Wednesday, June 17, 2009

Cause and Effect: Washington to Main Street to Wall Street

The president had finished his speech today about his new proposal (yet another) on the sweeping reform (and another) in the nation's financial institutions.

The prepared text of the speech was already available before the speech (here), so I took a look.

It's basically the same as what was leaked by an anonymous administration official on Tuesday night and reported on this post here.

After the preamble about the administration's favorite topics (energy, education, and heath care, which quickly made me wonder what they've got to do with financial reform), the president starts to talk about financials. And I start having problems right away. I quote:

"It is an indisputable fact that one of the most significant contributors to our economic downturn was an unraveling of major financial institutions and the lack of adequate regulatory structures to prevent abuse and excess. A culture of irresponsibility took root from Wall Street to Washington to Main Street. "

Is it? Indisputable? Fact? An unraveling of major financial institutions didn't quite occur until after September 2008. The nation's economists tell us that the U.S. went into the economic recession in December 2007. How could an unraveling in September 2008 contribute to a recession started in December 2007?

But more importantly, I think he got the flow mixed up. If I were to craft the last sentence, it would read: "A culture of irresponsibility took root" from Washington to Main Street to Wall Street.

The super easy money policy of the Federal Reserve actually started in the 90's to get out of the mini recession in the early 90's. The Federal Reserve didn't come up with this idea on its own. It was guided by the policies of Washington. It contributed significantly to the sharp rise in all asset prices in the mid to late 90's and to the dot-com bust in 2000. (Read this article written in September 1999. The writer predicted an imminent stock market crash at the time when Dow was high but the global political and economic indicators as he saw them were deteriorating.)

Then this policy was re-instituted anew in 21st century in order to get out of the recession in the wake of the dot-com bust and 9/11.

One of the main focus of Washington for nearly 2 decades has been home ownership. Home ownership was increasingly treated as American Dream, and some kind of "right" of the U.S. residents. President Clinton started it by rewriting the rules for Fannie and Freddie, and then broadened Carter-era Community Reinvestment Act and unveiled his National Homeownership Strategy. "Having your own home is the ultimate expression of optimism," the president said. (See this video from 1994 speech before National Association of Realtors.)

Please watch this video of President Bush back in 2002. He was proposing taxpayer-funded (he spoke so softly when he said the word taxpayer) down payment fund for low income buyers, affordable housing in "certain" neighborhoods (i.e. inner city), "streamlining" the application process so that "fine print" doesn't discourage the buyers (and now Washington is saying the bankers lied), bringing in the real estate industry in, encouraging measures to create a sustained commitment by the private sector. 5.5 million new, minority home owners was Mr. Bush's goal. He challenged the private sector to get after this goal, get focused. $440 billion more capital would be available for minority home owners from Fannie and Freddie, and FHA, who would also quickly securitize the loans made by the banks so that the banks could make more loans.

Is there still any doubt that it all came from Washington?

The government passed a series of legislation to make home ownership "affordable". Now people who wouldn't have qualified for mortgages before or who never thought of owning a home could be the home owners. American Dream. This was the Main Street component of the flow.

Then came the banks. There was clearly a huge demand from the Main Street for mortgages, and the government legislation and various schemes by non-profit organizations put increasing pressure on the banking system to come up with innovation to satisfy this demand. And satisfy they did, with innovation.

They came up with mortgage plans that allowed the borrower a super-low teaser rate, no money down, interest only mortgages. They sold off these mortgages off to Fannie and Freddie who quickly securitized them. Banks securitized the mortgages themselves, too, creating complex bond securities that were supposed to reduce risk by slicing up the mortgages and bundling back together. Prime mortgage slice and sub-prime slice together, but supposedly risk well managed. Investors who wanted more risk and higher return could opt for the lower tranches of mortgage-backed securities.

Then, housing advocate organizations, emboldened by the government measures and pressure, grew more aggressive. Here's an article from October 2007, describing how one such organization, Neighborhood Assistance Corp. of America under Bruce Marks, effectively forced Countrywide (now part of Bank of America) to modify at-risk loans. The very fact that the deal was announced in Washington D.C. shows it was a political issue, not economic or financial.

The hilarious story I heard involved Washington Mutual: a Hispanic man walked in to a WaMu branch, wanted to get a mortgage. The bank gave him the mortgage after reviewing a photograph of him dressed as a mariachi singer.

The housing market, by all indicators, topped in 2006. Smarter investors in real estate, particularly in residential real estate, got out then. But the party continued, on inertia, and people were fooled by continued low-interest and easy access to credit. It's not just Main Street people, but Washington people, too. The policy makers, the Fed officials, they all continued the mantra of "Everything is fine", "Our financial system is sound". Pundits on financial news channels like CNBC openly derided a few people who sounded alarm. (Remember this? These people openly laughed at Peter Schiff and they said Merrill Lynch was ridiculously cheap at $76 and recommended WaMu.)

Washington and its enabler Federal Reserve started it. Main Street and Wall Street followed. Main Street started to buckle first. Two years later, Wall Street collapsed, because the pillars, or the foundation, substrate that supported Wall Street (i.e. Main Street), collapsed. The economists say the current recession started in December 2007. The spectacular collapse of Wall Street didn't happen until September 2008, with a scare of Bear Stearns in March 2008 along the way (which feels like such a trivial event right now, but at that time it felt like the whole world was collapsing).

Who's still standing? Washington.

If the new policy is to be crafted on the assumption, in my mind wrong assumption, that it all started because of Wall Street's greed which dragged Main Street and unwilling Washington into the mess and recession, the policy will not address the core issue (= Washington) at all. I doubt therefore it will achieve the desired result - stable financial system - unless "stable" means "dead" or "near-dead".

The title of the speech says "21st Century Financial Regulatory Reform". Piling more regulation and more bureaucracy doesn't seem to me to be 21st century thing. I cannot help feeling that the speech writer missed the date by nearly a century.

Here's the plan itself, from the Treasury Department special website ( (So that's another new czar right there: Financial Stability Czar.)

The stock market, with 45 minutes to trade, has remained listless. Dow Jones Industrial Average is up 22 points to 8,526, S&P 500 up 1 point to 913, Nasdaq up 17 points to 1,813. Nasdaq's outperformance is not surprising, as it has more companies far less affected by the government regulations and controls.


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