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Financial meltdown: How it all happened
As Arizona state
treasurer, my office manages a $12 billion portfolio and last year
distributed profits of over $500 million to state and local governments.
Last week, I watched
in horror as the U.S. government's schizophrenic actions created this
financial meltdown. Now, they want nearly a trillion taxpayer dollars to fix
it.
Action is needed
immediately, but taxpayers should not pay for others' mistakes. The last
thing we need is FEMA running our local bank.
Our financial system
is in a logjam, gripped by fear. The proposal to buy all the logs to remove
the jam is expensive and rewards those who took large risks as much as those
who did not. Instead, treat the disease directly, make the system more
transparent and separate the good loans from the bad, saving taxpayers
hard-earned cash.
Main Street home
buyers, Wall Street investors and the federal government are sitting on
piles of debt. Easy money led to low lending standards, fueling housing
speculation in Arizona and elsewhere. Because money was easy to get, lenders
lowered standards to attract more borrowers. These debts were then bundled
together and sold on Wall Street to institutional investors to raise capital
to make more loans.
The problem was a lack
of transparency; bundling loans obscured the risks from investors. Prime
loans were bundled together with jumbos, subprime loans and others while
still receiving "A" ratings. Many investors just assumed the "A" rating
meant all mortgages inside were safe.
In August of last
year, Wall Street realized that it owned subprime loans in portfolios that
did not plan for that risk. At that point, the market froze. The housing
bubble had burst and subprime loans were now seen as contaminated; anything
they touched was considered toxic risk that no one wanted to buy.
The lack of
transparency in bundled mortgages made it difficult to know how many
subprime loans were inside. Therefore, all mortgage securities were treated
as toxic. Investors avoided all mortgages to prevent accidentally buying
subprime.
It's like the adage:
"One bad apple spoils the barrel." So it was with subprime spoiling the
entire mortgage market.
New accounting rules
designed for liquid markets now began to put the squeeze on banks even
though more than 90 percent of Americans are still paying their mortgages.
After the fraud at
Enron, Congress changed the accounting rules to "mark to market." Assets had
to be priced according to what the market said they were worth if you
liquidated them today. This was a very good rule for preventing unscrupulous
individuals from overinflating their balance sheets. However, it works only
when a functioning and liquid market exists to price the assets.
When mortgage markets
froze last August, demand evaporated for the now-toxic mortgage bundles.
This crushed many banks' balance sheets as they had to list mortgages at
pennies on the dollar. Instead of having these assets on the books as
collateral to make more loans, banks now needed to borrow money to stay
afloat. Banks, however, stopped lending to other banks due to fear of
getting indirect exposure to subprime loans. Banks depend on short-term cash
to stay afloat. A total credit freeze puts our financial system in peril.
Since the Great
Depression, the Federal Reserve has been the lender of last resort to banks.
During a crisis, if short-term cash ran dry, they could borrow from the Fed
in order to prevent a run on the bank. When Bear Stearns faced a liquidity
crisis, the Fed provided backstop lending to JPMorgan to assume Bear's
assets and liabilities. It promised the same assurances to other investment
banks in this liquidity crisis.
This contained the
problem for a while. Confidence was shaken, but given the commitment to help
banks get through any short-term liquidity crisis, the market was likely to
avoid catastrophic failure.
Then, the government
caused the catastrophic failure it was trying to prevent.
Despite nearly a year
of promises, after the markets closed, the government reversed its position.
It would not provide the same backstop as Bear Stearns to Lehman Brothers,
an investment bank with positive net assets of $26 billion. It forced a
company that was "A" rated on a Friday to file bankruptcy the following
Sunday.
Panic gripped the
financial markets. The forced bankruptcy of Lehman destroyed insurance
company AIG's balance sheet. As fear ravaged investment portfolios, the
government reversed itself again. It seized control of AIG, nationalizing it
and pouring in $85 billion. By week's end, the government had spent more
money trying to contain the firestorm it unleashed by reneging on Lehman
than it would have cost to support its sale.
Worldwide, investors
(and taxpayers) were losing confidence in U.S. government economic leaders.
The government is supposed to be the referee, calling a fair game, not
choosing winners and losers.
The original strategy
of providing only emergency lending during a liquidity crisis made sense.
Nationalizing financial institutions does not. When your neighbor's house is
on fire, you lend him a hose; you don't have him sign over the deed to the
house before you help put out the fire.
Congress needs to take
action to fix this problem immediately; the longer it waits, the more damage
is done. But it needs to treat the disease. Allow the mortgage bundles to be
broken up, separate the toxic subprime loans that are causing the logjam
from all other loans. Provide insurance for all other mortgages. This way,
the 90 percent of Americans who are still paying their mortgages are
rewarded for doing so, and the fear that has gripped the markets about the
housing bubble will subside.
Allow banks to value
the now-insured loans based upon how many are still paying their mortgages,
rather than liquidation value. This will unfreeze credit and get our economy
moving again (and it's a lot cheaper than just buying everything).
I would rather bet on
the majority of Americans who pay their mortgages, rather than bail out
those who made risky investments.
Dean Martin, a
Republican, is Arizona's Treasurer |
