2008 is rapidly shaping up to be the year of the disappearing Wall Street giants. The early part of the year saw the rapid weekend collapse of Bear Stearns, bought by JP Morgan Chase for a song.
At 12:58 a.m. this morning, Lehman Brothers announced it was filing Chapter 11 bankruptcy, soon after Merrill Lynch, facing its own financial weaknesses, offered itself up to Bank of America for $50 billion.
The NYT:
In one of the most dramatic days in Wall Street’s history, Merrill Lynch agreed to sell itself on Sunday to Bank of America for roughly $50 billion to avert a deepening financial crisis, while another prominent securities firm, Lehman Brothers, announced it will file for Chapter 11 bankruptcy. [snip]
But even as the fates of Lehman and Merrill hung in the balance, another crisis loomed as the insurance giant American International Group appeared to teeter. Staggered by losses stemming from the credit crisis, A.I.G. sought a $40 billion lifeline from the Federal Reserve, without which the company may have only days to survive.
Analysis below.
The Fed is in a horrible position. If it saves AIG, it won't help for very long, and if AIG fails, then the mess could be as bad as Ike was for Texas. The conflation of crises that we face are staggering, far worse than the late 1970's, quite possibly as bad as the early 1930's, and to explain this, a little history will be necessary.
When Wall Street crashed in October 1929, a lot of people had been purchasing stocks on margin (credit), and so the market was a house of cards that had been waiting for one card to be pulled from the wrong spot. When it was, the whole house came crashing down. What most people don't know is after the initial first few weeks of panic, the market began to stabilize, and in fact, had recovered to its pre-crash levels by spring 1930. However, a combination of fear from Americans (and in economics, psychology is as important as the money; more on that later) and the passing of the biggest economic mistake in history, the Smoot-Hawley Tariff Act, led Wall Street and the nation back to the cliff of financial disaster. The tariff act led to a halving of import-export business, and with key industries such as agriculture losing markets, the system began its collapse. Lack of investment+halving of international business+credit collapse from farm failures (most farmers bought their seed and equipment on credit, a practice dating back to the 19th century, and farm failures then led to Panics, as they were termed in those days, known as recessions today)+bank failures= the Great Depression.
Bank failures are especially scary for depositors. We saw this recently in California, where loaning giant IndyMac failed and was taken over by the FDIC, and people lined up outside the branches to withdraw their money, even though it is insured by the FDIC up to $100,000. This happened back in 1930, except there was no FDIC back then, and the legitimate fear that people felt then helped collapse the banking industry in near-entirety as everyone withdrew their money and kept it at home, out of the market. It may have been "safe," but it accentuated the deepening economic turmoil.
The current Wall Street situation can be traced to several problem areas. The worst is the credit crisis. The foundation of the crisis is the billions of dollars of subprime lending that occurred to boost the housing market post-9/11. Financial institutions gave out subprime loans with all sorts of catches, such as adjustable rate mortages, which have become the bete noire of the banking industry. An ARM allowed for low-interest payments when economic times were doing well, but when the times got worse, the ARM adjusted upwards at a vast rate, and many holders of these mortgages were suddenly paying twice as much a month for their house payment. Unable to afford such a staggering increase, bankruptcies and foreclosures started appearing in large numbers in 2006 and have been steadily rising since.
The problem was accentuated by the massive influx of houses that these foreclosures brought into the market. What had been a booming housing market stagnated, as buyers had far more choices, and could afford to be patient before purchasing a home. The surplus of housing brought prices down anywhere from 18 to 27% on average in areas such as Southern California. New developments, which had also been doing brisk business, lost steam, and would often go bankrupt or stop building halfway through projects, leaving homeowners that bought from these developments with unfinished or slapdash houses, yards, streets, etc. These problems made new buyers leery of purchasing a new house, and added to the time took to decide on and purchase a home. All of this left banks with houses they couldn't sell, which meant thousands of loans totalling millions of dollars that couldn't be recouped, and therefore some serious debt load on their backs.
