The Financial Tsunami
“We are in the midst of a serious financial crisis,” President Bush told the American people in a televised national address on September 24. The “entire economy” of the U.S. was in danger, he explained; the market was “not functioning properly, and “more banks could fail.” Alan Greenspan, former Chairman of the Federal Reserve, a few days earlier had described the crisis as a “once-a-century” phenomenon and the worst he had ever seen. Others referred to the meltdown on Wall Street as a financial “tsunami” that could overwhelm all regular economic activity in the U.S. and create not just a recession but an economic depression not seen in the U.S. or the world since the Great Depression that followed the Wall Street Crash of October 1929.
The headline-grabbing parts of the economic collapse were the catastrophic events that started on the weekend of September 7, 2008. The U.S. mortgage giants Fannie Mae and Freddie Mac were taken into U.S. government “conservatorship,” in the words of U.S. Secretary of the Treasury, Henry Paulsen, because they had gotten so seriously into debt. The next weekend, the 158-year-old Wall Street investment bank Lehman Brothers, a corporation with assets of more than $600 billion, declared bankruptcy. It was saved from total liquidation by being bought by the British international banking giant, Barclays, for a fraction of what its what its net worth had been just a few months earlier. The Lehman Brothers bankruptcy was the largest ever recorded in U.S. history.
Then, over the same two days, Merrill Lynch, a global financial services firm whose advertising image was a rampaging bull signifying the prosperity to be acquired in a “bull” stock market, was bought out by Bank of America. Next, a third shoe dropped; AIG, the world’s largest insurance corporation, and the world's 18th biggest corporation, suffered a liquidity catastrophe that threatened its imminent collapse. This was averted only when the Federal Reserve provided a bridge loan of $85 billion dollars.
On September 25, 2008, federal agents from the Office of Thrift Supervision—despite its Dickensian-sounding name, this organization is part of the Department of the Treasury and was formed only in 1989—descended upon Washington Mutual Bank and seized its assets a week after it announced that it had put itself up for sale. With assets close to $310 billion, Washington Mutual’s collapse was the largest bank failure in U.S. history. The day before, President Bush, in his national TV appearance, had given his warning that “more banks could fail.” The grim story seemed likely to continue.
The White House, oddly, seemed almost muted in its response to the cascading financial crisis until the President’s TV appearance on September 25. The man it seemed eager to push forward to explain the crisis and propose a solution was Secretary of the Treasury Hank Paulsen. A lanky former lineman for Dartmouth College and a Christian Scientist, Paulsen teamed up with Federal Reserve Chairman, Ben Bernanke, to try to create a taxpayer-funded financial rescue package for an American economy that was teetering on the brink of complete collapse. Paulsen’s solution was a gargantuan federal government bailout that would pump $700 billion into the U.S. financial system to try to unclog the arteries of the U.S. financial credit system.
Did this financial tsunami sweep onto the beach while no one was watching? Hardly. Several Cassandras had warned that the long years of easy credit was imperiling financial stability. And who was to blame? Was it the “greedy” Wall Street titans of finance? Well, in part, but only in part. The 2008 financial crisis fell upon the U.S. and the world because of a “perfect storm” of differing factors.
First, former Federal Reserve Chairman Alan Greenspan kept the U.S. Federal Reserve interest rate extremely low for several years in a row out of concern that a tight interest policy would inhibit U.S. economic growth. The low prime rate did provide funds for the U.S. economy, which grew at a respectable rate during 2006 and 2007, even while the rest of the world seemed to be slowing down. But low interest rates both encouraged home mortgage corporations and banks to market new home-loan packages and tempted potential buyers into the sub-prime market out of a belief that home prices would continue to appreciate. The American housing market had been rising in value for several years; it was thus easy for lenders to assume that there was almost no risk of a “bad” loan because houses that were foreclosed through the failure of a buyer to pay make mortgage payments could be quickly sold at a profit. Borrowers were tempted to ask for loans far beyond their capacity to pay with the suggestion that they could “refinance” quite soon on the basis of the increased value of the property they were buying.
Inevitably, however, with the pressure to buy houses, overbuilding itself started to happen. With that came a deflation of the bubble of ever-increasing home prices. The housing market went into a serious downturn in 2007 and the area of loans most vulnerable to the decline in property values were the “sub-prime” market of loans to people with weak, or even questionable credit records.
Meanwhile, the mortgage loan officers who had, in many cases, authorized loans on the basis of skimpy or downright negligent claims of income on the part of buyers, passed their risk on to financial institutions who then resold the loans as “assets” to banks and financial institutions in a variety of increasingly complex forms that were generally categorized as “derivatives.” The investment billionaire Warren Buffett had described such financial artifices several months ago as “weapons of mass destruction” in the financial arena. The explanation: the packages of assets contained a sizable portion of deadbeat mortgages whose paper value would probably never be recovered.
