With all the clamoring for new legislation (frankly by people who really have no idea what they’re talking about), I thought it would be a good idea to refresh everyone on why we are where we are, what COULD have been done to prevent the financial mess enveloping our markets and some of its “storied” firms (the stories typically being better suited for how-to training for assistant AG’s than for any kind of hall of fame or other forum of acclaim), and lastly who should be investigated and why this would help solve future messes now.
Before I name culprit #1, I want to share something I learned in Macroeconomics (Ec 1 at Tufts University).Specifically, I want to discuss the 3 ways that I learned that the Federal Reserve…can influence the economy using monetary policy.
- Raising or lowering the discount rate: this involves changing the rate on borrowed money that the Federal Reserve lends to “member banks. For example, if Citibank wanted to borrow funds directly from the Fed, this is the rate they would pay. How it works: if the Fed wanted to boost economic activity, it could lower the discount rate to make it cheaper for banks to borrow money and encourage them to lend it out cheaper, thereby spurring economic activity. This works in reverse also – raising rates stifles lending. Note: this hasn’t been used often in the past few years but Bernanke did lower this last Fall in a surprise move. Now I guess we just simply bail people out…
- Raising/lowering the “reserve requirement.” By rule, banks must keep a certain percentage of their assets in ‘reserve,’ meaning they can not lend this out. How it works: if a bank has $100M in deposits, with a 10% reserve requirement, then $10 million must be kept in reserve and can not be lent out.
- Open Market Operations: this is what we see most often – the Federal Reserve buys or sells treasury bonds in the open market in order to put money in or take money out of the system. How it works: the fed wants to stimulate the economy so they buy treasury bonds which puts more money into the financial system (Fed cash is basically printed money). By putting more cash in the system, more money gets lent, and money that was in the treasury market goes elsewhere. Note: by putting more money into the system, you have more dollars chasing the same amount of goods – the classic definition of inflation.
So why explain all that? Because I want to help explain why some of the smartest people I know of blame Alan Greenspan for much of our troubles. I also want to explain that the regulations EXISTED already that could have been used to keep this mess from happening. This is important to point out because politicians seem always to want us to believe that ADDITIONAL regulation solves all problems – NO – enforcement of our existing regulations would have done just fine. Let me explain.
Back in 2001-2002, we were in a recession – big deal this has happened many times in our history. Apparently though, or at least in the minds of policymakers, it seems the average person can’t handle the slightest amount of pain – perhaps someone’s BMW would get repossessed or something like that…So therefore, in order to alleviate this pain (there’s a reason that the current generation was not chosen as “The Greatest Generation”), Greenspan chose to lower the Fed Funds target rate (using option 3 above – open market operations). By lowering rates eventually to 1% (FREE MONEY!) and by NOT raising the reserve requirement (#2 above), he opened the door to RAMPANT LOOSE LENDING!
Example – pretend you are a bank. You can borrow money at 1% and lend it out at 5.5%. This means for every $100M you borrow and lend out, you make $4,500,000 per YEAR! So how much would you borrow and lend? Would there be any limit? Oh and if you didn’t want mortgages, you could eventually package and sell them to Wall Street investors. So, would you care about who the borrowers were and what their credit score was? Why worry? You could just dump the loans on some investor who doesn’t do due diligence anyway. Let me tell you, the local conservative banks faced tremendous temptation to go outside their comfort zone,follow the big banks, and make some of this profit. Thankfully, not all did. But enough did to create the mess we have now – these bad mortgages are the “assets” that financial firms use for collateral and those assets are DEFAULTING which means the banks’ asset levels are being decimated.
If Greenspan had not lowered rates, we would have had a longer recession, but house prices would not have lit up and we would not be where we are now. You see, we ALREADY had the regulatory structure in place – it was the PERSON in charge that was at fault. Unless regulation is AUTOMATIC (which would be foolish), you have to rely on the REGULATOR (the person with the fancy title e.g. Fed Chairman, SEC chairman, FDIC Commissioner) to make the right decision and as long as they are POLITICALLY MOTIVATED, and here this means making people happy NOW but don’t worry about later, they will often choose the wrong choice. Greenspan wanted people to love him and with every rate cut, that love grew. Agency regulators are appointed by the president and approved by Congress and they want to make their bosses happy.
Bottom line: we will continue to have future problems in different forms of course, as long as politics and ego are involved in ANY regulation. Easy Al Greenspan, as Bill Fleckenstein calls him, deserves a lot of blame. Just a note – for personal disclosure, I don’t see a problem with people losing their homes and having to rent. It’s called being responsible. I bought a home WITHIN my budget and I made no contingencies on rates going lower, house prices rising, or me increasing my income 100% – strangely, one of these 3 typically WAS the hopeful strategy upon which many homebuyers purchased a home.
Moving on, I would also like to offer blame to CEO’s of the mortgage lenders and Fannie and Freddie (and to many other firms). Their CEO’s came out on conference calls and repeated how safe and solvent their companies were. In a couple of cases, the CEO was reassuring people on a call that everything was fine and then their company was GONE 2 weeks later. Why aren’t these claims INVESTIGATED? This was part of the reason for Sarbanes-Oxley – full disclosure that executives have to SIGN OFF ON! No we won’t investigate them, lets blame short sellers instead – since’short sellers” means noparticular discernable individual, then it is effectly like blaming the bogeyman – how convenient.
Our politicians are also to blame. The ONLY elected official who directly and publicly addressed this issue to Fed Chairman Ben Bernanke was Ron Paul. Watch his questions of Ben Bernanke in this video from last year:
Ron Paul on Youtube explains the problem perfectly from LAST YEAR (look at the market levels at the top of the video screen)
On this video, Bernanke says our current system of flooding the economy with dollars (#3 above) is in his words “UNSUSTAINABLE.” What were other politicans saying before and what are they saying now?
Well, in Part two of this discussion, I will explain what mistakes the politicians are making and who is to blame there…
Chris Grande
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