Why couldn't so many of these people afford to pay? First off, many of them had no business carrying a mortgage in the first place. Secondly, inflation reared its ugly head. As oil prices shot to dizzying heights, it had a trickle-down effect on the price of food, clothing, and other necessities of life, not to mention gas for owners' vehicles. Before the invasion of Iraq in 2003, gas averaged $1.53/gallon nationwide (I am not making a political point, just using this as a timeline point). Five years later, as Bear Stears was collapsing, gas cost an average of $3.85/gallon. Assuming an average-sized gas tank of 15 gallons, two vehicles, and a once a week fillup, the extra money spent on gas alone for a family in a week ran to $70/week. That's $280/month, and that extra money represents a car payment. Add to that the extra costs for food and clothing, and it only gets worse.
The inflation caused by gas prices made it harder for many families to cope. The continued job losses put many of them out on the streets, and the job losses come from companies such as the Big Three automakers, who, having failed to see the trends and invest early in hybrid vehicle development and small vehicle development, were left with gas-guzzling SUV's that no one wanted or could afford with the steep rise in gas. Other places cutting back included Circuit City, who slashed over 10,000 longtime employees who made decent ($10-$15/hour) wages from their stores. Other retailers such as Sharper Image went out of business and filed bankruptcy protection. Airlines, staggered by the fuel price increases, have been folding, filing bankruptcy (in United's case, twice since 9/11), and cutting jobs.
At the top of this mess are the banks. Bear Stearns and IndyMac were bellweathers, indicative of deeper problems on Wall Street. As banks have consolidated over the past 15 years due to relaxed regulation, more money is concentrated in less hands, and a bank failure, which would at one time affect mere thousands, now affects millions. Merrill Lynch, Bear Stearns and Lehman Brothers were all investment banks, not just lenders, but powerhouse firms dating back to the halcyon days of the 1920's. They have mutual funds for millions of Americans, and move billions of dollars with little thought, and they are disappearing with the blink of an eye, absorbed into new institutions. I titled this post the way I did because this financial crisis represents a doubling down by the Federal Reserve and the remaining giants of the banking industry, consolidating even further an industry that had already seen its membership rolls shrinking.
The moves by Bank of America and JP Morgan Chase are stopgap measures, but they don't fix the underlying problems. Not only are these acquired companies carrying severe debt load which will tax the abilities of their new masters, but the underlying issues haven't been resolved in the economic world. The worst of those issues currently is fear.
The polls show that Americans are very preoccupied with the economy. At work, at the gym, at home, on the news, it's all anyone can talk about. The five-year debate over the Iraq War has been reduced to a footnote of the economic debate. This preoccupation rises out of fear.
As I noted earlier, psychology plays a major role in economic crises. Fear tends to cause bad decisions in people, chief amongst them the run on the banks starting in 1930 and the lack of investment in the market. Because Wall Street trading was such a new thing to the majority of the public, when one major downfall struck, people heard the horror stories of those who lost their life's savings and decided they would have no part of it. The lack of investment and lack of faith in banks was a fatal blow for the banking industry and our economy at the time, already suffering from retaliatory tariffs being imposed by foreign nations as a response to the Smoot-Hawley Tariff Act (the SHTA was signed into law in June 1930, but retaliation started months before when the Act passed the House).
As an example of a worst-case scenario coming true. economic fears from this point in time brought us World War II. The sudden drop in worldwide trading combined with our insistence upon being paid our World War I reparations from Allies who received loans (Britain, France) to losers who were being punished (Germany, Austria-Hungary) caused deepening worries in these nations. Britain elected its first Labour government ever (the Labour party at the time being near-socialistic, not the Tony Blair centrists of today), and Germany, well, Germany elected the Nazis, as Hitler's rhetoric about the unfairness of reparations and the steep unemployment in Germany took hold on a nation rife with domestic unrest. While this scenario is unlikely to happen in America, economic crises and the fear that comes with them does produce unwanted results.
