« Health care savings start in the cafeteria. | Main | Real Financial Reform. »

In a NY Times review of Andrew Ross Sorkin's - "Too Big to Fail" - and John Cassidy's "How Markets Fail," Paul Barrett has some very interesting observations and concise remarks about the credit crises and what we just went through.

For instance:

Alan Greenspan (the Chairman of the Federal Reserve), as Cassidy recounts, credited Adam Smith, the bookish Scotsman, as a pivotal influence. "Our ideas about the efficacy of market competition have remained essentially unchanged since the 18th-century Enlightenment, when they first emerged, to a remarkable extent, largely from the mind of one man, Adam Smith," Greenspan asserted in his 2007 memoir, "The Age of Turbulence." But how carefully, Cassidy asks, did Greenspan and his ilk read what their hero actually wrote?

Smith did observe that butchers and brewers pursuing individual enrichment tend to produce societal advantages. When it came to financial institutions, though, Smith advocated government restrictions -- for example, preventing banks from issuing too many promissory notes to unworthy borrowers. "Such regulations may, no doubt, be considered as in some respects a violation of natural liberty," Smith wrote. "But these exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments."

Cassidy writes: "Alan Greenspan and other self-proclaimed descendants of Smith rarely mention his skeptical views of the banking system. . . . The notion of financial markets as rational and self-correcting mechanisms is an invention of the last 40 years."

Barrett goes on:

Big banks are different from ordinary companies. When a factory or a trucking firm or a chain of retail stores goes bankrupt, groups of employees and shareholders may suffer terribly. But the damage is contained. When major financial institutions simultaneously make reckless bets with borrowed money, and then approach collapse, the entire economy can freeze up. Credit disappears. Businesses can't borrow for payroll. Layoffs ensue. Consumers stop spending. Stocks plummet.

Without careful oversight, financial markets tend naturally toward excess and crisis. The easy-lending housing bubble was preceded by the dot-com stock craze of the 1990s, and before that by the savings-and-loan fiasco of the 1980s, and so on back through time.

The best part of the review, though, is this passage, which is as clear a description of what actually happened last decade on Wall Street as you'll find anywhere:

It's rational for a mortgage company to loan $500,000 to a borrower who can't pay back the money if the lender can immediately sell the loan to a Wall Street investment bank. It's also rational for the investment bank to bundle a bunch of risky home loans and resell them -- for a tidy profit, of course -- to hedge funds as a bond. Such bonds, known as mortgage-backed securities, were attractive to hedge funds and other investors because they paid relatively high interest. Sure, the bonds were risky (remember that the home buyers never really should have qualified as borrowers in the first place), but many investors bought a form of insurance against the bonds' defaulting. The sellers of this insurance, called credit default swaps, assumed they'd be able to collect premiums and never have to pay out very much because real estate prices would keep rising forever -- so those original dubious borrowers would be able to refinance their unrealistic loans. Everyone felt especially rational about all of this because prestigious credit--rating agencies issued triple-A stamps of approval for the exotic, high-interest securities. Never mind that the rating agencies were paid -- i.e., bought off -- by the very investment banks peddling the mortgage-backed securities.

And there you have it. As long as the real estate bubble continued, Wall Street could feed it's crack addiction to exorbitant returns by borrowing more and more against wildly inflating real estate prices - that everyone knew was a bubble!

The tricky part with bubbles, though, is that you never know when they'll pop. So -- just like the dot com bubble back in the '90's, when there were plenty of "investors" who knew there was a bubble going on yet refused to step off the conveyor belt of higher and higher returns - so, too, were there many "investors" willing to flip real estate, hoping to sell to the next guy before the rug was pulled out from everyone at the same time.

Back to the dot-com blow up: what happened next? Alan Greenspan kept interest rates artificially low for far too long in order to re-inflate the economy (remember the short recession right after 9/11?), and lo-and-behold, the dot com bubble was replaced with the even more crushing real estate bubble. And here we are now...picking up the pieces.

Check out the review for a few more nuggets by Paul Barrett. It's worth the trouble. And after your done, pick up those two books, especially Cassidy's, "How Markets Fail."

Name (required)
Email
Website
Remember personal info? Yes   No
Comments

home | music | democracy | earth | money | projects | about | contact

Site design by Matthew Fries | © 2003-23 Consilience Productions. All Rights Reserved.
Consilience Productions, Inc. is a 501(c)(3) non-profit organization.
All contributions are fully tax deductible.