Current Event (Part I)

It is yet another day that major stock indexes plunged deeply. The specter of a global recession is looming large. Given the financial turmoil that we are in, attention seems to be shifting away from the upcoming presidential election. I feel urged to jot down some thoughts on current events to remind myself later that I’ve once lived through this tumultuous time.

On the Financial Crisis

The financial collapse, I think, can be understood from a very basic economic principle, the principal-agent problem.

Back in the old day, the home mortgage industry was fairly simple - banks offered loans, those loans were purchased, held and backed by Fannie Mae, Freddie Mac. But when financial legislation allowed investment and securities firms to enter the mortgage world in the 90s, mortgage financing became vastly different. Banks still issued mortgages, but rather than holding them, sold them to an aggregator (like Lehman and Goldman) who then packaged these loans into various kinds of mortgage securities to sell to all kinds of investors. So your mortgage payments did not go to the bank who lent you money, but to pay the interest on those securities.

The principals in this case are the poor investors who bought these securities from an opaque network of trading and securitizing firms. They relied on the mortgage originating institutions – the agents – to tell the truth about the risk involved. But the banks’ agenda was to write as many mortgages as possible – including high risk mortgages to people with questionable credit– to gain more fees since after all, they would sell mortgages to a bundler and recover the money upfront; the incentive for banks to carefully assess borrowers' default risk was simply not there. The agents (banks) then lied about the amount of risk involved. The principals (investors) had no idea how exposed they are.

The consequences of imprudent lending are disastrous. When borrowers couldn’t service their debts, mortgage-backed securities lost value and the banks that held them lost capital. The results are the freezing up of credit and downward spiral in asset values, both of which are lethal to the economy.

In such a crisis, government emerges as the lender of last resort, the only entity with overarching power and discretionary resources to infuse the much-needed liquidity to the capitalist system. A plausible plan, proposed by Paulson-Bernanke is to buy off the toxic mortgages from the banks’ balance sheets, hold them and sell them in an orderly way later. In theory, this removal of bad assets will restore confidence to banks so that they can start lending again. It can also potentially be a lucrative investment (buying in at low price, selling at higher price later). With some luck, we might even hope that the strategy will reduce the current fiscal deficit. But when Congress finally got past bi-partisan politics and ideological differences to legislate this remedy, it seems that it's already too little, too late. So far, the rescue package hasn't done much to stop the market crash from propelling even further.

It all started with capitalist greed – financial institutions’ desire for accelerated profit - and lax government oversight and regulations. What would have previously been unthinkable --the buyout of private sector’s bad debts and partial government control of Wall Street firms-- had become real. Contrary to neo-liberalists’ thinking, unfettered market planted the seeds of its own destruction. We are at the end of an era, the end of ‘leave it to the market’. Less government is NOT always better government.