Where Everybody Knows You're Numb

Speculation is a problem associated with the perceived value of a thing depending at least to some degree on the expectation that the real price of a good will be higher later on. This speculative force draws its sustaining force from new people entering the marketplace, usually because a good is appreciating at a remarkable rate of increase. The joining phenomenon brings new players into the system, driving up prices. Then, when there are no more people entering the marketplace, the scheme collapses. Who is hurt most depends on the specifics of the game, but it is frequently the last to join the frenzy. To understand this game we must look at some historical examples

Of Tulipmania and Ponzi Schemes

An early example of this was the seventeenth century Dutch Tulipmania. People would purchase new tulip cultivars, hold them, then resell them a little later, and realize a significant increase in price. The breadth and depth of the craze was profound. Early on many people made a fortune. The mania spread and expectations grew wiith the extent of the infection. There were cases in which people mortgaged their homes to purchase a single tulip bulb in order to ride the speculative frenzy to new heights. But by that time the fever had almost run its course. Soon the market collapsed for lack of fresh fuel. If everyone has morgaged their house to buy a single tulip bulb, where does the money come from for the next wave of investors to purchase bulbs at an even higher level? Eventually such a scheme must collapse. Tulipmania is a classic, if somewhat exaggerated, example of a speculative bubble.

To get a handle on things we need to define some rarely used terms. The first is non-speculative price. Or normal price. This is the price that a widely traded good would fetch on an open market when the expectation of speculative gain is identically zero. A person buys the item not for what they expect it will fetch later, but for what it is right now. They buy it soley for the normal utility it provides.

Suppose one goes to a Wal-Mart to buy a pair of sneakers. One pays no premium on the sneakers. Its because one does not expect that at some point in the forseable future those sneakers will fetch far more than one pays for them. This is what we mean by normal price. One can define a normal price for most goods that are widely traded. For one-of-a kind items such as an original Van Gogh painting it is not so easy to do. But for homes, for cars, for sneakers, for commodity goods, for most things that are purchased partly or mostly for their utility, one can always estimate a normal price. And when a price exceeds this level it is, by definition a speculative price.

Some kinds of speculative pricing is sometimes justified. A tulip bulb can be had on the open market for something like half a dollar. This is the normal price. A new introduction might be priced at two or three times this price. Here, a buyer might pay an extra amount to be the first in the neighborhood to grow a particular tulip. So if one is in the tulip business, one might purchase a handful of new tulip bulbs for many tens of thousands of dollars, paying for the exclusive propagation and distribution rights for a season or two.

The distributor might pay hundreds or thousands of dollars per bulb. We might define this increment as speculative price. But at least here the value of the speculative price is secured by a cartel agreement. The nature of the speculation is different. The speculative value depends on limiting distribution, not on creating an unsustainable psychological game of chance.

It is a very different kind of speculation from the sort at work during tulipmania. It limits the losers to the bulb company - if it fails to sell as many new bulbs as it expects to sell - and the bulb companys customers who pay more than they otherwise would for new tulip varieties. But these losses are losses based on clearly defined risks. The people who lose know the parameters of the game going in. They enter the game understanding and accepting the risks.

The tulipmania game is categorically different. The nature of the speculation derives from the creation of buzz. It derives from the expectation of excess gain that exists only by virtue of someone else later on joining the game because it provides excess profits. This hope of gaining excess profits by controlling ownership of an appreciatiing asset we will call greed. Tulipmania existed because of greed. And it was sustained byan ever increasing body of new members who joined not because they were interested in growing tulips but because they were interested in making a quick profit.

The purest form of the game was invented in the early twentieth century by a New York whiz-kid named Ponzi. Ponzi advertised accounts that would pay15 percent interest per annum. This is quite a huge return on investment; but if money is very shrewdly invested it is not impossible to get these kinds of returns. Warren Buffet has done it. Early investors in Ponzis scheme, in fact, realized the advertised gains. They told their friends, neighbors. and business contacts. And many of them joined in, too. The game continued in this way for a while, but the population of joiners was finite and, as it turns out, Ponzi was a great marketer by a lousy investor.

