Summary
The value of studying history is in the lessons learned from the past. In financial history, that does not appear to be the case. In my financial lifetime, I have lived through the bear markets of the 70's, hyper and stagflation, the revaluing of corporate assets in the 80's, the crash of 1987, the growth of the derivatives markets, the RTC Savings and Loan crisis, the "Long Term Capital"debacle, mortgage-backed derivatives, Enron, and now the mortgage credit market crisis. Most of these had the best and the brightest right in the middle. What was the common element: -NO CHECKS AND BALANCES, OR INCENTIVES TO PROVIDE THEM. -NO OVERSIGHT, EITHER LACK OF REGULATION OR ENFORCEMENT. -NO PROPER MEASUREMENT OF COUNTER-PARTY RISK, DUE TO GUARANTEES FROM GOVERMENT. -NO APPARENT PENALTIES FOR PEOPLE PUTTING DOWN INCORRECT OR FRAUDULENT INFORMATION. All of these were under the guise of being Politically Correct, without consideration given to plain common sense.
Analysis
I have been involved in Market Regulation in the Securities, Futures, and Options (Derivatives) Industry, since graduating Law School. The success of the Exchange traded products was simple. Besides the supply and demand being the there for the product to thrive, there was constant monitoring of counter-party risk, through the clearing house's use of cash, mark to the market. There is open risk for only one days market movement. The capital balances are monitored by adjusting the "haircutting", on a pro forma interim basis. Where there is a question about the validity of the asset, increase the haircut against capital or reduce the assets value. Finally, there are monetary and criminal sanctions, associated with nonpayment or fraud. This is real encouragment for people to be honest. This was absolutely necessary because of the leverage afforded to derivatives. However...
When mortgages go to 90% of an inflated estimate of "market value", with ARMS and other payment reductions, there are also tremendous amounts of leverage. When the government guarantees the debtor's ability to pay, why should the creditor check the information submitted? When the Mortgage Broker gets paid at closing regardless of whether the information on the application is correct, without any jail or financial penalties, fraud or malpractice charges to face, there is no deterrent to NOT telling the truth. In fact, many of the most financially successful brokers, knew what number was needed on each line of the HUD, FHA, etc. form, without regard for the borrower's true information.
When a Bank does not have to mark to the market, assets whose value has declined, there is no impact on their usable capital and a limitation on their lending ability. These are each major factors in contributing to our current situation. Each one eliminates a real "checks and balances" system. We then rely solely on the representations of Individuals, which we should have learned from Long-Term Capital, Bernie Madoff, Enron, etc., can be self-serving and not truthful. (I am uncharacterticaly being kind in the way I just said that). As an astute observer of financial history, we appear to reward people for what they say, no necessarily what they do.
On the horizon... the Credit Card blow-up. Using an increase in credit card interest rates and fees to pay for defaults. Credit Card Companies gave unsecured credit to people who never deserved it. When they abused it and ran into their own individual pre-determined credit limit, we let the credit card companies charge a fee to increase this line, after the fact. Then, when they could not pay for something they should never have had, in the first place, we allow the the same "quasi-bank" credit card companies to increase the interest rate, late charge penalties, etc. to compensate for these defaults. We excepted the Usury Laws to do so. This theoretically "taxed" the same segment, people who can not keep current with their payments. Since the appropriate users don't incur these charges it appears to be a no nonsense solution to the problem. One that is not only " politically correct", but expedient. It makes total sense that someone who can't make the current payment should pay $39 dollars and 29.7% interest, to cover his or her breathern who have already defaulted. I would be willing to bet just about everything that I have that many of the same people facing home mortgage default, foreclosure and eviction, have credit card debt that is not current. Notice how most credit cards payments are due on the weekend, in the hope that they will be received late?
Finally, imagine the ramifications over the past nine month of the Administration's proposal to allow individuals to manage their own Social Security account...
One of the many morals to learn from all of this is trying to solve problems in a politically correct manner, causes more problems. PC is really an oxymoron... if the solution is one arrived through compromise, because of politics, it is probably not the correct one. Doing the right thing usually works.
