the government does much of anything to prevent or deflate bubbles either.
2) Financial dumb-dumbs. Very few Americans understand the basics of investing. American consumers know that it is better to buy low than to buy high, and to sell high rather than to sell low, except, it seems, when it comes to financial assets. Many confess to dumb mistakes like putting all of their savings into a single investment such as Fannie Mae, staying invested in stocks as their retirement looms, and extrapolating trends far too far. Because it controls most education K through 12 and even much of the college market, the government could work wonders here, but it hasn’t. Most people never take a course in finance or investing and it shows.
3) Skewed tax incentives. Americans do, however, follow their self-interests when the rational path is unambiguous. When the government basically told them via the IRS code to borrow to the hilt on their houses in order to invest in the stock market, they did so. I refer to the combination of the mortgage interest deduction and the ability to make pre-tax contributions into retirement accounts like 401Ks. No longer rewarded for striving to own their homes outright as they once were, Americans in the final quarter of the last century increasingly rented – for lack of a better term -- their homes from mortgage lenders and bought equity shares in corporations over which they had no control. The ability to put little or nothing down and to easily tap accrued equity through lines of credit of course fueled the real estate bubble. Those tax distortions have not been addressed and are unlikely to be anytime soon.
4) EZ money. Low interest rates basically reward borrowing and were a major factor in the dotcom and housing bubbles, as well as most of the scores of other bubbles that have troubled the U.S. economy since before the nation’s inception. Overnight interest rates are now near zero and the Fed shows no signs of increasing them anytime soon. So once again the government is encouraging investors to borrow to the hilt in the apparent hope of ending the ill effects of one bubble with yet another.
5) Abominations of Nature, a.k.a. Government Sponsored Enterprises or GSEs. Colloquially known as Fannie Mae and Freddie Mac, the GSEs were privately owned but publicly backed. They provided an important service called securitization, or the bundling of individual mortgages into bonds for resale to institutional investors worldwide. It is not at all clear, however, why the market for such securities needed to be subsidized with the full faith of the U.S. government, or in other words with taxpayers’ wallets. The original Fannie Mae was a government agency and should have remained as such. The government spun it off in 1968 to get it off its books, which were under pressure due to LBJ’s Great Society programs and the Vietnam War. With the government’s financial position again rather tenuous there will be tremendous pressure to spin the recently nationalized GSEs off again and no guarantee that it will be done properly this time.
6) Low ratings for rating agencies. Of the many institutions responsible for the financial crisis of 2007-8, the big U.S. credit rating agencies rank among the most odious because they profited by giving high ratings to securities that ultimately proved nearly worthless and practically impossible to resell. The agencies’ original business model closely aligned the incentives of the rating agencies and investors. For the first half century or so of their existence, the agencies sold ratings to investors, who continued to purchase them only if they were generally accurate. Unsurprisingly, early ratings were as reliable as market prices and other performance indicators. But in the 1970s two disasters struck. The advent of cheap photocopying made it easy for illicit entrepreneurs to make a fast buck by selling photocopies of ratings for a fraction of the price they cost the rating agencies to produce. That cut into revenues and profits, which sent the rating agencies scurrying for a new business model. Unfortunately, the one they hit upon – charging issuers -- was highly problematic to say the least. No sensible person or business bites the hand that feeds them. The new model therefore transformed rating agencies from pro-investor watchdogs into pro-issuer lapdogs. Before that happened, however, the government bailed out the agencies by designating five of them as Nationally Recognized Statistical Rating Organizations or NRSROs. The government also effectively perpetuated that cartel by barring new entry and forcing institutional and public investors, like public pension funds, to rely on the NRSROs’ ratings when making investment decisions. Unsurprisingly, over the next few decades the quality of ratings deteriorated. In 2006, the government passed legislation that facilitated new entry and abolished NRSRO-status. It did nothing, however, to change the perverse incentives at the heart of the system and does not appear prepared to nudge agencies back toward the original subscriber model, one that computerization has again made viable.
7) Managerial entrenchment. Common stockholders these days have very little say in the management of the corporations they own. That was not always the case. Before the Civil War, stockholders reigned supreme. The situation changed in the second half of the nineteenth century, however, so that by the Great Depression Adolph Berle and Gardiner Means could rightly complain about the separation of ownership and control. At the same time, government regulations purposely stripped institutional investors of their governance rights due to some overblown fears about J. P. Morgan and his crew. As a result, we have a system of weak owners and strong managers. It is not surprising that those strong managers rigged the game in their favor with big bonuses, golden parachutes, and perks galore, including $35,000 dollar commodes. And what has the government done about this deplorable situation? Exactly nothing. Instead, it threatens to limit executive pay itself, a policy that could have devastating effects.
