More Problems from Government Solutions

Mike McDaniel

As long as we look to the government for solutions there will always be a problem.

I would be a hypocrite to be a financial advisor and not believe in free market capitalism.  Anyone invested in the markets must believe in free market capitalism.  A characteristic of our free market system is the fact that there will be good times and bad times.  An investor must learn to take the good with the bad. No one faults the markets when they are rocketing higher. But, when it comes time to revert to the mean we look for bailouts.  So the main stream media calls on our politicians in Washington to relieve the free market participants of the bad times inherent in free markets.

[The “fat cat” bankers are not free from blame even though the government did not catch their hands in the cookie jar. Their punishments have been handed to them by the markets (see the demise of Bear Stern, Lehman Brothers, and others).  The market continues to levy justice to the executives that engineered, concealed and pawned off the toxic debt to investors.]

It has been reported that the recent $700,000,000,000 bailout sparked a 99-1 ratio of constituents against the bailout to those who favored it. Could it be that Americans don’t think our politicians are capable of solving this crisis? Could it be that our politicians (both past and present) helped create the financial crisis of today?  Yes and Yes.

In my opinion, the current crisis was generated and has frustrated investors due to the following:

 The socialist dream of housing for every American mandated by our politicians (regardless of the homeowner’s ability to pay back the mortgage) was a catalyst for the crisis.  Each of the State of the Union addresses going back to 1994 that I can remember showed a president (Clinton and Bush) touting their administrations ability to get the uneducated, less financially fortunate Americans into homes of their own.  This “accomplishment” comes at a price.

 The Federal Reserve (under Alan Greenspan) kept key interest rates too low for too long.  The over supply of funds to our nations bankers encouraged our bankers to design unconventional loans as a means of getting funds into circulation.  Once qualified homeowners refinanced 2-3 times in 3-5 years, bankers designed plans to expand the definition of “qualified.”

 Bankers looked to a laundry list of government regulatory agencies (SEC, OST, FDIC, HUD, US Treasury, and Federal Reserve to name a few) for acceptance, oversight and approval of the newly designed loans.  The banker’s new “unconventional loans” passed EVERY government agency's litmus test.

 Investors and credit rating agencies relied on and made investments based on the perceived oversight by the SEC, OST, FDIC, US Treasury, and Federal Reserve that was non existent.   Supervision was entrusted to various government agencies at the peril of investors around the world.

 The corruption, mismanagement, and inabilities of management at Freddie Mac and Fannie Mae (both are Government Sponsored Enterprises) produced, concealed and then exacerbated the problem.

 Lastly, investors that flocked to “safe haven” investments such as gold/silver, energy, agriculture, foreign currencies have not been rewarded for their beliefs/actions due to our government’s heavy handed intervention.  Our government’s bailout inclinations have stepped in to manipulate the world markets.  The market will return to a “free market” when the government returns to its typical role. 

The overall trend is clear. Systems put into place by politicians to aid the free market system have and will continue to fail taxpayers and investors.  As long as we look to our politicians for solutions there will always be problems. 

Mike McDaniel is a Financial Advisor and principal of McDaniel Wealth Management. He can be reached at (530) 478-0326. 

Comments

[nate Beason]

Hey guys- You've got a hole in your bucket. A lot of "free market" capitalists took a free ride in the mortgage market along with all the tradespeople, retailers, etc., who made a living off the excesses. We've had enough finger pointing. What's your solution?

Love, Nate

[George Rebane]

Don't know Mike's solution, but mine is to let them take a fall like any company that made dumb decisions. The assets will survive and be taken over by viable institutions - 95+% of the loans are being serviced and in fine fettle. By no means give the feds any additional permanent powers, and don't start the next cycle with another dumb law like the Community Reinvestment Act of 1977 (see 'Bailout Bungle'). This will shake out the quickest and get things back to normal - otherwise, long recession and no more facile capital flows as the US is bypassed by those building the world. What's yours Nate?

Love, George

[Larry Press]

George,

Letting them take the fall is just, but you are a systems guy -- can you predict the side effects of their taking a fall with confidence? It is as tough as the proverbial butterfly flapping its wings.

Also -- can we fully explain this mess as a product of the socialist dream of housing for every American, government regulation, rating agencies duped by the government, Alan Greenspan keeping interest rates down and bad apples at Freddie and Fannie? Aren't there other contributing factors?

For example, might some of those generous AAA ratings been motivated by the folks doing the rating being paid by the folks being rated? Or, how about the impact of legislation stopping regulation on "insurance-like" instruments like credit default swaps?

Insurance is regulated -- things like requiring that the insurance companies have some capital in case they had to actually pay to cover things like bad loans or having to keep track of their policies. But now we have 40, 50, no-one-knows-how-many trillion dollars worth of these unregulated "insurance-like" instruments floating around and no person or market knows how to evaluate them when they do turn up. Those "insurance-like" instruments sure look like "insurance" today.

