It was in the early part of this decade that I first wrestled with the phenomenon of capitalist pigs. In the public sphere, the wealthy businessman is constantly under attack. He is the cartoonish villain in movies and the scapegoat for opportunistic politicians. But I grew up in a household that celebrated individualism and entrepreneurship. In my family, the businessman was the Randian hero who, purely in pursuit of his own self-interest, invented new technologies, spurred productivity, and generated wealth for the economy—while envious looters and parasites tried to tear him down and bleed him dry.
However, working as a financial journalist from 2001 to 2004 forced me to reexamine this view when a wave of corporate accounting scandals rocked Wall Street, and the arrogance, stupidity, and corruption at a number of large American corporations and at the highest levels of its financial institutions made for an embarrassing display.
I began to ask myself: how will I be able to defend capitalism from those who seek to destroy it when actual capitalists are behaving so indefensibly? This is a question that free-market conservatives are now forced to grapple with on a much larger scale in the wake of the collapse of the financial markets.
This magazine, along with other conservative outlets, has rightly documented how a raft of government policies, some dating back decades, helped create the current economic crisis. The Community Reinvestment Act, which was originated during the Carter administration and updated by President Clinton, encouraged more lending to those with patchy credit histories. Fannie Mae and Freddie Mac were able to use their government backing to borrow money cheaply, allowing them to absorb trillions of dollars in mortgages. And under the leadership of Chairman Alan Greenspan, the Federal Reserve Board pursued one of the most aggressive rate-cutting campaigns in history, which helped drive mortgage rates down to the lowest levels since the Eisenhower administration—yet the Fed resisted jacking up interest rates despite mounting evidence that housing prices were inflating to unsustainable levels.
While all of this is true, the causes of the current financial collapse, as with any economic calamity of this magnitude, are complex. The government may have helped create an environment that made us susceptible to a housing bubble, but at the end of the day private banks took advantage of that environment. They threw prudent risk management out the window, they pushed mortgages on un-creditworthy borrowers, they financed those mortgages with complicated financial instruments that few—if any—understood, and they escaped with millions as their companies begged for taxpayer dollars.
At a time when the nation is rushing toward socialism, there's an obvious temptation among conservatives to rally around the market and lay all of the blame for the financial crisis on big government. But any full accounting of the current mess requires us to reconcile our belief in capitalism with the fact that this is a case in which actual capitalists behaved recklessly. Their behavior, and the public outrage that it generates, presents more of a threat to capitalism than an army of Paul Krugmans.
THE SEVERITY OF THE FINANCIAL CRISIS came as a surprise to many, but recent history provided plenty of warnings. When the housing boom started earlier in this decade, the stock market was still dealing with the fallout from the bursting of the Internet bubble in 2000. Separately, in 1998, the hedge fund Long-Term Capital Management, which made huge bets on small market fluctuations and had enjoyed several years of extraordinary growth, cratered from its exposure to the Russian financial crisis. "The fund had entered into thousands of derivative contracts, which had endlessly intertwined it with every bank on Wall Street," Roger Lowenstein explained in When Genius Failed. "These contracts, essentially side bets on market prices, covered an astronomical sum—more than $1 trillion worth of exposure." Fearing that the collapse of LTCM could bring down the major investment banks, the Fed pulled the banks together to orchestrate a bailout of the fund.
When the Internet bubble burst, it didn't have the ramifications of the popping of the housing bubble, because investors weren't able to build up enough leverage. When LTCM ran into trouble, it was bailed out for $3.65 billion—a number that is quaint by today's standards. In this decade, investors returned to the "irrational exuberance" and created the housing bubble. But through the use of leverage, they were able to place bets on a much more massive scale, raising the consequences of the inevitable fall.
Responding to an easy lending environment ushered in by the Fed's acceleration of interest rate cuts in the wake of the Sept. 11 attacks, mortgage lenders became increasingly aggressive in pushing loans toward homebuyers, regardless of their income or credit histories. They pumped up sales by designing a variety of loan types, from interest-only mortgages to adjustable-rate mortgages that came with low "teaser" rates that expired after a few years.
