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Looking Backwards to Look Forward
By: Dr. Charles Lieberman
Date: 12/21/2009
In anticipation of our next commentary on the economic and investment outlook for 2010, it seems appropriate to review what happened over the past year to better understand where we are. Conventional wisdom holds sub-prime and Wall Street lending practices responsible for the meltdown that produced the worst recession since the Great Depression. Lending practices were poor, but these faults were exacerbated by poor regulatory and supervisory activities and compounded by pro-cyclical accounting rules that enlarged losses further by forcing sales at depressed prices. Since these failings are still largely unaddressed (nor do they seem to be the focus of various reforms), the possibility remains for a repeat performance somewhere down the road.
It is all too easy to blame the collapse in housing on bad behavior behind sub-prime lending. But all sub-prime loans taken together were a small fraction of the losses suffered by the financial system. The problems really did begin with housing, where construction in 2005 and 2006 was significantly above the rate of household formation, yet builders continued to build. The easy credit terms of the period clearly helped, as did the willingness of some bad actors to fabricate loan documents to enable poor credits to qualify for mortgages, as well as the sloppiness of lenders to accept such faulty documents. But this activity postponed and exacerbated the day of reckoning. If the unethical behavior had never occurred, the housing market would have still experienced a significant meltdown because there was simply no way to reconcile the high level of new construction with the size of the population.
The regulatory system did nothing to protect against these practices. The lending mistakes that placed sub-prime debt on the balance sheets of banks and other investment firms were clearly not adequately supervised either by bank risk managers or by bank supervisors. Compensation practices at banks are now under review to ensure that they do not provide undue incentives for employees to take excessive risk. As expected, the government is pressuring banks over bonuses in its typical ham fisted way, with high regard for show and little regard for substance. Even worse, the bank regulatory system is being revamped, but subjected to all kinds of political pressures. Sheila Bair is fighting hard to prevent the FDIC from being subsumed by other agencies in the reform. But she is not alone. Every regulatory agency is being defended. So, the alphabet soup of regulators is not overly likely to be whittled down, thereby keeping alive overlapping and disjointed regulatory responsibilities. Politicians are trying to blame Bernanke and the Fed for the failures, which diverts thinking away from the regulatory mish mash they created and continue to support. There is still a possibility for success in that the new regulatory system has not emerged yet. However, Congres's approach does not inspire hope that the new system will be efficiently designed to do the job.
The role of the accounting system in the crisis has been noted, with little effect so far. It is recognized that the accounting system forced firms to recognize losses on performing loans and to raise capital at the most inhospitable time, diluting shareholders and depressing asset values across the board. Nevertheless, it is not clear that debate or thought has advanced beyond recognition that mark-to-market accounting contributed to the crisis, yet advocates remain convinced that all assets must be valued at markets prices under all circumstances. There is an unambiguous need for financial firms to retain sufficient capital to absorb losses, but the system should not create new capital needs at the very time the system is under stress. These issues are far from being resolved.
Regarding the economic environment, the economy nearly collapsed in the aftermath of the intellectually deficient logic of Henry Paulson that allowed Lehman to fail. The economy was already weak and in a mild recession before Lehman went under, but the situation worsened dramatically afterwards. The Lehman failure caused credit markets to freeze up and firms and households to hunker down to cope with the uncertainty. This was not unlike the shocks that hit during the early stage of the Great Depression. Importantly, the shock was recognized this time and the Treasury and the Fed took strong action fairly quickly to support the system. Still, some politicians prefer to pander to the populist atmosphere by trying to punish anyone involved in the failure, which could be counterproductive by keeping uncertainty high, forcing noneconomic decisions, and possibly postponing recovery. The government forced the sale of Citigroup's commodities division for a pittance over compensation issues and drove down the stock price as Citi was trying to raise capital. Then, the government chose not sell off any of its shares in the offering, because the price was too low. And politicians are still telling Fannie Mae and Freddie Mac to lend to low income households, as if they have learned nothing. Well, politicians will be politicians. At least the Administration and Treasury have been stalwart in support of fiscal stimulus, while the Fed has been heroic in its efforts to unclog credit markets and providing monetary stimulus. These efforts are bearing fruit and the system is recovering very nicely.
The economic environment is vastly improved at the end of 2009 compared to the chaos that reigned a year ago. Even the most troubled credit markets have recently reopened, including commercial mortgages, asset-backed securities and bank loans. Across the board, firms are raising equity, rolling over debt, and pre-paying debt maturing over the next few years. Significantly, firms are loaded with cash, even as profits are rising and the outlook is improving. The normal cyclical pattern of production falling far more than sales has occurred, depleting inventories at a record pace. The rundown in unsold stocks helps provide additional impetus for a rebound in activity during the recovery. The stage has been set for an economic recovery, which will be the subject of our next commentary.
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