What a weird world we live in. The leading business pundits (in
print, television, and the blogosphere) have convinced themselves,
along with many investors, that professional doomsayers, Meredith
Whitney and Nouriel Roubini, know more about banking than the CEOs
of Goldman Sachs, Bank of America, Citigroup, and JP Morgan —
Lloyd Blankfein, Brian Moynihan, Vikram Pandit, and Jamie Dimon —
combined.
Ever since the financial panic of 2008, when analysts like
Whitney and Roubini earned kudos for predicting economic mayhem,
they have been treated like all-knowing royalty. Many investors
have lost faith in common sense and have begun to believe anything
these analysts tell them. For example, when Whitney told 60
Minutes that municipal bonds would default in record numbers,
the market crashed almost overnight. She has been wrong and the
muni-market has recovered. Roubini’s pessimistic pronouncements
regularly make major headlines, scaring retail investors out of
stocks at exactly the wrong time.
This is not personal. There is nothing wrong with Whitney and
Roubini. Whitney is a stock analyst. She just started her own
company. Roubini has had a career in academics and government. They
seem to be intelligent and diligent. They certainly are telegenic
and articulate, and have a great sense of marketing. But to argue
that they know more about banking than Blankfein, Moynihan, Pandit,
and Dimon — a group with more than a century of combined banking
experience — seems awfully far-fetched.
So, why do so many people believe it? The answer is that the
conventional wisdom has built a narrative of the 2007–2009
financial crisis that deifies shortsellers, puts halos on the
analysts who apparently predicted it, gives government a free pass,
and belittles Wall Street and capitalism. This narrative has sent
roots so deep that many free-market types, even some conservatives,
believe it despite the fact that it gives comfort and aid to
interventionists and statists.
They believe that greedy, evil, shortsighted bankers jammed
unpayable mortgages down unsuspecting homebuyers’ throats, packaged
up this toxic waste and then sold it to other stupid and greedy
bankers. Wall Street created such a mess that the economy was
almost incinerated. And it would have been if government had not
stepped in just in time, with TARP, Quantitative Easing, stimulus,
and dozens of other government programs.
Whitney and Roubini, along with a few others, are credited with
sniffing this crisis out before it happened. The fact that Roubini
had been predicting recession for years (after Katrina, for
example) does not seem to matter. Because things got so bad and so
scary, anyone who got it right is credited with wisdom and
knowledge beyond actual human abilities. And, of course, because
the bankers caused it all, they cannot be believed. The narrative
says the analysts, economists, and short-sellers who profited from
or predicted the crisis know more about banking than the bankers
themselves.
But this belies common sense. The leaders listed above, their
boards, and their key employees are not in business to rip people
off, nor do they play dice with their businesses. They obviously
take risks (in the sense that business and life are risky), and
they are clearly competitive people who want to beat the
opposition. They may make some people mad, they have made some bad
decisions, and they are not above using their government
connections to cut a good deal. In fact, they went along for the
ride in the mortgage fiasco, hoping to jump before it all crashed,
when they probably should have known better. But analysts who act
like they know more than these bankers, and the journalists who put
them on thrones, are not being honest with
themselves. Analysts are smart and can sometimes see things
that managers cannot. But, when MeredithWhitney says “zombie banks”
and Jamie Dimon says “that’s not true,” who are you going to
believe? The answer depends on what narrative you listen to. The
conventional wisdom says to listen to Whitney because she got it
right once. History and common sense say listen to Dimon.
THE REAL STORY about the financial panic of 2008, the one that
explains what really happened, is totally different from the
conventional wisdom. This better narrative blames government and
regulation for the crisis, not capitalism.
Politicians on both sides of the aisle created Fannie Mae and
Freddie Mac, and then pushed the Community Reinvestment Act — a
regulation that forced banks to make low-income loans. Combined,
these institutions and regulations caused lenders to absorb the
risk of smaller down payments and lower credit scores. Subprime
loans, and therefore risks, proliferated. Peter Wallison has
argued these points effectively in these pages and in the Wall
Street Journal.
In addition, Alan Greenspan held interest rates at absurdly low
levels in the early 2000s (1 percent in 2003-2004). This encouraged
people to take more risk and borrow more money than they would have
if interest rates had been held at normal levels. Once this low
rate regime ended, the spigot of new loans was turned off, the
bubble began to burst, and losses began to proliferate. In other
words, the bubble was not caused by greedy bankers, but by
politicians and Fed officials who intentionally over-stimulated the
housing market. This could not last, and it didn’t.