He was not investing the funds at all. Rather, he was using the deposits of new investors to pay interest to existing investors. The interest was a wholesale distribution of funds from new entrants to older ones. If an account pays 15 percent interest in such a game, the game is sustainable only so long as the pool of new participants grows at more than 15 percent per year. Once that no longer holds, the obligations to investors quickly dwarf the assets available to fulfil them. And the institution comes crashing down. It is a mathematical fact that this conditon cannot be fulfilled; therefore the scheme must fail.

What was brilliant about Ponzis scheme was that it achieved what tulipmania did without there existing any underlying asset. Tulipmania participants, at least, could argue that the value of an asset is what it will bear on the open market, so if I mortgage my house to buy a tulip bulb, that must be the value of the bulb. Precisely the same reasoning was heard on Wall Street just before the dotcom crash. It illustrates the difference between normal price and speculative price and the dangers of confusing the two.

But in Ponzis scheme there was no underlying asset. People were trading on trust. And if they had understood how Ponzi was creating 15 percent returns, most of his investors would have looked elsewhere. Ponzis scheme, then, is a compelling argument for two qualities in investment instruments:

1) Transparency. Ideally, every financial transaction that might potentially affect value is represented on the publicly available books. A recent article about Citibank suggested that up to half its assets were off-balancesheet. No wonder it is selling itself cheap to offshore sovereign funds.
2) Comprehensibility. Ideally, every person who invests has a pretty firm grasp of what it is, fundamentally, that causes an investment to create wealth. This understanding allows an investor to assess risk. Financial instruments that require a PhD in mathematics to comprehend deserve to be used only by investors who can employ PhD mathematicians to protect their interests in real time.

In the Ponzi scheme the whole of the value of the investment is secured by subsequent joiners. This means that the last people to join must necessarily lose most or all of their investment.

Of Leverage and Levitation

This brings us up to the market crash that led to the Great Depression. In the roaring twenties new industries such as steel, and oil had passed through infancy and adolescence and were in early middle ages and t were turning out huge amounts of cash. Railroads were in their late middle ages. and were still turning out healthy profits. With the possible exception of automobiles, there were not so many new industries in which to invest - not on the same scale, anyway. Consequently, the price of equities was driven above the normal price. Meanwhile, speculators saw that share prices had been going up steadily for a long time, and they chose to exploit that fact.

Anytime an asset has appreciated steadily for a decade or more, there is a temptation to believe that the trend is permanent. And speculators did just this. But the real money was to be made by borrowing money to buy stocks. If one borrowed money at five percent and one realized ten percent in the stock market, it was like getting free money. Rich individuals did this. So did banks. It seemed like a sure bet. And it might have been, so long as the price of the equities was a normal price.

The result of this was that the price of assets slowly began to rise abovr the normal price. After some time they departed significantly from the normal price. A significant portion of the price of an equity became speculative. And because the continued rise in this speculative value relied on ever-increasing amounts of money entering the system, it was, by definition, not sustainable. On Black Friday in 1929 the market collapsed.

In normal circumstances, if a person buys an equity and the equity loses half its value, then the equity stake loses half its value. But these were not normal circumstances. Many speculators, individuals and banks had borrowed money to puchase equities, on the assumption that the price of equities could only go up.

If a person had borrowed an amount equal to their personal assets in land and other fungible assets to buy stocks; and if the stocks they bought fell by half, they could sell their stock holdings and half their other assets to make good on the loan. But, in fact, many investors were leveraged more than this. And some investments fell by more than half. As a result, many investors were wiped out. Many banks went bust. And their depositors lost their deposits. The capital markets dried up. And unemployment reached 25 percent. It was hard times.

The basic system can be described in many terms. It was a normal sort of speculative bubble driven by greed and hope of easy money. It was a speculative game that relied on an ever increasing number of players to sustain the excess return of early entrants. It was a case in which a significant portion of the price of an asset was speculative in nature - it was based on the expectation of future appreciation. And the effects of a downturn were amplified by leverage. The fact that borrowed assets were used as instruments to purchase a speculative asset meant that smaller downturns resulted in more devastating losses.

