Although the magazine itself isn’t noted for its social and economic commentary, there are two brief essays in the December, 2008 edition of Scientific American that should be required reading for members of the incoming Obama Administration. The messages may not be what Council of Economic Advisors wants to hear, but these essays should (hopefully) serve to inject a bit of sanity and realism into what has become a Never-Never Land of the confused, and often contradictory, federal interventions in the financial markets.
On page 45 of the print edition these new advisors will find “After the Crash,” a brutal criticism of the consequences that can be traced to the 2004 decision of the Securities and Exchange Commission to remove the rules that had previously required investment banks and related firms to maintain long-established debt limits and capital reserves.
Once this restriction was out of the way the major players in the financial industry were free to create, buy, and sell a host of new financial instruments including the now-toxic residential and commercial mortgage-backed securities (RMBSs and CMBSs, respectively). Since no one had any real idea as to the relative risk behind these new securities, the industry turned to that elite group known as the “quants.”
The quants get their name from what they were supposedly the best at doing, which was determining (“quantifying”) the amount of risk related to investment in the new mortgage-backed securities. After some analysis, the quants confidently proclaimed that the newly created securities were indeed a sound investment and suddenly the new securities were replacing the previously mandated capital reserves of the investment banks and other institutions.
There was, however, one thing that the quants hadn’t forseen: the mathematical models that they had used to make these predictions were faulty.
In these models the quants had assumed that, as a whole, there would not be 1) more than few defaults on the mortgages behind the new investments and 2) a sudden downturn in the housing market. Such assumptions as to the stability of the industry may have been fine in the best-case scenarios, but they failed miserably in the worst-case scenario of reality.
By simply turning the page (to page 46) the new administration’s economic team can read Jeffrey Sachs’ “Priorities for Fixing the Financial Crisis.” An expanded version of this essay, entitled “How to Fix the U.S. Financial Crisis,” is available in the online edition of Scientific American.
Dr. Sachs, Director of Columbia University’s Earth Institute, identifies the roots of the crisis as a direct result of irresponsible consumer lending by financial institutions to borrowers that were unable to meet the terms of their lending agreements and were subsequently forced into default. He then identifies four critical events that could send the economy of the United States into a major recession:
1) Short term loans to businesses and interbank lending will decrease in response to the tightening of credit requirements;
2) Banks and other financial institutions will curtail lending as they are forced to adjust their capitalization downward to reflect default losses in mortgages and consumer loans;
3) Homeowners will default on mortgages and consumer loans, and
4) A decline in consumer spending on housing and durable goods will trigger layoffs in housing construction and in factories that produce consumer goods;
While he admits that there is some overlapping of events, his proposed course of action is to prevent this “Humpty Dumpty” or “House of Cards” collapse begins with minimizing the effects of event 1.
The immediate threat is to the net capitalization of financial institutions brought about by defaults of over-valued mortgages. His solution is for financial institutions to aggressively renegotiate the terms of “non-performing” mortgages to more affordable terms and for government funding to cover any “reasonable” losses incurred by the institutions as a result of refinancing such contracts. Interventions at other levels, he feels, should only come after the recapitalization of the mortgage and consumer loan-making institutions. In other words, to put Humpty Dumpty back together again you have to find all the pieces.
In the eyes of this writer the above-mentioned essays call attention to, if I may paraphrase Al Gore, more than a few inconvenient truths. Unfortunately, these facts seem to be either downplayed or ignored in the current debates regarding a course of action that could very well decide whether or not the United States of America retains its position as the world’s premier economy.
As unpleasant as it may be for the “distressed” financial institutions to admit it, it was their total disregard for what can be best described as sound business practices (read “common sense”) that led to their current troubles. Instead of working within the framework established by the Securities and Exchange Commission, the supposed guardian of the financial industry, the removal of oversight led to what can be described as pure and simple fraud.
The other inconvenient truth is that the “bailout” of the financial industry has, to this point, been administered with much the same competence as was France during the reign of Louis XVI. In the light of the actions of the current administration (as an example, see “Why Would Anyone Believe Hank Paulson?”), any actions by the Obama Administration would probably be seen as timely and competent.
In the next year, the trick will come in distinguishing between any action and competent action.