First Quarter 2009
The Meltdown Blame Game
Perspectives on the causes of and the correct solutions for the economic crisis tend to vary tremendously based on one’s political leanings. Two recently published books, both titled Meltdown, provide substantially different viewpoints.
R Katrina Vanden Heuvel and the editors of “The Nation” wrote Meltdown: How Greed and Corruption Shattered Our Financial System and How We Can Recover1. It consists of a collection of left-leaning articles published in “The Nation” between 1990 and December 2008. In an article included from early October 2008, Ralph Nader writes, “The cause of the financial markets meltdown is simple: powerful greed fanned by fraud and reckless risk transfers.” An article by Howard Zinn that appeared later that month adds, “It is sad to see both major parties agree to spend … taxpayer money to bail out huge financial institutions that are notable for two characteristics: incompetence and greed.”
A number of the other articles in “The Nation’s”Meltdown cite deregulation of the financial services industry, conducted over the last 30 years by both political parties, as the primary enabling factor of the crisis. In a September 2008 article, co-authors Vanden Heuvel and Eric Schlosser write that both the Great Depression and the current financial chaos were preceded by years of laissez-faire economics.
Because numerous authors wrote the articles in “The Nation’s”Meltdown, some inconsistencies occur.Several early articles complain that the Community Reinvestment Act was being violated, claiming that too few loans were being made to lower and middle income people. But more of the articles condemn predatory lending to lower and middle class borrowers, where too much money was loaned at too high rates. Stories of working class families that are now in dire financial condition due to predatory lending are included in the text, but its authors seem to ignore the concepts of personal responsibility and thrift. It’s hard to be sympathetic to those home equity loan borrowers who signed applications vastly overstating income and assets. Such borrowers were complicit in loan fraud.
Thomas E. Woods Jr.’s Meltdown2 is subtitled: “A free-market look at why the stock market collapsed, the economy tanked, and government bailouts will make things worse.” The author states that blaming the crisis on greed is like blaming plane crashes on gravity and that the current crisis was caused not by the free market but by the government’s intervention in the market.
Woods contends that the housing bubble was largely created by government policies. “The Fed’s policy of intervening in the economy to push interest rates lower than the market would have set them, was the single greatest contributor to the crisis,” he writes. The federal funds rate3 was cut 11 times starting in 2001, to 1% by 2003, and remained at 1% for a full year. According to Woods, this inexpensive credit encouraged excessive leverage, speculation and indebtedness.
Woods also cites more direct government involvement in housing. Fannie Mae and Freddie Mac are U.S. government sponsored entities that borrow money from the public and purchase home loans from the originators with historically implicit (and currently more explicit) federal guarantees on their debt. These entities also have special tax and regulatory privileges. Fannie and Freddie had access to low-cost funds and grew rapidly. In 2003, efforts in Congress to rein in Fannie and Freddie were unsuccessful, as some politicians argued that reforms would reduce housing affordability. Fannie and Freddie failed in 2008, and were taken over by the government. They were involved with nearly 75% of new mortgage loans and own or guarantee half of the nation’s mortgages. Fannie and Freddie did not dominate subprime lending, but 10% of the loans held by Fannie and Freddie, or about $500 billion, are below prime.4
Woods writes that community organizations also intimidated banks to make billions of loans that they would have otherwise avoided. Many in the conservative media also blame the Community Reinvestment Act for forcing looser lending standards but Woods believes the Act played a modest role in the collapse. He rejects the liberal allegation that adjustable mortgages primarily preyed on low-income borrowers, as adjustable prime loan volumes grew faster than adjustable subprime loans.
Both Meltdown books assert that government bailouts of “too big to fail” financial institutions are incongruous with deregulation. There were many precedents for bailouts long before the current crisis, creating expectations of future bailouts and consequently increasing moral hazards. Moral hazards arise when entities take higher risks on the belief that they can make higher profits if successful, but will be bailed out if they fail. “The Nation’s” Meltdown book strongly advocates more regulation while Woods’s book strongly advocates allowing firms to fail.
