The Sub-Prime Crisis: The Search for Scapegoats Begins

The Sub-Prime Crisis: The Search for Scapegoats Begins

Now that we are experiencing the INITIAL REVERBERATIONS from the residential real estate collapse the hunt for the malefactors has begun. We suspect that this search will intensify as conditions worsen. We are a sophisticated society now, and we might reasonably be expected to behave better than the simple, superstitious folk of colonial New England. But human nature does not change. Consequently, we may well witness a modern Salem witch hunt. We can only hope that the Federal Reserve will act responsibly and promptly to prevent a tidal wave of misery from hitting large segments of the middle and blue collar classes.

The Fed, and the political leadership of the country, need to bear in mind that the political and social consequences of the subprime and FORTHCOMING junk bond crisis will NOT be proportional to macro-economic statistics, which may convey the information that, overall, things are not that bad. Rather, it is the impact of the meltdown on the lives of ordinary people that will be critical. We can be certain that political opportunists will seek to exploit the misery of the soon-to-be-foreclosed, and the anxiety of the larger number who will come to live IN FEAR OF FORECLOSURE. This very sizable group will be susceptible to demagoguery of all sorts. The successful exploitation of popular outrage and fury could have significant negative impact on US trade and immigration policies, as well as upon international financial cooperation. This danger will grow if deep anger takes root among those who suffer the cruel destruction of their American dream, just as they had come to believe that it was finally in reach. Nor is it only the impact on this group which could prove significant. There is the much larger group of relatives, friends, and neighbors who will live in growing apprehension that they will be the next to be engulfed by the nightmare.

The wavelets which are now striking our financial sandcastles are likely to be followed by more powerful waves. It is doubtful that the debt-laden household balance sheets of many American families can withstand the coming financial stress, even if these households manage to avoid dispossession. The standard of living of a substantial number of Americans will decline noticeably. There will be much pain.

There are different levels of responsibility for the unfolding crisis. In the final analysis, four elements underly every mania and subsequent bust: greed, the herd instinct, lack of foresight, and fear. The dynamics of manias are quite well known. They have been comprehensively documented in the marvelous 150-year old classic, Charles MacKay's "Extraordinary Popular Delusions and the Madness of Crowds." This remarkable book provides the best explanation even of manias which have taken place 150 years after its publication: the tek stock bubble and now- punctured real estate bubble.

To add our own small refinement to MacKay, we would suggest that there is a crucial distinction among manias in terms of their origin and course of development. In many cases, manias arise in an essentially spontaneous manner. The Dutch tulip mania, the South Seas bubble, the Mississippi bubble and others fall into this category. And then there are other manias, those which are nourished, stoked, manipulated, and even created by self-seeking individuals and organizations. The residential real estate and facilitative financing mania falls into the latter category. And it is here that the political and social danger resides.

One could plausibly argue that the recent real estate mania is but the latest in a series which have punctuated American economic history. Indeed, recurrent bouts of land speculation have historically gone to extremes -- culminating in crashes which have produced shockwaves transmitted to the economy through the attendant liquidity crisis and producing a general economic depression. We believe, however, that the just-punctured mania did NOT arise spontaneously.
In our view, the FEDERAL RESERVE PLAYED THE DECISIVE ROLE in generating the mania. It was the erroneous Fed decision to inundate the financial system with liquidity which fueled the real estate frenzy, transforming it from a limited speculative movement into a true mania.. Consequently, PRIMARY RESPONSIBILITY for the mania rests with the FED. This does NOT mean that we should feel gratitude to the FED for deliberately puncturing the bubble it created in the first place. (Yes, we know that the Fed continually denies that it targets asset prices. We are inclined to doubt the veracity of these denials, however. Perhaps we are too cynical, but we are inclined to see here a demonstration of Shakespeare's insight: "Thou doth protest too much.")

The FED not only produced the requisite flood of liquidity, but then proceeded to bury its head in the sand as the mania it created intensified. Thus, the second echelon of Responsibles, the "financial engineers" of Wall Street, were permitted to design and market instruments to bundle and securitize huge numbers of dubious mortgages without the slightest regulatory oversight or interference.
Then came the next level of Responsibles, the rating agencies, who cast prudence to the winds as they awarded gilt-edged ratings to securities whose value could be maintained ONLY IF HOUSE PRICES ESCALATED AD INFINITUM. Since it is well know in the financial industry that markets are CYCLICAL, and since it is equally well known that real estate is both HIGHLY LEVERAGED AND HIGHLY ILLIQUID, all those who had a hand in creating, marketing, and rating these mortgages and the securities they were used to underwrite share responsibility for the subsequent debacle.

The next level of RESPONSIBLES are the sophisticated financial institutions who purchased these securities. These institutions--the most important of whom were BANKS--failed to exercise the appropriate due diligence. While greed-driven outfits like hedge funds could perhaps be held to a lower standard of accountability, banks must be held to the highest standard. They are not only fiduciaries backstopped by taxpayer money, but they play a crucial role in the economy. The sad, but inescapable truth is that banks are prone to cast prudence aside when there are big bucks to be made.

The American banking system does indeed seem to have an incurable penchant for engaging in ever greater risk-taking as asset prices and loan profits mount. Their behavior during the real estate mania once again demonstrates the eerie accuracy of the Minsky/Fisher financial instability model. And here it should be noted that this model can hardly be unknown to those FED policymakers who are professional economists by training.

In the end, those principally responsible for the catastrophe will escape blame, we suspect. The FED, in particular, is likely to emerge unscathed. There is simply too much at stake for the powers that be to allow blame to be placed where it belongs. Wall Street investment banks will probably get a slap on the wrist and be required to fork over a billion or two. Ditto the rating agencies, though their fines will be lower (in view of their inferior degree of wealth). The major banks will be sternly instructed to tighten up on their "risk control" procedures.

The brunt, we suspect, will fall on the little fish, as is customary, while the big fish go merrily on their way. Individual mortgage salesmen and brokers, appraisers, low-level lending officers, real estate agents, small mortgage companies and banks will likely be the sacrificial lambs offered up to appease public fury.

And what of the victims? Are they blameless? We think that, in large measure, they are. Yes, they got greedy. But their greed was very limited. They wanted a home, a tiny sliver of the American dream. They were naive. They were ignorant. They were untutored. A modern, liberal society demands government regulation to keep the haves from crushing utterly the have-nots. The regulatory apparatus, in limiting slightly the opportunities for riches and power of the few, actually protect this elite from its own voracious appetite. The failure of the regulators to regulate has caused incalculable losses and will soon generate enormous misery. These losses will ultimately be absorbed, and the worst consequences of the debacle avoided, on the back of the much abused American taxpayer.