Warning:

Even my most loyal readers cannot read this entire essay in one sitting. My recommendation is get a bottle of scotch, and slowly imbibe your alcohol while you are digesting this essay. Hopefully, you will find some of my comments incisive.

Overview

On Friday, August 31, 2007 both the Chairman of the Federal Reserve, Ben Bernanke, and President Bush, speaking for the administration, made important economic statements in order to alert the financial community, the overall business community, and the general public about their intended policies to prevent the economy from sliding into a recession or reduce the possibility of a financial crisis.

In my essay, Fire Next Time, written several days before the Federal Reserve lowered the discount rate, I expressed optimism that corrective steps could prevent a recession this time; however, the government must take pro-active steps to change the business, investment, and consumer mind set. Otherwise, we will confront a financial problem beyond the scope of the Federal Reserve and the Administration to resolve. Stated succinctly, the task of remedying the economy while not “bailing out” speculators require walking a financial tight rope, particularly in an environment where capital flows have global opportunities and where we currently borrow $2 billion daily to support our current federal and trade deficits.

The Federal Reserve and the Administration have stated explicitly that they will not implement policies that “bail-out” financial speculators because they recognize the long-range danger of encouraging financial excesses. Nevertheless, until recently, the system has richly rewarded financial speculators; thus, for long term stability we need a seismic change in the willingness of market participants to undertake Herculean risks. That is, we need to strike a balance between entrepreneurship and prudence. Finding and promoting corporate and financial leaders that are less risk prone will take significant time. For example, it took a generation to replace the commercial bank officers who gained ascendancy during the depression. The firing of a selective traders and executives will not be sufficient to change the risk culture that permeates America society. Moreover, the school of hard knocks can cause intense anguish on the part of innocent by-standers. The employees of Portland General Electric were financially decimated by the bankruptcy of their corporate parent, Enron.

Over the last few weeks, we have seen ample evidence that financial problems have spread from just sub prime mortgages to other sectors of the American and global economies. The task of remedying the financial crisis requires co-ordination not only of domestic agencies but also foreign central banks.

The Bigger They Are, the Harder They Fall

Bigness does not guarantee financial stability. In fact, it frequently leads to hubris. For example, Japan suffered more than a decade of financial recession because its behemoth banks made many bad loans to corporations and real estate investors that they had an incestuous relationship with. That is, in Japan, commercial banks can legally have financial interests in industrial companies and real estate conglomerates. This interdependence led to outsized loans to below investment grade borrowers and real estate speculators.

In the United States, the three largest commercial banks have collectively thirty percent of all credit balances, and even higher percentage of commercial and industrial loans. The size of these commercial banks has encouraged significant exposure to derivative products, the underwriting of below investment grade loans, and substantial stand-by guarantees. “Too big to fail” is a false hypothesis.

Notable Quotes about Today’s Reckless Mind Set

Income Inequality

“This (growing inequality) is not the type of thing which a democratic society can really accept without addressing.” 

— Former Federal Reserve Chair Alan Greenspan [1]

Conflicts of Interest

“We are totally conflicted — get used to it.” 

— Morgan Stanley Vice Chairman of Investment Banking Robert Kindler [2]

Debt Risk

“I am not a forecaster of the future; I’m a historian. And history says this will blow up. It always has. And there will be some blood on the street.” 

— Wells Fargo & Co. CEO Richard Kovacevich [3]

“We are close to a time when we’ll look back and say we did some stupid things…We need a little more sanity in a period in which everyone feels invincible and thinks this is different.’” 

— Bank of America CEO Kenneth Lewis [4]

“[T]he fabulous profits that we have been able to generate for our limited partners are not solely a function of our investment genius, but have resulted in large part from a great market and the availability of enormous amounts of cheap debt. . . . Frankly, there is so much liquidity in the world financial system, that lenders (even ‘our’ lenders) are making very risky credit decisions. This debt has enabled us to do transactions that were previously unimaginable.” 

— Carlyle Group Co-founder Bill Conway [5]

Private Equity Exuberance

“This is going to end with people getting sand-bagged the same way they did in the tech boom.” 

— Keefe Bruyette & Woods, Inc Chairman and CEO John Duffy [6]

“[I]n a market as frenzied as this, there will eventually be one difficult private equity deal where the bank is left holding the equity and trying to plug the hole blown through its books.” 

— Financial Times Columnist Lina Saigol, [7]

Cost Cutting

“Their success has put pressure on many public companies to adopt their strategies and tactics — whether it’s being ruthless in reducing costs or taking on more leverage or giving big pay packages to top managers.” 

