Congressional approval of a new entity mandated to carry out a far-reaching government rescue of troubled financial markets will boost the overall price tag for the bailout of the industry to well over $2 trillion.
That’s the word from author Charles R. Morris, who has been keeping score of the mushrooming defaults, write-downs and various forms of government aid to the ailing financial sector since recurring credit crunches began in August 2007. In one way or another, he says, U.S. taxpayers will end up saddled with much of the bill for the industry’s bad practices.
Morris has written 10 books. His latest — “Trillion Dollar Meltdown,” published early this year — was the first to examine the causes, implications and ultimate costs of the turmoil in the credit markets.
In it, he more or less accurately foresaw the mounting costs of the troubles that have grown from the subprime mortgage crisis. The book, based on events that had occurred by last November, put the likely total at just over $1 trillion. Now he’s updating his estimates to more than $2 trillion in a soft-cover edition of the book, due out early next year.
I talked with Morris in a lengthy phone interview over the weekend.
A reckoning ahead?
He argues that as painful as cleansing the system of the toxic financial derivatives that financed the housing boom will be, the recessionary impact of working down the massive debt that consumers have piled up in recent years could hurt even more.
His rationale: Consumer spending rose from about 65 percent of the economy in the mid-1990s to 72 percent — “probably its highest level ever” — in early 2007. It’s slipped by a percentage point or two since then, but could fall much more as weary consumers pull back on spending. They financed much of their spending spree by tapping the equity in their homes, but that option has faded as the values of their homes have sunk over the last year.
“We have built this giant water wheel where the financial sector cycles money from the world into the hands of American consumers to buy stuff,” Morris said. “People were spending way more than they earned.”
“Trillion Dollar Meltdown” won many favorable reviews, particularly for the author’s ability to shine light on arcane but hugely important niches of Wall Street such as structured finance.
Morris, who has written articles for many newspapers and magazines, now does a column for the Washington Independent, an online news site. He is a lawyer and former banker for what is now JPMorgan Chase. Morris got a close-up look at the surging debt levels that fueled the housing boom when he ran a software company. The firm created software that investment banks, hedge funds and others used to design the exotic debt vehicles imperiling so many financial institutions today.
Many who have pushed these products assumed that housing prices would always rise. But after the subprime crisis erupted and home prices began falling, these instruments didn’t fare so well. Continued stresses on such complex securities, aggressively promoted as profit-centers by Wall Street’s financial engineers, have played a big part in the intermittent seizing-up of the credit markets over the last 14 months.
Chicago School takes body blows
Morris lays much of the fault for the excessive levels of debt at the doorstep of the “Chicago School of Economics” — a metaphor for the theories behind deregulation and unfettered free markets. Economists and others at the University of Chicago have been leading advocates of these views, which came into fashion during the Reagan administration and have provided much of the foundation for the nation’s economic policies ever since.
This month, grim realities have driven a stake through the heart of this orthodoxy. Regulators, whose basic job is to act as a fire prevention department, are suddenly intervening directly in the markets by putting out fires instead of preventing them. Most of all, the troubles center on investors’ lack of confidence in the value of mortgage-back securities and other complex instruments carried on financial institutions’ books.
The federal government has decided that many of the players in the financial sector are simply too globally interconnected to fail. In attempting to ward off a much-feared, domino-like collapse of global financial markets, it has in the span of two historic weeks starting on Sept. 7:
• Nationalized Fannie Mae and Freddie Mac, which together account for roughly half of the U.S. mortgage market.
• Actively pushed industry consolidation, notably by encouraging the sale of Merrill Lynch, one of the country’s most storied and largest investment banks, to Bank of America.
• Seized American International Group, which is the nation’s largest insurer.
• Propped up the market for plunging stocks by banning short-selling of the shares in 799 financial stocks.
• Promised to insure $3.4 trillion of deposits in money market mutual funds.
• Agreed to regulate as commercial banks the nation’s only two remaining large, free-standing investment banks, Goldman Sachs and Morgan Stanley. These lightly regulated firms were at the center of the belief that investment bankers should be allowed to operate free of the restrictions governing commercial banks on debt, disclosure and risk-taking. Now they will be regulated far more closely than they were.
• Asked Congress to approve up to $700 billion in taxpayer money to finance a new agency empowered to buy the toxic mortgage debt imperiling many companies’ balance sheets.
Morris says the Chicago School’s financial market theories were often based on unrealistic mathematical models. “That’s not the way markets work,” he says.
Many of these theories did make sense in the 1980s and 1990s, he adds, but not today.
Morris used an expletive to describe what he thinks of them now. Asked to clean up his language, he replied: “It looks like a failed model.”
Adding up the bill
In his book, Morris forecasts net losses of $450 billion in the residential mortgage market, $345 billion in the corporate debt market and $215 billion in the commercial mortgage-backed securities and credit card markets.
Now, nearly a year after his deadline for the book, he has doubled the size of that estimate. His higher forecast is driven by additional money the Federal Reserve will put into the system, costs of the bailout of Fannie and Freddie, other funds needed to shore up the housing market, more write-downs at banks and insurers and the enormous costs that could be incurred by the federal entity proposed this weekend by Treasury Secretary Henry Paulson.
Many have compared this proposed agency with the Resolution Trust Corp., which was established by the federal government in 1989 to clean up the savings and loan mess. But Morris says the new agency’s task will be far more difficult than the RTC’s mandate. The new entity will buy and then sell investment instruments whose elusive values are much tougher to estimate than the real estate properties that were held by the failed S&Ls. Also, the government already owned the assets in the case of the RTC, while the new entity doesn’t yet own them.
Morris praises Paulson, CEO at Goldman Sachs before he was named treasury secretary, for his handling of the situation thus far.
“This is a guy who walked in with a very weak hand,” he says, noting that Paulson is working for a lame-duck president. He adds that while media outlets have often described Paulson and Federal Reserve Chairman Ben Bernanke as co-leaders of the government’s effort to put out the financial firestorms, “it looks like Bernanke is working for Paulson now.”
Morris believes the economy faces either a short, severe recession now or a lingering, more shallow downturn. He thinks the cost of repairing the damage to the financial system is likely to be so high that it will greet the new president with a sober fiscal picture. That would mean the new administration, regardless of whether it is led by John McCain or Barack Obama, likely won’t be able to make good on rosy campaign promises of either tax cuts or new programs.
His solutions, generally: stronger financial regulation, an admission that we need government to solve our most vexing problems and, as soon as practical, overhauls that will lead to a more comprehensive and less inefficient health-care system. He believes these changes would strengthen the economy over the long term and rebalance the inequities in wealth that have worsened in recent decades.
His critics fear that tougher regulation will lead to unintended consequences and discourage the risk-taking and innovation needed to stimulate economic growth.
But as a reasonably accurate forecaster of today’s financial firestorm, his views have taken on the ring of credibility. Until the last two weeks, many leading economists and politicians have been mired in denial about the scale of the troubles battering the financial sector.
Not Charles Morris.
Dave Beal, a former business editor and columnist for the Pioneer Press, writes about business and the economy. He can be reached at dbeal [at] minnpost [dot] com.