Countrywide Financial was one of the major beneficiaries of the boom. The Calabasas, California-based company saw its earnings explode from $374 million in its 2001 fiscal year to $2.67 billion in 2006—at its peak, the company was financing nearly $500 billion in mortgages annually. CEO Angelo Mozilo, who doled out lower rate "VIP loans" to the likes of Senate Banking Committee Chairman Sen. Chris Dodd (D-CT), unloaded $300 million in Countrywide stock between 2005 and October of 2007, according to the New York Times, as the company was plagued by rising delinquencies on risky loans that should have never been issued in the first place. The company was sold to Bank of America last year.
What enabled Countrywide and other mortgage lenders to finance all of their loans was the ability to bundle up thousands of loans into securities and then sell them off to Fannie, Freddie, as well as other banks and financial institutions. Ratings agencies such as Moody's and Standard and Poor's played a major role in the debacle by slapping high ratings on risky mortgage assets, because issuers convinced them that packaging geographically diverse home loans lowered the chances of default, even if the ultimate borrowers—regardless of their location—were financially strapped. (By definition, an AAA-rating is supposed to mean there is a one in 10,000 chance of default.)
Investment banks became increasingly eager to get a piece of the housing boom. Led by the likes of Richard Fuld of Lehman and Jimmy Cayne of Bear Stearns (who were both involved in the LTCM drama), Chuck Prince of Citigroup, and Stan O'Neal of Merrill Lynch, the banks and brokerages vacuumed up as many mortgage assets as they could. In Merrill's case, they were operating with leverage ratios as high as 40-to-1, meaning for every dollar in equity it had $40 in debt. This was made possible, in part, by a 2004 decision by the Securities and Exchange Commission to exempt large firms from restrictions on the amount of debt they could hold.
Leverage allows investors to borrow money to purchase more than they can immediately afford, with the hopes that the return on their investments will exceed the costs of paying the interest on their debt. In a strong market, the more leverage firms can build up, the more money they'll earn, but taking on excessive risk can have disastrous consequences when things go sour. While financial institutions should limit the amount of risk they take on, much like the spread of steroids in baseball, high leverage proliferated on Wall Street, because any bank that didn't partake would be at a competitive disadvantage— at least in the short run.
Meanwhile, American International Group (AIG), which over the course of decades had grown into the world's largest insurer by market value, expanded from the solid businesses that had fueled its growth in the first place, into the realm of credit default swaps, which are financial instruments that insure bondholders against the risk of default.
IT'S NOT AS IF PEOPLE WERE completely ignorant of the possible dangers stemming from derivatives. Warren Buffett had declared them "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." At the time, many books and articles were written pointing out that housing prices had inflated to unsustainable levels, and questions were raised about the risky nature of these subprime mortgages. It wouldn't have taken a genius to understand that the day of reckoning would come at some point.
But at the time, too many people were benefiting from the boom to raise a fuss. From the borrower living in a new home to the mortgage lenders raking in the dough, from the rich bankers earning staggering bonuses to the policymakers in Washington who didn't want to mess with the one thing that was sustaining American growth, everybody had a stake. In July of 2007, Citigroup's Prince summed up the attitude best when he told the Financial Times, "As long as the music is playing, you've got to get up and dance. We're still dancing." (He resigned that fall.) Once the defaults started piling up among cash poor homeowners, it was only a matter of time before the problems worked their way up the food chain—from the mortgage lenders to the financial institutions that purchased their mortgage-backed securities, and up to AIG, which insured those securities against the risk of default.
Even as Wall Street executives left tremendous wreckage behind, they walked away with extraordinary sums of money. While conservatives should defend the right of an individual in a free society to be compensated based on his or her value as determined by the employer, it's difficult to make the case that those CEOs who nuked the market truly deserved what they were receiving.