— Washington Post Columnist Steven Pearlstein [8]

Transparency

“We have got to move out of the shadows and open up to scrutiny and regulation. It’s not that tough. And actually it’s a good discipline.” 

— 3i Global Head of Buyouts Jonathan Russell [9]

“We should act like a public industry. The funds are private but they are so large that we need to deal with the public, with labor unions, with environmental groups, as if they [private equity funds] are a public company.” 

— Carlyle Group Co-founder David Rubenstein [10]

 “How can we fight this fight with the brightest and best educated rushing off and working night and day to do private equity deals and derivatives trading? How can we fight this fight with the ruling class absent by its own sweet leave? … We’re in a war with people who want to kill us all and wreck our civilization. They’re taking it very seriously. We, on the other hand, are worrying about leveraged buyouts and special dividends and how much junk debt the newly formed private entity can support before we sell it to the ultimate sucker, the public shareholder … If we don’t win this war against the terrorists, there’s not going to be business as usual ever again. If the terrorists get to their goal, there’s not going to be a stock exchange or hedge funds or Bain Capital or the Carlyle Group or even Goldman Sachs. If the terrorists get their way — and so far, they’re getting their way — there’s not going to be business, period.  Everyone with the really big money at stake is — again — bidding for the best deck chairs as the iceberg looms, not so far, any longer, under the surface, and very large and very cold and very solid.”

–Expert:  Ben Stein

Historical Problems:

While we have all heard the expression that Rome was not built in a day, we should also remember that Rome did not fall in a day. That is, the Roman Empire collapsed after several centuries of abuse. Stated differently, The Federal Reserve and the Administration must now confront financial problems that have festered for a long time.

The solutions will tax their resourcefulness for several reasons: 1) Home prices both in the United States and in Europe have increased faster than disposable income over the past decade. In fact, prices in Europe might have increased more dramatically than in the United States. For example, the average price of a dwelling in Great Britain significantly exceeds the average price in the United States, despite the lower per capita income in Great Britain. 2) The increased reliance upon adjustable-rate mortgages both in Europe and the United States significantly adds to the risk of ownership. In Great Britain, adjustable-rate mortgages represent about 95% of the market. 3) The politically popular policy of encouraging widespread home ownership has led to ownership by sub prime borrowers who have scant financial resources to overcome financial adversities such as job losses or rising interest costs. For example, the largest mortgage bank in the country, Countrywide, only avoided bankruptcy by selling 17% of its equity at a significant discount to Bank of America.  The Federal Reserve had to approve on very short notice a commercial bank taking an equity position in Countrywide. While commercial banks do own mortgage bankers, commercial banks cannot take long term equity positions in industrial companies without explicit Federal Reserve approval. 4) The escalation of real estate prices encouraged speculative investments. Speculators represent thirty-two percents of defaults in California, Florida, and Arizona.

History does repeat itself. In 1929, the stock market crash was magnified by the ability to purchase stocks using 90% margin. Real estate speculators used similar leverage to acquire investment properties. The widespread use of home equity loans and reverse mortgages significantly reduced the margin of error for borrowers. Moreover, the lending rates on home equity loans and reverse mortgages generally exceeded conventional mortgage rates.

The evolution of financially engineered products involving trillions of dollars such as asset-backed loans encouraged broad ownership by creditors who did not have the financial skills to assess the credit standards of their investments. For example, a middle size German bank recently failed because of their huge exposure to sub prime mortgages originated in the United States. State Street Bank has recently admitted that 32% of their balance sheet represents investments in asset-backed loans.

The incredible leverage employed by major Wall Street firms, hedge funds, private equity buyers, and even money market mutual funds magnify the risks because these institutions depend upon relatively short-term borrowing to finance their investments. Stated differently, the lifeline of these institutions is tenuous because their large balance sheets require constant rolling-over of credit to maintain their investments. For example, Bear Stearns has a balance sheet 30 times its equity base. The proposed acquisition of Sallie Mae would have created a company with debt 100 times its equity base.

The current practice of providing substantial junk loan commitments to private equity buyers jeopardizes the credit markets when commercial and investment banks cannot syndicate these loans to reduce their risk exposure. In brief, commercial banks and investment banks have made financial commitments of hundred of billions of dollars to finance proposed takeovers. While the commercial banks have access to the Federal Reserve discount window to gain liquidity, investment banks do not have this financial latitude.

