Moral Culpability And The Crisis: Our Least Sexy Title Ever

Ever since we experienced the highly enjoyable financial panic of 2008, people have been casting about for someone to blame. And why not? Every great crisis needs an equally great bad guy. It's fun, and it increases the chance that your abject misery will eventually get optioned into movie rights.

But there's one bad guy that's proving surprisingly popular: The homebuyers themselves. Why not? They were the irresponsible borrowers who took on too much debt, far too soon, and sent the economy into crisis. This is America, after all. If you have to hate someone, you might as well hate the common man.

We're probably behind the ball on this one, seeing as how the recession ended while we were suffering a particularly bad hangover during the entire month of June, 2009, so we should probably let this one go. But we're immodest fellows here at the Strawman Blogger, so late or not, we're going to put this myth to rest.

Don't worry. You can thank us later.

First, let's get a few things out of the way. Homeowners assumed too much debt in the crisis. That much is obvious:

And it also had very predictable consequences:

But participating in a crisis doesn't make you culpable for it. When you buy a home, you work with a team of people: Real estate agents who help you shop for a home, lenders who finance it, and industry experts who provide advice and perspective along the way. Each one earns money when you buy a home. And each one earns more money the more home you buy.

And, during the worst housing bubble in American history, each one argued that a bubble wasn't possible.

Realtors fed that delusion. In 2005, David Lereah, Chief Economist and Senior VP for the National Association of Realtors (NAR), argued that, "[t]here is virtually no risk of a national housing price bubble based on the fundamental demand for housing." In 2006, he predicted a "soft landing for the housing markets." Even as late as October, 2007, the NAR continued to peddle the line that, "[t]he speculative excesses have been removed from the market and home sales are returning to fundamentally health levels."

Nor were they alone. On August 18, 2007, celebrity columnist Ben Stein appeared on Cavuto on Business to state that, "[t]he credit crunch is way overblown ... The subprime problem is a problem, but it's a tiny problem in the context of this economy ... It's a buying opportunity, especially for the financials, maybe like I've never seen before in my entire life.

Financial firms were not immune to the excess. Abetted by the ratings agencies, which catastrophically failed to recognize the growing risks in the mortgage market, large investment banks were net long in housing until the bitter end. Even the previously responsible JPMorgan Chase, which had long avoided the collateralized debt obligation business, was eventually burned by the infamous Magnetar trade, losing $880 million on the Squared CDO alone.

But perhaps the most memorable remark came from then-Fed Chairman Alan Greenspan, who stated, "Although a 'bubble' in home prices for the nation as a whole does not appear likely, there do appear to be, at a minimum, signs of froth in some local markets ... Although we certainly cannot rule out home price declines, especially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications."

Homeowners took on too much debt. More than they could afford. But they didn't do it alone. They did it on the advice of their realtors, who assured them that housing was a good investment. They did it with loans from their banks, who were eager to finance mortgages in any way possible. They did so with liquidity provided by Wall Street, who's addiction to mortgage securitization fueled the crisis. And they did it on the advice and encouragement of financial experts and the Federal Reserve itself.

Each of these actors were experts in their own field. Should home buyers have ignored their advice? Perhaps. But arguing that means admitting that the entire mortgage industry was engaged in an exercise of bad faith - providing bad advice to good people, in hopes of turning a profit.

So who was at fault, you ask? Everyone. And no one. That's the trouble with bubbles. They work because they're so damn convincing. If no one believed in them, they wouldn't happen in the first place.

Well. That, and the bankers, of course.

The Bookstores! Won't Someone Please Think Of The Bookstores

We've nothing but respect for Ezra Klein, but this is odd.

Borders probably can't be saved. But what about Barnes and Noble? Over at GigaOm, Michael Wolf argues that they're going to need a radically different model if they're to survive: "In the collapsing world of books, it’s every man for himself, and its time for B&N to accelerate its push into becoming a digital publisher."