The tulipmania speculators lost only their own houses. They did not lose, as well, the houses of everyone on the block. But leverage which allowed an institution to make excess gains using other peoples money to buy speclative assets, also destabilized the system. It both led to a kind of speculative frenzy, and it assured that the end of the speculative frenzy would be ruinous not only to those who chose to play but also to people who did not even know they were participating.

My Stodgy Bank

The lessons of the Great Depression were not lost on legislators of the ninteen thirties and forties. They passed legislation that isolated banks from other kinds of financial institutions. From the point of view of depositors; they should be able to correctly presume when they deposit money in a checking or savings account that it will always be there to use when they need to usel it. The bank is presumed by depositors to be a safe place to put money. When this condition does not hold, it is a swindle to bank customers and it is a blot against the reputation of the banking industry.

Banking simply cannot survive without this high level of trust. If it is both to sustain this trust and warrant it, banking institutions must simply never lose peoples deposits through speculative misfeasance or malfeasance. They simply cannot be allowed to play unduly risky games with the money - whether they are smart enough to understand those risks or not. This was the thinking that underlay the legislation. And, until 1996, this kind of organizational principle made banking secure for bank investors and depositors.

Consider a simple case; the home mortgage lender of the mid-fifties. It was a neighborhood bank. It lent mortgage money to home owners who put twenty percent down on their homes. It lent from a pool of capital that came primarily from local savings. And so if Mr Smith defaulted on his mortgage, Mrs Jones and several of her neighbors may not be able to withdraw their savings to spend on cars or college for the children.

Actually; reserve requirements made it hard for this to actually happen; but the threat was always there. Banks lent wisely, for the most part, because it was in the best interest of the institution, because it was in the best interest of the community, and because it was in the best interest of the banks officers. They took their fiduciary responsibilities personally. They also lent wisely because there was a body of law that would prevent practices that would lead to the unstable conditions of the 1920s.

But things changed. Banks began trading mortgages. This was good because some places had an excess of capital; large cities for example. And commercial or industrial institutions sometimes generated huge sums of cash. And some areas, such as bedroom communities, had large demand for debt. All other things being equal, the business of selling mortgages helps efficiently allocate financial resources.

But already, all things are not quite so equal. Already the practice of selling a mortgage comes with a problem; if the originating institution - be it a bank or a service company - has no stake whatsoever in the quality of the debt instrument and the creditworthiness of the debtor, the game is set up to encourage companies that manufacture and sell morgage debt insturments without making sure these instruments actually have any minimal level of quality. Furthermore; institutional safeguards alone are not always so powerful as are safeguards that include a risk to reputation as well.

Still, economic theory predicts that in the long term market forces might weed out those institutions that are the worst offenders; but this takes time to discover. And it requires that one price mortage securities in accordance with this lower expetation of creditworthiness. In other words; when one changes the rules of writing mortgage securities in a way that increases risk; the securities need to be valued in accordance with this fact. Perhaps in some recent cases this has not been the case.

What actually happened over the last decade or so was that even if an institution that wrote a loan did have some financial stake, if it was a publicly held company that originated a loan, the company could flourish so long as it increased its monthly loan-writing volume. Fees for originating new loans would paper over losses from bad loans. for some time. Then, when the whole thing went south, the officers would bail out, keep their houses and big bonuses, and the shareholders and creditors would be left holding the bag.

Unlike the olden days when a bank loan officer was part of the community from which the equity originated, loans came from nameless pools of money. Now, nobody who benefitted from this legal sort of Ponzi scheme had to look a depositor in the eye and say sorry Mrs Jones, I behaved like an idiot with your money. Your retirement is cancelled.

The behavior of knowingly writing bad loans is destructive; and it is reasonable to have laws that punish people who are responsible for it. But things got much worse. Morgage securities were bundled into huge pools of securities. Then they were sliced up. This meant that certain kinds of risk - geographical, for instance, might be spread evenly through a large number of portfolios. This certainly did decrease the amount of risk in any given portfolio. And that is good. But the practice did not eliminate all kinds of risk. For instance, mortgage securities depended upon increasing home prices for borrowers to keep making payments. This meant that the creditworthiness of the whole pool depended upon consistently rising home prices. The risk associated with the failure of this condition was essentially the same, regardless of how things were sliced and diced.