Excessive fiscal policies have stimulated inflation. That is, our large government deficits have created excessive demand for goods and services, leading to higher prices. Historically, high inflation rates distort rational investment and undermine saving. Unfortunately, in 2006, real savings in the United States was negative for the first time since 1932. In the long run, for capitalism to function properly real investment requires appropriate savings levels.

The twin deficits of the federal budget and our trade imbalance have necessitated borrowings of more than $2 billion dollars per day to support our on-going consumption and governmental operations. The prospect of foreign ownership of a wide spectrum of American corporations and real estate is inevitable when the assets of sovereign investment funds grows from the current $2 Trillion dollars to $14 Trillion dollars over the next decade.

Federal and State governments have enormous unfunded health and pension liabilities that will eventually become onerous. That is, there are predictions that within five years the Federal Government will lose its AAA status, and within twenty years it will lose its investment grade status.

The Extent of the Financial Crisis Surprised both the Administration and the Federal Reserve

Just three weeks ago, both the Federal Reserve and the administration indicated publicly that they were not prepared to intervene in the economy, because they felt that the financial problems were just focused on the sub prime mortgage market. Over the next few weeks, financial problems mushroomed globally as well as to different sectors of the United States Economy. That is, their optimism was misplaced when the crisis spilled over to other financial institutions both domestically and abroad.

Why the Federal Reserve and the White House Dramatically changed their attitudes about remaining on the sidelines since early August 2007.

Let me reiterate some of the negative occurrences over the past few weeks: (1) The failure of several major mortgage banks (2) the failure of major hedge funds both in the United States and in Europe (3) the bankruptcy of a German commercial bank that had overly invested in American sub prime mortgages,  (4) the dramatic downgrading of the credit rating of commercial paper backed by mortgage assets, (Standard and Poor fired the head of their company because of failure of its analysts to properly assess the credit risk of asset backed securities), (5)  the dramatic increase in interest costs between Treasury backed securities and corporate borrowers, (6) the significant withdrawal of funds from money market funds that were either leveraged or had exposure to asset- backed paper (7) the decline in commercial paper issuance by asset-backed borrowers that once represented over 50% of the two trillion dollar commercial paper market (8) the dramatic decline in junk bond new issuance, (9) the inability of investment banks and commercial banks to syndicate hundreds of billions of dollars of junk bond loans, (10)  the slowing up of merger activity by private equity funds, and the (11) volatility of the stock market.

What is our current financial status?

To paraphrase Winston Churchill, we are certainly not at the “beginning of the end” and maybe not even at the “end of the beginning” in taking the appropriate monetary and fiscal steps required to remedy the problem. That is, the Federal Reserve is expected to lower the Federal Funds target by at least 75 basis points by the end of the year, and possibly as much as 125 basis points over an extended time period in order to reduce borrowing costs and encourage investment. The Executive and legislative bodies need to take major steps to shore up the housing sector beyond the comments made by the President on Friday. That is, the President’s program this past Friday called for helping some 80,000 sub prime borrowers by expanding the authority of the Federal Housing Authority. The scope of the housing problem is much larger. As many 2 million home owners facing escalating mortgage costs on their adjustable-rate mortgages.

Capitalism puts a premium on the individual making rational financial judgments. Thus, while judicial system should take action against fraudulent mortgage practices, fiscal responsibility dictates that lending 100% of home costs or failure to require third party verification of income to support loan applications is irresponsible and cannot be condoned.

What are legitimate concerns that fiscal remedies could become excessive?

There is ample evidence to suggest that empowering FNMA and Freddie Mac to make jumbo loans, loosen their credit standards, and increase significantly their balance sheets would empower these questionable organizations. That is, both FNMA and Freddie Mac have recently transgressed egregiously their fiduciary responsibilities. That is, both of these organizations meaningfully misstated their earnings and incorrectly priced their huge portfolios in order to achieve significant bonus pools for their key employees. Also, empowering FNMA and Freddie Mac could emasculate their competitors who depend solely on private financing. The implied federal backing for FNMA and Freddie Mac allowed these organizations to take unwarranted leverage and make questionable derivative investments. Recalculation of the book value of both organizations involved several years work on the part of outside auditors and the write-down of billions of dollars of overstated earnings. Both FNMA and Freddie Mac spent millions of dollars to influence legislators. These legislators in turn postponed or prevented remedial action for many years by regulators who had supervisory authority over FNMA and Freddie Mac. Thus, using the current financial crisis to empower FNMA and Freddie Mac to increase significantly their market presence could be as dangerous as letting a fox into a hen house.

