Who Crippled Capitalism?

                                                                                         

"Capitalism is dead," said Steven Brant of the Huffington Post. If it isn't, it is certainly badly injured. Financial markets are frozen. Credit has evaporated. It seems our economic system is teetering on the brink of collapse. Jeremy Siegel, finance professor at the University of Pennsylvania's Wharton School of Finance commented, "Two weeks ago was the first time in my life that I was worried about the very stability of the United States financial system."

So who is ultimately to blame for this crisis?

Last week U.S. legislators approved the Emergency Economic Stabilization Act of 2008 (EESA). The measure arms the United States Treasury with $700 billion in capacity to purchase and guarantee illiquid and distressed assets (primarily toxic commercial and residential mortgage-backed paper) from financial institutions.

America is conflicted about the government's role in the crisis, and about EESA in particular. Some say it unfairly transfers the financial costs of Wall Street's avarice to work-a-day citizens. Representative Marcy Kaptur of Ohio's 9th District states that "Wall Street game masters have kept billions of dollars of their gains and shifted their losses to American tax payers." Senator Jim Bunning (R-Kentucky) warned that "[EESA] is financial socialism, and it is un-American."

Others argue that EESA wisely allocates community resources to avert the collapse of our financial system. Jonathan Laing wrote in a recent Barron's cover article: "There's no question that the Bush Administration's $700 billion bailout plan is necessary." Siegel adds, "We were on the verge of falling into an abyss, which was only averted when news leaked out of the bailout plan." And Yale economics professor Robert Shiller reports in the Washington Post, "Today's federal involvement offers bailouts as a strictly temporary measure to prevent a system-wide financial calamity. This is entirely in keeping with our basic principles."

Some see government intervention as the origin of the whole debacle. The Chicago Tribune recently editorialized that the economy is in trouble because of "too much government. Not too little." In a September 29, 2008, article titled "In Times of Crisis, Trust Capitalism" and published on Real Clear Markets, investment officer Joseph Calhoun argues that the housing bubble stemmed from government interference in the form of artificially low interest rates, legislation encouraging home loans for low credit borrowers, and subsidized mortgages from quasi-governmental agencies FNMA and FHLMC.

Others cite a lack of government oversight and urge tighter regulatory controls and more intervention as the only way to resolve the problem. "Capitalism require[s] checks and balances to ensure that [it] work[s] properly," wrote Robert S. McElvaine in the Washington Post. "One of the most prominent dangers of capitalism is that income will become too concentrated at the top, undermining the functioning of a consumer-based economy."

FINDING BALANCE

Clearly, policies like EESA are polarizing. We like clarity, not grey areas, so in the face of complexity we tend to make ideological biased judgments. Moreover, we want someone to blame, whether "gluttonous financial tycoons" or "pig-headed politicians." So we take a stand and point fingers.

But if there's one truth that emerges from this economic carnage, it is that "irrational exuberance" is costly; temperance and prudence in the recent boom would have been a desirable alternative. Why then, would we not apply that same lesson to the bust?

Our current financial crisis was created by greed—in overreaching home buyers and insatiable bankers alike. All enjoyed the benefits of hyper-liquidity. The bubble grew incrementally, and none of us wanted it to contract. Like frogs in a warming pot, we collectively failed to recognize an overheating economy in the form of unsustainable expansion.

But as always, the dam broke. And it broke hard. At the point of inflexion, the financial markets flipped from unrestrained greed to unrestrained panic. Irrational pessimism replaced irrational exuberance seemingly overnight. We called it "flight to quality," "risk aversion" or "unwillingness to catch a falling knife." Those who were able chased profits through short trading, credit default swaps and other bearish wagers that punished the weak. Like greed in a bull market, fear in a bear market is a self-fulfilling prophecy. Thus, self-preservation has contributed as much to this financial crisis as the self-indulgence that seeded it.

Rather than stampeding over a cliff like lemmings, perhaps we would be better served by taking stock of the situation, accepting personal responsibility, modifying our behaviors and moving forward. EESA has been approved by the legislators elected to make such decisions. How might we expect it to help?

EESA: HOW WILL IT WORK?

Illiquid debt assets on the balance sheets of our financial institutions are the heart of the problem; there is no meaningful market for afflicted institutions to sell these troubled assets. Consequently, value is in a vortex. Laing comments "A negative feed-back loop has developed for the banks in their pell-mell rush to deleverage, raise capital and remain liquid. The more mortgage securities they sell, the weaker the prices get, which, in turn, forces even more security sales at ever lower prices in a futile attempt to outrun the credit tsunami."