If home prices stopped going up. And if people were borrowed to the max against their home equity, they would have financial incentive to walk away. Seeing this day coming, Congress revised bankrupcy laws in the early 2000s to make this eventuality less attractive to homeowners. But this did not change the workings of the financial machine that derived its value from lending money it did not have. It did not fix the problem of leverage. It did not change the expectation of the average Joe that his own home would accumulate value almost like magid indefinitely.

The Value of a Home

Its hard to say precisely when todays real estate boom took off. There is a kind of continuity to it that can be traced all the way back to the end of WWII. The parents of todays boomer generation began building sprawling suburbs at the end of the war. And the building trend has continued apace ever since. People have become ever more productive, and the amount of resources they can dedicate to buying a house, in real terms, has increased. At the same time, inflation has changed the value of a dollar. All of these factors have conspired to drive up the nominal price of a home.

There have been ups and downs. Boomtimes occurred when real interest rates dropped. Bust times occurred when interest rates rose or when significant economic retrenchment occorred. But for the most part, homes kept pace with inflation or did a little better over the stretch from 1950 to 1996.

There was a point in time in the early 1970s in which the inflation rate was nearly seven percent and the interest rate on a long-term loan was five percent. If one believed that the inflation rate was not going to become lower, then the only rational behavior was to borrow as much money as one could, and invest in real estate. All other things being equal, the house would appreciate at the inflation rate but the loan value would appreciate at a lower rate. It was like printing money. Paul Volker, whom President Carter brought in to chair the Federal Reserve thought it was a dangerous game. He jacked up interest rates to almost userous levels and inside of four years he had killed inflation dead.

That put an end to the most abusive kind of manipulations. But, nonetheless, homes have appreciated in nominal value almost monotonically since the early ninteen fiftees. If they have not proven good real investments; at least they have proven to be good hedges against inflation.

What this means is that if one looks at the trend in nominal home prices, houses appear to be a good investment. And if one wishes to really take advantage of the fact, there are good ways to do so. One way is to borrow money and buy investment properties. So long as the properties appreciate at a nominal rate that is higher than the rate of the note, one makes money. And it is easy money because the gains come from using other peoples money. A variation on the theme is to buy properties that are run-down, restore them, and flip them. These games are not without their risks. And the risks in the game have limited the amount to which they were played. It is probably true that most of the excess returns caused by such behavior was offset by risk. Nor is it possible to pin much of the current crisis on this sort of speculation.

But most home buyers understand nominal price better than they understand the real value. We need to illustrate. At seven percent inflation, a good will cost twice as much in ten years as it does now. Every good will. Even a house. So if one invests $100,000 in a home today and sells the home for $200,000 in ten years, the $200,000 (ignoring taxes) will buy precisely what the $100,000 did a decade earlier. It will buy the same house, the same number of recent model cars, the same number of dishwashers, the same number of barrels of crude oil and so on.

There is no real gain on the home, just a nominal one. What has changed in value is not the value of the house but the value of the currency. This idea is not well dealt with in the tax code. And it is not well understood by most home buyers. And for this reason it is easy for a home buyer to imagine that gains on a home amount to much more than they actuallly do.

To the extent that this is true, it means that homeowners will be inclined to commit too much to buying a home. That is, they will factor in the future price and the nominal gains into their buying decision, misinterpreting nominal gains for real ones. Part of the purchase price, then, becomes speculative in nature. And the speculative hope is attached to a fictional gain. So long as the portion of people who buys homes employs this this speculative thinking in buying a home, and so long as the number of people in the market is roughly constant, there is not much harm in the game. The system reaches equilibrium at an inflated price, perhaps, But not much bad stuff happens after that. Not until some condition comes along that challenges the assumption. At that point the speculative spell is broken and homes trade again near their normal price.

So long as people buy a home for what it is - a shelter that delivers a suite of comforts and amentities - not for what it might fetch when it is sold, the price of a home remains at a normal level. But when people buy a home primarily as an investment part of the price of the home is speculative. There are places in the nation where, arguably, most of the value in the price of a home is non-speculative. And there are places where a good portion might be speculative.