The bursting of this bubble did not have to threaten the entire
economy. Total losses, when the dust finally settles, will probably
be near $400 billion. In a $15 trillion economy, this is too small
to cause a Depression. Yet, losses ballooned into the trillions
because of a little understood accounting rule that was put in
place in November 2007 — “mark-to-market accounting.” According to
Milton Friedman, mark-to-market accounting was a key reason so many
banks failed in the Great Depression. In 1938, after studying its
negative impact, even FDR stopped its use. But it came back from
the dead.
In 2008, as markets froze and became illiquid, the value of
mortgage-backed securities tumbled to pennies on the dollar.
Mark-to-market accounting forced banks to mark down the value of
this debt to prices well below its true worth. Even though there
were no actual trades at these rock-bottom prices, the accounting
rule, enforced by the Financial Accounting Standards Board (FASB),
caused markdowns, capital impairment, and bankruptcy.
It is widely understood that mark-to-market accounting is
pro-cyclical — it makes the good times look better than they
really are and the bad times worse. And as long as this accounting
rule was in place, and as long as a vicious downward spiral of
markdowns, capital impairment, bankruptcies, frozen credit, and
economic pain were occurring, banks could not secure financing and
bank runs became a real threat.
Lehman Brothers, Bear Stearns, AIG, Wachovia, and Washington
Mutual all succumbed to this downward spiral. But,
without mark-to-market accounting, they probably would have all
survived. AIG was berated for its Credit Default Swap business, but
looking back, the portfolio that it held has actually made money,
not lost hundreds of billions of dollars as many analysts said it
would.
In other words, Whitney and Roubini (and a few others)
were right about the economy, but only because mark-to-market
accounting created a downward spiral that could not be stopped. The
proof is in the pudding, as they say. The market bottom in the
stock market coincides perfectly with the announcement of a hearing
by Barney Frank’s committee in the House of Representatives. The
hearing took place on March 12, 2009, but was announced in the days
preceding this date. Even though FASB did not officially change
mark-to-market accounting rules until April 2, 2009, the panic and
recession ended when markets knew that this mayhem-causing rule
would be changed.
To be clear, it did not end when TARP and Quantitative
Easing One (QE1) were started in October 2008. It ended when
mark-to-market accounting was changed. Only then could banks raise
private capital. Only then did the viscous downward spiral of
bankruptcies stop. And since then, the economy has grown for nine
consecutive quarters, the stock market has doubled, bond yields and
spreads have come down sharply, and default rates have plummeted.
Consumption and investment have returned to pre-crisis
levels.
Pessimists, short-sellers, and liberal politicians will
tell you that the only reason the economy Bbegan growing again is
that the government saved it, and many wish we had spent more. But
the reality is that if government had done nothing — except get
rid of mark-to-market accounting — the recovery would have been
stronger, the recession shallower, and the aftershocks less
severe.
Ben Bernanke says quantitative easing lifted stock prices.
But, if this were true, then price-earnings ratios would have risen
in the past two years because equity prices would have been lifted
on a wave of liquidity regardless of earnings growth. Instead,
earnings growth has soared and P-E ratios have fallen. The two
areas that the government has targeted the most — housing and
employment — are the worst performing sectors of the economy. The
more the government interferes, the more damage is done to the
sectors it in which interferes.
THE REAL STORY, the free market narrative, is so far
removed these days from the conventional wisdom that very few find
it easy to believe. And because Republicans were in power during
the crisis — passing TARP and supporting quantitative easing —
it’s hard for them to admit they made a mistake. As a result, every
time the stock market goes into a correction mode or economic data
get a little dicey, the pessimistic soothsayers are given lots of
airtime and investors run for the hills.
This is a mistake. The economy was never as bad as they
said, Wall Street was never as corrupt or stupid as they think, and
the analysts who were predicting calamity are not as smart and
all-knowing as many people seem to believe. Just like in the Great
Depression, the economy is recovering more slowly than it should
because government has done too much, not because it always
recovers slowly after a financial crisis.
The narrative of the past that you believe in determines
how you see the future. If you think government saved us from the
abyss and had nothing to do with the crisis to begin with, then
Whitney and Roubini are your guides. If you can hear what the
giants of free market thought — Friedman, Mises, Smith, Bastiat,
and Hayek — are saying from the grave, then the other narrative —
the real story — suggests that having faith in markets and those
who build successful businesses is the much better
alternative.
