The genesis of this economic meltdown we are facing is now starting to come into focus. The underlying reasons for it are complex, but they boil down to this: We removed most of the constraints on financial players through deregulation, then we removed the risk of investing for them, and they responded by exploiting that system for all it was worth, completely unrestrained by any sense of fair play or morality.
In a profanity-laced article in the December issue of Conde Nast Portfolio, Michael Lewis starts by wondering why anybody would have hired him and paid him hundreds of thousands of dollars to dispense investment advice, when in his words, “I didn’t have a clue”. He was not alone. Wall street had invented a money machine, and he and others were there to perform “tasks of no obvious social utility”. Presumably, in order to justify the unimaginably large bonus packages, the bosses had to at least pretend to have a research staff. After all, the amazing results they were producing must have been a result of the hard work performed by lots of really smart people, right?
In the old days a bank or other “investor” lent money for a mortgage only after thoroughly checking on the credit-worthiness of the borrower, required the borrower to take on substantial risk of loss by requiring large down-payments, and then kept the loan in-house as an investment asset. If anything went really wrong, they looked to the underwriters, whose jobs would be on the line. And they often would find out how they could help the struggling customer regain his footing. But if they had to, they would not hesitate to foreclose. Lately, though, that became a quaint old relic of a business model.
The new model worked like this. Every loan ended up in the hands of Fannie Mae or Freddie Mac, or in the hands of investors who had no idea just how shabby the “asset” was. The new model meant that none of the players had any real risk. If the loan went bad, nobody lost what they had already been paid – not the realtor, not the mortgage broker, not the settlement agent or even the lender. When the ‘players’ realized that they had no risk of loss, the only remaining constraint on them was their moral fibre. Sadly, we have learned all to well that many of them were already bankrupt morally, and their unrestrained pursuit of the wealth of Croesis has now bankrupted much of the world financially.
Not to put too fine a point on it, but when a strawberry picker with an income of $14,000 and no savings or investments or assets can buy a house priced at $720,000 just by signing his name, something is going to give. Most of us had no idea it had gotten that absurd.
Meanwhile, the ‘movers and shakers’ on Wall street figured out how to leverage even that. I don’t want to get too technical, so I’ll just put it this way: It wasn’t good enough for them to make the fees on deals like the one with the strawberry picker – they wanted much more, and in the end, they invented a kind of financial alchemy that allowed them to make fees on many multiples of the mortgage deals that were actually made!
Have you ever wondered how Wall Street executives could make $50 million and more in annual compensation? Where does all that money come from? Are the guys who make that much money really that much better than everybody else? It turns out they never were. It turns out they had their hands in our pockets all along. It turns out that they were thieves on a scale that makes even Bernie Madoff look bush league.
So we tried to deregulate, but we left out the checks and balances. Once we had a system in place that removed all risk, the greedy money grubbers played the system to the hilt. So what do we do? How do we keep this kind of thing from happening again?
My belief is that we can’t and we won’t. Oh, we’ll try, and try we should. But human nature being what it is, fair and moral behavior needs something else to keep it honest. It needs, as Sen. Charles Schumer said this week, a carrot and a stick. The carrot here is a system of checks and balances and the stick is a system of penalizing the wrongdoers so as to make them hesitate at some point for fear of the consequences. We will almost certainly get a very big stick once we are done with the wailing and gnashing of teeth, and on balance, that’s probably a good thing. One can only hope that our leaders can come up with some really good carrots.