EESA intends to establish a value for these assets, accelerate recognition of appropriate losses, rebalance the capital ratios of participating institutions, increase confidence in short-term interbank lending, and (it is hoped) clear the log jam in our capital markets. Essentially, the Treasury will attempt to leverage the largest balance sheet in the world (the U.S. government's) to break the negative feedback loop that is destroying capitalism.

Some are concerned that $700 billion in asset purchases may not be sufficient to absorb all of the troubled assets. According to Goldman Sachs in its October 3 US Economics Analyst report, approximately $11.3 trillion in face-value residential mortgage debt is currently outstanding. Of this, roughly $1 trillion is delinquent or in foreclosure as of the second quarter 2008. Another $150 billion in commercial loans are delinquent or in foreclosure. Given that the Treasury will buy assets at a substantial discount to face value (Bill Gross of PIMCO estimates 65 cents on the dollar), it is likely that the $700-billion-capitalization yields buying power approximately equivalent to the face value of bad real estate debt.

It is not yet clear how the assets to be purchased will be valued. The Treasury is required to provide guidance within 45 days of enactment (mid-November) or two days after the first auction is held. Goldman Sachs expects the first purchases in the first week of November. A major purpose of EESA is to establish a value for troubled mortgage assets that is greater than the current "fire-sale" pricing. According to Goldman Sachs however, congressional testimony and legislative discussions imply that the program should not attempt to artificially infuse capital into troubled institutions by paying inflated prices to buy bad assets. Instead, the Treasury is likely to estimate the intrinsic "hold-to-maturity" value of the securities, and use this price as a benchmark in auctions.

The program will probably focus on helping major money-center banks on Wall Street, which hold the majority of the illiquid securities being targeted. However the balance sheets of main street institutions, such as regional banks, are equally troubled by bad residential loans (primarily land and construction debt). It is yet unclear how EESA may benefit or ignore thousands of small banks. However, enhanced liquidity at the top of the food chain should flow throughout the system and relieve pressure everywhere.

Laing dismisses the notion that U.S. tax payers will get stuck with the bill. His analysis (and that of Warren Buffet among others) suggests that the whole endeavor could turn a tidy profit. The Treasury is taking advantage of an extraordinarily low cost of funds (3 percent to 4 percent T-Bills) to "invest" in assets at a historic benchmark low; even with draconian default and recovery assumptions, the Treasury stands to make a positive 7 percent to 8 percent yield spread on the purchase. What's more, the Treasury is unhampered by balance sheet ratio requirements or shareholder return expectations that could force untimely liquidation.

The sheer volume of the investment may reverse pricing. Jeffrey Gundlach, Chief Investment Officer at TCW Group, an important mortgage fund managing firm, sees this as a distinct possibility. "Essentially this secondary effect would do much to lift housing out of its funk and actually improve the performance of the securities that Treasury ends up buying," he says. "Thus, I think that there's a good chance that the bailout plan will be a win-win for both the taxpayer and the financial system." If the Treasury buys right and holds these assets long enough, prospects for the U.S. taxpayers are good.

PERSONAL RESPONSIBILITY

So who crippled capitalism? We all did. Everyone played a role in creating this crisis-admittedly some more than others. So there's little point bickering now.

Opinions on how best to prevent further problems-or worse, a recurrence-will vary. Tighter regulation and legislation will no doubt play a role, to the dismay of some and the relief of others. But we cannot regulate away this social issue because capitalism, like democracy, is flawed, as is our ability to legislate human nature.

Our systems are inherently unstable because they rely on an unstable source of authority-us. Capital markets are supposedly disciplined by the "invisible hand," the notion that an individual pursuing his own self-interest tends also to promote the good of his community. But the carnage created by our increasingly dramatic cycles of greed and fear suggest that the "invisible hand" of self-interest cannot save us.

Perhaps we should consider reliance on an authority greater than ourselves-an invisible hand that is both benevolent and omniscient. What the world needs now is a cool head, a commitment to move forward, and the character to temper our self-preservation instincts.
This kind of peace and resolution stems from only one source. Currency is merely a symbol of the value we imbue to our economic and political systems. So when our systems fail and our wealth becomes vapor, where can we turn for stability and assurance? Look no further than the pleasant phrase printed on every U.S. coin: "In God We Trust."

About the author:
Author, Steven Orchard, contributes articles on current events and politics, social issues and society and culture for Vision Media. More information on these and other topics can be found at www.vision.org.

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