Special Report

On the Brink of Depression

By any measurement, the financial crisis of 2007-2009 deserves endless examination and inspection.

By 3.19.10

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"Observe, my son, with what little wisdom the world is run."
-- Baron von Oxenstiern

By any measurement, the financial crisis of 2007-2009, maybe still going on, has been the biggest finance story since Drexel/Milken and maybe since 1929. It deserves endless examination and inspection. Herewith, in a few "short stops and high hops," as Phil Rizzuto used to call them, are a few issues that seem to me to bear substantial inquiry.

1.) It has been the policy of the government of the United States at least since the enactment of the Federal Reserve Act just before World War I to smooth out the business cycle, to keep credit flowing, to keep the economy humming and to keep employment high. This was further enunciated in many federal enactments including the Securities Act, the Securities Exchange Act, the Employment Act of 1946, Humphrey-Hawkins, and many stimulus plans of both parties.

That kind of imperative was relied upon by the Bush Administration and the Federal Reserve under Ben Bernanke to use extreme innovation and imagination to rescue Bear Stearns in early 2008. Seeing "systemic risk," as the popular phrase goes, the Fed created a "special purpose vehicle" to buy bad debts and dicey assets of Bear and thus allow Bear to be a candidate for purchase and salvation.

Why, several months later, did the Fed and the administration decide that they could not use the same level of imagination and flexibility to save Lehman? It was clear to everyone that allowing Lehman to fail would be a disaster for the markets, for credit, for the entire nation's economy. Not bad -- a disaster.

Why, in that case, did the government adopt a "no more bailouts" policy about Lehman?

On the Brink, the new and fascinating book by Henry Paulson, Bush's last Treasury Secretary and the man largely in charge of the financial situation in 2007-2008, says over and over again that he realized that letting Lehman go down would be extremely bad. He also says that the government was playing hardball and pretending it would not pitch in to help a private solution to the Lehman problem. But he never says when the pose became reality and/or why. (By the way, the title of my first novel, written with my father, was also On the Brink. From Simon and Schuster. Long out of print.)

Put another way, Mr. Paulson says that various persons counted that Lehman might have a capital hole of more than $10 billion, maybe much more, and that the government did not want to be responsible for plugging that hole.

But the losses to the economy following the failure of Lehman have been on the order of hundreds of billions, maybe trillions. Certainly the rescue and stimulus packages needed in the wake of the Lehman failure have amounted to the trillions.

Why didn't the government put in the small amounts needed in Fall of 2008 rather than have to virtually bankrupt the state later to pick up the pieces after Lehman? If the U.S. went into severe recession, very foreseeable if Lehman failed, losses to the economy on a large scale were extremely foreseeable.

Or, let me try to put it another way: In his book, Mr. Paulson stresses that he had no authority to rescue Lehman. But if Mr. Paulson had simply had a press conference and said, "We will not let Lehman fail. We will take whatever measures are necessary to save it, including asking for an emergency measure from Congress and the same kind of energy from the Fed that it showed in the case of Bear," Lehman would not have failed. Why didn't Mr. Paulson do it?

And I know Mr. George W. Bush. He is not an ideologue and he listens and learns. If Mr. Paulson and Mr. Bernanke had gone to him and told him that there must be a bailout, he would have pushed for it and gotten it right away.

Or, I will put it yet another way.

I recently had the great pleasure of speaking to a man at a conference with extreme first hand knowledge of the rescue of AIG. He explained to me why the CDS creditors of AIG had to be paid in full by the taxpayers. His explanations had much to do with that old "systemic risk" again. But if systemic risk justified taking over $10 billion of taxpayer money and paying it to Goldman Sachs on highly questionable credit default swap (CDS) contracts, why didn't that same systemic risk justify saving Lehman?

Why was there so much urgency about saving Bear, making us taxpayers pay off Goldman Sachs (I am a stockholder), and why so little about saving Lehman?

Something is not right at all here, and bears investigation.

2.) Thanks to a series of e-mails from a friend at a hedge fund, I was being told as long ago as 2007 that there was a major disconnect between the prices of collateralized mortgage obligations (CMO's) and the rate of mortgage defaults. The default rate was bad and getting worse, but the prices of the CMO's and the CDS's on them reflected a far worse situation than reality would support.

We know now, thanks to fine reporting by McClatchy, the Wall Street Journal, and Gretchen Morgenson in the New York Times, that the falling prices of these securities were a major reason why Lehman failed, why Wall Street was (in a canned phrase) "On the Brink" and why the entire nation's credit system went into default.

We also know that the huge marks that Goldman Sachs and others were allowed to take on the CDS's they had made with AIG on CMO's were a major cause of AIG's problems and the main reason why AIG (really, the taxpayers) had to pay off the holders of the CDS's.

But we also now know that those marks were mistaken. As Ms. Morgenson pointed out in a recent piece and as my source at the hedge fund tells me, the people who own those CMO's and who bought them or got them back from AIG at fire sale prices are now making fortunes as the prices of the CMO's rebound -- even as foreclosure rates are still dismal.

Question: Was there fraud and manipulation and an intent to deceive in the pricing of those CMO's and the marks taken on the related CDS's? Maybe not. Maybe it was just a panic. Markets do tend to overreact in both directions. But there was a hurricane of gossip and negative hype on the subject. Was it an attempt to manipulate the market? Was it criminal? One reads that the SEC is looking into it. But maybe we need a Special Prosecutor. Maybe we need a man or woman who will spend years looking into this and getting convictions if they are warranted and not a bureaucrat with a million other things on his desk.

The effects of this debacle with the CMO's were so drastic and hurt so many people that if they were caused by criminal acts, we surely want to know about it.

3.) Something extremely frightening has happened to our financial system. For most of the history of the U.S. until 1913, panics and depressions were caused by excess liquidity created by private banks and then suddenly withdrawn. This was supposed to stop with the creation of the Fed.

Instead, we got Fed mistakes -- detailed brilliantly by Anna Jacobson Schwartz and Milton Friedman in A Monetary History of the United States -- that led to a Great Depression. After that, economic dislocations were more moderate, to put it mildly, and were generally caused and then ameliorated by Fed mistakes and then doing things right. In any event, the Fed seemed to be in charge.

In the current situation, we cannot really blame Fed action for the recession. It came through the crisis on Wall Street, largely caused by immense traders betting against each other, with some triumphing on such a scale as to stop credit in its tracks. We certainly can blame Fed inaction about Lehman for a big part of the current misery, but that is not the same as a Fed action causing the problem. More frightening, Fed action now is lifting the financials, but because of the persistent fear after Lehman, the economy is still by no means robust. Of course we all know we have to be patient and we know we "cannot push a string." But the question looms as to whether the power of the traders has gotten so big that it can cause a severe recession (really, a depression), and create so much fear that even the Fed is hamstrung in bringing about a recovery. If the traders have gotten that big, we are in uncharted and dangerous waters.

Enjoy your day.

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About the Author

Ben Stein is a writer, actor, economist, and lawyer living in Beverly Hills and Malibu. He writes "Ben Stein's Diary" for every issue of The American Spectator.