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.
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