Are you sure all regulation is bad -- regardless of the number and size of the players in a market and their ability to influence the market? Might not some regulation dampen volatility or mitigate the effects of executives and employees inside a firm who are tempted to act to maximize their personal income rather than shareholder wealth and the long-term well-being of the firm?

[Michael McDaniel]

Nate, my solution is to let the market play out WITH the relaxing of "mark to market" accounting rules until some semblance of order is restored to the credit markets.

[facts]

http://uk.youtube.com/watch?v=_MGT_cSi7Rs

http://uk.youtube.com/watch?v=_S_FotSAHDY

[George Rebane]

Thanks Larry for your thoughtful comments. I’ll marble my replies between your words to keep them short.

Letting them take the fall is just, but you are a systems guy -- can you predict the side effects of their taking a fall with confidence? It is as tough as the proverbial butterfly flapping its wings.

[gjr – I always find it remarkable that so many folks see the government as a wingless insect incapable of causing unknown collateral effects when history shows us the exact opposite. More often than not ‘we’re from the government and we’re here to help’ has been the preamble to misery and/or disaster.]

Also -- can we fully explain this mess as a product of the socialist dream of housing for every American, government regulation, rating agencies duped by the government, Alan Greenspan keeping interest rates down and bad apples at Freddie and Fannie? Aren't there other contributing factors?

[gjr – undoubtedly there were other attendant contributors, but one would have to start by showing that the 1977 CRA was not a necessary AND sufficient condition that started the tipping of every domino in the string (formally ‘causal beam’). The short sighted capitalists gamed the system that the government unwittingly set up and fostered over the last twenty years – chapter and verse are readily available for the interested.]

For example, might some of those generous AAA ratings been motivated by the folks doing the rating being paid by the folks being rated? Or, how about the impact of legislation stopping regulation on "insurance-like" instruments like credit default swaps?

[gjr – absolutely. See above about greedy capitalists gaming the system.]

Insurance is regulated -- things like requiring that the insurance companies have some capital in case they had to actually pay to cover things like bad loans or having to keep track of their policies. But now we have 40, 50, no-one-knows-how-many trillion dollars worth of these unregulated "insurance-like" instruments floating around and no person or market knows how to evaluate them when they do turn up. Those "insurance-like" instruments sure look like "insurance" today.

[gjr – as also a systems guy, you know that the trigger mechanism for this crisis is formally known as a Black Swan (cf. Taleb). If insurance companies charged premiums to cover themselves against Black Swans, no one could afford insurance. Life contains Black Swans, and the unprepared suffer and die. It was ever thus.]

Are you sure all regulation is bad -- regardless of the number and size of the players in a market and their ability to influence the market? Might not some regulation dampen volatility or mitigate the effects of executives and employees inside a firm who are tempted to act to maximize their personal income rather than shareholder wealth and the long-term well-being of the firm?

[gjr – have never claimed that “all regulation is bad”. All complex societies need some level of regulation to provide for predictable and salutary behavior. In small mono-cultural societies tradition and taboos served. In today’s large, multi-cultural societies, where cultural traditions conflict and the correcting impulses of shame are proscribed, more regulations restricting individual liberties are required to keep blood from the gutters. And there lies the gulf between the left and right.]

[Larry Press]

[gjr – I always find it remarkable that so many folks see the government as a wingless insect incapable of causing unknown collateral effects when history shows us the exact opposite ...]

I did not mean to say that. What I was trying to say, is that I fear that the side effects of letting a bunch of those firms crumble might be devastating to the economy.

That being said, I admit that I have that fear ("fear itself") because Paulson, Bush, McCain, Obama and many professors say is likely. I also grant that I have little respect for Paulson -- he and his colleagues owe us an apology and retribution -- or the politicians. The professors, perhaps Bernanke, a bit more. Still, I am reluctant to bet what is left of my retirement nest egg on the hope that they are all crying wolf.

[gjr - the 1977 CRA was not a necessary AND sufficient condition that started the tipping]

We've had the CRA since 1977. When did the default rate on mortgages begin to rise? While the CRA may have led to some excesses (and the curbing of non-economic red-lining), it seems to me that greed without the constraint of regulation was a stronger and more proximate contributor to the crash.

Deregulation, begun with Regan and hustled along by Clinton with a hand from Phil Gramm in the congress, opened the gates for the self-serving speculation that ensued. Without regulation, everyone in the food chain -- loan brokers, securitizers, "insurance-like" companies and their employees -- was making a fortune. It seems to me that that is a more direct explanation than the socialist dream of home ownership.

[gjr – If insurance companies charged premiums to cover themselves against Black Swans, no one could afford insurance.]