Its not so difficult to get a handle on it. Find out what people are paying in rent per square foot in an area; and find out what they are paying per square foot for homes. If there is a rough equivalence; or if the differences can easily be explained entirely by objective desireability factors, then homes are priced at their nominal value. If, however, home owners are paying three or four times as much per square foot, there is good reason to believe that a majority of the price of the home is speculative in nature.

There was a point in recent history when this muiltiple was something like two or three for parts of coastal California. Perhaps the same was true in some parts of the east coast. It was not hard to tell that we were approaching the crest of the wave when one read in 2005 in the Economist that a clever fellow had worked out that in real terms the price homes had reached levels unprecedented for over a century; and one could see cartoons in the New Yorker depicting adolescents on the beach in front of an elaborate sand-castle saying lets flip it before the tide comes in. Sensible people saw this one coming. So what about the experts?

The New Derivative

One recent article describes the financial underpinnings of the crisis. A bank makes money by lending. The more it lends, the more it makes. If that were all there were to it, there would not be much mess to clean up. But what happened in this case was that financial institutions used instruments that they falsely assumed to be secure to acquire new assets. Now in the old days, the days between the Great Depression and 1996 these instruments were primarily deposits. They were monies in checking and savings accounts. Banks could make loans on the basis of these accounts. The dollars were in the vault. Some portion they would hold in reserve in case lots of depositors withdrew money at the same time. And the Federal Reserve would lend money on favorable terms to cover day-to-day shortfalls so that banks could always meet their obligations to depositors.

But when banking deregulation came along, the kinds of financial instruments banks could use to collateralize new loans increased. It was no longer, cash. It was also other kinds of securities. Among these securities was mortgage-backed securities. These were securities whose value ultimately depended on the value of homes. What this meant was that banks could, in effect, lend money they did not have. Rather, they were lending money that they would have, assuming home prices kept going up and people kept on paying their mortgages. But it was money they did not have when home prices stopped going up and people defaulted on the mortgages. The problem for the banks was that once home prices started to fall and defaults exceeded expectations they had lent money they imagined they had but they actually didnt have. Thats a violation of a fundamental rule of banking. And if a bank fails to bridge the gap, it collapses.

The reason financial institution behaved this way was because it was profitable, so long as the securities they used as collateral were sound. But ultimately it amounted to taking on debt obligations that were secured by the assumed inevitable rise in price of some asset. And when that assumption no longer held, the game was over. Just like Black Friday.

One might imagine that the game could go on forever but there were physical limitations. In order to realize excess profits on the scheme, they had to keep on expanding the pool of mortgage holders. And so long as they could do this by writing mortgages to creditworthy customers, the game would continue. Once this pool was exhausted there were two alternatives. One was to stop the game and settle on normal returns. The other was to lend to people who were known not to be creditworthy and keep pusihing the envelope. The motivation to do the latter was big because everyone saw a way to make a quick buck from pushing the game along. And everyone who knew the risks imagined that they could be passed along to other players.

What we have just described is a kind of game that sensible people will understand cannot be sustained indefinitely. It gains its power to enrich by enlisting new people in the gaime. And when it collapses it is generally the latest joiners who are hurt the most. What we describe is an old game in new clothes. It is a game that exploits a long term trend in the value of an asset. It is a game that derives a significant portion of its its percieved value from that long term upward trend in the value of an asset. It is a game that exploits speculative pricing. It is a game that ultimately depends on an ever-expanding pool of players. It is a game in which gains, then, ultimately depend on unsustainable conditions. And it is a game that hurts a lot of people when it collapses.

This game is pretty much like the Ponzi scheme. Two of the reasons it was not properly recognized as one are lack of transparency and lack of comprehensibility. Investors in companies engaged in the practice of securitizing loans with shaky mortgage investments often did not understand the risks. Sometimes it was because the people who wrote subprime loans purposefully lent to uncreditworthy customers. And people who were paid to know and care were paid more not to know and not to care.

To a significant degree, too, the problem was invisible because large institutitions carried risky assets off balance sheet. A recent article mentioned that half of Citibanks assets were off balance sheet. And one can bet that the half that were so were the risky ones. So transparency certainly was a problem. Enron should have been enough to teach us the lesson; but evidently it did not.

