Sunday, July 20, 2008

American Hubris

The good book tells us of the perils of false pride and the sure come uppance that one will realize at the end of a prideful life. The current problem in the US housing mortgage industry is probably a great example of what can happen when a lemming like mentality in our business leaders, coupled with arrogance, pride and hubris of the American legislators and consumers all coalesce to form perfect storm conditions for the serious economic hurt we are experiencing.

The banking industry was reformed during the Great Depression. The economists of the New Deal came up with some very reasonable checks and balances to prevent banks from becoming diversified financial entities that could play in retail, commercial, mortgage and investment banking. They did this to prevent a failure in one sector cascading through the US economy and causing an overall run on the banking sector. Additionally we also saw the creation of the FDIC in 1933 which insured deposits up to 100K per institution.

These common sense laws lasted for about half a century which is remarkable given the amount of money that the Finance lobby throws around in Washington DC. They started to unravel in the 80s and picked up steam in the 90s. The end result is that we have several of the conditions that existed prior to the New Deal back in the economy.

Historically the viability of mortgage lending was to ensure that the principal and interst was returned. This is how banks made money and stayed in business. They lent money against an asset, charged interest and recovered principal.

All this started to change when banks realized that they could lend money and then sell of the mortgage as a financial instrument on the bond market. Banks therefore stopped worrying about a borrowers ability to pay back the loan since a large portion of the risk of repayment was now being shifted to the bond market investors.

Therefore banks decided that they could maximize profit by charging huge lending fees up front and also by asking very few questions from the borrower so as to obtain as many borrowers as possible. This worked like a charm for a few years. Eventually the chickens came home to roost as the borrowers started defaulting and the bond and banking sector took the hit we are currently experiencing. So far all major US banks and underwriters have been affected. The most serious ones have been Bear Stearns, Fannie Mae, Freddie Mac and IndyMac.

Additionally the FDIC which has a very noble purpose (ie to reassure depositors) is actually being abused by bank management. Because at some level the bank managers know that the Feds will bale them out should things get really bad they take on additional and unnecessary risk. This has been evident in the decisions that they have taken.

One of the reasons this has happened is because of the move towards large scale deregulation of the financial sector which started in the Reagan years and accelerated under the GOP dominated Congress after 1994. The New Deal watchdogs were essentially made largely toothless. No one should be surprised that the smart Harvard and Stanford MBAs that run Americas businesses would expose this loophole, book stellar profits and reap handsome bonuses. Its common sense - anyone would have done it. It goes to show that business left unregulated will eventually (like Enron) go too far.

As Gordon Gecko said so cynically in the movie Wall Street....Greed is Good. The question is who exactly is it Good for. It has certainly been good for many people at the top of the American economic ladder and it was briefly good for those middle and low income Americans (of questionable credit) who for a brief moment tasted their slice of the American pie and lived the American Dream of home ownership.

This has sadly turned to dust and now we have a Katrina size clean up to fix the sins of our excesses. In a country which is largely anti-intellectual and pays no heed anymore to history (because we just don't teach it at our schools) we are bound to keep repeating the mistakes our ancestors made. Our collective memories are so narrow, so short and so transient.

One of the solutions of these kinds of problems is better History and Civics education in our schools - an informed voter is after all a useful voter and the best bulwark against hubris.

1 Comments:

Blogger Dr. Reason said...

good article especially in light of the recent developments on Wall Street. It is staggering that CEOs of some firms make the kind of money that they do. The CEO of Blackstone group made 350 million last year. I believe that there should always be a balance between reward and punishment. If the guy is worth 350 M as a reward, how can losing your job be the worst thing that happens to him on the punishment side - it does not add up? I am not advocating anything extreme - it is just that compensation has gotten completely out of hand. - Ajit

1:27 PM  

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