In the wake of the worst financial panic since the Great Depression, Americans and the world are anxiously awaiting passage of the allegedly vital Emergency Economic Stabilization Act (EESA)of 2008. An act of Congress that might maintain confidence and liquidity in our tattered banking system until the next train wreck occurs.
At its core is a simple fact about this latest financial debacle. Government created a moral hazard in the housing bubble culminating in the sub prime mortgage credit crisis. It did that by eliminating customary underwriting standards for mortgages made to normally unqualified applicants to purchase homes. These applicants couldn't possibly repay the mortgages. The originators of these sub prime mortgages were betting that escalating housing prices would bail them out. Disaster followed naturally in the wake of this human folly. The magnitude of that moral hazard can be seen in the more than 18 million 'new home owners' created during the peak of the bubble. Not so long ago President Bush and those low income housing advocates in the Congress trumpeted 'the great home ownership society.' Scam artists like Countrywide and other mortgage origination companies and the corrupt leaders of Fannie and Freddie Mac made sure they got paid off handsomely, while exploiting the moral hazard. The old dictum: "bulls make money, bears make money, but pigs get slaughtered' has been proven once again by this latest disastrous caper.
Then, where were Congress, the Securities and Exchange Commission and the Commodity Futures Trading Commission doing nothing to control the ballooning derivatives and credit default swap markets trading trillions of dollars every day? Back in 2003, Buffet called these complex, not very well understood financial instruments, 'financial weapons of mass destruction.'
One illustration of that is the demise of AIG because of the trading in this toxic stuff out of the unregulated London market. Just imagine that a group of less than 377, out of 120,000 employees were able to generate one quarter of AIG's income through these virtually naked trades. Amazing! Then they got greedy a few years ago and succumbed to the siren-like suggestions by both Goldman Sachs and JP Morgan Chase about underwriting credit default swaps (CDS). Poof went AIG. The major international insurance group was saved from extinction by an $85 billion dollar bridge loan the proceeds of which will be used to cover the losses of the defaulted CDS trades. Witness this comment from Joseph Cassano, the head of the AIG derivatives trading unit at an August, 2007 industry forum in a front page story on the AIG demise in the Sunday New York Times:
“It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of those transactions.”
Markets are not perfect. However markets are generally better than governments at setting asset prices. In this crisis the markets can't price defaulted mortgages, collateralized debt obligations and credit default swaps - a toxic brew. On top of that we lack transparency, accountability and oversight. What's the old saw - "who is watching the watchers?" No one was watching the watchers in this debacle.
Stock markets, as Warren Buffet said last week, are very emotional in the short run. However, Buffet said that they may in the long run enable one to weigh values. Buffet learned well from the fabled Ben Graham at Columbia Business School, that value investing, not gambling on earnings forecasts, pays off. That insight was the product of the Great Depression. It has minted a veritable fortune for the 'wizard of Omaha' and some others who follow the dictates of the 'bible', "Security Analysis,” originally authored back in 1933 by Graham and Dodd.
Watching the folks down here on the Gulf Coast scrambling this morning after Wachovia 'merged' with Citigroup, another winner, has got to make them all very uneasy about who and what will be next on the list of 117 'troubled' banking institutions being watched by the FDIC.
One of them may be BB&T a middle-Atlantic and Southeastern regional depository institution with 138 billion in assets, 1,500 branches and a troubled $8.6 residential mortgage and construction lending book. The chairman, John A. Allison, IV had the ultimate chutzpah of sending the bank's depositors a blitz email via the branch heads excoriating the subsidizing of failed major banks under the proposed EESA, while trumpeting his group as being allegedly well run and well capitalized. That was Friday morning. Friday afternoon, I received a Bloomberg.com news alert indicating that Merril Lynch had downgraded BB&T because of its questionable loan book. Go figure.
There is an old industry joke that was I fond of retelling at moments like this when "schaden freude" (joy at the anguish of others) occurs in the Calcutta of Wall Street (I lived through black Tuesday in October, 1987 just after a number of us had purchased via an LBO, a regional broker dealer and small investment bank) comes to mind.
The scion of a wealthy New England family graduates from Harvard College with what we called a 'gentleman's C average'. In a family wainscoted drawing room speaking in quiet anguish with his dad, a Harvard alum, he says: "I can't get into the law school, business school, even the graduate school of education-what am I going to do, dad???”
His father attired in a quilted smoking jacket, hands curled around a brandy snifter turned to his son and said: “Don't worry, there's always banking and insurance.”