8) The Importance of Incentives. The structure of executive compensation, on the other hand, is a matter of public interest because of its clear connection to financial system stability. If their compensation structure rewards them for making short-term profits but doesn’t punish them for making long-term losses, managers will take big, short-sighted risks, thus greatly exacerbating systemic fragility. The proper policy here is fairly simple. Managers should not receive bonuses on the basis of alleged accounting profits. Such a system is too easy to game, either by manipulating the accounting assumptions or by deliberately backing projects that are short-term winners but long-term losers like -- oh I don’t know – subprime mortgages, CMOs, and other risky projects. Deferred compensation, clawback, bonus-malus -- call it what you will – they all mean no more big paydays today on the basis of loans or other contracts with 15, 30, or more years to run. Stockholders liberated from the straitjackets I just described would push for more incentive-compatible contracts but while they rebuild their management monitoring skills the government should step in and force compensation deferment. And it should get other governments to sign on too, lest we lose some of our most innovative financiers and most important financial companies to London, Zurich, or Shanghai.
9) Static regulatory cling. Regulators are problematic for many reasons but primarily because they breed complacency. Why most investors believe that salaried government bureaucrats care more about their money than the investors themselves do is a difficult question to answer. I suspect that many people reason that because the U.S. government has the capability of putting a man on the moon, destroying the planet 100 times over, and so forth, it can surely stop financial fraud. Of course such reasoning is a tragic non sequitur. Regulators are not rewarded for stopping fraud or crises so they don’t do it. They are rewarded for upholding the letter, rather than the spirit, of the law, so that is what they do. Like generals, regulators are prepared to fight the previous war rather than the forthcoming one. Sarbanes-Oxley was the Maginot Line of the 2008 financial panic. In the 1990s, companies incentivized managers with stock options. Some managers responded as hoped and increased the efficiency of their firms by lowering costs, expanding into new markets, gaining market power in established markets, and so forth. Others, however, found that to be too much work and instead increased stock prices with shady accounting practices. Sarbox stopped that from happening again, just as the Maginot Line prevented the Nazis from invading France directly. But it didn’t stop the other major way of getting stock prices up, by undertaking risky projects. Just as the Germans swept through the Ardennes and the Low Countries and from there moved into France, U.S. financiers simply outflanked the regulators sitting complacently behind Sarbox.
10) Too Big To Fail policy. There is a notion, not necessarily a bad one, that the government should prevent the financial system from freezing, exploding, or otherwise causing negative externalities for economies foreign and domestic. The Federal Reserve was created, in part, to serve as a so-called lender of last resort, as a safety net for the financial system. As part of that mission, the Fed announced in the mid-1980s that it would allow small banks to fail but in times of trouble it would step in to save the 11 largest banks on the grounds that their failure would threaten the stability of the entire financial system. The problem with the policy -- which is still in effect and has metastasized into investment banking, hedge funds, and insurance – is two-fold. First, because the government still offers its guarantee free of charge those institutions that are clearly “too big to fail” can pursue risks with reckless abandon, safe in the knowledge that ole Uncle Sam has their back. Second, those institutions that think that they are close to being considered “too big to fail” have major incentives to grow bigger so that they too can reap the rewards of taking on more risk – free of cost and, ironically enough, free of risk!
11) Government Hubris. Bureaucrats and politicians thought that they could raise homeownership rates by implementing a number of policies, including the tax breaks and GSEs formerly alluded to. Via policies like the Community Reinvestment Act, they also encouraged lenders to make loans to weaker borrowers when they should have instead eased entry requirements for credit unions and community banks. The government also allowed the doctrine of secret liens to erode, thus enabling the growth of “silent second” and “piggyback” mortgages, or loans for down payments. When you let a borrower borrow the down payment you don’t really have a down payment, which was traditionally the number one defense against default because it served as a sort of life jacket that kept the borrower above water or with positive equity. Finally, the government allowed the development and proliferation of non-recourse loans. Essentially, it gave borrowers a free put option on their homes by allowing them to walk away when they are under water or in the bucket -- or in other words have negative equity – and to do so without serious adverse consequences. Such largesse certainly did increase homeownership rates, however temporarily, but did not increase the total amount of equity in homes. The put options, the silent seconds, and the Community Reinvestment Act all remain more or less intact.
Clearly, then, the government has done nothing to redress the root causes of the financial crisis of 2007-8. Fair enough. But it should not use the opportunity, as many term it, to foist their pet reform projects upon a still shaky economy and financial system. I think if anything needs reformation it is Congress. I would like to see two changes:
1. Truth in lawmaking. Bills and laws ought to accurately state their contents, including both their objectives and the path to achieve them. Too often the titles of our laws are nothing more than political spin or marketing ploys;
2. Effectiveness monitoring. No bill should be allowed to pass until it is scientifically proven that its provisions will probably lead to the intended outcomes. All laws should be subject to review at 1, 3, and 5 years to ensure that they are in fact furthering their stated goals. Finally, all laws should automatically expire after 10 years unless explicitly renewed.
Until such reforms are implemented, all new government policies should be eyed with the utmost suspicion. The world is a complex place, too complex for half-wits, especially those up for re-election.
On that note, thank you for your time and attention and have a wonderful afternoon.