Right. So we're pathologically lazy, and didn't really want to take the time to research the current size of the e-book market - not that anyone likes to disclosure their sales figures, anyway. A year-old Forrester research study will have to do. A quick and dirty look at their projections suggest around 5 million consumers. Fine.

Let's put that in perspective. How big is the book trade? Again, we turn to 2009 numbers of questionable veracity: 23.9 billion. E-books pulled in a respectable $313 million.

Hang on a tick. Just north of $300 million? Even if we postulated that the e-book market increased ten-fold in the intervening two years, they'd still comprise somewhere north of 10% of total sales¹. That's big, but it's not THAT big.

It's also assuming a zero-sum situation - at least one of the studies we read suggested that owning an e-reader increased the number of books read, but didn't decrease paperback sales.

Curiouser and curiouser. We're no trained retailer, but it's possible a market the size of the e-book could destroy a company. It just seems unlikely. While we usually promise not to source the Wall Street Journal, we'll make the exception and direct you here. Their take, at least, is that problems facing Borders are a bit more traditional - $1.29 billion in liabilities and intense competition from online retailers. One assumes the recession didn't help.

Anyway. All of this is to say two things: There is no collapsing world of books.  When a book moves to an e-reader, it doesn't disappear. It moves onto a new medium. That's a good thing!

And while book sales might be down, so are sales in everything else. Toyota had to be rescued by the Japanese government back in 2008. That doesn't mean we face the collapsing world of the car.

Border's bankruptcy wasn't driven by the e-book, although it probably didn't help. It was driven by a crap economy and a lot of debt, plus stiff competition from a very efficient online retailer. Eventually the e-reader will own the market - just not quite yet.

 ¹Yes, this is an unedifying miscarriage of basic mathematics. We do not bother to dwell upon the expected market size or the commiserate decline in paper book sales. Forgive us.

The Greece Crisis, Redux

After a long blogging hiatus, we’d planned on bringing you a startling, insightful, and typically lyrically written expose into the Greek crisis. But not for the first time, the bloody Germans have ruined our plans.

For those of you not yet aware, the European Central Bank and the IMF have joined hands to inject a cool trillion of liquidity into the Eurozone. Even in these dark times, that’s not a number to be sneezed at. Markets around the world perked up at the news, ending a rather turbulent two week slide. Happy times for all. Break out the bubbly and the bitter.

The SMB is a little amazed by this turn of events. The Germans run the ECB, in fact if not name, and your typical German is about as fond of your typical Greek as they are of venereal disease. The idea that a group of staid, humorless German bankers would ride to the rescue of the freewheeling Aegeans over the objections of the German public was, if not impossible to imagine, at least a little bit farfetched.

But they did, and they deserve some credit for that. In Germany, children are still told scary bedtime stories of Weimar hyperinflation and that, if they’re not gute kleine jungen und mädchen, a devaluing Reichmark will get them in their sleep. They’re a happy bunch, these German bankers.

As a result, you’ve an ECB that’s terrified of any action that might be seen to encourage inflation or underwrite the fiscal irresponsibility of others. When they first announced a rather underwhelming rescue package of a mere 140 billion euros, the SMB was both unsurprised and nervous. The euro project still looked like it was going to crater in a fairly spectacular fashion, taking a big chunk of the world economy with it.

Since then, the ECB has gotten its act together. But what then, for the future?

First, make no mistake – the can has been simply kicked down the road. The liquidity injections will be used to purchase bonds in distressed countries, allowing Greece to roll over her debt for the foreseeable future. It does nothing to address the long-term potential of Greek default, nor does it change the structural imbalances that have driven Greece debt and deficit to the astronomic levels of 140% and 13% of GDP, respectively.

The first lesson, then, is to not read too much into the rescue. Just as the rescue package hasn’t answered the question of Greece, it hasn’t answered the growing doubt about the viability of the Eurozone. The inquiry has simply been rescheduled to a more favourable time, when the European economy has returned to ruder health and the possibility of contagion is mitigated. But rescued? Hardly. Scratch the skin of the major players, and beneath the surface you’ll see nothing has changed.