There is some evidence that even many people in the business did not really understand the nature of many of the financial instruments they were dealing with.. Some of the instruments were highly complex derivatives whose movement was understood only by PhD mathematicians. To people who used them, the instruments were black boxes - just like Ponzis accounts.

This makes rational valuation impossible. It also makes a rational market impossible. It is one thing to allow markets to create fnancial instruments that are abstract and esoteric and to use these instruments at the margins for the purpose of arbitrage, with the goal of achieving an efficient market. But it is something else entirely to have people who are oblivious to how they work deal in them every day. Its kind of like the difference between having a small nuclear arsenal that is very carefully controlled by trained people and handing out nuclear weapons to anybody who shows up at the corner of High Street anb Main. One can find good arguments for the former; but its not so easy to find good arguments for the latter.

Meltdown

Banking deregulation, then, produced a huge supply of new money. And it produced a huge supply of esoteric instruments. The money first went into homes, causing them to double in price since 1996. Some homeowners borrowed against the increase in value of their homes to buy consumer goods. This did not tend to drive up the cost of consumer goods in nominal terms; so it was not considered inflationary. It may be, however, that such goods would have fallen more in price were money not quite so loose.

More recently, the flood of money has driven up commodity prices. The spin on Wall Street is that it is demand in China and India that is responsible for spiraling oil, copper, and iron prices. Gold is speculative. Wheat is driven by the rise in corn. Corn is driven by ethanol. Ethanol is driven by oil. But the fundamental fact is that once all homes and raw materials have doubled in price; it is not long before other things will as well. A 30 percent drop in the dollars value against other currencies suggests something like the same kind of rise in the price of imported goods. Once every good one can buy has doubled in price; it is a safe bet that the currency is worth half as much. So it is not impossible that some significant portion of the rise in prices of all of these goods is simply an artifact of money produced by the same mechanism that caused the crisis. The world was awash in liquidity for a decade and now we pay the price. In other words, inflation.

If this is true then by the time the thing is over, the dollar will be worht half of what it was in 2005. Maybe less. In nominal dollars, we might hope our homes will be worth what they were in 2005, but in real terms they will be worth half that. Or less. The people who will be screwed will be the poor sods who held paper. It will be the people who held bonds of any sort. As it was in the 1920s the people who were net savers, the people who placed their trust in financial institutions to vouchsafe their lifes savings will be screwed. Nobody else can afford to pay; not the federal government, not the financial institutions who profited from the scheme, not the people who borrowed the money, not the banks who used bad loans to securitize worse ones.

This, of course, assumes that the Fed is capable of keeping the whole system from coming unravelled. With each bailout and each rescue the picture looks worse and worse. The amount of leverage in the system appears to be pretty big. We know this because a few tens of billions of non-performing debt threatens to destabilize a system that has trillions of dollars in assets. Back before banking deregulations the level of assets held in reserve against adverse conditions was much bigger than this. And as any person with a bit of sense might have predicted, this increased leverage would flood the market with excess liquidity and it would threaten to destabilize the system. Its a no-brainer.

One is forced to the conclusion that either the people who advocated for deregulation and those who voted for it were idiots. Or they were scoundrels. Theres a good chance that it was mostly idiots led by scoundrels. One more crusade.

Blame

No analysis of disaster is complete without an accounting of blame. So who owns responsibility for the mess? We offer some opinions for consideration.

1) The American electorate at large for voting into power a group of politicians who somehow never heard of the Great Depression or at least failed completely to comprehend the forces that caused it. Americans might argue that we did not know what these politicians might do. But this is nonsense. They ran and won elections on the premise that they would slash taxes and deregulate everything. Also they would put people in jail who objected to bad policy by burning flags. These candidates appealed first to greed and jingoism in their campaigns. They appealed to our meaner animal instincts, not to our better judgment. What should we expect? Politicians gave us what we voted for.

2) People in major financial institutions who should have known better than to leverage speculative instruments. Again, most of the people were just trying to make a buck. But the small portion of people who actually understood what was going on should have been voicing concern. There was none. It is so bad that we must wonder whether the whole system is run by idiots or whether it is run by and for scoundrels. For it is inconceiveable that a fair portion of the people who saw what was going could not have understood the non-sustainable nature of the game. Were players at the highest levels totally incompetent? Or did they intend for a crisis to occur?

