Wednesday, November 28, 2007

where's the protest? Sub-Prime lending excesses as one more failure of capitalism

I don’t get it. Violations of honest business practices that produced the scandals at Enron, WorldCom, Health South brought about widespread rejection of short-termist thinking as a basic principle for capitalism. But the current crisis in American credit markets precipitated by rather similar violations of best practices has not provoked a similar degree of alarm and concern.

But the current failure of market-behavior to reach beneficial outcomes is more damaging perhaps to the American economy and society than the scandals of only a few years ago.

The consequences of Enron and related abuses of financial reporting obligations punctured a liquidity bubble in the stock market which led to a large fall in the prices of securities. Employees of Enron in particular, which was forced into bankruptcy suffered heavily and many who were buying stocks in the hopes of a continued rise in prices lost money. Within a few years, however, the markets recovered. Short term losses were made up with longer term gains.

New legislation was introduced mandating better financial reporting and oversight of the auditing function to prevent a re-occurrence of those particular scandals.

But this time, excessive extension of credit to sub-prime borrowers seeking to buy houses has boomeranged into a serious threat to the entire American economy. Investors are in a hurried, unreflective, general flight to quality and so many would-be borrowers are being left without cash and needed working capital to sustain their businesses and to expand the production of goods and services.

The system of finance and credit supports an economy; any dysfunction or retrenchment in this sector undermines the entire society’s well-being.

But in particular, the sub-prime crisis has led to more foreclosures on homes, lower housing sales, and falling house values. The poor and the middle class are most affected by this negative move in the activity volume in the housing industry and sectors that depend on consumer demand for housing and related fixtures, etc.

More wealthy Americans have a range of assets at their disposal; the poor and most of the middle class have their houses as their primary source of equity capital. Lower housing prices errode the wealth available to those who need it most, making them more financially vulnerable just as the economy becomes more difficult.

This is not the outcome we should want from modern capitalism.

A price will be paid by those who spawned the excess in risky lending. Both Merrill Lynch and Citibank have lost their CEO’s as a result and taken huge write-owns in their equity. And more bad news for the banking and financial sectors and for the owners of derivatives is still to come we hear.

One reassuring point, I suppose, about markets is that reality always sets in. There is no escaping karma; consequences cannot be avoided by wishful thinking. Raising the level of risk by making too many risky loans leads to some degree of risks actually coming true. And somebody must pay the price associated with those losses when they occur.

So it is with every speculative bubble: someday the bubble bursts.

The trouble, I think, with running transactions on a fee basis (some promoter takes some money and runs) is that fees shield the instigators of the transaction from having to live with long-term risk. Their market function is only to put the deal together. Others are left to bear the consequences.

So it was with the aiders and abettors of Enron special purpose entities, excessive investment in telecom and dot-com companies in the late 1990s and with the packagers of sub-prime mortgages and related derivatives.

Where fees are too high and too easily obtained, systemic risk management suffers. This is an iron law of human nature.


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