I don't see this as a lone black swan, but a swarm of utterly predictable white swans. For this house of cards to have worked, housing prices would have had to keep rising by, what 10 or 20 percent a year, for ever. Do you think the executives at, say, AIG, really expected that to happen?

Had they been regulated as what they were -- insurance companies -- they would not have been allowed to get leveraged to the hilt guaranteeing mortgages that assumed constant housing price increases and refinancing for ever.

When is the first time you heard about funky NINJA -- no income, no job, no asset -- loans? Don't you think the executives at AIG heard about it before you did?

[gjr – have never claimed that “all regulation is bad”...]

Sorry if I misrepresented. My guess is that, even if McCain gets in, we will see a bunch of re-regulation. The pendulum is about to swing back.

(What does McCain have to say about Gramm these days -- is he distancing himself from Gramm)?

Lar

[George Rebane]

Lar – My points can be summarized as –

• When free markets screw up everyone looks to government for the answer. Government answers by more laws/regs that further constrict freedoms. When govt screws up, the answer almost always is more govt laws/regs to fix the broken ones, and those restrict freedoms even further. How often do we hear the call to re-extend liberties and give free markets another chance? It’s almost as if most people believed that our wealth and quality of life has been brought about through careful social planning and dedicated enforcement of government policies, and not the aggregate efforts of a free and industrious people acting in their own best interests. As a free market libertarian, I believe that governments are capable of wreaking orders of magnitude more havoc on their people than are the people left to their own devices. History is the teacher of those who would learn.

• Complex systems don’t always react immediately, and finding the causal origins is a bit more complex than identifying what happened just before it all hit the fan. My point is that the 1977 CRA is the most identifiable initial act that gave rise to subsequent private and public actions over the years which made us vulnerable to many other inputs that finally caused this – in its name many sins were committed during the interval. Truly, an unintended consequence of attempting to put more (financially/morally unqualified) people into their own homes. By fiat the govt tried to dictate what human nature does not support. (Your excerpt inadvertently misrepresents what my full statement says about the CRA; a good example of how journalists can use direct quotes to tell any story they want.)

• Yes, as I have pointed out, many warned against the excesses that actually began building up in the housing markets at the end of the millennium. But, contrary to what you believe, this financial crisis is not a swarm of white swans. NO ONE (not Buffet, not Soros, not …) knew either the timing or extent of this meltdown, nor do they know now. EVERYONE believed that after a while we would magically have a soft landing during which the excesses could be worked down with some minor pains. There were countless wealthy and smart people who could have shorted the financial institutions and by now made billions while the crisis is still in full force. No one did, but many tried to place their bets after the wagon went off the cliff. This is what a Black Swan looks like – unexpected arrival, devastating effects, and afterward everyone can explain its advent. We’re similarly fooling ourselves with SS, Medicare, etc of the $55+T unfunded liabilities debacle, no one knows when and how that catastrophe will precipitate.

[Michael McDaniel]

Is McCain just another politician? During McCain's acceptance speech he promised American's that he would veto any bill that was laden with "pork" and make the names known of the politicians that put the "pork" into the bills known. Here is McCain's chance to act on his promise.

But the Senate Bailout bill is laden with pork, including:

* $223M for Alaskan fisherman
* $192M for rum producers in Puerto Rico and the Virgin Islands
* $128M for auto racing
* $33M for companies operating in American Samoa
* $10M for film & TV production
* $6M for producers of wooden arrows

[Russ Steele]

Mike,

I am waiting for Rush to post his stack of stuff for today, He talked about tax breaks for employers who buy bikes for their employees to ride to work, $300 a year for each bike bought. Also, there was a clip by Pelosi saying she had gotten her a global warming CO2 reduction stuff in the Senate Bailout bill which she could not get through the House earlier this year. How much is that going to cost? I think your pork list is going to grow. Stay tuned.

[Russ]

EMERGENCY ECONOMIC STABILIZATION
I found Pelosi's CO2 crap on ICECAP
Subtitle B—Carbon Mitigation and Coal Provisions

Sec. 115. Tax credit for carbon dioxide sequestration.
Sec. 116. Certain income and gains relating to industrial source carbon dioxide
treated as qualifying income for publicly traded partnerships.
Sec. 117. Carbon audit of the tax code.

This appears to be an attempt by global warming fanatics to lay the foundation for an economy-killing carbon tax just like the “cap-and-tax” system that is now destroying European industry

[Russ Steele]

Anthony Watt at Watts Up With That has some more comments on Sneaky: Current credit bailout bill contains carbon tax provisions!