3) People in financial services sector who originated loans without the adequate safeguards against bad debt. This group was the ground troops. They bore responsibility for the crisis in approximately the way draftees into the Wehrmacht owned responsibility for WWII. Maybe it could not have happened without them. But they were pretty much doing what was expected of them by the society they were a part of.. And thats the way societies work, pretty much.

4) Irresponsible borrowers. Yes. It is true. Some borrowers got loans without either the means or the intention of paying them off. There exist cases in Ohio and Florida in which mortgagees have stopped paying loans but refused to vacate homes until the holder of the loan can produce the appropriate proof off ownership. And in some cases this has gone on for years. Simillarly, there are those who misjudge their ability to pay. And there are those whose financial position deteriorates due to loss of a job or health problems. And, it would seem that the portion of borrowers who fall into this category was artificially inflated by the recent practices of group 3) working to sell loans originated by group 2). based on a policy that can be traced back to group 1) One can argue to what extent bad debtors are abusers of trust and to what extent they are victims. There is a mix here. . We hope that laws and law enforcement make good distinctions here; but it looks like who has the best lawyers in this game wins.

Who will pay?

1) The American electorate. The taxpayer. Some portion of the crisis is being handled by handing money from the federal government to the banking system. Or at least by loan guarantees. Thus, the taxpayer is underwriting the failures of financiall institutions. There is a sense of justice here, because we elected the guys who deregulated the banks. We are getting what we asked for.

2) Head honchos in financial institutions whose primary assets were secured by the value of stock abd stock options they held in their failed instittuions Again, there is a sense of justice here. But one wonders whether some of them ought to spend some time in jail.

3) The people who touted deregulation at any cost rightly ought to lose their intellectual credentials. People who advocated for a kind of economic anarchy preached by the neocons and the radical libertarians of the eighties and ninnties ought to be laughed out of town. Really, the village idiot ought to be listened to more carefully. For, at least, we know that the village idiot hopes, at most , to end up getting a free meal out of any exchange we might have; while the radical libertarian hopes for a contract whose clever terms allow him permanent rights to your house and car and retirement assets.

4) Irresponsible borrowers. Again, there is some sense of justice here.

Whether the pain will be distributed roughly according to blame is doubtful. More probable is that the pain will be felt most by who has the least political and economic power.

Speculative Questions

In any Ponzi scheme, the early players do well and the later players do poorly. Tulipmania, the Roaring Twenties, and the Dotcom boom all relied on simple normal greed. Malfeasance was not involved. Or it was not the primary force motivating the game. The outcome was an almost inevitable result of the general shape of the investing environment and of attitudes at the time. It followed naturally from the rules of the game. The consequence of this is that it is reasonable for governments to set up rules that make these sorts of instabilities rare. It is reasonable that they set up rules that require that if one enters a speculative game, one both knows it is so, and one understands the nature of the risks. It was not true for bank depositors in the twenties. The Fed is working to assure it is, however, true today.

There is an important distinction between saving and investing. Its a fundamental distinction. And it is all but impossible to understand why, given a long history of speculative booms and busts a legislature of well-informed and well-intentioned people put an end to it by dissolving the distinction between bank and brokerage. The most generous thing one might say is that they were duped. Or they were blinded by a loyalty to an ideal that they really did not understand. I mean, if Adam Smith were alive today and saw the kinds of abuses done in the name of his invisible hand, he would turn over in his grave!

The fact that we can explain the whole of the legislative snafu in terms of simple greed and slavish adherence to bad policy is suggestive of the idea that nothing nefarious is going on behind the scenes. But it does not remove all doubt. For example, we mentioned the bill making it more difficult for consumers to walk away from bad debts that was passed by Congress ca.. 2005. Who sponsored that bill saw this coming.

And at about the same time there was an article about the fact that the Chinese were beginning to buy mortgage securities instead of US Treasuries because of their perception that the federal debt was growing too big to be sustainable. In Wall Street language, the credit rating agency within the Chinese government that decides how to rate debt downgraded the credit rating of the US government.