Today, we are seeing early signs of the effect that these crises are having. Travel and tourism is down. Gas usage has been cut by nearly 30%. Gift cards, typically used for nice presents, are being redeemed for basic necessities. Stimulus checks (tax rebates) issued this spring were mainly used to pay bills or clear up debt. In short, people are not spending much beyond the necessities of life, and a long-term situation of that short could lead to retail collapse. Retail sales in January of this year were the lowest in over 40 years. Last month's retail sales were in line with January's. This is the greatest sector of employment in our nation, and it is facing some massive hard times. Clearly, without some changes, we will face a drastic economic adjustment, affecting people on a scale not seen since at least the 1970's, if not the Depression itself.
I will not claim to know all the answers, but I have tried to detail the causes of our problems. These are my own personal suggestions.
• Short-term re-regulation of the banking industry and the markets. Enabling legislation should be passed with a three-year sunset, and renewal required thereafter. Clearly, the market is not correcting itself, and sometimes, as in the Depression, it is necessary for the government to step in and sort things out.
• A tax readjustment. Tax credits should be issued to companies in trouble if such action will prevent mass layoffs, bankruptcy, etc. These credits would also be temporary, with a 24-month maximum period of enactment, but might be a better lifeboat than loans, which could disappear in days. Furthermore, such credits should go to companies that keep jobs here instead of moving them to other nations.
• Accelerate timetable for departing Iraq. Since the Iraqi government is sitting on a massive surplus right now, and since violence has abated, now would be the time to accelerate our departure (and yes, I know we've all been screaming this for months, but this is something that should get through to the Wall Street lovers in the White House). We can't hold their hands any longer, they need to get the job done, and they now have the financial resources to allocate to being able to manage their own nation. The money saved from a more rapid departure would help shore up the sinking dollar in international trading by allowing us to buy back a lot of the Treasury bonds (T-bills) being held by foreign nations. Buying back those T-bills is tantamount to paying off our debt, and it brings a weak currency out of circulation, allowing for its rapid strengthening.
• Accelerate investment in renewable energy. Oil prices are causing the inflation that is choking our economy. Drilling, even if began in weeks, wouldn't create an effect for five years. Renewable energy, such as windmill farms, can be erected within 24 months, and would send a signal to investors that we are fervently trying to wean ourselves from oil, which would help bring the prices down (note the drop caused by our sinking consumption until Hurricane Ike hit) and allow for a reduction in the current inflation levels.
These are simply my thoughts as to possible solutions to our current challenges, however, I hope I have provided a decent explanation of the problems we face, along with a historical perspective on economic downturns.
UPDATE: Floyd Norris from the NYT chimes in:
- The capital rules were far too lax, and they still are. They may have made sense if you assumed perfectly liquid and smoothly functioning markets, but that is like saying a roof does not leak when it is sunny and mild.
- The end of the rules separating commercial banks from investment banks — Gramm Leach Bliley — is one reason the government is much more deeply involved now. Bank of America and J.P. Morgan Chase, the fire-sale buyers of Merrill and Bear, have government guaranteed deposits. That amounts to a subsidy, and when times get tough the subsidized firm has a big advantage over the unsubsidized one. To keep the others going, the Fed now will lend them money secured by almost anything they can find, including common stocks.
- Those who were complaining, only months ago, that excessive regulation was making American markets uncompetitive, had it exactly wrong. It was a lack of regulation of the shadow financial system and its players that allowed this to happen. The regulators might not have gotten it right if they had tried to put limits on leverage, or assure that it was clear what risks were being taken, in the world of derivatives and securitizations. But deciding not to even try, and assuming that risks traded secretly would somehow end up in the hands of those most able to bear them, reflected ideology, not analysis.