Many critics do not want to encourage excessive borrowing. Otherwise, we could repeat the financial disasters that befell the commercial banks and saving and loan associations in the late 1980’s and early 1990’s. For example, almost every commercial bank in Houston, Texas failed during that period. Many saving and loan associations failed. Some twenty percent of all commercial and industrial properties changed hands because of their owners’ insolvencies.

The Golden Age of Risk

Unfortunately, Wall Street firms have earned billions of dollars and paid out huge bonuses to financial executives who have taken on enormous risks for their organizations by investing in questionable credits, leveraged their balance sheets, and made trillion-dollar bets on derivative products that have uncertain values. In essence, the mindset of prominent investment bankers, commercial bankers, and hedge fund managers is to make out-sized bets. Stated differently, until now the financial rewards for risk-taking have greatly exceeded the downside for both major institutions and their key employees. Proprietary trading and investing have become the buzz word in today’s economy.

Rick Bookstaber, the author of A Demon of Our Own Design, points out that the financial world is ever edging toward disaster. As a hedge fund ‘rocket scientist,’ Bookstaber provides an insider’s perspective to the tumultuous management decisions made by some of the world’s most powerful financial figures from Sandy Weill to John Meriweather.

Beware of Government Interference in the Market Place

Unfortunately, Congress could easily set-in motion policies that encourage financial speculation by expanding dramatically the lending authority of the Federal Housing Authority, FNMA, and Freddie Mac. Congress could also increase substantially the deficit by allocating billions of dollars to bail-out borrowers.

Also, the “flip side” of keeping mortgage rates low is lenders loose incentive to provide funds. That is, converting adjustable-rate mortgages to low thirty-year fixed rate mortgages dries up private pools of capital. Capital today has a global reach. Thus, lenders will make rational investment decisions on worldwide opportunities. A close friend of mine who has major responsibilities at one of the largest insurance companies in the world daily dispenses billions of dollars throughout the globe depending upon relative value opportunities. The bankruptcy of many federal saving and loan associations and mutual savings banks derived from their financial imbalance. That is, they committed to long term fixed rate investments, but borrowed short term on an adjustable basis. Thus, when their borrowing costs rose, they were stuck with low paying assets.

Leveraged Equity Financing

We must reconsider the threat to the economy of the proliferation of leverage equity financings. Approximately 30% of all mergers and acquisitions this year were on behalf of private equity funds. The ownership of major companies in almost every industry class by leveraged private equity funds has ominous repercussions for long term investment strategies.

Let me state the problem differently. When I came to Wall Street, companies were proud of their high credit ratings. However, with the pressure to maximize stock prices, companies have employed leverage to make acquisitions or buy back stock. That is, since I came to Wall Street, credit ratings of major industrial companies have declined dramatically. Warren Buffet has repeatedly warned against the use of leverage to finance acquisitions, the widespread use of derivative products, the use of debt to buy back stock and the huge American fiscal and trade deficits.

Policy Recommendations

  1. Federal and State Governments must stop deficit spending, and address the escalating problem of unfunded pension and health liabilities.

  2. The Government should require major investment banks such as Morgan Stanley, Lehman Brothers, Bear Stearns, and Goldman Sachs to become part of the Federal Reserve System. The emasculation of the Glass Steagall barriers between commercial banks and investment banks has led to overlapping financial activities by these institutions. It seems reasonable therefore to have uniform regulations for these heretofore separate classes of financial institutions.

  3. The Federal Reserve should increase the margin requirements on derivative products

  4. The Federal Reserve should require stiffer down payment requirements for home purchases.

  5. The Federal Reserve should limit the interest rate increases on adjustable-rate mortgages over the life of the loan.

  6. The Federal Reserve should require mutual funds to post reserves on mutual funds. The required reserves should vary depending upon the investment objective of the fund, the investment vehicles of the fund, the leverage employed by the fund, and the investment grade quality of the fund.

  7. The Federal Reserve should require mutual funds to alter their refund policies. That is, investors should not be able to withdraw all of their funds on a daily basis.

  8. The Federal Reserve should increase significantly their margin requirements on below investment grade loans.

  9. The Federal Government should provide regulatory oversight of hedge funds. Moreover, hedge funds should be required to provide transparency to their investors. To protect hedge fund performance, the hedge fund could delay revealing their positions for thirty days. Many hedge funds mislead their investors about their investment activities and employment of leverage. Opening up their books provides needed light on these opaque, behemoth financial players.

  10. The Federal Reserve should not allow the sale of hedge funds in the United States where the hedge fund is incorporated overseas. The use of off shore incorporation prevents remedial legal action by American investors and regulators.