Gilbert NMO Morris – the noted economist and legal scholar – recently offered his views on the meltdown on Wall St .
 

Hath Hell a Fury this Fine?
By Gilbert NMO Morris

There are two main problems facing the American economy reflected in the current crisis on Wall St. : First, there are over 8,000 banks in the United States . There are too many banks chasing too few actual qualified borrowers. This has cultivated an industry in defiance of supply and demand. As such, a new class of borrower was added to the loan rolls, a borrower that could not repay.

Second, at the same time these unqualified borrowers have been convinced into buying houses at approximately 30% - 60% above their actual objectively appraised value and at a higher interest rate. (This is what is known as a B or C borrower).

If this were the basic situation – just having given bad loans – then the problem would be easily solved. Simply repossess the houses, revalue them, write down the loss in value and rid oneself of the inventory by means of “fire sales”. However, things are not that simple.

I wrote 6 months ago, and again three months previously that the banking system in the US changed, starting in 1977 in a final assault on the Glass-Steagall Act 1933 through a new emphasis on the Community Reinvestment Act (aimed at lending to “underserved” communities). From that three “floodgates” opened:

(1). The Clinton administration tore down the walls between banks, investment companies and insurance companies on the investment side. This lead to new financial products but also to the assumption of risks as never has been seen before.

(2). Those risks could be categorized in types of mortgages: There are two types open for consideration here: Conforming or non-conforming borrowers.

The distinction turns on the differences in the creditworthiness of the borrowers; A conforming borrower or an ‘A’ Borrower pays a lower interest rate (although, it must be said, that if one is buying an overvalued house, the rate of interest may be meaningless). ‘B’ and ‘C’ Borrowers pay higher interest rates. (Even though many of them should not have had loans at all). The core problem here is that both the A, B & C Borrowers end up getting loans larger than they can afford for houses worth less than was borrowed to purchase them.

(3).  Whilst the number of actual mortgages affected directly is very small, because of syndication and leveraging, the impact has been very large; leading to “structural back-flow”. That is to say, in the case of syndication, banks no longer give mortgages. This is now the purview of mortgage brokers. They select the borrowers, the banks lend the money; each bank taking a little piece of each mortgage (this is syndication), followed by aggregators who bundled the loans as financial instruments. Then something funny happened: banks invested in these very instruments containing their loans.  Pension funds and employee savings institutions also bought in. So even though the bad mortgages as a percentage of total mortgages was small, (about 7%), the structural back-flow touches almost every financial institution in America and around the world.

It is for this reason that the Federal Reserve bailed out American International Group (AIG) today. The structural back-flow of pensions, savings plans, the insurance policies of global corporations and institutions worldwide means a meltdown of AIG would have been catastrophic. The problem is, along with the misjudgments described above between the financial institutions and borrowers the problem is even greater between the financial institutions themselves.

Essentially, these institutions must be able to borrow money from each other at favourable interest rates. However, the main problem here they have come to have little, if any, faith in each other’s financial solvency or more importantly, the value of each other’s collateral. As such, intra-bank transactions have been undermined.

The core of the problem is that because of the falling valuation of the houses discussed above (A,B & C Borrowers), they could not place a value on the bank’s assets. Because of syndication, no one institution could vouch for that value. Because of leveraging, the various banks over-borrowed against their assets on the basis that syndication had spread the risk to negligible levels. They were and are wrong. And those chickens are coming home to roost.

I wrote three months ago that because of the leverage positions of financial institutions, the public should expect more bank failures. I myself, welcome the recent bank failures. I would like to see at least 2,000 of the 8,000 banks in the US collapse. The reason is that because of the number of banks, the profit margins of financial institutions narrowed. This meant that the only way to make money was to leverage their balance sheets, sometimes 30 to 1; that is $30 for every $1.00 of actual value. I believe that every investment bank will eventually go out of business. The future of Wall Street will be mainline banks and private equity funds.

The US government’s response to this crisis has been mixed. They misunderstood capitalism (and I am a rapacious small government capitalist), and failed to understand the need for good sense regulation that is both effective and flexible. Their approach to the crisis was to “save” BEAR STEARNS, allow INDYCMAC to fail, allow LEHAMN BROTHERS to die, save FREDDIE and FANNIE MAE and nationalize AIG.

Ultimately, there is no correct decision here. The real failure is not to have maintained or restored confidence in the marketplace. Unfortunately, that has not happened, because again, no one knows the extent of the damage that was forestalled, so no one knows whether it has actually been forestalled and the US government has been less than forthcoming or clear about the broader policy reasons for their actions or the implications likely to follow them. They are trying to deal with a negative balance sheet problem with a liquidity solution. (Think about it, even though Goldman Sachs and Morgan Stanley are sound financially, the crisis of confidence is undermining the market perception of their ability to operate).

Last, a real problem here is that the US government is merely printing money to finance its way out of this problem. This means it is creating the same problem it is attempting to solve by means of expediency. I have written that the Chinese, Koreans and Middle Easterners would diversify away from the dollar. They are. Gold shot up in the largest one-day increase in history today. Additionally, again as I have written, the euro/pound insurgency has proved to be temporary and the weakness of the Euro area economies is now revealed. This is occurring at the same time of a temporarily strengthening dollar, limiting European purchasing advantages. However, the dollars will soon show unprecedented inflationary tendencies as result of the US Treasury’s habit of printing its way out of problems.

What is the global impact of this?

First, the structural back-flow into financial institutions worldwide means we have a contagion on our hands, that may continue to undermine banks around the world. Second, the impoverishment of the American consumer destroys demand for exports from countries ( Japan , China , India , Brazil ) with significant export dependencies. Third, a weakened dollar against the backdrop of the current crisis has the pernicious effect that at the same time that it undermines that purchasing power of the American consumer, that consumer is so debt ridden, and his financial institutions now so anemic that his consumerism can no longer serve as the driver of the global economy. That is to say, higher unemployment rates and a cheapening dollar, would so impact the global economy as to reduce world trade to America and reduce American capacity to absorb that trade.

For nations in the Caribbean , the failure to have diversified our reserve currency positions means we will likely suffer precipitous declines in our purchasing power, and severe reductions in the value of our US dollar reserves.  Second, our economies are so wedded to tourism (and one dimensionally so) that the financial struggles of the American consumer will mean a significant decline in tourist numbers.

A Princeton professor, Immanuel Wallerstein wrote a book some years ago called “The Eagle has Crash Landed”.  He posited that since 1950, America had already been defeated and that we would witness the particulars of that defeat in a host of military and economic upheavals; such as the current meltdown. One may question the various aspects of his thesis – as with any thesis - but altogether, we may be witnessing a visceral financial decline in America ; one that is likely to result in a seismic shift in the global balance of economic power. The US has a trade deficit of  $600 billion; national debt of $10 trillion; is spending $100 billion in Iraq and $40 trillion in unfunded liabilities. Something’s got to give.