Getting Off Track,5by John B. Taylor, is a less politicized and a more analytical book about the financial crisis. He asserts that the Federal Reserve Board should employ a formula that uses inflation rates and the gap between current and potential GDP to set the federal funds rate. Other economists have since labeled the formula the “Taylor Rule.”6 Taylor notes that during the turbulent 1970s interest rates deviated substantially from his rule, but during the long period of relative economic stability between the early 1980s and 2001, federal fund rates rarely deviated from it.
From 2002 through 2005 however, federal fund rates were set far below Taylor Rule levels. The tech bubble had burst, and low rates were deemed appropriate by the Fed in order to reduce the chance of a Japanese-style deflationary period. Low rates created an artificial demand for housing, pushing up both home prices and home construction. Another Taylor model suggests that around one million excess homes were constructed as a result.
Taylor notes that mortgage delinquency and foreclosure rates tend to drop when housing price inflation is high. Lenders typically rely on historical loss rates in setting lending standards. Home price hikes during the housing bubble appeared to depress losses and encouraged lower mortgage underwriting standards. Government efforts designed to promote home ownership, including unrestrained growth of Fannie and Freddie, also contributed to the bubble.
Getting Off Track also analyzes government responses to the crisis. Comparing interest rates on varying loans and securities in 2007, Taylor determined that lenders were concerned about counterparty risks.7 The government, in contrast, initially responded with general interest rate cuts as if there was a liquidity problem. Taylor asserts that once the government recognized the nature of the problem, in September 2008, it proposed the Toxic Asset Relief Plan (TARP), but provided few details. The financial market then realized that conditions were far worse than previously believed and became concerned that the intervention plan was not fully baked. Markets were subsequently shaken by inconsistent, ad hoc bailouts, some reportedly made to firms that neither wanted nor needed bailout money.
Our Views
Clearly there are other factors involved in the economic crisis and bailouts that are beyond the scope of these books and this essay. Exotic derivative securities, for example, magnified counterparty risk for many firms and caused the failure of AIG.
The bailouts have become highly politicized. Bailouts, at least so far, have not created windfalls for shareholders of firms that took excessive risk. Shareholders of failed firms were zeroed out and shareholders of firms subject to forced mergers incurred huge percentage losses. Bailout money for surviving firms is very costly capital and in many cases likely dilutive to shareholder value.
There were certainly excesses by the managements of financial companies during the boom. Just as during the dot-com boom, a number of company managers fabulously enriched themselves, some possibly via unethical or possibly illegal practices. Justice was served to several villains of the last bubble, and may well be served to some this time around as well.
Former Fed Chairman Alan Greenspan used to be considered the Maestro8 in some circles, but now is being attacked as the architect of the housing bubble. One should keep in mind that the implosion of the dot-com bubble destroyed more wealth than the 1929 market crash, and most observers at the time applauded the Fed’s subsequent loose money policy as a solution to that crisis.
“The Bank Credit Analyst”9 believes there has been a debt supercycle, whereby since the 1960s the domestic economy has become increasingly leveraged. Increasing amounts of debt have been created to fund each economic recovery, with a dollar’s worth of new debt stimulating less GDP growth each cycle. The excessively low interest rates from 2002 to 2005 may have been needed to revive the economy but they also furthered this debt overindulgence.
Currently, the domestic economy is receiving unprecedented stimulus. “Grant’s Interest Rate Observer”10 measures fiscal stimulus by government deficit as a percentage of GDP, and monetary stimulus by the cumulative increase in the Fed’s balance sheet. Grant estimates fiscal stimulus this cycle at 11.9% and monetary stimulus at 18.0%. Those rates are off the charts when compared to prior recessions and the Great Depression. Prior peak fiscal stimulus was 5.9% in 2001, while the 1929-1933 fiscal stimulus was 4.9%. Prior peak monetary stimulus, according to Grant, was 3.4% in 1929-1933, while the 2001 monetary stimulus was 1.3%.