Secondly, commentators should resist the urge to view Greece as a moral tale. True, the Greeks were almost comically irresponsible. The idea that an incoming president can discover that his deficit is double the official estimates is stupidity on a breathtaking scale.

But while the Greeks have been a partner to their own downfall, the Spanish haven’t. And in Spain lies the more cautionary tale. Fiscal responsibility didn’t protect Spain from large capital inflows, which drove a bubble economy, a rise in asset prices and wages, and an unsustainable housing binge. And fiscal responsibility hasn’t helped Spain deal with the euro straitjacket on the downside, which makes it impossible to devalue their currency as they’d like.

Perhaps Greece can be saved. Perhaps it simply fails at a time more convenient for its currency partners. The question of the euro, though, is as pertinent, and as unanswered, as ever.

ADDENDUM: It’s now clear to us that the ECB has said that the liquidity operations will be sterilized – even as they purchase bonds, they’ll withdraw an offsetting amount of money from elsewhere in the system. If this all sounds like sewing up someone’s chest wound before stabbing them in the throat, then it’s probably because it is. Hopefully, they aren't serious.

ADDENDUM 2: They’ve also tied up a majority of the funds in a special vehicle that requires parliamentary approval. It’s like they’re actually afraid of doing anything that might result in a degree of measurable success.

Special thanks to John for the German.

In Which We Ridicule Too-Big-To-Fail

Meet the new boss
Same as the old boss
- The Who
Over the next few weeks, the Strawman Blogger is going to try to bury the hatchet when it comes to healthcare reform. The headlines have moved on, and the Strawman Blogger doesn't want to get left behind. Frankly, we need the page hits.

Instead, we're going to transition back into the world of finance. No more individual mandate in this blog; the SMB is all about leverage limits and the crisis in Greece. Get with the times, people.

To kick it all off, we're going to talk about the thing that's on everyone's mind: Too-big-to-fail. These are the bailout banks, the institutions large enough that, when the financial crisis rolled around, the government stepped in to keep them afloat. No one likes them very much, but they're here to stay.

So today we'll talk about the common solutions for the too-big-to-fail problem. We'll discuss their merits and we'll tell you what needs to be done.

Solutions you can use. That's what were about at the SMB.

The Contenders

There are quite a few suggestions to the too-big-too-fail problem, but they mostly fall into three discrete themes. Let's jump right in:

The first theme, as the old quote goes, is that too-big-too-fail is too big to exist. Got a big bank? Break 'em up. Either redraw the old line between investment banks and commercial deposit-takers or find another way to take them to pieces. But they gotta go.

We have sympathy for this position.

The second theme - championed by the likes of Paul Krugman - is that too big to fail isn't the problem. Or at least, not the problem worth focusing on. Krugman in particular has commented that a widespread series of small bank failures would pose the same risk to the financial system as the collapse of one or two large institutions. In his mind, it's the resolution powers of the FDIC that protect us from this risk. When a small bank collapses, the FDIC steps in to mop up the mess. Deposits are protected, assets are stripped and sold.

There is no similar protection for large institutions that have significant operations in the shadow banking sector, relying heavily on short-term borrowing. As these uninsured operations fall outside the purview of the FDIC, there is no mechanism that allows for an orderly collapse.

In this school of thought, something similar to the FDIC is needed for the shadow too-big-to-fail banks. If a capable resolution authority is able to dismantle big firms, protect their deposits, and impoverish their shareholders, the problem goes away. The too-big-to-fail fails.

Thirdly and lastly, there's the package of financial reforms preferred by the administration and congress. They don't do much more than nod in the direction of the too big to fail phenomena. Instead, they believe that a better regulatory structure - in particular, investing the Federal Reserve with oversight of important financial firms, bringing over-the-counter financial products like derivatives onto traded exchanges, and (maybe) creating a consumer protection board will prevent those nefarious and negligent practices that so nearly destroyed the world economy.