[Wade]

I remember when poor people (socialists) pushed for, and won, the Gramm-Leach-Bliley Act. Those poor people can barely pay their government mandated mortgages much less maintain a prudent differentiation between loans, deposits, and securities! These poor people (socialists) exacerbated the situation by demanding in 2004 that the SEC relax the net capital rule for the 5 broker dealers on Wall Street, allowing their debt to net ratios go way beyond 12-1. They claimed that the 12-1 limit was an unnecessary restriction, but you know how poor people are -- always trying to use the government to abet and / or clean up after their risky financial schemes, when they're not demanding that the Federal Government print money and maintain artificially low interest rates in order to prop up a Republican economy that is.

When these same poor people (socialists) insisted that the some $13 trillion in Fannie/Freddie mortgage loans be extended into a $45 trillion market based on exotic securities and derivatives, loosely premised on the original mortgages, whose value was dependent on home prices rising forever, well, that was the final straw. They misused some heretofore obscure law from the '70s originally intended to address racism in the home loan market. With this devious act in hand, they bought and sold CDOs and mortgage backed securities until nobody knew their worth any longer! That's what Big Government get's ya -- uncertainty in the financial markets...

[J. Gault]

Wade, your sarcasm says to me that the government was used (bought and paid for) by Wall St.? That would support the idea that the countless federal regulatory agencies were 'unable' to do their damn jobs. I believe the problem stems from 3 areas: Unqualified home buyers, greed (Main St. and Wall St), and inept government systems (oversight to monetary policy). What sucks is the fact that the typical American taxpayer who is not the problem; ultimately funds the "solution."
-J
p.s. Where does your "poor = socialist" correlation come from?

[George Rebane]

[gjr 8oct08 - due to some bug only known to Typepad, the following comment was not posted nor emailed to me. When correspondent Larry Press informed me of this lapse, I asked him to send what he had wanted to post and I would post it. He sent the following.]

> Government answers by more laws/regs that further constrict freedoms.

I think one can make the case that from the time of Reagan to date, the trend has been toward reduced regulation in the area of finance, see, for example:

http://en.wikipedia.org/wiki/Gramm-Leach-Bliley_Act

http://en.wikipedia.org/wiki/Commodity_Futures_Modernization_Act_of_2000

There has surely been a strong trend toward reliance on the market in telecommunication (globally as well as in the US) during this period.

I believe both McCane and Obama are now condemning the lack of regulation in the financial markets, so you are probably going to see the pendulum swing back the other way. (As I have mentioned, I think McCain has to distance himself from Phil Gramm, see, for example :
http://money.cnn.com/2008/02/18/news/newsmakers/tully_gramm.fortune/index.htm).

> the 1977 CRA is the most identifiable initial act

How have CRA-related loans done? What part of the total debacle do they account for? (These are not rhetorical questions -- I have no idea). I did a Google search on "cra loan performance" and found one study from the year 2000:
http://www.clevelandfed.org/research/commentary/2000/1100.htm.

Assuming they have done worse than others, they contribute, but they are only one cause of many.

> Your excerpt inadvertently misrepresents what my full statement says about the CRA; a good example of how journalists can use direct quotes to tell any story they want.

I don't understand why it misrepresents -- surely unintended.

> EVERYONE believed that after a while we would magically have a soft landing during which the excesses could be worked down with some minor pains.

You can put it in all CAPS, but that does not make it true. A single counterexample can disprove your assertion, but rather than Google one up for you, let me shift gears a bit. Last week I attended a forum at the Milken Institute:

http://www.milkeninstitute.org/events/events.taf?function=detail&ID=246&cat=Forums

Two Milken economists presented a pretty dense picture of the background, causes, predictability, extent, etc. of the crisis. The Web site has a video of the presentation and 84 slides presenting data. I recommend it.

They did not make policy recommendations during the presentation, but Michael Milken was in the audience, and he hung around for informal chat after the talk. He favors government purchase of preferred stock, not toxic loans, and would cap executive compensation at $1 million per year, but give them options on common stock to be exercised only after the government divested itself of what it had bought to encourage long-term decision making. He was highly critical of the entire enterprise -- said any business that relied on 30:1 leveraging had a broken business model and anyone who would make non-recourse loans to folks like home owners or a government (like Argentina) was also less than shrewd.

He said the banks in some nations -- notably China and Japan -- were strong. I kicked myself afterward for not asking him if they would not rush in to fill the liquidity gap if we decided to sit back and let the market sort things out. (I believe that is what you favor, right)?

If you download the slides check numbers 33 and 35 and see if you remain certain that, say, the executives of AIG could not have foreseen that the run up in housing prices upon which the viability of their unregulated insurance policies depended could not have foreseen that it would have to end one day soon.

[gjr 8oct08 - my argument holds since if any of the key decision makers (the intended EVERYONE) had foreseen a hard landing, they would have taken measures to prevent it. That they did not and hit a brick wall indicates that they were blind to the evidence that I also presented graphically in a previous post.]