Since the Chinese purchase perhaps a quarter of the US Treasuries; such a policy change risks putting a crimp in the Republicrat bad habit of spending more and taxing less. To attract the same amount of money, the US treasury would have to offer significantly higher rates of interest. And that would drive up the costs of borrowing. Since interest on the national debt is the largest line item behind entitlements and military spending, a big swing in the cost of borrowing could either force tax hikes or iresult in nsolvency.

A third alternative to the treatment of national debt is inflation. Weimar Germany did it; why should we not do it, too? As we noted earlier, if one has a high rate of inflation - one that exceeds interest rate, the advantage goes to the borrower.

One might argue that the whole speculative bubble in home prices was an attempt to create money and defile the currency. One might argue that banking deregulation was designed precisely to allow the kinds of abuses that occurred, knowing they would occur. By doing so, it would create a huge wash of currency and this, in turn, would drive inflation. If one set out to do this, one would have to have a ready-made piece-wise explanation why every single good and service became more expensive in order that nobody suspected the actual cause, too much money.

Inflation is a simple way to transfer money from creditors to debtors. It is a swindle that drives down the cost of borrowing. And if the Federal Government set out to do just this in 1996, it would have been difficult to invent a better scheme.

But in the end, a nations creditors wise up. They will not lend if they cannot expect to be fairly paid. If the US government gets a reputation for playing financial games that allow it to weasel out of its debt obligations, its credit standing will erode. And it will need to pay a lot more for loans in the future. Thats not some esoteric threat. It means some combination of higher taxes and less in the way of government protections.

There are other questions one might ask. If we grant that the inflationary cycle was created intentionally, we might also ask whether the credit crisis was engineered as well. In retrospect, it is impossible to imagine how it might have turned out differently.

But if it was engineered, to what end? Recall that the Southwest Savings and Loan scandal ended with billions of dollars missing, presumably in offshore accounts of some of the BCCI principals. The point is that there might be much money to be made from failed or failing banks, if one understands how to play the game; and if one has friends who are bankers and high government officials in places like Saudi Arabia. There were rumors that certain members of the Bush family did farily well in that BCCI debacle, being well connected with some of the principals. To what extent does the family hold interests in the sovereign funds that are rescuing the likes of Citibank? Here some transparency might help.

Conclusion

The machinery that manufactured this crisis was put in place in 1996 when the a body of legislation deregulating banks allowed for the kinds of practices that led to the problem. That it would happen was known to Congress in 2005 when it passed legislation making bankrupcy for individuals more difficult and costly. Exactly how the situation might affect the financial system might not have been known; but fact that creditworthiness among consumer borrowers was going to hell in a handbasket was well known.

We know that loose credit practices must have begun soon after deregulation since home prices began to escalate sharply at that point. We know that the cycle was propelled by greed among borrowers and lenders alike and that the financial machinery employed was leverage. Mortgage securities were used by banks to securitize new loans, knowing that this entailed ever bigger risks should housing prices ever fail to appreciate. We know that this kind of game was sustainable only so long as new players entered the game. We know that it had to break down soon after it ran out of new blood. And we know that the means used by financial institutions to carry out these practices involved hiding assets off balance sheet. There was a lack of transparency. These qualities, the fiasco shared with any Ponzi scheme.

In response to the crisis there might be a temptation to outlaw certain kinds of speculative games; but we believe a small number of controls might suffice. One is to require by law a kind of transparency in financial transactions that would properly reveal the risks. And to enforce that law.

Another is to change the requirement for collateral against which mortgages might be written by financial institutions. Mortgage-backed securities might be allowed as a small portion of the portfolio; but certainly once the quantity rises above a third, minor fluctuations in the housing market risk ruining the institution.

It is still a good idea to distinguish between institutions whose chief purpose is to vouchsafe savings from those whose purpose is to allow investors and speculators to invest and speculate. If such institutions offer other financial services that do not involve risking their own capital or that of their depositors, thats not a problem. But there is a problem when an institution holds deposits for customers and, in a far-flung subsidiary, makes huge speculative bets on the currency market or the price of homes or the price of gold or oil or other commodities or securities. Such bets, ultimately, risk losing depositors money or destabilizing an entire banking system.

There is something to be said for that stodgy bank.