That's it. Better regulators? Consider us under-fucking-whelmed. In case you haven't noticed, our current crop of barely competent, functionally handicapped, practically illiterate regulators managed to miss the biggest financial crisis in the last eighty years until it was steamrollering over their fucking legs. It is unclear how they can be trusted to catch the next one.

Not that they would bother to look in the first place. Most regulators are too busy maneuvering for cushy exit jobs in the same companies they're supposed to be policing. Enforcing cuts in your future employer's leverage ratio is unlikely to endear you to Human Resources. It's called regulatory capture: See examples here and here. And here.

But honestly? All of that doesn't even matter. Here's the dirty little secret of the Great Recession: They didn't see it coming. There was no small army of brave regulators railroaded by the power of the Street. There was no corrupt cabal of crooked public servants, turning a blind eye to excess in return for their thirty pieces of silver. No one was outgunned or corrupt. They were just stupid. They drank the Kool-Aid, same as everyone else, and they thought the good times would last and last.

So the next time a financial crisis rolls around, new rules won't help. Caution is temporary. Stupidity is forever.

Our Estimable Opinion

So where does that leave us? Should we break up the big banks, create a resolution authority, or just cross our fingers and hope for the best?

Far be it for us to disagree with a Nobel Laureate, but we think Krugman has it wrong. Or at least, he's right in the wrong way. See, we weren't entirely fair to Congress in the description above. Chris Dodd's bill does include a resolution authority, and it forces big firms to pay into an insurance fund for that purpose. Congress has even bandied about the idea of strict leverage limits. The truth is muddled between our extremes. We lied to you. We're very sorry.

But we did it for a reason. There's a problem with resolving a big, failed firm. No one's ever done it before. Big firms fails during big crisis, and a big crisis is an unlikely time to grow a pair of testicles. We're unconvinced that, faced with a climate like that of September '08, the Federal Reserve would take a cool look around, let out a whistle, and take the axe to a bank like Citigroup. That requires a supreme level of cold badass. Cold badass is not what public servants are known for.

So we take a resolution authority with a grain of salt, for the same reasons we don't believe in better regulation. They both take someone smart, capable, and ballsy in the drivers seat. That combination doesn't come around too often.

Our Estimable Solutions

Break them up. So Krugman disagrees with us. Who cares? Cordon off investment banks from commercial deposit takers, impose strict leverage limits, impose capital ceilings, and then hell, regulate whatever's left if it makes you feel better.

We think this for two reasons. First, the collapse of many small firms can endanger the financial sector, but that's ok. The collapse of a broad number of small firms tends to happen because of a market failure, and market failures may just be unpreventable.

The failure of single-institutions, on the other hand, can be an isolated phenomenon. Long-Term Capital Management didn't fail because the broader economy stopped functioning. It just made a spectacularly ill-timed arbitrage and watched the world play hell with its spreads while its capital drained away. But because it was large enough, and interconnected enough, LCTM was saved anyway.

We don't actually mind saving banks during a market failure. We do mind having to clean up the mess of the rich kids during the not-so-bad times. Too-big-to-exist clears this up nicely.

And lastly, we'll level with you. Why do we really want to break up Wall Street and the big banks? Because we can. Because it's not clear that Wall Street isn't just full of rent-seekers who add nothing to productive society. Because it's not clear that Wall Street today is any more efficient at allocating capital than they were forty years ago. Because there are no real efficiencies of scale for a bank that holds ten percent of America's deposited assets, and a hell of a lot of drawbacks. Because together they drain talent from areas of American industry that could actually use it. Because. We. Bloody. Well. Can.

Maybe, as Krugman says, there will be market failures and global panics and financial catastrophes long after the big banks are dead and buried. Why not? There were before. But given a choice between a world of panics with big banks and panics without, we'll opt for the latter. We'd rather spend our money on people we like.