Fuld, for example, earned $484 million in salary, bonuses, and stock options from 2000 until the time he drove Lehman into bankruptcy last fall, according to ABC News (though he claimed at a Congressional hearing that the drop in Lehman's stock put his actual holdings at around $350 million). In January it was reported that Fuld sold his $13 million mansion on Jupiter Island in Florida to his wife for $100 to protect it in advance of civil lawsuits he expects to face from angry investors.
The actions of Fuld and other top executives, as well as the disposition of assets as part of the firm's bankruptcy sale to Barclay's, infuriated one former Lehman employee who spoke to TAS but asked not to be identified.
"It's like the building is burning down and they're running out with all of the furniture," he said. "They're looters."
The financial crisis that imperils the U.S. economy has already put the American taxpayer on the hook for trillions of dollars in direct bailouts and exposure to troubled assets. Milton Friedman once noted that "what we have is not a profit system; it's a profit and loss system." But Wall Street titans who reaped the benefits from the market when the getting was good, were quick to abandon it and seek government help once things were bad. As of this writing, the nationalization of the nation's largest banks remains a realistic possibility.
IN A FREE MARKET, it's inevitable that individuals will make mistakes, and in a perfectly free market, they should suffer for their bad judgment. But when misjudgment occurs on such a mass scale that it guts the entire financial system and all taxpayers end up picking up the tab anyway, where does that leave us free marketers?
Asked about the challenge the financial crisis poses to free-market conservatives, Paul Singer, founder of the hedge fund Elliott Associates and a prominent Republican contributor, suggested avoiding "stupefying" regulations and simply setting strict margin requirements to limit the amount of leverage investors take on. The regulations would apply regardless of whether the entity is a bank, hedge fund, or individual and they would have to be global in scope.
Even if investors make mistakes in such an environment, Singer said, the limits on their positions would prevent the explosion of the entire financial system. For conservatives, prudent regulation focused on improving disclosure is a noble goal, as transparency is key to a functioning free market.
If conservatives err by allowing their ideological commitment to capitalism to make them place too much trust in the actual capitalists, liberals make a mistake by not recognizing that government regulators are also susceptible to corruption, conflicts of interest, and poor judgment.
Former Fannie CEO Franklin Raines, and other top executives at the public-private mortgage financier, lined the pockets of Democratic politicians who in turn protected the company from further scrutiny. Raines, who led a student strike at Harvard in 1969, held positions in the Carter and Clinton administrations. He was awarded $90 million in compensation over five years at Fannie before he was forced to resign in 2004 amid a multi-billion dollar accounting scandal at the mortgage giant. As chairman of the Fed, Greenspan diligently evaluated arguments warning about dangers from the housing bubble and widespread use of derivatives, but ultimately dismissed them. He was dangerously wrong.
THE PROBLEM FOR CONSERVATIVES is that any failure of the market leads to more government, and any failure of government also tends to lead to more government. In this case, we are facing a major financial crisis caused by failures by both the public and private sectors. The crisis could not have happened without certain government policies, but it could have been prevented if Wall Street had shown more wisdom, humility, long-term thinking, discipline, and, ultimately, some common sense.
Even in holding the most piggish of capitalists into account, however, it is important to argue forcefully against intrusive government regulations that will smother the type of activity that is essential to successful financial markets, which help fuel economic growth. American capitalism has suffered its share of downturns, a few of them severe, but its record of generating prosperity stacks up quite nicely against European socialism.
In the United States, when unemployment went north of 7 percent, it was declared a crisis, but when it hit 7.2 percent in France early last year, President Nicolas Sarkozy boasted, "This is an important achievement, it is the best figure in 25 years." Over the last quarter-century (1983–2008), gross domestic product in the United States averaged 3.19 percent annual growth, compared to 2.29 percent in the 27 European Union countries, according to an analysis of data from the Economic Research Service. In 2008, real per capita income was $43,512 in the U.S. and just $29,796 in the EU.
In pursuit of money and power, humans are capable of doing contemptible things. But let us not forget that when people behave badly in a capitalist system we end up with the likes of Fuld, Mozilo, and Prince, whereas when government control over the economy is taken to the extreme, we end up with Lenin, Stalin, and Mao.
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