Many of the derivatives were sold to British banks and other foreign financial services, whose corporate officers failed to do due diligence on the inherent worth of the packages they were buying from American banks. The result was a steep downturn in the housing market of Britain and several other countries.
Simultaneously with the decline in the value of houses in the U.S. came a relentless rise in the price of oil—close to $150 a barrel at its peak— spurred by increasing global demand from countries like China, and a worldwide rise in the price of foodstuffs. The food price increase stemmed from rising living standards in China and India which had played a major role in the expansion of the global economy.
The U.S. crisis led to finger-pointing in several directions. The most obvious and available culprits were the highly paid CEOs and other executives of the financial services institutions that had failed. Just as newspaper columnists had complained about the 1980s economic expansion being the “greed” decade, so many writers were eager to lay the blame on Wall Street “greed.” The financial high-fliers in New York investment corporations who had dreamed up these often incredibly complex packages of financial instruments and had made big money selling them to other institutions were an obvious target. But “Main Street” greed surely was also to blame. Consumers were encouraged by the lure of a soaring housing market to over-extend themselves financially to the point that, if the market reversed—as it did—they would get into serious trouble and face foreclosure. This happened to a record number of homeowners throughout the U.S. during 2007 and 2008.
A bail-out scheme of some magnitude was obviously needed to free up the inter-bank and corporate lending that keeps the American economy dynamic and expanding. But from the beginning, it was clear that many Americans—perhaps a majority—were unhappy with, in effect, turning colossal amounts of hitherto private property to the control of the government. Representative Jeb Hensarling (R-Texas) said, “We may be looking at national bankruptcy and the road to socialism.” Some were angry that Wall Street fat cats were being bailed out while homeowners in danger of foreclosures would not be cared for under Paulsen’s package. Everyone was unhappy that Secretary Paulsen seemed to want almost czar-like power to fix the economy.
The White House hoped that the Paulsen proposals—which initially were outlined on a mere three-page piece of paper—would be adopted with only minor revisions requested by the Democrat-controlled Congress. But after a day of fiercely contentious negotiations September 25 among Democratic and Republican Members of Congress at the White House with Paulsen and President Bush present, meetings attended by both presidential candidates Barack Obama and John McCain, the promise of an agreement seemed remoter than it had at the beginning of the day. Senator McCain had announced that he was suspending presidential campaigning until concrete steps were taken to rescue the economy. But Democratic Senators and Congress Members complained bitterly that his entry into the bail-out negotiations had increased, rather than reduced, partisan acrimony over the bail-out.
As the weekend approached, McCain and Obama flew to Mississippi for the first of their three scheduled presidential debates. McCain for a while had left in doubt whether he would attend because of the financial crisis. McCain had suffered setbacks in polling as he, initially, seemed less equipped to deal with the financial crisis than Obama did. It remained to be seen whether he would make up any losses in popularity during the first presidential debate, on foreign policy.
Even assuming a bail-out agreement takes the form of a Congressional bill that could quickly be voted on by the Congress, it would represent only the very beginning of dramatic moves that will be needed to rescue the U.S. economy from years of overspending and from a growing national deficit. According Congressmen Jim Cooper (D-Tenn.) and Frank Wolf (R-Va), the U.S. is in debt to the tune of $9 trillion, of which $1 trillion is held by China. In addition, the deficit between entitlement spending and money available actually to fund the entitlements is already $54 trillion and growing annually. The U.S. dollar has lost 15 percent of its value against the Euro in little over a year and Standard and Poor’s Investment service predicts that the U.S. could lose its triple-A bond rating as early as 2012. If that occurred, the U.S. would probably not be able to borrow any serious foreign funds for the indefinite future.
Cooper and Wolf have crafted a bipartisan bill, already co-sponsored by nearly one hundred Members of Congress, to create a bi-partisan commission tasked with the specific charge of recommending cuts in entitlements. Congress—as was the case with the military base closing challenges of the 1990s—would then have to vote up or down on the commission’s recommendations.
It’s not clear whether the current economic crisis will lend wings to that bill or will obscure its significance because of the immediacy of the American credit crunch. One thing is clear; the days of easy credit and careless financial speculation are gone for a long, long time. Perhaps forever.
Dr. Aikman, a Senior Fellow of the Trinity Forum, was for many years senior correspondent for Time.
Columns, David Aikman, Business, Character and Ethics, Leadership, Mon 29 Sep 2008