This unprecedented stimulus is likely to revive the economy. But, given that excessive stimulus after the dot-com bust drove the housing boom and set the stage for the current financial bust, one has to be concerned about whether the current stimulus will enable a whole new bubble or substantial future inflation. There could be a substantial market recovery if the stimulus works, prior to those concerns developing.
We at Columbia Wanger Asset Management have sought to do our best in managing the Columbia Acorn Funds in these turbulent, painful times. Some decisions worked well. We’ve owned no companies that were primarily mortgage brokers, and we owned few homebuilders during the housing collapse. We did profitably sell some Irish and British banks that later became troublesome, and the remaining banks we owned performed relatively well. Other investments, such as owning companies with higher levels of debt, resulted in losses.
Company management can indulge in excesses, and shareholders need to be vigilant. We are strongly biased toward shareholder-oriented management. We counted stock options and stock grants as compensation expenses well before accounting standards forced the issue. We review proxy statements seriously and vote our shares as business owners. When warranted, we’ve voted contrary to management recommendations for or against company directors. We believe company managers should profit only if Columbia Acorn shareholders stand to benefit; we therefore weigh total manager compensation against company performance. Dozens of times a year, we’ve voted against authorization of what we believe to be excessive stock options or grants. We take our ownership responsibility seriously.
Charles P. McQuaid
President and Chief Investment Officer
Columbia Wanger Asset Management, L.P.
The information and data provided in this analysis are derived from sources that we deem to be reliable and accurate. These views are not guarantees of future performance and involve certain risks, uncertainties and assumptions that are difficult to predict so actual outcomes and results may differ significantly from the views expressed. The views/opinions expressed in “Squirrel Chatter II” are those of the author and not of the Columbia Acorn Trust Board, are subject to change at any time based upon economic, market or other conditions, may differ from views expressed by other Columbia Management associates or other divisions of Bank of America and the respective parties disclaim any responsibility to update such views. These views may not be relied on as investment advice and, because investment decisions for a Columbia Acorn Fund are based on numerous factors, may not be relied on as an indication of trading intent on behalf of any particular Columbia Acorn Fund.
1 Vanden Heuvel, Katrina and the editors of “The Nation,” Meltdown: How Greed and Corruption Shattered Our Financial System and How We Can Recover, (New York, NY, Nations Books, 2009).
2 Woods Jr., Thomas E., Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse, (Washington, D.C., Regnery Publishing, Inc., 2009).
3 The federal funds rate is the interest rate charged by banks, with excess reserves at a Federal Reserve district bank, to banks needing overnight loans to meet reserve requirements. The federal funds rate is the most sensitive indicator of the direction of interest rates, since it is set daily by the market.
4 “Fannie, Freddie Are Pressured As Homeowners Fall Behind,” The Wall Street Journal, 1 April 2009.
5 Taylor, John B., Getting Off Track: How Government Actions and Interventions Caused, Prolonged and Worsened the Financial Crisis, (Stanford, California, Hoover Institution Press, 2009).
6 The Taylor Rule states that the interest rate should be one-and-a-half times the inflation rate plus one-half times the GDP gap plus one. The GDP gap measures how far GDP is from its normal trend level.
7 Counterparty risk is the risk to each party of a contract that the other party will not live up to its contractual obligations. Taylor notes that during the financial crisis, banks became reluctant to lend to other banks because of the perception that the risk of default on the loans had increased and/or the market price of taking on such a risk had risen.
8The reference to Alan Greenspan as a Maestro originated in Bob Woodward’s Maestro: Greenspan’s Fed and the American Boom. This glowing appraisal of Greenspan was published in 2000 (New York, NY, Simon & Schuster).
9 “The Bank Credit Analyst” is a monthly newsletter produced by BCA Research, an independent investment research firm, which offers forecasts and analysis of the U.S. economy and financial markets. The information included in this essay was referenced in the October 2008 – Vol. 60 – No. 4 issue.
10“Grants Interest Rate Observer,” a bi-weekly newsletter, (New York, NY, Grant’s Financial Publishing, April 3, 2009), Vol. 27, No. 7.
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